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ANNAMALAI UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION
M.B.A. E-Business
.B.A. Financial Management
RSE – 1.2
MANAGERIAL ECONOMICS
LESSONS : 1 – 24
Copyright Reserved
(For Private Circulation Only)
ii
MANAGERIALECONOMICS
Editorial Board
Members
Dr. R.Rajendran
Dean
Faculty of Arts
Annamalai University
Annamalainagar.
MANAGERIAL ECONOMICS
SYLLABUS
Objectives
This course gives students an understanding of the concepts and tools needed
for economic decision making in the organisations operating in competitive
markets. At the end of the course, students should be able to link real business
decisions to theoretical models.
Unit–I : The scope and Method of Managerial Economics
Introduction to Economics; Nature and Scope of Managerial Economics –
Significance in Decision-Making and Fundamental Concepts - Objectives of a Firm -
Role of Economic Analysis in managerial decisions.
Unit–II : Demand Analysis and Forecasting
Meaning, Characteristics and Determinants of Demand, Demand Functions,
Demand Elasticities – Income, Price, and Cost, Elasticity of demand – Measurement
of Elasticity of Demand - Demand Forecasting and Forecasting methods - Uses of
Elasticity of Demand for Managerial Decision Making
Unit–III : Cost Analysis and Production
Cost Concepts – Cost Function –Analysis Distinction between Accounting Cost
and Economics Costs – Determinants of Cost - Cost–output Relationship. Returns
to Scale Concept - Production Concepts; Production Function, Single Variable-Law
of Variable Proportion - Two Variable-Law of Returns to Scale.
Unit–IV : Market Structure and Pricing
Various Forms of Market Structure - Features of Various Types of Market
Structure - Analysis of Firm in an Open Economy. Perfect competition. Monopolistic
Market. Oligopolistic Market; Pricing of products under different Market Structure,
Price Discrimination - Techniques of Pricing - Factors affecting Pricing Decision -
Joint Product Pricing.
Unit–V : Profit Management
The Concept of Profit. Nature and Measurement of Profits. Profit Maximization.
Profit Planning and control – Profit Policies – Cost Volume Profit Analysis.
Unit–VI : National Income and Business Cycle
National Income – Definition, Concepts and Various Methods of its
Measurement– Inflation, Types and Causes - National Income and Economic
Welfare - Business Cycles and Business Forecasting – Measuring Business Cycles
Using Trend Analysis.
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ReferencesBooks
1. Mote, Paul, Gupta, Managerial Economics, Tata McGraw Hill, 2004.
2. Varshney, R.L.Maheswari, K.L, Managerial Economics, Sultan Chand & sons,
2014.
3. Damodaran Suma, Managerial Economics, Oxford, 2006
4. Hirschey Mark, Economics for Managers, Thomson, India Edition, 2007
th
5. Dwivedi D.N., Managerial Economics, 7 Edition, Vikas Publication, 2008.
6. Dr. H. L. Ahuja, Managerial Economics, S. Chand, Chennai, 2010.
7. D.M.Mithani, Economics for Management (Text and Cases, Himalaya Publishing
House), 2013.
Journals and Magazines
1. Journal of Managerial Economics
2. International of Managerial Economics
3. Journal of Economics and Management Studies
4. Journal of Managerial and Decision Economics
5. International Journal of Managerial Economics
6. The Global Journal of Managerial Economics.
Web Resources
1. global.oup.com/us/companion.websites/9780199811786
2. highered.mcgraw-hill.com/sites/.../information_center_view0/
3. wps.prenhall.com/bp_keat_managerial.../0,10878,2398017-,00.html
4. www.pearsonhighered.com/.../Managerial-Economics.../9780136040040.
5. www.wiley.com/WileyCDA/.../productCd-EHEP002067.html
6. ocw.usu.edu/economics/managerial-economics/
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Profit
The primary objective of every business is to earn profit. Profit is the lifeblood
of business, without which no business can survive in a competitive-market. Profit
is the financial gain or excess of return over investment.
It is the reward for bearing risk and uncertainty in the business. It is a
lubricant, which keeps the wheels of business moving. Profit is essential for the
survival, growth and expansion of the business.
Innovation
Innovation is the act of introducing something new. It means creativity i.e. to
come up with new ideas, new concepts and new process changes, which bring
about improvement in products, process of production and distribution of
goods.Innovation helps in reducing the cost by adopting better methods of
production. Reduction in the cost and quality products increase the sales thereby
increasing the economic gain of the firm. Hence to survive in the competitive world,
the business has to be innovative.
Consumer Suppliers
Creditors Environment
Social objective means objective relating to the society. This objective helps to
shape the character of the company in the minds of the society. The obligation of
any business to protect and serve public interest is known as social responsibility
of business.
Society comprises of the consumers, employees, shareholders, creditors,
financial institutions, government, etc. Business has some responsibility towards
the society. Businessmen engage themselves in research for improving the quality
of products; some provide housing, transport, education and health care to their
employees and their families.In some places businessmen provide free medical
facility to poor patients. Sometimes they also sponsor games and sports at national
as well as international level etc.
Towards the Employees
Employee of a business firm contributes to the success of the business firm.
They are the most important resource of the business. Every business is
responsible towards their employees in respect of wages, working conditions, etc.
The interest of the employees should be taken care of. The authorities should not
exploit the employees.
Towards the Consumers
Business has some obligation towards the consumers. No business can
survive without the support of customers. Now-a-days consumers have become
very conscious about their rights. They protest against the supply of inferior and
harmful products.This has made it obligatory for the business to protect the
interest of the consumers by providing quality products at the most competitive
price. They should charge the price according to the quality of the goods and
services provided to the consumers. There must be regularity in supply of goods
and services
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Towards Shareholders
Shareholders are the owners of the company. They provide finance by way of
investment in debentures, bonds, deposits etc. They contribute capital and bear the
business risks. The primary responsibilities of business towards.
It is the responsibility of the business to safeguard the capital of the
shareholders and provide a reasonable dividend. Business and Society are
interdependent. Society depends on business for meeting its needs and welfare,
whereas, Business depends on society for its existence and growth.
Towards the Creditors/financial institutions
Towards the Suppliers
Suppliers supply raw material, spare parts and equipment‘s necessary for the
business. It is the responsibility of the business to give regular orders for the
purchase of goods, avail reasonable credit period and pay dues in time. The
business should maintain good relations with the supplier for regular supply of
quality raw material.
Towards the government
Government frame certain rules and regulations with in which the business
has to act.These are the following responsibilities of the business towards
government are:Paying taxes regularlyii. Conducting business in a lawful manner,
setting up business enterprise as per the government guidelines, avoiding
indulgence into monopolistic and restrictive trade practices and avoiding
indulgence into corruption and unlawful practices.
Towards the environment
The business is also responsible towards the environment. It is the
responsibility of the business to keep the environment pollution free by producing
pollution free products. Business is also responsible to conserve natural resources
and wild life and hence promote the culture.
3.3.4 Human Objectives of the firm
Human objective refers to the objectives aimed at well being of the employees
in the organization. It includes economic well-being of the employees and their
psychological satisfaction.Hence the human objectives of the business organization
can be explained with the following points:
Economic well-being of the employees
Employees should be given fair wages and incentives for their work done. They
should also be provided with the benefits of provident fund, pension and other
amenities like medical facilities, housing facilities etc.
Human Resource development
The organization should undertake necessary human resource development
programmes. Employees always want to grow and prosper. Employees to grow, the
firm must conduct proper training and development programmes to improve their
skills and competencies.
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Motivating employees
Employees need continuous motivation to improve their performance in their
job. It is the job of the organization and managers to motivate their employees by
providing them monetary and non-monetary incentives like bonus, increments,
promotions, job-enrichment, proper working conditions, appreciations etc.
motivated employees put efforts and are dedicated towards their job.
Social and psychological satisfaction of the employees
This is the most important objective of the organization towards their
employees. The business should provide social and psychological satisfaction to
their employees. Employees can feel satisfied if they are put on the right job
according to their skill, talent and qualification.The firm should give prompt
attention to the employee grievances and necessary suggestions should be
provided. Psychologically satisfied employees put best efforts in their work.
3.3.5 National Objectives of the firm
The business enterprise contributes for the upliftment of the nation. Every
business has an obligation towards nation to fulfill national goal: and aspirations.
The goal can be increase employment opportunities, earn foreign revenue, promote
social justice etc. The following national objectives are explained in detail:
Employment opportunities
Public benefit is the basic national objective of a business firm. Business
creates employment opportunities directly or indirectly. People can be employed in
production and distribution activities by establishing new business units,
expanding markets, widening distribution channels, transportation, insurance etc.
Developing backward areas
Business undertakes projects in the backward region and thereby develops the
backward areas of the nation. Business also helps in providing infrastructure
facilities in the backward regions of the country like transportation, banking,
communication etc.Opening of small-scale industries in those backward areas also
provide employment opportunities to the people and results into balanced regional
development.
Promoting social justice
The term social justice indicates uniform rights and equality to all the sections
of the society. Business can do justice with the society by providing them better
quality products and services at reasonable prices.They should not undertake any
malpractices and prevent the customers from being exploited. The business should
also provide equal opportunities to all the employees to work and progress.
Raising standard of living
Business can raise the standard of living of the people of the country by
making quality goods and services available at reasonable prices. Consuming
quality products enhances the standard of living of the people.
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Contributes revenue to the government
Business helps in earning more foreign exchange to the government by
undertaking export activities. The revenue of the government also increases by
payment of taxes by the business entities, which can further be used for the
development of the nation.
3.3.6 Aims of the Firms
However, in the real world, firms may pursue other objectives apart from profit
maximisation.
Profit Satisfying
In many firms there is separation of ownership and control. Those who own
the company (shareholders) often do not get involved in the day to day running of
the company, This is a problem because although the owners may want to
maximise profits, the managers have much less incentive to maximise profits
because they do not get the same rewards, such as share dividends, Therefore
managers may create a minimum level of profit to keep the shareholders happy, but
then maximise other objectives, such as enjoying work, getting on with other
workers. (e.g. not sacking them) This is the problem of separation between owners
and managers and This ‗principal agent‘ problem can be overcome, to some extent,
by giving mangers share options and performance related pay although in some
industries it is difficult to measure performance.
Sales Maximization
Firms often seek to increase their market share – even if it means less profit.
This could occur for various reasons:Increased market share increases monopoly
power and may enable the firm to put up prices and make more profit in the long
run, Managers prefer to work for bigger companies as it leads to greater prestige
and higher salaries, Increasing market share may force rivals out of business. E.g.
supermarkets have lead to the demise of many local shops. Some firms may
actually engage in predatory pricing which involves making a loss to force a rival
out of business.
Growth Maximization
This is similar to sales maximization and may involve mergers and takeovers.
With this objective, the firm may be willing to make lower levels of profit in order to
increase in size and gain more market share.
Long Run Profit Maximization
In some cases, firms may sacrifice profits in the short term to increase profits
in the long run. For example, by investing heavily in new capacity, firms may make
a loss in the short run, but enable higher profits in the future.
Social/ Environmental concerns
A firm may incur extra expense to choose products which don‘t harm the
environment or products not tested on animals.Alternatively, firms may be
concerned about local community / charitable concerns.Many companies who have
adopted such strategies have been quite successful. This has encouraged more
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firms to consider these over objectives, but a cynic may argue they see it as another
opportunity to increase profits rather than a genuine sacrificing of profits in order
to promote other objectives.
Co-operatives Objectives
Co-operatives may have completely different objectives to a typical PLC. A co-
operative is run to maximise the welfare of all stakeholders – especially workers.
Any profit the co-operative makes will be shared amongst all members.
Diagram Showing Different Objectives of Firms
p
MC
p1
p2 AC
p3
p4
D=AR
Q1 Q2 Q3 Q4
Q1 = Profit maximisation (MR=MC)
Q2 = Revenue Maximisation (MR=0)
Q3 = Marginal cost pricing (P=MC) – allocative efficiency
Q4 = Sales maximisation – maximum sales whilst still making normal profit
(AR=ATC)
3.3.7 Profit maximizing objectives of the firm
We assume that the objective of the firm is to maximize its value to its
shareholders. Value is represented by the market price of the company‘s common
stock, which, in turn, is a reflection of the firm‘s investment, financing, and
dividend decisions.
Profit Maximization vs. Wealth MaximizationFrequently, maximization of
profits is regarded as the proper objective of the firm, but it is not as inclusive a
goal as that of maximizing shareholder wealth. For one thing, total profits are not
as important as earnings per share. A firm could always raise total profits by
issuing stock and using the proceeds to invest in Treasury bills. Even
maximization of earnings per share, however, is not a fully appropriate objective,
partly because it does not specify the timing or duration of expected returns. Is the
investment project that will produce Rs.100,000 return 5 years from now more
valuable than the project that will produce annual returns of Rs.15,000 in each of
the next 5 years? An answer to this question depends upon the time value of
money to the firm and to investors at the margin. Few existing stockholders would
think favorably of a project that promised its first return in 100 years. We must
take into account the time pattern of returns in our analysis.
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Another shortcoming of the objective of maximizing earnings per share is that
it does not consider the risk or uncertainty of the prospective earnings stream.
Some investment projects are far more risky than others. As a result, the
prospective stream of earnings per share would be more uncertain if these projects
were undertaken. In addition, a company will be more or less risky depending
upon the amount of debt in relation to equity in its capital structure. This risk is
known as financial risk; and it, too, contributes to the uncertainty of the
prospective stream of earnings per share. Two companies may have the same
expected future earnings per share, but if the earnings stream of one is subject to
considerably more uncertainty than the earnings stream of the other, the market
price per share of its stock may be less.
For the reasons above, an objective of maximizing earnings per share may not
be the same as maximizing market price per share. The market price of a firm‘s
stock represents the focal judgment of all market participants as to what the value
is of the particular firm. It takes into account present and prospective future
earnings per share, the timing, duration, and risk of these earnings, and any other
factors that bear upon the market price of stock. The market price serves as a
performance index or report card of the firm‘s progress; it indicates how well
management is doing in behalf of its stockholders.
3.3.8 Management vs. Stockholders objectives of the firm
In certain situations the objectives of management may differ from those of the
firm‘s stockholders. In a large corporation whose stock is widely held, stockholders
exert very little control or influence over the operations of the company. When the
control of a company is separate from its ownership, management may not always
act in the best interests of the stockholders Agency Theory. Managersnotes that
sometimes are said to be "satisficers" rather than "maximizers"; they may be
content to "play it safe" and seek an acceptable level of growth, being more
concerned with perpetuating their own existence than with maximizing the value of
the firm to its shareholders. The most important goal to a management team of
this sort may be its own survival. As a result, it may be unwilling to take
reasonable risks for fear of making a mistake, thereby becoming conspicuous to the
outside suppliers of capital. In turn, these suppliers may pose a threat to
management‘s survival.
It is true that in order to survive over the long run, management may have to
behave in a manner that is reasonably consistent with maximizing shareholder
wealth. Nevertheless, the goals of the two parties do not necessarily have to be the
same. Maximization of shareholder wealth, then, is an appropriate guide for how a
firm should act. When management does not act in a manner consistent with this
objective, we must recognize this as a constraint and determine the opportunity
cost. This cost is measurable only if we determine what the outcome would have
been had the firm attempted to maximize shareholder wealth.
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A Normative Goalbecause the principal of maximization of shareholder wealth
provides a rational guide for running a business and for the efficient allocation of
resources in society, we use it as our assumed objective in considering how
financial decisions should be made. The purpose of capital markets is to efficiently
allocate savings in an economy from ultimate savers to ultimate users of funds who
invest in real assets. If savings are to be channeled to the most promising
investment opportunities, a rational economic criteria must exist that governs their
flow. By and large, the allocation of savings in an economy occurs on the basis of
expected return and risk. The market value of a firm‘s stock embodies both of these
factors. It therefore reflects the market‘s tradeoff between risk and return. If
decisions are made in keeping with the likely effect upon the market value of its
stock, a firm will attract capital only when its investment opportunities justify the
use of that capital in the overall economy.
Put another way, the equilibration process by which savings are allocated in
an economy occurs on the basis of expected return and risk. Holding risk constant,
those economic units (business firms, households, financial institutions, or
governments) willing to pay the highest yield are the ones entitled to the use of
funds. If rationality prevails, the economic units bidding the highest yields will be
the ones with the most promising investment opportunities. As a result, savings
will tend to be allocated to the most efficient users. Maximization of shareholder
wealth then embodies the risk-return tradeoff of the market and is the focal point
by which funds should be allocated within and among business firms. Any other
objective is likely to result in the suboptimal allocation of funds and therefore lead
to less than optimal level of economic want satisfaction.
This is not to say that management should ignore the question of social
responsibility. As related to business firms, social responsibility concerns such
things as protecting the consumer, paying fair wages to employees, maintaining fair
hiring practices, supporting education, and becoming actively involved in
environmental issues like clean air and water. Many people feel that a firm has no
choice but to act in socially responsible ways; they argue that shareholder wealth
and, perhaps, the corporations vary existence depends upon its being socially
responsible. However, the criteria for social responsibility are not clearly defined,
making formulation of a consistent objective function difficult.
3.3.9 Social Responsibility of the Firm
Moreover, social responsibility creates certain problems for the firm. One is
that it falls unevenly on different corporations. Another is that it sometimes
conflicts with the objective of wealth maximization. Certain social actions, from a
long-range point of view, unmistakably are in the best interests of stockholders,
and there is little question that they should be undertaken. Other actions are less
clear, and to engage in them may result in a decline of profits and in shareholder
wealth in the long run. From the standpoint of society, this decline may produce a
conflict. What is gained in having a socially desirable goal achieved may be offset in
whole or part by an accompanying less efficient allocation of resources in society.
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The latter will result in a less than optimal growth of the economy and a lower total
level of economic want satisfaction. In an era of unfilled wants and scarcity, the
allocation process is extremely important.
Many people feel that management should not be called upon to resolve the
conflict posed above. Rather, society, with its broad general perspective, should
make the decisions necessary in this area. Only society, acting through Congress
and other representative governmental bodies, can judge the relative tradeoff
between the achievement of a social goal and the sacrifice in the efficiency of
apportioning resources that may accompany realization of the goal. With these
decisions made, corporations can engage in wealth maximization and thereby
efficiently allocate resources, subject, of course, to certain governmental
constraints. Under such a system, corporations can be viewed as producing both
private and social goods, and the maximization of shareholder wealth remains a
viable corporate objective.
3.4. REVISION POINTS
1. Organic objectives and economic objectives of the firm
2. Social and human objectives of the firm
3. National objectives of the firm
3.5. INDEX QUESTIONS
1. What are the Economic objectives of the firm?
2. Write a note on Social and human objectives of the firm
3. Discuss the overall objectives of the firm
3.6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives on
idea about overall objectives of the firm with respect to organic objectives of the
firm,economic objectives,social objectives of the firm,human objectives of the
firm,national objectives of the firm,aims of the firms, profit maximizing objectives of
the firm, management vs. stockholders objectives of the firm and social
responsibility of the firm. It is clear that one can clearly understand the overall
objectives of the firm through this lesson.
3.7. TERMINAL EXERCISE
1) The appropriate Objective of firm is
a) Maximization of Sales
b) Maximization of Profit
c) Maximization of Owner‘s Wealth
d) None of the Above.
2) The objective of the firm is:
a) Revenue maximization
b) Profit maximization
c) Revenue maximization and cost minimization simultaneous
d) None of the above.
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3.8. SUPPLEMENTARY MATERIALS
1. William J. Baumol (1961). "What Can Economic Theory Contribute to
Managerial Economics?," American Economic Review, 51(2), pp. 142-46
2. Carl Shapiro (1989). "The Theory of Business Strategy," RAND Journal of
Economics, 20(1), pp. 125-137
3.9. ASSIGNMENT
1. Write a note on Economic objectives of the firm
2. Discuss the National objectives of the firm
3. Explain the aim of the firm
3.10. SUGGESTED READINGS
1. Baye, Michael R. (2010) Managerial economics and business strategy. Vol. The
McGraw-Hill series economics. New York: McGraw-Hill/Irwin.
2. Boyes, William J. (2012) Managerial economics: markets and the firm. Boston,
Mass: Houghton Mifflin.
3. Hirschey M. and Bentzen E. (2014) Managerial economics. Andover: Cengage
Learning.
3.11. LEARNING ACTIVITIES
1. To conduct a workshop on Economic objectives of the firm
2. To conduct a group discussion on over all objectives of the firm
3.12. KEYWORDS
1. Economicobjectives, organic objectives, social objectives, human objectives,
national objectives
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LESSON-4
APPLICATION OF MANAGERIAL ECONOMICS IN BUSINESS
DECISION MAKING
4.1 INTRODUCTION
This lessons deals with application of managerial Economic in Business
decision making. Managerial economics applies economic theory and methods to
business and administrativedecision making. Managerial economics prescribes
rules for improvingmanagerial decisions. Managerial economics also helps
managers recognize how economicforces affect organizations and describes the
economic consequences of managerialbehaviour. It links traditional economics with
the decision sciences to developvital tools for managerial decision making. This
lessons deals with various aspects of application of managerial Economics in
Business Decision Making process.
4.2 OBJECTIVES
To study the Role of Managerial Economics in Decision making
To understand the Managerial Benefits of Managerial Economics
To study the application of Managerial Economics in profit maximization of firm
4.3 CONTENT
4.3.1 Application of Economics tools and Techniques
4.3.2 Managerial Economics In Business Decision Making
4.3.3 Benefits of managerial economics to the business manager
4.3.4 Areas of Applications of managerial Economics
4.3.5 Profit maximization versus other motivations behind managerial decisions.
4.3.6 Business versus economic profits oriented Decision Making
4.3.7 Mode of Getting Profit Maximization
4.3.8 The Theory of Consumer Behavior in Business Decision Making
4.3.9 Role of managerial economist in business decision making
4.3.1 Application of Economics tools and Techniques
Managerial economics identifies ways to efficiently achieve goals. For
example,suppose a small business seeks rapid growth to reach a size that permits
efficient useof national media advertising. Managerial economics can be used to
identify pricingand production strategies to help meet this short-run objective
quickly and effectively.Managerial economicsapplies economic tools andtechniques
to business andadministrative decision makingchapter.
36
Managerial Economics
Use of economics Concept anddecision
Science Methodology to Solve Managerial
DecisionProblems
Optimal Solutions to
Managerial Decision
problems
Quantity of Notebooks
Price per Notebook (Px
Demanded (Dx)
25 2
20 4
15 8
10 10
8 12
6.2 OBJECTIVES
To study the Elasticity of Demand
To understand the price Elasticity of Demand and income Elasticity of
Demand
To study the factors determining the Elasticity of Demand
6. 3. CONTENT
6. 3.1 Concept of Elasticity of Demand
6. 3.2 Definition of 'Price Elasticity of Demand'
6. 3.3 Price Elasticity of demand along a linear demand curve
6. 3.4 Price Elasticity of demand and revenue
6. 3.5 Need for Price Elasticity of Demand
6. 3.6 Determinants of Price Elasticity Of Demand
6. 3.7 Income Elasticity of Demand
6. 3.8 Diagrammatic representation of income elasticity
6. 3.9 Relationship between nature of commodities and income elasticity
6. 3.10 Measuring Elasticity of Demand
6. 3.11 cross elasticity of demand
6. 3.1 concept of Elasticity of Demand
Elasticity is one of the most important concepts in neoclassical economic
theory. It is useful in understanding the incidence of indirect taxation, marginal
concepts as they relate to the theory of the firm, and distribution of wealth and
different types of goods as they relate to the theory of consumer choice. Elasticity is
also crucially important in any discussion of welfare distribution, in particular
consumer surplus, producer surplus, or government surplus.
59
Price elasticity of demand is a measure used to show the responsiveness, or
elasticity, of the quantity demanded of a good or service to a change in its price.
More precisely, it gives the percentage change in quantity demanded in response to
a one percent change in price (ceteris paribus, i.e. holding constant all the other
determinants of demand, such as income).
For example, if the quantity demanded for a good increases 15% in response to
a 10% decrease in price, the price elasticity of demand would be 15% / 10% = 1.5.
The degree to which the quantity demanded for good changes in response to a
change in price can be influenced by a number of factors. Factors include the
number of close substitutes (demand is more elastic if there are close substitutes)
and whether the good is a necessity or luxury (necessities tend to have inelastic
demand while luxuries are more elastic).
PED>1
P PED=1
PED<1
D=AR
MR
Fig- 1
6. 3.4 Price Elasticity of demand and revenue
There is a precise mathematical connection between PRICE ELASTICITY OF
DEMAND and a firm‘s revenue.
There are three ‘types’ of revenue:
1. Total revenue (TR), which is found by multiplying price by quantity sold (P x Q).
2. Average revenue (AR), which is found by dividing total revenue by quantity sold
(TR/Q). Consider these figures and calculate Total, Marginal and Average
Revenue.
3. Marginal revenue (MR), which is defined as the revenue from selling one extra
unit. This is calculated by finding the change in TR from selling one more unit.
PRICE (£) Qd TR MR AR
10 1 2 2 6
9 2 1 3 5
8 3 5 5 8
7 4 6 7 1
6 5 7 10 9
5 6 8 4 3
4 7 4 8 4
3 8 10 6 7
2 9 3 1 2
1 10 9 5 10
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Observations
When TR is at a maximum, MR = zero, and PRICE ELASTICITY OF DEMAND =
price
PED> 1 TR
P PED=1
PED<1
D =AR
Q Quantity
MR
fig-2
Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and cancel
out the Qs to get P.
1. A curve plotting AR (=P) against Q is also a firm‘s demand curve.
2. TR increases, reaches a peak and decreases.
6.3.5 Need for Price Elasticity of Demand
There are several reasons why firms gather information about the Price
elasticity of demand of its products. A firm will know much more about its internal
operations and product costs than it will about its external environment. Therefore,
gathering data on how consumers respond to changes in price can help reduce risk
and uncertainly. More specifically, knowledge of Price Elasticity of Demand can
help the firm forecast its sales and set its price.
Sales forecasting
The firm can forecast the impact of a change in price on its sales volume, and
sales revenue (total revenue, TR). For example, if PRICE ELASTICITY OF DEMAND
for a product is (-) 2, a 10% reduction in price (say, from £10 to £9) will lead to a
20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from
£10,000 to £10,800.
Pricing policy
Knowing Price Elasticity of Demand helps the firm decide whether to raise or
lower price, or whether to price discriminate. Price discrimination is a policy of
charging consumers different prices for the same product. If demand is elastic,
revenue is gained by reducing price, but if demand is inelastic, revenue is gained by
raising price.
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Non-pricing policy
When Price Elasticity of Demand is highly elastic, the firm can use advertising
and other promotional techniques to reduce elasticity.
6. 3.6 Determinants of Price Elasticity of Demand
There are several reasons why consumers may respond elastically or in
elastically to a price change, including:
The number and ‘closeness’ of substitutes
A unique and desirable product is likely to exhibit an inelastic demand with
respect to price.
The degree of necessity of the good
A necessity like bread will be demanded in elastically with respect to price.
Whether the good is habit forming
Consumers are also relatively insensitive to changes in the price of habitually
demanded products.
The proportion of consumer income which is spent on the good
The price elasticity of demand for a daily newspaper is likely to be much lower
than that for a new car!
Whether consumers are loyal to the brand
Brand loyalty reduces sensitivity to price changes and reduces price elasticity
of demand
Life cycle of product
Price Elasticity of Demand will vary according to where the product is in its life
cycle. When new products are launched, there are often very few competitors and
Price Elasticity of Demand is relatively inelastic. As other firms launch similar
products, the wider choice increases PRICE ELASTICITY OF DEMAND Finally, as a
product begins to decline in its lifecycle, consumers can become very responsive to
price, hence discounting is extremely common.
The effects of advertising
price Firms may use persuasive advertising by
to win new customers and retain the
loyalty of existing ones.
Advertisers use a range of media,
TR including television, press, and
electronic media. Advertising will shift
P demand to the right, and make demand
less elastic.
There are three extreme cases of Price
D1 Elasticity of Demand
D Perfectly elastic, where only one
price can be charged, Perfectlyinelastic,
where only one quantity will be
purchased, Unit elasticity, where all the
Q MR Quantity possible price and quantity combinations
63
are of the same value. The resultant curve is called a rectangular hyperbola, Go to:
point elasticity of demand, Try a quiz on Price Elasticity of Demand
3.7 Income Elasticity of Demand
In economics, income elasticity of demand measures the responsiveness of the
demand for a good to a change in the income of the people demanding the good,
ceteris paribus. It is calculated as the ratio of the percentage change in demand to
the percentage change in income. For example, if, in response to a 10% increase in
income, the demand for a good increased by 20%, the income elasticity of demand
would be 20%/10% = 2.
A negative income elasticity of demand is associated with inferior goods; an
increase in income will lead to a fall in the demand and may lead to changes to
more luxurious substitutes
A positive income elasticity of demand is associated with normal goods; an
increase in income will lead to a rise in demand. If income elasticity of demand of a
commodity is less than 1, it is a necessity good. If the elasticity of demand is
greater than 1, it is a luxury good or a superior good.
A zero income elasticity of demand occurs when an increase in income is not
associated with a change in the demand of a good. These would be sticky goods.
Income elasticity of demand can be used as an indicator of industry health, future
consumption patterns and as a guide to firm‘s investment decisions. For example,
the "selected income elasticity‘s" below suggest that an increasing portion of
consumer's budgets will be devoted to purchasing automobiles and restaurant
meals and a smaller share to tobacco and margarine.
Income elasticity is closely related to the population income distribution and
the fraction of the product's sales attributable to buyers from different income
brackets. Specifically when a buyer in a certain income bracket experiences an
income increase, their purchase of a product changes to match that of individuals
in their new income bracket. If the income share elasticity is defined as the negative
percentage change in individuals given a percentage increase in income bracken the
income-elasticity, after some computation, becomes the expected value of the
income-share elasticity with respect to the income distribution of purchasers of the
product. When the income distribution is described by a gamma distribution, the
income elasticity is proportional to the percentage difference between the average
income of the product's buyers and the average income of the population.
