UNIT – I INTRODUCTION OF MANAGERIAL ECONOMICS

UNIT – I INTRODUCTION OF MANAGERIAL ECONOMICS 1. What is Managerial Economics? Critically examine its nature and scope? Ans: Economics is a social science. Its basic function is to study how people- individuals, households, firms & nations- maximize their gains from their limited resources & opportunities. In economic terminology, this is called maximizing behavior or, more approximately, optimizing behavior. Optimizing behavior is, selecting the best out of available options with the objective of maximizing gains from the limited resources. For most purposes, economics can be divided into two broad categories: Micro Economics and Macro Economics. Macroeconomics is the study of the economic system as a whole. It includes changes in total output, total employment, the unemployment rate and exports and imports. The goal of macroeconomics is to explain the economic changes that effect many household, firms and markets at once. Micro economics focuses on the behavior of the individual actors on the economic stage, i.e., firms and individuals and their interaction in markets. Economics is thus a social science, which studies human behavior in relation to optimizing allocation of available resources to achieve the given ends. Definitions of Economics According to Dr. Alfred Marshall ―Economics is a study of man‘s action in the ordinary business of life: it enquires how he gets his income and how he uses it‖ According to Pigou ―Economics is the study of economic welfare that can be brought directly and indirectly, into relationship with the measuring rod of money‖ The subject matter of economics science consists of logic, tool & techniques of analyzing economic as well as, evaluating economic options, optimizing techniques and economic theories. Application of economic science in business decision making is all pervasive. More specifically, economic laws and tools of economic analysis are now applied a great dealing in the process of business decision making. This has led, as mention earlier, in the emergence of separate branch of study called ―managerial economics.‖ Economics principles by themselves don‘t offer readymade solutions applicable in the changing business world. After the Second World War and particularly after 1950 with the expansion of business all over the world the business managers faced with many problems due to changing environment and the consequent variability and unpredictability of their achievements. There is a gap between economic theory and the exact procedure they have to apply to arrive at correct decisions in the treatment of business problems. These problems are attracted the attention of academics and resulted in a separate branch of knowledge for treatment of business problems and this has come to be Managerial Economics.

Managerial economics should be thought of as applied micro economics. It is an application of the part of micro economics that focuses on the topics that are of greatest interest and importance to managers. Managerial economics may be viewed as economics applied to problem solving at the level of the firm. It is a science which deals with the application of economic theory in managerial functions, It is a study of allocation of resources available to a firm relate to choices managerial economics implies that the focus of the subject is an identifying and solving the decision problems faced by the managers all the time. It has gained greater importance in the recent years mainly because it enables the management to take proper decision in their business at every stage whether it be allocation of resources, calculation of cost, determination of output, forecasting, expansion of market of production, profit planning etc..

While economics is concerned with determining the means of achieving given objectives in the most efficient manner, Managerial Economics is the application of economic theory and methodology to decision making problems faced by both public and private institutions. The two major components of managerial economics are decision making and forward planning. Economics applied in decision making. It fills the gap between Economic Theory and managerial practice.

In general, managerial economics can be used by the goal oriented manager in two ways. First, given an existing economic environment, the principles of managerial economics provide a frame work for evaluating whether resources are being allocated efficiently with in a firm. Second, these principles help managers respond to various economic signals.

Managerial Economics Definitions Managerial economics is defined by different authors according to their views. Some of the wellknown definitions are as follows: Milton H. Spencer and Louis Siegel man:defines Managerial Economics as ―The Integration of Economic Theory with business practice for the purpose of facilitating Decision Making and forward planning by management. According to Edwin Mansfield:―Managerial economics is concerned with the application of economic concepts and economic analysis to the problem of formulating rational managerial decisions‖. According to James Bates and J.R. Parkinson:―Managerial economics orBusiness economics is a study or the behavior of the firm in theory and practice‖.

The Nature and Scope of Managerial Economics Nature: Human needs are unlimited and moreover ever recurring. These wants may be either basic needs or comforts or even luxuries in respect of food, clothing, shelter, health, education, entertainment etc... In fact of such needs are endless. However, the means of satisfying these wants are in form of products and services. The resources are limited (scarce) to produce the products and services and at the same time all these scarce resource have alternative uses, their employment and utilization have to optimal and efficient. As in the same, all the enterprise engaged in offering various products and services to be small or large to allocate its scarce (limited) resources in most efficient manner for its basic survival and growth. Managerial economics studies about the firm and scarce resources for maximizing output, finding solutions to the firm to the problem of the firm for maximizing profit.

