Managerial Economics

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MANAGERIAL ECONOMICS

• Dr. ANANDA KUMAR
• Professor
• Department of Mgt. Studies
• Christ College of Engg. Tech.
• Puducherry, India.
• Mobile [phone]
• E-mail searchanandu_at_gmail.com

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Unit - 1

• General Foundation of Managerial Economics
  Economic approach, Circular flow of activity,
  Nature of the firm, Forms of organizations,
  Objectives of firms demand analysis and
  estimation Individual, market and firm demand,
  Determinants of demand, Elasticity measures and
  business decision making, Demand estimation and
  forecasting Theory of the firm Production
  functions in the short and long run, Cost
  concepts. Short run and long run costs.

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Managerial decision areas

• assessment of investible funds
• selecting business area
• choice of product
• determining optimum output
• determining price of product
• determining input-combination and technology
• sales promotion

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Managerial Economics

• Managerial Economics is a science which deals
  with the application of economics theory in
  managerial practice. It is the study of
  allocation of resources available to a firm among
  its activities. To be very precise, Managerial
  Economics is Economics applied in
  decision-making. It fills the gap between
  economic theory and managerial practice.

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Managerial Economics - Definition

• Managerial Economics is the integration of
  economic theory with business practice for the
  purpose of facilitating decision-making and
  forward planning by management.
• - Spencer Siegelman
• The purpose of Managerial Economics is to show
  how economic analysis can be used in formulating
  business policies.
• -Joel Dean

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Managerial Economics

Economic Theories, Concepts, Methodology and Tools
Business management Decision Problems
Managerial Economics Application of Economics in
analyzing and solving Business problems
Optimum solutions to business problems
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Relationship to.

• Production management (strategic decisions,
  operating decisions and control decisions).
• Marketing management (marketing strategy
  decisions, pricing decisions, value chain
  analysis, cost analysis.)
• Finance management (financial decisions)

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Relationship to.

• 4. Personnel management(strategic human resource,
  planning models, HR-performance management )
• 5. Operation research (advanced analytical
  methods to make better economic and business
  decisions).

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MICRO ECONOMICS

• Micro-economics is a branch of economics that
  studies the behavior of how the individual modern
  household and firms make decisions to allocate
  limited resources.
• Typically, it applies to markets where goods or
  services are being bought and sold.
  Micro-economics examines how these decisions and
  behaviors affect the supply and demand for goods
  and services, which determines prices, and how
  prices in turn, determine the quantity supplied
  and quantity demanded of goods and services.

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MACRO ECONOMICS

• Macroeconomics is a branch of economics dealing
  with the performance, structure, behavior, and
  decision-making of the entire economy. This
  includes a national, regional, or global economy.
  Macroeconomics study aggregated indicators such
  as GDP, unemployment rates, and price indices to
  understand how the whole economy functions.
  Macroeconomics develop models that explain the
  relationship between such factors as national
  income, output, consumption, unemployment,
  inflation, savings, investment, international
  trade and international finance.

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Characteristics of Managerial Economics

• It involves an application of Economic theory
  especially, micro economic analysis to practical
  problem solving in real business life. It is
  essentially applied micro economics.
• It is a science as well as art facilitating
  better managerial discipline. It explores and
  enhances economic mindfulness and awareness of
  business problems and managerial decisions.
• It is concerned with firms behaviour in optimum
  allocation of resources. It provides tools to
  help in identifying the best course among the
  alternatives and competing activities in any
  productive sector whether private or public.

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Scope of Managerial Economics

1. Demand Analysis and Forecasting
2. Cost Analysis
3. Production and Supply Analysis
4. Pricing Decisions, Policies and Practices
5. Profit Management, and
6. Capital Management

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1. Demand Analysis Forecasting

• A business firm is an economic organism which
  transforms productive resources into goods that
  are to be sold in a market. A major part of
  managerial decision-making depends on accurate
  estimates of demand. Before production schedules
  can be prepared and resources employed, a
  forecast of future sales is essential. This
  forecast can also serve as a guide to management
  for maintaining or strengthening market position
  and enlarging profits.

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2. Cost Analysis

• A study of economic costs, combined with the data
  drawn from the firms accounting records, can
  yield significant cost estimates that are useful
  for management decisions. The factors causing
  variations in costs must be recognized and
  allowed for if management is to arrive at cost
  estimates which are significant for planning
  purposes. An element of cost uncertainty exists
  because all the factors determining costs are not
  always known or controllable.

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3. Production Supply Analysis

• Production analysis is narrower in scope than
  cost analysis. Production analysis frequently
  proceeds in physical terms while cost analysis
  proceeds in monetary terms. Production analysis
  mainly deals which different production functions
  and their managerial uses.
• Supply analysis deals with various aspects of
  supply of a commodity. Certain important aspects
  of supply analysis are Supply schedule, curves
  and function, Law of supply and its limitations,
  Elasticity of supply and Factors influencing
  supply.

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4. Pricing Decisions, Policies and Practices

• Pricing is a very important area of Managerial
  Economics. In fact, price is the genesis of the
  revenue of a firm and as such the success of a
  business firm largely depends on the correctness
  of the price decisions taken by it. The important
  aspects dealt with under this area are Price
  Determination in various Market Forms, Pricing
  Methods, Differential Pricing, Product-line
  Pricing and Price Forecasting.

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5. Profit Management

• Business firms are generally organised for the
  purpose of making profits and, in the long run,
  profits provide the chief measure of success. In
  this connection, an important point worth
  considering is the element of uncertainty
  existing about profits because of variations in
  costs and revenues which, in turn, are caused by
  factors both internal and external to the firm.
  If knowledge about the future were perfect,
  profit analysis would have been a very easy task.

