UNIT-1

Economics/Principles of economicsEconomics deals with people and is a reflection of how they interact with each other as they go
about making decisions regarding their lives. We study economics by observing the principles of
decision making of the individuals who make up the economy, how they interact with one another
and how the economy as a whole works.
1. People make rational choices:
If you drove to work/school today, I bet you would disagree with this one (because of all of the
irrational drivers out there). However, it is an assumption that economists have to make. If
people behaved irrationally, then there would be no chance in the world to predict their behavior.
By assuming that people are rational, and make decisions based on what is best for them, we can
break down the decision making process. This allows us to study the factors that influence
decision making.
2. Costs and opportunity costs:
The most common use of the word cost is a monetary cost. We have to pay for food, or movies.
But there are other types of costs; in economics we call these opportunity costs.
3. Benefits:
The reason we incur costs is because we also derive benefits from them. Benefits can take many
forms, but the most common are monetary or happiness related. In economics we try to measure
happiness using the word utility, but this will be discussed later.
4. Incentives:
Incentives are the rewards and punishments we experience every day. We like to get rewards, so
we will generally make a decision so that we will get rewarded. At the same time we dont like
punishment so we will avoid decisions that will result in us getting punished. Economists are
interested in how people respond differently to rewards and punishments for similar scenarios.
For example, is it more effective to reward people for driving safe by lowering their car insurance
premium every year when they dont get in an accident, or is it better to punish them by jacking
up their rates when they do get in an accident? Economists would use surveys and data to see
which is more effective at getting people to drive safe. Another example about incentives can be
seen here.
5. Marginal
Analysis:
Almost everything analyzed in economics is done so on the margin. This means that economists
are interested in the NEXT decision being made. Focusing on the margin means only considering
the NEXT piece of pizza eaten, or the NEXT video game being made. If you are familiar with
calculus then this concept makes sense. If not, think about drinking beer with your friends.
Whenever you order your NEXT beer you consider how much you want that NEXT beer, and
how much money that NEXT beer will cost you. While decisions made in the past will affect
your happiness from that NEXT beer, and the amount of money you have, the decision to buy that
NEXT beer is made then.

For detailed answer refer to book Economics Principles and Application by MANKIW
Chapter-1

Microeconomics
Those who have studied Latin know that the prefix micro- means small, so it shouldnt be
surprising that microeconomics is the study of small economic units. The field of microeconomics
is concerned with things like:
Consumer decision making and utility maximization
Firm production and profit maximization
Individual market equilibrium
Effects of government regulation on individual markets
Externalities and other market side effects
Macroeconomics
Macroeconomics can be thought of as the big picture version of economics. Rather than
analyzing individual markets, macroeconomics focuses on aggregate production and consumption
in an economy. Some topics that macroeconomists study are:
The effects of general taxes such as income and sales taxes on output and prices
The causes of economic upswings and downturns
The effects of monetary and fiscal policy on economic health
How interest rates are determined
Why some economies grow faster than others

Difference between micro and macro economics?

1. Difference between micro and macro economics?
MICRO ECO = small
Individual analysis/ particular item analysis
:particular wants, efforts, satisfaction
Pricing study: demand analysis and supply
analysis
Factor pricing : wage, rent, profit, interest
Market analysis
Welfare analysis

MACRO ECO = large

Aggregates analysis: aggregate wants, efforts,
satisfaction etc,
National income analysis
Employment theories
Investment theories
Public finance and business cycle theories

Related and complementary to each other

Study of economic action or behaviour of
individual unit and small groups
Micro scopic study of the firm or industry
Study of particular economic unit
Deals with : individual behaviour; study of
firm in trying to maximize profit; study of
consumer tries to maximize satisfaction; study
of indivicual producer tries to maximize
production; study of family unit{ tries to
complete family wants,
method of slicing and studying.
Consumer analysis- demand analysis

Do
Study of aggregates and average economic
variables
Study of economic system as a whole
Deals with : national income; general price
level;
aggregate
investment;
general
unemployment; aggregate demand and supply;

method of lumping things together to study.

Income and employment consumption
theories, investment theories
Product pricing supply analysis and market General price level in economy and inflation,
structures
money supply , cost of money and credit
Factor pricing - distribution
Welfare economics
Growth & Distribution of economic wealth
theory

Managerial Economics:
Definition-According to Mc Nair and Meriam, Managerial economics is the use of economic
modes of thought to analyse business situations.
Managerial Economics is concerned with the application of economic principles and
methodologies to the decision making process with in the firm or organisation under conditions of
uncertainty, says Prof Evan J Douglas.
Spencer and Siegelman define it as The integration of economic theory with business practice
for the purpose of facilitating decision making and forward planning by management.
According to Hailstone and Rothwel, Managerial Economics is the application of economic
theory and analysis to practice of business firm and other institutions.
Managerial Economics can be defined as amalgamation of economic theory with business
practices so as to ease decision-making and future planning by management. Managerial
Economics assists the managers of a firm in a rational solution of obstacles faced in the firms
activities. It makes use of economic theory and concepts. It helps in formulating logical
managerial decisions.
The use of Managerial Economics is not limited to profit-making firms and organizations. But it
can also be used to help in decision-making process of non-profit organizations (hospitals,
educational institutions, etc). It enables optimum utilization of scarce resources in such

organizations as well as helps in achieving the goals in most efficient manner. Managerial
Economics is of great help in price analysis, production analysis, capital budgeting, risk analysis
and determination of demand.
Managerial economics uses both Economic theory as well as Econometrics for rational
managerial decision making. Econometrics is defined as use of statistical tools for assessing
economic theories by empirically measuring relationship between economic variables. It uses
factual data for solution of economic problems. Managerial Economics is associated with the
economic theory which constitutes Theory of Firm. Theory of firm states that the primary aim
of the firm is to maximize wealth. Decision making in managerial economics generally involves
establishment of firms objectives, identification of problems involved in achievement of those
objectives, development of various alternative solutions, selection of best alternative and finally
implementation of the decision.
The following figure tells the primary ways in which Managerial Economics correlates to
managerial decision-making.

Managerial Economics and Micro Economics

Managerial Economics is basically a blend of Economics and Management. Two branches of
economics i.e. micro economics and macro economics are the major contributors to managerial
economics.
Micro Economics is the study of the behaviour of individual consumers and firms whereas
microeconomics is the study of economy as a whole.
Managerial Economics and Micro Economics
All the firms operating in the market have to take under consideration the constituent of the
economic environment for its proper functioning. This economic environment is nothing but the
Micro economics elements.

Micro Economics is a broader concept as compare to Managerial Economics. Micro

Economics forms the foundation of managerial economics. Almost all the concepts of
Managerial Economics are the perceptions of Micro Economics concepts.
Managerial economics can be perceived as an applied Micro Economics. Demand Analysis and
Forecasting, Theory of Price, Theory of Revenue and Cost, Theory of Supply and Production are
major bare bones of Micro Economics that underpins the Managerial Economics. Managerial
Economics applies the theories of Micro Economics to resolve the issues of the organization and
for decision making.
All Managers want to carry out their function of decision making with maximum efficiency.
Their business planning can be effectively planned and performed with comprehensive
knowledge and understanding of micro economic concept and its applications. Optimum decision
making to achieve the objective of the organisation i.e. for profit maximizing or for cost
minimizing, is possible with proper compliance of micro economic know how, regardless of the
technological constraints and given market conditions. Micro Economic Analysis is important as
it is applied to day to day dilemma and concerns.
The reliance of Managerial Economics on Micro Economics is made clearer in the points below:

If a manager wants to increase the price of the product due to increase in cost of
production, he will analyze the price elasticity of demand for that product so that price rise
is not followed by substantial fall in the demand of the product. It is the application of
demand analysis to the real world situation.
For fixing the price of the products managers applies the pricing theories, cost and
revenue theories of micro economics.
Decisions regarding production and supply of the product in the market, knowledge of
availability of fixed and variable factors of production, state of technology to be used and
availability of raw-material are essential. This can be determined with the knowledge of
theory of production.
Determination of price and output is possible with the acquaintance of market structures
and approaches pertinent for determination of price and output in the given market setup.
Managerial economics utilizes statistical methods such as game theory, linear
programming etc for application of Economic Theory in Decision making.
One of the responsibilities of Manager is to workout budgets for different departments of
the organization which is learned from Capital Budgeting and Capital Rationing.
Cost and benefit analysis helps the manager in decision making.
Study of welfare economics helps Manager in taking care of social responsibilities of the
organization.
Microeconomics is the study that deals with partial equilibrium analysis which is useful
for the manager in deciding equilibrium for his organization.
Managerial Economics also uses tools of Mathematical Economics and econometrics such
as regression analysis, correlation analysis etc.

Nature/Features of Managerial Economics

Managerial Economics is a Science
Managerial Economics is an essential scholastic field. It can be compared to science in a sense
that it fulfils the criteria of being a science in following sense:

Science is a Systematic body of Knowledge. It is based on the methodical observation.

Managerial economics is also a science of making decisions with regard to scarce
resources with alternative applications. It is a body of knowledge that determines or
observes the internal and external environment for decision making.
In science any conclusion is arrived at after continuous experimentation. In Managerial
economics also policies are made after persistent testing and trailing. Though economic
environment consists of human variable, which is unpredictable, thus the policies made
are not rigid. Managerial economist takes decisions by utilizing his valuable past
experience and observations.
Science principles are universally applicable. Similarly policies of Managerial economics
are also universally applicable partially if not fully. The policies need to be changed from
time to time depending on the situation and attitude of individuals to those particular
situations. Policies are applicable universally but modifications are required periodically.

Managerial Economics requires Art

Managerial economist is required to have an art of utilising his capability, knowledge and
understanding to achieve the organizational objective. Managerial economist should have an art
to put in practice his theoretical knowledge regarding elements of economic environment.
Managerial Economics for administration of organization
Managerial economics helps the management in decision making. These decisions are based on
the economic rationale and are valid in the existing economic environment.
Managerial economics is helpful in optimum resource allocation
The resources are scarce with alternative uses. Managers need to use these limited resources
optimally. Each resource has several uses. It is manager who decides with his knowledge of
economics that which one is the preeminent use of the resource.
Managerial Economics has components of micro economics
Managers study and manage the internal environment of the organization and work for the
profitable and long-term functioning of the organization. This aspect refers to the micro
economics study. The managerial economics deals with the problems faced by the individual
organization such as main objective of the organization, demand for its product, price and output
determination of the organization, available substitute and complimentary goods, supply of inputs
and raw material, target or prospective consumers of its products etc.

Managerial Economics has components of macro economics

None of the organization works in isolation. They are affected by the external environment of the
economy in which it operates such as government policies, general price level, income and
employment levels in the economy, stage of business cycle in which economy is operating,
exchange rate, balance of payment, general expenditure, saving and investment patterns of the
consumers, market conditions etc. These aspects are related to macro economics.
Managerial Economics is dynamic in nature
Managerial Economics deals with human-beings (i.e. human resource, consumers, producers
etc.). The nature and attitude differs from person to person. Thus to cope up with dynamism and
vitality managerial economics also changes itself over a period of time.
Uses/Application of Managerial EconomicsTools of managerial economics can be used to achieve virtually all the goals of a business
organization in an efficient manner. Typical managerial decision making may involve one of the
following issues:

Deciding the price of a product and the quantity of the commodity to be produced
Deciding whether to manufacture a product or to buy from another manufacturer
Choosing the production technique to be employed in the production of a given product
Deciding on the level of inventory a firm will maintain of a product or raw material
Deciding on the advertising media and the intensity of the advertising campaign
Making employment and training decisions
Making decisions regarding further business investment and the mode of financing the
investment

It should be noted that the application of managerial economics is not limited to profit-seeking
business organizations. Tools of managerial economics can be applied equally well to decision
problems of nonprofit organizations. Mark Hirschey and James L. Pappas cite the example of a
nonprofit hospital. While a nonprofit hospital is not like a typical firm seeking to maximize its
profits, a hospital does strive to provide its patients the best medical care possible given its
limited staff (doctors, nurses, and support staff), equipment, space, and other resources. The
hospital administrator can use the concepts and tools of managerial economics to determine
theoptimal allocation of the limited resources available to the hospital. In addition to nonprofit
business organizations, government agencies and other nonprofit organizations (such as
cooperatives, schools, and museums) can use the techniques of managerial decision making to
achieve goals in the most efficient manner.
While managerial economics is helpful in making optimal decisions, one should be aware that it
only describes the predictable economic consequences of a managerial decision. For example,
tools of managerial economics can explain the effects of imposing automobile import quotas on

the availability of domestic cars, prices charged for automobiles, and the extent of competition in
the auto industry. Analysis of managerial economics will reveal that fewer cars will be available,
prices of automobiles will increase, and the extent of competition will be reduced. Managerial
economics does not address, however, whether imposing automobile import quotas is good
government policy. This latter question encompasses broader political considerations involving
what economists call value judgments.

