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MANAGERI AL ECONOMI CS

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MANAGERIAL ECONOMICS

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MANAGERIAL ECONOMICS

MANAGERIAL ECONOMICS CONTENTS

UNIT-1

MANAGERIAL ECONOMICS

01-21

INTRODUCTION OBJECTIVES, DEFINTION OF MANAGERIAL ECONOMICS ,SCOPE OF MANAGERIAL ECONOMICS,NATURE OF MANAGERIAL ECONOMICS, ROLES AND RESPONSIBILITIES OF MANAGIRIAL ECONOMIST,BUSINESS DECISION MAKING, BUSINESS FIRM

UNIT-2

DEMAND ANALYSIS

22-45

OBJECTIVES,INTRODUCTION,DEFINITION

OF

DEMAND,TYPES OF DEMAND,THE LAW OF DEMAND,CHANGES

IN

DEMAND,LAW

OF

DIMINISHING MARGINAL UTILITY,THE LAW OF EQUI-

MARGINAL UTILITY,INDIFFERENCE

CURVE ANALYSIS,CONSUMER EQUILIBRIUM, ELASTICITY

OF

DEMAND,

DEMAND

FORECASTING,

UNIT-3

COST AND PRODUCTION CONCEPTS OBJECTIVES,INTRODUCTION,COST

46-64

CONCEPTS RELEVANT TO MANAGERIAL ECONOMICS, DETERMINANTS OF COST, COST OUTPUT RELATIONSHIP,BREAK EVEN ANALYSIS ,PRODUCTION FUNCTION,RETURNS TO SCALE ,ECONOMIES

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OF SCALE

UNIT-4

CAPITAL BUDGETING

65-90

OBJECTIVES,INTRODUCTION,MEANING OF CAPITAL BUDGETING,TYPES OF CAPITAL BUDGETING DECISIONS, SUPPLY OF CAPITAL – SOURCES OF CAPITAL, CAPITAL RATIONING ,COST OF CAPITAL,PROJECT FEASIBILITY,METHODS OF PROJECT EVALUATION - METHODS OF RANKING INVESTMENT PROPOSALS,PRINCIPLES TO MEASURE CAPITAL PRODUCTIVITY – PROFITABILITY INDEX

UNIT-5

CONCEPTS OF MARKET MACRO ECONOMICS

STRUCTURE AND 91-120

OBJECTIVES,INTRODUCTION,MARKET STRUCTURE,NATURE AND TYPES OF COMPETITION,PERFECT COMPETITION ,MONOPOLY, MONOPOLISTIC COMPETITION, OLIGOPOLY,PRICE DISCRIMINATION, NATIONAL INCOME, CONSUMPTION FUNCTION, INFLATION, BALANCE OF PAYMENTS,MONETARY POLICY,FISCAL POLICY

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1: MANAGERIAL ECONOMICS - INTRODUCTION UNIT STRUCTURE 1:1 OBJECTIVES 1:2 INTORDUCTION 1:3 DEFINTION OF MANAGERIAL ECONOMICS 1:4 SCOPE OF MANAGERIAL ECONOMICS 1:5 NATURE OF MANAGERIAL ECONOMICS 1:6 ROLES AND RESPONSIBILITIES OF MANAGIRIAL ECONOMIST 1:7 BUSINESS DECISION MAKING 1:8 BUSINESS FIRM 1:1 OBJECTIVES -

To understand the nature and scope of managerial economics To understand the role of economics in decision making To explain the techniques of decision making To deliberate some of the economic models

1:2 INTORDUCTION Managers everywhere have to take decisions. They face situations daily which require decision making ability. The nature of these problems is mainly economic, that is, making the best of the scarce resources. These managerial problems pertain to getting the most out of expensive resources. The managers have to juggle a situation in which they are required to maximize the output with scarce capital and other resources and at the same time minimize costs. It may a minor decision of how much to spend on advertising to boost up the demand for the firm’s products or a major decision about the size of the firm to be set up. The problems relate to choices and are faced by managers all the time.

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2

There may be several alternative courses of action available to a manager. He may have to decide in favour of one of them to achieve the desired or set objectives of the firm. The manager’s decision must lead to the most efficient use of available funds or resources in the form of capital, land and labour. Managers are called upon to prepare plans for increasing future production. They have to take decisions on the expansion of existing plants or setting up of new ones. Forward planning or planning for the future becomes an integral part of the managerial function. Decision making and forward planning are thus, the two vital functions of managers. Managerial economics enables the managers to perform these two vital functions most efficiently. 1:3 DEFINTION OF MANAGERIAL ECONOMICS Many different definitions have been given but most of them involve the application of economic theory and methods to business decision-making. ‘Managerial Economics is concerned with the application of economic principles and methodologies to the decision making process within the firm or organization under conditions of uncertainty. It seeks to establish rules and principles of facilitate the attainment of the desired economic goals of management. These economic goals relate to costs, revenues and profits and are important within both the business and the nonbusiness institutions.’ Prof. Evans J. Douglas ‘Managerial Economics is concerned with application of economic concepts and economic analysis to the problems of formulating material managerial decisions’ E.Mansfield In simple words, ‘managerial economics may be viewed as principles of economics applied to problem-solving at the level of the firm.’

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1:3:1 DIFFERENCES BETWEEN MANAGERIAL ECONOMICS AND TRADITIONAL ECONOMICS Let us briefly examine in what way managerial economics is different from traditional economics. 1. Importance of Non-economic Consideration Managerial decisions are not merely influenced by economic considerations. They are greatly influenced by other considerations too, namely human and behavioral factors, environmental forces and technological considerations. The effect of certain decisions on employees may be a more important factor than just economic expediency in taking a managerial decision. Environmental forces also exert a great influence on managerial decision making. There are political and social pressures which may compel managers to change or modify their decisions based on purely economic reasoning. For example, under the prevailing spiraling cost scenario, a rise in price may be justified on economic considerations. However, social and political pressures may not allow a manager to take such a decision. 2. Technological factors to be considered The traditional economic theory assumes a given technology and proceeds to analyse factors leading to an equilibrium situation. However, in actual decision making process, it is necessary to examine very closely various technological alternatives, since new technologies and processes are continuously emerging on the world scene. Therefore, in making a sound investment decision, it is necessary to consider technological factors also along with economic considerations. 3. Profit maximization – Not the only Goal Managerial economics differs from the traditional economic theory with regard to its assumption of profit maximization. The age old assumption of the theory of production is

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that the firm and the industry are motivated by maximum profits in the short and the long run. However, it is now realized that this assumption has to be supplemented by other assumptions. -

The firm may be interested in a reasonable profit rather than in maximizing profits to the nth degree.

-

Legal, moral, public and community obligations may be equally important factors in taking decisions rather than the sole aim of profit-maximization.

-

Issues of water pollution or air pollution may weigh heavily against profitmaximization

-

The firm reduces its profit by laying more stress on welfare activities for its workers and in incurring expenditure on anti-pollution measures.

Thus, though profit-maximization, within the legal, moral, public and community constraints, may still continue to be one of goals of the firm yet other considerations may compel it to earn just satisfactory or a reasonable profit. Additional costs incurred due to legal imposition, welfare considerations, anti-pollution drive, charitable donations, etc., may not be passed on to consumers and the firm is satisfied with a certain percentage of its investment as its profits. 1:4 SCOPE OF MANAGERIAL ECONOMICS Scope of Managerial Economics: Can you tell what you mean by the scope of the managerial economics? Well scope is something which tells us how far a particular subject will go. As far as Managerial Economic is concerned it is very wide in scope. It takes into account almost all the problems and areas of manager and the firm. ME deals with Demand analysis, Forecasting, Production function, Cost analysis, Inventory Management, Advertising, Pricing System, Resource allocation etc.

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Following aspects are to be taken into account while knowing the scope of ME:

1. Demand analysis and forecasting:

Unless and until knowing the demand for a product how can we think of producing that product. Therefore demand analysis is something which is necessary for the production function to happen. Demand analysis helps in analyzing the various types of demand which enables the manager to arrive at reasonable estimates of demand for product of his company. Managers not only assess the current demand but he has to take into account the future demand also.

2. Production function:

Conversion of inputs into outputs is known as production function. With limited resources we have to make the alternative uses of this limited resource. Factor of production called as inputs is combined in a particular way to get the maximum output. When the price of input rises the firm is forced to work out a combination of inputs to ensure the least cost combination.

3. Cost analysis: Cost analysis is helpful in understanding the cost of a particular product. It takes into account all the costs incurred while producing a particular product. Under cost analysis we will take into account determinants of costs, method of estimating costs, the relationship between cost and output, the forecast of the cost, profit, these terms are very vital to any firm or business. 4. Inventory Management:

What do you mean by the term inventory? Well the actual meaning of the term inventory is stock. It refers to stock of raw materials which a firm keeps. Now here the question arises how much of the inventory is ideal stock. Both the high inventory and low inventory is not good for the firm. Managerial economics will use such methods as ABC

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Analysis, simple simulation exercises, and some mathematical models, to minimize inventory cost. It also helps in inventory controlling. 5. Advertising:

Advertising is a promotional activity. In advertising while the copy, illustrations, etc., are the responsibility of those who get it ready for the press, the problem of cost, the methods of determining the total advertisement costs and budget, the measuring of the economic effects of advertising ---- are the problems of the manager. There’s a vast difference between producing a product and marketing it. It is through advertising only that the message about the product should reach the consumer before he thinks to buy it. Advertising forms the integral part of decision making and forward planning. 6. Pricing system:

Here pricing refers to the pricing of a product. As you all know that pricing system as a concept was developed by economics and it is widely used in managerial economics. Pricing is also one of the central functions of an enterprise. While pricing commodity the cost of production has to be taken into account, but a complete knowledge of the price system is quite essential to determine the price. It is also important to understand how product has to be priced under different kinds of competition, for different markets. Pricing = cost plus pricing and the policies of the enterprise Now it is clear that the price system touches the several aspects of managerial economics and helps managers to take valid and profitable decisions. 7. Resource allocation:

Resources are allocated according to the needs only to achieve the level of optimization. As we all know that we have scarce resources, and unlimited needs. We have to make the alternate use of the available resources. For the allocation of the resources various advanced tools such as linear programming are used to arrive at the best course of action.

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1:5 NATURE OF MANAGERIAL ECONOMICS •

Managerial economics aims at providing help in decision making by firms. It is heavily dependent on microeconomic theory. The various concepts of micro economics used frequently in managerial economics

-

Elasticity of demand

-

Marginal cost

-

Marginal revenue

-

Market structures and their significance in pricing policies.

Macro economy is used to identify the level of demand at some future point in time, based on the relationship between the level of national income and the demand for a particular product. It is the level of national income only that the level of various products depends.

In managerial economics macro economics indicates the relationship between (a) the magnitude of investment and the level of national income, (b) the level of national income and the level of employment, (c) the level of consumption and the level of national income.

In managerial economics emphasis is laid on those prepositions which are likely to be useful to management.

1:6 ROLES AND RESPONSIBILITIES OF MANAGIRIAL ECONOMIST A Managerial Economist is well acquainted with Micro and Macro aspects of the Economy. He/ She is well aware of the Economical Aspects combined with Business Decision Making. That makes a managerial economist well equipped with Theoretical and practical (application based) knowledge. For any company, it is very critical to keep track of Changing Consumer Preferences Potential Product Demand Resource Availability and Supply Constraints, if any Domestic and Overseas Competition

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A managerial economist helps in such critical factor analysis. Most important of all, whether at all a company needs to invest in a certain product based on External Factors is a Crucial Decision to make. A managerial economist can judge these factors and provide a practical decision based on Cost-Benefit Analysis. Knowing the Micro and Macro economics is the edge where any managerial economist scores over others.

1:7 BUSINESS DECISION MAKING Decision-making is a crucial part of good business. The question then is ‘how is a good decision made? One part of the answer is good information, and experience in interpreting information. Consultation ie seeking the views and expertise of other people also helps, as does the ability to admit one was wrong and change one’s mind. There are also aids to decisionmaking, various techniques which help to make information clearer and better analysed, and to add numerical and objective precision to decision-making (where appropriate) to reduce the amount of subjectivity. Managers can be trained to make better decisions. They also need a supportive environment where they won’t be unfairly criticised for making wrong decisions (as we all do sometimes) and will receive proper support from their colleague and superiors. A climate of criticism and fear stifles risk-taking and creativity; managers will respond by ‘playing it safe’ to minimise the risk of criticism which diminishes the business’ effectiveness in responding to market changes. It may also mean managers spend too much time trying to pass the blame around rather than getting on with running the business. Decision-making increasingly happens at all levels of a business. The Board of Directors may make the grand strategic decisions about investment and direction of future growth, and managers may make the more tactical decisions about how their own

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department may contribute most effectively to the overall business objectives. But quite ordinary employees are increasingly expected to make decisions about the conduct of their own tasks, responses to customers and improvements to business practice. This needs careful recruitment and selection, good training, and enlightened management. 1:7:1 Types of Business Decisions 1. Programmed Decisions These are standard decisions which always follow the same routine. As such, they can be written down into a series of fixed steps which anyone can follow. They could even be written as computer program 2. Non-Programmed Decisions. These are non-standard and non-routine. Each decision is not quite the same as any previous decision. 3. Strategic Decisions. These affect the long-term direction of the business eg whether to take over Company A or Company B 4. Tactical Decisions. These are medium-term decisions about how to implement strategy eg what kind of marketing to have, or how many extra staff to recruit 5. Operational Decisions. These are short-term decisions (also called administrative decisions) about how to implement the tactics eg which firm to use to make deliveries. The model in Figure 2 above is a normative model, because it illustrates how a good decision ought to be made. Business Studies also uses positive models which simply aim to illustrate how decisions are, in fact, made in businesses without commenting on whether they are good or bad.

