Economic for Managers E-book

Economics Amity Directorate of for Distance & Online Managers Education Economics is essentially the study of logic, tools and techniques of making optimum use of the available resources to achieve the ends. Economics thus provides analytical tools and techniques that managers need to achieve the goals of the organization they manage. Therefore, a working knowledge of economics, not necessarily a formal degree, is essential for mangers. Managers are essentially practicing economists.

MBA 2yrs Semester -I

C O N T EN T S Module 1: Introduction To Economic Analysis 1.1. Objectives 1.2. Introduction 1.3.

Nature and scope of and its relationship with other disciplines

1.4. Scarcity and Efficiency 1.5. Basic Concepts and Principles of Micro-economic analysis 1.5.1.

Marginalism

1.5.2.

Opportunity Cost

1.5.3.

Discounting Time Perspective

1.5.4.

Risk and Uncertainty

1.6. Summary 1.7. Check Your Progress 1.8. Questions and Exercises 1.9. Further Readings Module 2: 2.1. Objectives 2.2. Introduction 2.3. Demand Function 2.4. Determinants of demand 2.5. Law of Demand 2.6. Exceptions to the Law of Demand 2.7. Shift of Demand v/s Expansion or Contraction of Demand 2.8. Demand Elasticity 2.9. Types of Elasticity 2.10. Methods of measuring elasticity and its significance 2.11. Demand Forecasting 2.12. Supply Function 2.13. Factors affecting Supply 2.14. Elasticity of Supply 2.15. Budget Constraint

2.16. Indifference Curves Analysis 2.17. Consumer Equilibrium and Consumer Surplus 2.18. Summary 2.19. Check Your Progress 2.20. Questions and Exercises 2.21. Further Readings

Module 3: Cost and Production Analysis 3.1. Objectives 3.2. Introduction 3.3. Production Functions 3.4. Law of Variable Proportion or Law of Diminishing Returns to Factors. 3.5. Difference between Returns to a Factor and Returns to Scale 3.6. Isoquants 3.7. Isocost Line or Equal Cost Line 3.8. Marginal Rate of Technical Substitution 3.9. Choices of Input Combination (Optimal Input combination) 3.10. Theory of Cost 3.11. Cost Functions 3.12. Various types of Costs 3.13. Relationship between AC and MC 3.14. Long and Short Run Cost Curves 3.15. Cost and Output Relationship (Cost Function) 3.16. Short Run and Long Run 3.17. Economies / Dis-economies of Scale 3.18. The Theory of firm (Profit Maximization Model) 3.19. Break-even and Shut-down Point 3.20. Managerial Theories of the Firm 3.21. Baumol’s Model 3.22. Marris Model. 3.23. Summary 3.24. Check Your Progress

3.25. Questions and Exercises 3.26. Further Readings

Module 4: Market Structure Analysis 4.1. Objectives 4.2. Introduction: - Perfect Competition 4.2.1.

Assumptions of perfect competition:

4.2.2.

Short run equilibrium

4.2.3.

Long Run Equilibrium

4.3. Monopoly: – Price Discrimination 4.3.1.

Monopoly

4.3.2. Price and Quantity Determination in Short Run 4.3.2.1. Supernormal Profit 4.3.2.2. Normal Profit 4.3.2.3. Subnormal Profit or Loss 4.3.3.

Price and Quantity Determination in Long Run

4.3.4. Price Discrimination 4.4. Monopolistic Competition 4.5. Oligopoly-Mutual Interdependence 4.5.1.

Non-collusive Oligopoly

4.5.2.

Sweezy’s Model of Kinked Demand Curve

4.5.3.

Collusive Oligopoly

4.5.4.

Price Leadership

4.6. Prisoner’s Dilemma 4.7. Summary 4.8. Check Your Progress 4.9. Questions and Exercises 4.10. Further Readings

Module 5: Capital Budgeting and Risk and Uncertainty Analysis 5.1 Objectives 5.2 Introduction 5.3 Investment Analysis

Managerial Economics 5.3.1 Project valuation

5.3.2

Capital Budgeting Techniques

5.4 Risk and Investment Analysis- Decision Tree Analysis 5.5 Concept of Behavioral Economics

NOTES

5.6 Summary

5.7 Check Your Progress 5.8 Questions and Exercises 5.9 Further Readings

Module 6: Macro-economics Analysis 6.1. Objectives 6.2 Introduction 6.3. Basic Concept – Circular Flow of Income and Money 6.4. National Income and Keynesian Model 6.5. Saving and Consumption Function 6.6. Investment Multiplier 6.7. Inflation 6.8. Monetary and Fiscal Policies 6.9. International Economics – Fixed and Flexible Exchange Rates 6.10. Spot and forward Exchange Rates 6.11. Current and Capital Account Convertibility – a case study of India. 6.12. Summary 6.13. Check Your Progress 6.14. Questions and Exercises 6.15. Further Readings

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Amity School of Distance Learning

UNIT 1 Introduction To Economic Analysis STRUCTURE

NOTES

1.1. Objectives 1.2. Introduction 1.3. Nature and scope of and its relationship with other disci- plines 1.4. Scarcity and Efficiency 1.5. Basic Concepts and Principles of Micro-economic analysis 1.5.1.

Marginalism

1.5.2.

Opportunity Cost

1.5.3.

Discounting Time Perspective

1.5.4.

Risk and Uncertainty

1.6. Summary 1.7. Check Your Progress 1.8. Questions and Exercises 1.9. Further Readings

1.1 OBJECTIVES The primary purpose of this chapter is to define and explain the scope of economics and the methodology economists’ use in solving problems. A unique feature of this chapter is that it explains the economic way of thinking and shows the student how to apply the tools of economic thinking to everyday decisions. Graphs are used consistently in this module, so the student will need a good knowledge of how a graph is constructed and how to interpret its lines. It would be best to follow the examples in the appendix so that the student has both the text and class notes to review. Stress that the concept of scarcity is a key element in all economic analysis and a link to the rest of the course. Key Terms Scarcity, resources, land, labor, capital, opportunity costs, marginalism, risk and uncertainty, discounting time perspective

1.2 INTRODUCTION Economics is essentially the study of logic, tools and techniques of making optimum use of the available resources to achieve the ends. Economics thus provides analytical tools and techniques that managers need to achieve the goals of the organization they manage. Therefore, a working knowledge of economics, not necessarily a formal degree, is essential for mangers. Managers are essentially practicing economists. In performing his functions, a manager has to take a number of decisions in conformity with the goals of the firm. Many business decisions are taken under the condition of uncertainty and risk. Uncertainty and risk arise mainly due to uncertain behavior of the market forces, changing business environment, emergence of complexity of the modern business world and social and political, external influence on the domestic market and

9

NOTES

social and political changes in the country. The complexity of the modern business world adds complexity to business decision-making. However, the degree of uncertainty and risk can be greatly reduced if market conditions are predicted with a high degree of reality. The prediction of the future course of business environment alone is not sufficient. It is important equally to take appropriate business decisions and to formulate a business strategy in conformity with the goals of the firm.

1.3. NATURE AND SCOPE OF AND ITS RELATIONSHIP WITH OTHER DISCIPLINES Taking appropriate business decisions requires a clear understanding of the technical and environmental conditions under which business decisions are taken. Application of economic theories to explain and analyze the technical conditions and the business environment contributes a good deal to the rational decision-making process. Economic theories have, therefore, gained a wide range of application in the analysis of practical problems of business. With the growing complexity of business environment, the usefulness of economic theory as a tool of analysis and its contribution to the process of decisionmaking has been widely recognized. Baumol has pointed out three main contributions of economic theory to business economics. First, ‘one of the most important things which the economic (theories) can contribute to the management science’ is building analytical models, which help to recognize the structure of managerial problems, eliminate the minor details, which might obstruct decisionmaking and help to concentrate on the main issue. Secondly, economic theory contributes to the business analysis ‘a set of analytical methods’ which may not be applied directly to specific business problems, but they do enhance the analytical capabilities of the business analyst. Thirdly, economic theories offer clarity to the various concepts used in business analysis, which enables the managers to avoid conceptual pitfalls.

Scope of The problems in business decision-making and forward planning can be grouped into four categories as follows: z

Problems of Resource Allocation: Source resources are to be used with utmost efficiency to get the optimal results. These include production programming and problems of transportation, etc.

z

Inventory and Queuing Problems: Inventory problems involve decisions about holding of optimal levels of stocks of raw materials and finished goods over a period. These decisions have to be taken by considering demand and supply conditions. Queuing problems involve decisions about installation of additional machines or not hiring labor, against the cost of such machines or labor.

z

Pricing Problems: Fixing prices for the products of the firm are important decisionmaking problems. Pricing problems involve decisions regarding various methods of pricing to be followed.

z

Investment Problems: It is related of allocating resources over time. These normally relate to: investing new plants, how much to invest, expansion programs for the future, sources of funds, etc.

(ME) seeks solutions to these problems. So, there is a wide spectrum of topics that fall under ME and they are as follows:

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1.

Profit Analysis.

2.

Cost Analysis

3.

Production Possibility Chart

4.

Pricing theory and policies

5.

Demand Analysis

6.

Market penetration studies

7.

Economic Forecasting

8.

Sales Forecasting

9.

Marginal analysis

10. Break-even analysis

11. Competitive market studies

12. Anti-Trust issues

13. Plant location studies

14. Mergers and Acquisitions

15. Labor cost studies

16. Inventory problem

17. Investment analysis

18. Capital Budgeting

19. Cost of Capital

20. Government regulations

NOTES

Out of the above lists, there are some major areas, which are very much important for management, they are as follows: z

Demand analysis and forecasting,

z

Production and cost,

z

Competition,

z

Pricing and output, and

z

Investment and capital budgeting.

1.4. SCARCITY AND EFFICIENCY Economics is the study of how economic agents or societies choose to use scarce productive resources that have alternative uses to satisfy wants which are unlimited and of varying degrees of importance. The main concern of economics is economic problem: its identification, description, explanation and solution. The source of any economic problem is scarcity. Scarcity of resources forces economic agents to choose among alternatives. Therefore, economic problem can be said to be a problem of choice and valuation of alternatives. The problem of choice arises because limited resources with alternative uses are to be utilized to satisfy unlimited wants, which are of varying degrees of importance. Scarcity is a relative concept. It can be define as excess demand, i.e., demand more than the supply. For example, unemployment is essentially the scarcity of jobs. Inflation is essentially scarcity of goods. The job of any efficient manager is of economic one. Decision-making is the main job of management. Decision-making involves evaluating various alternatives and choosing the best among them. For example, a marketing manager is to allocate his / her advertising budget among various media in such a way so as to maximize the reach.

1.5. BASIC CONCEPTS AND PRINCIPLES OF MICRO-ECONOMIC ANALYSIS deals with firms, more especially with the environment in which firms operate, the decisions they take and the effects of such decisions on themselves and their stakeholders like customers, competitors, employees and the society in which they operate. The key economic concepts and principles that constitute the broad framework of are explained here.

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1.5.1. Marginalism

NOTES

The root cause of all economic problems is scarcity. So, all should be careful about the utilization of each and every additional unit of resources. In order to decide whether to use an additional unit of resource you need to know the additional output expected there from. Economists use the term marginal for such additional magnitude of output. Marginalism concept will help to know the additional output expected from an additional unit of resource. Therefore, marginal output of labour is the output produced by the last unit of labour.

1.5.2. Opportunity Cost Economic decision is choosing the best alternative among available alternatives. Before choosing best alternative you rank them all based on their priority and probable return. This choice implies sacrificing the other alternatives. The cost of this choice can be evaluated in terms of the sacrificed alternatives. If the best alternative was not chosen then you could have chosen the second best alternative. So, the cost of this particular best choice is the benefit of the next best alternative foregone. This is called Opportunity Cost.

1.5.3. Discounting Time Perspective Discounting principle refers to time value of money, i.e., the fact that the value of money depreciates with time. The core discounting principle is that a rupee in hand today is worth more than a rupee received tomorrow. One rationale of discounting is uncertainty about tomorrow, i.e., future. Even if there is no uncertainty, it is necessary to discount future rupee to make it equivalent to current day rupee. In business situations, most of the decisions relate to outflow and inflow of money and resources that take place at different point of time. Most outflows normally occur in the current period, whereas inflows occur only in future, therefore, in order to take the right decision it is necessary to “discount” future inflows to their present value level. The simple formula for discounting is: PVF = 1 / (1+rn) Where PVF = present value of fund, n= period (year, etc.) and r = rate of discount.

1.5.4. Risk and Uncertainty The uncertainty is due to unpredictable changes in the business cycle, structure of the economy and government policies. This means that the management must assume the risk of making decisions for their organizations in uncertain and unknown economic conditions in the future. Firms may be uncertain about production, market-prices, strategies of rivals, etc. Under uncertain situation, the consequences of an action are not known immediately for certain. Economic theory generally assumes that the firm has perfect knowledge of its costs and demand relationships and its environment. Uncertainty is not allowed to affect the decisions. Uncertainty arises because producers simply cannot foresee the dynamic changes in the economy and hence, cost and revenue data of their firms with reasonable accuracy. Dynamic changes are external to the firm and they are beyond the control of the firm. The result is that the risk from unexpected changes in a firm’s cost and revenue cannot be estimated and therefore the risk from such changes cannot be insured. The managerial economists have tried to take account of uncertainty with the help of subjective probability. The probabilistic treatment of uncertainty requires formulation of definite subjective expectations about cost, revenue and the environment.

1.6. SUMMARY The can be viewed as an application of that part of microeconomics that focuses on such topics as risk, demand, production, cost, pricing and market structure.

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Understanding these principles will help to develop a rational decision-making perspective and will sharpen the analytical framework that the managers must bring to bear on managerial decisions.

CHECK YOUR PROGRESS

NOTES

1. Uncertainty and risk arise mainly due to (a) Uncertain behavior of the market forces, (b) Changing business environment, (c)

Emergence of complexity of the modern business world and social and political, external influence on the domestic market and social and political changes in the country,

(d) All above 2. Source resources are to be used with utmost efficiency to get (a) The optimal results,

(b)

The Sub-optimal results,

(c) The Normal results,

(d)

All the above.

(a) Over-population,

(b)

Scarcity,

(c) Capital

(d)

Poor management

(a) Time value of interest,

(b)

Time value of money,

(c) Time value of investment,

(d)

Time value of capital.

3. The root cause of all economic problems is

4. Discounting principle refers to

Questions and Exercises 1.1. “ is an integration of economic theory, decision science and business management.” Comment. 1.2. “Economics is a science of choice when faced with unlimited ends and scarce resources having alternative uses.” Comment. 1.3. “ uses the theories of economics and the methodologies of the decision sciences for managerial decision-making.” Elaborate. 1.4. Discuss the salient features and significance of . 1.5. Highlight the role and responsibilities of a business / managerial economist. 1.6. Write short notes on the followings: 1.6.1.

The Nature of .

1.6.2.

Functions of Managerial Economist.

1.6.3.

Decision Making under Uncertainty.

1.6.4.

Opportunity Cost.

1.6.5.

Marginal Analysis.

1.6.6.

Discounting Principles

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Fundamental Questions

NOTES

1.

What is economics?

2.

What are opportunity costs?

3.

How are specialization and opportunity costs related?

4.

What is Marginalism?

5.

What is Risk and Uncertainty?

6.

What is Discounting Time Perspective?

Skill Development i)

Prepare a mini case study of a business expansion strategy of a Laptop dealer in your area.

ii)

Prepare a hypothetical case study for an automobile firm in India to deal with would be problem of launching of small cars like NANO.

Further Readings z

Hirschey, Economics for Managers, Cengage Learning

z

Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning

z

Froeb, : A Problem Solving Approach, Cengage Learning

z

Mankiw,

Economics: Principles and Applications, Cengage Learning

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z

Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill

z

Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice Hall of India

z

R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics Macmillan.

z

Varshney, R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.

z

Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Review, 6th Edition, Tata McGraw Hill.

UNIT 2 Consumer Behavior STRUCTURE 2.1. Objectives 2.2. Introduction

NOTES

2.3. Demand Function 2.4. Determinants of demand 2.5. Law of Demand 2.6. Exceptions to the Law of Demand 2.7. Shift of Demand v/s Expansion or Contraction of Demand 2.8. Demand Elasticity 2.9. Types of Elasticity 2.10. Methods of measuring elasticity and its significance 2.11. Demand Forecasting 2.12. Supply Function 2.13. Factors affecting Supply 2.14. Elasticity of Supply 2.15. Budget Constraint 2.16. Indifference Curves Analysis 2.17. Consumer Equilibrium and Consumer Surplus 2.18. Summary 2.19. Check Your Progress 2.20. Questions and Exercises 2.21. Further Readings

2.1. OBJECTIVES The objective of this chapter is to define and analysis of . The chapter also focuses on the Demand Function, Determinant of Demand, Law of Demand and Exceptions, Elasticities of Demand and their Measurements, Demand Forecasting Methods, Supply Function, Elasticities of Supply, Indifference Curve Analysis, Consumer Equilibrium and Consumer Surplus. Graphs are used consistently in this chapter for understanding the subject matter easily. Key Terms Demand, Demand Function, Determinant of Demand, Law of Demand, Elasticity, Demand Forecasting Methods, Supply, Supply Function, Indifference Curve, Consumer Equilibrium and Consumer Surplus.

2.2. INTRODUCTION The amount of good that a consumer is willing to buy and able to purchase over a period of time, at a certain price is known as the quantity demanded of that good. The quantity desired to be purchased may be different from the quantity of good actually bought by the consumer. Quantity demanded is a flow concept, so the relevant time dimension has to be mentioned which will indicate the quantity demanded per unit of time.

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2.3. DEMAND FUNCTION Demand is a relationship between the price and the quantity demanded, other things remaining the same. If X1 denotes the quantity demanded and P1 its price per unit of the good, then other things remaining constant, the demand function is;

NOTES

X1 = f (P1 ), Which shows that quantity demanded depends on the price. This means that any change in price will result in a corresponding change in the quantity demanded.

2.4. DETERMINANTS OF DEMAND The determinants of demand for a product and the nature of relationship between demand and its determinants are very important factors for analyzing and estimating demand for the product. The most important determinants are as follows: 1. Price of the product. 2. Price of the related goods Complements and Supplements. 3. Level of consumers’ income. 4. Customers’ taste and preference. 5. Advertisement of the product. 6. Consumers’ expectations about future price and Supply position. 7. Demonstration effect and ‘Band-Wagon’ effect. 8. Consumer-credit facility. 9. Population of the country (Goods for mass consumption). 10. Distribution pattern of the National Income.

2.5. LAW OF DEMAND The law of demand states that other things being constant, price and quantity demanded have an inverse relationship; i.e. as price of a product increases quantity demanded decreases and vice versa. This law states that there is an inverse relationship between price and quantity demanded, as price increases, quantity demanded will decrease. The law of demand can be explained in terms of substitution and income effects resulting from price changes. The substitution effect reflects changing opportunity costs. When price of good increases, its opportunity cost in terms of other goods is also increases. Consequently, consumers may substitute other goods for the good that has become more expensive.

2.6. EXCEPTIONS TO THE LAW OF DEMAND Though normally law of demand applies to all situations, but there are few cases where the law does not hold goods, therefore these are regarded as exceptions to the law. These are the goods which are demanded less at low price and more at high price. Let us discuss some such exceptions here. Giffen goods: the case of Giffen Goods needs a little bit of story telling! In early Ireland it was observed that the poor population consumed two goods: meat (which was costly) and bread (which was cheap). A very strange phenomenon was observed when the price of the bread was increased, it made a large drain on the resources of the poor people and raised their marginal utility of money to such an extent that they were forced to curtail

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there consumption of meat and buy more of bread, which was still the cheapest food. This implied that quantity demand of bread (an inferior good) increased with the increase in its price. Sir Robert Giffin, an economist, was the first to give an explanation to this situation. Hence such goods which display direct price demand relationship are called Giffin Goods. These goods are considered inferior by the consumer, but they occupy a significant place in the individual’s consumption basket. It so happens that people in this case, with the rise of price of this good (say rice), are forced to reduce their purchase of other expensive goods (say, chicken) and increase the purchase of that good (rice) in larger quantity to supplement the reduction in luxury food item (chicken). These goods categorically are those on which major portion of consumer’s income is spent, hence they are termed as inferior.

NOTES

Snob Appeal: opposite to Giffen Goods, there are certain goods which have snob value, for which the consumer measures the satisfaction derived from there commodities not by their utility value, but by their social status. The consumer of this particular commodity wants to show it off to others, and as a result they buy less of it at lower prices and more at higher prices. Thus in this case, price and quantity move in the same direction. Diamond or antique works of art, latest model of mobile phones, sports cars, and designer clothes are example of such goods. Higher is the price of diamond, higher is the snob value attached to it and higher is its demand. These goods are sometimes also known as Vevlen Goods after the economist Thorstein Vevlen.

2.7. SHIFT OF DEMAND V/S EXPANSION OR CONTRACTION OF DEMAND Demand curve shows the relationship between price of a commodity and demand at that price, ceteris paribus. If the price changes, the demand will also change along the same demand curve. Thus movement along the same demand curve is known as a contraction or expansion in quantity demanded, which occurs due to rise or fall in price of the commodity.

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When price of a good remain the same but any one of the other determinants changed then we will get a new demand curve. So, when demand increases without any change in price of that good, the demand curve will shift to the right and with a reduction in demand, the demand curve will shift to the left.

NOTES

2.8 DEMAND ELASTICITY Law of demand gives us the direction of change in demand if the price of the product changes. But this information is not of much practical use since we know only the direction of change in the demand for a given change in the price. For decision making, we need the magnitude of this demand and elasticity of demand can gives this changes. The elasticity of demand helps to understand the extent to which the quantity demanded will rise (fall) due to fall (rise) in the price of the same good or a related good or due to rise (fall) in the income of the consumer. This involves an analysis of demand sensitivity with respect to prices of goods and income which helps the business to forecast market trends for the future.

2.9 TYPES OF ELASTICITY There are many types of elasticity but the main and important types are as follows. i)

Price elasticity of demand

ii)

Income Elasticity of Demand

iii) The Cross-price Elasticity of demand iv) Advertising Elasticity of Demand

2.10METHODS OF SIGNIFICANCE

MEASURING

ELASTICITY

AND

ITS

There are many types of elasticity of demand like determinants. But here we will discuss the most important three elasticity a) Price Elasticity of Demand, b) Income Elasticity of Demand, c) Cross-price Elasticity of Demand d) Advertising Elasticity of Demand.