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6. Capital Management

• Of the various types and classes of business
  problems, the most complex and troublesome for
  the business manager are likely to be those
  relating to the firms capital investments.
  Relatively large sums are involved, and the
  problems are so complex that their disposal not
  only requires considerable time and labour but is
  a matter for top-level decision. Briefly,
  capital management implies planning and control
  of capital expenditure.

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What is Decision-making?

• Decision-making is the process of selecting a
  particular course of action from among the
  various alternatives. Every business manager has
  to work on uncertainties and the future cannot be
  precisely predicted by anyone. If everything
  could be predicted accurately, then
  decision-making would become a very simple
  process.

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What is Decision-making?

Alternative course of Action available
Selection of a particular Action
Execution of Action
Result of Action
Full Realisation of objective
Action A Action B Action C
Decision Making
Chosen Action
Partial realisation of objective
Non-realisation of objective
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Basic Economic Tools in Managerial Economics

• 1. Opportunity cost principle
• 2. Incremental principle
• 3. Principle of time perspective
• 4. Discounting principle, and
• 5. Equi-marginal principle

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1. Opportunity Cost Principle

• The opportunity cost of the funds employed in
  ones own business is the interest that could be
  earned on those funds had they been employed in
  other ventures.
• The opportunity cost of the time an entrepreneur
  devotes to his own business is the salary he
  could earn by seeking employment.
• The opportunity cost of using a machine to
  produce one product is the earnings forgone which
  would have been possible from other products.

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2. Incremental Principle

• Incremental concept is closely related to the
  marginal costs and marginal revenues, for of
  economic theory. In actual business situations,
  it often becomes difficult to apply the concept
  of marginalism which has to be replaced by
  incrementalism, for in real world business, one
  is concerned with not unit change but chunk
  change. For instance, in a construction project,
  the labour which a contractor may change is not
  by one but by tens.

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3. Principle of Time Perspective

• The economic concepts of the long run and the
  short run have become part of everyday language.
  Managerial economists are also concerned with the
  short-run and long-run effects of decisions on
  revenues as well as costs. The really important
  problem in decision-making is to maintain the
  right balance between the long-run and the
  short-run considerations.

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4. Discounting Principle

• One of the fundamental ideas in economics is that
  a rupee tomorrow is worth less than a rupee
  today. This seems similar to saying that a bird
  in hand is worth two in the bush. A simple
  example would make this point clear.

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5. Equi-marginal Principle

• This principle deals with the allocation of the
  available resources among the alternative
  activities. It should be clear that if the value
  of the marginal product is higher in one activity
  than another, an optimum allocation has not been
  attained. It would, therefore, be profitable to
  shift labour from low marginal value activity to
  high marginal value activity, thus increasing the
  total value of all products taken together.

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Circular Flow of Economic Activities

• Economic resources

Purchasing goods services
Household
Firm
Income payment of wages, rent, dividend
interests
Goods Services
Imports
Foreign Countries
Exports
Taxes
Government
Expenditure
Savings
Banks
Investments
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Basic Economic activities

• Production The use of economic resources in the
  creation of goods and services for the
  satisfaction of human wants.
• Consumption The using up of goods and services
  by consumer purchasing or in the production of
  other goods.
• Employment The use of economic resources in
  production engagement in activity.
• Income Generation The production of maximum
  amount an individuals.

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Circular Flow of Production

• Economic Resources

Producing Units
Households
Goods and Services
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Circular Flow of Income

• Income flow of wages
• Interests rents

House holds
Producing Units
Purchase of Goods and Services
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NATURE OF THE FIRM

• Since modern firms can only emerge when an
  entrepreneur of some sort begins to hire people,
  Coase's analysis proceeds by considering the
  conditions under which it makes sense for an
  entrepreneur to seek hired help instead of
  contracting out for some particular task.
• The traditional economic theory of the time
  suggested that, because the market is "efficient"
  (that is, those who are best at providing each
  good or service most cheaply are already doing
  so), it should always be cheaper to contract out
  than to hire.

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Forms of Organisation

1. Sole proprietorship / Single ownership
2. Partnership
3. Joint Stock Companies
4. Cooperative organisation
5. State and central Government owned

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1. Sole proprietorship

• A sole proprietorship is a business with one
  owner who operates the business on his or her own
  or employ employees. It is the simplest and the
  most numerous form of business organization in
  the United States, however it is dangerous as the
  sole proprietor has total and unlimited
  liability. Self-contractor is one example of a
  sole proprietorship.
• In this type, the single ownership where an
  individual exercises and enjoys these rights in
  his own interest. It does well for those
  enterprises which require little capital and lend
  themselves readily to control by one person.

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2. Partnership

• A single owner becomes inadequate as the size of
  the business enterprise grows. He may not be in
  a position to do away with all the duties and
  responsibilities of the grown business. At this
  stage, the individual owner may wish to associate
  with him more persons who have either capital to
  invest, or possess special skill and knowledge to
  make the existing business still more profitable.
  Such a combination of individual traders is
  called Partnership.
• Partnership may be defined as the relation
  between persons who have agreed to share the
  profits of a business carried on by all or any of
  them acting for all. Individuals with common
  purposes join as partners and they put together
  their property ability, skill, knowledge, etc.,
  for the purpose of making profits

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3. CORPORATION

• It is a form of private ownership which contains
  features of large partnership as well as some
  features of the corporation. A corporation is a
  limited liability entity doing business owned by
  multiple shareholders and is overseen by a board
  of directors elected by the shareholders. It is
  distinct from its owners and can borrow money,
  enter into contracts, pay taxes and be sued. The
  shareholders gain from the profit through
  dividend or appreciation of the stocks but are
  not responsible for the companys debts.