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Figure 1: Levels of Decision-Making

1:7:2 DECISION MAKING TECHNIQUES Linear programming models help to explore maximising or minimising constraints eg one can program a computer with information that establishes parameters for minimising costs subject to certain situations and information about those situations. Spread-sheets are widely used for ‘what if’ simulations. A very large spread-sheet can be used to hold all the known information about, say, pricing and the effects of pricing on profits. The different pricing assumptions can be fed into the spread-sheet ‘modelling’ different pricing strategies. This is a lot quicker and an awful lot cheaper than actually changing prices to see what happens. On the other hand, a spread-sheet is only as good as the information put into it and no spread-sheet can fully reflect the real world. But it is very useful management information to know what might happen to profits ‘what if’ a skimming strategy, or a penetration strategy were used for pricing

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Figure 2: The Decision-Making Process

The computer does not take decisions; managers do. But it helps managers to have quick and reliable quantitative information about the business as it is and the business as it might be in different sets of circumstances. There is, however, a lot of research into ‘expert systems’ which aim to replicate the way real people (doctors, lawyers, managers, and the like) take decisions. The aim is that computers can, one day, take decisions, or at least programmed decisions (see above). For example, an expedition could carry an expert medical system on a lap-top to deal with any medical emergencies even though the nearest doctor is thousands of miles away. Already it is possible, in the US, to put a credit card into a ‘hole-in-the-wall’ machine and get basic legal advice about basic and standard legal problems. 1:7:3 GAME THEORY Game theory is a branch of mathematical analysis developed to study decision making in conflict situations. Such a situation exists when two or more decision makers who

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have different objectives act on the same system or share the same resources. There are two persons and multi-persons

games. Game theory provides a mathematical

process for selecting an OPTIMUM STRATEGY (that is, an optimum decision or a sequence of decisions) in the face of an opponent who has a strategy of his own. In game theory one usually makes the following assumptions: (1) Each decision maker ["PLAYER"] has available to him two or more well-specified choices or sequences of choices (called "PLAYS"). (2) Every possible combination of plays available to the players leads to a well-defined end-state (win, loss, or draw) that terminates the game. (3) A specified payoff for each player is associated with each end-state (a [ZERO-SUM game] means that the sum of payoffs to all players is zero in each end-state). (4) Each decision maker has perfect knowledge of the game and of his opposition; that is, he knows in full detail the rules of the game as well as the payoffs of all other players. (5) All decision makers are rational; that is, each player, given two alternatives, will select the one that yields him the greater payoff. The last two assumptions, in particular, restrict the application of game theory in realworld conflict situations. Nonetheless, game theory has provided a means for analyzing many problems of interest in economics, management science, and other fields. 1:7:4 INPUT-OUTPUT ANALYSIS Input-Output analysis creates a picture of a regional economy describing flows to and from industries and institutions •

Input-Output Analysis is an accounting framework

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Input-Output analysis can be used to predict changes in overall economic activity as a result of some change in the local economy

Provides a description of a local economy

Predictive model to estimate impacts

1:8 BUSINESS FIRM 1:8:1 OBJECTIVES OF BUSINESS FIRM Business objectives are something which a business organization wants to achieve or accomplish over a specified period of time. These may be to earn profit for its growth and development, to provide quality goods to its customers, to protect the environment etc. These are the objectives of business. In the following section let us classify the objectives of business. CLASSIFICATION OF OBJECTIVES OF BUSINESS It is generally believed that a business has a single objective, that is, to make profit. But it cannot be the only objective of business. While pursuing the objective of earning profit, business units do keep the interest of their owners in view. However, any business unit cannot ignore the interests of its employees, customers, the community, as well as the interests of society as a whole. For instance, no business can prosper in the long run unless fair wages are paid to the employees and customer satisfaction is given due importance. Again a business unit can prosper only if it enjoys the support and goodwill of people in general. Business objectives also need to be aimed at contributing to national goals and aspirations as well as towards international well-being. Thus, the objectives of business may be classified as – a. Economic Objectives b. Social Objectives

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c. Human Objectives d. National Objectives e. Global Objectives Now we shall discuss all these objectives in details. 1:8:2 ECONOMIC OBJECTIVES Economic objectives of business refer to the objective of earning profit and also other objectives that are necessary to be pursued to achieve the profit objective, which include, creation of customers, regular innovations and best possible use of available resources. Letus learn about these.

i. Profit earning Profit is the lifeblood of business, without which no business can survive in a competitive market. In fact profit making is the primary objective for which a business unit is brought into existence. Profits must be earned to ensure the survival of business, its growth and expansion over time. Profits help businessmen not only to earn their living but also to expand their business activities by reinvesting a part of the profits. In order to achieve this primary objective, certain other objectives are also necessary to be pursued by business, which are as follows: a) Creation of customers A business unit cannot survive unless there are customers to buy the products and services. Again a businessman can earn profits only when he/she provides quality goods and services at a reasonable price. For this it needs to attract more customers for its existing as well as new products. This is achieved with the help of various marketing activities. b) Regular innovations Innovation means changes, which bring about improvement in products, process of production

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and distribution of goods. Business units, through innovation, are able to reduce cost by adopting better methods of production and also increase their sales by attracting more customers because of improved products. Reduction in cost and increase in sales gives more profit to the businessman. Use of power-looms in place of handlooms, use of tractors in place of hand implements in farms etc. are all the results of innovation. c) Best possible use of resources As you know, to run any business you must have sufficient capital or funds. The amount of capital may be used to buy machinery, raw materials, employ men and have cash to meet day-to-day expenses. Thus, business activities require various resources like men, materials, money and machines. The availability of these resources is usually limited. Thus, every business should try to make the best possible use of these resources. This objective can be achieved by employing efficient workers, making full use of machines and minimizing wastage of raw materials.

1:8:3 SOCIAL OBJECTIVES Social objectives are those objectives of business, which are desired to be achieved for the benefit of the society. Since business operates in a society by utilizing its scarce resources, the society expects something in return for its welfare. No activity of the business should be aimed at giving any kind of trouble to the society. If business activities lead to socially harmful effects, there is bound to be public reaction against the business sooner or later. Social objectives of business include production and supply of quality goods and services, adoption of fair trade practices and contribution to the general welfare of society and provision of welfare amenities. i. Production and supply of quality goods and services Since the business utilizes the various resources of the society, the society expects to get quality goods and services from the business. The objective of business should be to produce better quality goods and supply them at the right time and at a right price. It is not desirable on the part of the businessman to supply adulterated or inferior goods

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which cause injuries to the customers. They should charge the price according to the quality of the goods and services provided to the society. Again, the customers also expect timely supply of all their requirements. So it is important for every business to supply those goods and services on a regular basis. ii. Adoption of fair trade practices In every society, activities such as hoarding, black-marketing and over-charging are considered undesirable. Besides, misleading advertisements often give a false impression about the quality of products. Such advertisements deceive the customers and the businessmen use them for the sake of making large profits. This is an unfair trade practice. The business unit must not create artificial scarcity of essential goods or raise prices for the sake of earning more profits. All these activities earn a bad name and sometimes make the businessmen liable for penalty and even imprisonment under the law. Therefore, the objective of business should be to adopt fair trade practices for the welfare of the consumers as well as the society. iii. Contribution to the general welfare of the society Business units should work for the general welfare and upliftment of the society. This is possible through running of schools and colleges for better education, opening of vocational training centers to train the people to earn their livelihood, establishing hospitals for medical facilities and providing recreational facilities for the general public like parks, sports complexes etc. 1:8:4 HUMAN OBJECTIVES Human objectives refer to the objectives aimed at the well-being as well as fulfillment of expectations of employees as also of people who are disabled, handicapped and deprived of proper education and training. The human objectives of business may thus include economic well-being of the employees, social and psychological satisfaction of employees and development of human resources. i. Economic well being of the employees In business employees must be provided with fair remuneration and incentives for performance, benefits of provident fund, pension and other amenities like medical

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facilities, housing facilities etc. By this they feel more satisfied at work and contribute more for the business. ii. Social and psychological satisfaction of employees It is the duty of business units to provide social and psychological satisfaction to their employees. This is possible by making the job interesting and challenging, putting the right person in the right job and reducing the monotony of work. Opportunities for promotion and advancement in career should also be provided to the employees. Further, grievances of employees should be given prompt attention and their suggestions should be considered seriously when decisions are made. If employees are happy and satisfied they can put their best efforts in work. iii. Development of human resources Employees as human beings always want to grow. Their growth requires proper training as well as development. Business can prosper if the people employed can improve their skills and develop their abilities and competencies in course of time. Thus, it is important that business should arrange training and development programmes for its employees. iv. Well being of socially and economically backward people Business units being inseparable parts of society should help backward classes and also people those are physically and mentally challenged. This can be done in many ways. For instance, vocational training programme may be arranged to improve the earning capacity of backward people in the community. While recruiting it staff, business should give preference to physically and mentally challenged persons. Business units can also help and encourage meritorious students by awarding scholarships for higher studies. 1:8:5 NATIONAL OBJECTIVES Being an important part of the country, every business must have the objective of fulfilling

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national goals and aspirations. The goal of the country may be to provide employment opportunity to its citizen, earn revenue for its exchequer, become self-sufficient in production of goods and services, promote social justice, etc. Business activities should be conducted keeping these goals of the country in mind, which may be called national objectives of business. The following are the national objectives of business. i. Creation of employment One of the important national objectives of business is to create opportunities for gainful employment of people. This can be achieved by establishing new business units, expanding markets, widening distribution channels, etc. ii. Promotion of social justice As a responsible citizen, a businessman is expected to provide equal opportunities to all persons with whom he/she deals. He/She is also expected to provide equal opportunities to all the employees to work and progress. Towards this objective special attention must be paid to weaker and backward sections of the society. iii. Production according to national priority Business units should produce and supply goods in accordance with the priorities laid down in the plans and policies of the Government. One of the national objectives of business in our country should be to increase the production and supply of essential goods at reasonable prices. iv. Contribute to the revenue of the country The business owners should pay their taxes and dues honestly and regularly. This will increase the revenue of the government, which can be used for the development of the nation. v. Self-sufficiency and Export Promotion To help the country to become self-reliant, business units have the added responsibility of restricting import of goods. Besides, every business units should aim at increasing exports and adding to the foreign exchange reserves of the country 1:8:6 GLOBAL OBJECTIVES

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Earlier India had a very restricted business relationship with other nations. There was a very rigid policy for import and export of goods and services. But, now-a-days due to liberal economic and export–import policy, restrictions on foreign investments have been largely abolished and duties on imported goods have been substantially reduced. This change has brought about increased competition in the market. Today because of globalisation the entire world has become a big market. Goods produced in one country are readily available in other countries. So, to face the competition in the global market every business has certain objectives in mind, which may be called the global objectives. Let us learn about them. i. Raise general standard of living Growth of business activities across national borders makes available quality goods at reasonable prices all over the world. The people of one country get to use similar types of goods that people in other countries are using. This improves the standard of living of people. ii. Reduce disparities among nations Business should help to reduce disparities among the rich and poor nations of the world by expanding its operation. By way of capital investment in developing as well as underdeveloped countries it can foster their industrial and economic growth. iii. Make available globally competitive goods and services Business should produce goods and services which are globally competitive and have huge demand in foreign markets. This will improve the image of the exporting country and also earn more foreign exchange for the country. 1:8:7 THEORY OF THE FIRM A microeconomic concept founded in neoclassical economics that states that firms (corporations) exist and make decisions in order to maximize profits. Businesses interact with the market to determine pricing and demand and then allocate resources according to models that look to maximize net profits. The theory of the firm goes along with the theory of the consumer, which states that consumers seek to maximize their

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overall utility. Modern takes on the theory of the firm sometimes distinguish between long-run motivations (sustainability) and short-run motivations (profit maximization). The theory of the firm is always being re-analyzed and adapted to suit changing economies and markets. Early economic analysis focused on broad industries, but as the nineteenth century progressed, more economists began to look at the firm level to answer basic questions about why companies produce what they do, and what motivates

their

choices

when

allocating

capital

and

labor.

Modern takes on the theory of the firm take such facts as low equity ownership by many decision-makers into account; some feel that CEOs of publicly held companies are interested not only in profit maximization, but also in goals based on sales maximization, public relations and market share. UNIT QUESTIONS 1. Define managerial economics. What are the differences between traditional and managerial economics? 2. Explain the scope of managerial economics 3. Discuss the role and responsibilities of managerial economist 4. What do you understand by Business Decision Making? Explain the various decision making techniques used in business environment. 5. Describe the objectives of business firm. Also explain the theory of firm.

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UNIT-2 DEMAND ANALYSIS UNIT STRUCTURE 2:1 OBJECTIVES 2:2 INTRODUCTION 2:3 DEFINITION OF DEMAND 2:4 TYPES OF DEMAND 2:5 THE LAW OF DEMAND 2:6 CHANGES IN DEMAND 2:7 LAW OF DIMINISHING MARGINAL UTILITY 2:8 THE LAW OF EQUI-MARGINAL UTILITY 2:9 INDIFFERENCE CURVE ANALYSIS 2:10 CONSUMER EQUILIBRIUM 2:11 ELASTICITY OF DEMAND 2:12 DEMAND FORECASTING

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2:1 OBJECTIVES To classify various types of demand To identify factors influencing demand To comprehend demand concepts and exemplify their use To understand the underlying principles of consumer behavior To understand the concept of consumer equilibrium and indifference curve To familiarize the concept of elasticity of demand To comprehend the techniques of demand forecasting

2:2 INTRODUCTION Companies across the world acknowledge that consumer demand plays a significant role in the creation and survival of a firm. In the initial stage, sufficient demand for a good or service is essential for setting up of a firm. The success or failure of a business depends mainly on its ability to generate revenues by satisfying consumer preferences. The greater the customer satisfaction, the more the market share and profitability of the firm. As a result, most companies generally introduce a change in the product –mix and service-mix with a change in customer requirements and expectations. Therefore, it can be said that, the customer is the pivot around whom the modern business revolves. In this unit, we will first define the concept of demand and the law of demand. We will also discuss the consumer equilibrium and indifference curve concept with reference to the demand concept. We will also discuss the response of price changes with reference to demand. Later we will also discuss the need and types of forecasting. 2:3 DEFINITION OF DEMAND The amount of a particular economic good or service that a consumer or group of consumers will want to purchase at a given price. The demand curve is usually

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downward sloping, since consumers will want to buy more as price decreases. Demand for a good or service is determined by many different factors other than price, such as the price of substitute goods and complementary goods. In extreme cases, demand may be completely unrelated to price, or nearly infinite at a given price. Along with supply, demand is one of the two key determinants of the market price. 2:4 TYPES OF DEMAND: 1. Composite Demand: if a particular goods or service is demanded to satisfy different needs, that demand is said to be composite. That is deriving different satisfaction from a particular commodity. A typical example of a commodity that has composite demand is crude oil. Crude oil is needed to produce different petroleum products like petrol, kerosene, cooking gas, etc. 2. Derived Demand: when a commodity is demanded for the satisfaction of another commodity, that demand is said to be derived. That is the demand for a commodity necessitating the demand for another commodity. A good example of derived demand is an increase in the demand of cars which automatically necessitate an increase in the demand of petrol. 3. Competitive Demand: when commodities have close substitute, the demand for such commodities are said to be competitive. Let us take beverage as example; there lots of different brand of beverages available and one can easily go for any in place of the others. In other words, beverage has a competitive demand. 4. Joint or Complementary Demand: A demand is said to be joint when the demand of two commodities is needed to satisfy one need. For example, the demand for cooking gas and gas cooker is jointly needed to satisfy one's cooking. Therefore, both demands are said to be joint or complementary since on complements the other.