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Price elasticity of demand (ep) ep = percentage change in quantity demanded resulting from one percent change in the price of the good, other things remaining constant. ep =

percentage change in quantity demanded percentage change in price

Percentage change in quantity demanded = [change in quantity demanded / original quantity demanded] * 100

NOTES

Percentage change in price = [change in price / original price] *100 Combining the above two, we have, ep =

change in quantity demanded/original quantity demanded change in price/original price = [œQ / œP] * [P / Q],

Where,

œQ = Infinitesimal change in quantity, œP = Infinitesimal change in price, P = original price and Q = original quantity demanded of the good. Some important concepts z

Perfectly elastic demand: A very small amount of change in the price will result in a change in the quantity demanded to the extent of infinity. Ep = •

z

Perfectly inelastic demand: A change in price, however large it may be, causes no change in quantity demanded. Ep = 0.

z

Unit elasticity of demand: When a given change in the price causes an equally proportionate change in the quantity demanded the value of price elasticity of demand id unitary. Ep = 1.

z

Relatively elastic demand: Here a change in the price results in more than proportionate change in the quantity demanded. Ep > 1.

z

Relatively inelastic demand: Here a change in the price results in less than proportionate change in the quantity demanded. Ep < 1. Unitary Elastic

% ÄQ = % ÄP

Ep = 1.

Relatively Elastic

% ÄQ > % ÄP

Ep > 1.

Perfectly Elastic

% ÄP = 0

Ep = “.

Relatively Elastic

% ÄQ < % ÄP

Ep < 1.

Perfectly Inelastic

% ÄQ = 0

Ep = 0.

Income Elasticity of Demand It is defined as the proportionate change in the quantity demanded resulting from a proportionate change in income. Ey = [œQ / Q] / [œY / Y] = [œQ / œY] * [Y / Q] It is clear that the sign of the elasticity depends on the sign of the derivative KQ / KY as both of the expressions Q and Y are positive, i.e., Q>0 & Y>0. The income elasticity is

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positive for normal goods. A commodity is considered to be a ‘luxury’ if its income elasticity is greater than unity. A commodity is considered to be a ‘necessity’ if its income elasticity is less than unity. The main determinants of income elasticity are: 1.

The nature of the need that the commodity covers: the percentage of income spent on food declines as income increases.

2.

The initial level of income of a country: for example, a TV set is a ‘luxury’ in an underdeveloped and poor country, while it is a ‘necessity’ in a country with high percapita income.

NOTES

3. The time period: consumption patterns adjust with a time lag to changes in income.

The Cross-price Elasticity of demand The cross-price elasticity of demand is defined as the proportionate change in the quantity demanded of product i resulting from a proportionate change in the price of the product j. Symbolically the cross-price elasticity is: Ecij = [Percentage change in the quantity demanded of the ith good / Percentage change in the price of the jth good] = [(œQi / Qi)*100] / [(œPj / Pj)*100] = [œQi / œPj] * [Pj / Qi], As price and quantity values cannot be negative terms, the sign of the cross price elasticity is determined by the sign of the derivative œQi / œPj. The sign of cross price elasticity is negative if i and j are complementary goods, and is positive if i and j are substitute goods. The higher the value of the cross-price elasticity the stronger will be the degree of substitutability or complementarities of i and j. The main determinant of the cross elasticity is the nature of the commodities relative to their uses. If two commodities can satisfy equally well the same need, the cross elasticity is high and vice versa.

Advertising Elasticity of Demand It is defined as the rate of change in the quantity demanded of a good due to change in the advertisement expenditure of the product. Ey = [œQ/Q] / [œADexp/ADexp] = [œQ/KADexp] * [ADexp/Q] It measures the response of quantity demanded to change in the expenditure on advertisement. It has been seen that some goods are more responsive to advertising, i.e., cosmetics.

2.11. DEMAND FORECASTING There are so many methods for forecasting demand. Here we will discuss the main methods. Broadly they are divided into two groups: 1. Survey Methods. 2. Statistical Methods.

1. Survey Methods. Survey methods are generally used where the purpose is to make short-run forecast of demand. Under the survey methods there are two types of survey: I) Consumer Survey Methods – Direct Interviews, and ii) Opinion Poll Methods

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i)

Consumer Survey Methods – Direct Interviews

The customer survey method of demand forecasting involves of the potential consumers. It may be in the form of: a) Complete enumeration, b) Sample survey, c) End-use method.

NOTES

a) Complete enumeration method By this method, almost all potential users of the product are contacted and are asked about their plan of purchasing the product in question. The quantities indicated by the consumers are added together to obtain the probable demand for the product. The main limitation of this method is that it can be used successfully only in case of those products whose consumers are concentrated in a certain region or locality. b) Sample survey In this method, only a few potential consumers and users selected from the relevant market through a sampling method are surveyed. Method of survey may be direct interview or mailed questionnaire to the sample-consumers. This method is generally used to estimate short-term demand from business firm, government department and agencies and also by the households who plan their future purchases. c) End-use method This method of demand forecasting has a considerable theoretical and practical value, especially in forecasting demand for inputs. This method requires building up a schedule of probable aggregate future demand for inputs by consuming industries and various other sectors. This method has two exclusive advantages. First, it is possible to work out the future demand for an industrial product in considerable details by types and size. Second, in forecasting demand by this method, it is possible to trace and pinpoint at any time in future as to where and why the actual consumption has deviated from the estimated demand.

ii) Opinion Poll Methods The opinion poll methods aim at collecting opinions of those who are suppose to possess knowledge of the market, i.e., sales representatives, professional marketing experts and consultants. This method includes; a) Expert-opinion method. b) Delphi Method. c) Market studies and experiments. a) Expert-opinion method The estimates of demand can obtain from different regions are added up to get the overall probable demand for a product. The firms are not having this facility; gather similar information about the demand for their products through the professional markets experts or consultants, who can, through their experience and expertise, predict the future demand. This is called opinion poll method. b) Delphi Method This method of demand forecasting is an extension of the simple expert opinion poll method. Under this method, the experts are provided information on estimates of forecasts of their experts along with the underlying assumptions. The experts may revise their own estimates in the light of forecasts constitutes the final forecast.

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c) Market studies and experiments It is an alternative method of collecting necessary information regarding demand is to carry out market studies and experiments on consumer’s behavior under actual, though controlled, market conditions. This method is known in common parlance as market experiment method.

NOTES

2. Statistical Methods This method is utilizes historical (time-series) and data for estimating long-term demand. This method is considered superior techniques of demand forecasting for the following reasons: z

In this method, the elements of subjectivity are minimum.

z

Method of estimation is scientific.

z

Estimates are relatively more reliable.

z

It involves smaller cost.

Statistical methods of demand projection include the following techniques; 1. Trend Projection Methods. 2. Barometric Methods. 3. Econometric Method.

2.12. SUPPLY FUNCTION Supply of a good refers to the various quantities of the good which a seller is willing and able to sell at different prices in a given market, at a particular point of time, other things remaining the same. Supply is related to scarcity. It is only the scarce goods which have a supply price. On the other hand, goods which are available freely have no supply price, i.e., air is available freely and hence does not have supply price. The law of supply states that other things remaining the same, more of a good are supplied at a higher price and less of it is supplied at a lower price. The law of supply takes into account only the most important determinant of supply, viz., the price of the good. So, the supply function is; Sx = f(Px), other things remaining the same, where, Sx = Amount of good X supplied, Px = Price of good X.

2.13. FACTORS AFFECTING SUPPLY The followings are the major factors affecting the supply of the good; i) Price of the Good. iv) State of Technology.

ii) Prices of other goods. iii) Prices of factors of Production.

2.14. ELASTICITY OF SUPPLY Price Elasticity of Supply refers to the percentage change in quantity supplied due to one percentage change in the price of that good. Es = [Percentage change in quantity supplied / Percentage change in the price]

22

= [œQs/Qs] / [œP/P] = [œQs/”P] * [P/Qs] Where, Qs = Original quantity supplied, P = Original price, œQs = Change in quantity supplied, œP = Change in price.

2.15. BUDGET CONSTRAINT

NOTES

The consumer has a given income which sets limits to his maximizing behaviour. Income acts as a constraint in the attempt for maximizing utility. The income constraint, in the case of two commodities, may be as: Y = PX QX+ PYQY The income constraint graphically present by the budget line, whose equation is derived as, 1 PX QYQXYPY PY Assigning successive values of Q X, we may find the corresponding values of QY. Thus, if QX = 0, the consumer can buy Y/ PY units of good y. Similarly, if QY = 0, the consumer can buy Y/ PX units of good x.

2.16. INDIFFERENCE CURVES ANALYSIS The consumer behaviour analysis was expanded to new horizons with the introduction of indifference curve analysis by J.R. Hicks and R.G.D. Allen. In this analysis, the utility is ordinally measurable. If we plot the quantities of two commodities on the two axes, then we get a set of points that would present alternative combination of the two commodities, between which the consumer would be indifferent. The curve joining such points is known as an indifference curve. So, indifference curve is the locus of points which show the different combinations of two commodities a consumer is indifferent about the points A or B or C or D.

23

NOTES

2.17. CONSUMER EQUILIBRIUM AND CONSUMER SURPLUS The consumer is in equilibrium when he maximizes his utility, given his income and market prices. Two conditions must be fulfilled for the consumer to be in equilibrium. The first condition is that the marginal rate of substitution be equal to the ratio of commodity prices MUx Px MRSx,y= MU y Py This is a necessary but not sufficient condition for equilibrium. The second condition is that the indifference curves be convex to the origin. This condition is fulfilled by the axiom of diminishing MRSx,y, which states that the slope of the indifference curve decreases as we move along the curve from left to right.

24

At the point of tangency the slopes of the budget line and of the indifference curve are equal: MUx Px = MU y Py Thus the first-order condition is denoted graphically by the point of tangency of the two relevant curves. The second-order condition is implied by the convex shape of the indifference curve. The consumer maximizes his utility by buying Xe and Ye amount of the two commodities.

NOTES

The concept of consumer surplus was first introduced by Marshal. Consumer surplus is the difference between the price consumers are willing to pay and what they actually pay. The amount that the consumer is willing to pay for the first unit of good he buys is termed as consumers’ marginal value. The marginal value decreases as more and more units are bought. A consumer who maximizes marginal value will buy to that extent where marginal value equals price. A graphically presentation of consumer surplus is given below.

AB is the demand curve of a consumer. The consumer is willing to pay a price of q 1p 1 for q1 units of goods. For q2 units of goods he will be willing to pay q2p2. And for Q, he will be willing to pay QN and so on. Now, suppose that the market price is OP, which the consumer can decide about the quantity of good he would like to demand. With the demand curve AB, he will demand OQ. Here, the consumer actually pays OP per unit of the good, but he was willing to pay more than OP for any unit to the left of Q. For the quantity q1, the consumer is willing to pay q1p1, but he actually pays q1r1. Hence, the consumer surplus is (q1p1 - q1r1) = r1p1. In the same way for q2, the consumer surplus is r2p2 and for Q, it is zero. If the quantities are finally divisible, the total amount that the consumer is willing to pay is the area OANQ, whereas what he actually pays is the area OPNQ and the consumer’s surplus is the area APN.

2.18. SUMMARY Demand refers to the number of units of a good or service that consumers are willing and able to buy at each price during a specified interval of time. Changes in demand can be caused by changes in tastes and preferences, income and prices of other goods and services also. Marginal revenue is the change in total revenue per unit change in demand.

25

Total revenue is increasing when marginal revenue is positive. Marginal revenue is zero at the maximum point of total revenue and total revenue is declining when marginal revenue is negative. Elasticity measures the responsiveness of demand to various factors. Price elasticity of demand is defined as the percentage change in quantity demanded per 1 percent change in price.

NOTES

CHECK YOUR PROGRESS 1. Which of the following statements is true? (a) When the supply increases, both the price and the quantity will increase, (b) When the supply increases, the supply curve shifts towards the left, (c) A shift in the supply curve towards the right results in a fall in the price, (d) A decrease in the quantity supplied results in shifting of the supply curve towards the left. 2. Which of the following statements is false? (a) An increase in tax will affect the customers more than the producers if the supply schedule is inelastic, (b) An increase in tax will affect the customers more than the producers if the demand schedule is inelastic, (c) Both (a) and (d) above, (d) An increase in tax will affect the customers less than the producers if the demand schedule is inelastic. 3. For complementary goods, the cross elasticity of demand will be (a) Zero,

(b)

Infinity,

(c) Positive but less than one,

(d)

Negative.

4. When the income elasticity of demand for a good is negative, the good is (a) Normal good,

(b)

Luxury good,

(c) Inferior good,

(d)

Giffen good.

5. If both income and substitution-effects are strong, this region of the demand curve must be (a) Relatively price elastic,

(b)

Relatively price inelastic,

(c) Unit-elastic,

(d)

Perfectly inelastic.

Questions and Exercises 1. Explain the utility analysis for understanding consumer behaviour and demand.

26

2.

What is the Law of Diminishing Marginal Utility? Explain law with empirical example.

3.

State and explain the properties of Indifference Curve.

4.

Explain the Law of Diminishing Marginal Rate of Substitutions.

5.

State the law of demand with some exceptions.

6.

“The law of demand is always applicable to marginal buyers and is usually applicable to intra-marginal buyers.” Comment.

7.

Distinguished between substitutes and complements with examples. How does this distinction of goods help in business decision making?

8.

If price of milk increases, what do you think will happen to the demand for cornflakes?

9.

What are the factors that cause the demand curve to shift?

NOTES

10. If the demand is fixed but supply of a product increases, what happens to equilibrium price and quantity? 11. If the market demand curve is given by Q d = 15 – 8P and the market supply curve Qs = 2P, find the equilibrium price and quantity graphically and mathematically. 12. Why is it said that the market equilibrium is a highly unstable one? 13. Given the following demand and supply functions, find the equilibrium price and quantity in the market: Demand Qd = 100 – P and Supply P = 10 + 2Qs. 14. Differentiate between the following on the basis of elasticity of demand. i)

Superior Goods and Inferior Goods.

ii)

Complements and substitutes.

Fundamental Questions 1. What is demand? 2. What are determinants of demand? 3. What are the different elasticities of demand? 4. What are the different measures of demand forecasting? 5. What is supply? 6. How do we measure supply elasticity? 7. How do you apply indifference curve analysis in analysis? 8. What is consumer surplus? Skill Development i)

In the context of demand analysis, review the air-fare season wise of Indigo Airlines and Kingfisher Airline.

ii)

Choose a branded cosmetic product (Shampoo, Hair Dye, Talcum Power etc.), collect monthly price-demand (sales) / advertising expenditure – sales revenue data on an average over a period of six months and measure the point and arc price and promotional elasticity of demand.

Further Readings z

Hirschey, Economics for Managers, Cengage Learning

z

Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning

z

Froeb, : A Problem Solving Approach, Cengage Learning

z

Mankiw,

Economics: Principles and Applications, Cengage Learning z

Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill

z

Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice Hall of India

R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics Macmillan. z

27

NOTES

28

z

Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.

z

Koutsoyiannis,A. Modern Economics, Third Edition.

z

Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Review, 6th Edition, Tata McGraw Hill.

z

Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking.

UNIT 3 COST AND PRODUCTION ANALYSIS STRUCTURE

Cost And Production Analysis

NOTES

3.1. Objectives 3.2. Introduction 3.3. Production Functions 3.4. Law of Variable Proportion or Law of Diminishing Returns to Factors. 3.5. Difference between Returns to a Factor and Returns to Scale 3.6. Isoquants 3.7. Isocost Line or Equal Cost Line 3.8. Marginal Rate of Technical Substitution 3.9. Choices of Input Combination (Optimal Input combination) 3.10. Theory of Cost 3.11. Cost Functions 3.12. Various types of Costs 3.13. Relationship between AC and MC 3.14. Long and Short Run Cost Curves 3.15. Cost and Output Relationship (Cost Function) 3.16. Short Run and Long Run 3.17. Economies / Dis-economies of Scale 3.18. The Theory of firm (Profit Maximization Model) 3.19. Break-even and Shut-down Point 3.20. Managerial Theories of the Firm 3.21. Baumol’s Model 3.22. Marris Model. 3.23. Summary 3.24. Check Your Progress 3.25. Questions and Exercises 3.26. Further Readings

3.1. OBJECTIVES The objective of this chapter is to define and application of the production and cost. The chapter also focuses on the Production Function, Total Product, Average Product, Marginal Product; Law of Variable Proportion or Law of Diminishing Returns to Factors, Returns to a Factor and Returns to Scale, Isocost and Isoquant, Marginal Rate of Technical Substitution (MRTS), Model of Profit Maximization, Sales Revenue Maximisation Model by Baumol, Managerial Utility Models, Growth Maximisation Models, Total Cost (TC), Total Fixed Cost (TFC), Total Variable Cost (TVC), Average Fixed Cost (AFC), Average Variable Cost (AVC), Average Total Cost (ATC) and Marginal Cost (MC), Long and Short Run Cost Curves, Cost and Output Relationship, Economies / Dis-economies of Scale, Break-even and Shut-down Point, Baumol’s Model and Marris Model. Graphs are used consistently for understanding the subject matter easily.

29

Key Terms

NOTES

Production, Production Function, Total Product, Average Product, Marginal Product, Law of Diminishing Returns to Factors, Returns to a Factor, Returns to Scale, Isocost, Isoquant, Marginal Rate of Technical Substitution (MRTS), Total Cost (TC), Total Fixed Cost (TFC), Total Variable Cost (TVC), Average Fixed Cost (AFC), Average Variable Cost (AVC), Average Total Cost (ATC), Marginal Cost (MC), Long and Short Run Cost Curves, Cost and Output Relationship, Economies / Dis-economies of Scale, Break-even and Shut-down Point.

3.2. INTRODUCTION Production is basically an activity of transformation which transfers inputs into outputs. Firms use land, labour, seeds and small amount of capital as inputs to produce output like corn. Similarly, a flour mill uses inputs like wheat, labour, capital for machinery, factory building to produce output like wheat flour. So, an input is the goods or services which produce an output. The firm generally uses many inputs to produce an output. Output of any firm may be the inputs of other firms, e.g., steel is an output of the steel producer, but this steel is also an input of automobile or rail coach manufacturing or refrigeration manufacturing or air-condition manufacturing industries. The transforming process of inputs into output can be three types: i) change in form (output should be new form compared to inputs, for example cloth as output and thread as input) ii) change in space (transportation) and iii) change in time (storage). The transformation process or production increases the consumer usability of goods and services.

3.3. PRODUCTION FUNCTIONS A production function is the technical relationship between inputs and outputs. A commodity may be produced by various methods using different combinations of inputs with given state of technology. Take the e.g. of cloth, it may be produced using cotton or silk or polymer as raw materials with handloom, power loom or computerized machines. You can see various types of raw materials and technology options will create several possible ways of producing the same product. Hence there can be several technically efficient methods of production. Production function includes all such technically efficient methods. It can be said that production function is purely a technological relationship between physical inputs and physical outputs over a given period of time; production is a function of inputs, their quality and quantity and interrelation, i.e., complementarities and substitutability. Hence it can be said that production function is: z Always related to a given time period z Always related to a certain level of technology z Depends upon relation between inputs Production function shows the maximum quantity of the commodity that can be produced per unit of time for each set of alternatives inputs, and with a given level of production technology. A given amount of output can be produced by different combinations of inputs and each of these combinations may be technically efficient. Technical efficiency is defined as a situation when using more of one input with either the same amount or more of the other input must increase output. Normally a production function is written as; Q = f (x 1, x 2,…………… xn) …………………………………..…………(i) Where, Q is maximum quantity of output of a good being produced, and x1, x 2,………. xn are the quantities of various inputs used in production. If we replace x 1, x 2,………x n in (i) by the factors of production discussed above, the production function may be;

30

Q = f (L, K, I, R, E) ………………………………………………………….. (ii) Where, Q =output and the inputs are L, K, I, R, E; L= labour, K = capital, I =land, R =raw material E = efficiency parameter

Cost And Production Analysis

NOTES

In short run, some inputs like plant, size, and machine equipments cannot be changed, so a producer trying to increase output in the short run will have to do so by increasing only the variable inputs. On the contrary in the long run input options are very wide. On the basis of such characteristics of inputs, production functions are normally divided into two broad categories :( i) with one variable input or variable proportion production function (ii) with two variable inputs or constant proportion production function Production Function with One Variable Input: In short run producers have to optimize with only one variable input. Let us consider a situation in which there are two inputs, capital and labour, capital is fixed and labour is variable input. You will notice as the amount of capital is kept constant and labour is increased to increase output, the ratio in which these two inputs are used will also change. Therefore any change in output can be manifested only through a change in labour input only. Such a production function is also termed as variable proportion production function; it’s essentially a short term production function in which production is planned with variable input. The short run production function shows the maximum output a firm can produce when only one of its inputs can be varied, other inputs remaining fixed. It can be written as: Q = f (L, K0)…………………………..………………(iii) Where, Q is output, L is labour and K0 denotes the fixed capital. This also implies that it is possible to substitute some of the capital by labour. It is easy to understand that as units of the variable input are increased, the proportion of use between fixed input and variable input also changes. Therefore short run production function is governed by law of variable proportions. To explain the concepts of average and marginal products of factor inputs consider the production function given in equation (iii), Assuming capital to be constant and labour to be variable, total product is a function of labour and is given as: TPL = f (K0, L)……….…………….(iv)

31

If instead labour is fixed in the short run, the total product of the capital function can be similarly expressed as: TPK = f (L0, K) ………………………………….(v)

NOTES

Average Product (AP) is total product per unit of variable input; therefore it can be expressed as: APL = TP/L…………………………………………..(vi) If instead labour is fixed in the short run, average product of the capital function(APK )can be similarly expressed as: APK = TP / K……………………….………………….(vii) Marginal Product (MP) is defined as addition in total output per unit change in variable input. Thus marginal product of labour (MP L) would be: MPL = œTP / œL ……………………...………….……(viii) Production Function with Two Variable Inputs: Most simplistic form of production function with two variable inputs, labour (L) and capital (K), and a single output, Q, is as follows; Q = f (L, K) ……………………….…………………(ix) This production function is constructed based on the assumption that the state of the technology is given and output can be increased by increasing inputs. When the state of technology changes, the production function itself changes. Further, it is assumed that the inputs are utilized in the best possible way, i.e., optimum utilization of inputs. The best utilization of any particular input combination is a technical, not an economic problem. Selection of best input combination for the production of a particular output level depends upon the input and output prices and is subject of economic analysis.

3.4. LAW OF VARIABLE PROPORTION OR LAW OF DIMINISHING RETURNS TO FACTORS. The slope of the total product curve is determined from the law of diminishing returns. The law of diminishing returns, being empirical in nature, states that with a given state of technology if the quantity of one factor input increased, by equal increments, the quantities of other factor inputs remaining fixed, the resulting increment of total product will first increase and then decrease after a particular point.

32

The law is also known as diminishing returns to factors. It states that as more and more one factor of production is employed, other factor remaining the same, its marginal productivity will diminishing after some time. For example, if we increase labour input and capital input remaining the same, then the marginal productivity of labour first increased, reaches maximum and then decreases. The law of diminishing returns to factors is depending on three assumptions. i) It is assumed that the state of technology is given. ii) It is assumed that one factor of production must always be kept constant at certain level. iii) This law is not applicable when two inputs are used in a fixed proportion and the law is applicable only to varying ratios between the two inputs.