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4. Public Limited Company

• A public enterprise is one that is (1) Owned by
  the state, (2) Managed by the state or (3) Owned
  and managed by the state.
• Public enterprises are controlled and operated by
  the Government either solely or in association
  with private enterprises. It is controlled and
  operated by the Government to produce and supply
  goods and services required by the society.
  Limited companies which can sell share on the
  stock exchange are Public Limited companies.
  These companies usually write PLC after their
  names.

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5. Private Limited Companies

• These are closely held businesses usually by
  family, friends and relatives. Private companies
  may issue stock and have shareholders. However,
  their shares do not trade on public exchanges and
  are not issued through an initial public
  offering. Shareholders may not be able to sell
  their shares without the agreement of the other
  shareholders.

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Objectives of Firm

• 1. Maximization of the sales revenue2.
  Maximization of firms growth rate3.
  Maximization of Managers utility function4.
  Making satisfactory rate of Profit5. Long run
  Survival of the firm6. Entry-prevention and
  risk-avoidance

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Conflict in McDonald and Pizza Hut

• The rapid growth of franchising during the last
  two decades can be explained largely by the
  mutual benefits the franchising partners receive.
  The franchiser increases sales via an
  ever-expanding network of franchisees. The
  parent collects a fixed percentage of the revenue
  that each franchisee earns (as high as 15 to 20
  per cent, depending on the terms of the
  contract). The individual franchisee benefits
  from the acquired know-how of the parent (the
  franchiser), its advertising and promotional
  support and from the ability to sell a
  well-established product or service.
  Nonetheless, economic conflicts frequently arise
  between parent and individual franchisees.
  Disputes can occur even in the loftiest of
  franchising realms the fast food industry. The
  case in point

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Conflict in McDonald and Pizza Hut
is the turmoil in the early 1990s between one of
the franchisee outlets of the McDonald and the
Mac itself in the USA. The franchisee outlet was
controlled by Chart House. The key issue centred
on the operating autonomy of the franchisee. The
conflict between parent and individual franchisee
were numerous. First, the parent insisted on
periodic remodelling of the premise, which the
franchisee resisted. Secondly, the franchisee
favoured raising prices on best selling items
which the parent opposed it wanted to expand
promotional discounts. Third, the parent sought
longer store hours and multiple express lines to
cut down on lunchtime congestion. Many
franchisees resisted both the moves.
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Conflict in McDonald and Pizza Hut
Yet another known name in the fast food industry,
Pizza Hut faced a similar problem in the late
1990s in Thailand. The Bangkok branch of the US
food franchisee broke away from Thailands Pizza
Plc., as the later said that after working
together for 20 years, it would no longer work on
the terms of the US franchiser. The US
franchiser wanted certain changes in the
operations of the chain in the same line of Mac
franchiser, which the franchisee objected to. As
a result, the franchiser decided to rebrand 116
new pizza parlours across the country. How would
one explain these conflicts? What is their
economic source? What ca the parent and the
franchisee do to promote cooperation?
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Conflict in McDonald and Pizza Hut
Above all, if franchising is a profitable
activity, why are there so many
conflicts? (McDonald levies a franchisee fee of
12,500, a royalty of 3 per cent, a marketing
fee of 3 per cent.)
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Consumers desire for a particular product
depends on

• ability to buy
• willingness to buy
• time period

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Demand

• Demand is the quantity of a good or service that
  customers are willing and able to purchase during
  a specified period under a given set of economic
  conditions. Conditions to be considered include
  the price of the good in question, prices and
  availability of related goods, expectations of
  price changes, consumer incomes, consumer tastes
  and preferences, advertising expenditures, and so
  on. The amount of the product that consumers are
  prepared to purchase, its demand, depends on all
  these factors.

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Demand Schedule
Quantity Demanded Per Month

• Price

1 320,000 1000 2 300,000 2000 3
280,000 3000 4 260,000 4000 5
240,000 5000 6 220,000 6000 7
200,000 7000 8 180,000 8000
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Demand
Rs. 11
Rs. 11
Rs. 10
Rs. 10
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Law of Demand
there is an inverse relationship between price
and quantity demanded.

• as the quantity demanded rises, the price falls
• as the price rises, the quantity demanded falls
  
• as income rises, the demand for the product
  rises
• as supply rises, the demand rises

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Elasticity

• Elasticity is a central concept in the theory of
  supply and demand. In this context, elasticity
  refers to how supply and demand respond to
  various factors, including price as well as other
  stochastic principles. One way to define
  elasticity is the percentage change in one
  variable divided by the percentage change in
  another variable (known as arc elasticity, which
  calculates the elasticity over a range of values,
  in contrast with point elasticity, which uses
  differential calculus to determine the elasticity
  at a specific point). It is a measure of relative
  changes.

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Concept of Elasticity

• Price Elasticity of Demand
• Income Elasticity of Demand
• Cross Elasticity of Demand

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1. Price Elasticity of Demand

• Price elasticity of demand is the change in
  quantity of a commodity demanded to the change in
  its price. The degree of change in the demand of
  different commodities due to change in the price
  of the commodities may vary. In certain cases,
  the changes in demand may be at higher rates.

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2. Income Elasticity of Demand

• Income elasticity of demand is the degree of
  responsiveness of demand to the change in income.
  
• The income elasticity of demand is a measure of
  the extent to which the demand for a good changes
  when income changes, other things remaining the
  same.

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3. Cross Elasticity of Demand
The responsiveness of demand to change in prices
of related goods is called cross elasticity of
demand (related goods may be substitutes or
complementary goods). In other words, it is the
responsiveness of demand for commodity X to the
change in the price of commodity Y.
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Elasticity Demand

• elastic
• inelastic
• unitary

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1. Elastic Demand

• An elastic demand is one in which the change in
  quantity demanded due to a change in price is
  large.