Now let us consider the data given below and calculate the income elasticity of
demand. Income of the consumer =Rs.5000/- Increased income =Rs.6000/-
Original demand for butter = 2 Kg Increased demand for butter =2.50Kg
From the data we get,
∆q = 0.50
∆y = 1000
y=5000
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q=2
Substituting these values in the formula for income elasticity we get,
Ey =(∆q/∆y)(y/q)
=(0.50/1000)(5000/2)
=5/4
=1.25
6.3.8 Diagrammatic representation of income elasticity
Y D1
Income
D1
Y2 Y Income
Y1
Y2
Y1
450
O Q1 Q 2 O Q1 Q2
Quantity demanded Ey>1 Quantity demanded Ey>1
ASDASD
D1
Income Y
Y - Income
Y2 Y2
Y1
Y1
O Q 1 Q2 O Q X
Quantity demanded Ey<1 Quantity demanded Ey=0
65
Y Income
commodities and income elasticity D1
Now let us understand the different
possibilities.
Normal good
Normal goods have positive income Y2
elasticity of demand. If with an increase
in the income there is an increase in the Y1
demand for the good, we refers to this as
positive income elasticity of demand.
D
The increase could be large or small.
Hence when the increase is such that
percentage change in demand is less
than the percentage change in income
(income elasticity being greater than zero
but less than one) it represents a O Q1 Q2
necessary good(0<Ey<1).However if the Quantity demanded Ey<0
percentageincrease in demand is more
than percentage increase in income then such commodities are considered as
luxury goodsInferior goods Inferior goods have negative income elasticity of
demand.If with an increase in the income there is a decrease in the demand for the
good, we refers to this as negative income elasticity of demand(Ey<0). When the
income of the consumer increases he finds it below his dignity to purchase some
goods and hence when his income increases he prefers to consume less of the
goods he used to purchase earlier or opts for some other good which according to
him has a better position and are consumed by people belonging to the higher
income group.
Note income elasticity of demand varies across product range.Further over a
longrun period with changes in the taste and preference and consumer‘s perception
of commodities elasticity of demand is likely to change.A product which was a
luxury at one point of time becomes a necessity today. Consider the market for
foreign travel.A few decades ago,long distance foreign travel was regarded as a
luxury. Now as real price levels have come down and incomes have grown, a large
number of people are travelling to different places for a short or long period.
Activity
Classify the commodities in your own consumption basket as normal
goods,luxury goods and inferior goods. b.Are the commodities mentioned below
normal goods,luxury goods or inferior goods ? Give reason for your answer.
Salt,camera,fruits,milk,Two wheeler,Cigarettes,medicines,Picasso's painting,Laptop.
The following table gives the quantity of a commodity X that a family would
purchase at various income levels. Find the income elasticity of demand of this
family for Commodity X for various successive levels of this family's income. ii)Over
66
what range of income is Commodity X a Luxury,a necessity,or an inferior good for
this family?
Income(Rs.per month) Quantity(Units per month)
4000 100
6000 250
8000 350
10000 380
12000 450
14000 440
15000 410
16000 380
6. 3.10 Measuring Elasticity of Demand
Demand curves can have many different shapes and so it is important to
derive a way to convey their shape with some precision. For example how would
you describe the difference between the two following curves?
Without a precise means of measuring differences you would be forced to
Conclude that one curve is steeper than the other. Still, people can interpret
the word ―steeper‖ differently. To avoid confusion about the shapes of these curves
a more scientific approach should be taken. To explain the shapes of demand
curves with precision refer to their price
Elasticity of Demandor in simple terms their elasticity. Elasticity is the
responsiveness of a change in one variable to a change in another. Consumers
generally respond to prices changes thus economists call this measurement the
Price elasticity of demand
To calculate the price elasticity of demand this simple formula is used:
Elasticity = the percentage change in quantity demanded divided by the percentage
change in price. Putting this definition into mathematical symbols yields:
E = % Δ in Qd / % Δ in P
Where the % Δ in Qd (the numerator) is calculated by solving Q2-Q1 / Q1, and
similarly the % Δ in P (the denominator) is calculated by P2-P1 / P1. The price
elasticity formula then appears as:
E = Q2-Q1 / Q1 P2-P1 / P1
The ―P‘s & Q‘s‖ in this formula represent the coordinates for two different
points along a demand curve, After making the appropriate substitutions into this
formula you will note that an elasticity coefficient results. Coefficients will be
greater than one, less than one, or equal to one. Demand and supply curves are
then named based upon their elasticity coefficients. When the coefficient is greater
than one the curve is known as elastic. If the coefficient is less than one the curve
is said to be inelastic. And of unitary elasticitywhen equal to one.
While calculating elasticity is simple some caution should be exercised when
working with linear demand curves. Due to the construction of the elasticity
67
formula coefficients will vary depending upon the points selected for the
calculation. Coordinates to the left of the midpoint of the line will always yield a
coefficient greater than one. Based on that coefficient one would be forced to
conclude that the curve is elastic. Coordinates selected to the right of the midpoint
will yield coefficients less than one. This would lead to the conclusion that the
curve is inelastic. Finally, coordinates selected at the midpoint will yield a
coefficient equal to one and a conclusion of unitary elasticity.Thus three entirely
different conclusions could be made about the shape of this one curve based on the
injudicious selection of coordinates. Therefore, if the elasticity measurement is
being used to convey the overall shape of a demand curve then it is important to
select coordinates that are to the left and right of the midpoint.
P Q Elasticity greater than one
Elasticity less than one
Elasticity = one
5. E = 12.90
The curve is considered to be elastic
Goods that have elastic curves show greater price sensitivity. This can
beobserved as you move downward to the right along a demand curve. As the price
declines notice how quantity demanded rises. Now in the above case the
elasticitycoefficient of 12.90 means that for each one percent change in price the
quantity demanded changes by 12.90%. Alternatively, a ten percent change in price
would yield a 67.10% change in quantity demanded.
Goods with inelastic curves are said to be relatively price insensitive. In this
case notice how as price increases the quantity demanded does not decrease
dramatically. This means the consumer was insensitive to that price increase. The
determinants of elasticity are:
Availability of substitutes — the greater the number of substitutes the more
price, sensitive the consumer can be because more choices are available, Whether
they are luxuries or necessities — luxuries tend to cost more making the consumer
more sensitive to their price than the price of necessities, What share of the budget
they represent — the more a product costs the more cautious we become as
consumers because we have limited incomes to satisfy all our desires.
6. 3.11 cross elasticity of demand
There is also a measurement known as the cross elasticity of demand.This is
calculated by taking the percentage change in quantity demanded of good A divided
by the percentage in price of good B. This measurement is used to measure good
A‘s sensitivity to changes in the price of good B. If the cross elasticity of demand is
positive, two commodities are substitutes. If the cross elasticity is negative the
commodities are complements. Using our understanding about elasticity lets
examine how producers and government may use this information.
68
Producers
The producers‘ concern is to maximize revenues. The sum of all their revenue
or total revenue (TR) is simply price times quantity (PxQ = TR). The question before
us is at what point is total revenue for our product maximized when faced with a
particular demand curve? Given the following demand schedule construct the
curve, calculate its total revenue, and relate your observations to elasticity.
Notice that when the firm reduces its price from $100 to $80 that total revenue
rises. Total revenue again rises when the price falls to $60. Between $100 and $60
the firm is operating in the elastic portion of its demand curve. In this region
consumers are price sensitive. Any decrease in price will be met with an increase in
the volume of sales.
Accordingly the firm reduces its price. Notice however that when the firm
reduces price again to $40 total revenue begins to fall. This implies that the firm is
now operating in the inelastic portion of its demand curve. Therefore, if a firm
wants to maximize its total revenue it will sell its product at the price at which
elasticity of demand is equal to one.
At that level of price and output no change in price can produce greater
revenue. Thus firms are very concerned about how much each unit of output
contributes to total revenue. if an increase in output causes total revenue to
increase it will be continued. If an increase in output causes total revenue to
decline it is likely to be discontinued.
The difference in total revenue that results from a unit change in quantity sold
is called marginal revenue (MR). Using the former table we can calculate marginal
revenue.
P Q TR MR
100 5 500
80 10 800 60
60 15 900 20
40 20 800 -20
20 25 500 -60
If a firm is operating in the area where MR is positive a price reduction will
continue to yield greater total revenue. For firms operating in a price range where
marginal revenue is negative, a price reduction will yield less total revenue.
Now since a firm is interested in maximizing total revenue (TR) it attempts to
effect the demand curve by either shifting the demand curve outward to the right,
or influencing the shape of the demand curve (making it more elastic or inelastic).
Government
Government is concerned about the shape of demand curves because it also
must raise revenues. The revenues in this case are in the form of taxes.
Government is interested in maximizing revenues but minimizing the impact of
69
those taxes on the economy. If the government plans to impose a tax on some
specific item it must consider its demand curve. Taxes imposed on luxury items
(goods to which consumers are price sensitive) will increase their cost while
decreasing the quantity demanded. If the quantity demanded decreases
significantly then instability will enter the market. For this reason you will notice
that taxes are generally imposed on goods with inelastic demand curves.
The price increase associated with the increased taxes in this case does not
dramatically decrease the quantity demanded because the consumer is insensitive
to the price increase.
P8
P6
Q1 Q2
Slight price increases on elastic goods results in dramatic declines in quantity
demanded.
P8
P6
Q1 Q2
6.4. REVISION POINTS
1. Understanding the concept of elasticity of demand
2. Price elasticity of demand
3. Income elasticity of demand
4. Factors determining the elasticity of demand
6.5. INDEX QUESTIONS
1. What do you mean by elasticity of demand?
2. Discuss the price elasticity of demand and income elasticity of demand
3. What are the factors determining the elasticity of demand
6.6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives an
idea about elasticity of demand with respect to concept of elasticity of demand,
definition of 'price elasticity of demand', price elasticity of demand along a linear
demand curve, price elasticity of demand and revenue, need for price elasticity of
demand, determinants of price elasticity of demand, income elasticity of demand,
diagrammatic representation of income elasticity, relationship between nature of
commodities and income elasticity measuring elasticity of demand and cross
elasticity of demand.
6.7. TERMINAL EXERCISE
1. Cross Elasticity of Demand between tea & Sugar
a) Positive
b) Negative
c) Zero
70
d) Infinity
2. Demand for a commodity refers to
a) Desire for a Commodity
b) Need for a commodity
c) Quantity demanded of that commodity
d) Quantity of the commodity demanded at a certain price during any
particular period of time
6.8. SUPPLEMENTARY MATERIALS
1. Thomas J. Webster (2003). Managerial Economics: Theory and Practice, ch. 13
& 14, Academic Press. Description.
2. Prof. M.S. BHAT, and A.V. RAU.Managerial economics and financial
analysis.Hyderabad.ISBN 978-81-7800-153-1
6.9. ASSIGNMENT
1. Write a note on income elasticity of demand and price elasticity of demand
2. Discuss the factors determining the elasticity of demand.
6.10. SUGGESTED READINGS
1. Hirschey M. and Bentzen E. (2014) Managerial economics. Andover: Cengage
Learning.
2. Hirschey, Mark (2008) Fundamentals of managerial economics. Mason, Ohio:
South-Western.
6.11. LEARNING ACTIVITIES
1. To conduct a group Discussion price elasticity of demand
2. To conduct a workshop on income elasticity of demand
6.12. KEYWORDS
1. Elasticity of demand, price elasticity of demand, income elasticity of demand,
factors determining elasticity of demand
71
LESSON – 7
DEMAND FORCASTING
7.1 INTRODUCTION
Forecasts are becoming the lifetime of business in a world, where the tidal
waves of change are sweeping the most established of structures, inherited by
human society. Commerce just happens to the one of the first casualties. Survival
in this age of economic predators, requires the tact, talent and technique of
predicting the future. This lesson deals with demand forecasting, types of demand
forecasting, approaches of demand forecasting and forecasting techniques. It points
out the Mathematical method of demand forecasting and demand forecasting
methods in India.
7.2 OBJECTIVES
To study the content and meaning of demand forecasting
To Examine the types and methods of demand forecasting
To study the demand forecasting approaches in India
To understand the application of demand forecasting in business decision
making process
7.3 CONTENT
1. Concept of Demand Forecasting
2. Procedure to Prepare Sales Forecast
3. Types of Forecasting
4. Classification of demand forecasting
5. Classification of demand forecasting on the basis of types of products
6. The choice forecasting demand
7. Forecasting Demand for Capital Goods
8. Forecasting Demand for New Products
9. Approaches of demand forecasting
10. Forecasting Techniques
11. Statistical Method of demand forecasting
12. Demand Forecasts in India
13. Criteria of a Good Forecasting Method
14. General Approaches to Forecasting
15. Experimental Approaches to Forecasting
7.3.1 Concept of Demand Forecasting
Forecast is becoming the sign of survival and the language of business. All
requirements of the business sector need the technique of accurate and practical
reading into the future. Forecasts are, therefore, very essential requirement for the
survival of business. Management requires forecasting information when making a
wide range of decisions.The sales forecast is particularly important as it is the
foundation upon which all company plans are built in terms of markets and
72
revenue. Management would be a simple matter if business was not in a continual
state of change, the pace of which has quickened in recent years.
It is becoming increasingly important and necessary for business to predict
their future prospects in terms of sales, cost and profits. The value of future sales is
crucial as it affects costs profits, so the prediction of future sales is the logical
starting point of all business planning.A forecast is a prediction or estimation of
future situation. It is an objective assessment of future course of action. Since
future is uncertain, no forecast can be percent correct. Forecasts can be both
physical as well as financial in nature. The more realistic the forecasts, the more
effective decisions can be taken for tomorrowIn the words of Cundiff and Still,
―Demand forecasting is an estimate of sales during a specified future period which
is tied to a proposed marketing plan and which assumes a particular set of uncon-
trollable and competitive forces‖. Therefore, demand forecasting is a projection of
firm‘s expected level of sales based on a chosen marketing plan and environment.
7.3.2 Procedure to Prepare Sales Forecast
Companies commonly use a three-stage procedure to prepare a sales forecast.
They make an environmental forecast, followed by an industry forecast, and
followed by a company‘s sales forecast, the environmental forecast calls for
projecting inflation, unemployment, interest rate, consumer spending, and saving,
business investment, government expenditure, net exports and other environmental
magnitudes and events of importance to the company.
The industry forecast is based on surveys of consumers‘ intention and analysis
of statistical trends is made available by trade associations or chamber of
commerce. It can give indication to a firm regarding tine direction in which the
whole industry will be moving. The company derives its sales forecast by assuming
that it will win a certain market share.
7.3.3 Types of Forecasting
Forecasts can be broadly classified into:
Passive Forecast andActive Forecast Under passive forecast prediction about
future is based on the assumption that the firm does not change the course of its
action. Under active forecast, prediction is done under the condition of likely future
changes in the actions by the firms.
From the view point of ‗time span‘, forecasting may be classified into two, viz
Short term demand forecasting and long term demand forecasting. In a short
run forecast, seasonal patterns are of much importance. It may cover a period of
three months, six months or one year. It is one which provides information for
tactical decisions.
Which period is chosen depends upon the nature of business. Such a forecast
helps in preparing suitable sales policy. Long term forecasts are helpful in suitable
capital planning. It is one which provides information for major strategic decisions.
It helps in saving the wastages in material, man hours, machine time and capacity.
73
Planning of a new unit must start with an analysis of the long term demand
potential of the products of the firm.
There are basically two types of forecast, viz.
External or national group of forecast and Internal or company group forecast.
External forecast deals with trends in general business. It is usually prepared by a
company‘s research wing or by outside consultants. Internal forecast includes all
those that are related to the operation of a particular enterprise such as sales
group, production group, and financial group. The structure of internal forecast
includes forecast of annual sales, forecast of products cost, forecast of operating
profit, forecast of taxable income, forecast of cash resources, forecast of the number
of employees, etc.
7.3.4 Classification of demand forecasting
At different levels forecasting may be classified into:
(i) Macro-level forecasting,
(ii) Industry- level forecasting,
(iii) Firm- level forecasting and
(iv) Product-line forecasting.
Macro-level forecasting is concerned with business conditions over the whole
economy. It is measured by an appropriate index of industrial production, national
income or expenditure. Industry-level forecasting is prepared by different trade
associations.
This is based on survey of consumers‘ intention and analysis of statistical
trends. Firm-level forecasting is related to an individual firm. It is most important
from managerial view point. Product-line forecasting helps the firm to decide which
of the product or products should have priority in the allocation of firm‘s limited
resources.
Forecast may be classified into (i) general and (ii) specific. The general forecast
may generally be useful to the firm. Many firms require separate forecasts for
specific products and specific areas, for this general forecast is broken down into
specific forecasts.
7.3.5 Classification of demand forecasting on the basis of types of products
There are different forecasts for different types of products like:
(i) Forecasting demand for nondurable consumer goods,
(ii) Forecasting demand for durable consumer goods,
(iii) Forecasting demand for capital goods, and
(iv) Forecasting demand for new-products.
Non-Durable Consumer Goods:
These are also known as ‗single-use consumer goods‘ or perishable consumer
goods. These vanish after a single act of consumption. These include goods like
food, milk, medicine, fruits, etc. Demand for these goods depends upon household
74
disposable income, price of the commodity and the related goods and population
and characteristics. Symbolically,
Dc =f(y, s, p, pr) where
Dc = the demand for commodity с
у = the household disposable income
s = population
p = price of the commodity с
pr = price of its related goods
(i) Disposable income expressed as Dc = f (y) i.e. other things being equal, the
demand for commodity с depends upon the disposable income of the household.
Disposable income of the household is estimated after the deduction of personal
taxes from the personal income. Disposable income gives an idea about the
purchasing power of the household.
(ii) Price, expressed as Dc = f (p, pr) i.e. other things being equal, demand for
commodity с depends upon its own price and the price of related goods. While the
demand for a commodity is inversely related to its own price of its complements. It
is positively related to its substitutes.‘ Price elasticities and cross elasticities of non-
durable consumer goods help in their demand forecasting.
(iii) Population, expressed as Dc= f (5) i.e. other things being equal, demand for
commodity с depends upon the size of population and its composition. Besides,
population can also be classified on the basis of sex, income, literacy and social
status. Demand for non-durable consumer goods is influenced by all these factors.
For the general demand forecasting population as a whole is considered, but for
specific demand forecasting division of population according to different
characteristics proves to be more useful.
Durable Consumer Goods:
These goods can be consumed a number of times or repeatedly used without
much loss to their utility. These include goods like car, T.V., air-conditioners,
furniture etc. After their long use, consumers have a choice either these could be
consumed in future or could be disposed of.
7.3.6 The choice forecasting demand
Whether a consumer will go for the replacement of a durable good or keep on
using it after necessary repairs depends upon his social status, level of money
income, taste and fashion, etc. Replacement demand tends to grow with increase in
the stock of the commodity with the consumers. The firm can estimate the average
replacement cost with the help of life expectancy table.
Most consumer durables are consumed in common by the members of a
family. For instance, T.V., refrigerator, etc. are used in common by households.
Demand forecasts for goods commonly used should take into account the number
of households rather than the total size of population. While estimating the number
75
of households, the income of the household, the number of children and sex-
composition, etc. should be taken into account.
Demand for consumer durables depends upon the availability of allied
facilities. For example, the use of T.V., refrigerator needs regular supply of power,
the use of car needs availability of fuel, etc. While forecasting demand for consumer
durables, the provision of allied services and their cost should also be taken into
account.
Demand for consumer durables is very much influenced by their prices and
their credit facilities. Consumer durables are very much sensitive to price changes.
A small fall in their price may bring large increase in demand.
7.3.7 Forecasting Demand for Capital Goods
Capital goods are used for further production. The demand for capital good is
a derived one. It will depend upon the profitability of industries. The demand for
capital goods is a case of derived demand. In the case of particular capital goods,
demand will depend on the specific markets they serve and the end uses for which
they are bought.
The demand for textile machinery will, for instance, be determined by the
expansion of textile industry in terms of new units and replacement of existing
machinery. Estimation of new demand as well as replacement demand is thus
necessary.
Three types of data are required in estimating the demand for capital goods:
The growth prospects of the user industries must be known,the norm of
consumption of the capital goods per unit of each end-use product must be known,
andthe velocity of their use.
7.3.8 Forecasting Demand for New Products
The methods of forecasting demand for new products are in many ways
different from those for established products. Since the product is new to the
consumers, an intensive study of the product and its likely impact upon other
products of the same group provides a key to an intelligent projection of demand.
7.3.9 Approaches of demand forecasting
Joel Dean has classified a number of possible approaches as follows:
(a) Evolutionary Approach:
It consists of projecting the demand for a new product as an outgrowth and
evolution of an existing old product.
(b) Substitute Approach:
According to this approach the new product is treated as a substitute for the
existing product or service.
(c) Growth Curve Approach:
It estimates the rate of growth and potential demand for the new product as
the basis of some growth pattern of an established product.
76
(d) Opinion-Poll Approach:
Under this approach the demand is estimated by direct enquiries from the
ultimate consumers.
(e) Sales Experience Approach:
According to this method the demand for the new product is estimated by
offering the new product for sale in a sample market.
(f) Vicarious Approach:
By this method, the consumers‘ reactions for a new product are found out
indirectly through the specialised dealers who are able to judge the consumers‘
needs, tastes and preferences.
The various steps involved in forecasting the demand for non-durable
consumer goods are the following:
(a) First identify the variables affecting the demand for the product and
express them in appropriate forms, (b) gather relevant data or approximation to
relevant data to represent the variables, and (c) use methods of statistical analysis
to determine the most probable relationship between the dependent and
independent variables.
7.3.10 Forecasting Techniques:
Demand forecasting is a difficult exercise. Making estimates for future under
the changing conditions is a Herculean task. Consumers‘ behaviour is the most
unpredictable one because it is motivated and influenced by a multiplicity of forces.
There is no easy method or a simple formula which enables the manager to predict
the future.
Economists and statisticians have developed several methods of demand
forecasting. Each of these methods has its relative advantages and disadvantages.
Selection of the right method is essential to make demand forecasting accurate. In
demand forecasting, a judicious combination of statistical skill and rational
judgement is needed.
Mathematical and statistical techniques are essential in classifying
relationships and providing techniques of analysis, but they are in no way an
alternative for sound judgement. Sound judgement is a prime requisite for good
forecast.
The judgment should be based upon facts and the personal bias of the
forecaster should not prevail upon the facts. Therefore, a mid way should be
followed between mathematical techniques and sound judgment or pure guess
work.
The more commonly used methods of demand forecasting are discussed below:
The various methods of demand forecasting can be summarised in the form of
a chart as shown in Table 1.
77
Table 1
Methods and Forecasting
Fitting Trend Line by Least Squaare Time Series Moving Average Exponential
Observation Regression Analysis Analysis and Annual Smoothing
Difference
Opinion Polling Method
In this method, the opinion of the buyers, sales force and experts could be
gathered to determine the emerging trend in the market.
The opinion polling methods of demand forecasting are of three kinds
Consumer‘s Survey Method or Survey of Buyer‘s Intentions
In this method, the consumers are directly approached to disclose their future
purchase plans. I has been by interviewing all consumers or a selected group of
consumers out of the relevant population. This is the direct method of estimating
demand in the short run. Here the burden of forecasting is shifted to the buyer. The
firm may go in for complete enumeration or for sample surveys. If the commodity
under consideration is an intermediate product then the industries using it as an
end product are surveyed.
Complete Enumeration Survey
Under the Complete Enumeration Survey, the firm has to go for a door to door
survey for the forecast period by contacting all the households in the area. This
method has an advantage of first hand, unbiased information, yet it has its share of
disadvantages also. The major limitation of this method is that it requires lot of
resources, manpower and time.
In this method, consumers may be reluctant to reveal their purchase plans
due to personal privacy or commercial secrecy. Moreover, at times the consumers
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may not express their opinion properly or may deliberately misguide
theinvestigators.
Sample Survey and Test Marketing
Under this method some representative households are selected on random
basis as samples and their opinion is taken as the generalised opinion. This method
is based on the basic assumption that the sample truly represents the population.
If the sample is the true representative, there is likely to be no significant difference
in the results obtained by the survey. Apart from that, this method is less tedious
and less costly.
A variant of sample survey technique is test marketing. Product testing
essentially involves placing the product with a number of users for a set period.
Their reactions to the product are noted after a period of time and an estimate of
likely demand is made from the result. These are suitable for new products or for
radically modified old products for which no prior data exists. It is a more scientific
method of estimating likely demand because it stimulates a national launch in a
closely defined geographical area.
End Use Method or Input-Output Method
This method is quite useful for industries which are mainly producer‘s goods.
In this method, the sale of the product under consideration is projected as the basis
of demand survey of the industries using this product as an intermediate product,
that is, the demand for the final product is the end user demand of the
intermediate product used in the production of this final product.
The end user demand estimation of an intermediate product may involve many
final good industries using this product at home and abroad. It helps us to
understand inter-industry‘ relations. In input-output accounting two matrices used
are the transaction matrix and the input co-efficient matrix. The major efforts
required by this type are not in its operation but in the collection and presentation
of data.
Sales Force Opinion Method
This is also known as collective opinion method. In this method, instead of
consumers, the opinion of the salesmen is sought. It is sometimes referred as the
―grass roots approach‖ as it is a bottom-up method that requires each sales person
in the company to make an individual forecast for his or her particular sales
territory.
These individual forecasts are discussed and agreed with the sales manager.
The composite of all forecasts then constitutes the sales forecast for the
organization. The advantages of this method are that it is easy and cheap. It does
not involve any elaborate statistical treatment. The main merit of this method lies
in the collective wisdom of salesmen. This method is more useful in forecasting
sales of new products.
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Experts Opinion Method
This method is also known as ―Delphi Technique‖ of investigation. The Delphi
method requires a panel of experts, who are interrogated through a sequence of
questionnaires in which the responses to one questionnaire are used to produce the
next questionnaire. Thus any information available to some experts and not to
others is passed on, enabling all the experts to have access to all the information
for forecasting.
The method is used for long term forecasting to estimate potential sales for
new products. This method presumes two conditions: Firstly, the panellists must
be rich in their expertise, possess wide range of knowledge and experience.
Secondly, its conductors are objective in their job. This method has some exclusive
advantages of saving time and other resources.
7.3.11 Statistical Method of demand forecasting
Statistical methods have proved to be immensely useful in demand
forecasting. In order to maintain objectivity, that is, by consideration of all
implications and viewing the problem from an external point of view, the statistical
methods are used.
The important statistical methods are
Trend Projection Method
A firm existing for a long time will have its own data regarding sales for past
years. Such data when arranged chronologically yield what is referred to as ‗time
series‘. Time series shows the past sales with effective demand for a particular
product under normal conditions. Such data can be given in a tabular or graphic
form for further analysis. This is the most popular method among business firms,
partly because it is simple and inexpensive and partly because time series data
often exhibit a persistent growth trend.
Time series has got four types of components namely, Secular Trend (T),
Secular Variation (S), Cyclical Element (C), and an Irregular or Random Variation
(I). These elements are expressed by the equation O = TSCI. Secular trend refers to
the long run changes that occur as a result of general tendency.
Seasonal variations refer to changes in the short run weather pattern or social
habits. Cyclical variations refer to the changes that occur in industry during
depression and boom. Random variation refers to the factors which are generally
able such as wars, strikes, flood, famine and so on.
When a forecast is made the seasonal, cyclical and random variations are
removed from the observed data. Thus only the secular trend is left. This trend is
then projected. Trend projection fits a trend line to a mathematical equation.
The trend can be estimated by using any one of the following methods:
The Graphical Method,the Least Square Method.
Graphical Method
This is the most simple technique to determine the trend. All values of output
or sale for different years are plotted on a graph and a smooth free hand curve is
80
drawn passing through as many points as possible. The direction of this free hand
curve—upward or downward— shows the trend. A simple illustration of this
method is given in Table 2.
Table 2
Sales of Firm
Year Sales (Rs.Crore)
1995 40
1996 50
1997 44
1998 60
1999 54
2000 62
Fig. 1, AB is the trend line which has been drawn as free hand curve passing through the
various points representing actual sale values.
70
60
B
50
40
30 A
20
10
1995 1996 1997 1998 1999 2000
Least Square Method
Under the least square method, a trend line can be fitted to the time series
data with the help of statistical techniques such as least square regression. When
the trend in sales over time is given by straight line, the equation of this line is of
the form: y = a + bx. Where ‗a‘ is the intercept and ‗b‘ shows the impact of the
independent variable. We have two variables—the independent variable x and the
dependent variable y. The line of best fit establishes a kind of mathematical
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relationship between the two variables .v and y. This is expressed by the regression
у on x.
In order to solve the equation v = a + bx, we have to make use of the following
normal equations
Σ y = na + b ΣX
Σxy =aΣ x+bΣ x2
(ii) Barometric Technique
A barometer is an instrument of measuring change. This method is based on
the notion that ―the future can be predicted from certain happenings in the
present.‖ In other words, barometric techniques are based on the idea that certain
events of the present can be used to predict the directions of change in the future.
This is accomplished by the use of economic and statistical indicators which serve
as barometers of economic change.
Generally forecasters correlate a firm‘s sales with three series: Leading Series,
Coincident or Concurrent Series and Lagging Series:
(a) The Leading Series
The leading series comprise those factors which move up or down before the
recession or recovery starts. They tend to reflect future market changes. For
example, baby powder sales can be forecasted by examining the birth rate pattern
five years earlier, because there is a correlation between the baby powder sales and
children of five years of age and since baby powder sales today are correlated with
birth rate five years earlier, it is called lagged correlation. Thus we can say that
births lead to baby soaps sales.
(b) Coincident or Concurrent Series
The coincident or concurrent series are those which move up or down
simultaneously with the level of the economy. They are used in confirming or
refuting the validity of the leading indicator used a few months afterwards.
Common examples of coinciding indicators are G.N.P itself, industrial production,
trading and the retail sector.
(c) The Lagging Series
The lagging series are those which take place after some time lag with respect
to the business cycle. Examples of lagging series are, labour cost per unit of the
manufacturing output, loans outstanding, leading rate of short term loans, etc.