Managerial economics is goal oriented. The course of action is chosen from available alternatives. It uses tools and techniques which are derived from management economics, statistics, accountancy, sociology and psychology. Economics is the study of economic actions of individual in daily life. Economic actions are under taken for the direct satisfaction of our wants Economics is a study of man‘s action in relation to the satisfaction of his wants. Economics thus study of human actions and behavior as a relationship between unlimited wants and limited means.

Economics as a branch of knowledge is concerned with the study of the allocation of scarce resources among completions ends. Managerial economics also has inherited this problem from economics. It is assumed that the firm or the buyer acts in a rational manner. The basic feature of economics is assuming that, other things remaining the same. This assumption is made to simplify the complexity of the managerial phenomenon. So many things are changing simultaneously.

Managerial Economics is also known as business economics since its major focus is on business problems, is has a blend of features on many a business elated discipline apart from economics from which it originates primarily. Since this is newly formed discipline no uniform pattern is adopted and different authors treat the subject in different ways.

Thus, the nature of Managerial Economics can be known through its relation with various other disciplines such as a micro and macroeconomics, normative and descriptive economics, the theory of decision making, operation research and statistics. It is said that a successful business economist will try to integrate the concepts and methods from all the disciplines.

1) Micro-Economic Frame work — The micro-economic analysis deals with the problem of an individual firm,industry, etc… In the case of managerial economics micro economics helps in studying what is going on with in the firm. The micro economic theory is also known as the price theory. It provides various concepts for the determination of the price of commodities, services and factors of production. The chief source of concepts and analytical tool for managerial economics is micro economic theory, some of the popular micro economic concepts are elasticity of demand, production analysis, cost analysis, opportunity cost, present value, pricing under various market structures and profit management etc.., It also includes the behavior of the consumer in his individual capacity. Managerial Economics use some well accepted models in price theory such as the model for monopoly price, model of price discrimination and behavioral and marginal models Macro Economics: A successful manager has to acquaint himself with the general business conditions, which influence supply and price of commodities as well as factors of production. Especially in forecasting demand, the general economic environment is taken into account,. The other macro variables like income, general price levels, rate of foreign exchange etc.. Influence business so closely. Hence, the managers has to grasp the various concepts related to them form macroeconomics also. 2) Managerial Economics is Normative approach (Normative Vs Descriptive Economics): Managerial Economics is considered as a part of normative economics. This is because it is prescriptive in nature rather than descriptive. It is concerned with those decisions which are to be made keeping in view the objectives of a firm, if profit is taken as the objective of the firm. Managerial economics proved various alternatives to achieve the desired profit. The descriptive economics only describes relations and situation. It indicates only the possible consequence based on certain relations but the best choice amongst them is not made. Normative approach of managerial economic decide the logic which fits into a given purpose.

Integration of Economic Theory and Business practice: Managerial economic prefers the practical approach. It is concerned with the application of economics theories in the business practices. With the help of economics one can understand the

actual business behavior. Managerial Economics attempts to estimate and predict the economic quantities and relationships It cannot ignore the environment within which they operate. Scope: The main focus in managerial economics is to find an optimal solution to a given managerial problem. The problems are concerned with managerial decisions such as production, reduction or control of costs, determination of price of a given product or service, make or buy decisions, inventory decisions, capital management or profit planning and management, investment decisions or human resource management. To overcome these problems economist makes use of concepts, tools and techniques of economics and other related disciplines to find an optimal solution to a given managerial problem.

Concepts, techniques and tools of managerial economics

Production Costing Capital management Inventory Profit planning Human resource Demand analysis Investment decisions Make or buy decisions Determination of price of given product or service

Optimal solution of problems

Managerial economics can be used to analyze the demand of a product. The subject also suggests several ways and methods for estimating the present and future demand of any product. Managerial economics and its cost concepts can be employed to analyze the cost of a product. Besides analyzing cost, a manager would also like to know the exact amount of cost. Managerial economics provides alternative methods for estimating the cost of a product. Another important aspect of managerial decision making is a price of a product. Lastly M.E provides a frame work for planning the capital expenditure decisions of a firm. It also helps a manager to estimate the cost of firm‘s capital and the cash flows associated with a project. Managerial economics has a close connection with economic theories, OR, statistics, mathematics and the theory of decision making. It also draws together end relates ideas from various functional areas of management. Different authors have given different definitions to the scope of Managerial economics leaving divergence of opinion about the subject matter. However the following elements accepted in general and provides‘ scope of managerial economics:

1) 2) 3) 4)

Area of study (or) subject matter of managerial economics Managerial economics with other disciplines Profits Optimization

1).Area of study (or) subject matter of managerial economics: Broadly, managerial economics is concerned, the following aspects constitute it: A)

Demand analysis and forecasting

B)

Cost and production analysis

C)

Pricing decisions and policies, practices

D)

Profit management

E)

Capital management (or) capital budgeting

A) Demand analysis and forecasting: Demand analysis attempts to understand the consumer behavior. This analysis answers he questions such as why do consumer buy a commodity? When do they buy or stop consuming a commodity? How they react if price changes? Thus, knowledge of demand theory and demand analysis is essential in making decisions in choice of commodities for production. Demand analysis attempts at finding out the forces determining the sales. It strengthens market position and also enlarges profits. Therefore, demand determination, demand distinction and demand forecasting occupy a strategic role in the subject matter of managerial economic. Two main managerial purposes in demand analysis are 1)

Forecasting sales

2)

Manipulating demand

B) Production and Cost Analysis: Production theory describes the cost behavior. It explains how average and managerial cost vary when production is varied. It forecast the level of output due to the changes made in the factor of inputs. In brief, it helps in determining the size of the firm, size of the total output, and the factor proportion. In decision making cost estimates are very essential, Production, profit planning depend upon sound pricing practices and accurate cost analysis. The cost analysis makes a manager of a firm to produce in an ideal way and make it to serve in midst of other competitive producers, while

ensuring considerable profit. Production analysis deals with physical terms of product. Cost analysis deals with monetary terms C) Pricing Decisions, Pricing Policies &Practices: Price theory basically explains the way the prices are determined under different market structures. The success (or) failure of a firm mainly depends on accurate price decisions. Price theories determine the price policies of a firm. Price and production theories together, in fact, help in determining optimum size of the firm. Thus, the pricing methods, price determinants, price polices and price forecasting are also dominating the subject contention of managerial economics. D)Profit Management: The survival as well as the success of every firm depends on its ability to earn and also maximize profit. It must also be understood that for maximizing profits, the firm needs to take care of its long-range decisions i.e. investment decisions. However, a satisfactory level of profit is not always guaranteed as the firm has to carry out its activities under conditions of uncertainty in regard to demand for the product, inputs prices in the factor market, degree of competition, price behavior under changing conditions etc. therefore an element of risk always exist even if most efficient techniques are used for predicting future. The firms are therefore supposed to safeguard their interest and avert as far as possible the possibilities of risk or minimize the risk. Profit theory guides in the measurement and management of profit, in making allowances for risk premium, in calculating the pure return of capital and pure profit and also in future profit planning. Profit management thinks the profit policies, techniques and profit planning like BEP analysis.

E)Capital Management: Capital is a scare and an expensive factor in firms and it is a foundation of a business. Efficient capital allocation and management is one of the most important tasks of the managers. The major issues related to capital are A) Choice of capital B)Assessing the efficiency of capital C)Allocation of capital Efficient Capital theory can contribute a great deal in investment decision, choice of projects, maintaining capital intact, capital budgeting etc., has its own vital bearing in the subject code of managerial economics. Capital budgeting deals with planning and control of capital expenditure, cost of capital, rate of returns

2) Profits:Profits are primary measure of success of any business; these are the acid test of the economic strength. Economic theory makes a fundamental assumption that maximizing profit. Modern firms pursue multiple objectives such as welfare, obligations to the society and consumers. 3) Optimization:Optimization is a basic to managerial economics in decision making It offers numerical solutions to problem of making optimum choices. Managerial Economics is concerned with optimization of certain objective functions of a firm within given constraints. Obviously, the goals of business have to be determined resources assessed and their use pattern decided upon, so as to accomplish the goal of business in the best possible manner. In recent years, optimization researchers have discovered the term ―sub optimization‖