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2. Inelastic Demand

• An economic term used to describe the situation
  in which the supply and demand for a good or
  service are unaffected when the price of that
  good or service changes.
• The most famous example of relatively inelastic
  demand is that for gasoline. As the price of
  gasoline increases, the quantity demanded doesn't
  decrease all that much. This is because there are
  very few good substitutes for gasoline and
  consumers are still willing to buy it even at
  relatively high prices.

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3. Unitary elastic

• If the elasticity coefficient is equal to one,
  demand is unitarily elastic as shown in below
  figure. For example, a 10 quantity change
  divided by 10 price change is one. This means
  that a one percent change in quantity occurs for
  every one percent change in price.

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3. Unitary elastic (Example)

• Consider a situation in which milk costs Rs. 10
  per liter. A grocer notices that he is not
  selling as much milk as he would like, so he puts
  the milk on sale, dropping the price to Rs. 7 per
  liter. With unitary elasticity, the number of
  sales would double because the price was cut in
  half. So if the grocer would sell 100 liter of
  milk at Rs. 10, that would lead to revenues of
  Rs. 1,200. Cutting the price to Rs. 7 would then
  yield sales of 200 liter, still leading to
  revenues of Rs. 1,200 .

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Determinants of Demand

• Changes of Income
• Changes of Taste or Preferences
• Changes of Prices of Related Goods
• Changes of Price Expectations
• Changes of Size of Population

Look at the relationship between the quantity
demanded and each of the determinants in turn
separately price quantity relationship is the
demand curve.
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Factors Affecting Elasticity Of Demand

1. Availability of Substitutes
2. Postponement of Consumption
3. Proportion of Expenditure
4. Nature of the Commodity
5. Different Uses of the Commodity
6. Change in Income
7. Habits
8. Distribution of Income
9. Price Level

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DEMAND FORECASTING

• Demand forecasting is the activity of estimating
  the quantity of a product or service that
  consumers will purchase. Demand forecasting
  involves techniques including both informal
  methods, such as educated guesses, and
  quantitative methods, such as the use of
  historical sales data or current data from test
  markets. Demand forecasting may be used in
  making pricing decisions, in assessing future
  capacity requirements, or in making decisions on
  whether to enter a new market.

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Necessity for forecasting demand

• Often forecasting demand is confused with
  forecasting sales. But, failing to forecast
  demand ignores two important phenomena. There is
  a lot of debate in demand-planning literature
  about how to measure and represent historical
  demand, since the historical demand forms the
  basis of forecasting. The main question is
  whether we should use the history of outbound
  shipments or customer orders or a combination of
  the two as proxy for the demand.

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Demand Forecasting Methods
FORECASTING METHODS
Survey Method
Statistical Method
Brometric method
Opinion Survey
Consumers' Interview
Trend projection
Correlation Regression
End-use method
Sample survey
Complete enumeration
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Concept of Supply

• Supply is defined as the quantity of a product
  that a producer is willing and able to supply
  onto the market at a given price in a given time
  period.
• Note Throughout this study companion, the terms
  firm, business, producer and seller have the same
  meaning.
• Supply is the amount of a good that producers are
  willing and able to offer for sale at various
  price.

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Concept of Supply
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The law of Supply

• All else equal, the quantity supplied is
  positively related to price.
• Prices quantity supplied
• Prices quantity supplied
• The law of supply explains that if people are
  willing to pay more money for a product, a
  company will produce or manufacture more of that
  product to capitalize on the increased revenue.
• The opposite also holds true that as the price of
  a product drops, a company is likely to
  manufacture less of that product. In fact, if
  sales drop too far, the company may discontinue
  the product altogether.

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Determinants of Supply

• Market price
• Input prices
• Technology (new production methods)
• Expectations
• Number of producers

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Equilibrium of Supply and Demand

• A situation in which the supply of an item is
  exactly equal to its demand. Since there is
  neither surplus nor shortage in the market, price
  tends to remain stable in this situation.

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Equilibrium of Supply and Demand
A situation in which the supply of an item is
exactly equal to its demand. Since there is
neither surplus nor shortage in the market, price
tends to remain stable in this situation.
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THEORY OF FIRM

• The theory of the firm consists of a number of
  economic theories that describe the nature of the
  firm, company, or corporation, including its
  existence, behaviour, structure, and relationship
  to the market. In simplified terms, the theory of
  the firm aims to answer these questions

1. Existence 2. Boundaries 3. Organization 4.
Heterogeneity of firm actions / performances
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Production

• Production refers to the transformation of inputs
  or resources into outputs or goods and services.
  Production process is a process in which economic
  resources or inputs (composed of natural
  resources like labour, land and capital
  equipment) are combined by entrepreneurs to
  create economic goods and services (outputs or
  products).

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Production
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Theory of Production

• Production theory generally deals with
  quantitative relationships, that is, technical
  and technological relationships between inputs,
  especially labour and capital, and between inputs
  and outputs.
• An input is a good or service that goes into the
  production process. As economists refer to it, an
  input is simply anything which a firm buys for
  use in its production process. An output, on the
  other hand, is any good or service that comes out
  of a production process.

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• In the managers effort to minimise production
  costs, the
• fundamental questions faces are
• (a) How can production be optimized or costs
  minimised?
• (b) What will be the behaviour of output as
  inputs increase?
• (c) How does technology help in reducing
  production costs?
• (d) How can the least-cost combination of inputs
  be achieved?