Scope Of Managerial Economics:

Managerial Economics deals with allocating the scarce resources in a manner that minimizes the
cost. As we have already discussed, Managerial Economics is different from microeconomics and
macro-economics. Managerial Economics has a more narrow scope - it is actually solving
managerial issues using micro-economics. Wherever there are scarce resources, managerial
economics ensures that managers make effective and efficient decisions concerning customers,
suppliers, competitors as well as within an organization. The fact of scarcity of resources gives
rise to three fundamental questionsa. What to produce?
b. How to produce?
c. For whom to produce?
To answer these questions, a firm makes use of managerial economics principles.
The first question relates to what goods and services should be produced and in what
amount/quantities. The managers use demand theory for deciding this. The demand theory
examines consumer behaviour with respect to the kind of purchases they would like to make
currently and in future; the factors influencing purchase and consumption of a specific good or
service; the impact of change in these factors on the demand of that specific good or service; and
the goods or services which consumers might not purchase and consume in future. In order to
decide the amount of goods and services to be produced, the managers use methods of demand
forecasting.
The second question relates to how to produce goods and services. The firm has now to choose
among different alternative techniques of production. It has to make decision regarding purchase
of raw materials, capital equipments, manpower, etc. The managers can use various managerial
economics tools such as production and cost analysis (for hiring and acquiring of inputs), project
appraisal methods( for long term investment decisions),etc for making these crucial decisions.
The third question is regarding who should consume and claim the goods and
services produced by the firm. The firm, for instance, must decide which is its niche marketdomestic or foreign? It must segment the market. It must conduct a thorough analysis of market
structure and thus take price and output decisions depending upon the type of market.
Managerial economics helps in decision-making as it involves logical thinking. Moreover, by
studying simple models, managers can deal with more complex and practical situations. Also, a
general approach is implemented. Managerial Economics take a wider picture of firm, i.e., it deals
with questions such as what is a firm, what are the firms objectives, and what forces push the
firm towards profit and away from profit. In short, managerial economics emphasizes upon the

firm, the decisions relating to individual firms and the environment in which the firm operates. It
deals with key issues such as what conditions favour entry and exit of firms in market, why are
people paid well in some jobs and not so well in other jobs, etc. Managerial Economics is a great
rational and analytical tool.
Managerial Economics is not only applicable to profit-making business organizations, but also to
non- profit organizations such as hospitals, schools, government agencies, etc.

What is Demand?
Demand for a commodity refers to the quantity of the commodity that people are willing to
purchase at a specific price per unit of time, other factors (such as price of related goods, income,
tastes and preferences, advertising, etc) being constant. Demand includes the desire to buy the
commodity accompanied by the willingness to buy it and sufficient purchasing power to purchase
it. For instance-Everyone might have willingness to buy Mercedes-S class but only a few have
the ability to pay for it. Thus, everyone cannot be said to have a demand for the car Mercedes-s
Class.
Demand may arise from individuals, household and market. When goods are demanded by
individuals (for instance-clothes, shoes), it is called as individual demand. Goods demanded by
household constitute household demand (for instance-demand for house, washing machine).
Demand for a commodity by all individuals/households in the market in total constitute market
demand.

Demand Function
Demand function is a mathematical function showing relationship between the quantity
demanded of a commodity and the factors influencing demand.
Dx = f (Px, Py, T, Y, A, Pp, Ep, U)
In the above equation,
Dx = Quantity demanded of a commodity
Px = Price of the commodity
Py = Price of related goods
T = Tastes and preferences of consumer
Y = Income level
A = Advertising and promotional activities
Pp = Population (Size of the market)
Ep = Consumers expectations about future prices
U = Specific factors affecting demand for a commodity such as seasonal changes, taxation policy,
availability of credit facilities, etc.

Law of Demand
The law of demand states that there is an inverse relationship between quantity demanded of a
commodity and its price, other factors being constant. In other words, higher the price, lower the
demand and vice versa, other things remaining constant.
Demand Schedule
Demand schedule is a tabular representation of the quantity demanded of a commodity at various
prices. For instance, there are four buyers of apples in the market, namely A, B, C and D.
Demand schedule for apples
PRICE (Rs. Buyer
per dozen)
(demand
dozen)

A Buyer
in (demand
dozen)

B Buyer
in (demand
dozen)

C Buyer
in (demand
dozen)

D Market
in Demand
(dozens)

10

14

25

11

12

10

37

13

14

12

45

The demand by Buyers A, B, C and D are individual demands. Total demand by the four buyers
is market demand. Therefore, the total market demand is derived by summing up the quantity
demanded of a commodity by all buyers at each price.
Demand Curve
Demand curve is a diagrammatic representation of demand schedule. It is a graphical
representation of price- quantity relationship. Individual demand curve shows the highest price
which an individual is willing to pay for different quantities of the commodity. While, each point
on the market demand curve depicts the maximum quantity of the commodity which all
consumers taken together would be willing to buy at each level of price, under given demand
conditions.

Demand curve has a negative slope, i.e, it slopes downwards from left to right depicting that with
increase in price, quantity demanded falls and vice versa. The reasons for a downward sloping
demand curve can be explained as follows1. Income effect- With the fall in price of a commodity, the purchasing power of consumer
increases. Thus, he can buy same quantity of commodity with less money or he can
purchase greater quantities of same commodity with same money. Similarly, if the price
of a commodity rises, it is equivalent to decrease in income of the consumer as now he has
to spend more for buying the same quantity as before. This change in purchasing power
due to price change is known as income effect.
2. Substitution effect- When price of a commodity falls, it becomes relatively cheaper
compared to other commodities whose price have not changed. Thus, the consumer tend
to consume more of the commodity whose price has fallen, i.e, they tend to substitute that
commodity for other commodities which have not become relatively dear.
3. Law of diminishing marginal utility- It is the basic cause of the law of demand. The law
of diminishing marginal utility states that as an individual consumes more and more units
of a commodity, the utility derived from it goes on decreasing. So as to get maximum
satisfaction, an individual purchases in such a manner that the marginal utility of the
commodity is equal to the price of the commodity. When the price of commodity falls, a
rational consumer purchases more so as to equate the marginal utility and the price level.
Thus, if a consumer wants to purchase larger quantities, then the price must be lowered.
This is what the law of demand also states.

Exceptions to Law of Demand

The instances where law of demand is not applicable are as follows1. There are certain goods which are purchased mainly for their snob appeal, such as,
diamonds, air conditioners, luxury cars, antique paintings, etc. These goods are used as
status symbols to display ones wealth. The more expensive these goods become, more
valuable will be they as status symbols and more will be there demand. Thus, such goods
are purchased more at higher price and are purchased less at lower prices. Such goods are
called as conspicuous goods.
2. The law of demand is also not applicable in case of giffen goods. Giffen goods are those
inferior goods, whose income effect is stronger than substitution effect. These are
consumed by poor households as a necessity. For instance, potatoes, animal fat oil, low

quality rice, etc. An increase in price of such good increases its demand and a decrease in
price of such good decreases its demand.
3. The law of demand does not apply in case of expectations of change in price of the
commodity, i.e, in case of speculation. Consumers tend to purchase less or tend to
postpone the purchase if they expect a fall in price of commodity in future. Similarly, they
tend to purchase more at high price expecting the prices to increase in future.

For assumptions and determinants of Demand refer to T.N. CHHABRA Chapter No.4.

DEFINITION of 'Price Elasticity Of Demand'

A measure of the relationship between a changes in the quantity demanded of a particular good
and a change in its price. Price elasticity of demand is a term in economics often used when
discussing price sensitivity. The formula for calculating price elasticity of demand is:
Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price
If a small change in price is accompanied by a large change in quantity demanded, the product is
said to be elastic (or responsive to price changes). Conversely, a product is inelastic if a large
change in price is accompanied by a small amount of change in quantity demanded.

Price elasticity of demand measures the responsiveness of demand to changes in price for a
particular good. If the price elasticity of demand is equal to 0, demand is perfectly inelastic (i.e.,
demand does not change when price changes). Values between zero and one indicate that demand
is inelastic (this occurs when the percent change in demand is less than the percent change in
price). When price elasticity of demand equals one, demand is unit elastic (the percent change in
demand is equal to the percent change in price). Finally, if the value is greater than one, demand
is perfectly elastic (demand is affected to a greater degree by changes in price).
For example, if the quantity demanded for a good increases 15% in response to a 10% decrease in
price, the price elasticity of demand would be 15% / 10% = 1.5. The degree to which the quantity
demanded for a good changes in response to a change in price can be influenced by a number of
factors. Factors include the number of close substitutes (demand is more elastic if there are close
substitutes) and whether the good is a necessity or luxury (necessities tend to have inelastic
demand while luxuries are more elastic).
Businesses evaluate price elasticity of demand for various products to help predict the impact of a
pricing on product sales. Typically, businesses charge higher prices if demand for the product is
price
inelastic.

DEFINITION of 'Income Elasticity Of Demand'

A measure of the relationship between a change in the quantity demanded for a particular good
and a change in real income. Income elasticity of demand is an economics term that refers to the
sensitivity of the quantity demanded for a certain product in response to a change in consumer
incomes. The formula for calculating income elasticity of demand is:
Income Elasticity of Demand = % change in quantity demanded / % change in income
For example, if the quantity demanded for a good increases for 15% in response to a 10%increase
in income, the income elasticity of demand would be 15% / 10% = 1.5. The degree to which the
quantity demanded for a good changes in response to a change in income depends on whether the
good is a necessity or a luxury.
Normal goods have a positive income elasticity of demand. As incomes rise, more goods are
demanded at each price level. The quantity demanded for normal necessities will increase with
income, but at a slower rate than luxury goods. This is because consumers, rather than buying
more of the necessities, will likely use their increased income to purchase more luxury goods and
services. During a period of increasing incomes, the quantity demanded for luxury products tends
to increase at a higher rate than the quantity demanded for necessities. The quantity demanded for
luxury goods is very sensitive to changes in income.
Inferior goods have a negative income elasticity of demand - the quantity demanded for inferior
goods falls as incomes rise. For example, the quantity demanded for generic food items tends to
decrease during periods of increased incomes.
Businesses evaluate income elasticity of demand for various products to help predict the impact
of a business cycle of product sales.

DEFINITION of 'Cross Elasticity Of Demand'

An economic concept that measures the responsiveness in the quantity demand of one good when
a change in price takes place in another good. The measure is calculated by taking the percentage
change in the quantity demanded of one good, divided by the percentage change in price of the
substitute good:

Cross elasticity of demand is synonomous to "cross price elasticity of demand"

The cross elasticity of demand for substitute goods will always be positive, because the demand
for one good will increase if the price for the other good increases. For example, if the price of
coffee increases (but everything else stays the same), the quantity demanded for tea (a substitute
beverage) will increase as consumers switch to an alternative.
On the other hand, the coefficient for compliments will be negative. For example, if the price of
coffee increases (but everything else stays the same), the quantity demanded for coffee stir sticks
will drop as consumers will purchase fewer sticks. If the coefficient is 0, then the two goods are
not related.

For uses and determinants elasticity of demand refer TN CHHABRA Chapter-5.