Cost And Production Analysis

NOTES

3.5. DIFFERENCE BETWEEN RETURNS TO A FACTOR AND RETURNS TO SCALE The law of diminishing returns factors states that as more and more one factor of production is employed, other factor remaining the same, its marginal productivity will start diminishing after some time, e.g., if we increase one factor of production i.e., labour and other factor of production i.e., capital remaining the same, then the marginal productivity of labour first increased, reaches maximum and then decreases. So, returns to a factor (variable factor) of production is first increasing in the initial level of production and then decreasing if we increase the amount of that variable factor of production. But, if we increase more and more of that variable factor then the returns to the variable factor is negative. In the very first stage of production, if additional units of labour are employed, the total output increases more than proportionately; so marginal product rises. In the following figure, stage I would begin from the origin and continue to a point where AP L attains its maximum value. In this stage, MP L > 0, and MPL > APL. This stage is called as increasing returns to the variable factor.

33

In the second stage, the total product increases but less than proportionate to increase in labour. In this stage, marginal product of labour falls and this stage is called as diminishing returns to variable factors. Here, MPL > 0 and MPL < APL. The stage three is a technically inefficient stage of production and a rational producer will never produce in this stage. Here, MPL < 0 and total product is decreasing.

NOTES

The law of returns to scale refers to the long run analysis of production. It refers to the effects of scale relationships which implies that in the long run output can be increased by changing all factors by the same proportion, or by different proportions. If the production function is Q0 = f (K, L) and we increase all the factors of production by the same proportion p. So, the new production function is Q* = f (p.K, p.L). If Q* increases in the same proportion as the factors of production, p, then we can say there are Constant Returns to Scale (CRS). If Q* increases less than proportionately with an increase in the factors of production, p, then we can say there are Decreasing Returns to Scale (DRS). If Q* increases more than proportionately with an increase in the factors of production, p, then we can say there are Increasing Returns to Scale (IRS).

)

3.6. ISOQUANTS An isoquant is the firm’s counterpart of the consumer’s indifference curve. It is a curve representing the various combinations of two inputs that produce the same amount of output. It is also known as iso-product curve or equal product curve or production indifferent curve. It is the collection of inputs in the form of factors of production labour (L) and capital (K), which yield the same output. For a definite level of output, i.e., for Q 0, say 1000 units of output or for Q1, say 2000 units of output, the equation of production function is Q0 = f (L, K) or Q1 = f (L 1, K1) Where, Q 0 and Q1 are parameters.

34

Cost And Production Analysis

NOTES

The locus of all the combinations of L and K which satisfy the above equation forms an isoquant. Since the production function is continuous, an indefinite number of input combinations will lie on each and every isoquant. The two factors of production are substitutable and can employ more of one input and less of another input to get the same level of output. A higher level of output is represented by a higher isoquant. If we assume that that the marginal productivities of both the factors of production are positive and decreasing as more of them are used, the isoquant will be downward sloping and convex to the origin. Types of Isoquant: Isoquants are various shapes depending on the degree or elasticity of substitutability of inputs. These are as follows; i)

Linear Isoquant: This type assume perfect substitutability between factors of production, i.e., a given output can be produced by using only capital or only labor or by a large number of combinations of capital or labor.

35

ii) Input-Output Isoquant: It assume strict complementary or zero substitutability between the factors of production, we get input-output isoquant.

NOTES

iii) Kinked Isoquant: This assume limited substitutability of capital and labor. Since there are only a few processes available for producing any commodity, substitutability of factors is possible only at kinks. This form is also called activity analysis isoquant or linear programming isoquant.

iv) Smooth Convex Isoquant: This form assumes continuous substitutability of capital and labor only over a certain range, beyond which factors can not be substituted for each other. Such an isoquant appears as a smooth curve convex to the origin.

36

NOTES

An isoquant is a curve showing all combinations of inputs that can be used to produce a given output. The characteristics of isoquant are as follows. Isoquants are Downward Sloping: Technological efficiency connotes that an isoquant must slope downwards from left to right, which implies that using more of one input to produce the same level of output must imply using less of the other input. Thus if more of labour is used in the production process, then less of capital must be used to produce the same level of output. Slope of the isoquant is equal to: K/L, ratio of capital and labour.

37

NOTES

A higher Isoquant represents a higher output: In the panel I of above figure, if we consider point A on the curve Q1 and the point C on Q2, it can follow that C has more of both labour and capital as compared to A. Thus as per given technology, more of both factors should produce greater output. However you should learn that it is not necessary than on a higher isoquant a point will have greater quantity of at least one of the two inputs as in case of A and B. Hence a greater quantity of any one of the two inputs will render a higher level of output. In short, using more of both inputs and more of either of the inputs must increase output given the state of technology. Hence a higher isoquant Q2 would represent a higher output than isoquant Q1 . Isoquants do not intersect each other: An isoquant represents the same level of outputs with different units of two inputs: intersection of two isoquants would signify single input combinations producing two levels of output. This is explained by Panel II of above figure. Let A and B be two different points on Q1 and Q2 respectively. Suppose two isoquants Q1 and Q2 interested each other at point C. At point B and C of isoquant Q1 the firm produces the same level output Q1. Again points A and C of isoquant Q2 denote the same level of output Q2 any the firm. Thus it follows that at points A and B, the same level of output should be produced. But from the fig it is clear that point A denotes a higher level of output than B; this is contradictory, and hence we conclude that isoquants cannot intersect each other. Convex to the origin: Given substitutability between factor inputs, as the firm continues to employ more of one input say labour and less of other say capital, a situation comes when it becomes difficult to substitute labour for capital. Since labour and capital are not perfect substitutes, therefore as capital (K) is kept fixed to produce additional units of outputs only by increasing laour (L), it would require successively increasing units of labour. This is better understood with the help of the law of the marginal technical substitution (MRTS). The absolute slope of the isoquant falls as we move down the isoquant and the declining MRTSlk determining the convexity of an isoquant.

3.7. ISOCOST LINE OR EQUAL COST LINE The cost equation of the firm is Co = w.L + r.K, where w is the cost of labour, i.e., wages and r is the cost of another input capital, i.e., rate of interest. This equation will be satisfied by different combinations of L and K. the locus of all such combinations is called the equal cost line or isocost line.

38

Cost And Production Analysis

NOTES

In the above figure, if the firm spend entire amount of money i.e., C0 in hiring lanour, the firm will get OB units of labour which is equal to C0 / w. On the other hand, if the firm spends the entire money in purchasing capital, the firm will get OA units of K which is equal to C0 / r. By joining the two points A and B we get the isocost line C0 . With the given cost C0 the firm can purchase any combination of labour and / or capital on the line AB.

3.8. MARGINAL RATE OF TECHNICAL SUBSTITUTION Marginal Rate of Technical Substitution (MRTS) measures the reduction in per unit of one input, due to unit increase in the other input that is just sufficient to maintain the same level of output. Thus for the same quantity of output, marginal rate of technical substitution of labour (L) for capital (K) (MRTSLK) would be willing to give up for an additional unit of labour. Similarly, marginal rate of technical substitution of capital for labour (MRTS KL) would be the amount of labour that firm would be willing to give up for an additional unit of capital.

Consider the isoquant Q1 of above figure, MRTSLK would measure the downward vertical distance (representing the amount of capital that the producer is willing to sacrifice) per

39

unit of the horizontal distance (representing additional units of labour).In other words, MRTS is expressed as the ratio between rates of change in L and K, down the isoquant. Thus:

NOTES

MRTS LK = –

'. 'L

MRTS of labour for capital is equal to the slope of the isoquants, it is also equal to the ratio of the marginal product of one input to the marginal product of other input. Since output along an isoquant is constant, if 'K units of labour are substituted for 'K units of capital, then the increase in output due to increase in , i.e (x ) should match with the decrease in output due to decrease in i.e., (-x MPK). In other words: 'L x MPL = -'Kx MPK Or,

'. 'L

MPL / MPK = 'K- / 'L A change in the level of output can be expressed as change in total output (Q) equals to the sum of change in labour input ('L) times MP of labour and change in capital input ('K) times MP of capital. In other words: 'Q = MPL x + MPK x 'K However, along a given isoquant, output remains unchanged, ie. 'Q = 0. Hence we have MPL x + MPK x 'K= 0 Or, = MPL / MPK - / 'K- / 'L => MRTSLK = MPL / MPK So, the marginal rate of technical substitution between two inputs is equal to the ratio of the marginal physical products of the inputs.

3.9. CHOICES OF INPUT COMBINATION (OPTIMAL INPUT COMBINATION) Maximization of Output Subject to the Cost Constraint: Let us suppose that the production function of the firm is given as Q = f(L,K), given the factor prices w and r for labor and capital, respectively. The firm is in equilibrium when it maximizes its output given its total cost outlay. Suppose that the firm decides on a given cost level Co. With this cost the firm can purchase different combinations of the two factors of production. All these combinations will lie on the isocost line AB in following figure. The objective of the firm is to maximize the level of output while remaining on the given isocost line. In the figure we see that the firm remains on the isocost line AB and purchase any combination of the two inputs lying on the line AB. All the points on the isocost line AB represent equally costly combinations. When the firm is moving from E3 to E1, it can increase its output, since E1 is on a higher isoquant compared to E3. Similarly, by moving from E1 to E, the firm can again increase the level of its output further. E is also

40

the highest possible point that can be attained by a firm while increasing its output at a given cost constraint that can be attained by a firm while increasing its output at a given cost constraint of Co. The movement from E to E2 and further to E4 is not desirable by the firm as by moving to these points the firm decreases its level of output and shift to lower isoquants. The geometric interpretation of the objective of the firm to maximize output subject to the cost constraint, is that the firm tries to attain the highest possible isoquant with the given cost constraint. This happens only when the isoquant is tangent to the isocost line.

Cost And Production Analysis

NOTES

The necessary condition for the maximization of output given the factor prices is that the isoquant line must be tangent to one of the isoquants. This means that the slope of the particular isoquant must be equal to the slope of the isocost line. We know that the slope of the isoquant is given by the ratio of the marginal productivities, i.e.-(MP L/MPK) also known as the MRTSL, K and the slope of the isocost line is given as the ratio of the factor prices, i.e.- w/r. So at the point of tangency we have MPL/MPK = w/r, i.e., the ratio of the marginal products is equal to the ratio of the factor prices. The above condition can also be written in the form: fL / fK = w / r, Where, fL is marginal productivity of labour and fK is the marginal productivity of capital. Rearranging the above equation, we have fL / w = fK / r. Now, fL / w is the amount of output that can be obtained by spending one unit of money in purchasing the factor labor. Similarly, f K / r is the amount of output that can be attained by spending one unit of money in purchasing the factor capital. When these two expressions are equal it means that the firm gets the same amount of output by spending one unit of money either in labor or in capital. In any case, if the equality does not hold, e.g; when fL / w > fK / r the firm will get more output in spending one unit of money on labor than that on capital. Reallocation of the factors of production continues in this way until a point is reached where total output cannot be increased further by such reallocation of expenditure between labor and capital. At such a point total output is maximum.

41

So, in a nutshell, the necessary condition of output maximization can be mathematically represented as MPL / w = MPK / r

NOTES

An underlying assumption to the fulfillment of the above condition is the isoquants must be convex to the origin. However, if the isoquants are concave to the origin, the tangency solution will give us the lowest possible output level. This is because, in the case of concave isoquants the marginal productivity of the factors of production are negative. So, obviously, the highest attainable point on a concave isoquant will rise to the lowest possible output level. Minimization of cost for a given level of output: Least Cost Conditions: In the above part, we have seen how output can be maximized for a given cost constraint. Here we will discuss how the firm minimizes its cost of production for a particular level of output. The conditions of equilibrium of the firm are formally the same as in the previous section.

As the level of output is fixed, we will be having only one isoquant and different levels of cost combinations. For equilibrium, there must be tangency of the given isoquant and the lowest possible isocost line, the shape of the isoquant being convex to the origin. However, the problem is conceptually different in the case of cost minimization. The entrepreneur, in this case wants to produce a given level of output (e.g., a bridge, a building, or q tons of a particular commodity Q) with the minimum possible cost outlay. In this case we will have a single isoquant denoted by Q o which represents the desired level of output, but we have a set of isocost lines denoted by AB, CD and GH in the above figure. Lines closer to the origin will show a lower total cost outlay and vice-versa. The isocost lines are parallel because they are drawn on the assumption of constant prices of the factors of production. The level of output Q o can be produced by different combinations of the two factors of production. The locus of all such combinations is an isoquant for the output level Qo. The problem of the firm is to select a point on the isoquant which is least costly. The firm can produce at any point such as, E 2, E 1, E, E 3, E 4, etc. If we proceed from the points E2 or E4 towards the point E we see that the level of cost at E is much less then the points like E 1, E 2, E 3, or E 4. Here E is the point which corresponds to the lowest possible isoquant line. When we move from E2 to E1 we substitute labor for capital. Such a substitution is possible since total cost is reduced as a result of the substitution. Similarly, as we move from the point E4 to point E3 we substitute capital for labor. Once

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the point E is reached further substitution is no more possible, as any deviation from this point implies an increase in the cost of production. Hence at point E, the cost of production the output level Qo is the minimum. Points below the point E are desirable because they show lower cost, but are not attainable for the output level Qo . Points above the E, shows higher costs. Hence the point E is the least cost point for the output level Qo. The least cost combination is fulfilled when the given isoquant Qo is tangent to the lowest possible isocost line AB, i.e; the slope of the isoquant is equal to the slope of the isocost line, i.e; the ratio of the marginal productivities must be equal to the ratio of the factor prices. This is given as follows:

Cost And Production Analysis

NOTES

MPL/MPK = w / r, which is the same necessary condition, that we had deduced for output maximization given the cost constraint.

3.10. THEORY OF COST Cost is a sacrifice or foregoing that has occurred or has potential to occur in future, measured in monetary terms. Cost results in current or future decrease in cash or other assets, or a current or future increase in liability. Cost is determined by various factors and each of this has significant implications for cost decisions. An increase in any of these will affect cost pattern. The most important determinant is price(s) of factor(s) of production, which are uncontrollable, as they are largely determined by the external environment of any business. The marginal efficiency and productivity of these factors is strongly related to their cost, higher the productivity or efficiency, lower will be the cost of the production, other things remaining the same. Technology is the third important determinant and has the same relationship with the cost as the efficiency of inputs. Other things remaining the same, better the technology enhances productivity and reduces the cost of production. Production and cost analysis constitute the supply side of the market. The production analysis deals with the supply side in terms of physical units of inputs and output, the cost analysis is concerned with the supply side in terms of physical units of output and the cost of production as expressed in nominal terms.

3.11. COST FUNCTIONS Cost functions are derived functions. They are derived from the production function, which describes the availability of efficient methods of production at any one time. Economic theory distinguishes between short-run costs and long-run costs. Short-run costs are the costs over a period during which some factors of production (usually capital equipment and management) are fixed. The long-run costs are the costs over a period long enough to permit the change of all factors of production. In the long run all factors become variable. Both in the short run and in the long run, total cost is a multivariable function, that is, a total cost is determined by many factors. Symbolically we may write the long run cost function as C= f (X, T, Pf) And the short – run cost function as C = f (X, T, Pf, K) Where C = total costs X = output

43

T = technology Pf = prices of factors K = fixed factor(s)

NOTES

Graphically, costs are shown on two-dimensional diagrams. Such curves imply that cost is a function of output, C = f (X), ceteris paribus. The clause ceteris paribus implies that all other factors which determine costs are constant. If these factors do change, their effect on costs is shown graphically by a shift of the cost curve. This is the reason why determinants of costs, other than output, are called shift factors. Mathematically there is no difference between the various determinants of costs. The distinction between movements along the cost curve (when output changes) and shifts of the curve (when the other determinants change) is convenient only pedagogically, because it allows the use of two-dimensional diagrams. But it can be misleading when studying the determinants of costs. It is important to remember that if the cost curve shifts, this does not imply that the cost function is indeterminate.

3.12. VARIOUS TYPES OF COSTS In economic analysis, the following types of costs are considered in studying costs data of a firm: z

Total Cost (TC)

z

Total Fixed Cost (TFC)

z

Total Variable Cost (TVC)

z

Average Fixed Cost (AFC)

z

Average Variable Cost (AVC)

z

Average Total Cost (ATC). and

z

Marginal Cost (MC)

Total Cost (TC) Total cost is the aggregate of expenditures incurred by the firm in producing a given level of output. Total cost is measured in relation to the production function by multiplying factors of prices with their quantities. If the production functions is: Q = f (a, b, c….n), then total cost is TC = f (Q) which means total cost varies with output. For measuring the total cost of a given level of output, thus, we have to aggregate the product of factors quantities multiplied by their respective prices. Conceptually, total cost includes all kinds of money costs, explicit as well as implicit. Thus, normal profit is included in total cost. Normal profit is an implicit cost. It is a normal reward made to the entrepreneur for his organizational services. It is just a minimum payment essential to retain the entrepreneur in a given line of production. If this normal return is not realized by the entrepreneur in the long run, he will stop his present business and will shift his resources to some other industry. Now, an entrepreneur himself being the paymaster, he cannot pay himself, so he treats normal profit as implicit costs and adds to the total cost. In the short run, total costs may be bifurcated into total fixed cost and total variable cost. Thus, total cost may be viewed as the sum of total fixed cost and total variable cost at each level of output. Symbolically, TC=TFC + TVC.

44

Cost And Production Analysis

Total Fixed Cost (TFC) Total fixed cost corresponds to fixed inputs in the short run production function. It is obtained by summing up the product of quantities of the fixed factors multiplied by their respective unit prices. TFC remains the same at all levels of output in the short run. Suppose a small furniture shop proprietor starts his business by hiring a shop at a monthly rent of Rs. 1,000 borrowing Rs. 50,000 from a bank at an interest rate of 10% and buys capital equipment worth Rs. 2,000. Then his monthly total cost is estimated to be: Rs. 1,000 (Rent)

+

Rs. 2,000 + (Equipment cost)

Rs.500 (Monthly interest on th loan)

NOTES

= Rs. 3,500

Total Variable Cost (TVC) Corresponding to variable inputs in the short-run production is the total variable cost. It is obtained by summing up the product of quantities of input multiplied by their prices. Again, TVC = F (Q) which means, total variable cost is an increasing function of output. Suppose, if a shop proprietor starts with the production of chairs and he employs a carpenter on a wage of Rs. 200 per chair. He buys wood worth Rs. 2,000 rexine sheets worth Rs. 1,500, spends Rs. 400 for other requirements to produce 3 chairs. Then this total variable cost for producing 3 chairs is measured as Rs. 2,000 (wood price) + Rs. 1500 (rexine cost) + Rs. 400 (allied cost) + Rs. 600 (labour charges) = Rs. 4,500.

Average Fixed Cost (AFC) Average fixed cost is total fixed cost divided by total units of output. AFC = TFC / Q Where, Q stands for the number of units of the product. Thus, average fixed costs are the fixed cost per unit of output. In the above example, thus, when TFC = Rs. 3,500 and Q = 3. Therefore AFC = 3,500 /3 = Rs. 1,166.67

Average Variable Cost (AVC) Average variable cost is total variable cost divided by total units of output. AVC = TVC / Q where, AVC means average variable cost. Thus, average variable cost is variable cost per unit of output. In the above example, TVC = Rs. 4,500 for Q = 3, Therefore AVC = 4,500 / 3 = Rs. 1,500

Average Total Cost (ATC) Average Total Cost or average cost is total cost divided by total units of output. Thus: ATC or AC = TC / Q In the short run, since TC = TFC + TVC ATC = TC / Q = TFC + TVC / Q = (TFC / Q) + (TVC / Q) Since = TFC / Q = AFC and TVC /Q = AVC, Therefore ATC = AFC + AVC. Hence, average total cost can be computed simply by adding average fixed cost and average variable cost at each level of output. To take the above example, thus ATC = Rs. 1,166.67 + Rs. 1,500 = Rs. 2,666.67 pr chair.

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Marginal Cost (MC) The marginal cost is also per unit cost of production. It is the addition made to the total cost by producing one more unit of output. Symbolically, MCn = TCn –TCn – 1, that is, the marginal cost of the nth unit of output is the total cost of producing n units minus the total cost of producing n – 1 (i.e. one less in the total) units of output.

NOTES

Suppose the total cost of producing 4 chairs (i.e. n = 4) is Rs. 10,000 while that for 3 chairs (i.e. n – 1 is Rs. 8,000. Marginal cost of producing the 4th chair, therefore, works out as under: MC4 = TC4 – TC3 = Rs. 10,000 – Rs. 8,000 = Rs. 2,000. Marginal cost is the cost of producing an extra unit of output. In other words, marginal cost may be defined as the change in total cost associated with a one unit change in output. It is also an “extra – unit cost” or incremental cost, as it measures the amount by which total cost increases when output is expanded by one unit. It can also be calculated by dividing the change in total cost by the one unit change in output. Symbolically, thus, MC = 'TC / '1Q where, ' denote change in output assumed to change by 1 unit only. Therefore, output change is denoted by ' 1.

It must be remembered that marginal cost is the cost of producing an additional unit of output and not of average product. It indicates the change in total cost of producing an additional unit.

3.13. RELATIONSHIP BETWEEN (AVERAGE COST) AC AND (MARGINAL COST) MC Economists have observed a unique relationship between the two as follows: z

When AC is minimum, the MC is equal to AC. Thus, MC curve must intersect at the minimum point of ATC curve.

z

When AC is falling, MC is also falling initially, after a point MC may start rising but AC continues to fall. However AC is greater that MC (AC > MC). Hence ultimately at a point both costs will be equal. Thus, when MC and AC are failing, MC curve lies below the AC curve.

z

Once MC as equal to AC, then the output increases AC will start rising and MC continues to rise further but now MC will be greater than AC. Therefore, when both the costs are rising, MC curve will always lie above the AC curve.

The above stated relationship is easy to see through geometry of AC and MC curves, as shown in following figure. It can be seen that

46

z

Initially, both MC and AC curve are sloping downward; MC curve lies below AC.

z

When AC curve is rising, after the point of intersection, MC curve is above it.

z

It follow thus when MC is less than AC, it exerts a downward pull on the AC curve. When MC us more than AC it exerts an upward pull on the AC curve. Consequently, MC must equal AC, while AC is at the minimum. Hence, MC curve intersects at the lowest point of AC curve. It may be recalled that MC curve also intersects the lowest point of AVC curve. Thus, it is a significant mathematical property of MC curve that it always cuts both the AVC and ATC curve at their minimum points.

In the following figure, the MC curve crosses the AC curve at point P. At this point, for OQ level of output the average cost of PQ which is minimum.

Cost And Production Analysis

NOTES

It should be noted that no such relationship can ever be traced between the MC curve and the AFC curve simply because by definition, the MC curve is independent. Further, the area underlying the MC curve is equal to the total variable cost of the given output. In fact, the point on each average cost curve measures the average cost but the area underlying them denote total costs as under: z

Total, area underlying the AFC curve measures the total fixed cost.

z

The area underlying the AVC curve measures the total variable cost.

z

The area underlying the MC curve measures the total variable cost.

z

The area underlying the ATC curve measures the total cost.

Finally, the MC curve is important because it is the cost concept relevant to rational decision making. It has greater significance in determining the equilibrium of the firm. In fact, the increasing MC due to diminishing returns sets a limit to the expansion of a firm during the period. Further, it is the MC curve which acts on the supply curve of the firm. From the above discussion of cost behavior we may conclude that short run average cost curves (AVS, ATC and MC curves) are U shaped, except then AFC curve, which is an asymptotic and downward sloping curve.