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Short Run Production Function
The short run is defined in economics as a period
of time where at least one factor of production
is assumed to be in fixed supply i.e. it cannot
be changed. We normally assume that the quantity
of capital inputs (e.g. plant and machinery) is
fixed and that production can be altered by
suppliers through changing the demand for
variable inputs such as labour, components, raw
materials and energy inputs. Often the amount of
land available for production is also fixed. The
time periods used in textbook economics are
somewhat arbitrary because they differ from
industry to industry. The short run for the
electricity generation industry or the
telecommunications sector varies from that
appropriate for newspaper and magazine publishing
and small-scale production of foodstuffs and
beverages.
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Long Run Production

• In the long-run, both capital (K) and labour (L)
  is included in the production function, so that
  the long-run production function can be written
  as
• A production function is based on the following
  assumptions
• (i) perfect divisibility of both inputs and
  output
• (ii) there are only two factors of production
  capital (K) and labour (L)
• (iii) limited substitution of one factor for the
  other
• (iv) a given technology.

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COST CONCEPT
The term cost simply means cost of production. It
is the expenses incurred in the production of
goods. It is the sum of all money-expenses
incurred by a firm in order to produce a
commodity. Thus it includes all expenses from the
time the raw material are bought till the
finished products reach the wholesaler. A
managerial economist must have a proper
understanding of the different cost concept which
are essential for clear business thinking. The
cost concept which are relevant to business
operation and decision can be grouped on the
basis of their propose under two overlapping
categories 1. Concept used for accounting
purpose 2. Concept used in economics analysis of
the business
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THEORY OF COST
Business decisions are generally taken based on
the monetary values of inputs and outputs. Note
that the quantity of inputs multiplied by their
respective unit prices will give the monetary
value or the cost of production. Production cost
is an important factor in all business decisions,
especially those decisions concerning (a) the
location of the weak points in production
management (b) cost minimisation (c) finding the
optimal level of output (d) determination of
price and dealers margin and, (e) estimation of
the costs of business operation.
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Various Types of Costs
1. Opportunity Cost vs Outlay Cost 2. Past Cost
vs Future Cost 3. Traceable vs Common Cost 4.
Out-of-Pocket vs Book-Cost 5. Incremental Cost vs
Sunk Cost 6. Escapable vs Unavoidable Cost 7.
Shut Down and Abandonment Costs 8. Urgent and
Postponable Costs 9. Controllable and
Non-Controllable costs 10. Replacement vs
Historical Cost 11. Private and Social Cost 12.
Short-run and Long-run Costs 13. Fixed cost and
Variable Cost
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1. Opportunity Cost vs Outlay Cost
Outlay costs are those costs which involve
financial expenditure at some time and hence are
recorded in the books of account. Opportunity
costs are those costs of displaced
alternatives. They represent only sacrificed
alternatives and hence are not recorded in any
financial account. The economic principle behind
cost in the modern sense is not the pain or
strain involved, nor the money cost involved in
producing a thing.
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2. Past Cost vs Future Cost
Past costs, as the name itself implies, are those
costs which have been actually incurred in the
past and find entry in the books of accounts.
Those costs are incurred by the firm at the time
of purchase of various items of plant equipment,
etc. From the decision-making point of view,
future cost is more important. Future costs are
those costs which are likely to be incurred in
future periods or to be very precise, the costs
that are contemplated to be incurred in future
periods. Since future is uncertain, these costs
are only estimations and they are not accurate
figures.
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3. Traceable vs Common Costs
When the cost can be easily identified with an
unit of operation, it is called traceable cost or
direct cost. For example, when the total cost of
production per unit has to be arrived at, it has
to be broken into cost of raw materials, cost of
labour, etc. Non-traceable costs are called
common costs which are not traceable to any one
unit of operation. They cannot be attributed to a
product, a department or a process.
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4. Out-of-Pocket vs Book-Costs
Out-of-pocket cost denotes immediate current
payment. Hence it is called cash cost. For
example, the cost of raw material or the wages to
labour require immediate payment. On the other
hand, book-cost is one which need not be
immediately made. For instance, depreciation
does not require immediate cash payment and it is
not taken into the current expenditure account.
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5. Fixed Cost and Variable Cost
Variable costs are those costs that vary
depending on a company's production volume they
rise as production increases and fall as
production decreases.  Variable costs differ
from fixed costs such as rent, advertising,
insurance premiums and loan payments etc. which
tend to remain the same regardless of production
output.
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6. Incremental Cost vs Sunk Cost
Incremental cost refers to the additional cost
incurred due to a change in the level or nature
of activity. A change in the activity connotes
addition of a product, change in distribution
channel, expansion of market, etc. Incremental
cost are also known as differential costs.
Incremental cost measures the difference between
old and new total costs. Sunk costs are the costs
which remain unaltered even after a change in the
level or nature of business activity. These are
known as specific costs. The best of the sunk
cost is depreciation. Incremental cost are very
useful in business decision, but sunk costs
appear to be irrelevant to managerial decisions,
as they do not change with the changing business
activity.
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7. Urgent and Postponable Costs
As the name itself implies, urgent costs are
those costs which are incurred to keep the
continuance of operations of the firm. It is the
money spent on materials and labour. Postponable
costs can be post-poned temporarily. For
example, the cost on maintenance of building can
be postponded. Painting and white washing can be
postponed.
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COST AND OUTPUT RELATIONSHIP
Now you will also come to know about cost and
output relationship. Cost and revenue are the two
major factors that a profit maximizing firm needs
to monitor continuously. It is the level of cost
relative to revenue that determines the firms
overall profitability. In order to maximize
profits, a firm tries to increase its revenue and
lower its cost. While the market factors
determine the level of revenue to a great extent,
the cost can be brought down either by producing
the optimum level of output using the least cost
combination of inputs, or increasing factor
productivities, or by improving the
organizational efficiency. The firms output
level is determined by its cost. The producer has
to pay for factors of production for their
services.
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Managerial Economics
Unit - 2
89
Unit - 2

• Product Markets Market Structure, Competitive
  market, Imperfect competition and barriers to
  entry, Pricing in different markets Recourse
  Markets Pricing and Employment of inputs under
  different market structures, Wages and wage
  differentials.