UNIT-2
Market Structure
Meaning of Market: A market is a group of people and firms which are in contact with one
another for the purpose of buying and selling some product. It is not necessary that every member
of the market be in contact with each other.
Markets and Competition: While all of us often use the word-'Market, we-do' or do not realize
that very few, markets possess a well defined place in a geographical area or have a postal
address. The Bombay, Stock Exchange is one such market with a building and an area earmarked
for transacting shares. The central phenomenon in the functioning of any market is competition.
Competitive behavior is molded by the market structure of the product under consideration. It is
therefore necessary to have a thorough understanding of this concept.
Meaning of Market structure: A simple definition of this concept can be found in Pappas and
Hirschey (1985). According to them "Market structure refers to the number and size distribution
of buyers and sellers in the market for a good or service. The market structure for a product not
includes firms and individuals currently engaged in Buying and selling but also the potential
entrants.
Classification of Market Structures:
Markets are traditionally classified into four basic types. These are:
Types of Market Structures
Structure

Perfect
competition

No. of Producers
&
Degree of
Product
Differentiation
Many producers,
Identical products

Part of economy
where prevalent

Firms degree
of control over
price

Methods of
Marketing

Financial markets,
&
Some agricultural
products

None

Market
exchange
or auction

Retail trade
(Gasoline, PCs,
etc.)

Some

Advertising
and
Quality
rivalry,
Administered
prices

Imperfect
competition:
Monopolistic
competition

Oligopoly

Many producers,
Many real or
perceived
differences in
product
Few producers,
No differences in
product.

Steel, chemicals,
etc.

Monopoly

Few producers,
Some
differentiation
of products
Single producer,
Product without
close
substitutes

Autos, aircraft, etc.

Local telephone,
electricity, and gas

Considerable
but
usually
regulated

Advertising
and
Service
promotion

Perfect competition is characterized by a large number of buyers and sellers of an essentially

identical product. Each member of the market, whether buyer or seller is so small in relation to
the total industry volume that he is unable to influence the price of the product. Individual buyers
and sellers are essentially price takers. At the ruling price a firm can sell any quantity. Since there
is free entry and free exit, no firm can earn excessive profits in the long run.
Monopoly: In this situation there is just one producer of a product. The firm has substantial
control over the price: Further, if product is differentiated and if there are no threats of new firms
entering the same business, a monopoly firm can manage to earn excessive profits over a long
period.
Monopolistic Competition: It is coined by E.M. Chamberlin implies a market structure with a
large number of firms selling differentiated products. The differentiation may be real or is
perceived so by the customers. Two brands of soaps may just be identical but perceived by
customers as different on some fancy dimension like freshness. Firms in such--a market structure
have some control over price! By and large they are unable to earn excessive profits in the long
run. Since the whole structure operates on perceived product differentiation entry of new firms
cannot be prevented. Hence, above normal profits can be earned only in the short run.
Oligopoly: It is a market structure in which a small number of firms account for the whole
industry's output. The product may or may not be differentiated. For example only 5 or 6 firms in
India constitute 100% of the integrated steel industry's output. All of them market almost identical
products. On the other hand, passenger car industry with only three firms is characterized by
marked differentiation in products. The nature of products is such that very often one finds entry
of new firms difficult. Oligopoly is characterized by vigorous competition where firms
manipulate both prices and volumes in an attempt to outsmart their rivals. No generalization can
be made about profitability scenarios.
Duopoly: A duopoly is a form of oligopoly occurring when two companies (or countries) control
all or most of the market for a product or service. There are two kinds of duopolies. In the first,
the Cournot duopoly, competition between the two companies is based on the quantity of
products supplied. The duopoly members essentially agree to split the market. The price each
company receives for the product is based on the quantity of items produced, and the two
companies react to each other's production changes until equilibrium is achieved. In a Bertrand
duopoly, the two companies compete on price. Because consumers will purchase the cheaper of
two identical products, this leads to a zero-profit price as the two competitors attempt to attract
more customers (and thus more profit) through price cuts.

Barriers to Entry:
In a classic book J .S. Bain (1956) analyzed the character and significance of the condition of
entry in manufacturing industries. Till that time, most analyses of how competition works gave
little emphasis to the force of the potential or threatened competition of possible new competitors.
The attention was simply focused on the competition among firms already established in an
industry. Lately, however the meaning of competition is inclusive of potential entrants. The
existence or otherwise of 'entry barriers' in a given industry has profound impact on its
performance and the behavior of firms in it.
If has been found that the firms in an industry are always worried about the possibility of a new
entrant. If the existing number is few then the degree of insecurity will be correspondingly higher.
To be sure, the existing firms, especially in an oligopoly, have some advantages over the
potential, entrant. But, because of the threat of new entrants, the existing members cannot, exploit
these advantages (by raising prices continuously) beyond a point. What that point is and when the
new entrants would find it profitable to break the entry barriers are also not known. One thing is
clear, that this potential competition always puts a check on the pricing strategies of oligopolists.
High Initial Investment; A new passenger car plant with a capacity to assemble say
50,000 automobiles per annum can cost around Rs.100, crore. You know that not many
firms have the capacity to mobilize resources of that order. Naturally, there are high entry
barriers to the automobile market due to high level of initial investment. For similar
reasons, one does not find too many integrated steel plants coming up too often. On the
other hand, it takes only a few lakhs of rupees to set up a biscuit making unit. The barrier
on account of investment is quite low in such industries.
Economies of Scale in Non-production Activities: Scale economies are not restricted to
manufacturing. These extend to distribution, marketing and advertising. Consumer
products like soaps, toothpastes display considerable economies of scale in marketing and
distribution. A nation-wide presence in these industries presupposes an efficient and
penetrating distribution network, high order of brand related marketing skills and ability to
service a fairly differentiated product line. Thus, one may find numerous local soap
makers but there are substantial entry barriers to a new national brand penetrating the
market.
Technology, Patents and Research: The ability to possess and commercially exploit
certain specialized technology is one more source of entry barrier. Especially chemical
drugs; plastics are some of the industries where the difficulty of developing a new product
or a process is well understood. These are knowledge related factors. It is very difficult to
penetrate an industry where a few existing firms have a strong research base and a large
pool of product related patents. New entrants in such industries are often the employees of
the existing firms breaking away to form a new entity.
Switching Costs: Take an industry like earthmoving machinery. For such an industry
each firm has a few large customers like contractors, project authorities or coal mines.
Consider that a customer has a fleet of say 10 machines of a given brand. When he
replaces one machine or augments his fleet, more likely the choice would fall on the same
brand. For him it means a familiar machine, known operational details, already trained
operators and a host of other things like spare parts stocks. Thus, the cost of switching to a

new brand can be fairly high; these costs can act as entry barriers. Along with
earthmoving machines the customer also has related equipment like loaders and dump
trucks which he had purchased on the ground of compatibility with a given brand of the
main machine.
Meaning of Firm and Industry:
It is essential to know the meanings of firm and industry before analysing the two. A firm is an
organisation which produces and supplies goods that are demanded by the people. According to
Prof. S.E. Lands-bury, Firm is an organisation that produces and sells goods with the goal of
maximising its profits. In the words of Prof. R.L. Miller, Firm is an organisation that buys and
hires resources and sells goods and services. Industry is a group of firms producing
homogeneous products in a market. In the words of Prof. Miller, Industry is a group of firms that
produces a homogeneous product. For example, Raymond, Maffatlal, Arvind, etc., are cloth
manufacturing firms, whereas a group of such firms is called the textile industry.
Perfect Competition:

A perfect competition is a market situation which is having the following characteristics:

Many buyers and sellers exist that no one can influence the price.
All firms sell identical products or are perceived so by the buyers.
All resources and inputs like materials, labor and capital are perfectly mobile so that firms
can enter the market and fold up shop as and when 'they wish.
Members in the market have, perfect knowledge; decisions are made as if everything was
certain.
Short-run Equilibrium
In the short-run firms cannot increase their production capacities because it takes time to arrange
for resources to do so. The industry demand and supply operate in a ' market where processes
similar10 an auction are in force. At the intersection of the falling demand curve and the rising
supply curve the market price of a commodity for, that particular period is settled. Being too
small in re1ation to the total industries, output every individual firm and the buyer have to accept
this price can be seen that at price P and quantity Q the industry's equilibrium is established. If the
price were higher than P, excess supply would come in forcing it downwards. Conversely if it
were lower than P excess demand would prevail pushing it up. For an individual firm, the
quantity Q that it would offer to the market will depend on its objectives and the cost conditions:
Market price being given; the firm is confronted with a horizontal demand curve at the height P.
'Since all the output can be sold at P, ' an extra unit of output can be sold at the same price. Thus,
for the firm, the demand curve and the average revenue curve are identical.

Fig: Short-run Equilibrium

We therefore have Maximum profits will be obtained at the output rate where marginal cost MC
equals marginal revenue MR. This has to be so. because if the cost of producing an additional unit
is less than what it can fetch in the market, then profits can be improved by producing and selling
it. If; however, it costs more to produce that additional unit than what it earns, the firm would be
better off by not producing it Thus, when MC=MR, the firm is in equilibrium producing an output
Q1. It has been assumed that the firm is confronted with a U shaped cost curve. The firm takes the
market price P and produces that quantity Q1 which equates MC and MR so as to fulfill the
objective of profit maximization.
Long-run Equilibrium: This is defined as 'economic profit' and represents an abnormal profit
situation for the firm. A normal profit is defined as a rate of return on capital which is just
sufficient to attract the investment necessary to set up and operate a firm. It is customary to
include normal profit as a part of 'economic costs'. Thus any profit which is more than whatever is
already included as an element of cost becomes abnormal profit. Over the long-run, any such
positive economic profits will attract new firms in the industry or an expansion by the existing
firms or both. As this happens, the industry supply gets expanded depressing the price of the
product. Long-run equilibrium will be reached when each and every firm operates at a level of
output that minimizes average economic costs of producing it (which includes normal profit).
Under this condition price will equal not only marginal cost but also average cost.
P=MC=AC=MR
It must be appreciated that as long as the price is above AC there is room for abnormal profit and
hence new firms will enter. Conversely, if for some firms the AC is above the price, they will not
even earn the minimum incentive to stay in business (normal profit) and will fold up shop in the
long-run. When every firm is making just the normal profit, no new firms enter, none of the
existing firms quit and equilibrium prevails. The industry as such is, in equilibrium when no firm
is earning abnormal profits.

Fig: Long run Equilibrium

Monopolistic Competition: We now know that many firms selling differentiated Products
provide the essence of monopolistic competition. Each firm in the industry strive hard to
differentiate its, products from the competitors be it soap or toothpaste or toy, Products of no two
firms will be perceived as identical. This perceived differentiation gives each firm an element of
control over the price it can charge. At the same time, the firm cannot expect to reap the benefits
of a differentiated product too long since others can always duplicate the effort albeit with a time
lag. Similarly, the price variation between two competing brands of a given product is also not too
large.
Monopolistic competition therefore has several interesting aspects. The nature of competition is
not restricted to variations in price and volume but extends to promotion, distribution, research
and development also. Cross elasticity of demand for various products are fairly high.
Zero Profit in Perfect Competition:
Zero economic profit is not the same as zero accounting profit. When a firm is making zero
economic profit, it is still making some accounting profit. In fact, the accounting profit is just
enough to cover all of the owners costs including compensation for any foregone investment
income or foregone salary. Suppose, for example, that a wheat farmer paid $100,000 for land and
works 40 hours per week. Suppose, too, that the money could have been invested in some other
way and earned $6,000 per year, and the farmer could have worked equally pleasantly elsewhere
and earned $40,000 per year. Then the farms implicit costs will be $46,000, and zero economic
profit would mean that the farm was earning $46,000 in accounting profit each year. This wont
make a wheat farmer ecstatic, but it will make it worthwhile to keep working the farm. After all,
if the farmer quits and takes up the next best alternative, he or she will do no better. To emphasize
that zero economic profit is not an unpleasant outcome, economists often replace it with the term
normal profit, which is a synonym for zero economic profit, or just enough accounting profit
to cover implicit costs. Using this language, we can summarize long-run conditions at the typical
firm this way.
PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION:
Imperfect competition covers all situations where there is neither pure competition nor pure
monopoly. Both perfect competition and pure monopoly are very unlikely to be found in the real
world. In the real world, it is the imperfect competition lying between perfect competition and
pure monopoly. The fundamental distinguishing characteristic of imperfect competition is that
average revenue curve slopes downwards throughout its length, but it slopes downwards at