(iii) Regression Analysis
It attempts to assess the relationship between at least two variables (one or
more independent and one dependent), the purpose being to predict the value of the
dependent variable from the specific value of the independent variable. The basis of
this prediction generally is historical data. This method starts from the assumption
that a basic relationship exists between two variables. An interactive statistical
analysis computer package is used to formulate the mathematical relationship
which exists.
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For example, one may build up the sales model as
Quantum of Sales = a. price + b. advertising + c. price of the rival products + d.
personal disposable income +u
Where a, b, c, d are the constants which show the effect of corresponding
variables as sales. The constant u represents the effect of all the variables which
have been left out in the equation but having effect on sales. In the above equation,
quantum of sales is the dependent variable and the variables on the right hand side
of the equation are independent variables. If the expected values of the independent
variables are substituted in the equation, the quantum of sales will then be
forecasted.
The regression equation can also be written in a multiplicative form as given below
Quantum of Sales = (Price)a + (Advertising)b+ (Price of the rival products) c +
(Personal disposable income Y + u
In the above case, the exponent of each variable indicates the elasticities of the
corresponding variable. Stating the independent variables in terms of notation, the
equation form is QS = P°8. Ao42 . R°.83. Y2°.68. 40
Then we can say that 1 per cent increase in price leads to 0.8 per cent change
in quantum of sales and so on.
If we take logarithmic form of the multiple equation, we can write the equation
in an additive form as follows
log QS = a log P + b log A + с log R + d log Yd + log u
In the above equation, the coefficients a, b, c, and d represent the elasticities
of variables P, A, R and Yd respectively.
The co-efficient in the logarithmic regression equation are very useful in policy
decision making by the management.
(iv) Econometric Models
Econometric models are an extension of the regression technique whereby a
system of independent regression equation is solved. The requirement for
satisfactory use of the econometric model in forecasting is under three heads:
variables, equations and data.
The appropriate procedure in forecasting by econometric methods is model
building. Econometrics attempts to express economic theories in mathematical
terms in such a way that they can be verified by statistical methods and to measure
the impact of one economic variable upon another so as to be able to predict future
events.
Utility of Forecasting
Forecasting reduces the risk associated with business fluctuations which
generally produce harmful effects in business, create unemployment, induce
speculation, discourage capital formation and reduce the profit margin. Forecasting
is indispensable and it plays a very important part in the determination of various
policies. In modem times forecasting has been put on scientific footing so that the
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risks associated with it have been considerably minimised and the chances of
precision increased.
7.3.12 Demand Forecasts in India
In most of the advanced countries there are specialised agencies. In India
businessmen are not at all interested in making scientific forecasts. They depend
more on chance, luck and astrology. They are highly superstitious and hence their
forecasts are not correct. Sufficient data are not available to make reliable
forescasts. However, statistics alone do not forecast future conditions. Judgment,
experience and knowledge of the particular trade are also necessary to make proper
analysis and interpretation and to arrive at sound conclusions.
7.3.13 Criteria of a Good Forecasting Method
There are thus, a good many ways to make a guess about future sales. They
show contrast in cost, flexibility and the adequate skills and sophistication.
Therefore, there is a problem of choosing the best method for a particular demand
situation.
There are certain economic criteria of broader applicability. They are:
Accuracy, Plausibility,Durability, Flexibility, Availability, Economy, Simplicity
and (Consistency.
(i) Accuracy
The forecast obtained must be accurate. How is an accurate forecast possible?
To obtain an accurate forecast, it is essential to check the accuracy of past
forecasts against present performance and of present forecasts against future
performance. Accuracy cannot be tested by precise measurement but buy
judgment.
(ii) Plausibility
The executive should have good understanding of the technique chosen and
they should have confidence in the techniques used. Understanding is also needed
for a proper interpretation of results. Plausibility requirements can often improve
the accuracy of results.
(iii) Durability
Unfortunately, a demand function fitted to past experience may back cost very
greatly and still fall apart in a short time as a forecaster. The durability of the
forecasting power of a demand function depends partly on the reasonableness and
simplicity of functions fitted, but primarily on the stability of the understanding
relationships measured in the past. Of course, the importance of durability deter-
mines the allowable cost of the forecast.
(iv) Flexibility
Flexibility can be viewed as an alternative to generality. A long lasting function
could be set up in terms of basic natural forces and human motives. Even though
fundamental, it would nevertheless be hard to measure and thus not very useful. A set
of variables whose co-efficient could be adjusted from time to time to meetchanging
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conditions in more practical way to maintain intact the routine procedure of
forecasting.
(v) Availability
Immediate availability of data is a vital requirement and the search for reasonable
approximations to relevance in late data is a constant strain on the forecasters
patience. The techniques employed should be able to produce meaningful results
quickly. Delay in result will adversely affect the managerial decisions.
(vi) Economy
Cost is a primary consideration which should be weighted against the
importance of the forecasts to the business operations. A question may arise: How
much money and managerial effort should be allocated to obtain a high level of
forecasting accuracy? The criterion here is the economic consideration.
(vii) Simplicity
Statistical and econometric models are certainly useful but they are intolerably
complex. To those executives who have a fear of mathematics, these methods would
appear to be Latin or Greek. The procedure should, therefore, be simple and easy so
that the management may appreciate and understand why it has been adopted by the
forecaster.
(viii) Consistency
The forecaster has to deal with various components which are independent. If
he does not make an adjustment in one component to bring it in line with a
forecast of another, he would achieve a whole which would appear consistent.
7.3.14 General Approaches to Forecasting
All firms forecast demand, but it would be difficult to find any two firms that
forecast demand in exactly the same way. Over the last few decades, many different
forecasting techniques have been developed in a number of different application areas,
including engineering and economics. Many such procedures have been applied to the
practical problem of forecasting demand in a logistics system, with varying degrees of
success. Most commercial software packages that support demand forecasting in a
logistics system include dozens of different forecasting algorithms that the analyst can
use to generate alternative demand forecasts. While scores of different forecasting
techniques exist, almost any forecasting procedure can be broadly classified into one of
the following four basic categories based on the fundamental approach towards the
forecasting problem that is employed by the technique.
1. Judgmental Approaches. The essence of the judgmental approach is to
address the forecasting issue by assuming that someone else knows and can tell
you the right answer. That is, in a judgment-based technique we gather the
knowledge and opinions of people who are in a position to know what demand will
be. For example, we might conduct a survey of the customer base to estimate what
our sales will be next month.
2. Experimental Approaches. Another approach to demand forecasting,
which is appealing when an item is "new" and when there is no other information
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upon which to base a forecast, is to conduct a demand experiment on a small group
of customers and to extrapolate the results to a larger population. For example,
firms will often test a new consumer product in a geographically isolated "test
market" to establish its probable market share. This experience is then extrapolated
to the national market to plan the new product launch. Experimental approaches
are very useful and necessary for new products, but for existing products that have
an accumulated historical demand record it seems intuitive that demand forecasts
should somehow be based on this demand experience. For most firms (with some
very notable exceptions) the large majority of SKUs in the product line have long
demand histories.
3. Relational/Causal Approaches. The assumption behind a causal or
relational forecast is that, simply put, there is a reason why people buy our
product. If we can understand what that reason (or set of reasons) is, we can use
that understanding to develop a demand forecast. For example, if we sell umbrellas
at a sidewalk stand, we would probably notice that daily demand is strongly
correlated to the weather – we sell more umbrellas when it rains. Once we have
established this relationship, a good weather forecast will help us order enough
umbrellas to meet the expected demand.
4. "Time Series" Approaches. A time series procedure is fundamentally
different than the first three approaches we have discussed. In a pure time series
technique, no judgment or expertise or opinion is sought. We do not look for
"causes" or relationships or factors which somehow "drive" demand. We do not test
items or experiment with customers. By their nature, time series procedures are
applied to demand data that are longitudinal rather than cross-sectional. That is,
the demand data represent experience that is repeated over time rather than across
items or locations. The essence of the approach is to recognize (or assume) that
demand occurs over time in patterns that repeat themselves, at least
approximately. If we can describe these general patterns or tendencies, without
regard to their "causes", we can use this description to form the basis of a forecast.
In one sense, all forecasting procedures involve the analysis of historical
experience into patterns and the projection of those patterns into the future in the
belief that the future will somehow resemble the past. The differences in the four
approaches are in the way this "search for pattern" is conducted. Judgmental
approaches rely on the subjective, ad-hoc analyses of external individuals.
Experimental tools extrapolate results from small numbers of customers to large
populations. Causal methods search for reasons for demand. Time series
techniques simply analyze the demand data themselves to identify temporal
patterns that emerge and persist.
Judgmental Approaches to Forecasting
By their nature, judgment-based forecasts use subjective and qualitative data
to forecast future outcomes. They inherently rely on expert opinion, experience,
judgment, intuition, conjecture, and other "soft" data. Such techniques are often
86
used when historical data are not available, as is the case with the introduction of a
new product or service, and in forecasting the impact of fundamental changes such
as new technologies, environmental changes, cultural changes, legal changes, and
so forth. Some of the more common procedures include the following:
Surveys
This is a "bottom up" approach where each individual contributes a piece of
what will become the final forecast. For example, we might poll or sample our
customer base to estimate demand for a coming period. Alternatively, we might
gather estimates from our sales force as to how much each salesperson expects to
sell in the next time period. The approach is at least plausible in the sense that we
are asking people who are in a position to know something about future demand.
On the other hand, in practice there have proven to be serious problems of bias
associated with these tools. It can be difficult and expensive to gather data from
customers. History also shows that surveys of "intention to purchase" will generally
over-estimate actual demand – liking a product is one thing, but actually buying it
is often quite another. Sales people may also intentionally (or even unintentionally)
exaggerate or underestimate their sales forecasts based on what they believe their
supervisors want them to say. If the sales force (or the customer base) believes that
their forecasts will determine the level of finished goods inventory that will be
available in the next period, they may be sorely tempted to inflate their demand
estimates so as to insure good inventory availability. Even if these biases could be
eliminated or controlled, another serious problem would probably remain. Sales
people might be able to estimate their weekly dollar volume or total unit sales, but
they are not likely to be able to develop credible estimates at the SKU level that the
logistics system will require. For these reasons it will seldom be the case that these
tools will form the basis of a successful demand forecasting procedure in a logistics
system.
Consensus methods
As an alternative to the "bottom-up" survey approaches, consensus methods
use a small group of individuals to develop general forecasts. In a ―Jury of
Executive Opinion‖, for example, a group of executives in the firm would meet and
develop through debate and discussion a general forecast of demand. Each
individual would presumably contribute insight and understanding based on their
view of the market, the product, the competition, and so forth. Once again, while
these executives are undoubtedly experienced, they are hardly disinterested
observers, and the opportunity for biased inputs is obvious. A more formal
consensus procedure, called ―The Delphi Method‖, has been developed to help
control these problems. In this technique, a panel of disinterested technical experts
is presented with a questionnaire regarding a forecast. The answers are collected,
processed, and re-distributed to the panel, making sure that all information
contributed by any panel member is available to all members, but on an
anonymous basis. Each expert reflects on the gathering opinion. A second
questionnaire is then distributed to the panel, and the process is repeated until a
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consensus forecast is reached. Consensus methods are usually appropriate only for
highly aggregate and usually quite long-range forecasts. Once again, their ability to
generate useful SKU level forecasts is questionable, and it is unlikely that this
approach will be the basis for a successful demand forecasting procedure in a
logistics system.
Judgment-based methods are important in that they are often used to
determine an enterprise's strategy. They are also used in more mundane decisions,
such as determining the quality of a potential vendor by asking for references, and
there are many other reasonable applications. It is true that judgment based
techniques are an inadequate basis for a demand forecasting system, but this
should not be construed to mean that judgment has no role to play in logistics
forecasting or that salespeople have no knowledge to bring to the problem. In fact, it
is often the case that sales and marketing people have valuable information about
sales promotions, new products, competitor activity, and so forth, which should be
incorporated into the forecast somehow. Many organizations treat such data as
additional information that is used to modify the existing forecast rather than as
the baseline data used to create the forecast in the first place.
7.3.15 Experimental Approaches to Forecasting
In the early stages of new product development it is important to get some
estimate of the level of potential demand for the product. A variety of market
research techniques are used to this end.
Customer Surveys are sometimes conducted over the telephone or on street
corners, at shopping malls, and so forth. The new product is displayed or
described, and potential customers are asked whether they would be interested in
purchasing the item. While this approach can help to isolate attractive or
unattractive product features, experience has shown that "intent to purchase" as
measured in this way is difficult to translate into a meaningful demand forecast.
This falls short of being a true ―demand experiment‖.
Consumer Panels are also used in the early phases of product development.
Here a small group of potential customers are brought together in a room where
they can use the product and discuss it among themselves. Panel members are
often paid a nominal amount for their participation. Like surveys, these procedures
are more useful for analyzing product attributes than for estimating demand, and
they do not constitute true ―demand experiments‖ because no purchases take
place.
Test Marketing is often employed after new product development but prior to
a full-scale national launch of a new brand or product. The idea is to choose a
relatively small, reasonably isolated, yet somehow demographically "typical" market
area. In the United States, this is often a medium sized city such as Cincinnati or
Buffalo. The total marketing plan for the item, including advertising, promotions,
and distribution tactics, is "rolled out" and implemented in the test market, and
measurements of product awareness, market penetration, and market share are
88
made. While these data are used to estimate potential sales to a larger national
market, the emphasis here is usually on "fine-tuning" the total marketing plan and
insuring that no problems or potential embarrassments have been overlooked. For
example, Proctor and Gamble extensively test-marketed its Pringles potato chip
product made with the fat substitute Olestra to assure that the product would be
broadly acceptable to the market.
Scanner Panel Data procedures have recently been developed that permit
demand experimentation on existing brands and products. In these procedures, a
large set of household customers agrees to participate in an ongoing study of their
grocery buying habits. Panel members agree to submit information about the
number of individuals in the household, their ages, household income, and so
forth. Whenever they buy groceries at a supermarket participating in the research,
their household identity is captured along with the identity and price of every item
they purchased. This is straightforward due to the use of UPC codes and optical
scanners at checkout. This procedure results in a rich database of observed
customer buying behavior. The analyst is in a position to see each purchase in light
of the full set of alternatives to the chosen brand that were available in the store at
the time of purchase, including all other brands, prices, sizes, discounts, deals,
coupon offers, and so on. Statistical models such as discrete choice models can be
used to analyze the relationships in the data. The manufacturer and merchandiser
are now in a position to test a price promotion and estimate its probable effect on
brand loyalty and brand switching behavior among customers in general. This
approach can develop valuable insight into demand behavior at the customer level,
but once again it can be difficult to extend this insight directly into demand
forecasts in the logistics system.
Relational/Causal Approaches to Forecasting
Suppose our firm operates retail stores in a dozen major cities, and we now
decide to open a new store in a city where we have not operated before. We will
need to forecast what the sales at the new store are likely to be. To do this, we
could collect historical sales data from all of our existing stores. For each of these
stores we could also collect relevant data related to the city's population, average
income, the number of competing stores in the area, and other presumably relevant
data. These additional data are all referred to as explanatory variables or
independent variables in the analysis. The sales data for the stores are considered
to be the dependent variable that we are trying to explain or predict.
The basic premise is that if we can find relationships between the explanatory
variables (population, income, and so forth) and sales for the existing stores, then
these relationships will hold in the new city as well. Thus, by collecting data on the
explanatory variables in the target city and applying these relationships, sales in
the new store can be estimated. In some sense the posture here is that the
explanatory variables "cause" the sales. Mathematical and statistical procedures
are used to develop and test these explanatory relationships and to generate
forecasts from them. Causal methods include the following:
89
Econometric models, such as discrete choice models and multiple
regressions. More elaborate systems involving sets of simultaneous regression
equations can also be attempted. These advanced models are beyond the scope of
this book and are not generally applicable to the task of forecasting demand in a
logistics system.
Input-output models estimate the flow of goods between markets and
industries. These models ensure the integrity of the flows into and out of the
modeled markets and industries; they are used mainly in large-scale macro-
economic analysis and were not found useful in logistics applications.
Life cycle models look at the various stages in a product's "life" as it is
launched, matures, and phases out. These techniques examine the nature of the
consumers who buy the product at various stages ("early adopters," "mainstream
buyers," "laggards," etc.) to help determine product life cycle trends in the demand
pattern. Such models are used extensively in industries such as high technology,
fashion, and some consumer goods facing short product life cycles. This class of
model is not distinct from the others mentioned here as the characteristics of the
product life cycle can be estimated using, for example, econometric models. They
are mentioned here as a distinct class because the overriding "cause" of demand
with these models is assumed to be the life cycle stage the product is in.
Simulation models are used to model the flows of components into
manufacturing plants based on MRP schedules and the flow of finished goods
throughout distribution networks to meet customer demand. There is little theory
to building such simulation models. Their strength lies in their ability to account
for many time lag effects and complicated dependent demand schedules. They are,
however, typically cumbersome and complicated.
7.4. REVISION POINTS
1. Content and meaning of demand forecasting
2. Classification of demand forecasting
3. Techniques of demand forecasting
7.5. INDEX QUESTIONS
1. What do you mean by demandforecasting?
2. Write a note on methods and Techniques of demand forecasting
3. Discuss the application of demand forecasting in Business activities
7.6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives an
idea about demand forecasting with respect to concept of demand
forecasting,procedure to prepare sales forecast,types of forecasting,classification of
demand forecasting, classification of demand forecasting on the basis of types of
products,the choice forecasting demand, forecasting demand for capital
goods,forecasting demand for new products, approaches of demand
forecasting,forecasting techniques,statistical method of demand forecasting,
90
demand forecasts in India,criteria of a good forecasting method,general approaches
to forecasting and experimental approaches to forecasting.
7.7. TERMINAL EXERCISE
1. Demand forecasting is important for
a) Price Control
b) Business Planning
c) Competitive Strategy
d) All of Above
2. Demand forecasting is important for
a) Price Control
b) Business Planning
c) Competitive Strategy
d) All of Above
7.8. SUPPLEMENTARY MATERIALS
1. Thomas J. Webster (2003). Managerial Economics: Theory and Practice, ch. 13
& 14, Academic Press. Description.
2. Prof. M.S. BHAT, and A.V. RAU.Managerial economics and financial
analysis.Hyderabad.ISBN 978-81-7800-153-1
3. Alan Hughes (1987). "managerial capitalism," The New Palgrave: A Dictionary of
Economics, v. 3, pp. 293–96.
7.9. ASSIGNMENT
1. Write a note on Application of Demand Forecasting techniques in managerial
decision making process
2. Discuss the Application of various statistical methods in demand Forecasting
7.10. SUGGESTED READINGS
1. Mansfield, Edwin and Mansfield, Edwin (2002) Managerial economics: theory,
applications, and cases. New York: W.W. Norton.
2. Png, Ivan (2012) Managerial economics. Abingdon, Oxon: Routledge.
3. Salvatore D. (2015) Managerial economics: principles and worldwide
applications. New York: Oxford University Press.
7.11. LEARNING ACTIVITIES
1. To conduct a group discussion on demand forecasting techniques
2. To conduct a workshop on application of demand forcasting techniques in
business
7.12. KEYWORDS
1. Demand forcasting,demand forcasting techniques, application of demand
forcasting techniques
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LESSON – 8
APPLICATION OF ELASICITY OF DEMAND IN MANAGERIAL
DECISION MAKING
8.1 INTRODUCTION
Elasticity of demand, or more specifically price elasticity of demand, is a
measure of percentage change in quantity demanded for one percentage change in
price of the good. Thus: Price elasticity of demand = percentage change in quantity
demanded)/in terms of percentage change in price Please note that when price
increases the quantity demanded decreases, and when price decreases the quantity
demanded increases. Because of this, strictly speaking the value of ratio as per the
above equation is negative, but for measuring demand elasticity we take the
positive value. This lesson deals with Application of elasticity of demand in
managerial decision. It outlines the applications of price elasticity of demand and
income elasticity of demand. This lesson points out the effects of elasticity of
demand in managerial applications.
8.2 OBJECTIVES
To study the application of price elasticity of demand
To examine the benefits of income elasticity of demand
To understand the factors determining the price elasticity of demand and
income elasticity of demand
8.3. CONTENT
8.3.1 Explanation of Elasticity of Demand
8.3.2 Application
3.3 3.Importance of Price Elasticity of Demand are Given Below:
8.3.4 Importance price elasticity of demand in International Trade of Price Elasticity
of Demand
8.3.5 Importance of price elasticity of demand in Determination of Factors Prices
8.3.6 Explanation of Paradox of Poverty
8.3.7 Elasticity of demand and Types of Products
8.3.8 Elasticity of demand and Types of Customers
8.3.9 Elasticity of demand and Product Life Cycle
8.3.10 Factors Determining Income Elasticity
8.3.1 Explanation of Elasticity of Demand
When the demand elasticity is more than one, we call the demand elastic. For
such type of demands, a reduction in price results in increase in total revenue.
When the demand elasticity is less than one, we call the demand inelastic. For such
type of demands, a reduction in price results in decrease in total revenue.When the
demand elasticity is more than one, we call the demand unit-elastic. For such type
of demands, the total revenue does not change the total revenue. Analysis of
elasticity of demand helps management to take decisions on pricing of products.
When price elasticity is less than one, any increase in price will reduce the total
revenue, but the costs will increase because of increased production. Therefore, the
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total profits will be reduced. In such cases it is best for management to not to
reduce the price. Rather they may consider increase in price.
When elasticity of demand is more than one, a reduction in price will increase
the total revenue. At the same time,the costs will also increase because of increase
in production volume. If this increase in the total cost is less than the increase in
total revenue then the company can increase its profits by reducing price.
8.3.2 Application of Price Elasticity of Demand
The price elasticity of demand for a certain good or service has considerable
implications for businesses. If an ice cream shop, for example, was to increase the
price of vanilla ice cream by ten percent, and if demand fell by 5 percent as a result,
management would then know that the price elasticity of demand for that
particular good was elastic. But if they also increased the price of their top-selling
flavor, chocolate, by the same amount, and if prices remained the same, then they
would have a relatively inelastic product. Thus, elasticity‘s differ with respect to
variety of product in question. Businesses must therefore make pricing decisions
based on these elasticity assumptions.
Impact on Business Management Problems
Price elasticity of demand affects a business's ability to increase the price of a
product. Elastic goods are more sensitive to increases in price, while inelastic goods
are less sensitive. Assuming that there are no costs in producing the product,
businesses would simply increase the price of a product until demand falls. Things
become more complicated, however, after introducing costs. Let's say that the cost
of vanilla flavoring increases as a result of short market supply. As profits equal
revenue minus costs, this would lower the ice cream shop's profits. If costs were
close to the price of vanilla ice cream, profits would be almost zero. As vanilla ice
cream is elastic, the shop manager would be unable to increase the price without
damaging demand. Some businesses, therefore, sell some goods that have little to
no profit margin. Their main profits come from products in higher demand. In this
case, the ice cream shop would increase the price of the more inelastic good,
chocolate ice cream, in order to compensate for the loss in profits.
The concept of price elasticity of demand has important practical applications
in managerial decision-making. A business man has often to consider whether a
lowering of price will lead to an increase in the demand for his product, and if so, to
what extent and whether his profits would increase as a result thereof. Here the
concept of elasticity of demand becomes crucial.Knowledge of the nature of the
elasticity of demand for his products will help a business to decide whether he
should cut his price in a particular case. Such knowledge would also help a
businessman to determine whether and to what extent the increase in costs could
be passed on to the consumer. In general for items those whose demand is elastic it
will pay him to charge relatively low prices, while on those whose demand is elastic,
it would be better off with a higher price. A monopolist would not be able to
increase his price if the demand for his product is elastic.
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In practice, an accurate estimate of the probable response of volume of sales to
price changes is extremely difficult. Moreover, the cost of the statistical analysis
required may in some cases, exceed the benefit especially when uncertainty is great
or when the volume is too small to provide a reason also return on the amount
spend on research. The subjective judgment of certain managers, beyond on years
of experience, sometimes exceeds in accuracy the best of the present statistical
techniques. Uses of price elasticity can be point out as below:Price distribution: A
monopolist adopts a price discrimination policy only when the elasticity of demand
of different consumers or sub-markets is different. Consumers whose demand is
inelastic can be charged a higher price than those with more elastic demand.
Public utility pricing: In case of public utilities which are run as monopoly
undertakings e.g. elasticity of water supply railways postal services, price
discrimination is generally practiced, charging higher prices from consumers or
users with inelastic demand and lower prices in case of elastic demand.Joint
supply: Certain goods, being products of the same process are jointly supplied, e.g.
wool and mutton. Here if the demand for wool is inelastic compared to the demand
for mutton, a higher price for wool can be charged with advantage.
Super Markets
Super-markets are a combined set of shops run by a single organization
selling a wide range of goods. They are supposed to sell commodities at lower prices
than charged by shopkeepers in the bazaar. Hence, price policy adopted is to
charge slightly lower price for goods with elastic demand.
Use of Machine: Workers often oppose use of machines out of fear of
unemployment. Machines need not always reduce demand for labor as this
depends on price elasticity of demand for the commodity produced. When machines
reduce costs and hence price of products, if the products demand is elastic, the
demand will go up, production will have to be increased and more workers may be
employed for the product is inelastic, machines will lead to unemployment as lower
prices will not increase the demand.
Factor Pricing: The factors having price inelastic demand can obtain a higher
price than those with elastic demand. Workers producing products having inelastic
demand can easily get their wages raised.
International Trade: (a) A country benefits from exports of products as have
price inelastic demand for a rise in price and elastic demand for a fall in price. (b)
The demand for imports should be inelastic for a fall in price and elastic for a rise
in price. (c) While deciding whether to devalue a country‘s currency or not, price
elasticity of demand for a country‘s exports would be an important factor to be
taken into consideration. If the demand is price elastic, it would lead to an increase
in the country‘s exports and devaluation would fail to achieve its objective.
Shifting of Tax Burden: It is possible for a business to shift a commodity tax
in case of inelastic demand to his customers. But if the demand is elastic, he will
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have to bear the tax burden himself, otherwise demand for his goods will go down
sharply.
Taxation Policy: Government can easily raise tax revenue by
taxingcommodities which are price inelastic.
8.3.3 Importance of Price Elasticity of Demand in Determination of price policy
While fixing the price of this product, a businessman has to consider the
elasticity of demand for the product. He should consider whether a lowering of
price will stimulate demand for his product, and if so to what extent and whether
his profits will also increase a result thereof. If the increase in his sales is more
than proportionate, to the reduction in price his total revenue will increase and his
profits might be larger. On the other hand, if increase in demand is less than
proportionate to fall in price, his total revenue we will fall and his profits would be
certainly less.Therefore, knowledge of elasticity of demand may help the
businessman to make a decision whether to cut or increase the price of his product
or to shift the burden of any additional cost of production on to the consumers by
charging high price. In general, for items having inelastic demand, the producer
will fix a higher price and items whose demand is elastic the businessman will fix a
lower price.
Price Discrimination
Price discrimination refers to the act of selling the technically same products
at different prices to different section of consumers or in different in sub-markets.
The policy of price-discrimination is profitable to the monopolist when elasticity of
demand for his product is different in different sub-markets. Those consumers
whose demand is inelastic can be charged a higher price than those with more
elastic demand.
Shifting of Tax Burden
To what extent a producer can shift the burden of indirect tax to the buyers by
increasing price of his product depends upon the degree of elasticity of demand. If
the demand is inelastic the larger part of the indirect tax can be shifted upon
buyers by increasing price. On the other hand if the demand is elastic than the
burden of tax will be more on the producer.
Taxation and Subsidy Policy
The government can impose higher taxes and collect more revenue if the
demand for the commodity on which a tax is to be levied is inelastic. On the other
hand, in ease of a commodity with elastic demand high tax rates may fail to bring
in the required revenue for the government. Govt should provide subsidy on those
goods whose demand is elastic and in the production of the commodity the law of
increasing returns operates.
8.3.4 Importance price elasticity of demand in International Trade
The concept of elasticity of demand is of crucial importance in many aspects
of international trade. The success of the policy of devaluation to correct the
adverse balance of payment depends upon the elasticity of demand for exports and
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imports of the country. The policy of devaluation would be beneficial when demand
for exports and imports is price-elastic. A country will benefit from international
trade when: (i) it fixes lower price for exports items whose demand is price elastic
and high price for those exports whose demand is inelastic (ii) the demand for
imports should be inelastic for a fall in price and inelastic for arise in price.
The terms of trade between the two countries also depends upon the elasticity
of demand of exports and imports of two countries. If the demand is inelastic, the
terms of trade will be in favour of the seller country.
8.3.5 Importance of price elasticity of demand in Determination of Factors Prices
Factor with an inelastic demand can always command a higher price as
compared to a factor with relatively elastic demand. This helps the trade unions in
knowing that where they can easily get the wage rate increased. Bargaining
capacity of trade unions depend upon elasticity of demand for workers services.
Determination of Sale Policy for Supper Markets
Super Markets is a market where in a variety of goods are sold by a single
organization. These items are generally of mass consumption. Therefore, the
organization is supposed to sell commodities at lower prices than charged by
shopkeepers in the other bazars. Thus, the policy adopted is to charge a slightly
lower price for items whose demand is relatively elastic and the costs are covered by
increased sales.
Pricing of Joint Supply Products
The goods that are produced by a single production process are joint supply
products. The cost of production of these goods is also joint. Therefore, while
determining the prices of these products their elasticity of demand is considered.
The price of a joint supply product is fixed high if its demand is inelastic and low
price is fixed for that joint supply product whose demand is elastic.
Effect of Use of Machines on Employment
Ordinarily it is thought that use of machines reduced the demand for labour.
Therefore, trade unions often oppose the use of machines fearing unemployment.
But this fear is not always true because use of machines may not reduce demand
for labour. It depends on the price elasticity of demand for the products.The use of
machines may reduce the cost of production and price. If the demand of the
product is elastic then the fall in price will increase demand significantly. As a
result of increased demand the production will also increase and more workers will
be employed. In such cases concept of elasticity of demand help the management to
pacify the trade unions. But if the demand of the product is inelastic than use of
more machines will cause unemployment.