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Market

• The term market has come to signify a public
  place in which goods and services are bought and
  sold. It is the act or technique of buying and
  selling.
• Market defines, any area over which buyers and
  sellers are in such close touch with one another,
  either directly or through dealers, that the
  prices obtainable in one part of the market
  affect the prices paid in other parts.

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Market

• Therefore, market in economic sense implies
• 1. Presence of buyers and sellers (Producers) of
  the commodity
• 2. Establishment of contract between the buyers
  and sellers
• 3. Similarity of the product
• 4. Exchange of commodity for a price

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Classification of Markets

1. Markets on the basis of Area
2. Markets on the basis of Time
3. Markets on the basis of Nature of Transactions
4. Markets on the basis of Regulation
5. Markets on the basis of Volume of Business
6. Market on the basis of Position of Sellers
7. Market on the basis of type of Competition

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1. Markets on the basis of Area

• On the basis of geographical area covered,
  markets are classified into (a) Local Markets,
  (b) Regional Markets, (c) National Markets, and
  (d) International Markets. A local market for a
  product exists when buyers and sellers carry on
  business in a particular locality or village or
  area where demand and supply conditions are
  influenced by local condition only.

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2. Markets on the basis of Time

• Alfred Marshall conceived the Time element in
  marketing and this is classified into (a) Very
  short-period market (b) Short-period market (c)
  Long-period market and (d) Very long-period or
  Secular market.

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3. Markets on the basis of Nature of Transactions

• On the basis of nature of transactions, markets
  are classified into (a) Spot market and (b)
  Future market. Spot transaction or spot markets
  refer to those markets where goods are physically
  transacted on the spot, whereas Future markets
  related to those transactions which involve
  contracts of the future date.

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4. Markets on the basis of Regulation

• On the basis of regulation, markets are
  classified into (a) Regulated market and (b)
  Unregulated market. In the former type of
  markets transactions are statutorily regulated so
  as to put an end to unfair practices. Such
  markets may be established for specific products
  or a group of products. Produce and stock
  exchanges are suitable examples of the regulated
  markets. Unregulated markets or free markets are
  those where there are no restrictions in the
  transactions.

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5. Markets on the basis of Volume of Business

• Based on the volume of business transacted,
  markets are classified into Wholesale market and
  Retail market. The wholesale market comes into
  existence when the commodities are bought and
  sold in bulk or large quantities. The dealers in
  this market are known as the wholesalers. The
  wholesaler acts as an intermediary between the
  producer and the retailer. Retail market, on the
  other hand exists when the commodities are bought
  and sold in small quantities. This is the market
  for ultimate consumers.

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6. Market on the basis of Position of Sellers

• On the basis of the position of the sellers in
  the chain of marketing, markets are divided into
  Primary market, Secondary market and the Terminal
  market. Manufacturers of commodities constitute
  the primary market who sell the products to the
  wholesalers. The secondary market consists of
  wholesalers who sell the products in bulk to the
  retailers. Retailers along constitute the
  terminal markets who sell the products to the
  ultimate consumers.

99
7. Markets on the basis of type of Competition

• Based on the type of competition, markets are
  classified into (a) Perfectly Competitive market
  and (b) Imperfect market. The broad
  classification is Perfect Competition and
  Imperfect Competition. The opposite type of
  perfect market is Monopoly. Under imperfect
  markets, there are many types, viz., oligopoly,
  Duopoly, Monopolistic competitions, etc. We shall
  study about the types of competition in greater
  detail.

100
Competitions

• Competition in business connotes the presence of
  more than one seller and one buyer in a
  particular market. In competitive markets
  sellers act independently of other buyers. It is
  incompatible with those conditions of market
  where there is only one seller or one buyer. So,
  the presence of more than one buyer and one
  seller is a necessary pre-condition for the
  existence of competitions.

101
Types of Competition

• Perfect Competition and Pure Competition
• Imperfect Competition
• a. Monopolistic Competition
• b. Oligopoly Competition
• 3. Monopoly Competition

102
Competition

Perfect Competition Large number of small firms
Oligopoly A few large firms dominate the industry
Monopoly One firm comprises the whole industry
103
1. Perfect Competition

• A perfectly competitive market is one in which
  economic forces operate unimpeded.

104
Perfect Competition

• Perfect competition is a firm behavior that
  occurs when many firms produce identical products
  and entry is easy. Characteristics of perfect
  competition
• There are many sellers.
• The products sold by the firms in the industry
  are identical.
• Entry into and exit from the market are easy, and
  there are many potential entrants.
• Buyers (consumers) and sellers (firms) have
  perfect information.

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Features of Perfect Competition

1. Large number of buyers and Sellers
2. Homogeneous Products
3. Free entry and exit conditions
4. Perfect knowledge on the part of buyers and
   sellers
5. Perfect mobility of factors of production
6. Absence of transport cost
7. Absence of Government or artificial restrictions

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Imperfect Competition
Number of firms
Ability to affect price
Entry barriers
Example
Many, but not too many
Corner Shop
Monopolistic Competition
Small
None
Few
Medium
Some
Cars
Oligopoly
One
Large
Huge
Post Office
Monopoly
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Imperfect Competition

• Imperfectly Competitive Firms
• Have some control over price
• Price may be greater than the cost of
  production
• Long-run economic profits are possible

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Monopoly

• Monopoly is the form of market organization in
  which there is a single firm selling a commodity
  for which no close substitutes. - D. Salvatore
• The price is under the full control of the
  monopolist but not the demand is determined by
  purchasers.