Q2. Define demand? Determine the determinants of demand? Ans: Demand Demand is on of crucial requirement for the existence of any business enterprise. Business executives have to make decision on such matters as what to produce and how much to produce and demand analysis helps managing to make decisions with respect to production, advertising, cost allocation, pricing, inventory holding etc. Information on the size and type of demand helps management in planning its requirement of men, material, machine and money. Similarly, executives entrusted with the task of selling the produces and promoting its sales, have to make a choice between alternative prices and between markets. For its successful operation the firm has to plan for future production, inventor of raw materials and advertising etc. Demand forecasting attempts to estimate the likely demand for a product in future. Production can be better planned if future demands are identified. Every want, supported by the willingness and ability, constitutes demand for a particular product or service. In other words, if a person wants to buy a car but he cannot pay for it, then there is no demand for the car from any side. A product or service is said to have demand when three conditions are satisfied: • • •

Desire on the part of the buyer to buy it Willingness to pay for it Ability to pay the specified price for it Unless all these conditions are fulfilled, the product is not set to have any demand

Meaning of Demand: Demand for a commodity refers to the desire backed by the necessary, purchasing power. By demand we mean the various quantities of a given commodity or service which consumer would buy in one market, in a given period of time, at a various prices or at various incomes or at

various prices of related goods. Demand refers to the quantity of a product or a service that the consumers are desired, willingness to buy, an ability to purchase during a specified period under given set of conditions. Demand for commodity implies ▪ ▪ ▪

Desire to acquire it Willingness to pay for it Ability to pay for it

All the three must be checked to identify and establish demand, It should also note that the demand for a product or service has no meaning unless it is stated with specific reference to the time, its price, price of related goods, consumer income and tastes and preferences etc.. Thus is because demand, is used in economics, varies with fluctuation in these factors. To sum up, the demand for a product is the desired for that product, backed by willingness as well as ability to pay for it. It is always defined with reference to a particular time, place, and price and given values of other variables on which it depends.

Determinants of Demand The demand for a commodity depends on the individual desire to purchase, and capability to purchase it. The desire to purchase is revealed by tastes of the individual, the capability to purchase depends on his purchasing power, his income, price of the commodity. This concept is a dynamic it means determinants changes in relation to change in the nature of the product. So, we can say that the amount demanded of a commodity depends upon the following determinants

General Factors

Price of the Income of the Taste product it self and consumer the Price preference of of consum related er goods

Factors Determining Demand Additional related to factors & luxury goods durabl es Consumer’s future Consumer’s expectations of prices future expectations of income

Additional related to factors dem market and Popu o Social, lati n Demographic Economic consu distribution of and mers

1). Change in price of goods (Price of the product) : The primary determinant for any product is its price. If the price of product changes like low and high the demand will be impacted. Obviously demand is affected by the change in the price of a commodity

i.e. there is an inverse relationship between price of the product and quantity demand i.e. Increase in price Decrease in price Decrease in demand

Increase in demand.

2) Price of other ―related commodities‖ (substitutes and complements) Substitute goods —The price of one product and the quantity of other products move in the same direction those products are called as substitute goods for the product. The related goods are substitute goods that satisfy the same want. When a commodity is substituted for another commodity, the price of one commodity determines the demand for another commodity. Ex: 1). An increase in price of Pepsi will create a huge demand for coke and vice versa. 2). An increase in price of Coffee will create a huge demand for Tea and vice versa. Complementary goods: The price increase of one product causes quantify of demand decrease in other products. The price of one commodity and quantity of other product move in the opposite direction. The compliments that are required together to satisfy the same want.Ex: Pen – Ink, Petrol – Automobile, Tea – Sugar. Ex:

1).

An increase in price of Petrol will impact on Automobile sales

2).

An increase in price of Bread price will have a negative impact on the sale of butter and Jam, they go together. If the price of the petrol falls and as a result you drive your car more. This extra driving will increase the demand for motor oil. Conversely an increase in price of Petrol will diminish a demand for motor oil.