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2:4:1 FACTORS THAT DETERMINE DEMAND: 1. Price: Price determines demand since a change in price causes an opposite change in demand. That is an increase in price causes a decrease in demand and vice versa. 2. Income of the Consumer: increase in the income of a consumer tends to increase the purchasing power of the consumer, hence increases demand. Thus income is proportional to demand. 3. The Prices of other Commodities: this affects commodities with close substitutes. An increase in the price of one shifts demand to its close substitute with a lower price. 4. Population: Population is proportional to demand. The higher the population, the higher the demand of goods and services and vice versa. 5. Change in Fashion: Since people tend to go for things in vogue, demand for obsolete commodities tends to drop while we experience increase in commodities that are in vogue. 6. Change in Taste: People's demand tends to increase with their taste. Therefore a change in taste causes a change in demand. 7. Age Distribution: The higher the population of a particular age group, the higher the demand in the commodity used by that age group and vice versa. Tobacco for example is taken by people between the age of 18 and above. Thus the demand in tobacco depends on the number of people within this age limit. 8. Taxation: Taxes place on particular goods increase the price of such goods, hence reducing the demand of the commodity. 9. Festive Period: The demand for certain kind of commodities tends to increase during festive periods. During the Muslim's Eid-El-Kabir, the demand for ram increase. While during Christmas season, demand for gift items increases.

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10. Expectation of Changes in Prices: If the price of a commodity is expected to either fall or rise, there will be an increase or decrease in the demand of that commodity. 11. Invention of New Commodity: People go for newer commodities thus reducing the demand for older ones. For example, the demand for Pentium 3 laptops is reducing as people tend to go for newer brands of computers. 2:5 THE LAW OF DEMAND The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

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2:5:1 EXCEPTIONS TO LAW OF DEMAND Giffen goods: these are those inferior goods on which the consumer spends a large part of his income and the demand for which falls with a fall in their price. The demand curve for these has a positive slope. The consumers of such goods are mostly the poor. A rise in their price drains their resources and the poor have to shift their consumption from the more expensive goods to the giffen goods, while a fall in the price would spare the household some money for more expensive goods. Which still remain cheaper? These goods have no closely related substitutes; hence income effect is higher than substitution effect. Articles of snob appeal: Goods which serve ' status symbol ' do not follow the law of demand. These are goods of ' conspicuous consumption '.they gives their possessor utility in the sense of their ownership. Rich buy diamond as their possession is prestigious. When their price raises the prestige value goes up. Expectations regarding future prices: If the price of a commodity is rising and is expected to rise in future the demand for the commodity will increase. Emergency: At times of war, famine etc. consumers have an abnormal behaviour. If they expect shortage in goods they would buy and hoard goods even at higher prices. In depression they will buy less at even low prices. Quality-price relationship: some people assume that expensive goods are of a higher quality then the low priced goods. In this case more goods are demanded at higher prices. 2:6 CHANGES IN DEMAND A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

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The demand curve usually slopes downwards from left to right; that is, it has a negative association (for two theoretic exceptions, see Veblen good and Giffen good). The negative slope is often referred to as "law of demand," which means people will buy more of a service, product, or resource as its price falls; see also price elasticity of demand. The demand curve is related to the marginal utility curve, since the price one is willing to pay depends on the utility. However, the demand directly depends on the income of an individual while the utility does not. Thus it may change indirectly due to change in demand of other commodities. These individual factors come together to determine the budget constraint and indifference curve of consumers. The demand curve is then generated by connecting the points where those lines are tangent to one another.

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If the price a consumer is willing to pay for an additional unit of a good increases initially as function of amount then the maximum price pmax he is willing to pay is more than the price he would be willing to pay for the first unit. At this price pmax there is a non-zero amount A for which the consumer surplus is zero; at this price and amount the negative consumer surplus for the first units is compensated by the more attractive later units, for each of which the consumer would be willing to pay more than pmax. At this amount the price he is willing to pay for an additional unit has decreased back to pmax. If the price is lower than pmax the consumer will buy more. Thus he buys either nothing or at least A. In this case the individual demand curve has a discontinuity, where, after decreasing with price as usual, the demand jumps to zero. At this price he is indifferent between buying this minimum amount and buying nothing (spending the money on something else). Geometrically pmax is the slope of the steepest line through the origin and another point of the graph of the total price the consumer is willing to pay as function of amount. In the case of a smooth function this line is tangent to the graph. If the price a consumer is willing to pay for an additional unit of a good goes up and down more often, then the demand curve has more discontinuities, each associated with a line through two points of the graph of the total price the consumer is willing to pay as function of amount, with no part of the graph above the line.

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2:6:1 CAUSES OF CHANGE IN DEMAND Changes in disposable income Changes in taste and fashion The availability and cost of credit Changes in the prices of related goods (substitutes and complements) Population size and composition 2:7 LAW OF DIMINISHING MARGINAL UTILITY Definition Psychological generalization that the perceived value of, or satisfaction gained from, a good to a consumer declines with each additional unit acquired or consumed. Even the most delicious food, for example, will appeal less and less to its partaker as its consumption reaches his or her satiation point and, if the consumption continues, will result in sickness (disutility). Consumers deal with this phenomenon by consuming a variety of goods rather than lots of one good. Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before - probably because you are starting to feel full or you have had too many sweets for one day.

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30

This table shows that total utility will increase at a much slower rate as marginal utility diminishes with each additional bar. Notice how the first chocolate bar gives a total utility of 70 but the next three chocolate bars together increase total utility by only 18 additional

units.

The law of diminishing marginal utility helps economists understand the law of demand and the negative sloping demand curve. The less of something you have, the more satisfaction you gain from each additional unit you consume; the marginal utility you gain from that product is therefore higher, giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded because your additional satisfaction

diminishes

as

you

demand

more.

In order to determine what a consumer's utility and total utility are, economists turn to consumer demand theory, which studies consumer behavior and satisfaction. Economists assume the consumer is rational and will thus maximize his or her total utility by purchasing a combination of different products rather than more of one particular product. Thus, instead of spending all of your money on three chocolate bars, which has a total utility of 85, you should instead purchase the one chocolate bar, which has a utility of 70, and perhaps a glass of milk, which has a utility of 50. This combination will give you a maximized total utility of 120 but at the same cost as the three chocolate bars.

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2:8 THE LAW OF EQUI-MARGINAL UTILITY The Law of Equi-Marginal Utility is an extension to the law of diminishing marginal utility. The principle of equi-marginal utility explains the behavior of a consumer in distributing his limited income among various goods and services. This law states that how a consumer allocates his money income between various goods so as to obtain maximum satisfaction. Assumptions: The wants of a consumer remain unchanged. The prices of all goods are given and known to a consumer. He is one of the many buyers in the sense that he is powerless to alter the market price. He can spend his income in small amounts. He acts rationally in the sense that he want maximum satisfaction Utility is measured cardinally. This means that utility, or use of a good, can be expressed in terms of "units" or "utils". This utility is not only comparable but also quantifiable. Suppose there are two goods 'x' and 'y' on which the consumer has to spend his given income. The consumer’s behavior is based on two factors: (a) Marginal Utilities of goods 'x' and 'y' (b) The prices of goods 'x' and 'y' The consumer is in equilibrium position when marginal utility of money expenditure on each good is the same.The Law of Equi-Marginal Utility states that the consumer will distribute his money income in such a way that the utility derived from the last rupee spent on each good is equal.

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The consumer will spend his money income in such a way that marginal utility of each good is proportional to its rupee. The consumer is in equilibrium in respect of the purchases of goods 'x' and 'y' when: MUx = MUy Where MU is Marginal Utility and P equals Price If MUx / Px and MUy / Py are not equal and MUx / Px is greater than MUy / Py, then the consumer will substitute good 'x' for good 'y'. As a result the marginal utility of good 'x' will fall. The consumer will continue substituting good 'x' for good 'y' till MUx/Px = MUy/Py where the consumer will be in equilibrium. Thus this is also known as the law of substitution. This law is based on the assumption that utility can be cardinally measurable. But in actual practices it cannot be measured in such cardinal numbers. It is also assumed that marginal utility of money is constant. But this is not true because when the quantity of money increases, its marginal utility will diminish. This law is not applicable in the case of indivisible goods like TV sets, refrigerators, etc. Normally a person will buy only a single unit of such goods. Hence it is ridiculous to prepare an individual marginal utility schedule for such goods. 2:9 INDIFFERENCE CURVE ANALYSIS The aim of indifference curve analysis is to analyse how a rational consumer chooses between two goods. In other words, how the change in the wage rate will affect the choice between leisure time and work time. Indifference analysis combines two concepts; indifference curves and budget lines (constraints) The indifference curve An indifference curve is a line that shows all the possible combinations of two goods between which a person is indifferent. In other words, it is a line that shows the

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consumption of different combinations of two goods that will give the same utility (satisfaction) to the person. For instance, in Figure the indifference curve is giben. A person would receive the same utility (satisfaction) from consuming 4 hours of work and 6 hours of leisure, as they would if they consumed 7 hours of work and 3 hours of leisure.

An indifference curve for work and leisure

An important point is to remember that the use of an indifference curve does not try to put a physical measure onto how much utility a person receives. The shape of the indifference curve Figure highlights that the shape of the indifference curve is not a straight line. It is conventional to draw the curve as bowed. This is due to the concept of the diminishing marginal rate of substitution between the two goods. The marginal rate of substitution is the amount of one good (i.e. work) that has to be given up if the consumer is to obtain one extra unit of the other good (leisure). The equation is below The marginal rate of substitution (MRS) = change in good X / change in good Y

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Using Figure 1, the marginal rate of substitution between point A and Point B is; MRS = -3 / 3 = -1 = 1 Note, the convention is to ignore the sign. The reason why the marginal rate of substitution diminishes is due to the principle of diminishing marginal utility. Where this principle states that the more units of a good are consumed, then additional units will provide less additional satisfaction than the previous units. Therefore, as a person consumes more of one good (i.e. work) then they will receive diminishing utility for that extra unit (satisfaction), hence, they will be willing to give up less of their leisure to obtain one more unit of work. The relationship between marginal utility and the marginal rate of substitution is often summarized with the following equation; MRS = Mux / Muy 2:10 CONSUMER EQUILIBRIUM When consumers make choices about the quantity of goods and services to consume, it is presumed that their objective is to maximize total utility. In maximizing total utility, the consumer faces a number of constraints, the most important of which are the consumer's income and the prices of the goods and services that the consumer wishes to consume. The consumer's effort to maximize total utility, subject to these constraints, is referred to as the consumer's problem. The solution to the consumer's problem, which entails decisions about how much the consumer will consume of a number of goods and services, is referred to as consumer equilibrium. 2:10:1 Determination of consumer equilibrium. Consider the simple case of a consumer who cares about consuming only two goods: good 1 and good 2. This consumer knows the prices of goods 1 and 2 and has a fixed income or budget that can be used to purchase quantities of goods 1 and 2. The consumer will purchase quantities of goods 1 and 2 so as to completely exhaust the budget for such

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purchases. The actual quantities purchased of each good are determined by the condition for consumer equilibrium, which is

This condition states that the marginal utility per dollar spent on good 1 must equal the marginal utility per dollar spent on good 2. If, for example, the marginal utility per dollar spent on good 1 were higher than the marginal utility per dollar spent on good 2, then it would make sense for the consumer to purchase more of good 1 rather than purchasing any more of good 2. After purchasing more and more of good 1, the marginal utility of good 1 will eventually fall due to the law of diminishing marginal utility, so that the marginal utility per dollar spent on good 1 will eventually equal that of good 2. Of course, the amount purchased of goods 1 and 2 cannot be limitless and will depend not only on the marginal utilities per dollar spent, but also on the consumer's budget. 2:11 ELASTICITY OF DEMAND Price elasticity of demand refers to the way prices change in relationship to the demand, or the way demand changes in relationship to pricing. Price elasticity can also reference the amount of money each individual consumer is willing to pay for something. People with lower incomes tend to have lower price elasticity, because they have less money to spend. A person with a higher income is thought to have higher price elasticity, since he can afford to spend more. In both cases, ability to pay is negotiated by the intrinsic value of what is being sold. If the thing being sold is in high demand, even a consumer with low price elasticity is usually willing to pay higher prices. Elasticity implies stretch and flexibility. The flexibility or the price elasticity of demand will change based on each item. Changing nature of both price and demand are affected by a number of factors.

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Generally, goods or services offered at a lower price lead to a demand for greater quantity. If you can get socks on sale you might buy several pairs or several packages, instead of just a pair. This means that though the seller offers the socks at a lower price, he usually ends up making more money, because demand for the product has increased. However if the price is set too low, the retailer may lose money by selling too many pairs of socks at a reduced rate. Price elasticity of demand evaluates how change in price influences demand. In certain circumstances, demand remains inelastic, despite higher prices. This is true of a number of medications that are available to treat certain conditions, where there is no substitute. Demand remains constant in spite of high prices. 2:11:1 Price elasticity of demand is defined as the measure of responsiveness in the quantity demanded for a commodity as a result of change in price of the same commodity. It is a measure of how consumers react to a change in price. In other words, it is percentage change in quantity demanded as per the percentage change in price of the same commodity. In simpler words, demand for a product can be said to be very inelastic if consumers will pay almost any price for the product, and very elastic if consumers will only pay a certain price, or a narrow range of prices, for the product. Inelastic demand means a producer can raise prices without much hurting demand for its product, and elastic demand means that consumers are sensitive to the price at which a product is sold and will not buy it if the price rises by what they consider too much. Drinking water is a good example of a good that has inelastic characteristics in that people will pay anything for it (high or low prices with relatively equivalent quantity demanded), so it is not elastic. On the other hand, demand for sugar is very elastic because as the price of sugar increases, there are many substitutions which consumers may switch to. Mathematical definition

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The formula used to calculate the coefficient of price elasticity of demand for a given product is

Conventions differ regarding the minus sign, considering remarks like "price elasticity of demand is usually negative". 2:11:2 Determinants of elasticity of demand A number of factors determine the elasticity: Substitutes: The more substitutes, the higher the elasticity, as people can easily switch from one good to another if a minor price change is made Percentage of income: The higher the percentage that the product's price is of the consumers income, the higher the elasticity, as people will be careful with purchasing the good because of its cost Necessity: The more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those that need it. Duration: The longer a price change holds, the higher the elasticity, as more and more people will stop demanding the goods (i.e. if you go to the supermarket and find that blueberries have doubled in price, you'll buy it because you need it this time, but next time you won't, unless the price drops back down again) Breadth of definition: The broader the definition, the lower the elasticity. For example, Company X's fried dumplings will have a relatively high elasticity, where as food in general will have an extremely low elasticity (see Substitutes, Necessity above)

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Classifications of Elasticity of Demand Point-price elasticity Point Elasticity = (% change in Quantity) / (% change in Price) Point Elasticity = (∆Q/Q)/(∆P/P) Point Elasticity = (P ∆Q) / (Q ∆P) Point Elasticity = (P/Q) (∆Q/∆P) 2:11:3 Income elasticity of demand The income elasticity of demand measures the responsiveness of the quantity demanded of a good to the change in the income of the people demanding the good. It is calculated as the ratio of the percent change in quantity demanded to the percent change in income. A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the quantity demanded 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 the quantity demanded. 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 (or inelastic) demand occurs when an increase in income is not associated with a change in the quantity demanded of a good. These would be sticky goods. Cross elasticity of demand

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39

The cross elasticity of demand and cross price elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in the price of another good. It is measured as the percentage change in quantity demanded for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the quantity of new cars that are fuel inefficient demanded decreased by 20%, the cross elasticity of demand would be 20%/10% = -2. Interpretation of elasticity

Value

Meaning

n=0

Perfectly inelastic.