3.14. LONG AND SHORT RUN COST CURVES In the long run, all inputs (factors of production) are variable and firms can enter or exit any industry or market. Consequently, a firm’s output and costs are unconstrained in the sense that the firm can produce any output level it chooses by employing the needed quantities of inputs (such as labor and capital) and incurring the total costs of producing that output level. The Long Run Average Cost (LRAC) curve of a firm shows the minimum or lowest average total cost at which a firm can produce any given level of output in the long run (when all inputs are variable).

47

In the long run, a firm will use the level of capital (or other inputs that are fixed in the short run) that can produce a given level of output at the lowest possible average cost. Consequently, the LRAC curve is the envelope of the short run average total cost (SR ATC) curves, where each SR ATC curve is defined by a specific quantity of capital (or other fixed input).

NOTES

In the short run, because at least one factor of production is fixed, output can be increased only by adding more variable factors. Hence we consider both fixed and variable costs. Fixed costs are business expenses that do not vary directly with the level of output i.e. they are treated as independent of the level of production. Examples of fixed costs include the rental costs of buildings; the costs of leasing or purchasing capital equipment such as plant and machinery; the annual business rate charged by local authorities; the costs of full-time contracted salaried staff; the costs of meeting interest payments on loans; the depreciation of fixed capital (due solely to age) and also the costs of business insurance.

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Amity School of Distance Learni ng

Fixed costs are the overhead costs of a business. They are important in markets where the fixed costs are high but the variable costs associated with making a small increase in output are relatively low. We will come back to this when we consider economies of scale. z

Total fixed costs (TFC) remain constant as output increases,

z

Average fixed cost (AFC) = total fixed costs divided by output

Cost And Production Analysis

NOTES

Average fixed costs must fall continuously as output increases because total fixed costs are being spread over a higher level of production. In industries where the ratio of fixed to variable costs is extremely high, there is great scope for a business to exploit lower fixed costs per unit if it can produce at a big enough size. Consider the new Sony portable play station. The fixed costs of developing the product are enormous, but these costs can be divided by millions of individual units sold across the world. A change in fixed costs has no effect on marginal costs. Marginal costs relate only to variable costs!

3.15. COST AND OUTPUT RELATIONSHIP (COST FUNCTION) Cost- output functional relationship is expressed by the cost function. Thus: C = f (Q), Where, C = total cost, Q = output Quantity The cost function of the firm gives the functional relationship between total cost and total output. The same level of output can be produced with the help of different cost combinations. The cost function gives the least cost combinations for the production of different levels of output.

3.16. SHORT RUN AND LONG RUN The short run is a period during which one of the factors of production is considered to be constant (assuming that there are only two factors of production labour and capital) and the other is variable. Usually it is assumed that capital is the fixed factor in the short run. All costs are variable in the long run since factors of production, size of plant, machinery and technology are all variable. This in turn implies radical changes in the cost structure of the firm. The long run cost function is often referred to as the ‘planning cost function’ and the long run average cost (LAC) curve is known as the ‘planning curve’. As all cost are variable, only the average cost curve is relevant to the firm’s decision-making process in the long run. The long run consists of many short runs, e.g., a week consists of seven days and a month consists of four weeks and so on. So, the long run cost curve is the composite of many short run cost curves.

3.17. ECONOMIES / DIS-ECONOMIES OF SCALE The LAC curve is the mirror image of the returns to the scale in the long run. It is apparent that since returns to the scale are based on the internal economies and the diseconomies of scale, the long run average cost curve traces these economies of scale. As a matter of fact increasing returns to scale can be largely traced to the economies which become available to a firm when it expands its scale of operations. As a result of these economies, the firm enjoys a number of cost advantages and return in terms of total output. Thus, economies of scale explain the falling segment of the LAC curve. This shows that the

49

decline average cost of output in the long run is due to economies of large scale enjoyed by the firm. Increasing LAC is attributed to the diseconomies of scale after a certain point of further expansion.

NOTES

In short economies and diseconomies of large scale play a significant role in determining the shape of the LAC curve. Again the structure of an industry is also affected by the cost consideration which is conditioned by the economies and diseconomies of scale. Of the many determinants of the number and size of firms in an industry , the, cost consideration and relevant economies and diseconomies are a significant determining factor. Increasing average costs in the long run, attributed to the growing diseconomies of scale, set a limit to the further expansion of the firm. Economies and diseconomies of scale reflect upon the behavior of LAC curve. Analytically speaking the downward slope of the LAC curve may be attributed to the internal economies of scale. Similarly, the upward slope of the LAC curve is caused by the internal diseconomies of scale. And the horizontal slope of the LAC curve may be explained in terms of the balance between internal economies and diseconomies.

In short, the internal economies and diseconomies have their significance in determining the shape of the LAC curve of a firm. However, the shift in the LAC curve may be attributed to the external economies and diseconomies. External economies reflect in reducing the overall cost function of the firm. Thus, a downward shift in the LAC may be caused by external economies as shown in following Figure. In above figure, ABCD is the LAC curve. Its AB portion – the downward slope – is subject to the internal economies. Its BC portion – the horizontal slope – is due to the balance between economies and diseconomies. Its CD portion – the upward slope – is subject to internal diseconomies. In following figure, the original LAC 1 curve shifts downward as LAC2 on account of external economies.

50

Cost And Production Analysis

NOTES

Similarly, an upward shift in the LAC curve may be attributed to the external diseconomies, as shown in following figure.

In above figure, the original LAC 1 curve shifts up as LAC2 owning to the external diseconomies.

3.18. THE THEORY OF FIRM (PROFIT MAXIMIZATION MODEL) Economists have been using the model of profit maximization for a long time. The ‘theory of firm’ has been developed on the basis of the assumption that rational firms pursue the objective of profit maximization, subject to the technical and market constraints. The basic propositions of the theory of firm may be summed up as:

51

(a) Firm is a unit which transforms valued inputs into outputs of a higher value, given the state of technology. (b) The firm strives towards the achievement of its goal- usually profit maximization. (c) The market conditions (like competition, monopoly, etc.) for a firm to operate are given.

NOTES

(d) While choosing between alternatives, the firm prefers the alternative which helps it to consistently achieve profit maximization. (e) The primary concern of the theory of firm is to analyze changes in the price and quantity of inputs and outputs. Taking these as central points, the theory of firm has been carried to varying degrees of elaboration and refinement. Before taking it up in detail, let us note the basic assumptions on which this theory rests. Assumptions of the Model: 1. The firm has a single goal , viz., to maximize profit( Motivational assumption) 2.

The firm acts rationally to pursue its goal. Rationality implies perfect knowledge of all relevant variables at the time of decision-making.

3. The firm is a single ownership one, i.e; run by its owner, called the entrepreneur. The Model: The term ‘profit maximization’ is usually taken to mean the generation of largest absolute amount of profits over the time period being analyzed. This then leads us to defining the term ‘time period’. Economists have suggested two broad time period: the short-run and long-run; consequently, there is short-run and long-run profit maximization. The short run is defined as a period where adjustments to changed conditions are only partial, e.g.; if defined for the product for a firm increases, in the short run it can meet the increased demand through changes in man-hours and intensive use of existing machinery, but it cannot increase its production capacity. On the other hand, long-run is a period where adjustment to changed circumstances is complete. For example, the above mentioned firm can meet the increased demand in the long-run by making changes in its production capacity or by setting up an additional plant, besides changes in man-hours and intensive use of its existing machinery. Thus, in the short-run there are certain constraints (physical or financial) on expansion. As time passes, these constraints can gradually be overcome. And, when all the constraints are overcome, the long-run is reached. No calendar time can be specified for short-run or long-run. It depends upon the nature of production. For example, a furniture workshop can increase its capacity and make complete adjustments within a matter of months, while a firm manufacturing automobile may take years to do so. The long-run will, therefore, be a matter of months in case of furniture workshop and a matter of years for an automobile firm. Relationship between Short-run and Long-run Profit Maximization: We know that the long-run consists of a number of short-run periods. But, it implies that if the firm maximizes profit in the short-run, it must be found to maximize in the long-run also. It depends upon the two following conditions; 1.

Assumption of independence of periods. Is each short-run period considered in isolation, in the sense that a short-run period has no effect which link this period to the next period?

2.

Assumption of period-linkages- Each short-run period is linked to the next short-run period.

Under the assumption of independence of periods, the short-run and long-run profit maximization is consistent. On the other hand, with the assumption of period-linkages,

52

the profit maximization in the two periods may conflict. For example, a firm which dominates the market may decide to restrict supplies in order to change higher price to maximize profits. This would, in the long-run, attract rival firms into the industry, thus forcing a reduction in the price and profits of the dominant firm. Had the firm not attended to maximize profits in the short-run the rival would not possible have been attracted to the industry, thus allowing the dominant firm to achieve long-run profit maximization. Here the short-run profit maximization policy results in the defeat of long-run profit maximization. Several instances may be cited where a conflict between the profit maximization in the two periods may exist, like:

Cost And Production Analysis

NOTES

(a) Higher profits in the short-run may in the long-run induce workers to demand higher wages. (b) Maximization of profits in the short-run may give an impression of being exploitative, thus inviting legal or government intervention which would affect long run profits adversely. (c

A firm trying to build up its reputation by charging low prices and supplying quality products in the short run would be able to make long run profits.

It may however be noted that the assumptions of independence of period are not found tenable in practice. On the other hand the period linkage are considerably affected by the condition of uncertainty since the dependence of one period on the other involves future reactions, there remains an element of uncertainty. The extent of uncertainty increases the further we go into the future. This perhaps is the reason why firm prefer short run profit maximization to the long run. There is however a major problem if the firms prefer long run rather than short run profit maximization. In such cases almost any decision can be defended on the basis that it aims at long run profit maximization, e.g. extravagancy in the reception facilities may be defended on the grounds of improving firms’ public image which would contribute to long run profits. Determination of profit maximizing output and price The approach of the traditional economic theory is that the firm compares the cost and revenue implication of different output levels and fix up the output level that maximizes the absolute difference between the two. Let TR and TC be the total revenue and total cost at a given level of output X .then profit (‡) at that level of output would be, ‡ =TR-TC For ‡ to attain the maximum value, the firm shall produce that level of output where the following two marginal conditions are satisfied:

53

which implies that the slope of MR curve is less than the slope of MC curve. An output level (X) which satisfies both the above conditions would be the profit-maximizing level of output.

NOTES

Since profit (ð) is the difference between total revenue (TR) and total cost (TC), the profitmaximizing output will occur when the gap between TR and TC is maximum. In Fig. 3.1, TR and TC curves represent the total cost and total revenue for different output levels. The gap between TR and TC is maximum at output Oq* where the slopes of the two curves are equal. Since slopes of total cost and total revenue curves are marginal cost (MC) and marginal revenue (MR) respectively, it implies that profit is maximized at that output level where MR=MC. Limitations: The traditional theory suggests a number of reasons as to why do a firm want to maximize profits. All these reasons essentially fall into the following categories: 1.

Traditional economic theory assumes that the firm is owner-managed, and therefore maximizing profit would imply maximizing the income of the owner. Owner would like to have adequate return for his activity as an entrepreneur. Maximizing-profits for a given amount of effort will, therefore, be quite a rational behavior for him.

2.

The very survival of the firm depends upon the entrepreneur’s ability to maximize profits in the long run. The goal of profit maximization is, in fact, forced upon him by the impact of the competing firms. By maximizing profits the firm can accumulate financial assets which allow it to grow faster than those firms which pursue goals other than profit maximization – share of the latter gradually shrinks and such firms eventually get eliminated. In case of monopoly situation, where there are no rivals to force him to maximize profits, he would like to pursue this goal to achieve the maximum return for his efforts.

3. Firm may pursue goals other than profit-maximization, but they can achieve these ‘subsidiary’ goals much easier if they aim for profit-maximization. These justifications of profit-maximization have been subjected to severe criticism and certain alternative goals have been suggested by economists. Some of the main points of criticism are the following: 1.

54

In the context of real business situation the assumption of profit-maximization is of doubtful validity. There is no reason to believe that all businessmen pursue the same goal. They may aim at sales maximization, expansion of market share, etc.

2.

The assumption of traditional theory that firms are owner-managed is not valid in the modern business world where firm is a complex organization run by salaried managers whose interests may, and often do, differ from those of the shareholders who want maximum profits.

3.

In the absence of usually incomplete information all the business decisions may not be optimal. This lack of information may be of two types: a) Since business decisions always, directly or indirectly, relate to the future, and since future is always uncertain, the businessman’s decisions may not always be what he wants them to be. b) Further, the lack of information also results from the failure or inability of the firm to collect the adequate information and to use the information it already possesses. Former results due to expensiveness of collection of information, and the latter due to the difference in what the business firm collects and what it actually needs.

4.

The modern business firm divides itself into separate departments, each having a considerable degree of autonomy in its operations. Under these conditions it is not possible for those at the top of the firm to ensure that decisions taken in particular departments or functions fit in with the overall policy of the firm and whether these decisions lead to the overall optima for the whole firm. It will be more appropriate to say that given the organization of the modern firm and its problems, firms are often too complex for any individual or group to be able to see them as a whole.

5.

One cannot say that in non-competitive situations the firms that do not maximize profits will be driven out of business; and that, under such a situation a profit-earning firm need not quickly adjust to changes in the economic environment. It is also not true that these adjustments will be done in the direction which economic theory has predicted. For example, if there is a large group of firms, demand for whose products remains at a very high level for a long period of time, any firm in this group, however inefficient, will be able to survive. It has been found that where profits are easy to come the keen quest for profits will be abandoned in many cases. Such a situation was there in advanced countries during the long period of inflation and full employment after World War II. Further, the firms might enter into open or tacit agreement to avoid some kinds of competition, especially price competition. These agreement are found quite often in markets like those for automobiles, aircrafts, detergents and chemicals. Thus, while the assumption of profit maximization has served economics well for many years, it is clear that it needs supplementing by other assumptions.

6.

It has been observed in the modern business world that the emerging dominant market structure is oligopoly, where a few large firms dominate the market. The small firms often have to follow these large firms in fixing the price. Under such circumstances how can these small firms (which are generally in majority) are expected to pursue the goal of profit-maximizations?

7.

Lack of predictive power of managers, and they generally being risk-averse, results in firms settling with less-than-maximum profit as their goal. Firms are prevented to maximize profits also because they generally suffer from lack of proper intra-firm communication.

Cost And Production Analysis

NOTES

Literature criticizing profit-maximization hypothesis is extensive and much of it is of considerable economic and philosophical subtlety. However, the attack on profit-maximizing hypothesis is threefold: a) Firms cannot have profit maximization as their goal as they lack the necessary information and ability to do so. b) Even if the firms could, they do not want to pursue profit-maximizations. There are multiplicity of goals a modern firm pursues and profit-maximizations may be only one of them; and,

55

c)

Firms do not maximize profits but face some bind of minimum profit constraint. The management has discretion in setting goals subject to minimum profit constraint.

Some alternatives suggested Economists have suggested the following alternatives to the goal of profit-maximization:

NOTES

1.

Papandreou argues that organizational objectives grow out of interaction among the various participants in the organization.

2.

Baumol argues that firms seek to maximize sales (i.e., total revenue) subject to a profit constraint.

3.

Rothschild suggests that the primary motive of enterprise is long-run survival. Decisions, therefore, aim to maximize the security of the organization. Feller has similarly argued that firms are interested in safety margins.

4.

Scitovsky argues that the entrepreneur chooses between greater profit and more leisure.

5.

Cooper suggests that businesses (mainly banks) attempt to maintain liquidity sufficient to assure the firm’s financial position and retention of control.

6.

The other objectives suggested include the maintenance of the firm’s share of the market, payment of good wages and the welfare of employees, growth of firm, excellence of a product, and the maintenance of good public relations.

These alternatives emphasize goals other than profits, though most of them do not exclude profit as a constraint within which firms pursue these goals. Some empirical studies point out that firms have a profit goal but that they do not attempt to maximize profits. But in defense of the goal of profit maximization, one may say that from the array of alternative goals suggested to dispense with the profit motive, no single goal has gained wide acceptance. It would be more appropriate to say that these alternative goals are not so much intended to replace the profit maximization hypothesis as to deny its primary importance. Business goals are probably multiple. Moreover, though profits enter into the calculations of every business, it is more difficult to sustain the views that firms do maximize profits. In a complex environment, where information is lacking and uncertainties prevail maximization of profits is generally unattainable. It may, therefore, be safe to conclude that there is no universally acceptable objective for business policy and, therefore, it is impossible to point out a single, simple, obvious criterion of business efficiency. Each business must define its own objectives, which may have to satisfy the needs of those groups whose co-operation makes the continued existence of business possible; the shareholders, management, employees and customers. Businesses have multiple goals and the needs of survival, goodwill, security or growth commonly call for some sacrifice of short-term profits. In short, though profit is not the only goal of the business, it is an extremely important one.

3.19. BREAK-EVEN AND SHUT-DOWN POINT Breakeven point is the point where total cost just equals to the total revenue; it is the no profit no loss point. It is an important application of cost analysis. It examines the relation between total revenue, total cost and total profits of a firm at different levels of output. This analysis is about determining profit at various projected levels of sales, identifying the breakeven point, and making a managerial decision regarding the relationship between likely sales and the breakeven point. ‘Break-even analysis’ is used synonymously with Cost Volume Profit Analysis, though many are of opinion that finding the breakeven point is just the first step in any planning decision. There are several approaches of breakeven

56

analysis, but here we would explain graphical method only. Total revenue and total cost measured in the vertical axis and output is measured in the horizontal axis. Here, total cost (TC) is total fixed cost (TFC) plus total variable cost (TVC); i.e., TC = TFC +TVC. Total revenue (TR) is 45o line, which starts from origin, where output (Q) is zero and TR is also zero. In the following figure, at point E, the total revenue is equal to total cost, i.e., TR=TC, that means no loss no profit case. In this case, the total output is OQe units. So, the breakeven point is E and Breakeven amount of output is OQe units.

Cost And Production Analysis

NOTES

The fixed cost is that cost which is occurs irrespective of output, which means the firm has to bear this TFC even when the production is stopped. To get normal profit or zero profit, the firm has to cover TC (TFC + TVC). But if the firm is not able to cover this TC then also the firm will continue to produce up to the level where the loss amount is equal to TFC. Because, the firm is identical in both the cases, i.e., if stopped production then the maximum amount of loss is TFC or if they produce then also they can bear the same amount of loss (equal to TFC). So, in the following figure, the shut-down point is S and shut-down output is OQs.

3.20. MANAGERIAL THEORIES OF THE FIRM The main argument of managerial theories is that in modern large firms, ownership and control are divorced. Managers, therefore, have a primary role in the effective control of the firm. The firm, then, seems to behave so as to maximize managerial objectives rather than shareholder’s profits. Like the traditional theory of firm the managerial theories are also optimizing theories, though what is maximized differs: in the theory of firm it is the profit maximization, while in the managerial theories it is the maximization of managerial utility. Different managerial theories of the firm view managerial utility as a function of different combinations of variable like, salary, status, power, growth and job security. Managerial theories may be broadly classified into three categories: 1. Sales Revenue Maximization Model by Baumol, 2. Managerial Utility Models, and 3. Growth Maximization Models.

57

3.21. BAUMOL’S MODEL Baumol pointed out that the oligopolistic firms aim is to maximize their sales revenue not profit maximization. According to him, the reasons behind this are as follows: z

NOTES z

Financial institutions judge the health of a firm largely in terms of the rate of growth of its sales revenue. Salaries of top management are correlated more closely to the firm’s sales than with its profits.

z

Growing sales help in keeping a healthy personnel policy, thus keeping employees happy by giving them higher salaries and better terms.

z

Managers prefer the steady performance with satisfactory profits than spectacular profit-maximization projects. This is so because if the managers declare their aim as spectacular profit maximization but, for obvious reasons, cannot give the spectacular profit year after year, they shall be penalized for the non-achievement of the goal.

z

Large and growing sales by maintaining or increasing the market share of the firm increases the competitive power of the firm.

Assumptions: The firms while pursuing the goal of sales maximization cannot completely ignore the shareholders. The goal of the firm is, thus, the maximization of sales revenue subject to a minimum profit constraint. The profit constraint is determined by the expectation of the shareholders and to enable it to raise new capital at a future date. The assumptions are follows. 1. Goal of the firm is sales maximization subject to minimum profit constraint. 2.

Advertisement is a major instrument of the firm as non-price competition is the typical form of competition in oligopolistic markets.

3. Production costs are independent of advertisement. 4. Advertisement will always result in creating favourable conditions for the product. 5. Price of the product is assumed as constant. The Single-Period model: According to Baumol, it is only after the profit constraint has been satisfied that profits became subordinate to sales in the firm’s hierarchy of goals. In the following figure, the profit constraint is shown by a line ‡. Obviously, sales maximiser will keep on selling till the MR remains positive. So, the sales maximiser’s level of output would be OQ1 where MR (dTR / dQ) equal to zero. If the minimum profit constraint (‡0 ) is above the level of profits where MR=0 (at point K1), the sales revenue maximiser is ‘constraint’ to stop at OQ3 output where minimum profit constraint ‡0 is met. On the other hand, if minimum profit constraint is ‡ (which is less than the profits where MR=0) then the sales revenue maximiser will face no ‘profit constraint’ and would, therefore, produce OQ1 output. Thus, if the minimum profit constraint is less than the maximum profit, the sales maximiser will produce a greater output than the profit maximiser.

58

TC

Cost And Production Analysis

NOTES

Implications of Baumol’s Model: If both the profit maximiser and a constrained sales maximiser face the same demand curve, the later will charge a lower price to sell the extra output (Q3 – Q1 ). A sales maximiser will spend more on advertisement than does a profit-maximiser firm. Baumol assumes that advertisement does not affect the product’s price but it does lead to increased output sold. It is also assumed that advertisement will always lead to a rise in TR; MR will never become negative. This is shown in the following figure. Since, advertisement will always increase TC; the management will increase advertisement until prevented by the profit constraint (‡0 ).