Public Utilities
The nationalization of public utility services can also be justified with the help
of elasticity of demand. Demand for public utilities such as electricity, water
supply, post and telegraph, public transportation etc. is generally inelastic in
nature. If the operation of such utilities is left in the hand of private individuals,
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they may exploit the consumers by charging high prices. Therefore, in the interest
of general public, the government owns and runs such services.
The public utility enterprises decide their price policy on the basis of
elasticity of demand. A suitable price policy for public utility enterprises is to
charge from consumers according to their elasticity of demand for public utility.
8.3.6 Explanation of Paradox of Poverty
Exceptionally good harvest brings poverty to the farmers and this situation is
called ‗Paradox of Poverty‘. This paradox is easily explained by the inelastic nature
of demand for most farm products. Since the demand is inelastic, prices of farm
products fall sharply as a result of large increase in their supply in the year of
bumper crops. Due to sharp fall in prices, the farmers get less income even by
selling larger quantity.This paradox of poverty is the basis of regulation and control
of farm products prices. Government fixes the minimum prices of farm products
because the demand for farm products is inelastic. Thus, the concept of elasticity of
demand helps the government in determining its agricultural policies.
Output Decisions
The elasticity of demand helps the businessman to decide about production. A
businessman chooses the optimum product- mix on the basis of elasticity of
demand for various products.The products having more elastic demand are
preferred by the businessmen. The sale of such products can be increased with a
little reduction in their prices. From the above discussion it is amply clear that
price elasticity of demand is of great significance in making business decisions.
Income elasticity measures the relationship between sales and consumers'
incomes, according to business expert, Graeme Pietersz, at Moneyterms.co.uk.
Small-business sales are likely to fall when consumers' incomes fall. This can be
highly evident during economic recessionary periods. People have less disposable
income during recessions. Some may not have jobs at all. Hence, companies need
to center their marketing strategies and decision making around the statuses of
consumers' incomes.
8.3.7 Elasticity of demand and Types of Products
Certain types of products are more affected by income elasticity. Consumers
usually take care of their basic needs when income elasticity is high. For example,
people need food, water, shelter and personal-care items. However, consumers
often cut back on luxury items when their incomes are limited. Consequently,
marketers of sports cars, vacations and computers may need to offer extra
incentives to spur sales, including discounts, long-term payments or "no money
down" deals. Food companies and restaurants are not exempt from income
elasticity. Small food companies may need to lower prices to compete with generic
brands, items consumers often buy during tough economic periods. When a
company's production costs get too high, it may also cut portions or sizes of their
brands, or use cheaper paper in packaging.
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8.3.8 Elasticity of demand and Types of Customers
A strategy for a small company is to focus marketing efforts on higher-income
consumers when consumer income elasticity is high. These individuals may be less
sensitive to price changes. Marketers may also target certain types of consumers
known for being the first to buy new products. "Innovators" are the consumers who
are first to buy new products. They typically represent about 2 percent of a
company's market, according to The Business Journal online. Adopters are the next
group of consumers to buy new products, representing about 15 percent of a
company's customers. Savvy small companies may stand to earn higher revenues
and profits by selling their products in locations innovators and adopters typically
shop. For example, a small manufacturer may start selling more to specialty stores
if this is where the innovators and adopters shop.
8.3.9 Elasticity of demand and Product Life Cycle
Income elasticity also comes into play with product life-cycle management.
Overall demands for products are usually higher during their introduction and
growth stages. The challenge comes as a product ages and more substitutes
become available. This usually happens in the maturity or decline stages of the
product life cycle. A small company may need to diversify its product line to attract
consumers with less disposable income. One way to accomplish this is to provide
new features, flavors or fragrances for the products while keeping prices the same.
A small company may also need to find new uses for their products to attract
customers with more disposable income. For example, a consumer soap
manufacturer may find that its products also sell well among workers in plants and
factories. The plants and factories would be the new market -- one that may be less
sensitive to price changes. And these entities would foot the bill for the products
instead of the consumers.
8.3.10 Factors Determining Income Elasticity
An easy way to determine income elasticity is through marketing research
surveys. Companies may divide users up into different income groups, and then
determine how their incomes impact their purchases. The surveyor could list
certain types of products and determine price ranges for which people are willing to
pay. Business owners could then use the information to determine the price ranges
for their entire product line.Income elasticity shows fluctuations in demand for
goods or services as precipitated by changes in the purchasing power of consumers.
Consumers adjust their spending habits along with changes in their disposable
income. The higher the disposable income, the greater the ability of consumers to
afford expensive items, and vice versa. This may either enhance or diminish your
business prospects depending on your industry of specialization. As such, your
business decisions should be sensitive to the impact of income elasticity on your
particular industry.
Coefficients of Elasticity
A coefficient is a metric that expresses the income elasticity of demand for a
particular product or service. To calculate your coefficient of income elasticity,
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divide the percentage change in the quantity of demand for a product by the
percentage change in income. This formula may yield either a positive or negative
elasticity.
Positive Elasticity
Positive income elasticity is a situation where the demand for a particular
product increases with growth in income levels and decreases with decline in
income. This type of elasticity is associated with superior products. McConnell Brue
Flynn, author of the online edition of Economics one9e, identifies restaurant
meals, automobiles and housing as some examples of superior goods. Positive
elasticity prevails during periods of economic prosperity because consumers earn
more money from their employment or business activities.
Negative Elasticity
Negative income elasticity prevails when the demand for certain products,
usually referred to as inferior goods, decline as a result of rising income. The
demand for these products increases with dipping income levels. These goods are
essential, and consumers must have them by all means, regardless of a fall in
income levels. As such, consumer preferences for inferior goods rise during periods
of economic decline. For example, consumers may opt to use public transport
instead of driving when oil prices rise as a result of inflation. This means that
higher demand for bus tickets would have been occasioned by falling income levels
among consumers.
Economic Growth
The dynamics of income elasticity reflect the trends of economic growth.
Income levels increase with economic growth and decrease with economic decline. It
is imperative to adjust your small-business activities according to changes in
economic conditions. For example, when incomes fall as a result of economic
downturn, demand for non-essential items such as jewelry and luxury vacations
drops. One has to be cautious and produce or stock fewer non-essential items
during such periods of economic decline.
8. 4. REVISION POINTS
1. Application of Elasticity of demand
2. Application of price Elasticity of demand
3. Importance of price Elasticity of demand
4. Determinants of Elasticity of demand
8. 5. INTEX QUESTIONS
1. What are the applications of Elasticity of demand in managerial decision making?
2. Write a note on benefits of income Elasticity of demand in managerial Applications
8. 6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives a broad
knowledge about the price Elasticity of demand with respect to explanation of
elasticity of demand, application 3.3 importance of price elasticity of demand are
given below, importance price elasticity of demand in international trade of price
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elasticity of demand, importance of price elasticity of demand in determination of
factors prices, explanation of paradox of poverty, elasticity of demand and types of
products, elasticity of demand and types of customers, elasticity of demand and
product life cycle and factors determining income elasticity. In nutshell one can
benefit from the subject matter coverage in this lesson.
8. 7. TERMINAL EXERCISE
1. Which of the following is NOT included in the decisions that every society must
make?
a) what goods will be produced
b) who will produce goods
c) what determines consumer preferences
d) who will consume the goods
2. Decision making situations can be categorized along a scale which ranges from:
a) Uncertainty to certainty to risk
b) Certainty to uncertainty to risk
c) Certainty to risk to uncertainty
d) Certainty to risk to uncertainty to ambiguity
8. 8. SUPPLEMENTARY MATERIALS
1. William J. Baumol (1961). "What Can Economic Theory Contribute to
Managerial Economics?," American Economic Review, 51(2), pp. 142-46
2. Carl Shapiro (1989). "The Theory of Business Strategy," RAND Journal of
Economics, 20(1), pp. 125-137
3. Thomas J. Webster (2003). Managerial Economics: Theory and Practice, ch. 13
& 14, Academic Press. Description.
8. 9. ASSIGNMENT
1. Write a note on areas of application of price elasticity of demand
2. Discuss the types of managerial decisions to be taken through income elasticity
of demand
8. 10. SUGGESTED READINGS
1. Baye, Michael R. (2010) Managerial economics and business strategy. Vol. The
McGraw-Hill series economics. New York: McGraw-Hill/Irwin.
2. Boyes, William J. (2012) Managerial economics: markets and the firm. Boston,
Mass: Houghton Mifflin.
8. 11. LEARNING ACTIVITIES
1. To conduct a workshop on application of price elasticity of demand
2. To conduct a group discussion on benefits of income elasticity of demand
8. 12. KEYWORDS
1. Price elasticity of demand, income elasticity of demand, managerial decision
making.
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UNIT–III : COST ANALYSIS AND PRODUCTION
LESSON – 9
COST CONCEPT
9.1 INTRODUCTION
In production, research, retail, and accounting, a cost is the value of money
that has been used up to produce something, and hence is not available for use
anymore. In business, the cost is one of acquisition, in which case the amount of
money expended to acquire it is counted as cost. In this case, money is the input
that is gone in order to acquire the thing. This acquisition cost may be the sum of
the cost of production as incurred by the original producer, and further costs of
transaction as incurred by the acquirer over and above the price paid to the
producer. Usually, the price also includes a mark-up for profit over the cost of
production. This lesson deals with cost concept relating to various types of cost and
cost curves. This lesson points out the output and cost.
9.2 OBJECTIVES
To study the various components of cost
To measure the cost components
To understand the output and cost relationship
9.3. CONTENT
9.3.1 Money Cost and Real Cost
9.3.2 Accounting Cost and Economic Cost
9.3.3 Accounting Profit = Sales Income - Accounting Cost
9.3.4 Private Cost and Social Cost
9.3.5 Fixed Cost, Variable Cost, Average Cost and Marginal Cost
9.3.6 Economic Cost
9.3.7 Types of Economic Costs
9.3.8 Cost measurement
9.3.9 Cost Curves for a Firm
9.3.10 Long-Run Cost with Constant Returns to Scale
9.3.11 Opportunity Cost
9.3.12 Output and cost
9. 3.1Money Cost and Real Cost
Money Cost of production is the actual monetary expenditure made by
company in the production process. Money cost thus includes all the business
expenses which involve outlay of money to support business operations. For
example the monetary expenditure on purchase of raw material, payment of wages
and salaries, payment of rent and other charges of business etc can be termed as
Money Cost.
Real Cost of production or business operation on the other hand includes all
such expenses/costs of business which may or may not involve actual monetary
expenditure. For example if owner of a business venture uses his personal land and
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building for running the business venture and he/she does not charge any rent for
the same then such head will not be considered/included while computing the
Money Cost but this head will be part of Real Cost computation. Here the cost
involved is the Opportunity Cost of the land and building. If the promoter of the
company had not used the land and building for the business venture then the
land and building could have been used elsewhere for some other enture and could
have generated some income for the promoter. This income/rent which could have
been earned under the next best investment option is the opportunity cost which
needs to be considered while calculating the Real Cost for the firm.
9.3.2 Accounting Cost and Economic Cost
Accounting Cost includes all such business expenses that are recorded in the
book of accounts of a business firm as acceptable business expenses. Such
expenses include expenses like Cost of Raw Material, Wages and Salaries, Various
Direct and Indirect business Overheads, Depreciation, Taxes etc. When such
business expenses or accounting expenses are deducted from the Sales income of
any firm the accounting profit is obtained. Such Accounting/Business expenses or
costs are also termed as Explicit Costs.
Accounting Cost: Various allowed business expenses. Such as Cost of Raw
Material, Salaries and Wages, Electricity Bill, Telephone Charges, Various
Administrative Expenses, Selling and Distribution Expenses, Production Overhead
Expenses, Other Indirect Overhead Expenses etc.
9.3.3 Accounting Profit = Sales Income - Accounting Cost
Economic Cost on the other hand includes all the accounting expenses as well
as the Opportunity cost of a business firm. Economic Cost and Economic
Profit is thus calculated as follows:
Economic Cost = Accounting Cost (Explicit Costs) + Opportunity Cost
Economic Profit = Total Revenues - (Accounting Cost + Opportunity Cost)
9.3.4 Private Cost and Social Cost
The actual expenses of individuals/ firms which are borne or paid out by the
individual or a firm can be termed as Private Cost. Thus for a business firm this
may include expenses like Cost of Raw Material, Salaries and Wages, Rent, Various
Overhead Expenses etc.
On the other hand Private Cost for an individual will be his or her private
expenses such as expense on food, rent of house, expenses on clothing, expenses
on travel, expenses on entertainment etc.
Social Cost on the other hand includes Private Cost and also such costs which
are not borne by the firm but by the society at large. For example the cost of
damage or disutility caused by the operations of a firm in an economy may not be
borne by the firm in question but it impacts the society at large and thus such cost
is added to the Private Cost to find the Social Cost of producing the product. Such
Cost (that is cost not borne or paid out by the firm) is also known as External Cost.
Another example of external cost can be the cost of providing the basic
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infrastructure facilities like good roads, sewage system or network, street lights etc.
Cost of such facilities is not borne by a business firm even though the firm is
benefits from such facilities. Such External Costs are thus added to the Private
Cost to find the Social Cost of producing a product or good.
Above can be understood by following example: If a Tannery firm (A firm
processing animal skins) releases its toxic wastes in the river flowing nearby its
factory premises then this act of the Tannery firm results in water pollution and
environmental damage. The Cost of such damage/loss (also known as External
Cost) is added to the private costs of the tannery firm to get fair idea of Social cost
involved in the production of the product in question. Social Cost of an individual
will include his private cost and the cost of damage on account of his actions that
has resulted in doing harm/damage to the environment/society at large.
9.3.5 Fixed Cost, Variable Cost, Average Cost and Marginal Cost
Fixed Cost is that cost which does not change (that is either goes up or goes
down) irrespective of whether the firm is operating or not. For example on account
of Strike on account of Lockout in Maruti-Suzuki‘s Manesar plant the production
process stands still. Even when the plant is not operating the Firm still has to bear
such expenses which are indirect in nature. For Example Rent of the factory
premises, Wages of administrative employees etc. In other Fixed cost is not related
direct production/manufacturing expenses.
Variable Cost on the Other hand is directly proportional to the production
operations. As the size of production at any business grows, along with that grow
the variable expenses. As the name suggests, the variable expenses vary with the
business operations. When the firm is not operating on account of Strike/Lockout
etc, then the variable cost of the firm is Zero. Average Cost is the cost that is
obtained after dividing Total Cost with the number of units produced.
9.3.6 Economic Cost
Economic cost is the gains and losses in money, time and resources of one
course of action compared to another. The comparison includes the gains and losses
precluded by taking a course of action, as the those of the course taken itself.
Economic cost differs from accounting cost because it includes opportunity cost.
Example As an example considers the economic cost of attending college. The
accounting cost of attending college includes tuition, room and board, books, food,
and other incidental expenditures while there. The opportunity cost of college also
includes the salary or wage that otherwise could be earned during the period. So for
the two to four years an individual spends in school, the opportunity cost includes
the money that one could have been making at the best possible job. The economic
cost of college is the accounting cost plus the opportunity cost.
Thus, if attending college has a direct cost of Rs.20,000 a year for four years,
and the lost wages from not working Rs.25,000 a year, then the total economic cost
of going to college would be Rs.180,000 (Rs.20,000 x 4 years + the interest of
Rs.20,000 for 4 years + Rs.25,000 x 4 years).
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9.3.7 Types of Economic Costs
Variable cost: Variable costs are the costs paid to the variable input. Inputs
include labour, capital, materials, power and land and buildings. Variable inputs
are inputs whose use varies with output. Conventionally the variable input is
assumed to be labor. Total variable cost (TVC) total variable cost is the same as
variable costs. Fixed cost (TFC) fixed costs are the costs of the fixed assets those
that do not vary with production.
Total fixed cost (TFC)
Average cost (AC) average cost is total costs divided by output. AC = TFC/q +
TVC/q Average fixed cost (AFC) = fixed costs divided by output. AFC = TFC/q. The
average fixed cost function continuously declines as production increases.
Average variable cost (AVC) = variable costs divided by output. AVC =TVC/q. The
average variable cost curve is typically U-shaped. It lies below the average cost curve
and generally has the same shape - the vertical distance between the average cost
curve and average variable cost curve equals average fixed costs. The curve normally
starts to the right of the y axis because with zero production, Marginal cost (MC)
COST THEORY
9.3.8 Cost measurement
n Accounting Cost Consider only explicit cost, the out of pocket cost for such
items as wages, salaries, materials, and property rentals n Economic Cost.
Considers explicit and opportunity cost. –Opportunity cost is the cost associated
with opportunities that are foregone by not putting resources in their highest
valued use. n Sunk Cost An expenditure that has been made and cannot be
recovered--they should not influence a firm‘s decisions.
Cost in the Short Run
Total output is a function of variable inputs and fixed inputs. nTherefore, the
total cost of production equals the fixed cost (the cost of the fixed inputs) plus the
variable cost (the cost of the variable inputs)- Fixed costs do not change with
changes in output-Variable costs increase as output increases.n Marginal Cost
(MC) is the cost of expanding output by one unit. Since fixed cost has no impact
on marginal cost, it can be written as
∆𝑉𝐶 ∆𝑇𝐶
𝑀𝐶 = =
∆𝑄 ∆𝑄
nAverage Total Cost (ATC) is the cost per unit of output, or average fixed cost
(AFC) plus average variable cost (AVC).
𝑻𝑭𝑪 𝑻𝑽𝑪 𝑻𝑪
This can be written: n 𝑨𝑻𝑪 = 𝑸
+ 𝑸
𝑨𝑻𝑪 = 𝑨𝑭𝑪 + 𝑨𝑽𝑪𝒐𝒓 𝑸
The Determinants of Short-Run Cost
The relationship between the production function and cost can be exemplified
by either increasing returns and cost or decreasing returns and cost.
Increasingreturns and cost–With increasing returns, output is increasing
relative to input and variable cost and total cost will fall relative to output.
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Decreasing returns and cost– With decreasing returns, output is
decreasing relative to input and variable cost and total cost will rise relative to
output.
Cost in the Short Run
For Example: Assume the wage rate (w) is fixed relative to the number of
workers hired. Then: MC-Marginal Cost, VC-Variable cost, VC-Average variable
cost
∆Variable cost
Marginal Cost = Variable cost = 𝑤𝐿
∆𝑄
𝑤∆𝐿 𝑤
∆Variable cost = 𝑤∇𝐿 Marginal Cost = ∆𝑄 Marginal Cost = 𝑀𝑃
𝐿
Conclusion: A low marginal product (MP) leads to a high marginal cost (MC)
and vise versa.AVC and the Production Function
𝑤
𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛𝐿=𝑄 Average variable cost
𝐿 𝐴𝑃𝐿
If a firm is experiencing increasing returns, average production is increasing
and Average variable cost will decrease. If firms are experiencing decreasing
returns, average production is decreasing and Average variable cost will
increase.The production function (marginal production&average production) shows
the relationship between inputs and output. The cost measurements show the
impact of the production function in dollar terms.
9.3.9 Cost Curves for a Firm
TC
VC
400
Price ($ per unit)
B
300
200
A
100
0 1 2 3 4 5 6 7 8 9 10 11 13
Output (unit per year)
105
Fig-1
In drawn from the origin to the tangent of the variable cost curve Fig-1:Its
slope equals AVCthe slope of a point on VC equals MC
Therefore, MC = AVC at 7 units of output (point A). The line drawn from the
origin to the tangent of the total cost curve: The slope of a tangent equals the
slope of the point.ATC at 8 units = MCOutput = 8 units.
Cost Curves for a Firm
MC
100
75
Price ($ per unit)
50
Marginal
decrease initially
then increases
25
ATC
AVC
AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (unit per year)
Unit Costs, AFC f
fig-2
Continuously, When MC<AVC or MC<ATC, AVC&ATC decrease,When MC > AVC or
MC > ATC, AVC & ATC increase
Fig-2:Reveals that MC = AVC and ATC at minimum AVC and ATC,
MinimumAVCoccurs at a lower output than minimum ATC due to FC, Long-Run
Versus Short-Run Cost Curves, Long-Run Average Cost (LAC), Constant Returns to
Scale, If input is doubled, output will double and average cost is constant at all
levels of output, Increasing Returns to Scale, If input is doubled, output will
more than double and average cost decreases at all levels of output.
106
107
Decreasing Returns to Scale
If input is doubled, the increase in output is less than twice as large and
average cost increases with output.
Long-Run Versus Short-Run Cost Curves
Long-Run Average Cost (LAC), In the long-run, Firms experience. Increasing
and decreasing returns to scale and therefore long-run average cost is ―U‖ shaped.
Long-Run Average Cost (LAC)
Long-run marginal cost leads long-run average cost: If LMC < LAC, LAC will
fall, If LMC > LAC, LAC will rise, Therefore, LMC = LAC at the minimum of LAC
Long-Run versus Short-Run Cost Curves
The Relationship Between Short-Run and Long-Run CostWe will use short and
long-run cost to determine the optimal plant size.
9.3.10 Long-Run Cost with Constant Returns to Scale
SAC1 SAC3
SAC2
SMC1 LAC=LMC
Price ($ per unit of out put)
SMC2 SMC3
Q1 Q2 Q3
LAC
SAC2
SMC3
LMC SMC2
Q1 Output
Fig-4
What is the firms’ long-run cost curve?
Firms can change scale to change output in the long-run, The long-run cost
curve is the dark blue portion of the SAC curve which represents the minimum cost
for any level of output.
Observations
The LAC does not include the minimum points of small and large size plants?
LMC is not the envelope of the short-run marginal cost, Breakeven Analysis,
1.Linear Breakeven Analysis, Profit= TR – TC, = (PQ)-[(Q*AVC)+FC]Example 7-4 on
page 263
9.3.11 Opportunity Cost
The resources of any firm operating in the market are limited and investment
options are many. The firm therefore has to decide or select only those investment
opportunities/options which provide the firm with the best return or best income
on investment. This means that if a firm can invest money/ resources only in one
investment option then the firm will select that investment option which promises
best return on investment to the firm. In other words while doing so the firm gives
up/rejects the next best option for investing the funds. The opportunity cost of a
company is thus this income/ return which the firm could have earned on the next
best investment alternative.
This can also be understood by a simple example - Let us assume that an
individual has two job offers in hand. One job offer is promising him a salary of Rs.
30, 000 per month while the other job offer will ensure salary of Rs. 25, 000 per
month. If the job profile and other factors related to the job offers are more or less
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same then it can be easily expected that the individual will select the job offer
which will provide him with higher salary that is salary of Rs. 30, 000 per month.
Thus, in this case, the opportunity cost is the return involved in the next best
alternative i.e; Salary of Rs. 25, 000 in the next best job offer.
Concept of opportunity cost is closely related to the concept of Economic profit
or Economic Rent. A firm earns or makes Economic profit only when besides
covering various costs of operation, a firm is also able to earn more than its
opportunity cost (or its possible earnings under the next best investment
alternative). Opportunity Cost is also termed as Implicit Cost.
9.3.12 Output and cost
Production decision time frame
Short run is the time span between one where the quantity of no input is
variable and where the quantities of all inputs are variable. Simply put, at least one
input is fixed. Long run is a frame in which the quantities of all inputs can be
changed. Put another way, there is no fixed input in the long run.
Sunk cost
We use concept of sunk cost to describe such investment-the cost already
incurred which cannot be recovered regardless of future vents. When a firm makes
production decisions, it should ignore sunk cost. The only relevant costs that
influence its decisions are the cost of changing variable inputs and the long-run
cost of changing its plant.
Short-run production
The production function is a table, a graph, or an equation showing the
maximum product output achieved from any specified set of inputs. The function
summarizes the characteristics of existing technology at a given time.
Average product (AP) is the ratio of total to the quantity of an input used to
produce the product. For example, the average product of labour is
AP=, holding K constant
Marginal product (MP) is the change in output that results from one additional
unit of a factor of production, all other factors remaining constant. For example, the
marginal product of labour is
MP= or MP= holding K constant
The general relation between marginal product and average product is:
MP<AP AP declines
MP>AP AP rises
MP=AP AP is maximized
The marginal cost (MC) of an additional unit output is the cost of the
additional inputs needed to produce that output. Mathematically, the marginal cost
is the derivative of total production costs with respect to the level of output.
IfTVC is the change in total variable costs resulting from a change in output
ofQ and if TFC is the changes in total fixed in total costs resulting from a
changes in output of Q then,
∆𝑇𝑉𝐶 + ∆𝑇𝐹𝐶
𝑀𝐶 =
∆𝑄
But TFC is constant in the short-run, which means that TFC is zero; therefore
∆𝑇𝑉𝐶 ∆𝐿
𝑀𝑃 = =𝑊∗
∆𝑄 ∆𝐿
Recall that we defined MP as
∆𝑄
𝑀𝑃 =
∆𝐿
Therefore we can rewrite MC as
1
𝑀𝐶 = 𝑊 ∗
Average total cost and average variable cost initially decreases, reach a
minimum, and then increase as output increases. The average total cost curve is
the vertical summation of the average fixed cost and the average variable cost at
their minimum level. Moreover, when marginal cost is above the average cost,
average cost rises. Average total cost because the increase in average variable cost
are, up to a point, more than offset by decreases in average fixed cost.
1) Technology. AP
AP and MP
2) Prices of inputs.
Diagram
MP
Phase A: rising MP and falling MC; rising
at Phase B.
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LESSON – 10
COST ACCOUNTING
10.1INTRODUCTION
Cost accounting is a process of collecting, analyzing, summarizing and
evaluating various alternative courses of action. Its goal is to advise the management
on the most appropriate course of action based on the cost efficiency and capability.
Cost accounting provides the detailed cost information that management needs to
control current operations and plan for the future. This lesson deals with cost
accounting. It outlines the financial accounting, and cost accounting procedures and
mode of calculating cost. It outlines the costing methods.
10.2 OBJECTIVES
To study the financial accounting, and cost accounting procedure
To understand the cost accounting methods
To examine the costing procedure
10.3. CONTENT
10.3.1Need for cost Accounting
10.3.2 Origin of cost accounting
10.3.3 Cost Accounting vs Financial Accounting
10.3.4 Types of cost accounting
10.3.5 Classification of costs
10.3.6 Decision Making Cost
10.3.7 Relevant Cost
10.3.8 Capacity Cost
10.3.9 Business development of throughput accounting
10.3.10 Activity-based costing
10.3.11 Integrating EVA and Process Based Costing
10.3.12 Lean accounting
10.3.13 Marginal costing
10.3.14 Contribution Margin Ratio
10.3.15 Implicit Costs
10.3.16 Explicit Costs
10.3.17 Accounting Profit
10.3.1Need for cost Accounting
Since managers are making decisions only for their own organization, there is
no need for the information to be comparable to similar information from other
organizations. Instead, information must be relevant for a particular environment.
Cost accounting information is commonly used in financial accounting information,
but its primary function is for use by managers to facilitate making decisions.
Unlike the accounting systems that help in the preparation of financial reports
periodically, the cost accounting systems and reports are not subject to rules and
standards like the Generally Accepted Accounting Principles. As a result, there is
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wide variety in the cost accounting systems of the different companies and
sometimes even in different parts of the same company or organization.
10.3.2 Origin of cost accounting
All types of businesses, whether service, manufacturing or trading, require
cost accounting to track their activities. Cost accounting has long been used to help
managers understand the costs of running a business. Modern cost accounting
originated during the industrial revolution, when the complexities of running a
large scale business led to the development of systems for recording and tracking
costs to help business owners and managers make decisions.
In the early industrial age, most of the costs incurred by a business were what
modern accountants call "variable costs" because they varied directly with the
amount of production. Money was spent on labor, raw materials, power to run a
factory, etc. in direct proportion to production. Managers could simply total the
variable costs for a product and use this as a rough guide for decision-making
processes.
Some costs tend to remain the same even during busy periods, unlike variable
costs, which rise and fall with volume of work. Over time, these "fixed costs" have
become more important to managers. Examples of fixed costs include the
depreciation of plant and equipment, and the cost of departments such as
maintenance, tooling, production control, purchasing, quality control, storage and
handling, plant supervision and engineering. In the early nineteenth century, these
costs were of little importance to most businesses. However, with the growth of
railroads, steel and large scale manufacturing, by the late nineteenth century these
costs were often more important than the variable cost of a product, and allocating
them to a broad range of products led to bad decision making. Managers must
understand fixed costs in order to make decisions about products and pricing.
For examplea company produced railway coaches and had only one product.
To make each coach, the company needed to purchase $60 of raw materials and
components, and pay 6 laborers Rs.40 each. Therefore, total variable cost for each
coach was Rs.300. Knowing that making a coach required spending Rs. 300,
managers knew they couldn't sell below that price without losing money on each
coach. Any price above Rs.300 became a contribution to the fixed costs of the
company. If the fixed costs were, say, Rs.1000 per month for rent, insurance and
owner's salary, the company could therefore sell 5 coaches per month for a total of
Rs.3000 (priced at Rs.600 each), or 10 coaches for a total of Rs.4500 (priced at
Rs.450 each), and make a profit of Rs.500 in both cases.
10.3.3 Cost Accounting vs Financial Accounting
Cost Accounting vs Financial AccountingFinancial accountingFinancial
accounting aims at finding out results of accounting year in the form of Profit and
Loss Account and Balance Sheet. Cost Accounting aims at computing cost of
production/service in a scientific manner and facilitates cost control and cost
reduction.Financial accounting reports the results and position of business to
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government, creditors, investors, and external parties.Cost Accounting is an
internal reporting system for an organization‘s own management for decision
making.In financial accounting, cost classification based on type of transactions,
e.g. salaries, repairs, insurance, stores etc. In cost accounting, classification is
basically on the basis of functions, activities, products, process and on internal
planning and control and information needs of the organization.
Financial accounting aims at presenting ‗true and fair‘ view of transactions,
profit and loss for a period and Statement of financial position (Balance Sheet) on a
given date. It aims at computing ‗true and fair‘ view of the cost of
production/services offered by the firm.