0 > n > -1

Relatively inelastic.

n = -1

Unit (or unitary) elastic.

-1 > n > -∞

Relatively elastic.

Perfectly elastic. n = -∞

2:12 DEMAND FORECASTING DEFINITION A demand forecast is the prediction of what will happen to your company's existing product sales. It would be best to determine the demand forecast using a multi-

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functional approach. The inputs from sales and marketing, finance, and production should be considered. The final demand forecast is the consensus of all participating managers. You may also want to put up a Sales and Operations Planning group composed of representatives from the different departments that will be tasked to prepare the demand forecast. 2:12:1 Steps of the demand forecasts: • Determine the use of the forecast • Select the items to be forecast • Determine the time horizon of the forecast • Select the forecasting model(s) • Gather the data • Make the forecast • Validate and implement results 2:12:2 Levels of Forecast Description Short-range Duration

Forecast Horizon Medium-range

Long-range

Usually less than 3 3 months to 3

More than 3 years

months, maximum years of 1 year Applicability

Job scheduling,

Sales and

New product

worker

production

development,

assignments

planning,

facilities planning

budgeting

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2:12:3 Criteria for Good Forecasting Method There are two approaches to determine demand forecast – (1) the qualitative approach, (2) the quantitative approach. The comparison of these two approaches is shown below: Description Applicability

Qualitative Approach

Quantitative Approach

Used when situation is vague &

Used when situation is stable &

little data exist (e.g., new

historical data exist

products and technologies) (e.g. existing products, current technology) Considerations Involves intuition and

Techniques

Involves mathematical

experience

techniques

Jury of executive opinion

Time series models

Sales force composite

Causal models

Delphi method Consumer market survey

2:12:4 Methods of Forecasting Qualitative Forecasting Methods Qualitative forecasting methods can be used if we do not have historical data on products' sales. Qualitative Method Jury

of

opinion

Description

executive The opinions of a small group of high-level managers are pooled and together they estimate demand. The

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group uses their managerial experience, and in some cases, combines the results of statistical models. Sales

force Each salesperson (for example for a territorial

composite

coverage) is asked to project their sales. Since the salesperson is the one closest to the marketplace, he has the capacity to know what the customer wants. These projections are then combined at the municipal, provincial and regional levels.

Delphi method

A panel of experts is identified where an expert could be a decision maker, an ordinary employee, or an industry expert. Each of them will be asked individually for their estimate of the demand. An iterative process is conducted until the experts have reached a consensus.

Consumer survey

market The customers are asked about their purchasing plans and their projected buying behavior. A large number of respondents is needed here to be able to generalize certain results.

2:12:5 Quantitative Forecasting Methods There are two forecasting models here – (1) the time series model and (2) the causal model. A time series is a s et of evenly spaced numerical data and is o btained by observing responses at regular time periods. In the time series model , the forecast is based only on past values and assumes that factors that influence the past, the present and the future sales of your products will continue. On the other hand, t he causal model uses a mathematical technique known as the regression analysis that relates a dependent variable (for example, demand) to an independent variable (for example, price, advertisement, etc.) in the form of a linear equation. The time series forecasting methods are described below:

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Time Series Forecasting Method

43

Description

Naïve

Assumes that demand in the next period is the same as

Approach

demand in most recent period; demand pattern may not always be that stable For example: If July sales were 50, then Augusts sales will also be 50

Moving

MA is a series of arithmetic means and is used if little or no

Averages (MA)

trend is present in the data; provides an overall impression of data over time A simple moving average uses average demand for a fixed sequence of periods and is good for stable demand with no pronounced behavioral patterns. Equation:

F 4 = [D 1 + D2 + D3] / 4 F – forecast, D – Demand, No. – Period A weighted moving average adjusts the moving average method to reflect fluctuations more closely by assigning weights to the most recent data, meaning, that the older data is usually less important. The weights are based on intuition and lie between 0 and 1 for a total of 1.0 Equation:

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WMA 4 = (W) (D3) + (W) (D2) + (W) (D1) WMA – Weighted moving average, W – Weight, D – Demand, No. – Period Exponential

The exponential smoothing is an averaging method that

Smoothing

reacts more strongly to recent changes in demand by assigning a smoothing constant to the most recent data more strongly; useful if recent changes in data are the results of actual change (e.g., seasonal pattern) instead of just random fluctuations

F t + 1 = a D t + (1 - a ) F t Where F t + 1 = the forecast for the next period D t = actual demand in the present period F t = the previously determined forecast for the present period • = a weighting factor referred to as the smoothing constant Time

Series The time series decomposition adjusts the seasonality by

Decomposition multiplying the normal forecast by a seasonal factor

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UNIT QUESTIONS 1. Define demand. Discuss the types and importance of demand. 2. What is law of demand? What are the exemptions of law of demand? 3. Explain the changes of demand curve with suitable diagram 4. Discuss the concept of Law of Diminishing marginal utility 5. Explain the concept of Law of Equi-Marginal Utility 6. Describe the principles of indifference curve analysis 7. What is Consumer Equilibrium? Explain. 8. Illustrate the elasticity of demand with its types and consequences 9. Discuss various methods of demand forecasting with their merits and demerits. RECOMMENDATIONS FOR FURTHER READINGS:

1. Business Economics, V.G.Monkar, Macmillan India Ltd. 2. Managerial Economics, Bharti Singh, Excel Books 3. Managerial Economics, D.N.Dwivedi, Vikas Publishing House Pvt. Ltd 4. Economic Foundations of Business Environment, S.Sumathi, Emarald Publishers 5. Managerial Economics, G.S.Gupta, Tata McGrawHill Publishing house Ltd 6. www.rru.worldbank.org/besnapshots 7. www.investopedia.com/university/economics/

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UNIT 3 COST AND PRODUCTION CONCEPTS UNIT STRUCTURE 3:1 OBJECTIVES 3:2 INTRODUCTION 3:3 COST CONCEPTS RELEVANT TO MANAGERIAL ECONOMICS 3:4 DETERMINANTS OF COST 3:5 COST OUTPUT RELATIONSHIP 3:6 BREAK EVEN ANALYSIS 3:7 PRODUCTION FUNCTION 3:8 RETURNS TO SCALE 3:9 ECONOMIES OF SCALE

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3:1 OBJECTIVES To apprehend the relevance of cost concepts in decision making To exemplify the behaviour of costs in the short run and long run To estimate the cost function and highlight its usefulness in managerial decisions To understand the significance of break even analysis To understand the basic concepts of production function To exemplify the principles of laws of returns to scale

3:2 INTRODUCTION Prudent decisions about optimal output and optimal prices to be charged require an understanding of relationship between output rate of the firm and costs. Managerial decisions with respect to quotation of prices, efficacy of a product line, change in volume of output, and use of excess capacity depends on the cost analysis. Efficient resource combinations to produce a specific output rate illustrated in the previous chapter can be translated into cost data.

3:3 COST CONCEPTS RELEVANT TO MANAGERIAL ECONOMICS Explicit costs: are expenses for which one must pay with cash or equivalent. Because a cash transaction is involved, they are relatively easily accounted for in analysis. Implicit costs: do not involve a cash transaction, and so we use the opportunity cost concept to measure them. This analysis requires detailed knowledge of alternatives that were not selected at various decision points. Relevant here are the opportunity cost of the firm's assets and cash, and of the owner's time invested in the firm. Opportunity Costs: The opportunity cost of an asset (or, more generally, of a choice) is the highest valued opportunity that must be passed up to allow current use. Thus the monthly opportunity cost of a latte cart owned by Isabel may be, for example, the

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monthly income the cart could have generated if Isabel had rented the cart for someone else to use. Incremental and Sunk Costs Incremental cost is the change in cost caused by a particular managerial decision. Thus the increment is at the decision level, and may involve multiple units of change in output or input. Incremental costs may be involved when considering a product or service modification or a change in production process. Sunk costs are those parts of the purchase cost that cannot later be salvaged or modified through resale or other changes in operations. Image advertising for a new product is a classic example of a sunk cost, as is an option or investment in assets whose value is specific to a particular situation. Sunk costs reflect commitment, or irreversibility, and so is not a part of incremental analysis. Short-Run and Long-Run Costs In microeconomics and managerial economics, the short run is the decision-making period during which at least one input is considered fixed. The fixed input is commonly considered to be some aspect of capital, such the production facility, but may also be a normally variable input that is fixed because of production technology requirements, or a contractual commitment (e.g., a facility lease) related to production. So when one refers to short-run analysis, the analysis is focused on a planning period in which some input is fixed and others are variable, and the manager is selecting levels of variable input and production output to optimize given the constraint of the fixed input. In contrast, the economic long run is a planning horizon that looks beyond current commitments to a future period in which all inputs can be varied. A typical long-run analytical problem is the decision of whether to adjust capacity, seek a larger (or smaller) facility, to change product lines, or to adopt a new technology. At any given time managers must be concerned with both short-run and long-run analysis. Firms

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must be concerned with both the problem of optimizing in the current (short-run) situation as well positioning the firm for optimizing in the future (long-run). Fixed Costs and Variable Costs Fixed costs do not vary with the volume of goods or services produced as output. Fixed costs are the costs associated with the fixed inputs that define the economic short run. Thus fixed costs are only relevant in the economic short run. Even if the firm temporarily shuts down, it still continues to incur the fixed cost expense. This is typical of capital loans or facility lease agreements. Variable costs, in contrast, vary (usually directly) with the volume of goods or services produced as output, and thus can be avoided by a temporary shutdown. Total Cost, Average Cost and Marginal Cost Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC) Average Fixed Cost (AFC) = TFC/Q Average Variable Cost (AVC) = TVC/Q Average Total Cost (ATC) = TC/Q Marginal Cost (MC) = @TC/@Q ('@' refers to 'change in')

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3:4 DETERMINANTS OF COST Several factors may influence the cost of a firm. The table briefly describes the major determinants of costs. Determinant

Description

Factor Prices

Input prices and the amount of inputs used to influence the total cost

Technology

Innovations and better techniques decrease cost

Size of the plant

In a big size plant, initial fixed cost is high and variable cost low

Law of returns

Cost

increases

with

decreasing

returns

and

decreases with increasing returns Efficiency

Costs decrease with input efficiency

Capacity Utilisation

Per unit cost of output is low with greater level of capacity utilisation

Lot size

The total cost and per unit cost decreases with the decreases with the manufacture of bigger lot

Production cycle

If output is stable and constant over a period of time, overall costs are lower. Production by breaks and disruption is bound to be costly

3:5 COST OUTPUT RELATIONSHIP In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are a few different types of cost curves, each relevant to a different area of economics.

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3:5:1 THE SHORT RUN COST OUTPUT RELATIONSHIP (SATC OR SAC) The average total cost curve is constructed to capture the relation between cost per unit and the level of output, ceteris paribus. A productively efficient firm organizes its factors of production in such a way that the average cost of production is at lowest point and intersects Marginal Cost. In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity where it has enjoyed all the possible benefits of specialisation and no further opportunities for decreasing costs exist. This is usually not U shaped; it is a checkmark shaped curve. This is at the minimum point in the diagram on the right.

Figure 1

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3:5:2 THE LONG-RUN AVERAGE COST CURVE (LRAC)

Figure 2

The long-run average cost curve depicts the per unit cost of producing a good or service in the long run when all inputs are variable. The curve is created as an envelope of an infinite number of short-run average total cost curves. The LRAC curve is U-shaped, reflecting economies of scale when negatively-sloped and diseconomies of scale when positively sloped. Contrary to Viner, the envelope is not created by the minimum point of each short-run average cost curve. This mistake is recognized as Viner's Error. In the long run, when all factors of production can be changed, the scale of the enterprise can be increased. In this case productive efficiency occurs at the optimum scale of output where all the possible economies of scale have been enjoyed and the firm is not large enough to experience diseconomies of scale. This is at output level Q2 in the diagram. 3:6 BREAK EVEN ANALYSIS Break-even analysis is a technique widely used by production management and management accountants. It is based on categorising production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).

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Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point"). It is also known as Cost-volume-profit (CVP) analysis The Break-Even Chart In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

Figure 3

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of

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intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made. 3:6:1 BEP CALCULATION Sales and cost information are used to calculate the breakeven point. Without getting into the argument as to what constitutes fixed or variable costs, fixed costs are defined as those which do not vary with output e.g. rent, rates, whereas variable costs do vary with increased or decreased output, e.g. labour, materials. Breakeven assumes fixed costs are constant, variable costs vary at a constant rate and there is only one selling price. However, with a higher or lower price, the breakeven point will be lower or higher respectively. Breakeven point is calculated by the formula:

By rearranging the formula breakeven costs or sales can be calculated. Note that profit level intentions should be added to the fixed costs as this is a "charge" to the company. Also, if one wishes to recover all new investment (value) immediately it should be added to fixed cost. In the linear Cost-Volume-Profit Analysis model the break-even point (in terms of Unit Sales (X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as:

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where: TFC is Total Fixed Costs, P is Unit Sale Price, and V is Unit Variable Cost.

Example 1: Calculate the break even volume and breakeven point for the following information: Price/Unit =

Rs.1.846

Variable cost/Unit = Rs.0.767 Fixed costs =

Rs.70.000

= 65, 000 units (volume) or Rs.120, 000

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Figure 4

3:6:2 Uses of Break Even Analysis The technique used carefully may be helpful in the following situations: a) Budget planning. The volume of sales required to make a profit (breakeven point) and the 'safety margin' for profits in the budget can be measured. b) Pricing and sales volume decisions. c) Sales mix decisions, to determine in what proportions each product should be sold. d) Decisions that will affect the cost structure and production capacity of the company. 3:7 PRODUCTION FUNCTION In economics, a production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs.