3). Change in the tastes and preferences of consumers: It has a decisive influence on their pattern of demand. A change in consumer tastes favorable to the product possibly prompted by advertising fashion changes will mean that more will be demanded at each price i.e. demand will increase. An unfavorable change in consumer preferences will cause demand to decrease 4). Money and income of consumers:This is another important influence factor on demand. As income (Real purchasing capacity) goes up, the demand for the product increases likewise when

income of consumers decreases the demand for the product also decreases. Thus, the income effect on demand may be positive or negative. Example: The impact of changes in money income upon demand is a bit more complex. For most commodities a rise in income will cause an increase in demand. Consumers typically buy more shoes, goggles, and T-shirts. Etc. As their incomes increase. Conversely the demand for such products will decline in response to a fall in incomes. Commodities the demand for which varies directly with money income are called as superior or normal goods. Commodities whose demand varies inversely with a change in money income are called as poor men / inferior goods. 5)Consumer expectations with respect to future prices and income : Consumer expectations of higher future prices may prompt them now to buy more in order to beat the anticipated price rises, and similarly the expectation of rising incomes may induce consumers to spend more. The demand for these products is known as speculative demand. Thus the price expectation effect on demand is not certain. 6) Change in money supply: INFLATION: A general increase in the level of prices accompanied by a fall in the purchasing power of money caused by an increase in the amount of money in circulation and money in circulation and credit available. DEFLATION : A reduction in the amount of money available in an economy resulting in lower levels of economic activity, industrial output and very low increase in the wage system of employees.

7). Change in money savings: Past income or accumulated saving out of that income and expected future income, its discounted value along with the present income, permanent and transitory (short-lived) all together determine the nominal stock of wealth of person. The real wealth of consumer will have an influence on his demand in the market i.e. this savings lead to further improvement of wealth or new purchases. 8). The number of consumers in the market (Total population):It is equally obvious that an increase in the number of consumers in the market brought about perhaps improvements in transportation and population growth will constitute an increase in demand. Few consumers decrease in demand.

9). Advertising and sales promotion: In today‘s world, advertisement has a major role to play in the demand creation for a product. Advertisement creates the awareness about product, so the customer will be influenced and the demand for the product goes up. 10). Physical Environmental conditions: The demand for commodities will also depend upon climate conditions.

Q3. What are the methods and Objectives of demand forecasting? Suggested Answer:Demand forecasting:While price and cross elasticity‘s are useful for pricing policy, income elasticity can be used for forecasting demand for the product in future. Thus, production planning and management in the long run depend significantly upon the knowledge of income elasticity, as the business man can then find out the impact of changing income levels on the demand for his commodity. Concept of demand forecasting: Planning is the most important function of managing. In the simplest terms, planning thinking before doing. It is done to minimize the risks arising out of an uncertain future. The risks associated with an uncertain future can be negated if one tries to make reasonable assumptions about the course that the future is likely to take. Such an estimation of the future situation is known as forecasting. The future can be predicted in two ways. As every variable depends upon some other variables, it may be possible to estimate the value of the dependent variables, while disregarding any action of the firm, which will affect the independent variables. Such forecasts are known as passive forecasts. On the other hand, if estimates of future situations are made considering the likely future actions of the firm they are called active forecasts. Both the active and passive forecasts are important to a manager in order to ascertain the survival of the firm in the long-run. Be it the raising of finance, planning of production or setting up of a distribution network, prediction of demand forms the basis of almost all important managerial decisions. Demand Forecasting essentially involves ascertaining the expected level of demand during the period under consideration. Sales is a function of demand. Likewise, even cost of production depends upon demand. The need for forecasting demand arises because production depends upon demand. The need for forecasting demand arises because production of any commodity requires time and resources. One thus has to know future demand in order to plan the level of production and make arrangements for the resources to be consumed. Methods of demand forecasting: A number of techniques are available for forecasting demand. In view of the important role of demand forecasting in managerial decision-making, it is crucial to use a technique that gives the most accurate forecast with the least possible cost and the minimum use of other resources. Besides accuracy and cost consideration, the choice of a