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Characteristics of Monopoly

• Only one seller in market and large number of
  buyers.
• No Close Substitutes
• Product totally differentiated
• No free entry or exit/ Barriers to Entry.
• Full Control over price
• Price discrimination (different price to
  different Consumer)
• Imperfect information
• Where a perfectly competitive firm is a price
  taker, the monopolist is a price searcher.

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Monopolistic Competition

• Monopolistic competition refers to market
  situation where there are many firms selling a
  differentiated products. There is competition
  which is keen, through not perfect, among many
  firms making very similar products
• Monopolistic competition is a market structure
  where there is large number of small sellers,
  selling differentiated but close substitute
  products - J.S Bains
• The term monopolistic completion refers to the
  market structure in which the sellers do have a
  monopoly (they are the only sellers) of their own
  product, but they are also subjects to
  substantial competitive pressures from sellers of
  substitute products. - Baumol

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Features of Monsopolistic

1. Existence of large number (but not too many
   large) of firms
2. Product Differentiation
3. Selling Cost
4. Freedom of entry and exit of firms

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Oligopoly

• A market with a few sellers./A few large firms
• The essence of an oligopolistic industry is the
  need for each firm to consider how its own
  actions affect the decisions of its relatively
  few competitors.
• A few large firms
• Products standardized or differentiated
• Difficult entry
• Knowledge not available to all firms

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Price Policy

• Formulating price policies and setting the price
  are the most important aspects of managerial
  decision-making. Price, infact, is the source of
  revenue which the firms seeks to maximise.
  Again, it is the most important device a firm can
  use to expand its 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. However, setting prices is a complex
  problem and there is no cut and dried formula for
  doing so.

114
Factors influence Price of a Commodity

1. The demand for a commodity
2. Cost of production
3. Objectives of the firm
4. Competition and
5. Governments policy

115
Objectives of Price of a firm

1. Achieving a target rate of return on investment
2. Accomplishing the target rate of growth
3. Maintaining and improving the market share
4. Maintaining the prestige of the firm
5. Enhancing the goodwill of the company
6. Stabilising the prices

116
Price Output Determination under Perfect
Competition

• In perfect competition, there are large number of
  buyers and sellers and, we have studied already
  that the actions of individual buyers and sellers
  cannot influence the market price. The prevailing
  price of the product in the market is taken for
  granted.
• The buyers have to make the outlay guided by the
  price. Similarly the producers have to supply
  guided by the price. But, how the price in the
  market has been arrived at? Price under perfect
  competition is determined by the interaction of
  two faces, viz., demand and supply.

117
Price Output Determination under Perfect
Competition

• Though individuals cannot change the price, the
  aggregate force of demand and supply can change
  the price. The demand side is governed by the
  law of demand based on marginal utility of the
  commodity to the buyers. The supply side is
  governed by the cost of the production. The law
  of supply operates. The interaction of demand
  and supply determines the price of the commodity.
  

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Price Output Determination under Monopoly

• We have studied earlier that Monopoly is a
  market structure where there is only one seller
  and there is no threat of competition and as such
  the monopoly producer is a price-maker. He can
  exercise sufficient control over price or output
  in order to earn maximum net monopoly revenue.
  Under monopoly, there is no distinction between
  the firm and industry. The firm and industry
  coincide by definition. The monopoly firm
  partakes all the characteristics of an industry.
  Therefore, the output of the monopoly firm is
  compared with that of the industry under pure
  competition.

119
Price Output Determination under Monopoly

• It would be a mistake to suppose that the
  monopolist will always push up his prices higher
  and higher. If he does so, he must consider the
  effect of such a procedure on demand which will
  shrink as prices rise. The very important point
  to be borne in mind is that unlike competitive
  firm, a monopolist firm will have a sloping down
  demand curve and his average revenue will
  dwindle, as the output is increased, because the
  buyers will take up large quantities only at a
  lower price.

120
Price Output Determination under Oligopoly

• Prices once established in oligopolistic
  industries, often tend to remain constant not
  only for months, but also for years. The quoted
  wholesale price of such a commodity remains
  unchanged for a long period. However it should be
  remembered that the constancy of prices is
  different from the rigidity of prices. The former
  indicates that prices do not change with changes
  in demand and costs. The latter indicates the
  lack of movement when changes occur in demand or
  in costs or in both. The kinky demand curve
  offers better explanation of price rigidity under
  oligopoly.

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Concept of 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.

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Pricing Methods

1. Cost-Plus or Full-Cost Pricing Method
2. Target Pricing or Pricing for a rate of return
3. Marginal Cost Pricing
4. Going-Rate Pricing
5. Customary Pricing
6. Differential Pricing

123
1. Cost-Plus or Full-cost Pricing

• The Full-Cost Pricing method is generally adopted
  by many of the firms for simple and easy
  procedure. This method is also called Cost-plus
  pricing, margin pricing and Mark-up pricing.
  Under this method, the price is set to cover all
  costs (material, labour and overhead) and a
  predetermined percentage for profit. This means
  the selling price of the product is computed by
  adding a certain percentage to the average total
  cost of the product.

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2. Target Pricing or Pricing for a rate of return

• This method of pricing is only a refinement of
  the full-cost pricing. According to this method,
  the manufacturer considers a pre-determined
  target rate of return on capital investment. In
  the case of full-cost pricing, the percentage of
  profit is marked up arbitararily. In the case of
  rate of return method, the companies determine
  the average make-up on costs necessary to produce
  a desired rate of return on the companys
  investment. In this case the company estimates
  future sales, future costs, and arrives at a
  mark-up that will achieve a target return on the
  companys investment.