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A meta-production function compares the practice of the existing entities converting inputs X into output y to determine the most efficient practice production function of the existing entities, whether the most efficient feasible practice production or the most efficient actual practice production. In either case, the maximum output of a technologically-determined production process is a mathematical function of input factors of production. Put another way, given the set of all technically feasible combinations of output and inputs, only the combinations encompassing a maximum output for a specified set of inputs would constitute the production function. Alternatively, a production function can be defined as the specification of the minimum input requirements needed to produce designated quantities of output, given available technology. It is usually presumed that unique production functions can be constructed for every production technology. By assuming that the maximum output technologically possible from a given set of inputs is achieved, economists using a production function in analysis are abstracting away from the engineering and managerial problems inherently associated with a particular production process. The engineering and managerial problems of technical efficiency are assumed to be solved, so that analysis can focus on the problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to use, given the price of the factor and the technological determinants represented by the production function. A decision frame, in which one or more inputs are held constant, may be used; for example, capital may be assumed to be fixed or constant in the short run, and only labour variable, while in the long run, both capital and labour factors are variable, but the production function itself remains fixed, while in the very long run, the firm may face even a choice of technologies, represented by various, possible production functions. The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those

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factors. Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production. 3:7:1 Production function as an equation There are several ways of specifying the production function. In a general mathematical form, a production function can be expressed as: Q = f(X1, X2, X3,...,Xn) Where: Q = quantity of output X1, X2, X3,...,Xn = factor inputs (such as capital, labour, land or raw materials). This general form does not encompass joint production that is a production process, which has multiple co-products or outputs. One way of specifying a production function is simply as a table of discrete outputs and input combinations, and not as a formula or equation at all. Using an equation usually implies continual variation of output with minute variation in inputs, which is simply not realistic. Fixed ratios of factors, as in the case of laborers and their tools, might imply that only discrete input combinations, and therefore, discrete maximum outputs, are of practical interest. One formulation is as a linear function: Q = a + bX1 + cX2 + dX3,... Where a,b,c, and d are parameters that are determined empirically. 3:7:2 Cobb-Douglas production function (multiplicative):

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Other forms include the constant elasticity of substitution production function (CES) which is a generalized form of the Cobb-Douglas function, and the quadratic production function which is a specific type of additive function. The best form of the equation to use and the values of the parameters (a,b,c, and d) vary from company to company and industry to industry. In a short run production function at least one of the X's (inputs) is fixed. In the long run all factor inputs are variable at the discretion of management. 3:7:3 Production function as a graph Any of these equations can be plotted on a graph. A typical (quadratic) production function is shown in the following diagram. All points above the production function are unobtainable with current technology, all points below are technically feasible, and all points on the function show the maximum quantity of output obtainable at the specified levels of inputs. From the origin, through points A, B, and C, the production function is rising, indicating that as additional units of inputs are used, the quantity of outputs also increases. Beyond point C, the employment of additional units of inputs produces no additional outputs, in fact, total output starts to decline. The variable inputs are being used too intensively (or to put it another way, the fixed inputs are under-utilized). With too much variable input use relative to the available fixed inputs, the company is experiencing negative returns to variable inputs, and diminishing total returns. In the diagram this is illustrated by the negative marginal physical product curve (MPP) beyond point Z, and the declining production function beyond point C. From the origin to point A, the firm is experiencing increasing returns to variable inputs. As additional inputs are employed, output increases at an increasing rate. Both marginal physical product (MPP) and average physical product (APP) is rising. The inflection point A, defines the point of diminishing marginal returns, as can be seen from the declining MPP curve beyond point X. From point A to point C, the firm is experiencing positive but decreasing returns to variable inputs. As additional inputs are employed, output increases but at a decreasing FOR MORE DETAILS VISIT US ON WWW.IMTSINSTITUTE.COM OR CALL ON +91-9999554621

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rate. Point B is the point of diminishing average returns, as shown by the declining slope of the average physical product curve (APP) beyond point Y. Point B is just tangent to the steepest ray from the origin hence the average physical product is at a maximum. Beyond point B, mathematical necessity requires that the marginal curve must be below the average curve.

3:7:4 STAGES OF PRODUCTION To simplify the interpretation of a production function, it is common to divide its range into 3 stages. In Stage 1 (from the origin to point B) the variable input is being used with

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increasing efficiency, reaching a maximum at point B (since the average physical product is at its maximum at that point). The average physical product of fixed inputs will also be rising in this stage (not shown in the diagram). Because the efficiency of both fixed and variable inputs is improving throughout stage 1, a firm will always try to operate beyond this stage. In stage 1, fixed inputs are underutilized. In Stage 2, output increases at a decreasing rate, and the average and marginal physical product is declining. However the average product of fixed inputs (not shown) is still rising. In this stage, the employment of additional variable inputs increase the efficiency of fixed inputs but decrease the efficiency of variable inputs. The optimum input/output combination will be in stage 2. Maximum production efficiency must fall somewhere in this stage. Note that this does not define the profit maximizing point. It takes no account of prices or demand. If demand for a product is low, the profit maximizing output could be in stage 1 even though the point of optimum efficiency is in stage 2. In Stage 3, too much variable input is being used relative to the available fixed inputs: variable inputs are over utilized. Both the efficiency of variable inputs and the efficiency of fixed inputs decline throughout this stage. At the boundary between stage 2 and stage 3, fixed input is being utilized most efficiently and short-run output is maximum. 3:8 RETURNS TO SCALE Returns to scale refers to a technical property of production that examines changes in output subsequent to a proportional change in all inputs (where all inputs increase by a constant factor). If output increases by that same proportional change then there are constant returns to scale (CRTS). If output increases by less than that proportional change, there are decreasing returns to scale (DRS). If output increases by more than that proportion, there are increasing returns to scale (IRS).

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Short example: where all inputs increase by a factor of 2, new values for output should be: Twice the previous output given = a constant return to scale (CRTS) Less than twice the previous output given = a decreased return to scale (DRS) More than twice the previous output given = an increased return to scale (IRS) 3:9 ECONOMIES OF SCALE Economies of scale and diseconomies of scale refer to an economic property of production that affects cost if quantity of all input factors is increased by some amount. If costs increase proportionately, there are no economies of scale; if costs increase by a greater amount, there are diseconomies of scale; if costs increase by a lesser amount, there are positive economies of scale. When combined, economies of scale and diseconomies of scale lead to ideal firm size theory, which states that per-unit costs decrease until they reach a certain minimum, then increase as the firm size increases further. Economies of scale refers to the decreased per unit cost as output increases. More clearly, the initial investment of capital is diffused (spread) over an increasing number of units of output, and therefore, the marginal cost of producing a good or service decreases as production increases (note that this is only in an industry that is experiencing economies of scale) An example will clarify. AFC is average fixed cost If a company is currently in a situation with economies of scale, for instance, electricity, then as their initial investment of $1000 is spread over 100 customers, their AFC is

.

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If that same utility now has 200 customers, their AFC becomes

63

... their

fixed cost is now spread over 200 units of output. In economies of scale this results in a lower average total cost. The advantage is that "buying bulk is cheaper on a per-unit basis." Hence, there is economy (in the sense of "efficiency") to be gained on a larger scale. Economies of scale tend to occur in industries with high capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms, and, especially, relative to the size of the market). A common example is a factory. An investment in machinery is made, and one worker, or unit of production, begins to work on the machine and produces a certain number of goods. If another worker is added to the machine he or she is able to produce an additional amount of goods without adding significantly to the factory's cost of operation. The amount of goods produced grows significantly faster than the plant's cost of operation. Hence, the cost of producing an additional good is less than the good before it, and an economy of scale emerges.

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UNIT QUESTIONS 1. Give some important cost concepts relevant to managerial economics. Explain their relationship. 2. Explain the cost-output relationship in short run and long run 3. What is break even analysis? Explain the usefulness of BEP with a suitable example 4. What is production function? Explain the importance and changes of production function 5. Discuss the concept of returns to scale with the stages of production function 6. Find the break - even point and volume for the following information: Sales 1000 units, Selling price per unit Rs. 60, Variable cost per unit Rs. 40, Fixed cost Rs. 1500.

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UNIT 4 CAPITAL BUDGETING UNIT STRUCTURE 4:1 OBJECTIVES 4:2 INTRODUCTION 4:3 MEANING OF CAPITAL BUDGETING 4:4 TYPES OF CAPITAL BUDGETING DECISIONS 4:5 SUPPLY OF CAPITAL – SOURCES OF CAPITAL 4:6 CAPITAL RATIONING 4:7 COST OF CAPITAL 4:8 PROJECT FEASIBILITY 4:9 METHODS OF PROJECT EVALUATION - METHODS OF RANKING INVESTMENT PROPOSALS 4:10 PRINCIPLES TO MEASURE CAPITAL PRODUCTIVITY – PROFITABILITY INDEX

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4:1 OBJECTIVES To understand the meaning and concepts of capital budgeting To evaluate the factors that determine the capital investment decision To examine the concepts used in decision making under risk and uncertainty To exhibit the principles to measure capital productivity, supply of capital and capital rationing To understand the meaning and calculation of cost of capital To analyse the various methods of appraising capital projects 4:2 INTRODUCTION Previous chapters were designed to help a firm to make decisions with its existing resources. Of equal importance are the long run investment decisions of a firm. Marketing executives may propose construction of new stores. Production engineers may plan construction of new plants to increase capacity and so on. These decisions are crucial for the firm as they involve costs and give rise to revenues over a number of years. Capital budgeting methods guide a manager in making such decisions. Long term investment decisions have an element of risk and uncertainty as well. In real world, a manager may not know the exact outcome of each possible course of action. Risk analysis helps in making decisions under risk and uncertainty. Therefore, in this chapter we will discuss methods of capital budgeting and risk analysis. 4:3 MEANING OF CAPITAL BUDGETING Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return.

Therefore, a

financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.

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4:3:1 NEED FOR CAPITAL BUDGETING In the form of either debt or equity, capital is a very limited resource. There is a limit to the volume of credit that the banking system can create in the economy. Commercial banks and other lending institutions have limited deposits from which they can lend money to individuals, corporations, and governments. In addition, the Federal Reserve System requires each bank to maintain part of its deposits as reserves. Having limited resources to lend, lending institutions are selective in extending loans to their customers.

But even if a bank were to extend unlimited loans to a company, the

management of that company would need to consider the impact that increasing loans would have on the overall cost of financing. In reality, any firm has limited borrowing resources that should be allocated among the best investment alternatives. One might argue that a company can issue an almost unlimited amount of common stock to raise capital. Increasing the number of shares of company stock, however, will serve only to distribute the same amount of equity among a greater number of shareholders.

In other words, as the number of shares of a

company increases, the company ownership of the individual stockholder may proportionally decrease. The argument that capital is a limited resource is true of any form of capital, whether debt or equity (short-term or long-term, common stock) or retained earnings, accounts payable or notes payable, and so on. Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital. Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital budgeting.

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4:4 TYPES OF CAPITAL BUDGETING DECISIONS a) By project size Small projects may be approved by departmental managers. More careful analysis and Board of Directors' approval is needed for large projects of, say, half a million dollars or more. b) By type of benefit to the firm •

an increase in cash flow

a decrease in risk

an indirect benefit (showers for workers, etc).

c) By degree of dependence •

mutually exclusive projects (can execute project A or B, but not both)

complementary projects: taking project A increases the cash flow of project B.

substitute projects: taking project A decreases the cash flow of project B.

d) By degree of statistical dependence •

Positive dependence

Negative dependence

Statistical independence.

e) By type of cash flow •

Conventional cash flow: only one change in the cash flow sign.

Non-conventional cash flows: more than one change in the cash flow sign

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4:5 SUPPLY OF CAPITAL – SOURCES OF CAPITAL A company might raise new funds from the following sources: The capital markets: i. new share issues, for example, by companies acquiring a stock market listing for the first time ii. rights issues Loan stock Retained earnings Bank borrowing Government sources Business expansion scheme funds Venture capital Franchising 4:5:1 Capital Markets The capital for new projects can be raised through capital markets in the form of shares, debentures and bonds. The shares may be through primary equity shares, right issues and other form of capital market sources. 4:5:2 Loan stock Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company. Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital.

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4:5:3 Retained earnings For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors. 4:5:4 Bank lending Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days. Short term lending may be in the form of: a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day; b) a short-term loan, for up to three years. Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.

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Lending to smaller companies will be at a margin above the bank's base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans will sometimes be available, usually for the purchase of property, where the loan takes the form of a mortgage. 4:5:5 Leasing A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time. Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment. There are two basic forms of lease: "operating leases" and "finance leases". 4:5:6 Hire purchase Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the exception that ownership of the goods passes to the hire purchase customer on payment of the final credit instalment, whereas a lessee never becomes the owner of the goods. An industrial or commercial business can use hire purchase as a source of finance. With industrial hire purchase, a business customer obtains hire purchase finance from a finance house in order to purchase the fixed asset. Goods bought by businesses on hire purchase include company vehicles, plant and machinery, office equipment and farming machinery. 4:5:7 Government assistance The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop the national economy, especially in

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high technology industries and in areas of high unemployment. For example capital assistance are provided by financial institutions like IDBE, SIDBE, IFICI and ICICI. 4:5:7 Venture capital Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A businessman starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term 'venture capital' is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management buy-out or a major expansion scheme. 4:5:8 Franchising Franchising is a method of expanding business on less capital than would otherwise be needed. For suitable businesses, it is an alternative to raising extra capital for growth. Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local business, under the franchisor's trade name. The franchisor must bear certain costs (possibly for architect's work, establishment costs, legal costs, marketing costs and the cost of other support services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on the subsequent regular payments by the franchisee for an operating profit. These regular payments will usually be a percentage of the franchisee's turnover. Although the franchisor will probably pay a large part of the initial investment cost of a franchisee's outlet, the franchisee will be expected to contribute a share of the investment himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the investment cost.

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4:6 CAPITAL RATIONING Many companies specify an overall limit on the total budget for capital spending. There is no conceptual justification for such budget ceiling, because all projects that enhance long run profitability should be accepted. The factors for putting limit •

Net present values or IRR may strongly influence the overall budget amount

Top management’s philosophy toward capital spending.

Same managers are highly growth minded whereas others are not.

The outlook for future investment opportunities that may not be feasible if extensive current commitments are undertake.

The funds provided by the current operations less dividends.

The feasibility of acquiring additional capital through borrowing or sale of additional stock. Lead-time and costs of financial market transactions can influence spending.

Period of impending change in management personnel, when the status quo is maintained.

Management attitudes toward not.

Capital Rationing occurs when a company has more amounts of capital budgeting projects with positive net present values than it has money to invest in them. Therefore, some projects that should be accepted are excluded because financial capital is limited. This is known as artificial constraint because the management may dictate the amount to be invested for project purposes. It is also the artificial constraints because the amount is not based on the product marginal analysis in which the return for each proposal is related to the cost of capital and projects with net present values are accepted.