10.3.4 Types of cost accounting
The following are different cost accounting approaches:Standard cost
accountingLean accountingActivity-based costingResource consumption
accountingThroughput accountingLife cycle costingEnvironmental
accountingTarget costingElements of cost[edit]Basic cost elements are:Raw
materialsLaborexpenses/overheadMaterial (Material is a very important part of
business) Direct material/Indirect materialLabor Direct labor/Indirect
laborOverhead (Variable/Fixed) Production or works overheadsAdministration
overheadsSelling overheads. Distribution overheadsMaintenance &
RepairSuppliesUtilitiesOther Variable ExpensesSalariesOccupancy
(Rent)DepreciationOther Fixed Expenses(In some companies, machine cost is
segregated from overhead and reported as a separate element)
10.3.5 Classification of costs
Classification of costs Classification of cost means, the grouping of costs
according to their common characteristics. The important ways of classification of
costs are:
By Element: There are three elements of costing i.e. material, labor and
expenses, By Nature or Traceability:Direct Costs and Indirect Costs. Direct Costs
are directly attributable/traceable to Cost Object. Direct costs are assigned to Cost
Object. Indirect Costs are not directly attributable/traceable to Cost Object. Indirect
costs are allocated or apportioned to cost object, 3.By Functions:
production,administration, selling and distribution, R&D, by Behavior: fixed,
variable, semi-variable. Costs are classified according to their behavior in relation to
change in relation to production volume within given period of time. Fixed Costs
remain fixed irrespective of changes in the production volume in given period of
time. Variable costs change according to volume of production. Semi-variable costs
are partly fixed and partly variable, By control ability: controllable, uncontrollable
costs. Controllable costs are those which can be controlled or influenced by a
conscious management action. Uncontrollable costs cannot be controlled or
influenced by a conscious management action.
By normality: Normal costs and abnormal costs. Normal costs arise during
routine day-to-day business operations. Abnormal costs arise because of any
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abnormal activity or event not part of routine business operations. E.g. costs
arising of floods, riots, and accidents etc, By Time: Historical Costs and
Predetermined costs. Historical costs are costs incurred in the past. Predetermined
costs are computed in advance on basis of factors affecting cost elements. Example:
Standard Costs.
10.3.6 Decision Making Cost
By Decision making Costs: These costs are used for managerial decision
making, Marginal Costs: Marginal cost is the change in the aggregate costs due to
change in the volume of output by one unit.Differential Costs: This cost is the
difference in total cost that will arise from the selection of one alternative to the
other.Opportunity Costs: It is the value of benefit sacrificed in favor of an
alternative course of action.
10.3.7 Relevant Cost
Relevant Cost: The relevant cost is a cost which is relevant in various decisions
of management, Replacement Cost: This cost is the cost at which existing items of
material or fixed assets can be replaced. Thus this is the cost of replacing existing
assets at present or at a future date, Shutdown Cost: These costs are the costs
which are incurred if the operations are shut down and they will disappear if the
operations are continued.
10.3.8 Capacity Cost
These costs are normally fixed costs. The cost incurred by a company for
providing production, administration and selling and distribution capabilities in
order to perform various functions.
Other Costs
In modern cost account of recording historical costs was taken further, by
allocating the company's fixed costs over a given period of time to the items
produced during that period, and recording the result as the total cost of
production. This allowed the full cost of products that were not sold in the period
they were produced to be recorded in inventory using a variety of complex
accounting methods, which was consistent with the principles of GAAP (Generally
Accepted Accounting Principles). It also essentially enabled managers to ignore the
fixed costs, and look at the results of each period in relation to the "standard cost"
for any given product.
For example: if the railway coach company normally produced 40 coaches per
month, and the fixed costs were still $1000/month, then each coach could be said
to incur an Operating Cost/overhead of $25 =($1000 / 40). Adding this to the
variable costs of $300 per coach produced a full cost of $325 per coach.
This method tended to slightly distort the resulting unit cost, but in mass-
production industries that made one product line, and where the fixed costs were
relatively low, the distortion was very minor.
For example: if the railway coach company made 100 coaches one month, then
the unit cost would become Rs.310 per coach (Rs.300 + (Rs.1000 / 100). If the next
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month the company made 50 coaches, then the unit cost = Rs.320 per coach
(Rs.300 + (Rs.1000 / 50), a relatively minor difference.
An important part of standard cost accounting is a variance analysis, which
breaks down the variation between actual cost and standard costs into various
components including volume variation, material cost variation, labor cost
variation, etc. so managers can understand why costs were different from what was
planned and take appropriate action to correct the situation.
10.3.9 Business development of throughput accounting
As business became more complex and began producing a greater variety of
products, the use of cost accounting to make decisions to maximize profitability
came into question. Management circles became increasingly aware of the Theory of
Constraints in the 1980s, and began to understand that "every production process
has a limiting factor" somewhere in the chain of production. As business
management learned to identify the constraints, they increasingly adopted
throughput accounting to manage them and "maximize the throughput dollars" (or
other currency) from each unit of constrained resource. Throughput accounting
aims to make the best use of scarce resources (bottle neck) in a JIT environment.[4]
Mathematical formula
throughput=sales revenue-totally variable costs
𝑟𝑒𝑡𝑢𝑟𝑛
throughput accounting ratio=𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑜𝑢𝑟𝑠
PRODUCER
COMMUNITY
· Employees
· Society
Money Market
Monetary
process
Monetary Market
T2
1
Value of Growth
caused by
productivity increase
T1 P2
P1
Production Function
Period 1 period 2
Quantity Price Value Quantity Price Value
210.00 7.20 1512 247.25 7.10 1755
Product 1
200.00 7.00 1400 195.03 7.15 1394
Asdasd
Period 1 period 2
Quantity Price Value Quantity Price Value
100.00 7.50 750 115.00 7.70 886
80.00 8.60 688 79.20 8.50 673
Product 2
400.00 1.50 600 428.00 1.55 663
160.00 3.80 608 164.80 3.90 643
2646 1865
Input : Surplus Value (abs.) 266.00 285.12
Surplus Value (rel.) 1.101 1.100
The scale of success run by a going concern is manifold, and there are no
criteria that might be universally applicable to success. Nevertheless, there is one
132
criterion by which we can generalise the rate of success in production. This
criterion is the ability to produce surplus value. As a criterion of profitability,
surplus value refers to the difference between returns and costs, taking into
consideration the costs of equity in addition to the costs included in the profit and
loss statement as usual. Surplus value indicates that the output has more value
than the sacrifice made for it, in other words, the output value is higher than the
value (production costs) of the used inputs. If the surplus value is positive, the
owner‘s profit expectation has been surpassed.
INCOME FORMATION-Changes between two periods
Income generation Income distribution
+/- Productivity +41.12 =Real income +58.12
-/- Volume +17.00 +/- Customers +9.00
=real income +58.12 +/- Suppliers -28.00
=producers income 39.12
-Labour compensation -20.00
-Taxes N/a
Total Generation 58.12
=Owner income +19.12
Total Distribution 58.12
Out Put
amount of capital increases to K, at a point of
time, the production function Q = f (L, K 1)
shifts upwards to Q = f (L,K2 ), as shown in
the figure.
On the other hand, if labour is taken
as a fixed input and capital as the
variable input, the production function Labour
takes the form Q =f (KL) Fig 11-2
This production function is depicted in Figure 2 where the slope of the curve
represents the marginal product of
capi-tal. A movement along the
Q=f (K,L)
production function shows the in-crease
in output as capital increases, given the
Out Put
A
Q. With the increase in inputs of capital 1
200Q
and labour to OK1 and OL1, the output
increases to 200 Q. The long-run 100Q
production function is shown in terms of
an isoquant such as 100 Q. In the long
run, it is possible for a firm to change all 0
Labour L
inputs up or down in accordance with its
scale. Fig 11-4
135
This is known as returns to scale. The re-turns to scale are constant when output
increases in the same proportion as the increase in the quan-tities of inputs. The
returns to scale are increasing when the increase in output is more than
propor-tional to the increase in inputs. They are decreas-ing if the increase in
output is less than propor-tional to the increase in inputs.
Let us illustrate the case of constant returns to scale with the help of our
production function.
Q = (L, M, N, К, T)
Given T, if the quantities of all inputs L, M, N, K are increased n-fold, the
output Q also increases и-fold. Then the production function becomes nQ –f (nL,
nM, nN, nK).
This is known as linear and homogeneous production function, or a
homogeneous function of the first degree. If the homogeneous function is of the Kth
degree, the production function is nk.Q = f (nL, nM, nN, nK) If k is equal to 1, it is a
case of constant returns to scale; if it is greater than 1, it is a case of increasing
returns of scale; and if it is less than 1, it is a case of decreasing returns to scale.
Thus a production function is of two types
Linear homogeneous of the first degree in which the output would change in
exactly the same proportion as the change in inputs. Doubling the inputs would
exactly double the output, and vice versa. Such a production function expresses
constant returns to scale,
Non-homogeneous production functions of a degree greater or less than one.
The former relates to increasing returns to scale and the latter to decreasing
returns to scale.
11.4. REVISION POINTS
1. Types of production
2. Stockholders of production
3. Purpose of production
4. Production function
11.5. INDEX QUESTIONS
1. What are the factors determining the production
2. Write a note on Stockholders of production
3. Discuss the process of production and production models
11.6. SUMMARY
It could be seen clearly from the above discussion that this lesson gives on
idea about production economics with reference to need for productionStakeholders
of production, producer community, purpose of production, production growth and
performance, absolute and average income from production, production models, the
procedure for formulating objective production functions, production function, the
short-run production function and the long-run production function
11.7. TERMINAL EXERCISE
1. Production Theory is also called __________________.
136
a) Micro Economics
b) Positive Science
c) Normative Science
d) Theory of Firm
2. Production refers to
a) Destruction of utility
b) Creation of utility
c) Exchange value
d) None
11.8. SUPPLEMENTARY MATERIALS
1. Carl Shapiro (1989). "The Theory of Business Strategy," RAND Journal of
Economics, 20(1), pp. 125-137
2. thomas J. Webster (2003). Managerial Economics: Theory and Practice, ch. 13 &
14, Academic Press. Description.
3. Prof. M.S. BHAT, and A.V. RAU.Managerial economics and financial
analysis.Hyderabad.ISBN 978-81-7800-153-1
11.9. ASSIGNMENT
1. Write a note on production function.
2. Discuss the various production models.
11.10. SUGGESTED READINGS
1. Salvatore, Dominick (2003) Managerial economics in a global economy.
Cincinnati, Ohio: South-Western.
2. Adams, John and Juleff, Linda (2003) Managerial economics for decision making.
Houndmills, Basingstoke: Palgrave Macmillan
11.11. LEARNING ACTIVITIES
1. To conduct a workshop on process of production in a company
2. To conduct a group discussion on types of production
11.12. KEYWORDS
1. Production economics, production function, production stockholders,
production process, production models.
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LESSON – 12
RETURNS TO SCALE
12.1 INTRODUCTION
In economics, returns to scale and economies of scale are related but different
terms that describe what happens as the scale of production increases in the long
run, when all input levels including physical capital usage are variable (chosen by
the firm). The term returns to scale arises in the context of a firm's production
function. It explains the behaviour of the rate of increase in output (production)
relative to the associated increase in the inputs (the factors of production) in the
long run. In the long run all factors of production are variable and subject to
change due to a given increase in size (scale). While economies of scale show the
effect of an increased output level on unit costs, returns to scale focus only on the
relation between input and output quantities. This lesson deals with law of returns
to scale it outlines the definition of law of returns to scale and types of law of
returns to scale. This lesson points out the causes of law of returns to scale and
application of law of returns to scale.
12.2 OBJECTIVES
To study the law of returns to scale
To understand the concepts of increasing returns to scale, diminishing
returns to scale and constant returns to scale
To examine the application of law of returns to scale in production process
12.3 CONTENT
12.3.1 Concept of Law of Returns to Scale
12.3.2 Definitions of Returns to Scale
12.3.3 Law of Returns to Scale
12.3.4 Increasing Returns to Scale
12.3.5 Constant Returns to Scale
12.3.6 Diminishing Returns to Scale
12.3.7 Causes of Increasing Returns to Scale
12.3.8 Causes of Diminishing Returns to Scale
12.3.9 Economies of Scale: Internal and External Economies
12.3.10 Types of Technical economies
12.3.1 Concept of Law of Returns to Scale
The laws of returns to scale are a set of three interrelated and sequential laws:
Law of Increasing Returns to Scale, Law of Constant Returns to Scale, and Law of
Diminishing returns to Scale. If output increases by that same proportional change
as all inputs change then there are constant returns to scale (CRS). If output
increases by less than that proportional change in inputs, there are decreasing
returns to scale (DRS). If output increases by more than that proportional change
in inputs, there are increasing returns to scale (IRS). A firm's production function
could exhibit different types of returns to scale in different ranges of output.
Typically, there could be increasing returns at relatively low output levels,
138
decreasing returns at relatively high output levels, and constant returns at one
output level between those ranges.
In mainstream microeconomics, the returns to scale faced by a firm are purely
technologically imposed and are not influenced by economic decisions or by market
conditions (i.e., conclusions about returns to scale are derived from the specific
mathematical structure of the production function in isolation).When all inputs
increase by a factor of 2, new values for output will be: Twice the previous output if
there are constant returns to scale (CRS) Less than twice the previous output if
there are decreasing returns to scale (DRS) More than twice the previous output if
there are increasing returns to scale (IRS)
Assuming that the factor costs are constant that is, that the firm is a perfect
competitor in all input markets, a firm experiencing constant returns will have
constant long-run average costs, a firm experiencing decreasing returns will have
increasing long-run average costs, and a firm experiencing increasing returns will
have decreasing long-run average costs. However, this relationship breaks down if
the firm does not face perfectly competitive factor markets.In this context, the price
one pays for a good does depend on the amount purchased. For example, if there
are increasing returns to scale in some range of output levels, but the firm is so big
in one or more input markets that increasing its purchases of an input drives up
the input's per-unit cost, then the firm could have diseconomies of scale in that
range of output levels. Conversely, if the firm is able to get bulk discounts of an
input, then it could have economies of scale in some range of output levels even if it
has decreasing returns in production in that output range.
12.3.2 Definitions of Returns to Scale
Formally, a production function is defined to have:
Constant returns to Scale if (for any constant a greater than 0) 𝐹(𝑎𝐾, 𝑎𝐿) =
𝑎𝐹(𝐾, 𝐿)
Increasing returns to scale if (for any constant a greater than1) 𝐹 𝑎𝐾, 𝑎𝐿 >
𝑎𝐹(𝐾, 𝐿)
Decreasing returns to scale if (for any constant a greater than1) 𝐹 𝑎𝐾, 𝑎𝐿 <
𝑎𝐹(𝐾, 𝐿)
Constant returns to scale if (for any constant a greater than 0) Increasing
returns to scale if (for any constant a greater than 1) Decreasing returns to scale if
(for any constant a greater than 1) where K and L are factors of production—capital
and labour, respectively.
In a more general set-up, for a multi-input-multi-output production processes,
one may assume technology can be represented via some technology set, call it,
which must satisfy some regularity conditions of production theory. In this case,
the property of constant returns to scale is equivalent to saying that technology set
is a cone, i.e., satisfies the property. In turn, if there is a production function that
will describe the technology set it will have to be homogeneous of degree 1.
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12.3.3 Law of Returns to Scale
Definition and Explanation
The law of returns are often confused with the law of returns to scale. The law
of returns operates in the short period. It explains the production behavior of the
firm with one factor variable while other factors are kept constant. Whereas the law
of returns to scale operates in the long period. It explains the production behavior
of the firm with all variable factors.
There is no fixed factor of production in the long run. The law of returns to
scale describes the relationship between variable inputs and output when all the
inputs or factors are increased in the same proportion. The law of returns to scale
analysis the effects of scale on the level of output. Here we find out in what
proportions the output changes when there is proportionate change in the
quantities of all inputs. The answer to this question helps a firm to determine its
scale or size in the long run. It has been observed that when there is a
proportionate change in the amounts of inputs, the behavior of output varies. The
output may increase by a great proportion, by in the same proportion or in a
smaller proportion to its inputs. This behavior of output with the increase in scale
of operation is termed as increasing returns to scale, constant returns to scale and
diminishing returns to scale. These three laws of returns to scale are now
explained, in brief, under separate heads.
12.3.4 Increasing Returns to Scale
If the output of a firm increases more than in proportion to an equal
percentage increase in all inputs, the production is said to exhibit increasing
returns to scale.For example, if the amount of inputs are doubled and the output
increases by more than double, it is said to be an increasing returns to scale. When
there is an increase in the scale of production, it leads to lower average cost per
unit produced as the firm enjoys economies of scale.
12.3.5 Constant Returns to Scale
When all inputs are increased by a certain percentage, the output increases by
the same percentage, the production function is said to exhibit constant returns to
scale.For example, if a firm doubles inputs, it doubles output. In case, it triples
output. The constant scale of production has no effect on average cost per unit
produced.
12.3.6 Diminishing Returns to Scale
The term 'diminishing' returns to scale refers to scale where output increases
in a smaller proportion than the increase in all inputs.For example, if a firm
increases inputs by 100% but the output decreases by less than 100%, the firm is
said to exhibit decreasing returns to scale. In case of decreasing returns to scale,
the firm faces diseconomies of scale. The firm's scale of production leads to higher
average cost per unit produced.
The three laws of returns to scale are now explained with the help of a graph
below:
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Output
q=8
q=6
a b Constant returns to scale
q=3
q=1 a Increasing returns to scale
1 2 4 8
Input
Fig-12-1
The figure 12.3.6 shows that when a firm uses one unit of labor and one
unit of capital, point a, it produces 1 unit of quantity as is shown on the q = 1
isoquant. When the firm doubles its outputs by using 2 units of labor and 2 units
of capital, it produces more than double from q = 1 to q = 3.So the production
function has increasing returns to scale in this range. Another output from
quantity 3 to quantity 6. At the last doubling point c to point d, the production
function has decreasing returns to scale. The doubling of output from 4 units of
input causes output to increase from 6 to 8 units increases of two units only.
The Law of Returns to Scale
The law of returns to scale describes the relationship between outputs and
scale of inputs in the long-run when all the inputs are increased in the same
proportion. In the words of Prof. Roger Miller, ―Returns to scale refer to the
relationship between changes in output and proportionate changes in all factors of
production. To meet a long-run change in demand, the firm increases its scale of
production by using more space, more machines and labourers in the factory‘.
Assumptions
This law assumes that:All factors (inputs) are variable but enterprise is fixed, A
worker works with given tools and implements, Technological changes are absent.
There is perfect competition, The product is measured in quantities.
141
Explanation
Given these assumptions, when all inputs are increased in unchanged
proportions and the scale of production is expanded, the effect on output shows
three stages: increasing returns to scale, constant returns to scale and diminishing
returns to scale.
Increasing Returns to Scale
Returns to scale increase because the increase in to-tal output is more than
proportional to the increase in all inputs. In the beginning with the scale of
production of (1 worker + 2 acres of land), total output is 8. To increase output
when the scale of production is dou-bled (2 workers + 4 acres of land), total returns
are more than doubled. They become 17. Now if the scale is trebled (3 workers + о
acres of land), returns become more than three-fold, i.e., 27. It shows increasing
returns to scale. In the figure RS is the returns to scale curve where R to С portion
indicates increasing returns.
Increasing Returns
Constant returns
Marginal returns
C D
Diminishing
Returns
0
Scale of Production
Fig12-2
2.3.7 Causes of Increasing Returns to Scale
Returns to scale increase due to the following reasons
Indivisibility of Factors
Returns to scale increase because of the indivisibility of the factors of
production. Indivisibility means that machines, management, labour, finance, etc.
cannot be available in very small sizes. They are available only in certain minimum
sizes. When a business unit expands, the returns to scale increase because the
indivisible factors are employed to their maximum capacity.
Specialisation and Division of Labour
Increasing returns to scale also result from spe-cialisation and division of
labour. When the scale of the firm is expanded there is wide scope of speciali-zation
and division of labour. Work can be divided into small tasks and workers can be
concentrated to narrower range of processes. For this, specialised equipment can
be installed. Thus with specialisation, efficiency increases and increasing returns to
scale follow.
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Internal Economies
As the firm expands, it enjoys internal economies of production. It may be able
to install better machines, sell its products more easily, borrow money cheaply,
procure the services of more efficient manager and workers, etc. All these
economies help in increasing the returns to scale more than proportionately.
External Economies
A firm also enjoys increasing returns to scale due to external econo-mies.
When the industry itself expands to meet the increased long-run demand for its
product, external economies appear which are shared by all the firms in the
industry.
When a large number of firms are concentrated at one place, skilled labour,
credit and transport facilities are easily available. Subsidiary industries crop up to
help the main industry. Trade journals, research and training centres appear which
help in increasing the productive efficiency of the firms. Thus these external
economies are also the cause of increasing returns to scale.
Constant Returns to Scale
Returns to scale become constant as the increase in total output is in exact
proportion to the increase in inputs. If the scale of production in increased further,
total returns will increase in such a way that the marginal returns become
constant. In the table, for the 4th and 5th units of the scale of production, marginal
returns are 11, i.e., returns to scale are constant.
Causes of Constant Returns to Scale
Returns to scale are constant due to internal economies and diseconomies.
But increasing returns to scale do not continue indefinitely. As the firm expands
further, internal economies are counterbalanced by internal diseconomies. Returns
increase in the same proportion so that there are constant returns to scale over a
large range of output.
External Economies and Diseconomies
The returns to scale are constant when external diseconomies and economies
are neutralised and output increases in the same proportion, Divisible Factors.
When factors of production are perfectly divisible, substitutable, and homogeneous
with perfectly elastic supplies at given prices, returns to scale are constant.
Diminishing Returns to Scale
Returns to scale diminish because the increase in output is less than
proportional to the increase in inputs. The table shows that when output is increased
from the 6th, 7th and 8th units, the total returns increase at a lower rate than before
so that the marginal returns start diminishing successively to 10, 9 and 8.
12.3.8 Causes of Diminishing Returns to Scale
A constant return to scale is only a passing phase, for ultimately returns to
scale start diminishing. Indivisible factors may become inefficient and less
productive. Business may become unwieldy and produce problems of supervision
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and coordination. Large management creates difficulties of control and rigidities. To
these internal diseconomies are added external diseconomies of scale.
These arise from higher factor prices or from diminishing productivities of the
factors. As the industry continues to expand, the demand for skilled labour, land,
capital, etc. rises. There being perfect competition, inten-sive bidding raises wages,
rent and interest. Prices of raw materials also go up. Transport and marketing
difficulties emerge. All these factors tend to raise costs and the expansion of the
firms leads to diminish-ing returns to scale so that doubling the scale would not
lead to doubling the output.
For the management increasing, decreasing or constant returns to scale reflect
changes in pro-duction efficiency that result from scaling up productive inputs. But
returns to scale is strictly a production and cost concept. Management‘s decision
on what to produce and how much to produce must be based upon the demand for
the product. Therefore, demand and other factors must also be considered in
decision making.
12.3.9 Economies of Scale: Internal and External Economies
An economy of scale exists when larger output is associated with lower per
unit cost. Economies of scale have been classified by Marshall into Internal
Economies and External Economies. Internal Economies are internal to a firm
when it expands its size or increases its output.
They ―are open to a single factory or a single firm independently of the action
of other firms. They result from an increase in the scale of output of the firm, and
cannot be achieved unless output increases. They are not the result of inventions of
any kind, but are due to the use of known methods of production which a small
firm does not find worthwhile.‖ (A.K. Caimcross).
External Economies are external to a firm which is available to it when the
output of the whole industry expands. They are ―shared by a number of firms or
industries when the scale of production in any industry or group of industries
increases. They are not mono-polised by a single firm when it grows in size, but are
conferred on it when some other firms grow larger‖.Modern economists distinguish
economies of scale in terms of real and pecuniary internal and external economies.
Real Internal Economies
Real internal economies are ―associated with a reduction in the physical
quantity of inputs, raw materials, various types of labour and various types of
capital (fixed or circulating) used by a large firm.‖Real internal economies which
arise from the expansion of a firm are the following:
Labour Economies
As the firm expands, it achieves labour economies with increased divi-sion of
labour and specialisation. When a firm expands in size, this necessitates division of
labour whereby each worker is assigned one particular job, and the splitting of
processes into sub-processes for greater efficiency and productivity.
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This, in turn, leads to the increase in the dexterity (skill) of every worker, the
saving in time to produce goods, and to the invention of large number of labour-
saving machines, according to Adam Smith. Thus division of labour and
specialisation lead to greater produc-tive efficiency and reduction in per unit cost in
a large firm.
Technical Economies
Technical economies are associated with all types of machines and
equipment‘s used by a large firm. They arise from the use of better machines and
techniques of produc-tion which increase output and reduce per unit cost of
production.
12.3.10 Types of Technical economies
Economies of Indivisibility
Mrs. Joan Robinson refers to economies of factor indivisibility. Fixed capital is
one such factor. It is indivisible in the sense that a machine, equipment or a plant
must be used in a fixed minimum size or capacity to justify its use. Such machines
can be most efficiently used at a fairly large output than at small outputs because
they cannot be divided into smaller units.
For example, an automated car assembly plant is not a viable proposition, if
the number of cars to be assembled is small because much of the plant would
remain idle. But a large firm assembling a large number of cars may be able to
utilise the plant to its full capacity and achieve lower per unit cost. Prof. Caimcross
gives a five-fold classification of technical economies.
Economies of Superior Technique
It is only a large firm which can afford to pay for costly machines and install
them. Such machines are more productive than small machines. The high cost of
such machines can be spread over a larger output which they help to produce.
Thus the per unit cost of production falls in a large firm which employs costly and
superior plant and equipment and thereby enjoys a technical superiority over a
small firm.
Economies of Increased Dimensions
The installation of large machines itself brings many advantages to a firm. The
cost of operating large machines is less than that of operating small machines.
Even the cost of construction is relatively lower for large machines than for small
ones.
The cost of manufacture of a double-decker bus is lower as compared to the
manufacture of two single-decker buses. Moreover, a double-decker carries more
passengers than a single-decker and at the same time requires only a driver and a
conductor like the latter. Thus its operating costs are relatively lower.
Economies of Linked Processes
A large firm is able to reduce it‘s per unit cost of produc-tion by linking the
various processes of production. For instance, a large sugar manufacturing firm
may own its sugarcane farms, manufacture sugar, pack it in bags, transport and
145
distribute sugar through its own transport and distribution departments. Thus by
linking the various processes of production and sale, a large firm saves the
expenses incurred on intermediaries thereby reducing unit cost of produc-tion.
Economies of the Use of By-products
A large firm possesses greater resources than a small firm and is able to utilise
its waste material as a by-product. For example, the molasses left over after
manufacturing sugar from the surgarcane can be used for producing spirit by
installing a plant for the purpose.
12.4. REVISION POINTS
1. Law of increasing return, Law of constant return, and Law of diminishing return
2. Causes of return to scale
3. Application of return to scale in production process
12.5. INDEX QUESTIONS
1. Discuss the Law of increasing return, Law of constant return, and Law of
diminishing return
2. Write a note on application of Law of return to scale in production decision
making process
12.6. SUMMARY
It could be seen clearly from above discussion that this lesson gives a broad
knowledge and understanding about the Law of return to scale with respect to
concept of law of returns to scale,definitions of returns to scale,law of returns to
scale,increasing returns to scale,constant returns to scale,diminishing returns to
scale,causes of increasing returns to scale,causes of diminishing returns to scale,
economies of scale: internal and external economies and types of technical
economies.
12.7. TERMINAL EXERCISE
1. The Manager tries to produce at ………………………Scale.
a) Minimum
b) Maximum
c) Optimum
d) Ideal
2. Production Theory is also called __________________.
a) Micro Economics
b) Positive Science
c) Normative Science
d) Theory of Firm
12.8. SUPPLEMENTARY MATERIALS
1. Lafontaine, Francine, and Kathryn L. Shaw. "Targeting Managerial Control:
Evidence fromFranchising." The Rand Journal of Economics, vol. 36, no. 1
(Spring 2005), 131-150.
2. Lazear, Edward P. ―Balanced Skills and Entrepreneurship.‖ The American
Economic Review, vol.94, no. 2 (May 2004), 208.
146
12.9. ASSIGNMENT
1. Write a note on return to scale
2. What are the causes of increasing return to scale and diminishing return to
scale in production process?
12.10. SUGGESTED READINGS
1. Salvatore, Dominick (2003) Managerial economics in a global economy.
Cincinnati, Ohio: South-Western.
2. Adams, John and Juleff, Linda (2003) Managerial economics for decision making.
Houndmills, Basingstoke: Palgrave Macmillan.
12.11. LEARNING ACTIVITIES
1. To conduct a workshop on increasing returns to scale
2. To conduct a group discussion on reasons for increasingreturns to scale and
diminishing returns to scale
12.12. KEYWORDS
1. Increasingreturns to scale, diminishing returns to scale, constant returns to
scale, causes of returns to scale
147
UNIT - IV : MARKET STRUCTURE AND PRICING
LESSON - 13
MARKET STRUCTURE/PERFECT COMPETITION
13.1 INTRODUCTION
The determination of price of any product is an important managerial function.
Price affects profit through its effect on revenue and cost. Profit is concerned with
the difference between cost and the revenue. It always depends on cost and volume
of sales. Therefore the management always tries to find out the optimum
combination of price and output which offers the maximum profit to the firm. Thus
pricing occupies on important place in economic analysis of firms.
The knowledge of market and market structure with which a firm operates is
more helpful in price output decisions. Market in economic term means a meeting
place where buyers and sellers deal directly or indirectly. Market structures are
different market forms based on the degree of competition prevailing in the market.
Broadly the market forms are classified into two types:
Perfectly competitive market
Imperfectly competitive market
13.2 OBJECTIVE
This unit aims at making the reader to understand the prevailing types of
various market types avail in an open economy. And this lesson aims at explaining
price output decision taken under perfect competition at different periods.
13.3 CONTENTS
i) Perfect Competition
The term perfect competition is used in wider sense. Perfect competition
means all the buyers and sellers in the market are aware of price of products. The
following are the characteristics of perfectly competitive market
1. Large number of buyers and sellers in the market
2. Homogeneous product
3. Free entry or exit
4. All the buyers and sellers in the market have perfect knowledge about the
market conditions.