different rates in different categories of imperfect competition. The monopolistic competition is

one form of imperfect competition.
Features of Monopolistic Competition:
Monopolistic competition refers to the market situation in which many producers produce goods
which are close substitutes of one another. Two important distinguishing features of monopolistic
competition are:
(a) Product differentiation, and
(b) Existence of many firms supplying the market.
(a) Product Differentiation: In contrary to perfect competition where there is only one
homogeneous commodity, in monopolistic competition there is differentiation of products. In
monopolistic competition, products are not homogenous nor are they only remote
substitutes. These are the products produced by competing monopolists that have separate
identity, brand, logos, patents, quality and such other product features. Product differentiation
does not mean that goods are completely different. Rather it means that products are different in
some ways, but not altogether so. These imaginary differences are created through advertising,
marketing, packaging and the use of trademarks and brand names.
(b) Existence of Many Firms: Under monopolistic competition, there is fairly large number of
sellers, let say 25 to 70. Each individual firm has relatively small part of the total market so that
each has a very limited control over the price of the product. And each firm determines its own
price-output policy without considering the reactions of rival firms.
(c) In monopolistic competition, in the long run, there is freedom of entry and exit.
(d) The commodity sold in a monopolistic competitive market is not a standardised product but a
differentiated product. Hence competition is no longer exclusive on price basis. Buyers are
buying a combination of physical product and the services which go with it.
(e) Because of consumers attachment to a particular brand, the seller acquires a monopolistic
influence on the market. Thus, the demand curve facing a firm under monopolistic competition is
a downward sloping curve, i.e., if he wants to sell more, he has to lower his price. The demand
curve or AR curve under monopoly also slopes downwards, but there is a difference between
demand curves facing under monopolistic competition and pure monopoly. The demand curve
faced by a competing monopolist is more elastic than the demand curve faced by the
monopolist, because there are no close substitutes available for the monopolist commodity.
Price determination under monopolistic competition:
Under monopolistic competition, the firm will be in equilibrium position when marginal revenue
is equal to marginal cost. So long the marginal revenue is greater than marginal cost, the seller
will find it profitable to expand his output, and if the MR is less than MC, it is obvious he will
reduce his output where the MR is equal to MC. In short run, therefore, the firm will be in
equilibrium when it is maximising profits, i.e., when MR = MC.
(a) Short Run Equilibrium: Short run equilibrium is illustrated in the following diagram:

In the above diagram, the short run average cost is MT and short run average revenue is
MP. Since the AR curve is above the AC curve, therefore, the profit is shown as PT. PT is the
supernormal profit per unit of output. Total supernormal profit will be measured by multiplying
the supernormal profit to the total output, i.e. PT OM or PTTP as shown in figure (a). The
firm may also incur losses in the short run if it is facing AR curve below the AC curve. In figure
(b) MP is less than MT and TP is the loss per unit of output. Total loss will be measured by
multiplying loss per unit of output to the total output, i.e., TP OM or TPPT.
(b) Long Run Equilibrium: Under monopolistic competition, the supernormal profit in the long
run is disappeared as new firms are entered into the industry. As the new firms are entered into
the industry, the demand curve or AR curve will shift to the left, and therefore, the supernormal
profit will be competed away and the firms will be earning normal profits. If in the short run firms
are suffering from losses, then in the long run some firms will leave the industry so that remaining
firms are earning normal profits.
The AR curve in the long run will be more elastic, since a large number of substitutes will be
available in the long run. Therefore, in the long run, equilibrium is established when firms are
earning only normal profits. Now profits are normal only when AR = AC. It is further illustrated
in the following diagram.

Monopoly: If perfect competition is at one extreme and of the market structure universe, the
other end is characterized by monopoly. It exists when just one firm is on the sole producer of a
product which has no close substitutes. Just as perfect competition is rare, monopoly is also rare
in less regulated market economics. The public sector in India has significant monopoly elements.
4nalytically public sector monopolies have a different place in managerial economies and we
shall not deal with them here. Although monopolys an extreme form of market concentration, its
study helps this in analyzing less extreme cases. Many of the economic relationships found under

monopoly can be used to estimate optimal behavior in the less precise but more prevalent/partly
competitive and partly monopolistic market structures that dominate the real world.
Under monopoly, the firm is the industry; naturally, a monopolist faces a downward sloping
demand curve. The fact that just one firm constitutes the industry imposes a crucial constraint on
a monopolist. He can set either the price or the quantity but not both. Given a demand curve, if
the monopolist decides to change the price, he has to accept the volume that it will accompany.
Similarly, with the volume determination, the price gets automatically established through the
demand curve. What will he do?
Oligopoly:
The term oligopoly is derived from two Greek words: oligi means few and polein means to
sell. Oligopoly is a market structure in which there are only a few sellers (but more than two) of
the homogeneous or differentiated products. So, oligopoly lies in between monopolistic
competition and monopoly.
Oligopoly refers to a market situation in which there are a few firms selling homogeneous or
differentiated products. Oligopoly is, sometimes, also known as competition among the few as
there are few sellers in the market and every seller influences and is influenced by the behaviour
of other firms.
Types of Oligopoly:
1. Pure or Perfect Oligopoly:
If the firms produce homogeneous products, then it is called pure or perfect oligopoly. Though, it
is rare to find pure oligopoly situation, yet, cement, steel, aluminum and chemicals producing
industries approach pure oligopoly.
2. Imperfect or Differentiated Oligopoly:
If the firms produce differentiated products, then it is called differentiated or imperfect oligopoly.
For example, passenger cars, cigarettes or soft drinks. The goods produced by different firms
have their own distinguishing characteristics, yet all of them are close substitutes of each other.
3. Collusive Oligopoly:
If the firms cooperate with each other in determining price or output or both, it is called collusive
oligopoly or cooperative oligopoly.
4. Non-collusive Oligopoly:
If firms in an oligopoly market compete with each other, it is called a non-collusive or noncooperative oligopoly.
Price Determination under Oligopoly:
Oligopoly is that market situation in which the number of firms is small but each firm in the
industry takes into consideration the reaction of the rival firms in the formulation of price
policy. The number of firms in the industry may be two or more than two but not more than
20. Oligopoly differs from monopoly and monopolistic competition in this that in monopoly,
there is a single seller; in monopolistic competition, there is quite a larger number of them; and in
oligopoly, there are only a small number of sellers.

CLASSIFICATION OF OLIGOPOLY:
The oligopolistic industries are classified in a number of ways:
(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is further
classified as below:
(i) Perfect or Pure Duopoly: If the duopolists in an industry are producing identical
products it is called perfect or pure duopoly.
(ii) Imperfect or Impure Duopoly: If the duopolists in an industry are producing
differentiated products it is called imperfect or impure duopoly.
(b) Oligopoly: If there are more than two firms in an industry and each firm takes consideration
the reactions of the rival firms in formulating its own price policy it is called oligopoly. Oligopoly
is further classified as below:
(i) Perfect or Pure Oligopoly: If the oligopolists in an industry are producing
identical products it is called perfect or pure oligopoly.
(ii) Imperfect or Impure Oligopoly: If the oligopolists in an industry are producing
differentiated products it is called imperfect or impure oligopoly.
CAUSES OF OLIGOPOLY:
1. Economies of Scale: The firms in the industry, with heavy investment, using improved
technology and reaping economies of scale in production, sales, promotion, etc, will
compete and stay in the market.
2. Barrier to Entry: In many industries, the new firms cannot enter the industry as the big
firms have ownership of patents or control of essential raw material used in the production
of an output. The heavy expenditure on advertising by the oligopolistic industries may
also be a financial barrier for the new firms to enter the industry.
3. Merger: If the few firms in the industry smell the danger of entry of new firms, they then
immediately merge and formulate a joint policy in the pricing and production of the
products. The joint action of the few big firms discourages the entry of new firms into the
industry.
4. Mutual Interdependence: As the number of firms is small in an oligopolistic industry,
therefore, they keep a strict watch of the price charged by rival firms in the industry. The
firm generally avoid price ware and try to create conditions of mutual interdependence.
PRICE DETERMINATION UNDER OLIGOPOLY:
The price and output behaviour of the firms operating in oligopolistic or duopolistic market
condition can be studied under two main heads:
1. Price and Output Determination under Duopoly:
(a) If an industry is composed of two giant firms each selling identical or
homogenous products and having half of the total market, the price and output policy of each is
likely to affect the other appreciably, therefore there is every likelihood of collusion between the
two firms. The firms may agree on a price, or divide the total market, or assign quota, or merge
themselves into one unit and form a monopoly or try to differentiate their products or accept the
price fixed by the leader firm, etc.

(b) In case of perfect substitutes the two firms may be engaged in price competition. The firm
having lower costs, better goodwill and clientele will drive the rival firm out of the market and
then establish a monopoly.
(c) If the products of the duopolists are differentiated, each firm will have a close watch on the
actions of its rival firms. The firm good quality product with lesser cost will earn abnormal
profits. Each firm will fix the price of the commodity and expand output in accordance with the
demand of the commodity in the market.
2. Price and Output Determination under Oligopoly:
(a) If an industry is composed of few firms each selling identical or homogenous products and
having powerful influence on the total market, the price and output policy of each is likely to
affect the other appreciably, therefore they will try to promote collusion.
(b) In case there is product differentiation, an oligopolist can raise or lower his price without
any fear of losing customers or of immediate reactions from his rivals. However, keen rivalry
among them may create condition of monopolistic competition.
There is no single theory which satisfactorily explains the oligopoly behaviour regarding price
and output in the market. There are set of theories like Cournot Duopoly Model, Bertrand
Duopoly Model, the Chamberlin Model, the Kinked Demand Curve Model, the Centralised Cartel
Model, Price Leadership Model, etc., which have been developed on particular set of assumptions
about the reaction of other firms to the action of the firm under study.
COLLUSIVE OLIGOPOLY:
The degree of imperfect competition in a market is influenced not just by the number and size of
firms but by how they behave. When only a few firms operate in a market, they see what their
rivals are doing and react. Strategic interaction is a term that describes how each firms business
strategy depends upon its rivals business behaviour.
When there are only a small number of firms in a market, they have a choice between
cooperative and non-cooperative behaviour:
Firms act non-cooperatively when they act on their own without any explicit or implicit
agreement with other firms. Thats what produces price wars.
Firms operate in a cooperative mode when they try to minimise competition between
them. When firms in an oligopoly actively cooperate with each other, they engage in
collusion. Collusion is an oligopolistic situation in which two or more firms jointly set
their prices or outputs, divide the market among them, or make other business decisions
jointly.
A cartel is an organisation of independent firms, producing similar products, which work
together to raise prices and restrict output. It is strictly illegal in Pakistan and most countries of
the world for companies to collude by jointly setting prices or dividing markets. Nonetheless,
firms are often tempted to engage in tacit collusion, which occurs when they refrain from
competition without explicit agreements. When firms tacitly collude, they often quote identical
(high) prices, pushing up profits and decreasing the risk of doing business. The rewards of
collusion, when it is successful, can be great. It is more illustrated in the following diagram:

The above diagram illustrates the situation of oligopolist A and his demand curve DaDa assuming
that the other firms all follow firm As lead in raising and lowering prices. Thus the firms
demand curve has the same elasticity as the industrys DD curve. The optimum price for the
collusive oligopolist is shown at point G on DaDa just above point E. This price is identical to the
monopoly price, it is well above marginal cost and earns the colluding oligopolists a handsome
monopoly profit.
PRICE DETERMINATION MODELS OF OLIGOPOLY:
1. Kinky Demand Curve: The kinky demand curve model tries to explain that in non-collusive
oligopolistic industries there are not frequent changes in the market prices of the products. The
demand curve is drawn on the assumption that the kink in the curve is always at the ruling
price. The reason is that a firm in the market supplies a significant share of the product and has a
powerful influence in the prevailing price of the commodity. Under oligopoly, a firm has two
choices:
(a) The first choice is that the firm increases the price of the product. Each firm in the
industry is fully aware of the fact that if it increases the price of the product, it will lose
most of its customers to its rival. In such a case, the upper part of demand curve is more
elastic than the part of the curve lying below the kink.
(b) The second option for the firm is to decrease the price. In case the firm lowers the
price, its total sales will increase, but it cannot push up its sales very much because the
rival firms also follow suit with a price cut. If the rival firms make larger price cut than the
one which initiated it, the firm which first started the price cut will suffer a lot and may
finish up with decreased sales. The oligopolists, therefore avoid cutting price, and try to
sell their products at the prevailing market price. These firms, however, compete with one
another on the basis of quality, product design, after-sales services, advertising, discounts,
gifts, warrantees, special offers, etc.