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4:6:1Types of Capital Rationing •

Hard Capital Rationing: This arises when constraints are externally determined. This will not occur under perfect market

Soft Capital Rationing: This arises with internal, management-imposed limits on investment expenditure.

4:6:2 Reasons for Capital Rationing There are basically two types of reasons of capital rationing. •

External Reasons These arise when a firm is unable to borrow from the outside. For example if the firm is under financial distress, tight credit conditions, firm has a new unproven product. Borrowing limits are imposed by banks particularly in relation to smaller firms and individuals.

Internal Reasons o

Private owned company: Owners might decide that expansion is a trouble not worth taking. For example there may that management fear to lose their control in the company.

o

Divisional Constraints: Upper management allocates a fixed amount for each division as part of the overall corporate strategy. This arise from a point of view of a department, cost centre or wholly owned subsidiary, the budgetary constraints determined by senior management or head office.

o

Human Resource Limitations: Company does not have enough middle management to manage the new expansions

o

Dilution: For example, there may be a reluctance to issue further equity by management fearful of losing control of the company.

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o

Debt Constraints: Earlier debt issues might prohibit the increase in the firms debt beyond a certain level, as stipulated in previous debt contracts. For example bondholders requiring in the bond contract, that they would accept a maximum Debt-to-Asset ratio = 40%.

Capital Rationing could be said to signal a managerial failure to convince suppliers of funds of the value of the available projects. Although there may be something in this argument, in practice it is not a well-informed judgment. Furthermore, even if there were no limits on the total amounts of available finance, in reality the price may vary with the size as well as the term of the loan. 4:7 COST OF CAPITAL 4:7:1 Definition The opportunity cost of an investment; that is, the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected. For example, when an investor purchases stock in a company, he/she expects to see a return on that investment. Since the individual expects to get back more than his/her initial investment, the cost of capital is equal to this return that the investor receives, or the money that the company misses out on by selling its stock. The cost of capital is the expected return that is required on investments to compensate you for the required risk. It represents the discount rate that should be used for capital budgeting calculations. The cost of capital is generally calculated on a weighted average basis (WACC). It is alternatively referred to as the opportunity cost of capital or the required rate of return. It is calculated based on the expected average rate of return of investors in a firm.

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4:7:3 CALCULATING COST OF CAPITAL We calculate a company's weighted average cost of capital using a 3 step process: 1. Cost of capital components. First, we calculate or infer the cost of each kind of capital that the enterprise uses, namely debt and equity. A. Debt capital. The cost of debt capital is equivalent to actual or imputed interest rate on the company's debt, adjusted for the tax-deductibility of interest expenses. Specifically: The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in %) We enter the marginal tax rate in cell C10 of worksheet "Inputs." B. Equity capital. Equity shareholders, unlike debt holders, do not demand an explicit return on their capital. However, equity shareholders do face an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with a similar risk profile. Thus, we infer the opportunity cost of equity capital. We can do this by using the "Capital Asset Pricing Model" (CAPM). This model says that equity shareholders demand a minimum rate of return equal to the return from a risk-free investment plus a return for bearing extra risk. This extra risk is often called the "equity risk premium", and is equivalent to the risk premium of the market as whole times a multiplier--called "beta"--that measures how risky a specific security is relative to the total market. Thus, the cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium). 2. Capital structure. Next, we calculate the proportion that debt and equity capital contribute to the entire enterprise, using the market values of total debt and equity to reflect the investments on which those investors expect to earn a minimum return.

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3. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each contributes to the entire capital structure. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business. 4:8 PROJECT FEASIBILITY 4:8:1 Facet of Project Feasibility Analysis The important facets of project analysis are: •

Market analysis

Technical analysis

Financial analysis

Economic analysis

Environmental Analysis

A. Market Analysis Market analysis is concerned primarily with two questions: •

What would be the aggregate demand of the proposed product/service in future?

What would be the market share of the projects under appraisal?

To answer the above questions, the market analyst requires a wide variety of information and appropriate forecasting methods. The kinds of information required are: •

Consumption trends in the past and the present consumption level (for telecommunication

companies

the

number

of

telephone

lines,

mobile

subscribers, air time rates, etc are important factors to be considered) •

Past and present supply position (Who supplies what services?)

Production

possibilities

and

constraints

(In

telecommunication

industry,

bandwidth and regulatory framework matters a lot) •

Structure of competition (the regulations regarding competitions)

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Cost structure (Cost models used in costing variable and fixed costs, direct and indirect costs)

Elasticity of demand

Consumer behaviour, intentions, motivations, attitudes, preferences, and requirements.(e.g. on telephone accessories and types of telephone products)

Distribution channels and marketing policies in use (Should the company use a pre-paid service or billing system?)

Administrative, technical, and legal constraints.

B. Technical Analysis Analysis of the technical and engineering aspects of a project needs to be done continually when a project is formulated. Technical analysis seeks to determine whether the prerequisites for the successful commissioning of the project have been considered and reasonably good choices have been made with respect to location, size, process, etc. The important questions raised in technical analysis for the ICT projects are: •

Whether the preliminary tests and studies have been done or provided for?

Whether the availability of human resources, power, and other inputs have been established?

Whether the selected scale of operation is optimal?

Whether the production process chosen is suitable?

Whether the equipment and machines chosen are appropriate?

Whether the auxiliary equipments and supplementary engineering works have been provided for?

Whether provision has been made for the treatment of effluents?

Whether work schedules have been realistically drawn up?

Whether the technology proposed to be employed is appropriate from the social point of view?

C. Financial Analysis Financial analysis seeks to ascertain whether the proposed project will be financially

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viable in the sense of being able to meet the burden of servicing debt and whether the proposed project will satisfy the return expectations of those the shareholders (owners of the firms). The aspects which have to be looked into while conducting financial appraisal in ICT projects are: •

Investment outlay and cost of project

Means of financing –Discussed in Module 2.4

Cost of Capital –Discussed in Module 2.3

Projected profitability-Discussed in Module 1.2

Break-even point –Discussed in Module 2.4 session 4

Cash flows of the project

Investment worth wholeness judged in terms of various criteria of merit.

Projected financial position.

Level of risk –Discussed in Module 2.2

D. Economic Analysis Economic analysis, also referred to as social cost benefit analysis, is concerned with judging a project from the larger social point of view. The questions sought to be answered in social cost benefit analysis are: •

What are the direct economic benefits and costs of the project measured in terms of shadow (efficiency) prices and not in terms of market prices?

What would be the impact of the project on the distribution of income in the society? What is the impact on digital divide of the investment project?

What would be the contribution of the project towards the fulfillment of certain merit wants like self-sufficiency, employment, and social order?

E. Environmental Analysis In recent years, environmental concerns have assumed a great deal of significance and rightly so. Investment in the ICT/Telecom industry should give much consideration on the environmental aspects. Among the question to be asked include:

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What is the likely damage caused by the project to the environment? E.g. how used prepaid vouchers/cards affect the environment? How installations of transmission stalls affect the environment?

What is the cost of restoration measures required to ensure that the damage in the environment is contained within acceptable limits?

4:9

METHODS

INVESTMENT

OF

PROJECT

EVALUATION

-

METHODS

OF

RANKING

PROPOSALS

Project appraisal and evaluation requires the following: •

Detailed statement giving the expected cash inflows and outflows to be assigned to the investment those relevant cash flows.

Assessment of the impact of taxation

Discount rate to account for the time value of money

Add level rate to account for the risk associated with the investment that the risk of use of project cash flows.

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A. Non Discounted Cash Flow Methods 1. Payback method (or Payback Period) The payback period is the number of years required to return the original investment from the net cash flows (net operating income after taxes plus depreciation). Example Assume the firm is considering two projects; project A and project B, each requires an investment of $100 millions. The cost of capital is 10%. Below is the summary of expected net cash flows in millions.

The payback from the two projects is Project A: 2 and1/3 years Project B: 4 years If the firm has the policy of employing three years payback period, project A will be accepted but project B will be rejected. Decision Rule • If payback? Acceptable time limit, accept project • If payback < acceptable time limit, reject project

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Advantages of PB method. • It is very easy to calculate, but it can lead to wrong decision • Put more emphasis to quick return of the invested fund so that they may be put to use in other

places or in meeting other needs.

• Easy to apply (Simple to understand Problems with the Payback Method • Does not consider post-payback cash flows • Does not consider time value of money • Does not explicitly consider risk • The "acceptable" time period is arbitrary Illustration In case two projects need initial outflow of $30m and has the following expected net cash inflows

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ARR is also known as accrual accounting rate of return unadjusted rate of return model and the book value model. Its compilations is related with

- Conventional accounting models of calculating income and required investment - Shows the effect of an investment on projectâ&#x20AC;&#x2122;s financial statement.

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Advantages of using ARR • It is simple to calculate using accounting data • Earning of each year is included in the calculating the profitability of the project Disadvantages of using ARR • It is inconsistency with wealth maximization as the objective of the firm • Since it uses the accounting data it includes the amount of accruals in calculating the earnings “net profit”. • It is based on the familiar accrual accounting. • It ignores the time value of money i.e. expected future dollars are erroneously regarded as equal to present dollars.

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B: Discounted Cash Flow Methods 1.Net Present Value Method (NPV) It is the method of evaluating project that recognizes that the dollar received immediately is preferable to a dollar received at some future date. It discounts the cash flow to take into the account the time value of money. This approach finds the present value of expected net cash flows of an investment, discounted at cost of capital and subtract from it the initial cash outlay of the project. In case the present value is positive, the project will be accepted; if negative, it should be rejected. If the projects under consideration are mutually exclusive the one with the highest net present value should be chosen.

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Problems with NPV • Difficult to explain to non-finance people • Solution is in dollars, not percentage rates of return

Some value of R will cause the sum of the discounted receipts to the equal the initial cost of the project, making the equation equal to zero, and that value R will be the project’s internal rate of return.

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From the above calculation, when rate is 15% the PV of investment A is zero, which indicates that its internal rate of return is 15%. The IRR for project B is approximately to 20%. IRR Decision Rules Independent Projects: Accept all as long as the IR ? hurdle rate Mutually Exclusive Projects: Compute (IRR - hurdle rate) for each project, rank from highest to lowest and accept the highest ranking project [assuming the computation (IRR - hurdle rate) > 0] IRR--Advantages/Disadvantages 1) Advantages • Considers all cash flows • Considers time value of money • Comparable with hurdle rate 2) Disadvantages • Does not show dollar improvement in value of firm if project is accepted • IRR can be affected by the scale (size) of the project, i.e., Io • Possible existence of multiple IRRs Relationship Between IRR and the NPV Profile 1) When the IRR = the firm's hurdle rate, NPV = 0 2) When the IRR < the firm's hurdle rate, NPV < 0 3) When the IRR > the firm's hurdle rate, NPV > 0 NPV and IRR Methods: Possible Decision Conflicts An accept/reject "conflict" occurs when NPV says "accept" and IRR says "reject" or NPV says "reject" and IRR says "accept" Ranking conflicts arise because of: 1) Timing differences in incremental cash flows

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2) Magnitude differences in incremental cash flows When a conflict arises among mutually exclusive projects, pick the one with the highest NPV

4:10 PRINCIPLES TO MEASURE CAPITAL PRODUCTIVITY â&#x20AC;&#x201C; PROFITABILITY INDEX Profitability index identifies the relationship of investment to payoff of a proposed project. The ratio is calculated as follows:

Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I. and Value Investment Ratio (V.I.R.). Profitability index is a good tool for ranking projects because it allows you to clearly identify the amount of value created per unit of investment, thus if you are capital constrained you wish to invest in those projects which create value most efficiently first. Nota Bene; Statements below this paragraph assume the cash flow calculated does not include the investment made in the project. Where investment costs are included in the computed cash flow a PV > 0 simply indicates the project creates more value than the cost of capital which is determined by the Weighted Average Cost of Capital (WACC). A ratio of 1 is logically the lowest acceptable measure on the index. Any value lower than 1 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.

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Rules for selection or rejection of a project: If PI > 1 then accept the project If PI < 1 then reject the project UNIT QUESTIONS 1. What do understand by capital budgeting? Explain the need and types of capital budgeting. 2. Discuss the different sources of capital for investment 3. What is capital rationing? What are reasons for capital rationing? Explain the types of capital rationing. 4. What is cost of capital? How do you calculate the cost of capital? 5. Explain the meaning and analysis of project feasibility 6. Describe the various methods of project appraisal with their merits and demerits 7. Ms Mary Temba is a financial analyst for the East Coast Consulting (T) Ltd. responsible for the consulting work awarded recently from the Tanzania Telecommunications Commission in the evaluating the two projects in the telecommunication industry. The projects costs $500mil each and the required rate of return for each of the project is 12%. The projects expected net cash flows are as follows:

a) Calculate each of the project's payback, net present value (NPV) and

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internal rate of return. b) Which project or projects should be accepted if they are independent? c) Which project should be accepted if they are mutually exclusive? d) How might a change in the required rate of return produce a conflict between NPV and IRR rankings of the two projects? Would this conflict exist if k is 5%? [HINT: Plot the NPV profiles] e) Why does the conflict exist?

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UNIT- 5 CONCEPTS OF MARKET STRUCTURE AND MACRO ECONOMICS UNIT STRUCTURE 5:1 OBJECTIVES 5:2 INTRODUCTION 5:3 MARKET STRUCTURE 5:4 NATURE AND TYPES OF COMPETITION 5:5 PERFECT COMPETITION 5:6 MONOPOLY 5:7 MONOPOLISTIC COMPETITION 5:8 OLIGOPOLY

5:9 PRICE DISCRIMINATION 5:10 NATIONAL INCOME 5:11 CONSUMPTION FUNCTION 5:12 INFLATION 5:13 BALANCE OF PAYMENTS 5:14 MONETARY POLICY 5:15 FISCAL POLICY

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5:1 OBJECTIVES •

To understand the features of different market structures prevalent in an economy

To comment on the relevance of classified market structure in India

To state the effect of time on price-output decisions of a firm

To understand few macro-economic concepts in terms of National Income, Inflation, Balance of Payments and Monetary, fiscal policies

To explain the impact if these macroeconomic indicators

To analyse the measures to control the effects these indicators

5:2 INTRODUCTION The competitive environment or the market structure in which an industry operates plays a decisive role in price and output decisions of a firm. Of the three factors of pricing, namely, customer, cost, and competition, two have already been examined. In the present chapter, we will classify the industry structure that is broadly called as market structure by the economists. A brief discussion is also done some of the important macroeconomic indicators like National Income, Consumption function, Inflation, Balance of Payments, Monetary Policy and Fiscal Policy. The various fundamental concepts of these indicators are discussed with their effects and measures.