5. Perfect mobility of factors of production
6. Absence of transportation costs.
When the first three assumptions are satisfied there exists pure competition.
Competition becomes perfect only when all the assumptions are satisfied. In perfect
competition, the demand for the output for each producer is perfectly elastic. With
the larger number of firms and homogeneous products, no individual firm is in a
position to influence the price.
ii) Equilibrium Price
The demand curve normally slopes downwards showing that more quantity of
commodity will be demanded at a lower price than at higher prices. Similarly
supply curve showing an upward trend where the producers will offer to sell a
148
larger quantity at a higher price than at a lower price. Thus the quantity demanded
and quantities supplied vary with price. The price that tends to settle down or
comes to stay in the market (where both buyers and sellers are satisfied) is at
which quantity demanded equals quantity supplied. The point so formed is known
as equilibrium point and price is known as equilibrium price.
iii) Effect of time on supply
According to Marshall Time has great influence on the determination of price.
The following are the market periods based on time i.e market period, short period
and long period.
1. Very short period (Market period)
2. Short period
3. Long period
Market period or very short period may be only a day or very few days. Change
in supply is not possible where the period is very short and quantity demanded will
be the determining factor in this period Further, supply curve in the market period
is remain fixed showing vertical straight line.
The short period is a period not sufficient to make any changes in the existing
fixed plant capacity. Increase in supply in the short period is possible by increasing
the variable factors of production only the supply curve slopes upward to right
showing that some increase in supply is possible when the price increases.
Long period is a time long enough to adjust the supply to any changes in
demand. The long run supply curve is less steep then short run supply curve
showing increase in quantity supplied when price changes.
iv) Equilibrium under perfect competition
In perfect competition the market
price of a commodity is determined by its
demand and supply. The price of a Y
D S
commodity determines at the point where
quantity demanded equates quantity
M N
supplied. It can be explained through the P1
following diagram. Price
P E
In the above diagram, DD denotes
the demand curve and SS denotes the P2 R
L
supply curve. Demand and supply curves
slopes in opposite direction. In this S D
diagram OP is the equilibrium price
where the demand curve equates with the O Q X
Quantity demanded and supplied
supply curve.
Diagram – 13.1
In this figure, the point E determines the equilibrium price and OQ is the
equilibrium quantity. From the diagram it can be noted that if the price increases to
OP1, the demand will be P1M and supply will be P1N.So MN will be excess supply.
149
Under this circumstance, the firm will be forced to lower the price in order to sell
the excess supply under this circumstance; the firm will be forced to lower the price
in order to sell the excess stock. It the firm can minimizes the price, the profit will
be low. Thus we can say that at the point of equilibrium firm can derive maximum
profit. At the point of equilibrium, there are two conditions to be satisfied.
MC = MR where MC = marginal Cost (Cost of producing an additional unit) MR
– marginal Revenue realized from the sale of an additional unit
MC Curve Cuts MR curve from below that is MC Curve should have positive
slope. Under perfect competition, the following equations are satisfied.
MC = MR, MR = AR Price = AR = AC
There fore, Price = MR = MC = AR = AC.
The equations can be satisfied with the following diagrams
P E
demand = AR = MR = price
P1
c) In the long run
In the long run, the firms in the
industry are eager to get super normal DC
profits. The price determination is S D1
explained through the diagram given O Q1 Q X
Quantity demanded and supplied
below; In output decision making long
Diagram – 13.5
run
Average Cost (LAC) and Long run Marginal Cost (LMC) are to be taken in to
consideration under this condition, the firm is in equilibrium.
When AR = MR = LAC = LMC.
In below diagram. (1) DD is the long run. Demand curve and S1S1 short run
supply curve. The price is determined at OP. In the figure 2, the equilibrium output
is at point E At this point. AR1=MR=LMC
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Y LMC
SMC
SAC
D S1 AR1 = MR1
P1
S P LAC
Price
S2
P1 P1 PB AR= MR
P P
P2 AR2 = MR2
P2 S1 P2
S D
S2 O Q2 Q Q1 X
O Q X Out put
Diagram – 13.6 Diagram – 13.6
13.4 REVISION POINTS
It should be understood the possibilities and impossibilities in a business
during market, short and long period. Supply curve is adjusted accordingly.
13.5IN TEXT QUESTIONS
1. Who is a price taker? Why?
2. Discuss the price output determination under perfect competition.
3. What is meant by equilibrium? bring out the conditions for equilibrium.
13.6 SUMMARY
The lesson clarified that in short run the firm entertains either profit or loss.
Loss making firms can not enter in to long run. Due to many number of sellers
and the product is homogeneous, the profit would be very less in long run.
13.7 TERMINAL EXERCISE
Analyse the price of homogeneous type ceiling fans produced by reputed
companies. Reader may not find much price difference in that.
13.8 ASSIGNMENT
1. Take IT sector as on example and analyse their equilibrium level. Note that IT
sector is producing services.
13.9 SUGGESTED READING
1. Micro Economics, KPM sundharam & EN Sundharam, sukar & chond
Publication.
13.10 SUPPLEMENTARY READING
1. Reader many go through tutorials through browsing and PPT Presentations
available through them.
13.11 LEARNING ACTIVITY
1. Compare the Price, demand and supply of same type of small cars available in
India. Prepare a list of above data for five continuous years.
13.12 KEY WORDS
1. Perfect competition, equilibrium.
152
LESSON -14
MONOPOLY
14.1 INTRODUCTION
Monopoly means ‘single ‘selling. In brief, monopoly is a market situation in
which there is only one seller or producer of a product for which no close
substitution is available. As there is only one firm under monopoly, that single firm
constitutes the whole industry. The monopolist can fix price of his product and can
pursue an independent price policy. A monopolist can take the decision about the
price of his product. For ex: electricity, water supply companies etc.
14.2 OBJECTIVE
To make the reader to understand the concept of private monopoly by using
diagrams
14.3 CONTENTS
a) Features
The following are the important features of monopoly
1. One seller and a large number of buyers.
2. No close substitutes for the product.
3. Monopolist is not the price taker and the price maker.
4. Monopolist can control the supply.
5. No entry of new firm to the market.
6. Firm and industry are the same
b) Causes of Monopoly
1. Legal restrictions
2. Exclusive ownership or control over the raw materials.
3. Economics of large scale production
4. Exclusive knowledge of a production technique.
c) Price Determination under Monopoly
A monopoly firm has complete control over the entire supply. It can sell
different quantities at different prices. It can sell more if it cuts down its price. Thus
the monopoly firm faces a downward sloping demand curve of the monopoly firm
and the industry will be the same. But under perfect competition the firm‘s demand
curve is a horizontal straight line, but the industry‘s demand curve slopes down
wards. Since average revenue falls when more units of output are sold marginal
revenue will be less than average revenue. MR curve thus declines at a greater rate
than. AR curve and it falls below AR curve.
Though the monopolist has the freedom to fix any price he will prefer a price
output combination that gives him maximum profit. He goes on producing so long
as additional units add more to revenue than to cost He will stop at that point
beyond which additional units of producti0on add more to cost than to revenue. In
other word he will be in equilibrium position at the output level at which MR equal
MC and MC cuts MR from below.
153
d) Short Run Monopoly Equilibrium
The monopolist will be in short run Y
equilibrium where the output having MR
equal MC.
In the following figure the
monopolist will be in short run
Price cost
equilibrium at output OM where MR
MC
equal to the short run marginal cost AC
P1
curve MC. P
At an output OM, MP‘ is the average T L
revenue (price) and ML is the average cost
of production Therefore P1L is the MR
AR
monopoly profit per unit. The total profit
O M
is equal to product of profit per unit with X
Out put
total output.
Diagram – 14.1
The following are the result of monopoly operation in the market
If AR greater than AC-results super normal profit
If AR equals AC results normal profit
If AR less than AC that results loss to the firm
e) Long run Monopoly Equilibrium
The monopolist is the single producer Y
and the new firms cannot cuts the industry
which enables the monopolist to continue
to earn super profit in the long run. In the
figure the long run equilibrium of the
monopolist will be at the output where the
Price cost
LMC
long run marginal cost curve MC Intersects
P1
LAC
the marginal revenue curve MR. P
P M
Price
O Q X
Output
Diagram – 15.2
Kinked demand curve DD with a kink at point M. The price prevailing in the
market is OP and the firm produces OQ output. Here .D, M is the relatively elastic
of the demand curve and MD Is the relatively inelastic protion. This difference in
elasticity of demand due to the particular competitive reaction pattern assumed by
the kinked demand Curve hypothesis.
ii) Pricing under Price Leadership
The price leadership means the leading firm determines the price and others
follow it. All the firms in the industry adjusts, the price fixed by the price leader.
The large firm, who fixes the price, is known as the price maker and the firms,
who follow it are known as price – takers. The price leadership may be four types.
They are:
1. Dominant price leadership: In this situation, there exist many small firs and one
large firm and the large firm fixes the price and the small firms in the market
accept that price.
2. Barometric Price Leadership: Under this situation one reputed and experienced
firm fixes the price and others may follow it.
3. Aggressive Price Leadership: Under this market condition, one dominating firm
fixes the price and they compel all others in the industry to follow the price.
4. Effective Price Leadership: Under this condition, there are small number of
firms in the industry.
iii) Price-Output determination Under Price Leadership
In order to determine the price and output under price leadership,we have to
make two assumptions. They are,
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1. There are two firms – L and F, in which the cost of production of L is less than
that of F and
2. Product are identical
The following diagram will give the clear picture of price output determination.
Y
MCF
MCL
P2 R
P1
E2
P/D/AR
E1
MR
O Q Q X
2 1
Diagram – 15.3
In the above diagram, MC and MC 1 are the marginal cost curves of the firms F
and L respectively. By analysing this diagram it can be known that the firm L will
fix at point E2, where MC = MR. The price of the firms F and L are OP 1 and OP2 and
the output are Oq1 and OQ2 respectively.
iv) Pricing under Collusive Oligopoly
The term Collusion means ‗to play together‘. To avoid the competition among
the firms, monopolistic firms arrive at a formal agreement called cartel. it is
common sales agency formed to eliminate competition and fix such a price and
output that will maximize profit of member firms. The firms output and price are
determined by this cartel. The following diagram will give the idea more clearly or to
make an assumption that there are only two firms viz. firm S and firm T.
In the Below diagram, MC denotes the marginal cost curve of industry and
MC1 and MC2 are the MC for the firm S and T. MR is Marginal Revenue Curve. The
industry is in equilibrium at point E and equilibrium output is OQ and the price is
OP. The equilibrium output of two firms are determined based on this own MC
curve. The share of output of each firm will be obtaining by drawing a parallel line
through E to the X axis.
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MC
MC MC
1
P
1
P2 C ac1 e1 ac2
1
C2 E
C2
MR PD=AR
O Q o Q2 O
1 Q X
Diagram – 15.4
The points E1 and E2 determine the level of output for the firm S and the firm
T respectively. OQ1 and OQ2 determine the market share of firms and Firm T
respectively Here, we can say that, OQ1+OQ2=OQ, OP1+OP2=OP
c) Price Discrimination
A monopolist is in a position to fix the price of his product. He enjoys the
control of supply of the product. A monopolist is able to charge different price for
his products to the different customers. This is known as price discrimination.
According to Mrs. John Robinson ‗the act of selling the same article, produced
under single control at different prices to different buyers is known as price
discrimination. This is also known as differential pricing
i) Types of Price Discrimination
1. Price relatively elastic portion of the demand curve of the first degree-
charging different price for different persons for the same product.
2. Price discrimination of the second degree – Under this, the buyers are
classified into different divisions.
3. Price discrimination of the third degree – Here, the markets are divided
according to elasticity of demand
ii) Conditions of Price Discrimination
1. There must be more than one separate market
2. The markets must have different elasticity of demand
3. The market should be such that no buyer of the market may enter the other
market and vice versa
iii) Dumping
When monopolist works in home market as well as foreign market, he is able
to discriminate the price between these two markets. If he has monopoly in home
market, and he faces competition in to foreign market, he will be able to charge
higher prices for his products in home market. This practice is known as ‗Dumping‘
or ‗price dumping‘
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15.4 REVISION POINTS
Reader must differentiate the equilibrium under independent pricing and price
leadership pricing under price leadership does not bring equilibrium to price
followers. And this may lead to monopoly.
15.5 IN TEXT QUESTIONS
1. Explain the concept ―price leadership‖
2. Discuss equilibrium under price leadership
3. Discuss equilibrium under independent pricing
4. Explain types of price discrimination.
5. Discuss equilibrium under monopolistic competition.
15.6 SUMMARY
Oligopoly will lead to monopoly at one day. Many small firms will be swallowed
by the big firms. Cut throat competition exists in oligopoly. Small firms will find
if difficult to complete with big firms.
15.7Terminal exercise
Analyse how many mobile service providing companies are merged with big
companies in India during the last ten years.
15.8 ASSIGNMENT
Take Indian passenger car making companies and analyse who is the leader
and what are the reasons for that.
15.9 SUGGESTED READING
Micro Economics, KPM sundharam & EN Sundharam, Sultan chand & sons.
15.10 SUPPLEMENTARY MATERIALS
Reader many browse tutorials and PPT from internet sources.
15.11 LEARNING ACTIVITIES
Learner can witness price wars among various competitors dealing
homogeneous products. Through advertisements they will try to show their
product as superior and unique. Costume products can be considered by the
learner for understanding the concept more in detail.
15.12 KEY WORDS
Monopolistic competition, Oligopoly, price leadership, price follower, kinked
demand curve.
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LESSON -16
PRICING POLICY AND PRACTICES
16.1 INTRODUCTION
Formulating price policies and setting the price are the most important aspects
of managerial decision making. Price in fact, is the source of revenue which the firm
seeks to maximize. Again, it is the most important device a firm can use to expand
the market. If the price is set too high, a seller may price himself out of the market.
If it is too low, his income may not cover costs, or at best, fall short of what it could
be. In other words, if the Company prices too much, it will make fewer sales. If it
charges too little, it will sacrifice profits. So the price must be fixed judiciously.
16.2 OBJECTIVE
To make the reader to understand various types of pricing methods and
policy framing.
16.3 Contents;
a) Meaning of price
Price is the money value of the goods and services. In other words, it is the
exchange value of a product or service in terms of money. To the seller, price is a
source of revenue. To the buyer, price is the sacrifice of purchasing power.
b) Factors governing prices and pricing decision
Price is very important to both the buyer and the seller. In this connection, it
may be noted that in economic theory, two parties should be generally emphasized
i.e. buyers and sellers. In practice, however, as pointed out by Oxenfeldt, certain
other parties are also involved in the pricing process, i.e. rival seller, potential
rivals, middlemen & government. All these parties also exercise their influence in
price determination.
Factors governing prices may be divided into external factors and internal
factors.
Internal Factors
These are the factors which are within the control of th organization. Various
internal factors are as follows.
1. Cost : The price must cover the cost of production including materials, labour,
overhead, administrative and selling expenses and a reasonable profit.
2. Objectives: While fixing the price, the firm‘s objectives are to be taken into
consideration. Objectives may be maximum sales, targeted rate of return,
stability in prices, increase market share, meeting or preventing competition,
projecting image etc.
3. Organizational factors: Internal arrangement of the organization.
Organizational mechanism is to be taken into consideration while deciding the
price.
4. Marketing Mix: Other element of marketing mix, product, place, promotion,
pace and politics are influencing factors for pricing. Since these are
interconnected, change in one element will influence the other.
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5. Product differentiation: One of the objectives of product differentiation is to
charge higher prices.
6. Product life cycle: At various stages in the Product Life Cycle, vaious strategic
pricing decisions are to be adopted, eg. at the introduction stage. Usually firm
charges lower price and in growth stage charges maximum price.
7. Characteristics of product: Nature of product, durability, availability of
substitute etc. will also influence the pricing.
External Factors
1. These factors are beyond the control of organization. The following are the main
external factors.
2. Demand: If the demand for a product is Inelastic it is better to fix a higher price
and if demand is elastic, lower price may be fixed.
3. Competition: Number of substitutes available in the market and the extent of
competition and the price of competition etc. are to be considered while fixing a
firm price.
4. Distribution channels: Conflicting interest of manufacturers and middleman is
one of the of the important factor that affect the pricing decision. Manufacturer
would desire that middleman should sell the product at a minimum mark up.
5. General economic conditions: During inflation a firm forced to fix a higher price
and in deflation forced to reduce the price.
6. Government Policy: While taking pricing decision, a firm has to take into
consideration the taxation policy, trade policies etc. of the Government.
7. Reaction of consumers: If a firm fixes the price of its product unreasonably high,
the consumer may boycott the product.
c) Pricing Policies
Price must not be too high or too low. Price setting is a complex problem. The
pricing decision is critical not only in the beginning but it must be reviewed and
reformulated from time to time. Price policies provide the guidelines within which
pricing strategy is formulated and implemented. It represents the general frame
work within which pricing decision are taken. Price policies are those management
guidelines that control the day to day pricing decision as a means of meeting the
objectives of the firm such as maximization of profit, maximization of sales, targeted
rate of return, survival, stability of prices, meeting or preventing competition etc.
d) Steps in formulating pricing policies
1. Selecting the target market or market segment on which marketer would
concentrate more.
2. Studying the consumer behavior and collecting information relating to target
market selected.
3. Studying the prices, promotion strategies etc. of the competitors and their
impact on the market segment.
4. Assigning a role to price in the marketing mix.
5. Collecting the cost of manufacturing the product at different levels of demand.
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6. Fixing suitable (strategic) price after determining the price objectives and
according to a selected method of pricing.
e) Objectives of pricing policy
Pricing decisions are usually considered a part of the general strategy for
achieving a broadly defined goal. Before determining the price itself, the
management should decide the objectives. while setting the price, the firm may aim
at one or more of the following objectives.
1. Profit maximization: Since the primary motive of business is to earn
maximum profit, pricing always aim at maximization of profit through
maximization of sales.
2. Market share: For maximizing market share a firm may lower its price in
relation to the competitor‘s product.
3. Target return in investment: The firm should fix the price for the product in
such a way that it will satisfy expected returns for the investment.
4. Meet or prevent competition: In order to discourage competition a firm may
adopt a low price policy.
5. Price stabilization: Another objective of pricing is to stabilize the product
prices over a considerable period of time.
6. Resource mobilization: Company may fix their prices in such a way that
sufficient resources are made available for the firms expansion, developmental
investment etc.
7. Speed up cash collection: Some firms try to set a price which will enable
rapid cash recovery as they may be financially tight or may regard future is
too uncertain to justify patient cash recovery.
8. Survival and growth: An important objective of pricing is survival and
achieving the expected rate of growth. Profit is less important than survival.
9. Prestige and goodwill: Pricing also aims at maintaining the prestige and
enhancing the goodwill of the firm.
10. Achieving product – quality leadership: Some Companies aim at
establishing product quality leader through premium price.
11. Methods of pricing
12. Cost Plus pricing.
13. Target pricing.
14. Going rate pricing.
15. Customary pricing.
16. Follwo up pricing.
17. Differential pricing.
18. Marginal cost pricing.
19. Barometric pricing.
1. Cost plus pricing: This is the most common method used for price. Under
this method, the price is fixed to cover all costs and a predetermined percentage of
profit. ie, the price is computed by adding a certain percentage to the cost of the
product per unit. this method is also known as margin pricing or average cost
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pricing or full cost pricing or mark up pricing. the business firm under oligopoly
and monopolistic market are following this pricing policy.
2. Target pricing: This is variant of full cost pricing. Under this method, the
cost is added with the predetermined target rate of return on capital invested. In
this case the company estimates future sales, future cost and calculates a targeted
rate of return on capital invested. This is also called as rate of return pricing.
3. Marginal cost pricing: Under the marginal cost pricing, the price is
determined on the basis of marginal cost or variable cost. In this method, fixed
costs are totally excluded.
4. Differential pricing: Under this method, the same product is sold at
different prices to different customers, in different places, and at different periods.
this method is called discriminatory pricing or price discrimination. Examples,
Cinema theater, telephone bills etc..
5. Going rate pricing: under this method, prices are maintained at par with
the average level of prices in the industry. I.e., under this method a firm charges
the prices according to what competitors are charging. Thus firm accepts the price
prevailing in the industry in order to avoid price war. This method is also called
acceptance pricing or parity pricing.
6. Customary pricing: in the case of some commodities the prices get fixed
because they have prevailed over along period of time. Example, price of a cup of
tea or coffee. In short the prices are fixed by custom.
7. Follow up pricing: this is the most popular price policy. Under this, a firm
determines the price policy according to the price policies of competitors. If the
Competitors reduce the price of the product; the firm also reduces the price of
its product. If the competitors increase the price, the firma also follow the same.
8. Barometric pricing: this is the method of leadership pricing. In this type of
price leadership, there is no leader firm. but one firm among the oligopolistic firms
announces a price change first. This is followed by other firms in the industry. The
barometric price leader need not be a dominant firm with the lowest cost or even
the largest firm in the industry but they responds to changes in business
environments rapidly. On the basis of a formal or informal tacit agreement, the
firms in the industry accept a firm as price leader who may act firstly upon the
environmental or market changes.
g) Pricing of a new product. (Methods and strategy)
In pricing a new product, generally two types of strategies are suggested. They
are;
1. Skimming price strategy
This is done with a basic idea of gaining a premium from those buyers who
always ready to pay a much higher price than others. Accordingly a product is
priced at a very high level due to incurring large promotional expenses in the early
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stages. Thus skimming price refers to the high initial price charged when a new
product is introduced in the market. Reasons for charging this price are;
1. When the demand of new product is relatively inelastic.
2. When there are no close substitutes
3. Elasticity of demand is not known.
4. When the buyers are not able to compare the value and utility.
5. To recover early the R&D and promotional expenses.
6. To recover early the R&D and promotional expenses.
7. When the product has distinctive qualities, luxuries etc.,
2. Penetration price strategy
This is the practice of charging a low price right forms the beginning to
stimulate the growth of the market and to capture large share of it. Since the price
is lower, the product quickly penetrates the market, and consumers with low
income are able to purchase it. Reasons for adopting this policy are:
1. Product has high price elasticity in the initial stage.
2. The product is accepted by large number of customers.
3. Economies of large scale production available to firm.
4. Potential market for the product is large.
5. Cost of production is low.
6. To introduce product into market.
7. To discourage new competitors.
8. Most of the prospective consumers are in low income class.
h) Kinds of pricing (pricing strategies)
Pricing policy means a policy determined for normal conditions of the market.
Pricing strategy is a policy determined to face a specific situation and is of
temporary nature. Simply pricing policies provide guidelines to carry out pricing
strategy. Following are the important pricing strategies.
Psychological pricing: Here manufacturers fix their prices of a product in the
manner that it may create an impression in the mind of consumers that the prices
are low. E.g. Prices of Bata shoe as Rs. 99.99. This is also called odd pricing.
Mark up pricing. This method of pricing is followed by wholesalers and
retailers. When the goods are received, the retailers add a certain percentage of the
wholesaler‘s price.
Administered pricing: here the pricing is done on the basis of managerial
decisions and not on the basis of cost, demand, competition etc.
Other pricing strategies: Geographical pricing, base point pricing, zone
pricing, dual pricing, product line pricing etc. are some other pricing strategies.
i) Roles of Cost in Pricing
Most of the wholesale and retail organizations add some percentage of profit or
mark up total cost per unit to arrive at selling price. According to Hall and Hitch,
business firms under the conditions of oligopoly and monopolistic competitive
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market do not determine price and output with the help ofthe principle MC = MR.
they determine price and output on the basis of full average cost of production.
Cost of production consists of fixed and variable costs. Inthe short run the firm may
nto cover the fixed cost but it must cover at least variable cost. In long run all costs
must be covered. if the entire cost is not recovered, the firm will incur losses, and
the firm must stop their production. Thus costs provide the basis for pricing. If the
cost increase price also increases. Cost represents a resistance point for lowering of
price, i.e., below which pricing should not be done. Cost also determines the profit
margin at various level of output.
j) Role of Demand factor in pricing
In the case of pricing of a product, demand plays a significant role. In some
cases demand occupies a vital role than cost. The demand is the factor which
determines the sales and profit. We know as per law of demand, demand and price
have inverse relationship. To increase the demand,, the firm has to reduce the
price. Similarly to decrease the demand the firm has to increase the price. The
elasticity of demand is to be considered in determining the price of the product. If
the demand for the product is elastic, the firm can fix lower price. If the demand is
inelastic, the firm can fix a higher price.
k) Consumer Psychology and Pricing
While fixing the price of product, the management should give importance to
consumer psychology. Actually demand of the product is based upon the behavior
of consumers. Some consumer may buy a product of high quality even though the
products are highly priced. Consumers think that highly priced products are of
high quality. If the price of product is less, consumer will think that such product is
of low quality. If the price is too high, the consumer may boycott the product and
they will go for substitute product of low price. If the price is too low the consumers
think that the goods are of inferior quality. They will not buy it. The important
elements that influence the consumer psychology are; price of the product, after
sales service, advertisement and sales promotion, personal income, fashions. So
consumer are many types, they follow different approaches to firms product. So in
case of price determination, the consumer psychology must given due weightage.
16.4 REVISION POINTS
In global scenario pricing of any product is a challenge, faced by the firms.
Reader must understand the sociological reasons which influence the pricing.
16.5IN TEXT QUESTIONS:
1. Define ‗Price‘
2. Explain the factors influence pricing decisions
3. Discuss various types of pricing policy.
4. Discuss methods of pricing.
16.6 SUMMARY
Reader must go through the pros and cons of various pricing policies adopted
by the firms. There is no standard successful pricing policy could be
suggested.
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16.7TERMINAL EXERCISE
Analyse the pricing policy of a new product and redesigned product. Also note
the pricing policy of a most needful product with others.
16.8 ASSIGNMENT
Take any innovative product and find out how it is priced. Analyse the product
unique features and its relationship with pricing.
16.9 SUGGESTED READING
Micro Economics, KPM sundharam & EN Sundharam, Suthan chand and
sons.
16.10 SUPPLEMENTARY READING
Reader may browse for tutorial and PPT to acquire more depth knowledge.
16.11 LEARNING ACTIVITY
Reader may find the method of pricing has direct nexus with the necessity of
the product. Pricing policy adopted for food itens can not be implemented for
cars.
16.12 KEY WORDS
Kind of prices, pricing policy.
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UNIT-V :. PROFITMANAGEMENT
LESSON - 17
PROFIT POLICY AND PRACTICE
17.1 INTRODUCTION
Profit is necessarily a residual sum. Land, labour and capital are frequently
used under contracts whereby they receive a predetermined return. Net profit is a
sum over and above the ordinary costs of business including such contractual
outlays. Nobody contracts to pay the entrepreneur the residual sum which
constitutes net profit. Business profits are, therefore, especially contingent upon
successful management of risk. Business is faced with a number of uncertainties.
(i) technical uncertainties-those relating to the physical process of production, (ii)
cost uncertainties either due to change in the prices of raw materials, wages, rent,
etc. or due to technology changes, (iii) demand uncertainties either due to changes
in consumer preferences or due to innovation of new products 1 and obsolescence of
the existing products, and (iv) market uncertainties-those relating to the future
price of the product and the volume of sales. The entrepreneur receives a reward for
combining the factors of production to meet the economic needs of a world faced
with uncertainties. He takes a risk which others are unwilling to bear, and if he
successfully manages the risk, he receives profits. This means that a businessman,
in order to earn profits, has to do two things. (1) select the risks which he wishes to
bear, and (2) manage them successfully. The selection of risk is made at almost
every step of a businessman‘s career. His important problem is the selection of
business in which he wishes to engage himself. In fact, success of profit would
depend upon the ability to foresee the future and prepare for it so that when
opportunity arises, it can be fully availed of. But even after, selection of a business,
many risks arise. Some of them he may have to bear even though he would rather
nor; others he may transfer to people more willing to bear them (or unable to
escape them); still others he may shift by insurance.
Profits vary from industry to industry and from businessman to businessman.
The greater the risk and uncertainty in business or industry, the greater are the
opportunities for large profits. Similarly, those businessmen who are
temperamentally cautious and are not willing to assume large risks get a smaller
margin of profit as compared to those who are more confident and adventurous.
Since risks, and, therefore, profits (and losses) appear because of changes and
uncertainties in a dynamic society, profits vary from year to year as well.
Profits are likely to be high in industries in which methods of production are
constantly changing so that there is continuous adoption of new techniques; in
nascent industries the prospects of which are rather uncertain; in industries in
which there is a large gestation period; and in industries in which resources are
irrevocably committed to narrowly specialised tasks.
Profits are also affected by the level of business activity. If business is brisk
and firms are operating at their maximum capacity, their average costs would be
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reduced to the minimum while their sales would be the maximum. This would lead
to higher profits. Profits would be reduced if the business activity is at a low ebb.
17.2 OBJECTIVE
To make the reader to understand the concept of profit and policies very
clearly.
17.3 CONTENTS
The basic function of profit is to provide businessman with an incentive to
produce what consumers want, when and where they want it at the lowest feasible
cost. This includes innovation of new products and new methods. In fact, the profit
motive is the kingpin of private enterprise, nay, of every business activity. In
addition, as pointed out by peter Drucker, profit serves three main purposes.
(1) Measure of Performance
It measures the net effectiveness and soundness of a business effort. A higher
profit is an indicator that the business is being run successfully and effectively.
It is true that profit is far from being a perfect measure of business efficiency but
it is probably the best indicator of the general efficiency of a firm. It is certainly the only
one which allows quick and easy comparison of performance of various firms.
(2) Premium to cover costs of staying in Business
Profit is the premium that covers the costs of staying in business-replacement,
obsolescence, market and technical risk and uncertainty. Seen from this point of
view, it may be argued that there is no such thing as profit; these are only the costs
of being and staying in business. The management of a business has to provide
adequately for these costs by generating sufficient profit.