In the above diagram, the demand curve is made up of two segments DB and BD. The demand
curve is kinked at point B. When the price is Rs. 10 per unit, a firm sells 120 units of output. If a
firm decides to charge Rs. 12 per unit, it loses a large part of the market and its sales come down
to 40 units with a loss of 80 units. In case, the producer lowers the price to Rs. 4 per unit, its
competitors in the industry will match the price cut. Its sales with a big price cut of Rs. 6
increases the sale by only 40 units. The firm does not gain as its total revenue decreases with the
price cut.
2. Price Leadership Model: Under price leadership, one firm assumes the role of a price leader
and fixes the price of the product for the entire industry. The other firms in the industry simply
follow the price leader and accept the price fixed by him and adjust their output to this price. The
price leader is generally a very large or dominant firm or a firm with the lowest cost of
production. It often happens that price leadership is established as a result of price war in which
one firm emerges as the winner.
In oligopolistic market situation, it is very rare that prices are set independently and there is
usually some understanding among the oligopolists operating in the industry. This agreement may
be either tacit or explicit.
Price Determination under Price Leadership: There are various models concerning priceoutput determination under price leadership on the basis of certain assumptions regarding the
behaviour of the price leader and his followers. In the following case, there are few assumptions
for determining price-output level under price leadership:
(a) There are only two firms A and B and firm A has a lower cost of production than the
firm B.
(b) The product is homogenous or identical so that the customers are indifferent as
between the firms.
(c) Both A and B have equal share in the market, i.e., they are facing the same demand
curve which will be the half of the total demand curve.

In the above diagram, MCa is the marginal cost curve of firm A and MCb is the marginal cost
curve of firm B. Since we have assumed that the firm A has a lower cost of production than the
firm B, therefore, the MCa is drawn below MCb.
Now let us take the firm A first, firm A will be maximising its profit by selling OM level of
output at price MP, because at output OM the firm A will be in equilibrium as its marginal cost is
equal to marginal revenue at point E. Whereas the firm B will be in equilibrium at point F, selling
ON level of output at price NK, which is higher than the price MP. Two firms have to charge the
same price in order to survive in the industry. Therefore, the firm B has to accept and follow the
price set by firm A. This shows that firm A is the price leader and firm B is the follower.
Since the demand curve faced by both firms is the same, therefore, the firm B will produce OM
level of output instead of ON. Since the marginal cost of firm B is greater than the marginal cost
of firm A, therefore, the profit earned by firm B will be lesser than the profit earned by firm A.

UNIT-3

Demand Forecasting

Characteristics of Forecasts,

Forecasting Horizons,

Steps to Forecasting,

Forecasting Methods,

Seasonal Adjustments,

Forecasting Performance Measures

Cost Estimation

Elements of cost,

Computation of Material Variances

Break-Even Analysis

Demand Forecasting
One of the crucial aspects in which managerial economics differs from pure economic theory lies in the
treatment of risk and uncertainty. Traditional economic theory assumes a risk-free world of certainty; but
the real world business is full of all sorts of risk and uncertainty. A manager cannot, therefore, afford to
ignore risk and uncertainty. The element of risk is associated with future which is indefinite and
uncertain. To cope with future risk and uncertainty, the manager needs to predict the future event. The
likely future event has to be given form and content in terms of projected course of variables, i.e.
forecasting. Thus, business forecasting is an essential ingredient of corporate planning. Such forecasting
enables the manager to minimize the element of risk and uncertainty. Demand forecasting is a specific
type of business forecasting

Concepts of Forecasting
The manager can conceptualize the future in definite terms. If he is concerned with future event- its
order, intensity and duration, he can predict the future. If he is concerned with the course of future
variables- like demand, price or profit, he can project the future. Thus prediction and projection-both
have reference to future; in fact, one supplements the other. Suppose, it is predicted that there will be
inflation (event). To establish the nature of this event, one needs to consider the projected course of
general price index (variable). Exactly in the same way, the predicted event of business recession has to
be established with reference to the projected course of variables like sales, inventory etc.
Projection is of two types forward and backward. It is a forward projection of data variables, which is
named forecasting. By contrast, the backward projection of data may be named back casting, a tool
used by the new economic historians. For practical managers concerned with futurology, what is relevant
is forecasting, the forward projection of data, which supports the prediction of an event. Thus, if a
marketing manager fears demand recession, he must establish its basis in terms of trends in sales data;
he can estimate such trends through extrapolation of his available sales data. This trend estimation is an
exercise in forecasting.

Need for Demand Forecasting

Business managers, depending upon their functional area, need various forecasts. They need to forecast
demand, supply, price, profit, costs, investment, and what have you. In this unit, we are concerned with
only demand forecasting. The reason is, the concepts and techniques of demand forecasting discussed

here can be applied anywhere. The question may arise: Why have we chosen demand forecasting as a
model? What is the use of demand forecasting?
The significance of demand or sales forecasting in the context of business policy decisions can hardly be
overemphasized. Sales constitute the primary source of revenue for the corporate unit and reduction for
sales gives rise to most of the costs incurred by the fir. Thus sales forecasts are needed for production
planning, inventory planning, and profit planning and so on. Production itself requires the support of
men, materials, machines, money and finance, which will have to be arranged. Thus, manpower planning,
replacement or new investment planning, working capital management and financial planning all depend
on sales forecasts. Thus demand forecasting is crucial for corporate planning. The survival and growth of
a corporate unit has to be planned, and for this sales forecasting is the most crucial activity. There is no
choice between forecasting and noforecasting. The choice exists only with regard to concepts and
techniques of forecasting that we employ. It must be noted that the purpose of forecasting in general is
not to provide an exact future data with perfect precision, the purpose is just to bring out the range of
possibilities concerning the future under a given set of assumptions. In other words, it is not the actual
future but the likely future that we build up through forecasts. Such forecasts do not eliminate, but
only help you to reduce the degree of risk and uncertainties of the future. Forecasting is a step towards
that kind of guesstimation; it is some sort of an approximation to reality. If the likely state comes close
to the actual state, it means that the forecast is dependable. A sales forecast is meant to guide business
policy decision. Without forecasting, forward planning by a corporate unit will be directionless.

Steps in Demand Forecasting Demand or sales forecasting

It is a scientific exercise. It has to go through a number of steps. At each step, you have to make critical
considerations. Such considerations are categorically listed below:
Nature of Forecast: To begin with, you should be clear about the uses of forecast data- how it is related
to forward planning and corporate planning by the firm. Depending upon its use, you have to choose the
type of forecasts: short-run or long-run, active or passive, conditional or non-conditional etc.
Nature of Product: The next important consideration is the nature of product for which you are
attempting a demand forecast. You have to examine carefully whether the product is consumer goods or
producer goods, perishable or durable, final or intermediate demand, new demand or replacement
demand type etc. A couple of examples may illustrate the importance of this factor. The demand for
intermediate goods like basic chemicals is derived from the final demand for finished goods like
detergents. While forecasting the demand for basic chemicals, it becomes essential to analyze the nature
of demand for detergents. Promoting sales through advertising or price competition is much less

important in the case of intermediate goods compared to final goods. The elasticity of demand for
intermediate goods depends on their relative importance in the price of the final product.
Time factor is a crucial determinant in demand forecasting. Perishable commodities such as fresh
vegetables and fruits can be sold over a limited period of time. Here skilful demand forecasting is needed
to avoid waste. If there are storage facilities, then buyers can adjust their demand according to
availability, price and income. The time taken for such adjustment varies from product to product. Goods
of daily necessities that are bought more frequently will lead to quicker adjustments. Whereas in case of
expensive equipment which is worn out and replaced after a long period of time, adaptation of demand
will be spread over a longer duration of time.

Determinants of Demand: Once you have identified the nature of product for which you are to
build a forecast, your next task is to locate clearly the determinants of demand for the product.
Depending on the nature of product and nature of forecasts, different determinants will assume different
degree of importance in different demand functions. In the preceding unit, you have been exposed to a
number of price-income factors or determinants-own price, related price, own income-disposable and
discretionary, related income, advertisement, price expectation etc. In addition, it is important to
consider socio-psychological determinants, specially demographic, sociological and psychological factors
affecting demand. Without considering these factors, long-run demand forecasting is not possible.
Such factors are particularly important for long-run active forecasts. The size of population, the agecomposition, the location of household unit, the sex-composition-all these exercise influence on demand
in. varying degrees. If more babies are born, more will be the demand for toys; if more youngsters marry,
more will be the demand for furniture; if more old people survive, more will be the demand for sticks. In
the same way buyers psychology-his need, social status, ego, demonstration effect etc. also effect
demand. While forecasting, you cannot neglect these factors.
Analysis of Factors &Determinants: Identifying the determinants alone would not do, their analysis is also
important for demand forecasting. In an analysis of statistical demand function, it is customary to classify
the explanatory factors into (a) trend factors, which affect demand over long-run, (b) cyclical factors
whose effects on demand are periodic in nature, (c) seasonal factors, which are a little more certain
compared to cyclical factors, because there is some regularly with regard to their occurrence, and (d)
random factors which create disturbance because they are erratic in nature; their operation and effects
are not very orderly. An analysis of factors is specially important depending upon whether it is the
aggregate

demand in the economy or the industrys demand or the companys demand or the

consumers; demand which is being predicted. Also, for a long-run demand forecast, trend factors are
important; but for a short-run demand forecast, cyclical and seasonal factors are important.
Choice of Techniques: This is a very important step. You have to choose a particular technique from
among various techniques of demand forecasting. Subsequently, you will be exposed to all such
techniques, statistical or otherwise. You will find that different techniques may be appropriate for
forecasting demand for different products depending upon their nature. In some cases, it may be
possible to use more than one technique. However, the choice of technique has to be logical and
appropriate; for it is a very critical choice. Much of the accuracy and relevance of the forecast data
depends accuracy required, reference period of the forecast, complexity of the relationship postulated in
the demand function, available time for forecasting exercise, size of cost budget for the forecast etc.
Testing Accuracy: This is the final step in demand forecasting. There are various methods for testing
statistical accuracy in a given forecast. Some of them are simple and inexpensive, others quite complex
and difficult. This stating is needed to avoid/reduce the margin of error and thereby improve its validity
for practical decision-making purpose. Subsequently you will be exposed briefly to some of these
methods and their uses.

Techniques of Demand Forecasting

-Broadly speaking, there are two approaches to

demand forecasting- one is to obtain information about the likely purchase behavior of the buyer
through collecting experts opinion or by conducting interviews with consumers, the other is to use past
experience as a guide through a set of statistical techniques. Both these methods rely on varying degrees
of judgment. The first method is usually found suitable for short-term forecasting, the latter for longterm forecasting. There are specific techniques which fall under each of these broad methods. We shall
now taker up each one of these techniques under broad category of methods suggested above.
Simple Survey Methods: For forecasting the demand for existing product, such survey methods are often
employed. In this set of methods, we may undertake the following exercise.

Experts Opinion Poll: In this method, the experts on the particular product whose demand is
under study are requested to give their opinion or feel about the product. These experts, dealing in the
same or similar product, are able to predict the likely sales of a given product in future periods under
different conditions based on their experience. If the number of such experts is large and their
experience-based reactions are different, then an average-simple or weighted is found to lead to unique
forecasts. Sometimes this method is also called the hunch method but it replaces analysis by opinions
and it can thus turn out to be highly subjective in nature.