125
3. Marginal Cost Pricing

• In the first two methods, i.e., full-cost pricing
  and the rate of return pricing, prices are fixed
  on the basis of total costs comprising of fixed
  costs and variable costs. Under marginal pricing
  method, the price of a product is determined on
  the basis of the marginal or variable costs. In
  this method fixed costs are totally ignored and
  only variable costs are taken into account. This
  is done on the assumption that fixed costs are
  caused by outlays which are historical and sunk.
  Their relevance to pricing decision is limited,
  as pricing decision requires planning the future.
• An example of calculating marginal cost is the
  production of one pair of shoes is 30. The total
  cost for making two pairs of shoes is 40. The
  marginal cost of producing the second pair of
  shoes is 10.

126
4. Going-Rate Pricing

• Going rate pricing is a pricing strategy where
  firms examine the prices of their competitors and
  then set their own prices broadly in line with
  these.
• Setting a price for a product or service
  using the prevailing market price as a basis.
  Going rate pricing is a common practice with
  homogeneous products with very little variation
  from one producer to another, such as aluminum or
  steel.

127
5. Customary Pricing

• A method of determining the price for a good or
  service based on the perceived expectations of
  customers. Customary pricing is generally used
  for products with a relatively long
  market history of being sold for a particular
  amount, and is driven by intuitive notions of
  value on the part of buyers.

128
6. Differential Pricing

• The term differential pricing is also used to
  describe the practice of charging
  different prices to different buyers for the same
  quality and quantity of a product, but it can
  also refer to a combination of price differentiati
  on and product differentiation. Differential
  pricing may be designed to encourage new uses or
  to attract new customers.

129
Market Structure and Pricing Decisions

1. Price Determination Under Perfect Competition
2. Price Determination Under Pure Monopoly
3. Monopoly Pricing and Output Decision in the
   Long-Run

130
1. Price Determination Under Perfect Competition

• In a perfectly competitive market, commodity
  prices are determined by the market forces of
  demand and supply. In other words, market prices
  are determined by the market demand and market
  supply, where the market demand refers to the
  industry demand as a whole this is the sum of
  quantity demanded by each individual consumer or
  user of the product at different prices.
  Similarly, market supply is the sum of quantity
  supplied by individual firms in the industry. The
  market price is determined for the industry and
  the individual firms and consumers take the
  market price as given. This is the reason sellers
  under a perfectly competitive market is referred
  to as price takers.
• The determination of commodity as well as
  services price under perfectly-competitive
  conditions are often analysed under three
  different time periods
• (i) the market period or very short-run
  (ii) short-run and
• (iii) long-run.

131
2. Price Determination Under Pure Monopoly

• The term pure monopoly connotes absolute power to
  produce and sell a product with no close
  substitute. A monopoly market is one in which
  there is only on seller of a product having no
  close substitute. The cross-elasticity of demand
  for a monopolists product is either zero or
  negative. A monopolized industry refers to a
  single-firm industry.

132
3. Monopoly Pricing and Output Decision in the
Long-Run

• The decision rules guiding optimal output and
  pricing in the long-run is same as in the
  short-run. In the long-run however, a monopolist
  gets an opportunity to expand the size of its
  firm with the aim of enhancing the long-run
  profits. Expansion of the plant size may,
  however, be subject to such conditions as
• (a) the market size
• (b) expected economic profit and,
• (c) risk of inviting .

133
Risk And Uncertainty

• Entrepreneur is always working under uncertainty
  and has to bear risks. In economic parlance
  profit is considered as a reward for risk taking.
  Only when an entrepreneur understands the nature
  of risks he can secure himself from the risks and
  uncertainty.
• Certainty is what is prevalent today and we can
  see or realize it., But uncertainty is a
  situation where one is unsure of what will happen
  tomorrow. For instance even the meteorological
  department may not be a able to say with any
  amount of certainty when the south west monsoon,
  will set in and how much rain fall it may bring.
  Therefore the managers will have to safeguard
  institutions by making sufficient precautions the
  measures.

134
RESOURCE MARKET

• A market used to exchange the services of
  resources labour, capital, and natural resources.
  The value of services exchanged through resource
  markets each year is measured as national income.
  Compare financial market, product market.
• Markets that exchange the services of the four
  factors of production-labour, capital, land, and
  entrepreneurship. The buyer of factor services is
  business sector. The seller of these services is
  the household sector. The study of macroeconomics
  is concerned with imbalances in the resource
  markets, especially surpluses and the resulting
  unemployment of resources. The resource markets,
  also termed factor markets, are one of three
  primary sets of macroeconomic markets. The other
  two are product markets and financial markets.

135
WAGES

• The term wages means payments made for the
  services of labour. A wage may be as a sum of
  money paid under contract by an employer to a
  worker for services rendered.
• A wage is a form of remuneration paid by an
  employer to an employee calculated on some piece
  or unit basis. Compensation in terms of wages is
  given to workers and compensation in terms of
  salary is given to employees. Compensation is a
  monetary benefit given to employees in return for
  the services provided by them.

136
NOMINAL WAGES

• If you are paid by the hour, you are paid
  a nominal wage, which is simply the amount of
  money that you earn per hour of labor. If you
  earn 20.00 per hour, your nominal wage is
  20.00. However, the nominal wage really doesn't
  tell you what your purchasing power is because
  the nominal wage isn't adjusted for inflation,
  which is a rise in the general price level.

137
REAL WAGES

• Real wage, on the other hand, takes inflation
  into account. An increase in real wages occurs
  when wages rise more quickly than inflation. On
  the other hand, if real wages rise more slowly
  than inflation, then your real wages - your
  purchasing power - has declined. It's important
  for you to know your real wage to determine if an
  increase in your wage is actually increasing your
  wealth, simply keeping pace with rising costs, or
  worse, falling behind rising prices.

138
FACTORS INFLUENCING ON REAL WAGE

1. Purchasing Power of Money
2. Additional Facilities
3. Extra Income
4. Conditions of