(3) Ensuring Supply of Future capital
Profit ensures the supply of future capital for innovation and expansion, either
directly, by providing the means of self-financing out of retained profits, or
indirectly, through providing sufficient inducement for new external capital which
will optimise the company‘s capital structure and minimise its cost of capital.
The primary goal of a business firm is to ensure its own survival. From this
point of view, the firm must make a profit because profits are indispensable to
remaining viable and to remain alive. Again, the firm must have growth because
that is the only way it can perpetuate itself as an institution. And profits are a
natural concomitant of the growth and development of business over time. In fact,
―Profits are essential as a means to an end; they are not an end in themselves,
although essential for the continuity and growth of the firm.‖
a) PROFITEERING AND PROFIT – EARNING
Profiteering has to be understood as distinct from profit-earning. Where the
amount of profit made exceeds a socially acceptable limit by questionable methods,
it is a case of profiteering. Profiteering is often done by creation of artifical
shortages through hoarding or curtailing production.
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b) Accounting Profit and Economic Profit
In the accounting sense, profit is regarded as the revenue realised during the
period minus the cost and expenses incurred in producing the revenue. This
concept of profit is also known as the Residual Concept.
The economist, however, does not agree with the accountant‘s approach to
profit. The accountant would only deduct the explicit or actual costs from the
revenues to determine profit. The economist points out that in addition to the
deduction of explicit costs, imputed costs, e.g., the cost that would have been
incurred in the absence of the employment of self-owned factors, should also be
deducted. The example are (1) entrepreneur‘s wages (which he could earn by
working for someone else), (2) rental income on self-owned land and building
employed in the business (which the owner could have earned by letting it on hire
to some other firm), and (3) interest on self-owned capital (which could have been
earned by investing it elsewhere). The profit arrived at by deducting imputed costs
form accounting profit can be called as economic profit. (Economic profit =
Accounting profit – Imputed costs).
From the managerial point of view, economic profits are more important than
accounting profits because they alone would reflect the true profitablility of the
business. A firm while making accounting profits may be incurring economic
losses. Such a firm would have to withdraw from business in the long run.
c) Measuring Economic Profits
Illustration
Lala Jugal kishore of Aminabad, Lucknow, prepared the following Trading and
profit and Loss Statement for his shop of jeweler and gold ornaments.
TRADING AND PROFIT AND LOSS ACCOUNT
For the Year Ending DECEMBER 31, 2001
Rs Rs
To Opening stock 5.00,000 By Sales 63,50,000
To Purchases 55,00,000 By closing Stock 6,00,000
To Inward Parcel Postage 50,000
To Gross Profit 9,00,000
69,50,000 69,59,000
To Salaries and Wages 2,50,000 By Gross Profit 9,00,000
To Advertisement 50,000
To Boxes and Wrappings 30,000
To Office Supplies and Postage 10,000
To Light and power 25,000
To Insurance, Taxes and Repairs of Building 70,000
To Telephone 20,000
To Depreciation 50,000
To Interest on Borrowings 1,00,000
To Misc. Expenses 75,000
To Net Profit 2,20,000
9,00,000 9,00,000
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The above statement was given to a managerial economist for this comments.
On enquiry, Lala jugal kishore supplied the following additional information.
1. His drawings during the year amounted to Rs. 1,80,000.
2. Up to the year 2000, he worked as manager of another jewellery shop where
he was getting a salary of Rs. 10,000 per month. Since then, he left the service
and started his own retail shop.
3. The building in which the retail shop is housed is a two-storey building owned
by Lala jugal kishore. The building is located in Aminabad which is the
busiest market place situated in the heart of the town. The building can
readily be let out any time for Rs. 8,000 per month.
4. Lala Jugal Kishore invested his own capital of the order of Rs. 20,00,000. If
borrowed, it would have been obtained at 15 per cent per annum.
The managerial economist made certain adjustments as follows to arrive at
another estimate of profits.
Rs
Net Profit 2,20,000
Add: Insurance, taxes and repairs of building 70,000
2,90,000
Less: Proprietor’s Salary 1,20,000
Building rent 96,000
Interest on owned capital 3,00,000 5,16,000
Net Loss 2,26,000
1. Which of the above figure (of profit and loss) truly represents the working result
of the business?
2. Lala jagal Kishore when told that he is actually running the business at a loss
was surprised and argued as follows.
a) ―I do not actually draw any salary from the business. Moreover, I am not
working for salary but for profits.‖
b) ―I own the building myself. The item of rent, therefore, is adequately taken
care of by the expenses incurred in connection with the building such as
taxes, insurance, etc.‖
c) ― I do not actually charge interest on my owned capital. In fact, I have
worked to put this business in a position where there would be no need for
borrowing money. I think there is a great difference if a person puts his own
capital rather then be continually in debt to banks and moneylenders.‖
Do you agree with the above arguments of Lala jugal Kishore? What economic
functions did he perform? Is he a successful businessman? Should he close down
his business?
Solution
The profit 2,20,000 as shown by the Trading and profit and Loss account is
accounting profit representing the total revenue realised during the year minus the
costs and expense actually incurred in producing this revenue. The net loss of Rs.
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2,26,000 however, takes into account the opportunity cost of proprietor‘s labour,
the imputed cost of owned capital and the imputed rent of his own building. Thus it
reflects much more truly the profitability or otherwise of the firm, because in the
absence of self-employed factors, these costs would also have been incurred.
The arguments given by Lala Jugal Kishore are more sentimental than
economic. Basides acting as an entrepreneur, he is performing other functions of
land, labour (or organisation) and capital. The accounting profit of Rs. 2,20,000
includes rewards for performing these functions as well. To arrive at the true
profitability of the business, implicit costs for these functions must be excluded. On
that basis, the business is show to run at a loss. Lala Jugal Kishore, therefore,
cannot be considered a successful businessman. He should not, however, close
down his business immediately but rather improve it. If he closed down his
business, the may not immediately be able to get employment, lend his capital or
let his building on hire.
17.4 REVISION POINTS
Readers should understand the nature of the product and its relevance in profit
policy. Reader should capable of illustrating economic and accounting profit.
17.5IN TEXT QUESTIONS
1. Define the term profit.
2. What is meant by profit management?
3. Illustrate Economic profit with an example.
4. Distinguish accounting and Economic profit.
5. Discuss the need for profit analysis.
17.6 SUMMARY
Profit making is not an easy way in the global competition today. Also that there
are more number of substitutes are available today. A firm survives only with a
successful profit policy.
17.7TERMINAL EXERCISE
1. Take a small Industry of Reader‘s choice and suggest them a suitable profit policy.
17.8 ASSIGNMENT
1. Write an essay on profit management includes factors governing profit
management.
17.9 SUGGESTED READING
1. Managerial Economics, R. Sharam, Lakshmi Narain Agarwal publication.
17.10 LEARNING ACTIVITY
Learner can visit a small or cottage industry and analyse the problems faced by
them in fixing prices practically and may find solutions.
17.11 SUPPLEMENTARY MATERIALS
1. Tutorials could be browsed and PPT preparations could be witnessed to acquire
more knowledge regarding pricing policy.
17.12 KEY WORDS
1. Profit, remuneration to the firm, payment to entrepreneur, profit management.
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LESSON - 18
SOCIAL RESPONSIBILITY OF BUSINESS
18.1 INTRODUCTION
Though the basic goal of business is to earn a profit, yet business does not
operate in a social vacuum and it is argued that business has a social responsibility
as well. We are, therefore, presenting in a nutshell the various areas of social
responsibility of a business. The phrase social responsibility of business, refers to
the business responsibility for the well-being of the society and the total
environment in which it operates. The concept of social responsibility of business
has many connotations. First, business is responsible for performing its economic
function in the most effective and efficient manner. Secondly, in making its
decisions, it should give appropriate weightage to considerations of public interest.
Thirdly, business should keep into consideration the national priorities. Fourthly,
business should assume responsibility for solving the many social and ecological
problems created by industrial operations like urban congestion. Environmental
pollution, industrial discharges into water, depletion of natural resources, etc.
Fifthly, business should take an active interest in contributing to the solution of
general socio-economic problems like poverty, unemployment, and training facilities
for the unemployed. Finally, it should pay due regard to the goals and interests of
the other sections of the society. A firm can demonstrate its commitment to social
responsibility by being a good corporate citizen. The social responsibility of
business to the various sections of the society is outlined below.
Customers
(a) To provide wholesome products and services on a sustained and regular
basis at reasonable prices. (b) To avoid false advertisement and to provide truthful
information to them on the technical and utilitarian aspects of the products and
services. (c) To ensure continous product improvement through research and
development to enhance customer satisfaction. (d) To establish sound and ethical
business practices.
18.2 OBJECTIVE
To make the readers to understand the corporate social responsibility (CSR).
18.3 CONTENTS
i) Investors
(a) To maintain the productive and operational capacity and solvency of the
enterprise on a sound basis. (b) To provide timely, factual and full information on
the performance of the enterprise. (c) To safeguard the assets and interest of the
enterprise. (d) To sustain the profit generating capacity of the enterprise. (e) To
search for and take advantage of the opportunities for long-range profitability.
ii) Employees
(a) To formulate fair and sound employment policies to attract and retain
qualified and competent employees. (b) To encourage and inspire them to sharpen
and utilise their knowledge and skills towards fulfillment of organisational and
individual goals. (c) To motivate them to do their best by monetary and other
incentives and to enhance their morale in general. (d) Enlist employee co-operation
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and commitment to the organisation through the process of their participation in
management.
iii) Suppliers
(a) To deal fairly, ethically and legally with them. (b) To establish sound
business relations with them on a reciprocal basis.
iv) Competitors
(a) To compete fairly and ethically. (b) To adopt a policy of live and let live. (c)
To avoid indulging in collusive and restrictive trade practices.
v) Government
(a) To adhere to plan priorities. (b) To abide by the various rules and
regulations. (c) To pay taxes honestly and in time. (d) To co-operate and collaborate
with the Government in various nation-building activities, as for example, by
increasing exports.
In the United States and other western countries, concept of social
responsibility of business has received a lot of emphasis. In our country, however,
the level of social consciousness in trade and industry is rather low, though some
business houses have definite awareness of their social responsibilities.
18.4 REVISION POINT
Reader must note the growing awareness in ecology and the government insists
the corporate on their social responsibility.
18.5IN TEXT QUESTION
1. Discuss the role of corporate in social responsibility.
2. Suggest measures to strengthen CSR.
18.6 SUMMARY
CSR is a concept of the day and each firm has to spend 3% of their profit for
social activities. Thus, reader must understand the need for the hour of this
growing awareness with regard to CSR.
18.7 TERMINAL EXERCISE
1. Analyse the services rendered by the CSR wing of reputed blue chip companies
in India.
18.8 ASSIGNMENT
1. Write an essay on the measures taken by India to strengthen CSR.
18.9 SUGGESTED READING
1. Managerial Economics, R.L. Varshney & KL Maheswari, Sultan Chand & sons.
18.10 LEARNING ACTIVITY
1. Reader may read schedule 7 of the Indian constitution in order to understand
the activities assigned in CSR activities.
18.11 SUPPLEMENTARY MATERIAL
1. Reader may go through the details of foundations; trusts run by the corporate
and acquire more knowledge about CSR.
18.12KEY WORDS
CSR, Indian constitution.
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LESSON- 19
PROFIT PLANNING AND FORECASTING
19.1 INTRODUCTION
The signs of a healthy business include making a profit consistent with the
various risks that it has to face. A firm is faced with a number of uncertainties.
These uncertainties are created by the dynamic nature of consumer needs, the
diverse nature of competition, the uncontrollable nature of most elements of cost,
and the continuous technological developments.
So far as demand is concerned, save for the basic needs essential for survival,
consumer preferences are highly subjective and, therefore, most unpredictable. The
uncertainty about the pattern and quantum of consumer demand for a particular
product increases the degree of risk faced by the firm.
The nature of competition may be related to either product or price or to both
simultaneously. Product competition is more important till the product reaches the stage
of maturity stage. During the growth stage, the risk of product obsolescence and hence
shortening of the product life cycle is great. Again, if the scope of market segmentation
and product differential is great, the risk of product obsolescence increases; if such a
scope is less, the risk of price competition increases. It is said that normally, the degree
of risk involved in product competition is greater than in price competition.
In a period of continuously rising prices, no firm can be certain of its own
internal cost structure, for it does not have any control over the prices of raw
materials, the wages it would have to pay and the prices of other inputs including
the elements susceptible to indirect taxation.
Continuous technological improvements may make today‘s established commercial
production completely obsolete in course of time. If an improved process is available, a
firm can limit its risk by discarding its fixed investment. However, if it does not have
access to the improved process, it may have to go out of business altogether.
Unless a firm is prepared to face the uncertainties created by these risks, its
profits would be left to chance. Naturally, the firm will have to plan for profits. In
this respect, a thorough understanding of the relationship of costs, price and
volume is extremely helpful to business executives. The most important method of
determining the cost-volume-profit relationship is that of Break-even Analysis, also
known as cost-volume-profit (C-V-P) analysis.
19.2 OBJECTIVE
This lesson aims at explaining the concept of break even to the readers and
makes them to understand the significance in business.
19.3 CONTENTS
Break-Even Analysis
Break-even Analysis involves the study of revenues and costs of a firm in
relation to its volume of sales and specifically the determination of that volume at
which the firm‘s costs and revenues will be equal. The Break-even Point (BEP) may
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be defined as that level of sales at which total revenues equal total costs and the
net income is equal to zero. This is also known as no-profit no-less point. The main
objective of the break-even analysis is not simply to spot the BEP, but to develop an
understanding of the relationships of cost, price and volume within a company‘s
practical range of operations. The break-even chart is an ―excellent instrument
panel for your guidance in controlling your business.
Determination of the Break-even point
It may be determined either in terms of physical units or in money terms, i.e.,
sales value in rupees.
Break-even Point in Terms of Physical Units
This method is convenient for the single-product firm. The break-even volume
is the number of units of the product which must be sold to earn enough revenue
just to cover all expenses-both fixed and variable. The selling price of a unit covers
not only its variable cost but also leaves a margin (contribution margin) to
contribute towards the fixed costs (costs remaining fixed irrespective of the volume).
The break-even point is reached when sufficient number of units have been sold so
that the total contribution margin of the units sold is equal to the fixed costs. The
formula for calculating the break-even point is:
Fixed cos ts
BEP
Contribution m arg in per unit
where the contribution margin is: Selling Price-Variable costs per unit.
Example 1
Suppose the fixed costs of a factory are Rs. 10,000 per year, the variable costs
are Rs. 2.00 per unit and the selling price is Rs. 4.00 per unit. The break-even
point would be:
10, 000
BEP 5, 000
4 2 units.
In other words, the company would not make any loss or profit at a sales
volume of 5,000 units as shown below:
Sales Rs. 20,000
Cost of goods sold
Variable cost @ Rs. 2.00 Rs. 10,000
Fixed costs Rs. 10,000 Rs. 20,000
Net profit Nil
Break-even point in Terms of Sales value
Multi-product firms are not in a position to measure the break-even point in
terms of any common unit of product. They find it convenient to determine to
determine their break-even point in terms of total rupee sales. Here, again, the
break-even point would be the point where the contribution margin (Sales value –
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Variable costs) would equal the fixed costs. The contribution margin, however, is
expressed as a ratio to sales. For example, if the sales are Rs. 200 and the variable
costs of these sales is Rs. 140, the contribution margin ratio is (200 - 140)/200, i.e,
0.3.
The formula for calculating the break-even point is:
Fixed cos ts
BEP
Contribution m arg in ratio
Example 2
Sales Rs. 10,000
Variable costs Rs. 6,000
Fixed costs Rs. 3,000
The contribution margin ratio is (10,000 – 6,000)/10,000 = 0.4
Fixed cos ts 3, 000
BEP Rs.7,500
Contribution m arg in ratio 0.4
It will be clear from the following calculation that at the sales value of
Rs.7,500 (BEP), there is no-profit no-loss.
Sales value Rs. 7,500
Less: Variable costs (0.6 7,500) Rs. 4,500
Fixed Costs Rs. 3,000 Rs. 7,500
Net profit Nil
Example 3
Sales were Rs. 15,000 producing a profit of Rs. 400 in a week. In the next
week, sales amount to Rs. 19,000 producing a profit of Rs. 1,200. Find out the
BEP.
Solution
Increase in sales 19,000 – 15,000 = Rs. 4,000
Increase in profit 1,200 – 400 = Rs. 800
Increases in variable costs 4,000 – 800 = Rs. 3,200
Over sales of Rs. 4,000, variable costs are Rs. 3,200.
Hence VC per rupee of sale is 3,200 4,000 = 0.80.
Hence, given sales of Rs. 15,000, fixed costs will be as under:
VC = 15,000 0.80 12,000
Profit 400
VC + Profit 12,400
Sales Value 15,000
Fixed Cost 2,600
Now, contribution margin ratio
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50 40 1
Lamp - 100 100 20 per cent
40 5
70 50 2
Chair - 100 100 28.57 per cent
70 7
Now, we multiply the contribution percentage of each of the products by the
percentage of sales volume for particular product and add the figures so obtained.
This gives the total contribution per rupee of sales volume for table, lamps and
chairs:
Contribution % % of Sales
Tables 25.00 20 = 5.00
Lamps 20.00 30 = 6.00
Chairs 28.57 50 = 14.28
25.28 % or say 25 %
This 25 per cent is the total contribution per rupee of overall sales given the
present product sales mix.
1.BEP
The BEP of the firm may now be calculated as under:
Fixed cos ts 20, 000
BEP 80, 000
Contribution m arg in ratio 25%
2. Profit
Calculation of profit or loss at various volumes can also be made easily. If the
firm produces at 80 per cent of capacity (assuming the same product mix), the
profit will be calculated as under:
Profit=Total revenue – Total costs
=80% of (1,50,000) – Fixed costs – Variable costs
=1,20,000 – 20,000 – 75% of (1,20,000)
=1,20,000 – 20,000 – 90,000 = Rs. 10,000
Break – even charts
Break-even analysis is very commonly presented by means of break-even
charts, also known as profit-graphs. A break-even chart prepared on the basis of
Example 1 above is given in Fig. 1. Units of product are shown on the horizontal
axis OX and revenues and costs are shown on the vertical axis OY. The fixed costs
of Rs. 10,000 are represented by a straight line parallel to the horizontal axis.
Variable costs are then plotted over and above the fixed costs. The resultant line is
the total cost line, combining both variable and fixed costs. There is no variable cost
line in the graph; variable costs are represented by the vertical distance between
the fixed cost and the total cost lines. The total cost at any point is the sum of Rs.
10,000 plus Rs. 2.00 per unit of variable cost multiplied by the number of units
sold at that point. Total revenue at any point is the unit price of Rs. 4.00 multiplied
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by the number of units sold. The break-even point corresponds to the point of
intersection of the total revenue and the total cost lines. Projecting a perpendicular
from the BEP to the horizontal axis shows the break-even point in units of the
product. Dropping a perpendicular from BEP to the vertical axis shows the break-
even sales value in rupees. Below the BEP (or to the left of it), total costs are more
than total revenue and the firm would suffer a loss. Above the BEP (or to its right),
total revenue exceeds total costs and the firm would be making profits. Since profit
or loss occurs between them is known as the profit zone (to the right of the BEP)
and the loss zone (to the left of the BEP).
Where the BEP is measured in terms of sales value rather than in physical
units, the break-even chart remains basically the same as in Fig.1. The only
difference is that the volume on the X-axis is measured in terms of sales value. In
that case, a perpendicular from the point BEP to either axis would show the break-
even rupee sales value. The same type of chart can be used to depict the BEP in
relation to full capacity; in this case, the horizontal axis would represent the
percentage of full capacity, instead of physical units or the sale value.
19.4 REVISION POINTS
1. Reader must know TR, TC curves, BEP point and break even quantity, FC &
AC curves. It has to be understood why graphically FC is parallel to x axis and
why TR starts from the origin. Understanding the diagram will make the
reader to learn the topic easily.
19.5.IN TEXT QUESTION
1. Illustrate BEP with an example
2. Discuss the usage of estimating BEP.
19.6. SUMMARY
1. BEP is the point where the firm enjoys no profit or no loss. After attaining BEP
quantity the firm starts earning profit. In long run this is the condition of any
profit making firm. Diversification of products of a multi product firm is more
conveniently achieves BEP. For example ITC was producing only cigarettes on
those days but now they produce goods for all levels of customers and thus
enjoy a comfortable position.
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19.7. TERMINAL EXERCISE
1. Prepare a list of items produced by ITC and examine how many products they
manufacture.
19.8. ASSIGNMENT
1. Evaluate a list of fixed and variable costs incurred by a firm.
19.9. SUGGESTED READING
1. Managerial Economics by Varshney and Maheswari, Sultan and Chands, New
Delhi publications.
19.10. LEARNING ACTIVITIES
1. Arrange a group discussion on this topic among readers.
19.11. SUPPLEMENTARY READING
1. BEP slide shows and pdf files are plenty available as web sources. Tutorials
are also available in internet.
10.12. KEY WORDS
1. Break even analysis, BEP, & breakeven point.
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UNIT - VI : NATIONAL INCOME AND BUSINESS CYCLE
LESSON- 20
MANAGERIAL USES OF BREAK-EVEN ANALYSIS
20.1. INTRODUCTION
To the management, the utility of break-even analysis lies in the fact that it
present a microscopic picture of the profit structure of a business enterprise.
Break-even analysis not only highlights the areas of economic strength and
weaknesses in the firm but also sharpens the focus on certain leverages which can
be operated upon to enhance its profitability. Ever-changing contributions are
characteristic of modern business life and through break-even analysis, it is
possible for the management to examine the profit vulnerability of a business firm
to the possible changes in business conditions, for example, sales prospects,
changes in cost structure, etc. Through break-even analysis, it is possible to devise
managerial actions to maintain and enhance profitability of the firm. The break-
even analysis can be used for the following purposes.
20.2. OBJECTIVE
This lesson aims at explaining the usage of BEP in business decisions.
20.3. CONTENTS
1. Safety Margin
The break-even chart can help the management to know at a glance the profits
generated at the various levels of sales. But while deciding upon the volume at
which the firm would operate, apart from the demand, the management should
consider the ‗Safety Margin‘ associated with the proposed volume. The safety
margin refers to the extent to which the firm can afford a decline in sales before it
starts incurring losses. The formula to determine the safety margin is:
Thus the difference between the gross aggregate and the net aggregate is depreciation.
i.e., GNP at market price/factor cost = NNP at market price/factor cost + depreciation.
National and Domestic Concepts
The term national denotes that the aggregate under consideration represents
the total income which accrues to the normal residents of a country due to their
participation in world production during the current year. Thus, the term ‗national‘
is used to emphasize that the aggregate under consideration covers all types of
factor incomes accruing to normal residents of a country irrespective of whether the
factors of production supplied by them are located at home or abroad.
As against this, it is also possible to measure the value of the total output or
income originating within the specified geographical boundary of a country known
as ―domestic territory‖. The resulting measure is called ―domestic product‖.
In other words, the distinction between ―national‖ and ―domestic‖ aggregates
lies in the frame of reference-the former takes the normal residents of a country;
the latter takes a given ―geographical area‖. Here, national product differs from
domestic product by the amount of net factor income from abroad.
GNP at market price/factor cost = GDP at market price/factor cost + Net factor income from
abroad.
NNP at market price/factor cost = NDP at market price/factor cost + Net factor income from
abroad.
Net factor income from abroad = Factor income received from abroad – Factor income paid
abroad.
Market Prices and Factor Costs
The valuation of the national product at market prices indicates the total
amount actually paid by the final buyers while the valuation of national product at
factor cost is a measure of the total amount earned by the factors of production for
their contribution to the final output.
GNP at market price = GNP at factor cost + indirect taxes-Subsidies.
NNP at market price = NNP at factor cost + indirect taxes – Subsidies.
And vice Versa.
Category A Category B
Type 1 GNP at market price GDP at market price
NNP at market price NDP at market price
Type 2 GNP at factor cost GDP at factor cost
NNP at factor cost NDP at factor cost
Difference between the aggregates in category A and aggregates in category B is
net factor income from abroad.
Difference between the aggregates of type 1 and aggregates of type 2 is indirect
taxes less subsidies.
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The difference between the two aggregates of each type in each category is
depreciation.
ii) Gross National Product and Cross Domestic Product
For some purposes we need to find the total income generated from production
within the territorial boundaries of an economy, irrespective of whether it belongs to
the inhabitants of that nation or not. Such an income is known as Cross Domestic
Product (GDP) and found as:
GDP = GNP – Net factor income from abroad
Net factor income from abroad = Factor income received from abroad – Factor
income paid abroad.
For example, if in 1986 the GNP is Rs 8,00,000 million, the income (including
tax on such incomes) received from and paid abroad Rs 60,000 million, and Rs 70,
000 million respectively, then, the GDP in 1986 would be:
(Rs. 8,00,000 – 70,000 + 60,000) million = Rs 7,90,000 million
iii) GNP as a Sum of Expenditures on Final Products
Expenditure on final products in an economy can be classified into the
following categories:
Personal consumption expenditure (c):- The sum of expenditure on both the
durable and non-durable goods as well as services for consumption purposes.
Gross Private Investment (Ig) is the total expenditure incurred for the
replacement of capital goods and for additional investment.
Government expenditure (G) is the sum of expenditure on consumption and
capital goods by the government, and
Net Exports (Exports – Imports) (X-M) constitute the difference between the
expenditure or rest of the world on output of the national economy and the
expenditure of the national economy on output of the rest of the world.
GNP is the aggregate of the above mentioned four categories of consumption
expenditure. That is,
GNP = C + Ig + G + (X – M)
iv) GNP as the total of factor Incomes
As mentioned above, national product gives a measure of a nation‘s productive
activity, irrespective of the fact whether this activity takes place at home or abroad.
When national income is calculated after excluding indirect taxes like excise duty,
sales tax, etc. and including subsides we get GNP at factor cost as this is the
amount received by all the factors of production (indirect taxes being the amount
claimed by the government and subsidies becoming a part of factor income).
GNP at factor cost = GNP at market prices – Indirect taxes + Subsidies
v) Net National product
The NNP is an alternative and closely related measure of the national income.
It differs from GNP in only one respect. GNP is the sum of final products. It includes
consumption goods plus gross investment plus government expenditures on goods
and services plus net exports, Here gross investment (I g) is the increase in
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investment plus fixed assets like buildings and equipment and thus exceeds net
investment (In) by depreciation.
GNP = NNP + Depreciation
NNP includes net private investment while GNP includes gross private domestic
investment.
We know that during the process of production, assets get consumed or
depreciated. So, during a year the net contribution to output is the production of
goods and services minus the depreciation during the year. This is known as NNP
at market prices because it is the net money value of final goods and services
produced at current prices during the year after depreciation.
NNP at Factor Cost (Or National Income)
Goods and services are produced with the help of factors of production.
National income or NNP at factor cost is the sum of all the income payments
received by these factors of production.
NI = GNP – Depreciation – Indirect taxes + Subsidies
Since factors receive subsidies, they are added while indirect taxes are
subtracted as these do not form part of the factor income.
NNP at factor cost = NNP at market prices – Indirect taxes + Subsidies
vi) Personal Income
National income is the total income accruing to the factors of production for
their contribution to current production. It does not represent the total income that
individuals actually receive. Personal income is calculated by subtracting from
national income those types of incomes which are earned but not received and
adding those types which are received and adding those types which are received
but not currently earned. So Personal Income = NNP at factor cost – Undistributed
profits – Corporate taxes + transfer payments.
vii) Disposable Income
Disposable income is the total income that actually remains with individuals to
dispose off as they wish. It differs from personal income by the amount of direct
taxes paid by individuals.
Disposable Income = Personal Income – Personal taxes
Value Added
The concept of value added is a useful device to find out the exact amount that
is added at each stage of production to the value of the final product. Value added
can be defined as the difference between the value of output produced by that firm
and the total expenditure incurred by it one the materials and intermediate
products purchased from other business firms. Thus, value added is obtained by
deducting the value of material inputs or intermediate products from the
corresponding value of output.
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Value added = Total sales + Closing stock of finished and semi-finished goods –
Total expenditure on raw materials and intermediate products – Opening stock of
finished and semi-finished goods.
The table below summaries the relationship among all of the above concepts:
Less: Depreciation or Capital Consumption Allowances Gross National product (GNP)
Less: Indirect Taxes plus Subsidies Net National Product (NNP)
Less: government income from property and National Income (NI)
entrepreneurship
Social security taxes
Corporate profit taxes
Retained earnings
Less: Plus Transfer Payments Personal Income (PI)
Personal Taxes Disposable Personal Income (DPI)
Which is available for
Personal consumption expenditure
National income Identities
There are many important concepts and measures in national income
accounts. National income identities are formulated in terms of these concepts and
measure. For Proper understanding of macroeconomic theory one is to be clear
about the distinction between identity and an equation or an equilibrium condition.
Several national income identities can be identified which are very useful in
macroeconomic discussions. National income accounting is also referred to as
social accounting. The identities explained below take care of national income and
other social accounts.
1. Net National Product (NNP) at market price = NNP at factor cost (or National
income) + Indirect taxes – Subsidies.
2. The above identity explains the relationship between NNP at factor cost and
NNP at market price.
3. Market price of a unit of a commodity = factor cost per unit + net indirect
taxes, net indirect taxes being indirect taxes minus subsidies.
4. Net National Disposable Income = NNP at market prices + Other current
transfer from rest of the world.
5. Net Domestic product at Market Price = NNP at market prices – Net factor
income from abroad.
6. Net Domestic Disposable Product at market = Net National disposable income –
Net factor income from abroad minus other current transfers from rest of the
world.
7. Net Domestic Product at factor cost = Net domestic product at market prices –
indirect taxes + Subsides.
8. Private income = Income accruing to private sector from domestic product +
Interest on public dept + Current transfers from goverment administrative
193
departments + other current transfers from rest of the world + Net factor
income from abroad.
9. Personal income = Private income – Saving of private corporate sector net of
retained earnings of foreign companies – Corporation tax.
10. Personal Disposable income = Personal income – Direct taxes paid by
households – Miscellaneous receipts of government administrative
departments.
11. When is gross national product (GNP)? The following identity tells us about
GNP.