Reasoned Opinion-Delphi Technique: This is a variant of the opinion poll method. Here is an
attempt to arrive at a consensus in an uncertain area by questioning a group of experts repeatedly until
the responses appear to converge along a single line. The participants are supplied with responses to
previous questions (including seasonings from others in the group by a coordinator or a leader or
operator of some sort). Such feedback may result in an expert revising his earlier opinion. This may lead
to a narrowing down of the divergent views (of the experts) expressed earlier. The Delphi Techniques,
followed by the Greeks earlier, thus generates reasoned opinion in place of unstructured opinion;
but this is still a poor proxy for market behavior of economic variables.

Consumers Survey- Complete Enumeration Method: Under this, the forecaster undertakes a
complete survey of all consumers whose demand he intends to forecast, once this information is
collected, the sales forecasts are obtained by simply adding the probable demands of all consumers. For
example, if there are N consumers, each demanding D then the total demand forecast is D i
i = 1 The principle merit of this method is that the forecaster does not introduce any bias or value
judgment of his own. He simply records the data and aggregates. But it is a very tedious and cumbersome
process; it is not feasible where a large number of consumers are involved. Moreover if the data are
wrongly recorded, this method will be totally useless.

Consumer Survey-Sample Survey Method: Under this method, the forecaster selects a few
consuming units out of the relevant population and then collects data on their probable demands for the
product during the forecast period. The total demand of sample units is finally blown up to generate the
total demand forecast. Compared to the former survey, this method is less tedious and less costly, and
subject to less data error; but the choice of sample is very critical. If the sample is properly chosen, then
it will yield dependable results; otherwise there may be sampling error. The sampling error can decrease
with every increase in sample size.

End-use Method of Consumers Survey: Under this method, the sales of a product are
projected through a survey of its end-users. A product is used for final consumption or as an intermediate
product in the production of other goods in the domestic market, or it may be exported as well as
imported. The demands for final consumption and exports net of imports are estimated through some
other forecasting method, and its demand for intermediate use is estimated through a survey of its user
industries.

Complex Statistical Methods

We shall now move from simple to complex set of methods of demand forecasting. Such methods are
taken usually from statistics. As such, you may be quite familiar with some the statistical tools and
techniques, as a part of quantitative methods for business decisions.

Time Series Analysis or Trend Method: Under this method, the time series data on the
under forecast are used to fit a trend line or curve either graphically or through statistical method of
Least Squares. The trend line is worked out by fitting a trend equation to time series data with the aid of
an estimation method. The trend equation could take either a linear or any kind of non-linear form. The
trend method outlined above often yields a dependable forecast. The advantage in this method is that it
does not require the formal knowledge of economic theory and the market; it only needs the time series
data. The only limitation in this method is that it assumes that the past is repeated in future. Also, it is an
appropriate method for long-run forecasts, but inappropriate for short-run forecasts. Sometimes the
time series analysis may not reveal a significant trend of any kind. In that case, the moving average
method or exponentially weighted moving average method is used to smooth the series.
Barometric Techniques or Lead-Lag Indicators Method: This consists in discovering a set of series of some
variables which exhibit a close association in their movement over a period or time. It shows the
movement of agricultural income (AY series) and the sale of tractors (ST series). The movement of AY is
similar to that of ST, but the movement in ST takes place after a years time lag compared to the
movement in AY. Thus if one knows the direction of the movement in agriculture income (AY), one can
predict the direction of movement of tractors sale (ST) for the next year. Thus agricultural income (AY)
may be used as a barometer (a leading indicator) to help the short-term forecast for the sale of tractors.
Generally, this barometric method has been used in some of the developed countries for predicting
business cycles situation. For this purpose, some countries construct what are known as diffusion
indices by combining the movement of a number of leading series in the economy so that turning points
in business activity could be discovered well in advance. Some of the limitations of this method may be
noted however. The leading indicator method does not tell you anything about the magnitude of the
change that can be expected in the lagging series, but only the direction of change. Also, the lead period
itself may change overtime. Through our estimation we may find out the best-fitted lag period on the
past data, but the same may not be true for the future. Finally, it may not be always possible to find out
the leading, lagging or coincident indicators of the variable for which a demand forecast is being
attempted.

Correlation and Regression: These involve the use of econometric methods to determine the
nature and degree of association between/among a set of variables. Econometrics, you may recall, is the

use of economic theory, statistical analysis and mathematical functions to determine the relationship
between a dependent variable (say, sales) and one or more independent variables (like price, income,
advertisement etc.). The relationship may be expressed in the form of a demand function, as we have
seen earlier. Such relationships, based on past data can be used for forecasting. The analysis can be
carried with varying degrees of complexity. Here we shall not get into the methods of finding out
correlation coefficient or regression equation; you must have covered those statistical techniques as a
part of quantitative methods. Similarly, we shall not go into the question of economic theory. We shall
concentrate simply on the use of these econometric techniques in forecasting. We are on the realm of
multiple regression and multiple correlation. The form of the equation may be:
DX = a + b1 A + b2PX + b3Py
You know that the regression coefficients b1, b2, b3 and b4 are the components of relevant elasticity of
demand. For example, b1 is a component of price elasticity of demand. The reflect the direction as well
as proportion of change in demand for x as a result of a change in any of its explanatory variables. For
example, b2< 0 suggest that DX and PX are inversely related; b4 > 0 suggest that x and y are substitutes;
b3 > 0 suggest that x is a normal commodity with commodity with positive income-effect. Given the
estimated value of and bi, you may forecast the expected sales (DX), if you know the future values of
explanatory variables like own price (PX), related price (Py), income (B) and advertisement (A). Lastly, you
may also recall that the statistics R2 (Co-efficient of determination) gives the measure of goodness of fit.
The closer it is to unity, the better is the fit, and that way you get a more reliable forecast. The principle
advantage of this method is that it is prescriptive as well descriptive. That is, besides generating demand
forecast, it explains why the demand is what it is. In other words, this technique has got both explanatory
and predictive value. The regression method is neither mechanistic like the trend method nor subjective
like the opinion poll method. In this method of forecasting, you may use not only time-series data but
also cross-section data. The only precaution you need to take is that data analysis should be based on the
logic of economic theory.

Simultaneous Equations Method: Here is a very sophisticated method of forecasting. It is also

known as the complete system approach or econometric model building. In your earlier units, we have
made reference to such econometric models. Presently we do not intend to get into the details of this
method because it is a subject by itself. Moreover, this method is normally used in macro-level
forecasting for the economy as a whole; in this course, our focus is limited to micro elements only. Of
course, you, as corporate managers, should know the basic elements in such an approach. The method is
indeed very complicated. However, in the days of computer, when package programs are available, this
method can be used easily to derive meaningful forecasts. The principle advantage in this method is that
the forecaster needs to estimate the future values of only the exogenous variables unlike the regression
method where he has to predict the future values of all, endogenous and exogenous variables affecting
the variable under forecast. The values of exogenous variables are easier to predict than those of the
endogenous variables. However, such econometric models have limitations, similar to that of regression
method. Thus we may conclude that each and every method has its own merits and demerits and we
need to bear in mind this when we select a particular tool.

Cost Analysis
Concept:
It is necessary for the proper understanding of cost analysis, to know various cost concepts that are often
employed. When an entrepreneur decides to produce a commodity, he has to pay the price for inputs
which he uses in production. When he employes labour, he pays wages to them and pays money when
buys raw materials, fuel and power, rent for the factory building and so on. All these are included in cost
of production. The kind of cost concept used in a particular situation dependes on cost of production. The
kind of cost concept used in a particular situation depends upon the business decision that the
management makes. An accountant will take into account only the payments and charges made by the
manager to the suppliers of various productive inputs, but the managerial economist views the cost in
some what different form. The cost estimates made by contentional, financial accounting are not
appropriate for all managerial uses, Further different problems call for different kinds of costs, therefore
it is necessary to have a complete understanding of different cost concepts for clear business thinking.

According to Marshall, the real cost of production includes the real cost of efforts of various Qualities
and real cost of waiting It is also known as alternative sacrificed cost, or transfer cost. Opportunity
cost of a commodity is the alternative sacrificed in order of order to order to obtain it. Cost concepts
differ because of differences in view point. Different combinations of cost ingredients are important for
various kinds of management problems. Disparities occur form deletions, from additions from
recombination which do not appear anywhere in the accounting records. Different cost concepts
explained in our study are
(a) Actual cost and opportunity costs
(b) Past and future costs
(c) Short run and long run costs
(d) Variable or Prime cost and fixed costs or supplementary costs
(e) Incremental costs and sunk costs
(f) Traceable and Non-Traceable costs
(g) Explicit and Implicit costs
(h) Controllable and Non-Controllable Costs
(i) Private, External and social costs
(j) Total. Average and Marginal Costs

Cost Function
Cost function is derived from the production function. Time factor is very important in cost theory. The
short-run costs are the costs over a period during which some factors of production are fixed. The longrun costs are the costs over a period long enough to permit changes in all factors of production. Both in
the short-run and in the long-run, cost is a multivariate function, i.e., it is determined by many factors
simultaneously, symbolically, the long run cost function is given as:

C = f(X,T,Pf)
And the shot-run-run cost function is: C = f(X, T, Pf, K)
Where C = Total Cost

X = Output
T = Technology
Pf = prices of factors
K = Fixed factor (s)
Graphically, the cost function is generally shown on a two-dimensional diagram by taking C= f(x), ceteris
paribus, If other factors (i.e.T,Pf) to change, then the cost curve will shift.

Determinants of Costs
Factors determining the cost are
(a) Size of plant: There is an inverse relationship between size of plant and cost. As size of plant increases,
cost falls and vice versa.
(b) Level of Output: There is a direct relationship between output level and cost. More the level of
output, more is the cost ( i. e., total cost) and vice Versa.
(c) Price of Inputs: There is a direct relationship between price of inputs and cost. As the price of inputs
rises, cost ruses and vice versa.
(d) State of technology: More modern and upgraded the technology implies lesser cost and vice versa.
(e) Management and administrative efficiency: Efficiency and cost are inversely related. More the
efficiency in management and administration better will be the product and less will be the cost. Cost will
case of inefficiencies in management and administration.

Cost Variances

STANDARD COSTING

MEANING

As per CIMA, London " a control technique which compares

standard costs and revenues with actual results to obtain
variances which are used to stimulate improved performance."

General Meaning: This technique connotes the setting up of definite standards

of performance in advance. These standards are expressed in monetary terms.
Actual performance is measured against these standards. The differences are
helping the management to initiate corrective actions. This is believed to be a
valuable tool in cost control.

PURPOSE

to investigate the reasons for significant variances and to take necessary

actions.

TERMS

Cost variance is the difference between a standard cost and the

comparable actual cost
Variance analysis is the analysis of the cost variances into its component
parts and the explanation of variances.

COMPUTATION OF VARIANCES

1. MATERIAL

a)Material cost variance = Std. Cost Actual Cost

= (SQ*AQ) (AQ*AP)
b) Material price variance = AQ (SP AP)
( It can also be computed using actual quantity purchased)
c) Material usage variance = SP (SQ AQ)
d) Material mix variance = SP (RSQ AQ)
e) Material Yield Variance =SP (SQ RSQ)
where SP = Standard Price
SQ = Standard Quantity
AQ = Actual Quantity consumed
AP = Actual Price
RSQ = Revised Standard Quantity
Variances may be positive( favourable) or negative ( unfavourable)

Also,
Material cost variance = Material price variance + Material

usage variance
Material usage variance = Material mix variance + Material

Yield Variance
Effect of FIFO And LIFO

FIFO and LIFO are the two pricing techniques and thus impact

On MATERIAL

Actual Price. Therefore the only impact would be on Material Cost

VARIANCES

Variance and Material Price Variance.