59

3.22. MARRIS MODEL

NOTES

Marris tried to improve upon Baumol’s model. He offered a variation of Baumol’s model that stressed the maximization of growth subject to the security of management’s position. Marris’ hypothesis is that executive actions are limited by the need for management to protect itself from dismissal or takeover raids in the event of failure. Like Williamson, Marris’ approach is also based on the fact that ownership and control of the firm is in the hands of two different sets of people. He, like Williamson, also suggested that manager have a utility function in which salary, status, power, prestige and security are important variables. Owners of the firm (i.e.; shareholders) are, however, more concerned about profits, market share, output etc. In other words, goals of the managers and shareholders differ from each other. The utility function of managers (Um) and that of the owners (Uo) may, therefore, be defined as: Um = f (salaries, power, status, job security) And, Uo = f (profits, market share, output, capital, public esteem). In contrast to Williamson, Robin Marris believes that most of the variables entering into the utility function of managers and owners are strongly correlated with a single variable: the size of the firm. He, therefore, postulates that the managers would be mainly concerned about the rate of the growth of size. However, various measures of size exist, like capital, output, revenue, and market share. Marris defines size in terms of corporate capital, which is measured as the “sum total of the book value of assets, inventory and short-term assets including cash revenue.” Further, it may be noted that managers aim to maximize rate of growth of size rather than absolute size, as the managers generally wish to stay in the concern and grow rather than move from a smaller size firm to a bigger size firm. Moreover, maximizing the rate of growth of size also satisfies the owners, while absolute size may not. Thus, the attraction of the growth rate of size stems from the fact that not only it has a positive effect upon the prospects of promotion of the managers, but it also keeps the shareholders satisfied. Marris recognizes that the drive for the rate of growth of size is not, however, without constraints. He lists mainly two constraints to the achievement of maximization of the rate of growth: (a) Marris adopts Penrose’s thesis of the existence of a sure limit on the rate of managerial expansion. In other words, the capacity of the managerial team in fact determines the upper limits to the growth of the firm. There is a high possibility that management would lose control over a rapidly growing firm. There is a limit to output increase by hiring new managers due to their lack of experience. And the time-lag involved in their acquiring the specific corporate culture and developing coordination with the existing managerial team. The ability of manager to find and successfully launch new products to take the place of old ones is also subject to a limit. Similarly, the research and development department cannot be expected to produce expanding flow of products continuously. All these factors are strong enough to set a limit to the rate of growth of size of the firm. (b) The second constraint on the rate of the growth stems from the voluntary slowing down process by the management itself. This slowing down process comes from the desire of the management for job-security. The management which holds high the consideration of job security would grow in such a way that it remains safe on the financial side. For example, in case management aims to achieve growth at any cost, it should not hesitate to borrow large sum of money from the capital market for investment purpose. But increased rate of borrowing may give out an impression of follow-

60

ing a less prudent financial policy, thus inviting take-over bid by another firm. This would definitely be real danger to the job-secure motivation of the managers. Obviously, there is definite disutility of risk and the managers would like to seek the job security through the adoption of a cautious and prudent financial policy which would consist of: non-involvement in risky investments; financing growth mainly from the profit levels being generated by the present set of products. The ratio of external to internal finance is not allowed to grow significantly.

Cost And Production Analysis

NOTES

To judge the prudent of a financial policy, Marris proposes the concept of financial constraint (a) which is mainly determined by the risk attitude of the top management. A risk-loving management would prefer a high value of a, while a risk-averting management would prefer a low value of a. Marris defines ‘a’ as the weighted average of the following three security ratios: Liquidity Ratio (a1) = Liquid Assets/Total Assets; Leverage Ratio (a2) = Value of Debts/Total Assets; Profit-Retention Ratio (a 3) = Retained Profits/Total Profits. Low liquidity ratio implies the possibility of insolvency of the firm. High liquidity, of course increases the security, but a too high liquidity ratio has an adverse impact on rate of growth. To ensure security the management has, therefore to choose a level of a1 which is neither too high nor too low. The leverage ratio relates to the extent of reliance on borrowing for expansion purposes. A high and growing leverage ratio would invite takeover bids and increase the rate of failure, while a too low leverage ratio would retard growth. Retained profits are perhaps the most important financial source for the growth of capital. But, a high level of retained profits is perhaps the most important financial source for the growth of the capital. But a high level of retained profits cannot keep the shareholders happy and a too high a3 would mean that management is taking a risk of displeasing the shareholders. As is obvious from the discussion above, value of the financial constraint (a) would increase if either a2 or a3 are increased or a1 is reduced. That is, liquidity ratio and profit-retention ratio are positively related. Marris further postulates that there is a negative relationship between job-security and the financial constraint: job security of managers is reduced if a is increased and job security increases if a is reduced. Thus, financial security constraint determines the level of job security and therefore limits the rate of growth of the capital supply and thereby the rate of growth of size of firm. Model: Merris argues that the managers would aim to have a balanced growth, in the sense that growth in demand (stemming mainly from new products) would be matched by growth in capital (making available the investible funds for launching and producing these products). That is, the managers would want to maximize balance growth rate (g), which is equal to the growth rate of demand for the product (gd) and growth rate of capital supply (gc): Max. g = gd= gc By this process the managers achieve maximization of their own utility as well as that of the shareholders. In case the management wants to expand too rapidly (by undertaking highly risky projects, resorting to heavy borrowing for expansion, etc.), it runs the risk of job security. On the other hand, if it wants to expand too slowly (due to lack of initiative in finding new market and products, keeping excessive reserves by high profit-retention ratio but shying away from new investment projects), it would be considered as an inefficient management, again impairing job-security. The first step to achieve balanced growth rate would be to identify the factors that go in to determining gd and gc. According to Marris, these determinants can be expressed in terms of two variables:

61

1. Diversification rate(d); 2. Average profit margin (m).

NOTES

Both these variables can be however determined only after the management has decided about its financial policy, a. The diversification rate can be chosen either by changes in style of the existing products or by expanding the range of products. Given the price of the product and the production cost, the average profit margin would be affected by the levels of advertising and R&D. Higher the expenditure on advertisement (A) as well as R&D, lower would be average profit margin (m). Thus, the Marris’ firm has three policy variables: a, d and m. Marris also points out that there can be a conflict between managers’ objective of maximizing growth and stockholders’ objective of maximizing profits. Therefore, if the growth maximizing solution does not generate sufficient profits, growth rate will have to be reduced to increase dividend to meet shareholders’ expectations. In brief in Marris model the management, whose actions are limited by the motivation to protect itself from dismissal or take over bids, takes to the following course: 1.

The management must walk on a knife-edge between debt/assets ratio high enough to stimulate growth but not low enough to suggest financial imprudence.

2.

The management must also maintain a low liquidity ratio, i.e; liquid asset/total assets. But this ratio must not be so low that it endangers paying all obligations on time.

3.

The management must try to keep a high retention ratio, viz., retained earnings/total profits. But this ratio should not be so high that shareholders are not paid satisfactory dividend.

3.23. SUMMARY The theory of cost is a fundamental concern of . The best measure of resource cost is the value of that resource in its highest-valued alternative use. The cost of a long-lived asset during the production period is the difference in the value of that asset between the beginning and end of the period. The cost function relates cost to specify rates of output. The basis for the cost function is the production function and the price of the inputs. In the short run, the rate of one input is fixed. The cost associated with that input is called fixed cost. In the long run, all costs are variable. The long-run average cost curve is the envelope of a series of short run average cost curves. The long run cost functions are used for planning the optimal scale of plant size.

Check Your Progress 1. If a change in all inputs leads to a proportional change in the output, it is a case of (a) Increasing returns to scale,

(b)

Increasing returns to scale,

(c) Diminishing returns to scale,

(d)

Variable returns to scale

(a) Equal cost lines,

(b)

Equal product lines,

(c) Equal revenue lines,

(d)

Equal total utility lines

2. Isoquants are

62

Cost And Production Analysis

3. When average product is highest (a) Total product is maximum,

(b)

Total product is maximum,

(c) Marginal product is zero, (d) Marginal product is equal to average product

NOTES

4. If marginal product is negative, it means that the (a) Total product is at maximum,

(b)

Average product is at maximum,

(c) Average product is falling,

(d)

Total product is increasing

5. Which of the following curves is called envelope curve? (a) Long run total cost curve,

(b)

Long run average total cost curve,

(c) Long run marginal cost curve,

(d)

Long run average variable cost curve

Questions and Exercises 1. Explain the concept of Production Function with the help of a two-input and oneoutput case. 2. What is the law of diminishing return as applied to any production system? 3. Define returns to scale. What is the significance of increasing, decreasing and constant returns to scale? 4. What are Isoquants? Describe the characteristics of Isoquants. 5. What is Isocost Line? How do they help in finding the least cost combination of inputs? 6.

Define and explain expansion path.

7.

The various possible combinations of two inputs, labour and capital, which can produce 100 units of output are given as below: L

2

3

4

5

6

K

20

15

12

10

9

If the prevailing prices of labour and capital are Rs. 15 per unit and Rs. 12 per unit, find out the least cost combination of these inputs. 8.

“The behaviour of costs is determined by several factors.” Comment.

9. Explain the short-run cost-output relationship with the help of a hypothetical example. How do the different costs behave with the changes in output? 10. Long-run cost-output relationship is an envelope of the family of short-run cost curves. Give your comment. 11. Explain economies and diseconomies of scale. Are these short-run and long-run phenomena? 12. Discuss in details the factors that cause economies and diseconomies of scale.

Fundamental Questions 1. What is production? 2. What are factors of production? 3. What are the difference between short run and long run?

63

4. What are the inputs and outputs? 5. What is cost? 6. How do we define total, average and marginal product of labour? 7. What is Marginal Rate of Technical Substitution (MRTS)?

NOTES

8. What is Law of Variable Proportion? 9. What are economies of scale? 10. What are the basic features of profit maximization model? 11. Why long run average cost curve is the envelope of short run average cost curves? 12. Why marginal cost curve passes through the minimum point of average cost curve?

Further Readings z

Hirschey, Economics for Managers, Cengage Learning

z

Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning

z

Froeb, : A Problem Solving Approach, Cengage Learning

z

Mankiw,

Economics: Principles and Applications, Cengage Learning z

Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill

z

Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice Hall of India

R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics Macmillan. z

64

z

Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.

z

Koutsoyiannis,A. Modern Economics, Third Edition.

z

Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Review, 6th Edition, Tata McGraw Hill.

z

Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking.

UNIT 4 MARKET STRUCTURE ANALYSIS STRUCTURE

Market Structure Analysis

NOTES

4.1. Objectives 4.2.

Introduction: - Perfect Competition 4.2.1.

Assumptions of perfect competition:

4.2.2.

Short Run Equilibrium

4.2.3.

Long Run Equilibrium

4.3. Monopoly: – Price Discrimination 4.3.1.

Monopoly

4.3.2.

Price and Quantity Determination in Short Run

4.3.2.1. Supernormal Profit 4.3.2.2. Normal Profit 4.3.2.3. Subnormal Profit or Loss 4.3.3.

Price and Quantity Determination in Long Run

4.3.4.

Price Discrimination

4.4. Monopolistic Competition 4.5. Oligopoly-Mutual Interdependence 4.5.1.

Non-collusive Oligopoly

4.5.2.

Sweezy’s Model of Kinked Demand Curve

4.5.3.

Collusive Oligopoly

4.5.4.

Price Leadership

4.6. Prisoner’s Dilemma 4.7. Summary 4.8. Check Your Progress 4.9. Questions and Exercises 4.10. Further Readings

4.1. OBJECTIVES The objective of this chapter is to define and application of market structure. The chapter also focuses on the Perfect Competition, Assumptions of perfect competiton, Short Run and Long Run Equilibrium, Monopoly, Price Discrimination, Price and Quantity Dtermination in short Run, Supernormal Profit, Normal Profit, Subnormal Profit or Loss, Price and Quantity Determination in Long Run, Price Discrimination, Monopolistic Competition, Oligopoly, Mutual Interdependence, Non-collusive Oligopoly, Sweezy’s Model of Kinked Demand Curve, Collusive Oloigopoly, Price Leadershuip, Prisoner’s Dilemma. Graphs are used consistently for understanding the subject matter easily.

Key Terms Perfect Competition, Assumptions, Short Run and Long Run Equilibrium, Monopoly, Price Discrimination, Price and Quantity Determination in Short Run, Supernormal Profit, Normal

65

Profit, Subnormal Profit or Loss, Price and Quantity Determination in Long Run, Price Discrimination, Monopolistic Competition, Oligopoly, Mutual Interdependenc, Non-Collusive Oligoply, Sweezy’s Model of Kinked Demand Curve, Collusive Oligopoly, Price Leadership, Prisoner’s Dilemma.

NOTES

4.2. INTRODUCTION: PERFECT COMPETITION Perfect competition is a market structure characterized by a complete absence of rivalry among the individual firms. Thus perfect competition in economic theory has a meaning diametrically opposite to the everyday use of this term. In practice businessmen use the word competition as synonymous to rivalry. In theory perfect competition implies no rivalry among firms.

4.2.1. Assumptions of perfect competition: Large number of sellers and buyers: the industry or market includes a large numbers firms (and buyers), so that each individual firm, however large, supplies only a small part of the total quantity offered in the market. The buyers are also numerous so that no monopsonistic can affect the working of the market. Under these conditions each fund alone cannot affect the price in the market by changing its output.

Product homogeneity: The industry is defined as a group of firms producing a homogenous product. The technical characteristics of the product as well as the services associated with its sale and delivery are identical. There is no way in which a buyer could differentiate among the products of different firms. If the products were differentiated the firm would have some discretion in setting its price. This is ruled out ex hypothesis in perfect competition. The assumption of large number of sellers and of product homogeneity imply that the individual firm in pure competition is a price taker, its demand card is infinitely elastic, indicating that the firm can sell any amount of output at the prevailing market price. The demand card of the individual firm is also its average revenue and its marginal revenue carves.

66

Free entry and free exit of the firm:

Market Structure Analysis

There is no barrier to entry or exit from the industry. Entry or exit may take time but the firms have freedom of movement in and out of the industry.

Profit maximization: The only goal of all firms is profit maximization.

NOTES

No government regulation: There is no government intervention in the market. Here the firm is a price-taker and have and infinitely elastic demand curve. The market structure in which the above assumptions are fulfilled is called pure competition, which is different from perfect competition. Perfect competition requires two more assumptions.

Perfect mobility of factors of production: The factors of production are free to move from one firm to another in the market. It is also assumed that workers can move between different jobs which imply that skills can be learned easily. The raw materials and other factors are not monopolized and labor is not unionized.

Perfect knowledge: It is assumed that all sellers and buyers have complete knowledge of the conditions of market. This knowledge refers not only to the prevailing conditions in the current period but in all future periods as well. Information is free and costless. In this market situation uncertainty about future developments in the market is ruled out.

4.2.2. Short Run Equilibrium In the short run, individual firm under perfect competition may either earn supernormal profit or normal profit or can incur losses. This depends on the short run cost curves. These three possibilities are shown by the three short run equilibrium of a firm. Supernormal profit: In the short run a perfectly competitive firm can earn supernormal profits which means revenue more than cost. The average cost (AC) and marginal cost (MC) curves are the usual short run cost curves. As the firm maximizes profits at the point where MR = MC and also where MC cuts MR from below, the point of equilibrium of the firm in figure is at point E, output at this price is OQ* and equilibrium price is P*. The total revenue earned by the firm is given by the rectangular area OP* EQ*. to produce this output, the total cost incurred by the firm is given by the rectangular area OABQ*. Therefore, profit earned by the firm is given by the rectangular region AP*EB. This is the supernormal profit earned by the firm in the short run, because the market price is greater than the average cost.

67

NOTES

Normal profit: In the short run, it is not possible to earn supernormal profit by all the firms, some of them may also earn normal profits, which means revenue is equal to cost. Like pervious case, the equilibrium of the firm is shown as E in the figure, the output that maximizes is OQ*. The total revenue earn by the firm is the rectangular area OP* EQ*, which is also the total cost of producing the equilibrium output OQ*. Therefore, in this case, the firm makes normal profit which means no profits. This is possible because the average cost curve is tangent to the average revenue line.

Loss or Subnormal profit: Here also the equilibrium point E determines the equilibrium level of output OQ* and price OP*. The total revenue is given by rectangular area OP* EQ* and total cost is the rectangular OABQ*, which is more than the total revenue by the amount is equivalent to the rectangular area P*ABE. This extra amount of cost incurred by the firm is called loss or profit, which occurs in the short run because the average cost is more than the market price.

68

Market Structure Analysis

NOTES

4.2.3. Long Run Equilibrium In the long run perfectly competitive firms earn only normal profits. This is due to the unrestricted entry into and exit of firms from the industry in the long run. Let us explain this with two extreme possibilities: first, when existing firms enjoy supernormal profits in the short run, and next, when the existing firms incur losses in the short run. If some of the existing firms earn supernormal profit, this attracts new firms to the industry to share the profits. With the entry of new firms, the supply of goods increases in the market. Assuming no change in the demand side, this extra supply of the good lowers the price of the good. This process of adjustment continues till the price becomes equal to the long run average cost. Due to this, supernormal profit of the existing firms is squeezed until all the firms in the industry earn normal profit. Alternatively, if the firms are making losses in the short run, then they may not be able to sustain for long time and as a result they will exit from the industry. After this exit, the supply of the product in the industry reduces and as a result the equilibrium price in the industry rises. This process of adjustment continues up to the point where the marginal firms no longer earn losses. Thus perfectly competitive firms earn only normal profit in the long run where P= MC=MR=LAC = AR.

69

4.3. MONOPOLY – PRICE DISCRIMINATION 4.3.1. Monopoly:

NOTES

Monopoly is a market in which a single seller sells a product or service which has no substitute. Economists distinguished between pure monopoly and monopoly. Pure monopoly is that market situation in which there is absolutely no substitute of the product, and the entire market is under control of a single firm. A monopoly exist if there is no close substitute to the product and also when there is a single producer and seller of the product, like Indian Railways, but it has a very remote substitute in the market, like Buss services, Flights etc. The features of monopoly are Single Seller, Single Product, No Difference between Firm and Industry, Independent Decision Making of the Firm and Restricted Entry. The monopolist can not set both the price and quantity at its own will. A monopolist firm is able to independently determine an optimal combination of price and quantity, and has a normal demand curve with a negative slope. The reason behind the negative slope is that although a monopoly firm is in total control of the market price, but it can sell more only when it reduces the price of its product. Here both the MR and AR curves are downward sloping. The reason is that, a monopoly firm faces a normal demand curve which is highly inelastic, therefore AR curve would be downward sloping and the MR curve would lie below the AR curve. This is because of fact that the monopolist has to lower the price of all units of products for selling an additional unit.

4.3.2. Price and Quantity Determination in Short Run A monopolist firm will be in equilibrium where MR = MC and MC is rising. Like perfectly competitive firms, monopolist firm also may earn supernormal profit or normal profit or subnormal profit (loss) in the short run.

4.3.2.1. Supernormal Profit

In the above diagram, a monopolist firm is in equilibrium at point E where MR equal to MC and MC is rising. In equilibrium, the firm sells OQ amount of output at price OP, so the total revenue is equal to the area OPCQ. The total cost is the area OABQ and

70

the total profit (supernormal) is the difference of total revenue and total cost, i.e. the area APCB.

Market Structure Analysis

4.3.2.2. Normal Profit In the diagram given below, a monopolist firm is in equilibrium at point E where MR equal to MC and Mc is rising. In equilibrium, the firm sells OQ amount of output at price OP, so the total revenue is equal to the area OPCQ, which is also the total cost of the firm and the total profit (normal) is the difference of total revenue and total cost, i.e. here nil or zero.

NOTES

4.3.2.3. Subnormal Profit or Loss

In the above diagram, a monopolist firm is in equilibrium at point E where MR equal to MC and MC is rising. In equilibrium, the firm sells OQ amount of output at price OP, so the total revenue is equal to the area OPCQ. The total cost is the area OABQ which is greater than the total revenue, so the total loss (subnormal) is the difference of total cost and total revenue, i.e. the area PABC.

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4.3.3. Price and Quantity Determination in Long Run

NOTES

In the long run, a monopolist firm has full control of the market price, so the firm would not continue to incur loss. It would instead try to reduce its cost of production by increasing control of raw materials etc., else it would it would close down in the long run. Therefore, the monopolist firm would try to earn at least normal profit in the long run and may earn supernormal profit due to entry restrictions in the market. So, a monopolist firm would either earn normal or supernormal profit, but would not incur loss in the long run.

4.3.4. Price Discrimination Price discrimination is the practice of discriminating among buyers on the basis of the price charged for the same good or service. Market imperfection and control are prerequisite for price discrimination. The monopoly market structure is the ideal market condition for price discrimination. There are three situations where price discrimination is possible: i) discrimination owing to consumers’ peculiarities, ii) discrimination owing to nature of the good, iii) discrimination owing to the distance and frontier barriers. There are many forms of price discrimination, but mainly three types or degrees of discrimination and they are First-degree, Second-degree and Third-degree discrimination. The first-degree price discrimination involves charging the maximum price possible for each unit of output. Thus the consumer who attaches the greatest value to the product is identified and charged a price of P1. Similarly, the consumers are willing to pay P 2 for second unit and P3 for third unit. Here, the MR curve coincides with the demand curve and the profit maximizing output is where MC and the demand curve intersect, i.e., at point B.

Second-degree price discrimination involves pricing based on the quantities of output purchased by individual consumers. In the following diagram, the first Q1 units sold at P1 price and the next (Q 2-Q 1) units sold at P 2 price etc.

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Third-degree price discrimination is the most common form of price discrimination. It involves separating consumers or markets in terms of their price elasticity of demand. This segmentation can be based on several factors. Often third degree price discrimination occurs in the markets that are geographically separated. Let us consider an example. It is often seen that books of US publication are sold in other countries at a lower price compared to US evidently; buyers in other countries have greater elasticity of demand than do US buyers. At the same time, cost of collecting and shipping books make it unprofitable for other firms to buy in foreign countries and resell in the United States.

Market Structure Analysis

NOTES

Discrimination can also be based on the nature of use. Telephone customers are classified as either residential or business customers. The monthly charge for a phone located in a business usually is somewhat higher than for a telephone used in a home. Finally, markets can be segmented based on personal characteristics of consumers. Age is a common basis for price discrimination. For example, most movie theatres charge for adults, though the cost of providing service to the two groups in the same.

4.4. MONOPOLISTIC COMPETITION Monopolistic competition is a market structure quite similar to perfect competition in that vigorous price competition among a large number of firms and individuals is present. The major difference between these two market structures is that at least some degree of product differentiation is present in monopolistically competitive markets. As a result, firms have at least some discretion in setting prices. However, the presence of many close substitutes limits the price-setting ability of individual firms, and drives profits down to a normal rate of return in the long-run. As in the case of perfect competition, abovenormal profits are only possible in the short-run before rivals are able to take effective counter measures. Examples of monopolistically competitive market structures include a broad range of industries producing clothing, consumer financial services, professional services, restaurants, and so on. The conditions which prevail in a monopolistic competitive market can be summarized as follows: 1.

There are relatively large numbers of firms, each satisfying a small, but not microscopic, share of the market demand for similar, but not identical, products.

2.

The product of each firm is not a perfect substitute for the products of product group represents several closely related, but not identical, products that serve the same general purpose for consumers. The sellers in each product group can be considered competing firms within the industry.

3.

The firms in the market do not consider the reactions of their rivals when choosing their product prices or annual sales targets.

4.

Relative freedom of entry and exit of firms exist in monopolistically competitive markets.

5.

Neither the opportunity nor the incentive exists for the firms in the market to cooperate in ways that decrease competition.

Equilibrium A firm in this market has limited control over the prices of their products. Generally, the consumers prefer the products of specific sellers and are ready to pay more, but within specific limit, to satisfy their preferences. The condition for the equilibrium of a firm is that it maximizes profit and the group or industry will be in equilibrium when each firm within

73

the group is in equilibrium earning normal profits and there is no tendency to enter into or exit from the group.