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5:3 MARKET STRUCTURE The term market structure refers to the set of industry characteristics that affect the extent of rivalry in the market, and ultimately affects market performance related to pricing and output. Elements of market structure include: •

Number and size of existing and potential entrant sellers, and number and size of existing and potential entrant buyers

The extent of entry/exit (sunk) costs and other difficulties associated with market entry (or exit)

The extent to which products are similar or different across firms

The extent of economies of scale in production

The extent to which costs are similar or different across firms

The extent of transaction costs, and the extent of travel or information costs on the part of buyers

A market is made up of an economic institution (set of rules governing how price is set and who trades), a set of traders, and a communication environment. The market facilitates voluntary trades between buyers and sellers. Thus, for example, fine art may be sold in a market that consists of an English auction institution (auctioneer calls for price bids), a set of potential buyers and a seller, and communication occurs via verbal and visual signals in a 'face-to-face' environment. The market for loaves of bread occurs through a posted-price economic institution, involves a set of rival grocery or bakery sellers and consumer buyers, and verbal face-to-face communication. A potential entrant seller is a firm that can and would enter a market under sufficiently favorable circumstances. Potential entrants constrain the behavior of existing firms in the market. 5:4 NATURE AND TYPES OF COMPETITION 1. Perfect Competition

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2. Monopoly 3. Monopolistic Competition 4. Oligopoly 5:4:1 Factors that Influence the Extent of Competition The extent to which firms compete against one another depends upon: •

The number and relative size of sellers (and buyers)

The extent to which the sellers' products are similar

The number and relative size of sellers depends on: •

Product characteristics: some product characteristics such as perishability can limit the number of sellers competing in a given regional market.

Production and cost characteristics: Products that feature very high fixed costs will also feature large economies of scale, which will naturally tend to restrict the number of sellers in a particular market. High fixed cost products include oil/gas/water pipelines, auto/jet/military product manufacture, etc.

Entry/Exit conditions: If there are large sunk costs associated with entry into a market (e.g., image advertising campaigns, development of specialized expertise, investment in specialized equipment, etc), and if there is a probability that the entrant will have to exit because market conditions failed to live up to forecasts, then there is an exit cost that reflects the sunk-cost investment. In addition, patents, copyrights, and trademarks are legal barriers to entry. Regulations limiting plant closures, or that require substantial regulatory approval can limit entry.

5:5 PERFECT COMPETITION 5:5:1 Nature

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95

There are many buyers and sellers, each of whom is small in size relative to the overall market •

There are no entry/exit costs or other difficulties associated with entry/exit

products made by different sellers are effectively identical

Economies of scale in production are exhausted at low output levels, which explains in part why there are many relatively small sellers

Costs are identical across firms

There are no transaction, travel or information costs

A consequence of this market structure is that there is vigorous competitive rivalry amongst the sellers, and buyers are unable to collude or monopsonize the market. Because sellers are so small relative to the overall market, no one seller can significantly affect market price by way of its output-setting behavior, implying that sellers are price takers -- they optimize by taking the market price as a parameter unaffected by their own behavior. 5:5:2 Pricing Under Perfect Competition It is difficult to find actual market structures that perfectly match this idealized market structure, but it is useful as a benchmark for comparing less competitive market structures by. We think that some commodities and financial markets have many of the characteristics of perfect competition In competitive markets, firms are small relative to the market and so take the market price as being independent of their output decisions. Thus from the profit expression Profit = PQ - C (Q) We get the condition for a firm's optimal output: P = MC

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We are used to the optimal output condition being MR = MC. Why is MR = P in the case of perfect competition? Because market P is unaffected by the firm's output level -- it is a fixed parameter. As a consequence, competitive firms supply along their marginal cost curves. Why? Because as market P varies, a firm's QS is determined by where P = MC. Thus the firm's MC curve is identical to its supply curve. 5:6 MONOPOLY Monopoly implies the following market structure characteristics: •

There is one seller, and any number of buyers.

There are high market entry/exit costs or other barriers to potential entrants, though these may recede over time

products made by other sellers are sufficiently differentiated as to be in different markets, and thus do not provide any competitive pressure on the monopolist

Economies of scale in production often occur at relatively high output levels, though this is not necessary; for natural monopoly we see economies of scale that occur at very high output levels, which gives the single firm a cost advantage over smaller potential entrants

The monopolist's cost structure may or may not be any different than those of other sellers

High transaction, travel, or information costs can lead to or sustain a monopoly structure, though they also be small or nonexistent

5:6:1 Conditions that Lead to Monopoly Recall that a pure monopoly occurs when there is a single seller in a market. Why might this happen? •

Very high entry/exit costs or other entry barriers

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o

Ownership of a highly valuable patent, copyright, or trademark

o

Access to technology or processes not available to others

o

Complete ownership of a key input

o

Natural monopoly: Very high fixed costs

â&#x20AC;˘

Government-created monopoly

â&#x20AC;˘

Mafia-style threats

5:6:2 The Model of Monopoly As with a competitive firm, monopolists also would like to maximize profit. A key difference is that monopolists are so large relative to the market that their output decisions affect the market-clearing price, and vice-versa. So a monopolist wishes to maximize the following profit expression: Profit = P (Q)Q - C(Q) Note the key difference -- P (Q) is the inverse demand function, relating QD to price along the demand curve. Thus as the monopolist sells larger and larger quantities, price falls (because the firm is moving down the market demand curve as Q rises, forcing price to fall). Thus P'(Q) is less than zero. 5:6:3 Market Structure and Competitive Strategy for Perfect Competition and Monopoly While other market structures admit strategic interaction, in the perfectly competitive model the firms are so small relative to the market that they cannot affect market price (and thus cannot affect one another) by their quantity choices. Competitive firms can enjoy positive, zero, or negative economic profits. Recall that economic profits are returns over and above all explicit and implicit costs, including opportunity cost. Since economic profit includes opportunity cost of assets owned by the firm (as well as the entrepreneur's time), normal economic profits in a competitive setting are zero. A synonym for economic profits is the term economic rents, where the

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term rent refers to a return over and above normal levels due to short-term changes in the market or unique attributes of the firm. Thus in the short term there are a variety of factors than can lead to positive or negative economic profits. In a perfectly competitive long-run environment, however, there are no limits to entry and thus no way for firms to maintain positive economic profits. In other words, in highly competitive markets it is entry and exit that works to cause excessive or deficient economic profits to adjust to the normal (risk-adjusted) rate of return. In contrast, monopolies may have durable entry/exit costs that eliminate the role of entry in driving down excessive economic profits. In fact, monopolies (and other firms with market power) will spend money to both acquire a monopoly position and to maintain the entry barriers necessary to maintain a monopoly position. Thus when municipalities or universities ask for firms to bid for the right to be a monopoly supplier of some service (e.g., cable access TV or campus food service), under competitive bidding conditions we would expect that the price paid for the right to be the monopolist would be equal to the discounted present value of the anticipated future stream of economic profits that derive from this government-created monopoly. Note, however, that the government entity has adopted a 'profit center' mentality and in fact has appropriated the discounted present value of the monopoly rents. Thus municipalities may do this as a substitute for tax revenues, and universities may do this as a substitute for tuition or state appropriations, but it is the consumers who are paying up the money to make that happen. 5:7 MONOPOLISTIC COMPETITION Monopolistic competition is a market structure that combines the features of a competitive market structure (many small buyers and sellers, similar costs, no significant entry/exit costs, no information costs) with product differentiation. Thus the monopolistic competition model is the model for situations in which there is competitive interaction

and

product

differentiation.

Monopolistic

competition

is

usually

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conceptualized using the Representative consumer model: In this model, all firms compete equally for all consumers. This model is appropriate for particular segments of the restaurant industry, (for example, the Mexican food restaurant market or the pizzaria market) in which firms produce differentiated products but all compete for the same consumers (people wanting Mexican food or pizza). This may also be a useful model for understanding urban gasoline station markets, where different brand-name gasolines compete against one another for same the pool of consumers, or the urban grocery store market. Another good representative consumer model application would be the airline travel market. The representative consumer model is the standard version of the monopolistic competition model. As we shall see, in the representative consumer model the firms dissipate all rents in equilibrium, either through entry or through non-price competition. 5:7:1 Nature In this model we have the following set of assumptions: •

There are many existing or potential entrant sellers

Sellers have very similar or identical costs

There are no significant entry/exit costs

Firms compete for the representative consumer, meaning that firms divide the market and each faces a downward-sloping demand

5:8 OLIGOPOLY Oligopoly is a very broad class of models that feature: •

few sellers

high entry/exit costs

cooperative (collusive) or non-cooperative (strategic) interaction

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Oligopolies are very common in many consumer products markets, such as automobiles, breakfast cereal, soft drinks, motion picture and filmed production and distribution, long-distance telecommunications, cigarettes, etc. High entry/exit costs can be generated in the form of rent-dissipating image advertising. Unlike any other class of market structure model, firms in a non-cooperative oligopoly engage in strategic rivalry with one another. Strategic interaction is a key defining characteristic of non-cooperative oligopoly models. Cooperative oligopoly models are models of collusion, which may be overt or tacit. Oligopolies may or may not feature product differentiation. The common homogeneous-product, non-cooperative oligopoly models are Cournot, Bertrand, and von Stackelberg (leader-follower). Oligopoly models that feature product differentiation is usually referred to as product differentiation models, and are described below. 5:8:1 Product differentiation can occur in a monopolistically competitive environment, or in more oligopolistic environments. Product differentiation is generally viewed in the context of non-cooperative rivalry, though it is possible to have a cooperative, differentiated-product market structure. When we refer to product differentiation models, however, these refer to differentiated-product oligopoly models, which are perhaps the single most common market structure scenario in US retail markets. 5:8:2 Deriving the Monopolistically Competitive Equilibrium 1. A good starting point for the monopolistically competitive market is the situation in which there are a number of firms that are monopolizing their own individual market shares. 2. New entrants are drawn into the market over time. As entry occurs, the given market demand is divided amongst more and more firms, meaning that entry causes an incumbent firm's demand to shift inward, reducing profits. 3. Recall that we assume that firms here have essentially identical costs. Thus the process of entry ends when economic profit is zero, which, interestingly, occurs at the point where a firm's demand is tangent to its average total cost curve. FOR MORE DETAILS VISIT US ON WWW.IMTSINSTITUTE.COM OR CALL ON +91-9999554621

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5:8:3 Properties of the monopolistically competitive equilibrium: •

zero economic profits

each firm sets p = ac to clear the market for its own product.

the number of firms in the market depends on: o

cost structure: lower average total costs ==) more firms for a given market demand

o

market demand: higher market demand ==) more firms for a given cost structure

5:8:4 Oligopoly Models Cournot model: This is a very commonly used model of noncooperative oligopoly. While it features firms engaging in quantity rivalry, which seems less reasonable than direct price competition, the Cournot model yields outcomes in which there is an inverse relationship between market concentration and the extent to which market outcomes yield marginal cost pricing. Cournot oligopoly models can feature identical or differentiated products, identical or heterogeneous costs, and a wide variety of numbers of firms. Cooperative Oligopoly Basically here we have the theory and practice of cartels and tacit collusion. Cartels are most likely to form when there is a relatively small number of firms (making coordination and monitoring easier), difficult entry conditions (allowing price increases to be more durable), a trade association that can coordinate output market shares, monitor prices, and even allocate orders, and some credible form of punishment for cheaters. Thus to be successful, cartels must be able to raise price without inducing substantial increased competition from nonmembers. Moreover, expected punishment for forming a cartel must be low relative to the advantages. Finally, the cost of establishing and enforcing an agreement must be low relative to the expected gains.

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5:8:5 Competitive Strategy in Monopolistic Competition and Oligopoly A key element of competitive stategy is to create a competitive advantage, meaning a unique ability to create, distribute, or service products valued by customers. Except in rare circumstances, it usually pays to try to differentiate your products from those of your rivals. Doing so steepens the demand curve for the firm's product, thus reducing consumers' price sensitivity. This is called the principle of maximum differentiation. One of the few situations in which this principle does not hold is when a firm has pioneered a new market, in which case other firms may have an incentive to imitate the pioneer firm, at least initially. 5:9 PRICE DISCRIMINATION The term price discrimination (PD) refers to the situation in which the exact same product or service is sold to different people at different prices. The term 'exact same' means that the full or delivered cost is the same. Examples of cases that are not PD: •

A good made in Arcata is priced at $10 in Arcata and $12 in Portland, when the price difference reflects shipping costs

Last-minute airline reservations are more expensive than ones made several weeks in advance, when the price difference reflects the cost that last-minute reservations place on airlines that are not given the time to select the optimal sized aircraft for a given flight)

Charging less for child-size portions, when the price difference reflects the reduced cost of producing a smaller unit size

Charging higher prices for delivered goods than when the customer picks up, when the price difference reflects the delivery cost

5:9:1 What conditions are required in order for a firm to engage in PD? •

There must be consumers (or market segments) with different price elasticities of demand

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The firm must be able to identify these consumers (or market segments), either directly or indirectly through their revealed preference

The firm must be able to prevent arbitrage (resales from high elasticity consumers or market segments to low elasticity consumers or market segments)

Thus student discounts to big-time college sporting events that cause student ticket prices to be much lower than those charged to professors and alumni are examples of PD. Scalping by students is an example of students and alumni exploiting an arbitrage opportunity. Arbitrage must be prevented for PD to be successful for firms, because otherwise traders in the resale markets will expropriate surplus (gains from trade) that would have otherwise gone to the seller. 5:9:2 Degrees of PD: •

First-degree PD: The firm charges each consumer exactly their willingness-topay. Under first-degree price discrimination, the firm gets all the gains from trade. Tyranny. Requires that the firm have a great deal of market power and a great deal of information on seller valuations.

Second-degree PD: Charging different prices for different size of purchase quantities. High markups on small orders, and smaller markups on larger orders. Note that second-degree PD only occurs when the markup exceeds any handling cost difference for small vs. large orders (i.e., for large orders, the unit handling cost is lower than for small orders). Often times we see second-degree PD that creates a wholesale-retail price difference, or a retail rate-commercial (contractor) rate difference.

Third-degree PD: Perhaps the most common form of PD. The firm separates its overall demand into segments that are distinguished by their elasticity characteristics, and charges different prices to different segments. A prime example is senior/student discounts at movie theaters, on airline flights, restaurants, and for newspaper and magazine subscriptions (there are many other examples). Another is that under traditional (non-HMO) health care,

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hospitals used to charge people with insurance higher rates than those without, because those who pay full price will be much more price sensitive than those whose insurance companies pay.

MACROECONOMIC CONCEPTS 5:10 NATIONAL INCOME Measures of national income and output are used in economics to estimate the total value of production in an economy. The standard measures of income and output are Gross National Product (GNP), Gross Domestic Product (GDP), Gross National Income (GNI), Net National Product (NNP), and Net National Income (NNI). In India, the Central Statistical Organisation has been estimating the national income. National income per person or per capita income is often used as an indicator of people’s standard of living or welfare.