SUMMARY CHARTS FOR BETTER UNDERSTANDING

MATERIAL COST VARIANCE

MATERIAL PRICE VARIANCE

MATERIAL USAGE/QUANTITY VARIANCE

( SP - AP ) * AQ

( SQ AQ )* SP

MATERIAL MIX VARIANCE

MATERIAL YIELD VARIANCES

( R.SQ AQ )* SP

( SQ RSQ)* SP

LABOUR COST VARIANCES

LABOUR RATE VARIANCE

LABOUR HOURS/EFFICIENCY VARIANCE

IDLE TIME VARIANCE

= ( SR AR )*AH

= ( SH AH )*SR
= IDLE HOURS * SR

LABOUR MIX VARIANCE

LABOUR YIELD VARIANCE

=( RSH AH )*SR

= ( SH RSH )*SR

COMPUTED IF
VARIOUS CATEGORIES
OF LABOUR

VARIABLE OVERHEAD COST VARIANCE

VARIABLE EFFICIENCY VARIANCE

VARIABLE RATE VARIANCE
= ( SH AH )* SR
= (SR AR )* AH

FIXED OVERHEAD COST VARIANCE

EXPENDITURE VARIANCE

VOLUME VARIANCE

EFFICIENCY

CAPACITY

CALENDER

VARIANCE

VARIANCE

VARIANCE

Breakeven Analysis
Breakeven analysis is performed to determine the value of a variable of a project that
makes two elements equal, e.g. sales volume that will equate revenues and costs.

Single Project
The analysis is based on the relationship:
Profit = revenue total cost
= R TC
At breakeven, there is no profit or loss, hence,
revenue = total cost
or,

R = TC

Note: It is to be noted that +ve sign is used for both the revenue and the costs. If we are
to use ve sign for costs and +ve sign for revenue, then the above relationships become:
Profit = R + TC and

R + TC = 0

at breakeven.

With revenue and costs given in terms of a decision variable, the solution yields the
breakeven quantity for the decision variable.
Costs, which may be linear or non-linear, usually include two components:

Fixed costs (FC) Includes costs such as buildings, insurance, fixed overhead,
equipment capital recovery, etc. These costs are essentially constant for all values of the
decision variable.
Variable costs (VC) Includes costs such as direct labour, materials, contractors, marketing,
advertisement, etc. These costs change linearly or non-linearly with the decision variable, e.g.
production level, workforce size, etc. For the analysis to be followed here, the variation will
generally be assumed to be linear.
Then, total cost,

TC = FC + VC

Revenue also changes with the decision variable. Again, for the analysis, the variation
will generally be assumed to be linear.

The following diagram illustrates the basics of the breakeven analysis.

Revenue

Total Cost, TC

Revenue
or
Cost

It can be seen that we have profit if the production level is above the breakeven quantity
and loss if it is below.
Two or more Alternatives
This is commonly applied to between alternatives that serve the same purpose. As a result,
breakeven analysis is carried out between the costs of the alternatives. It involves the
determination of a common variable between two or more alternatives. The procedure to
follow for two alternatives is as follows:

Define the common variable and its dimensional units.

Use AW or PW analysis to express the total cost of each alternative as a function of the
common variable. (Use AW values if lives are different).
Equate the two relations and solve for the breakeven value of the variable.
If the anticipated level is below the breakeven value, select the alternative with the higher
variable cost (larger slope). If the level is above the breakeven point, select the alternative
with the lower variable cost.

The same type of analysis can be performed for three or more alternatives. Then, compare the
alternatives in pairs to find their respective breakeven points. The results are the ranges through
which each alternative is more economical.

UNIT-4
Terminology and Definitions
A project is an interrelated set of activities that has a definite starting and ending point and
results in the accomplishment of a unique, often major outcome. "Project management" is,
therefore, the planning and control of events that, together, comprise the project. Project
management aims to ensure the effective use of resources and delivery of the project
objectives on time and within cost constraints.

An activity or task is the smallest unit of work effort within the project and consumes
both time and resources which are under the control of the project manager. A project is a
sequence of activities that has a definite start and finish, an identifiable goal and an
integrated system of complex but interdependent relationships.

A schedule allocates resources to accomplish the activities within a timeframe. The

schedule sets priorities, start times and finish times.

Project management is:

the adept use of techniques and skills (hard and soft) in planning and controlling tasks
and resources needed for the project, from both inside and outside of organization, to
achieve results.

The purpose of project management is to achieve successful project completion with the
resources available. A successful project is one which:

has been finished on time

is within its cost budget
Performs to a technical/performance standard which satisfies the end user.

Features of projects

Projects are often carried out by a team of people who have been assembled for that
specific purpose. The activities of this team may be co-ordinated by a project
manager.

Project teams may consist of people from different backgrounds and different parts of
the organisation. In some cases project teams may consist of people from different
organisations.
Project teams may be inter-disciplinary groups and are likely to lie outside the normal
organisation hierarchies.
The project team will be responsible for delivery of the project end product to some
sponsor within or outside the organisation. The full benefit of any project will not
become available until the project as been completed.

In recent years more and more activities have been tackled on a project basis. Project
teams and a project management approach have become common in most organisations.
The basic approaches to project management remain the same regardless of the type of
project being considered. You may find it useful to consider projects in relation to a
number of major classifications:
a)

Engineering and construction

The projects are concerned with producing a clear physical output, such as roads,
bridges or buildings. The requirements of a project team are well defined in terms of
skills and background, as are the main procedures that have to be undergone. Most
of the problems which may confront the project team are likely to have occurred
before and therefore their solution may be based upon past experiences.

b) Introduction of new systems

These projects would include computerization projects and the introduction of new
systems and procedures including financial systems. The nature and constitution of a
project team may vary with the subject of the project, as different skills may be
required and different end-users may be involved. Major projects involving a systems
analysis approach may incorporate clearly defined procedures within an organisation.
c)

Responding to deadlines and change

An example of responding to a deadline is the preparation of an annual report by a
specified date. An increasing number of projects are concerned with designing
organisational or environmental changes, involving developing new products and
services.

Responsibilities of the Project Manager

1. To plan thoroughly all aspects of the project, soliciting the active involvement of all
functional areas involved, in order to obtain and maintain a realistic plan that satisfies
their commitment for performance.

2. To control the organization of manpower needed by the project.

3. To control the basic technical definition of the project, ensuring that "technical" versus
"cost" trade-offs determine the specific areas where optimisation is necessary.
4. To lead the people and organizations assigned to the project at any given point in time.
Strong positive leadership must be exercised in order to keep the many disparate
elements moving in the same direction in a co-operative.
5. To monitor performance, costs and efficiency of all elements of the project and the
project as a whole, exercising judgement and leadership in determining the causes of
problems and facilitating solutions.
6. To complete the project on schedule and within costs, these being the overall standard
by which performance of the project manager is evaluated.

Why do projects go wrong?

There can be many reasons why projects go wrong. The most common reasons are as
follows:
a) Project goals are not clearly defined
b) There can be constraints on the completion of projects arising from the different
objectives of:
Short time scale
Resource availability
Quality factors
Human factors

Constraints on the completion of projects

a) Time
Our definition of a project stated that it was an activity which had a defined beginning
and ending point. Most projects will be close-ended in terms of there being a
requirement for completion by a certain point in time. This point may be the result of
an external factor such as new legislation, or may be derived from organisational
requirements. It may also be partly determined by other constraints. There is likely to
be some relationship between the time taken for a project and its cost. A trade-off
between the two constraining factors may then be necessary.

b) Resource Availability
There is likely to be a budget for the project and this will clearly be a major constraint.
Cost constraints may be set in a number of ways, for example as an overall cash limit
or as a detailed budget broken down over a number of expenditure headings. Labour
resources in particular may be a limiting factor on the completion of the project. In
the short run it is likely that labour will be fixed in supply. Whilst the overall resource
available may in theory be sufficient to complete the project, there may be difficulties
arising out of the way in which the project has been scheduled. That is, there may be a

number of activities scheduled to take place at the same time and this may not be
possible given the amount of resources available.

c) Quality factors
Whether the project delivers the goods to the right quality.

There are techniques which can be used to overcome the problems referred to above.
These include:

Budgeting, and the corresponding control of the project budget through budgetary
control procedures.
Project planning and control techniques such as Gantt charts and network analysis.

An important point to note at this stage is how the various constraints on project
completion are likely to be interlinked with each other. For example, problems with time
constraints or resource constraints may be overcome by spending more through working
overtime, employing more people or purchasing better machines. Budget problems may
have a knock-on effect on the achievement of deadlines.

It is important to remember that while project management techniques are important, they
tend to understate the importance of the key resource: people. In a fact changing
environment where tasks are often difficult, controversial with uncertain outcomes,
"people management" skills are called for.

The Process of Project Management

Traditional approaches to project management have emphasized the procedures involved.
This reflects an idea of project management which has emphasized physical resources
and the use of analytical techniques such as network analysis. Another approach which
has been found to be effective is much more people and organization oriented and can be
broken down into a series of steps:
a) Clarifying the nature of the project
b) Defining goals and objectives
c) Feasibility studies
d) Detailed organisation of the project:
Project definition
Planning and scheduling
e) Project implementation and control

We can have a look at these in turn.

Clarifying the nature of the project
The following need to be established at the planning stage of the project:
Resourcing,
management support,
nature of team working; the balance, for example, between creativity and
implementation skills,
clarity of objectives.

Defining goals and objectives

The success criteria for the project need to be defined. We have already seen that
there could be hard or soft.

Feasibility Studies

The basic questions to be asked are:

Is the project feasible?

How feasible are the alternatives under consideration?

The aim of the study would be to carry out a preliminary investigation which should help to
determine whether the project should proceed further and how it should proceed.

The relevance of this approach will vary with the nature of the project itself. The more
concrete the project is, the more likely that there will be established procedures in
relation to feasibility. At the other end of the scale there will be less need for a feasibility
study for an open project.
The project manager responsible for conducting the feasibility study would normally
consider:
a)
b)
c)
d)

Cost: is this within the budget set by the organisation or within the capabilities of the
organisation to finance it? How do the alternatives compare?
Timing: are there specific constraints on timing and is it possible to complete the project
within these constraints?
Performance: will the project satisfy performance criteria which have been determined?
Basically this means will it do the job it is designed to do?
Effect on the organisation: is it feasible in the context of the organisation and the effect
which it will have upon it?

We should have a look at these factors in a little more detail.

a)

Cost factors will be looked at through a financial appraisal. This should be related to
financial criteria which have been determined. You need to consider whether the following
criteria are relevant.
i) Capital expenditure implications:
What are the costs of the project?
If there are alternatives, what are the relative figures?
What effect will this have upon the organisation's finances particularly the capital
budget?
How will it fit with controls imposed upon the organisation by central government.
How will the expenditure be financed? What are the alternatives?
ii) Revenue implications:
How much will this cost both in the current year and in subsequent years?
What are the likely gains in terms of income?
What effect will this have upon the revenue budget?

The answers to these questions will determine the financial criteria upon which
the feasibility will be judged.
b)

Timing: the project schedule may need to comply with specific criteria which have been laid
down. Timing can be important:

c)

Performance specifications: these may be:

d)

to comply with legal or governmental requirements. For example, new legislation or

new requirements may need to be implemented by a certain date;
for operational reasons. A new system may be required as a matter of organisational
policy or to fit in with existing procedures and deadlines;
to assist with financing arrangements. Grants or borrowing approvals may need to be
spent within a specific period;
to give the organisation an edge over its competitors.

technical
service based
resulting from external regulations
required by clients and customers

Organisational context:

What is the policy of the organisation?

Organisational culture; does the project fit in with the general values and beliefs of the
organisation?
How will it affect resourcing? (Are the skills, technology and physical space available?)
How will the project fit in with existing procedures? What effect will it have upon
systems?

The actual questions asked and the shape of the study and the consequent report will depend
upon the type of project being investigated.

Human Factors
Gantt charts, PERT, CPM and other scheduling techniques have proven to be valuable tools in the
management of large and complex projects. A wide variety of software packages is available for
project managers, for use on micro- or larger computers, to assist in the handling of complex
network problems. PERT and CPM, however, cannot ever purport to be able to solve all project
scheduling and management problems in service or manufacturing industries. Good management
practices, clear responsibilities for tasks, and accurate and timely reporting systems are the most
essential qualities for successful project completions. The watchword is that useful as these
techniques are, they are only tools to assist the manager in making better, more calculated
decisions in the process of conducting large scale projects.
So far little mention has been made of the human issues involved in the management of projects.
These issues will now be addressed.