NOTES

Let us first consider the equilibrium of a single firm. A single firm may be regarded as a monopolist. Its equilibrium condition can, therefore, be determined by the same way as in case of a monopolist. Its AR (same as the demand curve) curve is downward sloping and the MR curve lies below the AR curve. The firm will be in equilibrium where MR=MC to maximize profits. At the equilibrium point, the firm may be earning normal profits or more than normal profits or less than normal profits as it happens in the case of a monopolist. In the above figure, let AR1 and MR1 be the AR and the MR curves of the first firm and MC1 be the MC curve of the firm. The equilibrium level of output is OQ1 and the equilibrium price level is OP1. The firm maximizes total profits. But under group equilibrium, the equality of MR and MC is not the sufficient condition for profit maximization though it is the necessary condition. Industry equilibrium is possible only when each firm is earning only normal profits, that is, the point where AR=AC for each firm. This is so because, if the existing firms earn more than normal profits, new firms will enter into the industry. This will reduce the volume of abnormal profits of the existing firms. Entry will continue until all the firms earn only normal profits. The situation of the group equilibrium can be analyzed with the help of the figure given below.

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In the above figure the firm is in equilibrium at point E where the AR curve is tangent to the LAC curve and the output level of OQ1 . It can be proved that at the output level where AR is tangent to AC. MR must be equal to MC. We know that, MR = AR + Q. dAR/dQ and MC = AC + Q. dAC/dQ, where, Q is the level of output. Now, when the level of output is the same, if AR = AC and it is such that dAR/dQ = dAC/dQ i.e. AR is tangent to AC, MR will be equal to MC. Note that each firm will be in equilibrium at a point on the AC curve which is to the left of its minimum point, F. if the firm operates under perfect competition, equilibrium will be achieved at the lowest point of the AC curve, where the level of output is OQ2 and the price is OP2. The long run equilibrium point under monopolistic competition (E) must be at the falling portion of the AC curve because here AR is falling and such an AR curve can be tangent to the AC curve only at the latter’s downward sloping portion.

Market Structure Analysis

NOTES

This property of equilibrium under monopolistic competition is known as the excess capacity theorem. This means that under monopolistic competition excess capacity remains in each firm in the sense that more output can be produced at a lower cost. Suppose that the number of firms is reduced but the output level of each firm is increased so that the total output of the industry remains the same. In this case, each firm will produce the output at a lower cost and hence total cost of obtaining the same level of output by eliminating some firm will be lower. Thus excess capacity remains under monopolistic competition and this capacity can be utilized by eliminating some firms form the industry. For social standpoint, monopolistic competition is inferior to perfect competition. Under perfect competition, capacity is fully utilized. Production takes place at the minimum point of the average cost curve. But this condition is not fulfilled under monopolistic competition.

4.5. OLIGOPOLY-MUTUAL INTERDEPENDENCE Oligopoly is a market structure, in which a few sellers dominate the sales of a product and the entry of new sellers is difficult or impossible. The product can be either differentiated or standardized. Automobiles, cigarettes, beer and chewing gum are examples of differentiated products, whose market structures are oligopolistic. Oligopolistic markets are characterized by high market concentration. In oligopolistic market, at least some firms can influence price by virtue of their large shares of total output produced. Sellers in oligopolistic markets know that when they or their rivals change their prices of output, the profit of all firms in the market will be affected. The sellers are aware of their interdependence. They know that a change in one firm’s price or output will cause a reaction by competing firms. The response an individual seller expects from his rival is crucial determinant of his choices. In this market: 1.

Only a few firms supply the entire market with a product that may be standardized or differentiated.

2.

At least some firms have a large market shares and thus can influence the price of product.

3.

The firms in the oligopolistic market are aware of their interdependence and always consider their rivals’ reactions when selecting prices, output goals, advertising budgets and other business policies.

4.

One more feature of the oligopoly market is the indeterminacy of the demand curve facing an oligopolistic firm. The demand curve face by an oligopolistic firm represents different quantities of output that the firm can sell at different prices. These quantities

75

cannot be definitely determined because the quantities will be different depending on the different reaction patterns of the rivals. When any firm changes its own price, rivals will also change their prices and as a result the demand curve faces by an oligopolist firm loses its definiteness. 5.

NOTES

The oligopoly market is concerned with group behaviour. There is no generally accepted theory on group behaviour. It basically depends on the behaviour of the members of the group. For example, it may happen that the members of the group may compete with one another (Non-Collusive oligopoly), or it may happen that the members come to an understanding (Collusive oligopoly) among themselves and form a general body to promote their common interests. It may also happen that there is a leader in the group and other members of the group follow the leader (Price Leadership), etc.

In oligopoly market, there exists interdependence among different forms. Due to this interdependence there is an uncertainty about the reaction patterns of the rivals. A wide variety of reaction patterns become possible and accordingly a large variety of models of price-output determination may be constructed. The actual solution is, therefore, indeterminate unless we specify a particular reaction pattern of the rivals.

4.5.1. Non-collusive Oligopoly The common characteristic of non-collusive oligopoly is that they assume a certain pattern of reaction of competitors, in each period and despite the fact that the expected does not in fact materialize, the firms continue to assume that the initial assumption holds. In other words, firms are assumed never to learn from past experience which makes their behavior at least naïve.

4.5.2. Sweezy’s Model of Kinked Demand Curve The concept of kinked demand curve was originally used to explain why, in an oligopoly market, the price which has been determined on the basis of average cost principle, would tend to remain rigid. The basic postulate of the average cost pricing is that the firm sets the price equal to average total cost which includes not only average variable cost but also a gross profit margin. The yield is a normal profit. However, the kinked demand curve, used by Paul Sweezy, explained the observed rigidity of price in an oligopoly market. The kinked demand curve model is based on the following assumptions. a. There are many firms in the oligopolistic industry. b. Each produces a product which is close substitute for that of the other firm. c. Product qualities are constant, advertising expenditures are zero. d.

Each oligopolist believes that if he lowers the price of his product, his rivals will also lower the prices of their products and that if he raises, they will maintain the prices at the existing levels.

Given these assumptions, the demand curve faced by any individual seller has a kink at the initial price-quantity combination. The kinked shape of the demand curve is based on the assumption that the rivals react differently to a rise in price or to a fall in price. It is also assumed that when an individual seller increases the price of his product other sellers will not increase their prices so that the sales of the seller increasing the price will be reduced considerably. This means that the demand curve is relatively elastic for a rise in price. On the other hand, it is assumed that when a single seller reduces the price, other sellers will also reduce the price so that the seller who reduces the price first cannot gain much for a

76

fall in the price. The kinked demand curve is, therefore based on the assumption that a rise in price by one seller will not be followed by a rise in the price of the other sellers, while a fall in the price of one seller will be followed by the corresponding fall in the price by others. A kinked demand curve is shown in the following figure.

Market Structure Analysis

NOTES

Suppose that we have drawn two demand curves dd and DD. The demand curve dd is drawn on the assumption that when one seller changes his price, the other sellers do not change their prices and keep their prices unaffected. The demand curve DD is drawn on the assumptions that when one seller changes his price, the other sellers also change their price is the same direction. The demand curves dd and DD intersect at the point P. In the kinked demand curve analysis it is assumed that the rise in price will be unmatched while a fall in the price will be matched. Hence the demand curve is dPD which has a kink at the point P. Let us consider a situation where price is reduced from OP1 to OP2. If the other sellers also reduce the price, the quantity sold by this seller will increase by QR. But if the sellers do not reduce prices the quantity sold will increase by QS. Similarly, when the price is increased form OP1 to OP3 the quantity demanded will be reduced by PQ’ (if other sellers do not increase their prices) and the quantity demanded will be reduced by PR’ if other sellers also increase their prices. Since it is assumed that price decrease by a firm will be matched by a price reduction by rivals but an increase in the price is not matched by the rivals, the relevant demand curve has a higher price elasticity than the lower part. The position of the curve is determined by the location of OP1, the price at which the oligopolist now happens to be selling his product. The price OP1 is the datum and it is not determined in the model. Consider now the implication of a kink in the demand curve faced by the seller in the market. If the demand curve is kinked, the corresponding MR curve will be discontinuous. This is seen in the following figure. In this figure dA portion of the MR curve corresponds to the dP portion of the demand curve, while the BC portion of the MR curve corresponds to the PD portion of the demand curve. The length of the discontinuity is equal to AB. The point P on the demand curve has two elasticities of demand. If we think that P is a point on DD we get another elasticity of demand.

77

NOTES

The greater the difference between the two elasticities of demand, the greater will be the length of the discontinuity. This is so because, we know from the relation between the MR, price and the absolute value of the demand elasticity (e) that MR = price [1-1/e].now at that point P, both the demand curves DD and dd have the same output level. The MR will therefore be different because of the differences in the elasticities are equal at point P, the discontinuous range will disappears. Suppose now that the MC curve of the firm passes through the discontinuous range of the MR curve, in this case, we cannot say that MR equals MC at the equilibrium point. Equality of MR and MC is not possible. All that we can say is that MR cannot be less than MC. In this situation the price and quantity remain the same at the kink point. Even if the MC curve shifts but passes through the discontinuous range B, the price-quantity combination remains constant. The price-quantity combination given by the point of the kink remains more or less stable in the oligopoly market. The price rise or the price fall is not profitable for a single seller because of the asymmetrical behavior of the sellers for a price rise or a price fall. The equilibrium of the firm is defined by the point of the kink because for any output level less than OM, MC is below MR, while for any output level greater than OM, MC is greater than MR. thus total profit is maximized at the kink through the profit maximizing condition (MR=MC) is not fulfilled at the kink point. The discontinuity of A and B of the MR curve implies that there is a range within which costs may change without affecting the equilibrium price and output of the firm. This level of price and output is compatible with a wide range of costs. Thus the kink can explain why the price and output will not change despite changes in cost within the range AB. If the demand curve is kinked, a shift in the market demand upwards or downwards, will affect the volume of output but not the level of price, so long as the MC curve passes through the discontinuous range of MR curve. In this case the demand curve shifts but the kink point lies on the horizontal straight line. As the market expands, the firm will not raise its price, although output will increase. In conclusion it can, therefore, be said that the kinked demand analysis as a method of price-output determinations not analytically sound. But it can be accepted as a reasonable explanation for the rigidity of price and output in the oligopolistic markets.

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4.5.3. Collusive Oligopoly An important characteristic of oligopoly is collusion in which rival firms enter into an agreement in mutual interest on various accounts such as price, market share, etc. Firms either openly declare their decision of collusion, or may collude tacitly. Basic oligopoly characteristics like interdependence of firms, constant consciousness of rival’s action, fear of price war, etc., create a good opportunity for collusion. You must be wondering as to why firms would collude after all. Give it a thought; it does make sense the companies come together in order to get better control over market. When a number of producers (or sellers) enter into such an agreement formally, it is called explicit collusion; on the other hand, collusion which is not overt is known as tacit collusion. The most commonly found form of explicit collusion is known as cartels. The aim of such collusion is to reduce competition and increase profits of individual members. However governments do not encourage collusions because it creates monopoly like situation and make various laws to identity and break up cartels. This has lead to the development of tacit collusion, in which firms do not document agreements to collude.

Market Structure Analysis

NOTES

4.5.4. Price Leadership The agreed upon price under collusion may have been fixed on the basis of going rate or the price charged by the largest or the most sophisticated player. Such kind of price determination is known as price leadership. What is this going rate? It is price which prevails in the market and existing players as well as new entrants agree to sell their product at this price. Now the next question is that how is this price determined? You will learn about this very unique aspect of oligopoly in the following sections.

Dominant Firm Often an oligopoly market is dominated by few firms, among which one may be the largest player. There can be numerous such examples, Google among search engines, Intel in the micro chips market, Nokia in mobile phones and IBM in the PC segment. Specific to Indian context, we can look at Bajaj Auto in the two wheeler market, Maruti in cars and Godrej in steel furniture. The highlight of this situation is that other companies acknowledge the leadership of this largest firm for price determination. The basis of such dominance is that a firm may emerge as a leader in terms of either market share, or presence in all market segments, or just being the pioneer in the particular product category. Normally the leader is very large in size and earns economies of scale; it produces optimum output at which it is able to maximize returns. This dominant firm may be either a benevolent firm or an exploitative firm. A benevolent leader is one which allows other firms to exist by fixing a price at which small firms may also sell. This price is higher than marginal cost of the overall market so that firms operating at higher cost of production may also survive. There are two major reasons behind the creation of a benevolent firm: (i) it lets others exist so that it does not have to face allegations of monopoly creation; (ii) it earns sufficient margin at this price and still retains market leadership. However, there is one limitation of this aspect and that is, the success of this type of leadership exists on the assumption that others will follow the leader. However, there may be a possibility that another rival takes advantage of the benevolence of the dominant firm’s leadership. Therefore in some cases the dominant firm acts exploitative, i.e., it fixes a price at which small inefficient players may not survive and thus it gains large share of the market.

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Barometric Firm

NOTES

Some markets may be such that no single player is so large to emerge as a leader, but there may be a firm which has a better understanding of the markets. This firm acts like a barometer for the market; it has better industry intelligence and can preempt and interpret its external environment in an effective manner. For example if the Indian Rupee is appreciating against US Dollar, how will it affect the market of a particular good, say television? A barometric firm would be able to see the link of this phenomenon with its impact on cost of production, on the demand for the product or on the general price index. If the appreciation of Rupee is likely to increase the cost of production, then the barometric firm will initiate a price rise with the declaration that due to rise in cost the price is being increased. Since all the firms in the industry are facing this threat in the same manner, they will also follow the barometric firm and will dissuade from price war.

4.6. PRISONER’S DILEMMA In 1984, Axelrod gave a new dimension to game theory by presenting “Prisoner’s Dilemma” which talks of importance of cooperation. The two players in the game can choose between two moves, either “cooperate” or “defect”. The idea is that each player gains when both cooperate, but if only one of them cooperates, the other one, who defects, will gain more. If both defect, both lose (or gain very little) but not as much as the “cheated” cooperator, whose cooperation is not returned. The game of Prisoner’s Dilemma needs a bit of story telling! This is a story of two prisoners. There are two criminals who have been arrested for stealing a car but the attorney suspects that they were also involved in a big bank robbery. However the evidence is not adequate to make the robbery charge stand unless one or both confess. Now car stealing is comparatively a lesser offense, and hence has punishment as compared to bank robbery. Thus the attorney keeps the two prisoners in separate cells so that no communication is possible between the two. Each prisoner is told that if he and his accomplice confess their imprisonment will only be five years but if only one confesses and others remain silent then the one who confess will get one year jail and the rest ten years jail. The prisoners know that if they both remain silent then they will get only two years jail which is the punishment for car stealing. In the table representing the payoff matrix, the two prisoners are the players, and the years of imprisonment are the payoffs. Each of the players is having two strategies, either to betray or confess, or not to confess and remain silent. Thus the outcome of each choice depends on the choice of the accomplice. But neither partner knows the choice of the accomplice. You know that each of them will try to reduce their term for jail but neither of them has any means of knowing that his accomplice will not betray. Prisoner B Stays Silent Prisoner A Stays Silent

Prisoner B Confesses

Both serve 2 years

A serves 10 years

(Win-win)

B serves 1 year A loses, B wins

Prisoner A Confesses

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B serves 10 years

Both serve 5 years

A serves 1 year

Lose-lose

A wins, B loses

(Nash Equilibrium)

By your understanding of game theory and Nash equilibrium you can easily infer that both the prisoners will confess and thus would serve five years imprisonment. This is because each of the prisoners knows that both the dominant strategy of the opponent is to confess, hence each will confess, while his accomplice keeps his strategy intact. This dominant strategies equilibrium is a special case of Nash equilibrium. Similarly if either A or B adopts maxmin or max-min strategy, the outcome in both the cases would be the same.

Market Structure Analysis

NOTES

4.7. SUMMARY Market structures can be characterized on the basis of four characteristics; i) number and size of distribution of sellers, ii) number and size distribution of buyers, iii) product differentiation and iv) ease of entry and exit. The model of perfect competition assumes a large number of small buyers and sellers, undifferentiated products, and ease of entry and exit. The profit maximization output for the perfectly competitive firm occurs where price equals to marginal cost. The monopolist is a single seller of a differentiated product. Entry into the market is difficult or prohibited. As a single seller, the monopolist has power over price. Chamberlin’s model for monopolistic competition assumes ease of entry and exit and a large number of small sellers. It differs from perfect competition by viewing sellers as providing products that are slightly differentiated. Thus, firms have some control over price. Oligopolistic market structures have many buyers but only few sellers dominate the market. The product may be differentiated or undifferentiated. Entry into this industry is somehow difficult.

Check Your Progress 1. In perfect competition, a firm maximizing its profits will set its output at that level where (a) Average variable cost = price

(b)

Marginal cost = price

(c) Fixed cost = price

(d)

Average fixed cost = price

2. Which of the following curves resembles supply curve under perfect competition in the short run? (a) Average cost curve above break even point (b) Marginal cost curve above shut down point (c) Marginal utility curve

(d)

Average utility curve

3. Which of the following is not a feature of perfect competition? (a) Low price (b) No one is large enough to influence the market price (c) Homogeneous products

(d)

Horizontal demand curve

4. In the long run, a perfectly competitive firm earns only normal profits because of (a) Large number of seller and buyer in the industry (b) Large number of seller and buyer in the industry (c) Free entry and exit of industry

(d)

Both (a) and (b) above

5. The horizontal demand curve for a firm is one of the characteristic features of (a) Oligopoly

(b)

Monopoly

(c) Monopolistic competition

(d)

Perfect competition

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Questions and Exercises 1. What are the assumptions required for perfect competition model? 2. Write down the differences between pure competition and perfect competition. 3. Explain the short run equilibrium of the firm in the perfectly competitive market.

NOTES

4. Explain the long run equilibrium of monopolist firm. 5. Write down the effects of price discrimination by a monopolist firm. 6.

Does product differentiation always refer to real difference between products? Use an example to explain your answer.

7.

Basically, perfectly competitive firms and monopolists use the same rule to determine the profit – maximizing outputs. Explain.

8.

Firms in a perfectly competitive market do not have to compete with the other individual firms in the market. True or False? Explain.

9. How is dead weight loss from monopoly affected by the slope of the demand curve? 10. Do non-profit institutions such as universities; ever engage in rent – seeking behaviour? Give an example. 11. The equilibrium price in a perfectly competitive market is $10. The marginal cost function is given by MC = 4 + 0.2Q the firm is presently producing 40 units of outputs per period. To maximize profit, should the output rate be increased or decreased? Explain. 12. A consultant estimates that the demand for the output of Marston Chemical is represented by the equation Q=2000-50P a.

If the mangers of Marston decide to maximize total revenue instead of profit, at what output rate should the firm operate? What is the revenue –maximizing price?

b.

Will the revenue – maximizing output be greater than or less than the profit – maximizing output rate? Explain

13. Explain cartels aiming at joint-profit maximization. 14. Explain the price leadership model.

Further Readings z

Hirschey, Economics for Managers, Cengage Learning

z

Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning

z

Froeb, : A Problem Solving Approach, Cengage Learning

z

Mankiw,

Economics: Principles and Applications, Cengage Learning z

Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill

z

Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice Hall of India

R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics Macmillan. z

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z

Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.

z

Koutsoyiannis,A. Modern Economics, Third Edition.

z

Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Review, 6th Edition, Tata McGraw Hill.

z

Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking.

UNIT 5 CAPITAL BUDGETING AND RISK AND UNCERTAINTY ANALYSIS

Capital Budgeting and Risk and Uncertainty Analysis

NOTES

STRUCTURE 5.1 Objectives 5.2 Introduction 5.3 Investment Analysis 5.3.1

Project valuation

5.3.2

Capital Budgeting Techniques

5.4 Risk and Investment Analysis- Decision Tree Analysis 5.5 Concept of Behavioral Economics 5.6 Summary 5.7 Check Your Progress 5.8 Questions and Exercises 5.9 Further Readings

5.1 OBJECTIVES The primary objective of this chapter is to define and explain the Investment Analysis, i.e., Project valuation and Capital Budgeting Techniques. The chapter also covers the Risk and Investment Analysis part, which includes Decision Tree Analysis and Concept of Behavioral Economics. A unique feature of this chapter is that it explains the very important concept of economics, i.e., Behavioral Economics. In most of the cases, explanations are incorporated with mathematical examples.

5.2 INTRODUCTION Any type investment is risky and investment decision is also difficult to make. It depends on availability of money and information of the economy, industry and company and the share prices ruling and expectations of the market and also of the companies. For making such decision the common investors may have to depend more upon a study of fundamentals rather than technical, although technical is also important. Otherwise they will burn their fingers as happened in 1992 following the Harshad Mehta Scam and in 2001 following Ketan Parekh Scam. For this purpose, a study of company’s performance, past record and expected future performance are to be looked into. It is necessary for a common investor to study the balance sheet and annual report of the company or analyze the quarterly or half yearly results of the company and decide on whether to buy that company’s share or not. This is called fundamental investment analysis.

5.3 INVESTMENT ANALYSIS 5.3.1 Project valuation Investment projects are classified as follows. According to project size, the investment

83

analysis is executed. Small projects may be approved by departmental managers. More careful analysis and Board of Directors’ approval is needed for large projects of, say, half a million dollars or more. Similarly, according to type of benefit to the firm, they are as follows. z

NOTES

an increase in cash flow, ? a decrease in risk, and ? an indirect benefit (showers for workers, etc).

According to degree of dependence, they are, z

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

z

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

z

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

According to degree of statistical dependence, z

Positive dependence,

Negative dependence z

z

Statistical independence.

According to type of cash flow, z

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

z

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

Project valuation analysis stipulates a decision rule for accepting or rejecting Investment projects

5.3.2 Capital Budgeting Techniques Capital budgeting is the process most companies use to authorize capital spending on long-term projects and on other projects requiring significant investments of capital. Because capital is usually limited in its availability, capital projects are individually evaluated using both quantitative analysis and qualitative information. Most capital budgeting analysis uses cash inflows and cash outflows rather than net income calculated using the accrual basis. Some companies simplify the cash flow calculation to net income plus depreciation and amortization. Others look more specifically at estimated cash inflows from customers, reduced costs, and proceeds from the sale of assets and salvage value, and cash outflows for the capital investment, operating costs, interest, and future repairs or overhauls of equipment. The Cottage Gang is considering the purchase of $150,000 of equipment for its boat rentals. The equipment is expected to last seven years and has a $5,000 salvage value at the end of its life. The annual cash inflows are expected to be $250,000 and the annual cash outflows are estimated to be $200,000.