12. GNP = NNP + depreciation
13. Thus GNP is gross of depreciation and the NNP is net of depreciation. As there
are no ways to determine precisely the amount of depreciation, the usual
national income measure used is GNP. For similar reasons gross domestic
product (GDP) is used instead of NDP.
14. GDP at market prices = NDP at factor cost + Consumption of fixed capital +
(indirect taxes - subsidies)
15. Expenditure on GDP = Government final consumption expenditure + Private
consumption expenditure + Gross fixed capital formation + change in stocks +
exports of goods and services – imports of goods and services + statistical
discrepancies = GDP.
16. Appropriation of disposable income = Government final consumption
expenditure + Private final consumption expenditure + Saving + statistical
discrepancy.
17. Disposable income = NDP at factor cost + Compensation of employees from the
rest of the world (Net) + Property and entrepreneurial income + indirect taxes –
subsidies + other current transfers from the rest of the world (net).
18. Gross accumulation = Domestic saving + Consumption of fixed capital + capital
transfers from the rest of the world (net).
19. Value of current transactions = Exports of goods and services + compensation
of employees from the rest of the world + property and entrepreneurial income
from the rest of the world + other current transfers from the rest of the world +
adjustment or merchandise exports to the change of ownership basis.
20. Disposal of current receipts = imports of goods and services + compensation of
employees to the rest of the world + Property and entrepreneurial income to the
rest of the world + other current transfers to the rest of the world + adjustment
of merchandise imports to the change of ownership basis – surplus of the
nation on current account.
21. Capital receipts = surplus of the nation on current account + capital transfers
form the rest of the world (net) + net incurrence of foreign liabilities.
22. Capital account disbursements = purchases of intangible assets from the rest
of world (net) + acquisition of foreign financial assets.
21.4. REVISION POINTS
1. Reader must familiar with the components of National Income parameters like
GNP, NNP, Disposable income etc.
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21.5. IN TEXT QUESTIONS
1. Elaborately discuss identities of national income.
2. Explain various needs for National Income estimation.
3. Explain the nexus between National Income and economic development.
21.6. SUMMARY
1. Estimation of National Income involves so many identities explained in the
lesson. Read carefully and understand the illustrations. As National Income is
the indicator of growth of a county, this study becomes vital.
2.7.TERMINAL EXERCISE
1. Find out factors not included in estimation of national Income and suggest
measures to get rid of that.
21.8. ASSIGNMENT
1. Prepare an essay to show the growth of National Income in various sectors
after globalization.
21.9. SUGGESTED READING
1. Macro Economics, ML Jhingam, Vrinda Publication.
21.10. LEARNING ACTIVITY
1. Students can arrange a group discussion to discuss the concepts of national
income.
21.11. SUPPLEMENTARY READING
1. Browse for the concept and see PPT available in order to deeper the
knowledge.
21.12. KEYWORDS
National Income, GNP, NNP, Disposable income.
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LESSON -22
APPROACHES TO MEASURE NATIONAL INCOME
22.1 INTRODUCTION
It is evident that the measurement of national income involves the
measurement of the size of the circular flow. Basically there are three ways of
looking at the circular flow of income. It arises out of the process of activity chain in
which production creates income, income generates spending and spending in turn
induces production. Accordingly there are three different ways in which we can
measure the size of the circular flow. We can measure it either at the production
stage by measuring the value of output or at the income accrual stage by
measuring the amount of factor income earned or at the expenditure stage by
measuring the size of total expenditure incurred in the economy.
22.2. OBJECTIVE
This lesson aims at explaining various approaches in calculating national income.
22.3. CONTENTS
Product Approach
Income Approach
Expenditure Approach
i) Product Approach
According to this method, the sum of net value of goods and services produced
at market prices is found. Three steps are involved in calculation of national income
through this method.
Gross product is calculated by sensing up the money value of output in the
different sectors of the economy.
Money value of raw material and services used and the amount of
depreciation of physical assets involved in the production process are
summed up.
The net output or value added is found by subtracting the aggregate of the
cost of raw material, services and depreciation form the gross product found
in first step.
This approach is used to estimate gross and net value added in the following
sectors of the Indian economy.
Agriculture and allied activities (e.g., animal husbandry)
Forestry and Logging
Fishing
Mining and Quarrying
Registered Manufacturing
ii) Income Approach
This approach is also known as the income-distributed method. According to
this method, the incomes received by all the basic factors of production used in the
production process are summed up. The basic factors for the purposes of national
income are categorized as labour and capital. We have three incomes.
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Labour income which includes wages, salaries, bonus, social security and
welfare contributions.
Capital income which includes dividends, pre-tax retained earnings, interest
on saving and bonus, rent, royalties and profits of government enterprises.
Mixed income, i.e., earnings from professions, farming enterprises, etc.
These three components of income are added together to get national income.The approach
is used for following activities.
Railways
Electricity, gas and water supply
Transport, storage and communication
Banking, finance and insurance
Real estate
Public administration and defence
For the first three groups almost complete data are available from annual
accounts. Such data are also available for parts of letter three-the part that is in the
organized sector. For the rest the indirect approach has to be employed.
Database is the weakest for unorganized sectors of the economy such as
unregistered manufacturing, trade, hotels and restaurants and a variety of personal
services. For these sectors rough and ready estimates based sometimes on
production approach, sometimes on income approach are used. Most often
estimates are obtained for a benchmark year during which a major survey had been
conducted and then these benchmark estimates are brought up to date using a
variety of indicators.
Constant price estimates using the income approach are obtained by updating
the base year estimates using some physical indices such as amount of electricity
sold, tonnekilometres of freight transport, etc.
iii) Expenditure Approach
This method is known as the final product method. According to this method,
the total national expenditure is the sum of the expenditure incurred by the society
in a particular year. The expenditures are classified personal consumption
expenditure. net domestic investment, government expenditure on goods and
services and net foreign investment (imports-exports).
These three approaches to the measurement of national income yield identical
results. They provide three alternative methods of measuring essentially the same
magnitude. If we follow the product approach or the expenditure approach, we are
in effect trying to measure national income by the size of the income flow in the
upper half of the circle. As against this if we follow income approach, we are
actually trying to measure the flow in the lower half of the circle.
iv) Real vs. Money National Product
Measurement of national income depends upon two types of factors: (a)
quantities of different products actually produced during the given year, and (b) the
corresponding set of money prices used for converting diverse physical quantities
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into standardized values for aggregation. If the latter also relates to the same year
as the former, the resulting aggregate is called national product at current prices or
money national product (money NNP). If one has the figures for two years, say 1960
and 1970, a direct comparison of the two figures will show the direction and
magnitude of change in the aggregate flow of factor incomes originating in the
economy between 1960 and 1970. However, it will not give us any indication
regarding magnitude and direction of change in volume of physical output
produced between 1960 and 1970. Both the types of factors determine money NNP.
Physical output and money price might have undergone a change between 1960
and 1970. To measure the change in the physical output, we should eliminate the
effect of changes in the price levels.
The measure that is devised for the purpose of comparing the volume of
physical output produced during different years is known as Real National product
(Real NNP). This is desired by ―deflating‖ the money NNP with an ―index number of
prices‖. Deflation is the procedure by which the effect of variations in the
measuring rod of money prices is ―eliminated‖.
The formula is
Money NNP
Real NNP = 100
Pr ice Index
c) Problem of Computation of per capita Income
Per capita income is arrived at by dividing GNP by the total population. It is
actually the per head average share in national income.
Increase in per capita income is determined by
rate of increase in GNP and
rate of growth of population
In case growth rate of GNP is lower than that of the growth of population, an
increase in GNP does not necessarily mean increase in per capita income. Per
capita income is given emphasis as a better measure of individual economic welfare
than GNP, which does not take into account the distribution aspect. Growth in GNP
cannot be used as an indicator of economic welfare since welfare is to be related to
individual‘s share in the national cake, namely, the per capita disposable income.
22.4. REVISION POINTS
1. Reader must familiar with the components of National Income parameters like
GNP, NNP, Disposable income etc.
22.5. IN TEXT QUESTIONS
1) Elaborately discuss GNP and NNP.
2) Explain various approaches on National Income estimation.
3) Explain the nexus between National Income and economic development.
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22.6. SUMMARY
Estimation of National Income involves so many technical aspects explained in
the lesson. Read carefully and understand the illustrations. As National Income is
the indicator of growth of a county, fool proof estimation of National income
becomes vital.
22.7.TERMINAL EXERCISE
1. Find out factors affecting the estimation of national Income and suggest
measures to get rid of theat.
22.8. ASSIGNMENT
1. Prepare an essay to show the growth of National Income in India offer
independence.
22.9. SUGGESTED READING
1. Macro Economics, ML Jhingam, Vrinda Publication.
22.10. LEARNING ACTIVITY
1. Students can arrange a group discussion to discuss above studied
approaches.
22.11. SUPPLEMENTARY READING
1. Browse for the concept and see PPT available in order to deeper the
knowledge.
22.12. KEYWORDS
1. National Income, GNP, NNP, Disposable income.
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LESSON - 23
BUSINESS CYCLE
23.1. INTRODUCTION
The economic progress the world has been achieved is not a steady and
continuous movement forward. Economic activities faced fluctuations at more or
less regular intervals. There were upward swings and downward swings. A period of
prosperity was generally followed by a period of depression. These ups and downs
in the economic activity moving like a wave at regular intervals is known as
business cycle. Business cycle simply means the whole course of business activity
which passes through the phases of prosperity and depression.
23.2. OBJECTIVE
To make the students to understand the conupt of business cycle very
clearly.
23.3. CONTENTS
a) Phase of business cycle
i) Boom
This is also known as prosperity phase. The products in this phase fetch an
above normal price which is above higher profit. This attracts more and more
investors. The existing production capacity is utilized at its full capacity. More and
more new machines are made use of the business of the capital goods industry also
shoots up. The price of the factors of production increases. Additional workers are
employed at higher wage rate. The increasing cost tendency of the factors of
production leads to a continuous increase in product cost. The fixed income group
on the salaried class found it difficult to cope with this increase in prices. The
income dose not increases accordingly and they ate now compelled to reduce
consumption. The demand is now more or less stagnant or it even decreases. Thus
boom or prosperity reaches its peak.
ii) Recession
Once the economy reaches the peak, the course changes a downward tendency
in demand is observed but the producers who are not aware of it go on producing
further. The supply now exceeds demand. Now the producers come to notice that
their stock piling up. They are compelled to give up the future investment plans.
The order for new equipments and raw materials are cancelled. A business even
cuts down its existing business. Workers are retrenched capital goods producers
who lose orders. Bankers insist on repayment stock accumulate and Business
failure increase investment ceases and unemployment leads to fall in income,
expenditure, prices, profits and industrial and trade activities. Desire for liquidity
increases all around producers are compelled to reduce price so that they can find
money to meet their obligations consumers who expect a still further decline in
prices postpone their consumption stock goes on piling up. some firms are forced
into bankruptcy. The failure of one firm affects other firm with whom it has
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business connections. There is a general distress. This phase of the business cycle
is known as the Recession. It is the period of utmost-suffering for a business.
iii) Depression
Underemployment of both men and material is the characteristics of this
phase. General demand falls faster than production. Producers are compelled to see
their goods at a price which will not even cover the full cost. Manufactures of both
producer‘s goods and consumers goods are forced to reduce the volume of
production. As a result workers are thrown out. The remaining workers are poorly
paid. The demand for bank credit is at its lowest which results in idle funds. The
interest rates also decline. The firms that cannot pay of their debts are wound up.
Prices of shares and securities fall down.
Pessimism prevails in the economy the less confident investors are not ready
to take up new investment projects the aggregate economic activity is at its bottom.
iv)Recovery
Depression phase does not continue indefinitely. Depression contains in itself
the gems of recovery. The rule workers now come forward to work at low wages. As
the prices are at its lowest the consumers, who postponed their consumption
expecting a still further fall in price, now starts consuming. The banks, with
accumulated cash reserves, now come forward to gives loans at easier terms and
lower rates. As demand increases the stock of goods become insufficient. The
economic activity now starts picking up. Investment pick up. Employment and
output slowly and steadily begins to rise. Increased income increases demand,
resulting in rise in prices, profits investment, employment and incomes. The wave
of recovery one initiated soon begins to feed upon Itself. Stock markets become live
thus hastening the revival. Optimism develops among the entrepreneurs. Bank
loans and demand for credit starts rising. the depression phase at its through then
given way to recovery.
Characteristics of a business cycle
1. The cycle is synchronic. The upward and downward movements tend to occur
at all the same period in all industries. The wave of prosperity or depression
generates a wave in other industries. When industry picks up to provides
more employment, more income etc. to workers and it given new orders for
raw materials and capital goods. This help other firms also to prosper.
2. A business cycle is a wave-like movement. The period of prosperity and
depression can be alternately seen in a cycle.
3. Cyclical fluctuations are recurring in nature. The various phases are repeated
is followed by depression and the depression again in followed by a boom.
4. Business cycle is cumulative and self-reinforcing in nature. Each movement
feeds on itself and keeps up the movement in the same direction. Once booms
starts it goes on growing till forces accumulate to reverse the direction.
5. There can be no indefinite depression or eternal boom period. Each phase
contain in itself the seed for other phase. The boom, when it reaches its peak,
turns to recession.
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6. Business cycles are pervasive in their effects. The cyclical fluctuations affect
each and every part of the economy. Depression or prosperity felt in one part
of the economy makes its impact in other part also. The cyclical movement is
even international in character. The mechanism of international trade makes
the boom or depression in one country shared by other countries also.
7. Presence of a crisis. The up and down movements are not symmetrical. The
downward movements are not symmetrical. The downward movement is more
sudden and violent than the upward movement.
8. b) Types of Business Cycle
9. Prof. James Arthur classified business cycle into 3 parts as follows:
10. Major and Minor Trade Cycles: Major trade cycles are those the period of
which is very large. Minor trade cycles are those which occur during the
period of a major cycle. Prof. Hanson determines the period of a major cycle
between 8 years and 33 years. Two or three minor cycles occur during the
period of a major cycle. Period of a minor cycle is 40 months.
11. Building Cycle: Building Cycles are those trade cycles which are related with
construction industry. period of such cycle range from 15 to 20 years.
12. Long Waves: Period of a long wave is of 50 years. It was discovered by a
Russian economist kondratief. One or two major trade cycle occur during the
period of a long wave.
c) Schumpeter distinguished 3 types of trade cycle as follows
1. Short Kitchin Cycle: The period of this cycle is very short, approximately 4
months duration.
2. Longer juglar cycle: This cycle has average 9.5 years duration.
3. Very long Kondratief Wave: If takes more than 50 years to run its course.
d) Causes of Business Cycle
Two kinds of element or forces bring about business cycle. They are internal
and external. Internal forces are elements within the very sphere of business
activity itself and include such things as production, income, demand, credit,
interest rates, and inventories. External forces are elements outside the normal
scope of business activity and include population growth, wars, basic changes in
the nation‘s currency and national economic policies. Also floods, droughts and
other catastrophes that have effect on business activity.
Important causes giving birth to business cycle may be summarized as follows.
1. Expansion of loans and contraction of loans by banks.
2. Monetary disequilibrium
3. Change in the volume of investment or decrease in the marginal efficiency of
capital
4. under consumption or excessive saving
5. Lack of adjustment between demand and supply
6. Dealings of entrepreneurs
7. Innovation
8. Seasonal fluctuations.
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e) Control of Business cycle
The business cycle leads to greater unemployment and poverty. The various
steps that can be taken to achieve economic stability are (i) monetary policy and (ii)
fiscal policy.
i) Monetary Policy
Monetary policy refers to the programs adopted by the central bank to control
the supply of money. The central bank may resort to open market operations,
changes in bank rate or changes in the variable reserve ratio. The open market
implies the purchase and sale of government bonds and securities. In the boom
period the central bank sells government bonds and securities to the public which
helps to withdraw money form the public. During periods of depression the central
bank purchases government securities which increase the cash supply in the
economy. This helps to increase investment. The central bank purchase
government securities which increase the cash supply in the economy. This helps
to increase investment. The central bank may change the bank rate or rediscount
rate. The bank rate is the rate at which commercial banks borrow from central
bank. When the central bank increases the bank rate the commercial banks in turn
will raise their discount rates for the public. This discourages public borrowing and
it reduces investment. During the depression the bank rate is lowered which will
end up the increased investment. The central bank can regulate the money supply
by changing the variable reserve ratio. When the central bank wants to reduce the
credit creation capacity of commercial banks, it will increase the ratio of the
deposits to be held by the commercial bank as reserve with the central bank.
ii) Fiscal Policy
This implies the variation in taxation and public expenditure programme by
the government to achieve certain objectives. Taxation helps to withdraw cash from
the public. An increase in tax results in reduction of private disposable income.
Taxes should be reduced during the depression will stimulate private sector. During
boom periods public expenditure must be curtailed, so that cash flow can be
reduced. The fiscal policy of the government to regulate purchasing power to control
business cycle is known as counter the cyclical fiscal policy. Counter-cyclical fiscal
policy in the boom period implies a reduction in the public expenditure and heavy
taxes and a surplus budget. The budget surplus can be used to eliminate previous
deficits. This implies an increase in public expenditure, reduction in taxation and
deficit budgeting during the depression. The monetary policy proves more effective
to control boom than to depression. A proper mix of fiscal and monetary policy will
be more fruitful in the control of business cycles.
23.4. REVISION POINTS
1. Fiscal and monetary policy is both money related policies. Prior related to
union government and later related to Reserve Bank of India.
23.5.IN TEXT QUESTION
1. Define the concept business cycle.
2. Explain various phases of business cycle.
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3. Mention the causes for business cycles.
4. Discuss the methods to control business cycle.
5. Distinguish monetary and fiscal policy.
23.6. SUMMARY
In order to control the money supply during the phases of trade cycle, the
union government and Reserve Bank of India use tools to control them.
23.7.Terminal exercise
1. Watch the inflation level day to day, and see what type of monetary policy is
announced by the finance minister and RBI governor.
23.8, ASSIGNMENT
1. Analyse inflation control measures adopted by RBI and union finance
ministry.
23.9. SUGGESTED READING
1. Managerial Economics, R. Sharma, Lakshmi Narayan Agarwal publication.
23.10. LEARNING ACTIVITY
1. Arrangement can be made for a group discussion to discuss the topic.
23.11. SUPPLEMENTARY READING
1. Browsing for material and PPT will help the reader to get deep knowledge in
the subject.
23.12. KEY WORDS
1. Business cycle, Fiscal policy, monetary policy.
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LESSON - 24
BUSINESS FORECASTING
24.1. INTRODUCTION
A forecast of sales of depends upon economic forecasts. This is because the
sales of almost every firm are affected by the state of general business. Periods of
depression and boom have an influence on the sales value. Sales may be at an
increase during the prosperity but might decline during the depression. The
businessman should take into consideration the business cycle he is facing so that
he can have an effective forecast of sales. The important methods of forecasting are
(1) Trend projection (2) Leading Indices, and (3) Econometric Models.
24.2 OBJECTIVE
To make the readers to understand the requirement of business forecasting in
business.
24.3 CONTENT
a) Trend projection
A graph showing the actual movement of a series is constructed and the
apparent trend of the data on future is projected (extrapolated). This is based on
the assumption that those forces which contributed past will continue to have the
same effect.
b) Leading Indices
The ‗Leading indices‘ refer to certain sensitive series which tend to turn
upward or downward in anticipation of other series. If one knows a series which
would reliably lead say, commodities, price indices etc. It would not be difficult to
purchase raw materials in advance if prices are expected to rise. Certain important
Leading Indices are (1) New orders for durable goods; (2) Building contracts; (3)
Number of new incorporations; (4) Whole sale prices of basic commodities, New
order placed with manufactures, building contractors etc have early reflection of the
coming demand for products, raw materials, labour loans, and capital.
c) Econometric Models
Econometrics combines Economics and mathematics. It is the science of
economic measurement. Econometrics explains past economic activity by deriving
mathematical equations that will express the most probable inter-relationship
between asset of economic variable. By combining the relevant variable the
econometricians proceed to predict the future course of one or more of these
variables on the basis of established relationship.
d) Techniques of Economic Forecasting
There are several methods or techniques of economic and business
forecasting, Important methods may be briefly discussed as follows.
1. Naive Method: This is one of the oldest and crudest methods of forecasting
business situation. This method neither is nor based on any scientific
approach. Projection is made purely by guesswork and sometimes by
mechanical interpretation of historical data. This method includes such
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techniques as tossing the coin, simple correlation and even some other simple
mathematical techniques.
Advantages of Naive Method
a. It is simple method.
b. It is less costly
c. It is suitable small firms
Disadvantage of Naive Method
a. It is not a scientific method.
b. It is not always reliable
2. Survey Techniques: One of the simplest forecasting devices is to survey
business firms or individuals and to determine what they believe will occur is
survey techniques. Under survey techniques, interviews and mailed questionnaires
are used for forecasting tools. These are helpful in making short-term forecasts.
These techniques may be used for forecasting the overall level of economic activity
or some special portion of it or they may be used within the firm for forecasting
future sales.
Advantages
a. This method is simple and less costly.
b. These techniques provide substantial amount of qualitative information that
may be useful in economic and business forecasting.
c. These techniques are usually used to supplement other quantitative forecasting
methods.
Disadvantage
a. When the opinions differ it will create problem
b. Not useful for long term forecasts
3. Expert opinion method
It is a qualitative technique. Under this method an expert or informed
individual uses personal or organizational experience as a basis for developing
future expectations.
4. Trend Projection method
Under this method historical data is used to predict future business activity.
Here actual data are presented on a graph and forecasts for the future are prepared
on the basis of analysis of trend of this data.
Advantages
a. Very simple and less expensive
b. More reliable
Disadvantage
When sudden fluctuations in data occur, this method will not be suitable.
Similarly it requires considerable technical skill and experience.
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5. Smoothing techniques (Exponential smoothing)
Under this method smoothed average of several past observations are
considered say, moving average, exponential smoothing average etc. This method is
very cheap and inexpensive. But it cannot provide accurate forecasts.
6. Barometric Techniques
In this method present events or developments are used for predicting the
future. Further, here we apply certain selected economic and statistical indicators
in time series to predict variables. They are leading, lagging and coincident
indicators. If changes in one series of data consistently occur prior to changes in
another series-leading indicators can be shown, If changes in one series of data
consistently occur after changes in another series-there is lagging indicators, if two
series of data frequently increase or decrease at the same time and one series may
be regarded as a coincident indicator of the other-there is coincidental indicators.
This method is the most complex and scientific one.
7. Econometric Methods
Econometrics is the combination of ―econo‖ and ―metrics‖ which means
measurement of economic variables. This method combines the economic theory,
statistical tools and mathematical model building to analyse economic relations. It
predicts the future activity on past economic activity by using mathematical and
statistical techniques.
a. These methods are more reliable,
b. It is possible to compare forecasts with actual results. The model can modify to
improve future forecasts.
c. These methods indicate both direction and magnitude of change in the
variables.
d. These methods have the ability to explain economic phenomena.
8. Input Output Table Method
This is another approach of economic forecasting. This method enables the
forecaster to trace the effects of increase in demand for one product to other
industries. An increase in the demand for automobiles will first lead to an increase
in the output of the auto industry. This, in turn, will lead to an increase in the
demand for steel, glass, plastics, rubber and upholstery fabric. In addition,
secondary impact will occur as the increase in the demand for upholstery fabric.
Economic Forecasting for Business
Businessmen must plan ahead. Every business decision is based on some
assumption about the future, whether right or wrong, implicit or explicit. And as
business plans and decisions have to be based either directly or indirectly on the
outlook of the national economy, economic projections or forecasts are increasingly
becoming a vital part of managerial decision-making.
Economic forecasting consists of making forecasts of general business or
economic activity such as movements of national income, aggregate industrial
production or employment, and total exports or imports. Economic forecasting may
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be distinguished from business forecasting which relates more directly to the activity of
the particular firm and comprises short and long-term forecasts of sales and price
forecasts for raw materials and equipment. However, the distinction between economic
forecasting and business forecasting is not always clear-cut. For example, from the
viewpoint of a firm which is one of many such firms in an industry, a sales forecast for
the entire industry would be somewhere between a forecast of general business
activity and of activity pertaining to the firms.
Why are Accurate Economic Forecasts Possible?
Though future is uncertain, there are several factors which explain why a fairly
accurate forecast of general business activity is possible:
1. The current economic situation contains many clues to the future; economic
events are not entirely capricious and haphazard but are caused largely by
ascertainable factors. Hence a detailed examination of the current economic
situation provides significant clues to what will take place in times ahead.
2. Many of the future economic developments result from the commitments which
have already been made in the past. The commitments are often publicly know,
e.g., in case of government appropriations, plans of government industrial
projects, unfilled orders of government departments or undertakings, etc.
3. Many business developments are part of a process which takes time. Once
forces have been set in motion, the process conforms to a fairly stable pattern.
Hence, the process having begun, the forecaster can project about future with
reasonable accuracy. For example, increases in sales after a while result in
increases business inventories; and increases in the number of hours worked
tend to be followed by an increase in the number of workers employed in
manufacturing. Also, when inventories become excessive, a fairly regular and
predictable process of inventory liquidation begins.
Uses of economic forecasts
Predicting Firm’s Sales
The most important single use of an economic forecast is to have a reasonable
basis for predicting the firm‘s sales volume. A firm‘s sales forecasts must rest upon
economic forecasts for the simple reason that almost every firm‘s sales are affected by
the state of general business. It is true that sales of certain firms might have risen
during depression; or conversely, sales of others might have declined during
prosperity. But almost invariably, the rise in sales would have been larger in the former
case and the fall in sales steeper in the latter, had the general business condition not
been changing. Moreover, because every firm‘s decisions about production, raw
material purchases, plant expansion, sales quotas, borrowing, etc., hinge on its sales
forecast, an economic forecast can be said to have its greatest signal value as the
basis of sales forecast.
As such, the economic forecast is the necessary first step in predicting a firm‘s
sales. The next step is a forecast of the industry‘s total sales. Based on theses, a firm
can estimate its own sales, say, by a projection of its market share. Different
industries vary in their sensitivity to changes in general business conditions and in
the speed with which they are affected by such changes. Hence, it is also necessary
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to determine the turning and amplitude of changes in its own industry‘s activity in
relation to changes in general business conditions.
Again, the economic forecast contains a prediction of several segments of the
economy. For example, it will given an estimate of gross national product,
consumer spending, wholesale and retail prices, employment, interest rates,
exports and the like. In practice, the business firms many be far more concerned
with certain segments of the economic forecast than with others. For example,
sellers of consumer goods will be affected much more by changes in consumer
expenditure and savings than by changes in government expenditure. In other
words, in building a sales forecast for one‘s own firm or industry, one finds certain
segments of an economic forecast more relevant than others.
Other Uses
Besides facilitating a sales forecast, and economic forecast has several uses for an
average business firm:
1. Labour
An economic forecast may tell about the severity of competition for labour and the
likely pressure on wages. Hence it is especially useful to those entrusted with labour
negotiations, training and recruitment. Often workers have to be trained before they
are useful to a firm.
2. Raw Materials
An economic forecast also suggests the likely intensity of competition for raw
materials which may be in short supply. Hence knowledge of general business outlook
will indicate when to place orders for raw materials and how much inventory to hold.
3. Finance
The economic forecast also indicates the response it will get in borrowing from
banks or public and the likely rates of interest it will have to pay. As such, it may
considerably help in planning the timing of a capital expansion programme.
4. Inventory and Investment
A forecast of price movements can be used with great advantage as a basis of
inventory and investment policy. Normally, an expected price increase will make it
advantageous to build up stocks in advance of the price rise, provided carrying costs
are not excessive.
5. Plant Expansion or Contraction Plans
These plans have to be bases on a long-term forecast of the demand for the firm‘s
output. Hence, a forecast should cover the period during which fixed capital equipment
is normally amortized.
Selecting a forecast
Several guidelines may be indicated with a view to choose among available
forecasts and use them effectively:
1. Prefer forecasts which are explicit about what is expected and in the reasoning
underlying the forecast, against those which are categorical and declaratory.
2. Disregard forecasts which lack qualifiers. Future is uncertain and if the
forecaster does not explain the assumption on which his predictions rest, his
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analysis may be shallow and it will be difficult to interpret his forecasts if
conditions change.
3. Examine the records of the reliability of various forecasts made in the past.
Such an examination should thoroughly see why the forecasts proved right or
wrong one should specially beware of the forecasters who have been right but
for wrong reasons.
4. Use several different forecasts which have good records of reliability. The
selected forecasts should be such as to have been prepared by forcasters
having different biases, and by employing different techniques of construction.
5. Reject a forecast if the forecaster has injected himself too strongly as an
individual into his forecast. In particular, one should beware of forecasters
who are given to sensationalism.
24.4. REVISION POINTS
Business forecasting involves factors involving social, economical, Political,
psychological and other factors. Reader must get aware of forecasting techniques
from this lesson.
24.5.IN TEXT QUESTION
1. Bring out the need for business forecasting.
2. Explain how economic models help in business forecasting.
3. Discuss various methods of business forecasting.
4. Explain econometric models in forecasting.
5. Discuss the role of forecasting in global scenario.
24.6. SUMMARY
1. Business forecasting many turn failed even in case of reputed companies.
Innovations place an important role in affecting forecasting.
24.7.Terminal exercise
1. Analyse a Firm‘s business forecasting and its relevance to their progress in
technology and other areas.
24.8. ASSIGNMENT
1. Out of your own experience find out the reasons for product failure even in
case with leading experienced companies.
24.9. SUGGESTED READING:
1. Managcrial Economics, RL varshney & KL maheswari, Sulthan chand & sons.
24.10. LEARNING ACTIVITY
1. Arrange a group discussion to discuss a suitable business forecasting which
have taken a firm to the new heights.
24.11. SUPPLEMENTARY READING
1. Browsing the tutorials and PPT will help the reader to understand the concept
more clearly.
24.12. KEY WORDS
1. Business forecasting, techniques of forecasting.
346EN 130
ANNAMALAI UNIVERSITY PRESS : 2015 - 2016