Human Factors in Project Management

Dinsmore uses the following definitions for projects and project management:

A project is a unique venture with a beginning and an end, conducted by people to meet
established goals within parameters of cost, time and quality.

Project management is the combination of people, systems, and techniques required to

coordinate the resources needed to complete projects within established goals.

It is all too easy to form the view that project management and network techniques such as
CPM and PERT are one and the same thing. Because networks are valuable tools for graphically
showing relationships between project activities, pinpointing critical activities and for estimating
the probability of project completion by a certain date, some managers believe that they
constitute the only important management tool in the planning, scheduling and controlling
phases of a project. No project is managed effectively without a good Gantt/CPM/PERT
approach but equally there are other management tools and practices required for effective
management of projects.

Motivation
Human motivation is a complex issue and a great deal of research has been done on how
best to motivate employees of an organisation to achieve good performance.

The term "Motive" has a dictionary definition of: causing motion: concerned with the
initiation of action, and "Motivate" has the definition: to provide with a motive, to
induce.
Various managerial strategies have been adopted to motivate people within an
organization, and they are often categorised under the headings:

Paternalistic,
Scientific,
Participative.

Paternalistic strategy assumes that simply by belonging to an organization with whose

aims and objectives an employee can identify, that employee will be sufficiently
motivated to perform well for the organization.
Scientific management, as championed by F. W. Taylor, is of the carrot and stick variety
and is based upon the assumption that motivation can be directly linked to reward for
good performance and a lack of reward for a poor performance. The reward is tangible
and in the form of increased payment.

Participative management is based upon the theory that if an employee is given an

objective then he or she should be left to sort out the best method of achieving that
objective without being told what to do by "the boss". [See also the Introduction to
Vroom Vroom & Deci, Management and Motivation, Penguin, 1989].

Whatever strategy adopted, they are all based upon the premise that performance =
ability times motivation, i.e. that more competent and the more motivated an employee
the greater will be his/her performance.

Project teams
As we have seen, the management of a project involves rather more than just the mastery
of Gantt charts, network analysis and other mathematical techniques. It includes the
creation and management of a team of people who are given the task of handling the
project from its inception to successful completion.
The benefits of effective teamwork are clear to those who have experienced the synergy
created by a team who work together well, who cooperate with each other, and who are
all committed to the project.
Synergy is the state in which the team 'takes off', working together as a whole to achieve
far more than the individuals, working separately, could have done.
The opposite of such a synergistic grouping is sometimes called dysfunctional conflict the unpleasant state when everyone seems to be willfully at cross purposes with everyone
else, and the group achieves much less than the individuals working separately, could
have done.
An effective team is more dependent upon the chemistry between the members of the
group than a strict matching of the various roles suggested by Belbin et al. to the
attributes of those group members. Mutual trust is an effective lubricant to the
effectiveness of team work.

Teamwork depends upon being able to persuade people to work together, to cooperate,
and to be committed to the project. By their very nature, projects are usually one-off
situations and the project team will usually be an ad-hoc matrix of individuals chosen for
their specialist skills and who may not be used to working together. The role of the
project manager is particularly challenging under these conditions.

For project evaluation, financial analysis and use of technology in project, Refer to
book Modern Project Management by RC Mishra.

VALUE ANALYSIS & VALUE ENGINEERING

Value Analysis is an effective tool for cost reduction and the results accomplished are far
greater. It improves the effectiveness of work that has been conventionally performed as
it questions and probes into the very purpose, design, method of manufacture, etc., of the
product with a view to pinpointing unnecessary costs, obvious and hidden which can be
eliminated without adversely affecting quality, efficiency, safety and other customer
features.
VALUE AND VALUE ANALYSIS
Let us consider at this stage what is meant by Value. Value is itself is some what
difficult to define. It means different things to different people. Also, it is often confused
with the cost and price of a product or service. One way of defining the value of an item
is:
Worth to you
Value
=
-----------------Price you pay
This means that if you feel that you have your moneys worth, then you have received
100 per cent value. Which indicates that Value has a subjective aspect, for what is good
value for one person need not necessarily be so far another. In general, if for any function
or a product or a service, you feel you are paying too much, or it costs you more than you
think it should, there is scope for improving its value into it. This leads us on to another
useful way of looking at value.
Value is the least cost that can accomplish reliably a function or a service. This implies
that in achieving reduced cost, the quality and performance of the item are maintained. It
follows, therefore, that value analysis is a technique which builds Value into an item.
Value can also be defined as that combination of quality, efficiency price, and service
which ensures the ultimate economy and satisfaction of the purchaser. Value Analysis
can be understood as a technique which helps everyone to determine this combination.
It can be seen, therefore, that several components make up Value. There is value arising
from the function or end use of an item, and from its ability to perform a useful function
reliable. There is the subjective aspect of value in terms of esteem or prestige value or
artistic value; for example, the extra chrome
and styling used to sell automobiles, or the neck-tie or diamond ring you may wear.
Again, there is the cost value made up of the material and labour costs, overheads and
any other costs incurred in producing the item.
However, in the popular mind, this is closely associated with esteem value, as there is a
mistaken belief that because something costs more it is worth more. Finally, there is the
resale or exchange value which may be taken as the ability to part with money for
possessing a particular product. In addition we have place value with regard to the
usefulness of a product at a particular place.

VALUE ANALYSIS JOB PLAN

Several versions of the VA Job Plan can be found in different literature. Some give file,
others six and yet many other seven phases. It is the systematic approach which is more
important to achieve the desired objectives.
The phases of VA Job Plan are as follows:
SELECTION & ORIENTATION
ANALYSIS
RECORDING IDEAS
SPECULATION
INVESTIGATION
RECOMMENDATION
IMPLEMENTATION
1)

SELECTION &
ORIENTATION

2)

ANALYSIS

3)

RECORDING IDEAS

4)

SPECULATION

to select those problems areas

where a potential for net higher
Savings is expected
use the common paretos
ABC analysis
general scope, restrictions and
aims of the study is defined
to examine the data at a coordinated syndicate meeting
to appoint a secretary to record
the minutes
to apply the Tests for Value
to propose further actions
the secretary writes clearly the
minutes of the analysis meeting
and circulates them to syndicate
members
it includes the agenda for the
next meeting
to hold additional syndicate

meetings in order to discuss the

ideas analysed and any new
information obtained.

5)

INVESTIGATION

to speculate upon practical

measures for reducing costs and
increasing value.

to investigate suggestions for

reducing costs and to make them
practical and acceptable
to obtain definite prices and costs
in order to estimate savings
accurately.

6)

RECOMMENDATION

7)

IMPLEMENTATION

recommended practical savings

to management for implementing
to present the recommendations
as a comprehensive report
to appoint a member to act as an
implementation consultant.
to decide on future plans for the
company for which the authority
of the management is needed
to implement the
recommendations acceptable to
the management.

APPLICATION OF VALUE ANALYSIS

Value analysis can be applied universally, i.e., to everything materials, methods,
processes, services, etc., where it is intended to bring about economics. One should
naturally start with items where the maximum annual saving can be achieved. This
immediately suggests that items whose total annual consumption in Rupees is high
should receive top priorities in the application of Value Analysis. In the same manner,
scarce materials, imported materials, or those difficult to obtain should also receive the
attention of the value analyst. Bearing this in mind, Value Analysis can be systematically
applied to categories of items, such as those listed below in order to bring about
substantial cost reduction.
1.
2.
3.
4.
5.
6.
7.
8.
9.

Capital goods plant, equipment, machinery, tools and appliances;

Raw and semi-processed material, including fuel;
Sub-contracted parts, components, sub-assemblies, etc;
Purchased parts, components, sub-assemblies, etc.,
Maintenance, repairs, and operational items;
Finishing items such as paints, oils, varnishes, etc.
Packing materials and packaging;
Printing and Stationery items;
Miscellaneous items of regular consumptions;

10.
11.

Power, water supply, compressed air, steam and other utilities (services) and
Materials handling and transportation costs.

As mentioned earlier, items where the saving can be substantial should obviously be
taken up first. Also, items which are imported, or difficult to obtain, and monopoly items,
should receive high priority.
However, even if no economy can be effected immediately by Value Analysis on any
particular item, then usefulness of the technique should not be forgotten altogether. The
item should be taken up again for value analysis after six months or a year, the period
being dictated by the findings of the investigation.
New ideas may come to your mind at some other time. Also, it should be noted that the
conditions in the market keep on changing fast, and new materials, new suppliers, and
new processes come into existence rapidly as a result of phenomenal technological
progress taking place at present.
A frequent and systematic review of the items already value analyzed, with advantage,
may result in further economies.
ORGANISATION FOR VALUE ANALYSIS
Value analysis is a staff function like, for instance, Industrial Engineering, and should be
organized as much. It should be directly under a high-ranking officer from the Senior
Management of an undertaking. This is necessary because
Value Analysis concerns all departments, and the analyst must have access to them and to
their records, performance, costs, etc. Depending upon the size of the undertaking and its
scale of operations, there can be a Central Value Analysis Cell to co-ordinate the work of
individual analysts attached to the design, purchase, production, and engineering
departments. Where there is only one Value Analyst, he may be attached to the Industrial
Engineering Department or to the Purchase Department.
Value Analysis is essentially a team effort. What particular items to be taken up for value
analysis, and what action is to be taken is usually decided by a small committee
comprising representatives from the Design, Production, Purchase and Accounts
Departments. Any other departmental representative can be co-opted if and when
necessary.
It is the Purchase Manager (or Material Manager) who has to initiate action, convene
meetings at regular intervals, and see that substantial results are obtained. A large share
of the initial phase of the Value Analysis work will be done by the Purchase Manager, or
by other departments, at his instance. It is his responsibility to seek the maximum value
when a product requirement comes upto the point of purchase. It is his duty to challenge
wasteful and avoidable costs inherent in the items he is asked to buy. It is, therefore,
inevitable that a large part of whatever Value Analysis work is done is initiated by the
Purchase
Manager.

VALUE ENGINEERING
Value engineering is the term applied to value analysis done the design and prototype
stage of a product. The potentials of saving are a more in case value analysis is done at
design stage. Other advantages is that any changes at this stage are less costly than to
effect the same at a latter stage, when the production is in full swing. There are a few
limitations however on value engineering work. At the design and proto-type stage, the
time is rather short since a company wants to put a new product in the market before any
of its competitors can set in and value engineering will have a very short time to apply
their techniques. Evaluation of the value at this stage becomes difficult in absence of any
customer reaction and opinion.
WHEN VALUE ANALYSIS
A product goes through 3 stages (1) Developmental (2) Growth and (3) Maturity before
being out of date. Consider now the design efforts put on a product. At developmental
stages the design effort is the maximum. At the growth stage the effort is much less and is
mainly modifications and changes. At maturity stage hardly any design attention is
needed. The value of the product slowly increases in development and growth stages as
more features are added and desired changes and modifications are effected. At maturity
stage the value increases to peak and then slowly starts reduction because of competition,
change of customer tastes and other factors till the product falls out and becomes out of
date. It is this stage where value analysis can, still enhance the value by cost reduction
and lengthen the Maturity period of a product. Thus when the design effort is diverted to
other products, it is the time for value analysis to be undertaken. The success of value
analysis for one product of course be made use of in the design of other products by
development wing.
CONCLUSION
Value analysis is a technique with immense possibilities, and systematically employed, it
can achieve great economies and increased efficiency. Although good results have been
obtained in several individual cases in some industries, only a large scale and systematic
application of this technique in all industries, and in defence production, can result in
substantial economies on a national scale.
This valuable technique, if systematically employed, promises rich dividends, and,
among other things, enables greater use of indigenous raw materials and equipment by
import substitution. It is, therefore, of special significance to a developing country like
India which has adopted a programme of rapid industrialization in the face of paucity of
foreign exchange and other handicaps.