Payback technique The payback measures the length of time it takes a company to recover in cash its initial investment. This concept can also be explained as the length of time it takes the project to generate cash equal to the investment and pay the company back. It is calculated by dividing the capital investment by the net annual cash flow. If the net annual cash flow is not expected to be the same, the average of the net annual cash flows may be used. For the Cottage Gang, the cash payback period is three years. It was calculated by Capital investment Cash Payback Period = Average annual net cash flow dividing the $150,000 capital investment by the $50,000 net annual cash flow ($250,000 inflows - $200,000 outflows)

84

The shorter the payback period, the sooner the company recovers its cash investment. Whether a cash payback period is good or poor depends on the company’s criteria for evaluating projects. Some companies have specific guidelines for number of years, such $150,000 $50,000

Capital Budgeting and Risk and Uncertainty Analysis

= 3.0 years

NOTES

as two years, while others simply require the payback period to be less than the asset’s useful life. When net annual cash flows are different, the cumulative net annual cash flows are used to determine the payback period. If the Turtles Co. has a project with a cost of $150,000, and net annual cash inflows for the first seven years of the project are: $30,000 in year one, $50,000 in year two, $55,000 in year three, $60,000 in year four, $60,000 in year five, $60,000 in year six, and $40,000 in year seven, then its cash payback period would be 3.25 years. See the example that follows.

The cash payback period is easy to calculate but is actually not the only criteria for choosing capital projects. This method ignores differences in the timing of cash flows during the project and differences in the length of the project. The cash flows of two projects may be the same in total but the timing of the cash flows could be very different. For example, assume project LJM had cash flows of $3,000, $4,000, $7,000, $1,500, and $1,500 and project MEM had cash flows of $6,000, $5,000, $3,000, $2,000, and $1,000. Both projects cost $14,000 and have a payback of 3.0 years, but the cash flows are very different. Similarly, two projects may have the same payback period while one project lasts five years beyond the payback period and the second one lasts only one year.

Net present value Considering the time value of money is important when evaluating projects with different costs, different cash flows, and different service lives. Discounted cash flow techniques, such as the net present value method, consider the timing and amount of cash flows. To use the net present value method, you will need to know the cash inflows, the cash outflows, and the company’s required rate of return on its investments. The required rate of return becomes the discount rate used in the net present value calculation. For the following examples, it is assumed that cash flows are received at the end of the period.

85

Managerial Economics

NOTES

Using data for the Cottage Gang and assuming a required rate of return of 12%, the net present value is $80,452. It is calculated by discounting the annual net cash flows and salvage value using the 12% discount factors. The Cottage Gang has equal net cash flows of $50,000 ($250,000 cash receipt minus $200,000 operating costs) so the present value of the net cash flows is computed by using the present value of an annuity of 1 for seven periods. Using a 12% discount rate, the factor is 4.5638 and the present value of the net cash flows is $228,190. The salvage value is received only once, at the end of the seven years (the asset’s life), so its present value of $2,262 is computed using the Present Value of 1 table factor for seven periods and 12% discount rate factor of .4523 times the $5,000 salvage value. The investment of $150,000 does not need to be discounted because it is already in today’s dollars (a factor value of 1.0000). To calculate the net present value (NPV), the investment is subtracted from the present value of the total cash inflows of $230,452. See the examples that follow. Because the net present value (NPV) is positive, the required rate of return has been met. Present Value of 1 Period 2%

4%

5%

1

0.980

0.961

4 2

3

4

5

6

7

8

9

10

11

12

86

6%

8%

10%

12%

14%

16%

18%

20%

22%

0.952 0.943

0.925

0.909

0.892

0.877

0.862

0.847

0.833

0.819

5

4

9

1

9

2

1

5

3

7

0.961

0.924

0.907 0.890

0.857

0.826

0.797

0.769

0.743

0.718

0.694

0.671

2

6

0

3

4

2

5

2

2

4

9

0.942

0.889

0.863 0.839

0.793

0.751

0.711

0.675

0.640

0.608

0.578

0.550

3

0

8

8

3

8

0

7

6

7

7

4

0

6

0.9238 0.8548 0.8227 0.7921 0.7350 0.6830 0.6355 0.5921 0.5523 0.5158 0.4823

0.451

8

8

7

0.905

0.821

7

1

0

0

5

1

3

8

3

4

0.783 0.747

0.680

0.620

0.567

0.519

0.476

0.437

0.401

0.370

9

5

6

9

4

4

1

1

9

0

0.888

0.790

0.746 0.705

0.630

0.564

0.506

0.455

0.410

0.370

0.334

0.303

0

3

2

2

5

6

5

4

4

9

3

0.870

0.759

0.710 0.665

0.583

0.513

0.452

0.399

0.353

0.313

0.279

0.248

6

9

7

5

2

3

6

8

9

1

6

0.853

0.730

0.676 0.627

0.540

0.466

0.403

0.350

0.305

0.266

0.232

0.203

5

7

8

3

5

9

6

0

0

6

8

0.836

0.702

0.644 0.591

0.500

0.4241 0.360

0.307

0.263

0.225

0.193

0.167

8

6

6

2

1

6

5

0

5

8

0

0.820

0.675

0.613 0.558

0.463

0.385

0.322

0.269

0.226

0.191

0.161

0.136

3

6

9

2

5

0

7

7

1

5

9

0.804

0.649

0.584 0.526

0.428

0.350

0.287

0.236

0.195

0.161

0.134

0.112

3

6

7

9

5

5

6

4

9

6

2

0.788

0.624

0.556 0.497

0.397

0.318

0.256

0.207

0.168

0.137

0.112

0.092

5

6

8

1

6

7

6

5

2

2

0

3

0

1

4

9

4

8

0

13

14

15

16

17

18

19

20

0.773

0.600

0.530 0.468

0.367

0.289

0.229

0.182

0.145

0.116

0.093

0.075

0

6

3

7

7

2

1

2

3

5

4

0.757

0.577

0.505 0.442

0.340

0.263

0.204

0.159

0.125

0.098

0.077

0.061

9

5

1

5

3

6

7

2

5

9

8

0.743

0.555

0.481 0.417

0.315

0.239

0.182

0.140

0.107

0.083

0.064

0.050

0

3

0

2

4

7

1

9

5

9

7

0.728

0.533

0.458 0.393

0.291

0.217

0.163

0.122

0.093

0.070

0.054

0.041

4

9

1

9

6

1

9

0

8

1

5

0.714

0.513

0.436 0.371

0.270

0.197

0.145

0.107

0.080

0.060

0.045

0.034

2

4

3

3

8

6

8

2

0

1

0

0.700

0.493

0.415 0.350

0.250

0.179

0.130

0.094

0.069

0.050

0.037

0.027

2

6

5

2

9

0

6

1

8

6

9

0.686

0.474

0.395 0.330

0.231

0.163

0.116

0.082

0.059

0.043

0.031

0.022

4

6

7

7

5

1

9

6

1

3

9

0.673

0.456

0.376 0.311

0.214

0.148

0.103

0.072

0.051

0.036

0.026

0.018

0

4

9

5

6

7

8

4

5

1

7

8

3

3

6

4

3

5

8

Cash Outflows

Capital Budgeting and Risk and Uncertainty Analysis

NOTES

Cash Inflows

Project Cost

$150,000

Cash from Customers (1) $250,000

Operating Costs (2)

200,000

Salvage Value

Estimated Useful Life

7 years

Minimum Required Rate of Return

12%

Annual Net Cash Flows ($250,000 - $200,000)

$50,000

5,000

(1) - (2)

Present Value of Cash Flows Annual Net Cash Flows ($50,000 × 4.5638) Salvage Value ($5,000 × .4523) Total Present Value of Net Cash Inflows

$228,190 2,262 230,452

Less: Investment Cost

(150,000)

Net Present Value

$ 80,452

When net cash flows are not all the same, a separate present value calculation must be made for each period’s cash flow. A financial calculator or a spreadsheet can be used to

87

calculate the present value. Assume the same project information for the Cottage Gang’s investment except for net cash flows, which are summarized with their present value calculations below

NOTES

Period

Estimated Annual Net Cash Flow (1)

12% Discount Factor (2)

Present Value (1) × (2)

1

$ 44,000

.8929

$ 39,288

2

55,000

.7972

43,846

3

60,000

.7118

42,708

4

57,000

.6355

36,224

5

51,000

.5674

28,937

6

44,000

.5066

22,290

7

39,000

.4523

17,640

Totals

$350,000

$230,933

The NPV of the project is $83,195, calculated as follows: Present Value of Cash Flows Annual Net Cash Flows

$230,933

Salvage Value ($5,000 × .4523)

2,26

Total Present Value of Net Cash Inflows

233,195

Less: Investment Cost

(150,000)

Net Present Value

$ 83,195

The difference between the NPV under the equal cash flows example ($50,000 per year for seven years or $350,000) and the unequal cash flows ($350,000 spread unevenly over seven years) is the timing of the cash flows. Most companies’ required rate of return is their cost of capital. Cost of capital is the rate at which the company could obtain capital (funds) from its creditors and investors. If there is risk involved when cash flows are estimated into the future, some companies add a risk factor to their cost of capital to compensate for uncertainty in the project and, therefore, in the cash flows. Most companies have more project proposals than they do funds available for projects. They also have projects requiring different amounts of capital and with different NPVs. In comparing projects for possible authorization, companies use a profitability index. The index divides the present value of the cash flows by the required investment. For the

88

Cottage Gang, the profitability index of the project with equal cash flows is 1.54, and the profitability index for the project with unequal cash flows is 1.56. Profitability Index =

Capital Budgeting and Risk and Uncertainty Analysis

Present Value of Cash Flows Required Investment

Equal Cash Flows = $ 230,452 / $ 150,000 = 1.54, and Unequal Cash Flows = $ 233,195 / $ 150,000 = 1.56

NOTES

Internal rate of return The internal rate of return also uses the present value concepts. The internal rate of return (IRR) determines the interest yield of the proposed capital project at which the net present value equals zero, which is where the present value of the net cash inflows equals the investment. If the IRR is greater than the company’s required rate of return, the project may be accepted. To determine the internal rate of return requires two steps. First, the internal rate of return factor is calculated by dividing the proposed capital investment amount by the net annual cash inflow. Then, the factor is found in the Present Value of an Annuity of 1 table using the service life of the project for the number of periods. The discount rate of the factor is the closest to is the internal rate of return. A project for Knightsbridge, Inc., has equal net cash inflows of $50,000 over its seven-year life and a project cost of $200,000. By dividing the cash flows into the project investment cost, the factor of 4.00 ($200,000 ÷ $50,000) is found. The 4.00 is looked up in the Present Value of an Annuity of 1 table on the seven-period line (it has a seven-year life), and the internal rate of return of 16% is determined.

89

NOTES

Annual rate of return method The three previous capital budgeting methods were based on cash flows. The annual rate of return uses accrual-based net income to calculate a project’s expected profitability. The annual rate of return is compared to the company’s required rate of return. If the annual rate of return is greater than the required rate of return, the project may be accepted. The higher the rate of return, the higher the project would be ranked. The annual rate of return is a percentage calculated by dividing the expected annual net income by the average investment. Average investment is usually calculated by adding the beginning and ending project book values and dividing by two. Annual Rate of Return =

Estimated Annual Net Income Average Investment

Assume the Cottage Gang has expected annual net income of $5,572 with an investment of $150,000 and a salvage value of $5,000. This proposed project has a 7.2% annual rate of return ($5,572 net income ÷ $77,500 average investment). Annual Rate of Return = Estimated Annual Net Income/Average Investment 7.2% = $5,572 / $77,500 (1) (2)

90

Capital Budgeting and Risk and Uncertainty Analysis

NOTES

The annual rate of return should not be used alone in making capital budgeting decisions, as its results may be misleading. It uses accrual basis of accounting and not actual cash flows or time value of money.

5.4 RISK AND INVESTMENT ANALYSIS- DECISION TREE ANALYSIS Decision Trees are useful tools for helping you to choose between several courses of action. They provide a highly effective structure within which you can explore options, and investigate the possible outcomes of choosing those options. They also help you to form

91

a balanced picture of the risks and rewards associated with each possible course of action. This makes them particularly useful for choosing between different strategies, projects or investment opportunities, particularly when your resources are limited. Uses:

NOTES

You start a Decision Tree with a decision that you need to make. Draw a small square to represent this on the left hand side of a large piece of paper, half way down the page. From this box draw out lines towards the right for each possible solution, and write a short description of the solution along the line. Keep the lines apart as far as possible so that you can expand your thoughts. At the end of each line, consider the results. If the result of taking that decision is uncertain, draw a small circle. If the result is another decision that you need to make, draw another square. Squares represent decisions, and circles represent uncertain outcomes. Write the decision or factor above the square or circle. If you have completed the solution at the end of the line, just leave it blank. Starting from the new decision squares on your diagram, draw out lines representing the options that you could select. From the circles draw lines representing possible outcomes. Again make a brief note on the line saying what it means. Keep on doing this until you have drawn out as many of the possible outcomes and decisions as you can see leading on from the original decisions. Once you have done this, review your tree diagram. Challenge each square and circle to see if there are any solutions or outcomes you have not considered. If there are, draw them in. If necessary, redraft your tree if parts of it are too congested or untidy. You should now have a good understanding of the range of possible outcomes of your decisions. An example of the sort of thing you will end up with is shown in Figure 1:

Figure 1

5.5 CONCEPT OF BEHAVIORAL ECONOMICS The main features of Concept of Behavioral Economics are as follows. z Fastest growing field in economics z

z

92

Behavioral economics is concerned with the ways in which the actual decision-making process influences the decisions that are made in practice; combines psychology and economics Assumes bounded rationality – meaning that people have limited time and capacity to weigh all the relevant benefits and costs of a decision.

z

Decision making is less than fully rational. People are prone to make predictable and avoidable mistakes.

z

At the same time, decision making is systematic and amenable to scientific study.

Capital Budgeting and Risk and Uncertainty Analysis

Six Key Ideas from Behavioral Economics 1.

Framing. Allowing the way a decision is presented to affect the choice that is selected even though the marginal benefit and marginal cost are unaffected.

2.

Letting Sunk Costs Matter. Allowing sunk costs, which have already been paid and do not affect marginal costs regardless of which option is chosen, to affect a decision.

3.

Faulty discounting. Being too impatient when it comes to decisions that involve benefits that are received in the future or discounting future benefits inconsistently depending on when the delay in receipt of benefits occurs.

4.

Overconfidence. Believing you will know what will happen in the future to a greater extent than is justified by available information.

5.

Status Quo Bias. It is a tendency to make decisions by accepting the default option instead of comparing the marginal benefit to the marginal cost.

6.

Desire for Fairness and Reciprocity. It is also a tendency, to punish people who treat you unfairly and to reward those who treat you fairly, even if you do not directly benefit from those punishments and rewards. Behavioral Economics recognizes that people respond to incentives, but their response is not always a rational one.

NOTES

5.6 SUMMARY Investment is very risky decision, so it needs priory analysis before finalizing. It depends on availability of money and information of the economy, industry and company and the share prices ruling and expectations of the market and also of the companies. For making investment decision the investors are depend more on a study of fundamentals rather than technical. It is necessary for a common investor to study the balance sheet and annual report of the company or analyze the quarterly or half yearly results of the company and decide on whether to buy that company’s share or not. This is called fundamental investment analysis. Capital budgeting is the process of spending capital on long-term projects and on other projects requiring significant investments of capital. Capital is usually limited in its availability. So, capital budgeting is individually evaluated using both quantitative analysis and qualitative information. Most of the capital budgeting analysis uses cash inflows and cash outflows rather than net income calculated using the accrual basis. Decision Trees analysis is also useful tools for choosing best one among available several courses of actions. This makes them particularly useful for choosing between different strategies, projects or investment opportunities, particularly when your resources are limited.

Check Your Progress 1. Capital budgeting analysis uses (a) Cash inflows,

(b)

Cash outflows,

(c) Cash inflows and cash outflows,

(d)

None of the above

2. Cost of capital is the rate at which the company could obtain (a) Capital (funds) from its creditors and investors, (b) Capital (funds) from its bankers, (c) Capital (funds) from its employees,

(d)

All the above.

93

3. Decision Trees are useful tools for helping you to choose between several courses of

NOTES

(a) Process,

(b)

Action,

(c) Plan,

(d)

Management

4. Behavioral economics is concerned with the ways in which the actual decisionmaking process influences (a)

Decisions that are made in practice; combines psychology and mathematical,

(b)

Decisions that are made unpracticed; combines psychology and economics,

(c) The decisions that are made in practice, (d) The decisions that are made in practice; combines psychology and economics.

Questions and Exercises 1. Explain how the investment analysis will help to achieve the target of the company. 2. What do you mean by capital budgeting? Explain with examples. 3. ‘The payback measures the length of time it takes a company to recover in cash its initial investment’, comment on it. 4. ‘Most companies’ required rate of return is their cost of capital’, explain with suitable example. 5. Why Decision Trees are useful tools for helping you to choose between several courses of action? 6. Write down the main features of Behavioral Economics. 7. Explain Six Key Ideas of Behavioral Economics. 8. Explain with example the Internal Rate of Return.

Further Readings z

Hirschey, Economics for Managers, Cengage Learning

z

Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning

z

Froeb, : A Problem Solving Approach, Cengage Learning

z

Mankiw,

Economics: Principles and Applications, Cengage Learning z

Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill

z

Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice Hall of India

R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics Macmillan. z

94

z

Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.

z

Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Review, 6th Edition, Tata McGraw Hill.

UNIT 6 MACRO-ECONOMICS ANALYSIS STRUCTURE

Macro-economics Analysis

NOTES

6.1. Objectives 6.2 Introduction 6.3. Basic Concept – Circular Flow of Income and Money 6.4. National Income and Keynesian Model 6.5. Saving and Consumption Function 6.6. Investment Multiplier 6.7. Inflation 6.8. Monetary and Fiscal Policies 6.9. International Economics – Fixed and Flexible Exchange Rates 6.10. Spot and forward Exchange Rates 6.11. Current and Capital Account Convertibility – a case study of India. 6.12. Summary 6.13. Check Your Progress 6.14. Questions and Exercises 6.15. Further Readings

6.1. OBJECTIVES The purpose of this chapter is to enable the student to follow the development of macroeconomic analysis and to finalize them with a number of basic concepts. Here, we highlight the main concept of macroeconomic variables, i.e., National Income and Keynesian Model, Saving and Consumption Function, Investment Multiplier, Inflation, Monetary and Fiscal Policies, International Economics – Fixed and Flexible Exchange Rates, Spot and forward Exchange Rates and Foreign Exchange Rates.

6.2 INTRODUCTION Microeconomics is the study of human behavior and choices as they relate to relatively small units, such as an individual, a firm, an industry, or a single market. Macroeconomics is the study of human behavior and choices as they relate to an entire economy. Economic analysis attempts to explain why problems arise in the economy and how these problems can be dealt with. It is, therefore, indispensable for formulating and conducting economic policy. However, before studying macroeconomic theory and policy, one must know the macroeconomic goals of the economy. There is no point in formulating a policy without definite objectives. Macroeconomic policy operates within a framework of goals and constraints. The most important goals of economic policy are; i.

Full employment – full utilization of human and non-human resources

ii.

High living standards

iii. Price Stability iv.

Reduction of economic inequality and removal of poverty

95

v.

Rapid economic growth

vi. External balance vs overall balance in economic relations with the rest of the world.

6.3. BASIC CONCEPT – CIRCULAR FLOW OF INCOME AND MONEY

NOTES

Stock and Flows When studying economics, one must be sure whether the variable being studied is a stock variable. Failure to do so can cause faulty economic reasoning. Stocks and flows are both variables that may increase and decrease with time. The crucial difference between the two is that one is measured at a specified point of time, whereas the other is measured for a specified period of time. For example, the total number of persons employed in India is a stock variable, whereas the number of persons who get new jobs is a flow variable. The balance sheet of a company is a stock statement, whereas the profit and loss account is a flow statement. Form macroeconomics, money supply, consumer price index, unemployment level, foreign exchange reserves, etc. are examples of stock variables. GDP, inflation, exports, imports, consumption, investment, etc. are examples of flow variables. Some flow macroeconomic variables have a direct counterpart stock macroeconomic variable, for examples, investment and capital stock, and inflation and price index. Flow variables which do not have direct stock counterpart are exports, wages, taxes, etc. Though these variables may not have direct stock counterparts, they could indirectly affect other stocks. Although a stock can change only as a result of flows, the flows themselves may be determined in part by changes in stock. For example, a country’s capital stock is determined by the level of investment. However, the flow of investment itself may depend partly on the size of the capital stock. In many theories of the business cycle, a critical factor explaining the business downturns is the decrease in the investment brought on by an excessive stock of capital resulting from an earlier, prolonged upsurge in investment.

Equilibrium and Disequilibrium In physical sciences, equilibrium is a state of balance between opposing forces or actions. The meaning of equilibrium in economic theory is exactly the same as it is in physical sciences. Again, in both the fields, disequilibrium means the absence of equilibrium. Values of economic variable usually keep changing over time; therefore, the state of balance that defines equilibrium may perhaps be better expressed as a state of no change over time. One must bear in mind that economic equilibrium does not mean a motionless state in which no action takes place; rather, it is a state in which there is action, but the action is of a repetitive nature. Each time period exactly duplicates the preceding time period. Even though the forces acting on the system may be in a continuous state of change, the state of equilibrium is maintained as long as the net effect of these changing forces does not disturb the established position of equilibrium.

National Product and Domestic Product A modern economy produces literally thousands of different goods and services. Some of these goods and services such as rice, wheat, shirts, shoes, cooking gas, doctor’s services, electricity, passenger transport, etc. are directly consumed by the population; some such as steel, fertilizers, raw cotton, cement, heavy chemicals, etc. enter as inputs in the production of other goods which may be directly used or further processed; finally some

96

goods such as machine tools, furnaces, railway wagons, factory buildings, etc. augment the productive capacity of the economy. Intermediate goods such as steel and cement are not desired in themselves but only as inputs in producing other goods. The ultimate aim of all economic activity is to make available goods and services for consumption now and for augmenting productive capacity so that consumption in future can be maintained or increased. Gross National Product (GNP) and Gross Domestic Product (GDP) and other variants are measures of aggregate production of all goods and services which either afford consumption now or add to productive capacity.

Macro-economics Analysis

NOTES

Aggregate Consumption This is the aggregate of all expenditures on current consumption of goods and services i.e. those which are consumed during the period. Living standards are usually correlated to per capita consumption of goods and services. This is obtained by dividing aggregate consumption by population. Current consumption is normally the proximate goal of economic activity. At low levels of income almost all of it has to be spent on current consumption – food, clothing, rent, fuel, education, etc. As income levels rise it is possible to set aside some income for saving. The relationship between aggregate consumption expenditures and aggregate income of household sector is known as the consumption function, that is C = C(Y). Consumption expenditure may be related to either national income or disposable income. It is one of the most important relationships in macroeconomics.

Gross Domestic Savings Income not devoted to current consumption is saved. In an economy during a particular year some units will consume less than their income while some will spend more than their income. Gross domestic savings is the difference between GDP and aggregate consumption. It is interesting to note that while most of the consumption can be attributed to the household sector, saving is done by various sectors of the economy. This is because part of the income generated in the productive process does not reach the households. Retained profits remain with the business units where they are generated. They constitute part of “business savings”. Government takes away some income in the form of taxes which constitutes bulk of government revenue .By not spending all of it on current goods and services government can generate savings. Gross Domestic Savings is the total of savings done by all sectors of the economy. The relationship between aggregate savings(S) and income (Y) is known as the saving function, i.e. S= S(Y). Saving may be related to either national or disposable income. The properties of the saving function are the inverse of those of the consumption function, since Y= C + S.