5:10:1 Definitions of National Income National income is a measure of the total value of the goods and services (output) produced by an economy over a period of time (normally a year). It is also a measure of the income flown from production, and/or the sum total of all the spending involved for the production of output. The following are some of the notable definitions. Alfred Marshal: “The labour and capital of the country acting on its natural resources produce annually a certain net aggregate of commodities, material and immaterial, including services of all kinds… This is the net annual income or revenue of the country, or the national dividend.” Irving Fisher: “The national dividend or income consists solely of services as received by ultimate consumers, whether from their material or from their human environment.” National Income Committee of India,:

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“National income estimate measures the volume of commodities and services turned out during a given period counted without duplication.” Paul A. Samuelson: “Gross national product (GNP) is the most comprehensive measure of a nation’s total output of goods and services. It is the sum of the dollar (money) value of consumption, gross investment, government purchase of goods and services and net exports”. Though there are some variations among these definitions, the basic idea is very clear – national income is simply the income of the whole nation. The basic concepts will help to understand it more precisely. 5:10:2 Basic Concepts Gross National Product Gross National Product (GNP) is the total value of output (goods and services) produced and income received in a year by domestic residents of a country. It includes profits earned from capital invested abroad. Gross Domestic Product Gross Domestic Product (GDP) is the total value of output (goods and services) produced by the factors of production located within the country’s boundary in a year. The factors of production may be owned by any one – citizens or foreigners.

GNP – Net income earned from abroad = GDP

Thus, GDP measures income from where it is earned rather than who owns the factors of production. Net National Product Net National Product (NNP) is arrived at by making some adjustment, with regard to depreciation, in GNP. As noted above, GNP is the total value of output produced and income received in a year by domestic residents of a country. Over this one year period, the available plant and machinery (capital) will wear and tear and get condemned. Such decline in the capital assets due to wear and tear is measured as ‘capital depreciation’.

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NNP is arrived at by deducting value of such depreciation from GNP. That is GNP – Depreciation = NNP Net Domestic Product Net domestic product (NDP) is also arrived from GDP by making adjustment with regard to depreciation in the same way described above. (NDP is calculated by deducting depreciation from GDP). GDP – Depreciation = NDP Per Capita Income Per capita income (or) output per person is an indicator to show the living standards of people in a country. If real PCI increases, it is considered to be an improvement in the overall living standard of people. PCI is arrived at by dividing the GDP by the size of population. It is also arrived by making some adjustment with GDP. GDP and GNP While GDP indicates productive capacity of an economy, GNP is a crude indicator for living standard. The significance of the distinction between GNP and GDP depends on the nature of a particular economy. For instance, if a country has more non-resident inflows and produces a considerable portion of its output by multinational corporations (i.e. with the help of external factors of production), its GNP will be higher than GDP. Otherwise the distinction will be negligible. 5:10:3 NI at Current Prices and Constant Prices The concepts of national income discussed above can be measured either at ‘current price’ or at ‘constant price’. The measure based on current price uses the ongoing market prices to compute the value of output. It is quite possible that the current price may always be higher than real value due to many factors like taxes and inflation (or rising prices). Hence, national income arrived at ‘current price’ includes such influences as inflation and taxes.

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With inflation as a common feature in almost all the economies, it is necessary to measure the national income after deducting any such increase in the value of any output or income. National income at ‘constant price’ measures the national income after making necessary adjustment to eliminate the effect of inflation. Thus it is based on unchanged price of output. As the national income at ‘constant price’ is computed based on the real worth of the purchasing power of income, it is also called as ‘real national income’ or national income in ‘real’ terms.

5:10:4 Need for the Study of National Income A national income measure serves various purposes regarding economy, production, trade, consumption, policy formulation, etc. The following are some such needs. 1. To measure the size of the economy and level of country’s economic performance. 2. To trace the trend or speed of the economic growth in relation to previous year(s) as well as to other countries. 3. To know the structure and composition of the national income in terms of various sectors and the periodical variations in them. 4. To make projection about the future development trend of the economy. 5. To help government formulate suitable development plans and policies to increase growth rates. 6. To fix various development targets for different sectors of the economy on the basis of the earlier performance. 7. To help business firms in forecasting future demand for their products. 8. To make international comparison of people’s living standards. 5:10:5 Methods of Calculating National Income There are three different methods of calculating national income. They are 1. Product or Output Method 2. Income Method 3. Expenditure Method

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As noted above, GDP is the measure of an economyâ&#x20AC;&#x2122;s total output. It is also used as a measure of total income and total expenditure in that economy. Hence, income is equal to expenditure and expenditure is equal to the value of output produced in the economy.

Income = expenditure = output Y=E=O The model can further be extended by adding the other components of national income namely investment (I), government (G), and foreign trade (X-M). In the extended model, savings of public, taxes and import payments will be deducted from the income. Hence, they are called leakages from the circular flow. Similarly, investment expenditure, government expenditure and net expenditure on trade will be added in to the circular flow. These additions are called injections. However, after aggregating all leakages (outflow) and injections (inflow) in any one year, the total income components of the economy will be equivalent to the total expenditure or total output. Therefore, all the three methods are supposed to give same results. 5:10:5:1 Output or Product Method In the output or product method, the measures of GDP are calculated by adding the total value of the output (of goods and services) produced by all activities during any time period, such as a year. The major challenge of this method is the problem of double-counting. The output of many businesses is the inputs of some other businesses. For example, the output of the tyre industry is the input of racing bike industry. Counting the final output of both industries will result in double-counting of the value of tyre. This problem can be avoided by including only the value added at each stage of production or by adding only the final value of output produced 5:10:5:2 Income Method In the income method, the measures of GDP are calculated, by adding all the income earned by various factors of production which are engaged in the production of output. The various incomes included to compute the gross national income are:

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Wages and salaries Income of self-employed Profits and dividends of business corporations Interest Rent Surplus of government enterprises Net flow of income from abroad All of them are known as factor incomes and they are paid in return for the inputs engaged in some productive process which have resulted in corresponding output. The sum of all these incomes (or factor prices ) provide us the measure of national income.

5:10:5:3 Expenditure Method In the expenditure method, the measures of GDP are calculated by adding all the expenditures made in the economy. The essential components of expenditure are: C = consumption expenditures I = domestic investment G = government expenditures X = exports of goods and services M = imports of goods and services NR = net income receipts from assets abroad The sum of all these aggregate expenditure provides us the measure of national income. GDP = E = C + I + G + (X-M) where E is aggregate expenditure 5:10:6 Problems in calculating National Income The measurement of national income encounters many problems. The problem of double-counting has already bee noted. Though there are some corrective measures, it is difficult to eliminate double-counting altogether. And there are many such problems and the following are some of them.

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Black Money In countries where level of illegal activities, illegal businesses and the level of corruption are very high, the circulation of black money is so high, it has created a ‘parallel economy’. It means unreported economy which is equivalent to the size of officially estimated size of the economy. GDP does not take into account the ‘parallel economy’ as the transactions of black money are not registered. In India, black money is allpervasive, affecting not only the economy but also the society at large. The black economy as percentage of GDP is estimated to have grown from about 3 percent in the mid-fifties to 40 per cent by 1995-96. Non-Monetization In most of the rural economy, considerable portion of transactions occurs informally and they are called as non-monetized economy. The presence of such non-monetary economy in developing countries keeps the GDP estimates at lower level than the actual.

Growing Service Sector In recent years, the service sector is growing faster than that of the agricultural and industrial sectors. Many new services like business process outsourcing (BPO) have come up. However, value addition in legal consultancy, health services, financial and business services and the service sector as a whole is not based on accurate reporting and hence underestimated in national income measures. Household ServicesThe national income analysis ignores domestic work, and housekeeping and social services. Most of such valuable work rendered by our women at home does not enter our national accounting. Social Services It ignores volunteer and unpaid social services. For example, the wonderful services of Mother Teresa is invaluable for millions of poor, destitute, orphans and the diseased but at the same time not included in our GDP. Environmental Cost

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National income estimation does not distinguish between environmental-friendly and environmental-hazardous industries. The cost of polluting industries is not included in the estimate. 5:11 CONSUMPTION FUNCTION In economics, the consumption function is a single mathematical function used to express consumer spending. It was developed by John Maynard Keynes and detailed most famously in his book The General Theory of Employment, Interest, and Money. The function is used to calculate the amount of total consumption in an economy. It is made up of autonomous consumption that is not influenced by current income and induced consumption that is influenced by the economy's income level. The Keynesian Consumption Function

Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits) The standard Keynesian consumption function is as follows: C = a + c Yd where, C= Consumer expenditure

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a = autonomous consumption. This is the level of consumption that would take place even if income was zero. If an individual's income fell to zero some of his existing spending could be sustained by using savings. This is known as dis-saving. c = marginal propensity to consume (mpc). This is the change in consumption divided by the change in income. Simply, it is the percentage of each additional pound earned that will be spent. There is a positive relationship between disposable income (Yd) and consumer spending (Ct). The gradient of the consumption curve gives the marginal propensity to consume. As income rises, so does total consumer demand. 5:12 INFLATION In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. The term "inflation" once referred to increases in the money supply (monetary inflation); however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflation. Inflation can also be described as a decline in the real value of moneyâ&#x20AC;&#x201D; a loss of purchasing power in the medium of exchange which is also the monetary unit of account. When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time. Inflation can cause adverse effects on the economy. For example, uncertainty about future inflation may discourage investment and saving. High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. 5:12:1 DEFINITIONS The term "inflation" usually refers to a measured rise in a broad price index that represents the overall level of prices in goods and services in the economy. Consumer

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Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCEPI) are two examples of broad price indices. The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities, which include food, fuel, metals, financial assets such as stocks and real estate, and service industries such as health care. Inflation is usually measured by calculating the inflation rate of a price index, usually the Consumer Price Index. The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time. 5:12:2 EFFECTS An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services. The effect of inflation is not distributed evenly, and as a consequence there are hidden costs to some and benefits to others from this decrease in purchasing power. For example, with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments. High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation. Uncertainty about the future purchasing power of money discourages investment and saving. And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates.

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With high inflation, purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation. This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation. 5:12:3 CONTROLLING INFLATION Monetary policy Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum. There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. Fixed exchange rates Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the

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currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. Wage and price controls In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.

5:13 BALANCE OF PAYMENTS Balance of Payment of a country is one of the important indicators for International trade, which significantly affect the economic policies of a government. As every country strives to have a favourable balance of payments, the trends in, and the position of, the balance of payments will significantly influence the nature and types of regulation of export and import business in particular. Balance of Payments is a systematic and summary record of a countryâ&#x20AC;&#x2122;s economic and financial transactions with the rest of the world over a period of time. (a) Transactions in good and services and income between an economy and the rest of the world, (b) Changes of ownership and other changes in that countryâ&#x20AC;&#x2122;s monetary gold, SDRs, and claims on and liabilities to the rest of the world, and

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(c) Unrequited transfers and counterpart entries that are needed to balance, in the accounting sense, any entries for the foregoing transactions and changes which are not mutually offsetting. 5:13:1 BALANCE OF TRADE AND BALANCE OF PAYMENTS The Balance of Trade takes into account only the transactions arising out of the exports and imports of the visible terms; it does not consider the exchange of invisible terms such as the Services rendered by shipping, insurance and banking; payment of interest, and dividend; expenditure by tourists, etc. The balance of payments takes into account the exchange of both the visible and invisible terms. Hence, the balance of payments presents a better picture of a countryâ&#x20AC;&#x2122;s economic and financial transactions with the rest of the world than the balance of trade. 5:13:2 Components of Balance of Payments Balance of Payments is generally grouped under the following heads i) Current Account ii) Capital Account iii) Unilateral Payments Account iv) Official Settlement Account. 5:13:3 Balance of Payments Disequilibirum The balance of payments of a country is said to be in equilibrium when the demand for foreign exchange is exactly equivalent to the supply of it. The balance of payments is in disequilibrium when there is either a surplus or a deficit in the balance of payments. When there is a deficit in the balance of payments, the demand for foreign exchange exceeds the demand for it. A number of factors may cause disequilibrium in the balance of payments. These various causes may be broadly categorized into: (i) Economic factors ; (ii) Political factors; and (iii) Sociological factors.

Correction Of Disequilibrium

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A country may not be bothered about a surplus in the balance of payments; but every country strives to remove, or at least to reduce, a balance of payments deficit. A number of measures are available for correcting the balance of payments disequilibrium. Automatic Corrections Deliberate Measures These measures are widely employed today. The various deliberate measures may be broadly grouped into; (a) Monetary measures (b) Trade measures; and (c) Miscellaneous.

5:14 MONETARY POLICY Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy should be contrasted with fiscal policy, which refers to government borrowing, spending and taxation Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and

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unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. 5:15 FISCAL POLICY 5:15:1 DEFINITION Fiscal policy is an additional method to determine public revenue and public expenditure. In the recent years importance of fiscal policy has increased due to economic fluctuations. Fiscal policy is an important instrument in the modern time. According to Arther Simithies fiscal policy is a policy under which government uses its expenditure and revenue programme to produce desirable effects and avoid undesirable effects on the national income, production and employment. 5:15:2 OBJECTIVES To achieve desirable price level: The stability of general prices is necessary for economic stability. The maintenance of a desirable price level has good effects on production, employment and national income. Fiscal policy should be used to remove; fluctuations in price level so that ideal level is maintained.

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To achieve desirable consumption level: A desirable consumption level is important for political, social and economic consideration. Consumption can be affected by expenditure and tax policies of the government. Fiscal policy should be used to increase welfare of the economy through consumption

level.

To achieve desirable employment level: The efficient employment level is most important in determining the living standard of the people. It is necessary for political stability and for maximization of production. Fiscal policy should achieve this level. To achieve desirable income distribution: The distribution of income determines the type of economic activities the amount of savings. In this way, it is related to prices, consumption and employment. Income distribution should be equal to the most possible degree. Fiscal policy can achieve equality

in

distribution

of

income.

Increase in capital formation: In under-developed countries deficiency of capital is the main reason for underdevelopment. Large amounts are required for industry and economic development. Fiscal policy can divert resources and increase capital.

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UNIT QUESTIONS: 1. Explain the different types of market structure with their nature and priceoutput decisions 2. Discuss the various models in oligopoly with suitable examples 3. What

is

price

discrimination? What

are

the

degrees

of

Price

discrimination? Explain. 4. Explain the meaning and various concepts of National Income. 5. Illustrate the methods of measuring National Income. What are the problems in measuring National Income? 6. What is Inflation? What are its effects? How do you overcome the effects of Inflation? 7. Discuss the meaning and consequences of Balance of Payments 8. Briefly explain the concepts of monetary policy and fiscal policy.

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MANAGERI AL ECONOMI CS

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