Gross Domestic Capital Formation Production requires services of fixed assets such as machinery, equipment and structures as well as working capital i.e. stocks of raw materials, work in process, finished goods etc. The act of replacing worn out assets and creating new assets is capital formation. Gross Domestic Capital Formation (GDCF) consists of 1. Making good the depreciation on existing fixed assets 2. Adding to the stock of fixed assets 3. Adding to inventories. Sometimes the first two of these together are called gross fixed investment while the third is called inventory investment. The word investment can be misleading. When you buy a

97

NOTES

corporate share on the secondary market i.e. an existing share you are making an “investment” in the popular sense of the word. However this may lead to any capital formation at all; the person who sells the shares might spend the entire proceeds on current consumption. All that has happened is ownership of a part of existing assets has changed hands. We are concerned with replacement and new additions to neither physical assets not merely financial assets nor transfer of ownership of existing assets. Bulk of domestic capital formation is financed from gross domestic savings (GDS). However, GDS need not equal GDCF. Domestic savings may be loaned to foreigners and contribute to capital formation abroad; conversely, foreigners may loan their savings to us for capital formation here. In the former case GDS will exceed GDCF; in the latter case GDCF will exceed GDS.

The Circular Flow of Income 1. The circular flow of income in a simple economy where all income is consumed. The operation of forces in an economy can be expressed in the form of a circular flow of incomes and spending between households and firms. A household is a group of people (consumers) earning incomes and spending them on goods and services produced by the firms. Money passes from households to firms in return for goods and services produced by firms and money passes from firms to households in return for factor services provided by households. The simple notion that the money value of the income of household must equal to the money value of output of firms and the money value of household expenditures to purchase this output provides the basis for national income accounting. In this simple economy we assume that the household spends all income. This spending on consumer goods (termed consumption (C) is the only component of aggregate demand (AD) in this simple economy.

Income (Y) Rs. 1000

This economy is in equilibrium because: Y = AD Y=C If Y is greater than C, Y will fall; if Y is less than C, Y will rise.

98

2. The circular flow of income in a closed economy: A closed economy exists when there is no international trade. We shall also assume that in this particular closed economy there is no government spending or taxation. Here, households have two alternative uses of the income – they can consume it or they can save it. Savings are (S). AD aggregate demand consists of consumption (C) and savings (S). Savings are lost to Y and will reduce the level of Y. However, some (if not all) of S will be used to finance investment (I). I is the creation of real capital goods such as machinery and factories, and adds to Y. If S = I, then Y is in equilibrium.

Macro-economics Analysis

NOTES

i.e. income (Y) Rs. 1000

In this economy Y = AD Therefore,

Y=C+I

In equilibrium S = I However, if S is greater than I, AD and Y will fall. If I is greater than S, AD and Y will rise. 3. The circular flow of income in an open economy: An open economy is one in which international trade exists. Assume also that there is government spending and taxation. Thus, households need not consume all of their income. Some may be saved (S), spent on imports (M), or taxed (T). So the savings (S) and imports (M) and taxes imposed (T) are known as “withdrawals” (W) or “Leakages” from the actual flow. An increase in withdrawals (W) will reduce the level of output and income (Y). However, Y will be added to investment (I), government spending (G) and money spent by foreigners on exports (X). These are known as “injections” (J). In an open economy the size of Y is determined by the size of AD, which is determined by C + I + G + X.

99

Income (Y) Rs. 1000

NOTES

Injections (J) Rs 200

Withdrawals (W) Rs 200

Over a period of time there are withdrawals (W) from the income flow. If individuals save, then the income is taken out of the circular flow. If an economy’s income is Rs. 1000 and it saves Rs.200, then only Rs. 800 is passed on as expenditure. Other withdrawals are taxes and imports. The later represents a loss of income from the domestic economy to some overseas economy. Alongside withdrawals there are also injections (J) into the flow of income. These are in the form of investment, government spending and exports, savings withdrawn and used to finance investment, either directly through the purchase of capital goods or indirectly via financial institutions such as Banks. Thus, the original withdrawal or savings ends up as an injection elsewhere in the system. Taxes end up as government spending on goods and services. Exports and financed from spending made by other countries. This spending enters into the circular flow as an injection of income. In this economy, Y = AD Therefore,

Y=C+I+G+X = C + J,

Where, J equals injections i.e. I, G and X. For equilibrium we require all withdrawals to equal all injections i.e. W = J. If injections are greater than withdrawals then the level of national income (i.e. total incomes) will rise and vice versa.

6.4. NATIONAL INCOME AND KEYNESIAN MODEL The most important aspects that shape the economy is the nation’s capacity to produce goods and services and keep various factors of production employed. The GNP growth rate, the most important indicator of the nation’s income, shows whether the nation’s income is expanding or contracting, and thus, it is the broadest statistical aggregate of our economic output and growth. The estimates of GNP and national income provide the policy makers and business community with the most useful tool for analyzing an economy’s economic performance, both in the short term and long term periods. However, it is crucial to prepare the accurate and reliable estimates of the nation product for purposes of meaningful economic analysis and reliable forecasting. In simple terms, GNP is the sum of all final goods and services produced during a specified time period usually a year, with each class of goods services measured at its market

100

value i.e. at price usually paid. If the same is estimated in terms of factor cost i.e. at the sum of all income earned by factors of production (i.e. wages and salary, rents, interest and profits), then the aggregate is GNP at factor cost. In the definition stated above the term ‘final’ is used to avoid the possibility of double counting and to ensure that only the value of final goods and services is counted in GNP. Why? Because of the value of an intermediate class of goods is embodied within the value of final goods and services. The term ‘gross’ refers to the fact that depreciation (or capital consumption) of structures and equipment is not deducted from the value of output. Moreover, the aggregate GNP is a ‘flow’ concept. It is typically measured in terms of an annual rate i.e. over a period of time. For instance, India’s GDP was Rs 14, 13,200 crore in 1997-98. This means that Rs 14, 13,200 crore worth of final goods and services were produced during 1997-98. Thus GDP is a device designed to measure the market value of production that flows through country’s various industries and shops per year.

Macro-economics Analysis

NOTES

When measuring GNP, or any other aggregate of nation product, we are interested in final value of goods and services. In other words, we are only interested in value added in each stage of production process. Value added is difference between the value of goods and services as they leave one stage of production and their cost when they entered that stage. We will consider one example- production of bread- to explain the concept clearly. As shown in the figure below, there are many stages in production of wheat by the farmer to milling of wheat into the flour, the baking of bread by the baker and its final sale to the customer by the retail shop owner. Value added in different stages of bread production Stage:1

Stage:2

Value added value added by

Stage:3

Stage:4

Stage:5

value added by

value added

final value

by farmer=

by Miller =

by baker=

by retailer=

baked bread=

Rs 0.80

Rs. 1.50

Rs. 1.80

Rs 0.20

Rs. 4.30

As indicated in the diagram given below between one stage and another, value is added to the product in terms of cost incurred at each stage of production. The final value of the bread is the sum total of value added at each stage. If we add up all the prices at each stage, it would be a gross mistake of double counting. This will distort the actual value of the product in a specified period.

101

Relationship among eight variants of national product

NOTES

The distinction between national product at market prices and national product at factor cost, based on whether or not net indirect taxes have been included and there is also a distinction between gross or net national product according to which whether investment is inclusive of capital consumption or not. Further, a distinction has been drawn between domestic and national product, according to whether we are measuring net factor income from abroad or whether we are measuring what is produced within the domestic economy. This implies that there are eight combinations of national product aggregates as shown below. Gross Domestic Product (GDP) at Market Price (MP) at Factor Cost (FC) Gross National Product (GNP)

at Market Price (MP) at Factor Cost (FC)

Net Domestic Product (NDP)

at Market Price (MP) at Factor Cost (FC)

Net National Product (NNP)

at Market Price(MP) at Factor Cost (FC)

The way that these national product aggregates are related to each other be understood from the figure given below.

We can sum up the differences between gross and net marketing prices and factor cost and national and domestic concepts in the following way: Gross

= Net + Depreciation

Market Prices

102

= factor cost + [indirect taxes – subsidies]

National

= Domestic + Net factor income from abroad.

Macro-economics Analysis

There are some national product aggregates that are more frequently met with and we have several ways to ordering them. One of these is as follow: Gross domestic product at market price + net factor income from abroad equals Gross national product at market price – net indirect taxes (indirect taxes- Subsidies)

NOTES

equals Gross national product at factor cost – capital consumption (depreciation) equals Net national product at factor cost, which is popularly known as national Income

REAL Vs. NOMINAL GNP It’s important to distinguish between real and nominal values of macroeconomics aggregates. When comparing data at different points in time, economists often use terms such as real wage, real income or real GNP. The “real” refers to the fact that data have been adjusted for change in level of prices. Thus real GNP is the GNP in current rupees deflated for changes in the prices of the items included in the GNP. In contrast, nominal GNP (or money GNP, as they are often called) is expressed in current rupees. It measures the value of output in given period in the price of that period, or as it is some times put in current rupees. Over a period of time, nominal values reflect changes both in a) the real size of an economics variable and b) the general level of prices. In contrast, real values eliminate the impact changes in the price level. Stated another way, real economic data are adjusted for changes in purchasing power of the rupee. Perhaps an example will clarify the difference between real and nominal values. In 199899 the nominal GNP in India was Rs 16, 01,065 crore, compared to only Rs. 7, 69,265 crore in 1993-94. Does this mean we produce two times as much output in 1993-94? Not hardly. In 1998-99 the general level of price was higher than the level of prices in 1993-94. Measured in terms of price level in 1993-94, real GNP in 1998-99 was worth Rs. 10, 71,073. Nominal GNP will increase either if a) more goods and services are produced or if b) prices rise. Often both a) and b) contribute to an increase in GNP. Since we are really interested in comparing only the output or actual production during two intervals, GNP must be adjusted for the changes in prices. A price index called GNP deflator is constructed to a price index to reveal the cost of purchasing the items included in GNP during the period relative to the cost of purchasing those same items during a base year (say 1993-94). Since the base year is assigned the value of 100, as the GNP deflator takes on values greater than 100, it indicates that prices have risen. The central statistical organization (CSO) estimates how much of each item included in GNP has been produced during a year. This bundle of goods will include automobiles, houses, office buildings, medical services, bread and all other goods included in GNP, in qualities actually produced during the current year. The agency then calculates the ratios of a) the cost of purchasing this representative bundle of goods at current price divided by b) the cost of purchasing the same bundle at the prices that were present during a designated base year. The base year chosen is given the value 100. The GNP deflator is equal to the calculated ratio multiplied by 100. If prices are, on average, higher during the current period than they were during the base year, the GNP deflator will exceed 100. The relative size of the GNP deflator is measure of the current price level compared to price level during the base year.

103

Changes in prices and the real GNP

NOTES

The above table illustrates how real GNP is measured and why it is important to adjust for price changes. Between 1987-88 and 1991-92, nominal GNP increased 83.09%. However, a large portion of this increase in nominal GNP reflected higher prices rather than a larger rate of output. The GNP deflector in 1991-92 was 147.08 compared 100 in 1987-88. Prices rose by 47.08% between 1987-88 and 1991-92. Determining the real GNP for 1991-92 in terms of 1987-88 prices, Real GNP (1991-92) =Nominal GNP (1991-92) x [GNP deflator (1987-88)] / [GNP deflator (1991-92)]. Because prices were rising, the letter ratio is less than one. In terms of 1987-88 prices, the GNP in 1991-92 was Rs. 3, 63,785 crore, only 24.49% more than in 1987-88. So, although money GNP expanded by 83.09%, real GNP increased by only 24.49%. A change in nominal GNP tell us nothing about what is happening to rate of real production unless we also know what is happening to prices. Money income could double while production actually declines, if prices more than double. On the other hand, money income could remain constant while real GNP increases, if prices fall during a time period. Data on money GNP and price changes are both essential for a meaningful duration a time period. Data on money GNP and price changes are both essential for a meaningful comparison of real income between two time periods. So we look at real rather than nominal GNP as basic measure for comparing output in different years. The measurement of national income: output, expenditure and income methods of measurement There are three methods of calculating national income, and they are all conceptually equivalent to each other. These are: the output method, the income method and the expenditure method. These three measures give rise to several different ways of describing the various macro-aggregates employed in compiling the national accounts and these are described and illustrated in tables. 1. The output method: The output method is followed either by valuing all final good and services produced during a year or by aggregating the value imparted to the intermediate products at each stage of production by the industries and productive enterprises in the economy. The sum of these values added gives the gross domestic product at factor cost which after a similar adjustment to include net factor income from abroad gives gross national product at factor cost. This approach is used to estimate gross and value added in the primary sector- Ex. Agriculture, and allied activities, forestry and logging, fishing, registered manufacturing, etc.-of the Indian Economy.

104

Macro-economics Analysis

The output (value added) method The agricultural and extractive industries

10

Plus

Manufacturing industries

40

Plus

Services and construction

40

Equals

Gross Domestic Product at factor cost

90

Plus

Net factor income from abroad (=income received from abroad- income paid abroad)

NOTES

10

Equal

Gross National Product at factor cost

100

Less

Capital consumption or depreciation

-20

Equals

NNP at factor cost or national income

80

2. The Expenditure method: The expenditure method aggregates all money spent by private citizens, firms and the government within the year, to obtain total domestic expenditure at market prices. This includes consumer spending and investment i.e. total domestic spending. It aggregates only the value of final purchases and excludes all expenditures on intermediate goods. However, since final expenditure at market price includes both the effects of taxes and subsidies and our expenditures on imports while excluding the value of our exports, all these transactions have to be taken into account before we obtain gross national product by this method. For instance, in case of private consumption expenditure, quantities of goods and services entering private consumptions are estimated by deducting from quantities produced, quantities used up in intermediate uses, purchased by government, etc. Similarly several items of machinery and equipment are identical and market values of their output are together to estimate capital in from of machinery and equipment. The Expenditure Method Consumer’s expenditure(C)

70

Plus

20

Plus Plus

Government current expenditures on goods and services (G) Gross domestic fixed capital formation (I) Value of physical increase in stocks and work in progress (I)

Equals Total domestic expenditure at market prices

20 10 120

Plus

Exports and factor income from abroad (E)

20

Less

Imports and factors income paid abroad (M)

-30

Equals GNPMP

110

Less

Indirect taxes

-20

Plus

Subsidies

Equals Gross national product at factor cost

10 100

105

NOTES

3. The Income Method: The income approach to measuring national income does not simply aggregate all incomes. It aggregates only those of those residents of the nation, corporate and individual, that obtain income directly from the current production of goods and services. It aggregates money payments made to the different factors of production i.e. factors income and excludes all incomes which cannot be concerned as payment for current services to production (i.e. Transfer incomes and which therefore do not enter national income). What is factor payment for the producers is factor income for factor owners. It includes wages and salaries (W), rent (R), interest (I) and profits (P). The last includes the profits of companies and surpluses of public corporations. Thus, the total of all factor income gives total domestic income which once adjusted stock appreciation gives gross domestic product at factor cost. If we then add on net factor income from abroad we have obtained one measure of gross national income or more properly known as gross national product. The Income Method Income from employment

50

Plus

Income from self-employment

10

Plus

Gross Trading profits of companies

10

Plus

Gross Trading surplus of public corporations

10

Plus

Rent

10

Equals Gross domestic product at factor cost

90

Plus

10

Net factor income from abroad

Equals Gross national product at factor cost

100

According to above table, conceptually whatever may be the method followed for the measurement of national income, with appropriate adjustments all three methods will give the same result. Hence, the three methods give rise to estimates of GNP which once adjusted to take account of capital consumption (depreciation) provides the measurement of national income by different methods, the consistency and accuracy of the national income estimates can be cross checked. Other measures of national output There are five alternative measures of national product and income: 1. Gross national product 2. Net National income 3. National income 4. Personal income 5. Disposable income The bar chart given below explains the relationship among five alternative measures of national product. The alternatives range from GNP, which is the broadest measures of output, to disposable income, which indicates the funds available to households for either personal consumption or saving.

106

Five alternative measures of income

Macro-economics Analysis

NOTES

GNP’s measured through expenditure method is the sum of consumption (C), Gross Private Domestic Investment (I), Government Purchases (G), and Net Export (E-M). Exports include factor income received from abroad and factor income paid abroad is included in imports. Therefore, net exports include net factor income from abroad (NFIA). By deducting depreciation from abroad net indirect taxes from NNP MP, we get NNPFC, widely known as National Income. Through income method, national income can also be calculated by summing up payments to all factors production: Land, Labor, Capital and Entrepreneurship. Factor payments to land are rents, to labor wages, to capital interest payments and to entrepreneurship profits. Therefore national income computed through income method is equally to sum of rents, wages, interests and profits. Total profits can be either from incorporated business or unincorporated business. Profits of incorporated are corporate profits and profits of unincorporated business (like self-employment, small scale industries, etc.) are proprietors’ income. Personal income is the total income received by individuals that is available for consumptions, saving and payment of personal taxes. When we subtract income that is earned but not directly received from and add income that is received but not earned during the current period to national income we get personal income. Thus, corporate profits (Profit before Taxes) which are equal to corporate profit taxes plus retained earnings plus dividends and social insurance taxes are deducted and transfer payments, net interest and dividends are added to national income to get personal income. Disposable income is the income available to individuals after personal taxes i.e. Disposable income = personal income minus personal taxes. It can be either spent on consumption or saved. Difficulties in measuring the national income in India There are some conceptual and statistical problems in measuring national product. Some items are excluded from the national income accounting, even though they would be properly classified as “current production” of goods and services. Sometimes production leads to harmful side effects which are not taken into consideration. A brief discussion of some of these limitations of national products is given below. 1. Non-market production The national product fails to account house hold production because such production

107

does not involve a market transaction. As a result the house hold services of millions of people are exactly from the national income accounts. e.g. house work done by housewives is not included but the same work done by paid servant is. 2. Imputed values

NOTES

Some self supplied goods and services are given as imputed values for their inclusion in national income accounts, for examples, owner-occupied houses and the value for food consumed by the farmers themselves. Sometimes this may results in overestimation or underestimation of national income. 3. The underground economy There are many transactions that go unreported because they involve either illegal activities or taxes evasion. Most of these underground activities produce goods and services that are valued by the purchasers. However, these activities are unreported and not included in national income accounts. They do not figure in our product estimate. 4. “Side-effects” and economic” bads” National income accounts make no adjustment for harmful side effects that sometime arise from several productive activities and the events of nature. If they do not involve market transactions, economic “bads” are not deducted from national product. When private rights are not defined properly, air and water pollution are sometimes side effects of the process of economic activity and reduce our future production possibilities. Similarly the growing defense and the greater outputs of military equipment might increase the national product but the moot point is whether the country has become better off or not. Since national accounts ignore these negative aspects of growth and development, it tends to over state a real national output. 5. Leisure and human cost According to Simon Kuznets, the failure to fully include leisure and human costs is one of the grave oddities of national income accounting. National income accounts exclude leisure, a commodity that is valuable to everybody. Similarly national product also fails to take into account human cost of employment in terms of the physical and mental strains associated with many jobs. On an average, jobs today are relatively less strenuous and less exhausting than they were some forty years ago, but they have become perhaps more monotonous. These limitations reduce the significance of national product comparisons in the long run. 3. Double counting There is a possibility that some output may be counted twice. Thereby the measure of national product is exaggerated. We must exclude the value of inputs if they have already been accounted for. Because, the distinction between intermediate product and final product is vital in connection with the welfare significance of the national product measure. To calculate real national income or national income at constant prices for year X: National income at market prices x

100(base year price index)

Price index of year X National income must be related to the size of population. When national income is divided by the total population, this gives per capita national income. The uses of national income statistics National income statistics have four main uses: 1) As an instrument of economic planning and review. 2) As a means of indicating changes in a country’s standard of living.

108

3) As a means of comparing the economic performance of different countries.

Macro-economics Analysis

4) To indicate changes in the economic growth of a country. 1) As an instrument of economic planning and review The statistics provide important background information on which the government can base its decisions. Private corporate sector can also use the statistics to assess future prospects. The figures help in answering numerous questions, such as whether the economy is growing and at what rate. Which industries are declining and which are expanding? What is happening to consumer spending, savings and the economy as a whole?

NOTES

2) As a means of indicating changes in a country’s standard of living. National income statistics are used to assess changes in the standard of living within a country. If the national income increases, it is normally assumed that the standard of living has improved. However, this may not be the case and certain factors have to be taken into account to understand why the living standard has not improved: z

National income statistics may be expressed in market or current prices and therefore show an increase due to inflation. Real national income or national income at constant prices, where statistics are expressed as an index of prices, is a more reliable indicator.

z

Another problem, however, is that this says nothing about the distribution aspects of a national income.

z

The increase in national income may be accompanied by high social costs such as pollution, congestion and damage to the environment. There may be less leisure time, too.

z

The national income increase may be due to more exports and fewer goods for home consumption or more defense spending. Both these situations may not improve citizens’ standard of living.

z

National income statistics say nothing about the quality of output.

3) To indicate changes in the economic growth of a country The best indicator of economic growth is changes in real national income per capita. However, usually growth is expressed in terms of percentage changes in GNP. Economic growth is usually thought to be desirable because it means a better standard of living for citizens and more wealth to be allocated. More money can be spent on social overheads such as education, health, etc. It is a fact that our economic growth during the past two decades has been disappointing compared to that of other developing and newly industrialized countries such as China, Taiwan, South Korea, etc. The reasons for this may include: z

Poor management of public and private sector undertakings;

z

Damage done by industrial disputes and frequent lockouts;

z

Education not fitting industry’s needs and requirements;

z

Lack of investment in new technology;

z

Propping up old and declining industry;

z

Government taxation policy reducing the amount of money corporate sector has for investment;

z

Constant changes in government economic policy- high interest rates, high exchange rates, inflations followed by changes in administered prices, budget deficits, etc.

109

NOTES

z

Low quality of labor;

z

Low level of productivity;

z

Lack of consistency in managing the economy and policy; and

z

Fragile Balance of payments (BOP) situation

4) As a means of comparing the economic performance of different countries National income statistic gives a guide to the standard of living in two different countries. However, there again some difficulties: z

The statistic may be calculated differently.

z

To avoid the effect of inflation and population size, the statistics are best presented as real national per capita.

z

The distribution aspect of national income does not fit into the statistics.

z

There is the problem of the exchange rate between the currencies of two countries.

z

The size and composition of unrecorded transactions may differ between the tow countries.

z

The two countries may have different cultures and climates, therefore commodities required in one country are not in demand in other.

z

National income statistics tell us nothing about the number of doctors per head of population, the availability of leisure activities, the climate rate or the number of people physically or mentally ill.

6.5. SAVING AND CONSUMPTION FUNCTION Consumption expenditure is a very important part of aggregate demand, generally the largest component of aggregate demand. Of the many variables influencing consumption expenditure, income is the most important. The relationship between consumption and income is described by consumption function. We assume that consumption demand increases linearly with increase in level of income: C = a+ bY;

a>0,

0