forecast technique is also guided by the urgency of a forecasting technique requirements and the availability of data. A more accurate forecast will require complex data and be expensive, while a simplest forecast will be easy to make, use readily available data and be less costly. Forecasts of greater accuracy will require more resources. The forecasting methods thus range from simple to complex and from relatively inexpensive to expensive. However, the ranking of forecasts is not universal. Which forecast is the best in a given situation, depends upon the nature of the concerned problem. It is very important for a manager to use the right forecasting technique in order to be more effective. Thus, while choosing a forecasting method, the manager should ascertain the desired level of accuracy, availability of data, the length of the forecast period and the associated costs and benefits. The cost of forecast error also effects the choice of the forecasting method. Where the cost of error is higher, it would be prudent to use a method with a higher degree of accuracy. Less accurate forecasts in such cases would lead to erroneous managerial decisions, which can be critical. Let us now discuss the important forecasting techniques, their advantages and drawbacks. Since a wide choice of forecasting techniques are available and choosing the right technique is crucial, it is important for managers to have knowledge of the whole range of forecasting techniques. Forecasting techniques can be broadly classified into two categories: Qualitative techniques and Quantitative techniques. The qualitative techniques obtain information about the likes and dislikes of consumers, while the quantitative ones forecast future demand by using quantitative data from the past and extrapolating it to make forecasts of future levels. These techniques are thus suited to short-term and long-term forecasting, respectively. Forecasts for new products for which no past data is available can be made only by qualitative methods because there is no quantitative data available that can be extrapolated.On the other hand, demand for existing products can be forecasted by employing any of these two methods. Expert opinion method: This technique of forecasting demand seeks the views of experts on the likely level of demand in the future. Experts are informed persons who know the product very well as they have been dealing with it and related products for a long time.They thus have a rich experience of the behavior of demand. This personal insight of experts is used for developing future expectations. If the forecasting is based on the opinion of several experts, then it is known as panel consensus. This kind of forecasting minimizing individual deviations and personal biases. A specialized form of panel opinion is the Delphi method. Instead of going in for direct identification, this method

seeks the opinion of a group of experts through mail about the expected level of demand.The responses so received are analyzed by an independent body. This method thus takes care of the disadvantage of panel consensus where some powerful individual could have influenced the consensus.

Advantages: 1. It is simple to conduct 2. Can be used where quantitative data is not possible. 3. The forecast is reliable as it is based on the opinion of people who know the product very well. 4. It is inexpensive 5. It takes little time Disadvantages: 1. The results are based on mere hunch of one or more persons and not onscientific analysis. 2. The experts may be biased 3. The method is subjective and the forecast could be unfavorable influenced by persons with vested interests. Consumers complete enumeration survey — This method is based on a complete survey of all the consumers for the commodity under consideration.

Interviews are used to ask consumers about the quantity of the commodity they would like to buy in the forecast period. All the data is then collected and added up to arrive at the total expected demand for that product. Advantages: 1.

Quite accurate as it surveys all the consumers of the product. 2. It is simple to use 3. It is not affected by personnel biases. 4. It is based on collected data. Disadvantages: 1. 2. 3. 4. 5.

It is costly. It is time consuming. It is difficult and practically impossible to survey all the consumers. The size of the data increases the chances of faulty recording and wrong interpretation. Useful only for products with limited consumers.

Consumers sample survey — This is miniature form of the complete enumeration method. Here instead of surveying all the consumers of a commodity, only a few consumers are selected and their views on the probable demand are collected. The sample is considered to be a true representation of the entire population. The demand of the sample so ascertained is then magnified to generate the total demand of all consumers for the commodity in the forecast period. The selection of an optimum sample size is crucial to this method. While a sample would be easily managed and less costly, it will be susceptible to larger sampling errors. The converse is true for large samples. Advantages: 1.

An important tool especially for short term projections. 2. It is simple and does not cost much. 3. Since only a few consumers are to be approached, the method works quickly. 4. The risk of erroneous data is reduced. 5. This method gives excellent results, if used carefully Disadvantages: 1.

The conclusions are based on the view of only a few consumers and not all of them. 2. The sample may not be a true representation of the entire population Sales force opinion survey —This method is similar to the expert opinion method. The difference here is that instead of external experts, employees of the company who are a part of the sales and marketing teams are asked to predict future levels of demand. The sales force,

which has been selling the product to wholesalers / retailers/consumers over a period of time is considered to know that product and the demand pattern very well. Moreover, they being company employees will be less likely to introduce the element of bias in their opinion. Advantages: 1.

Perhaps the simplest of the forecasting methods. 2. It is less costly. 3. Collecting data from its own employees is easier for a firm than to do it from external parties. Disadvantages: 1.

Consumer‘s tastes and preferences keep changing with time. What held good in the past may not necessarily continue to do so in the future as well. The opinion of the sales force may thus be erroneous.

2.

The sales force give biased views as the projected demand affects their future job prospects.

Consumer’s end use survey — we have seen in the previous chapter that goods can be either producer goods or consumer goods. They can be also a combination of these two wherein they may be used for the production of some other consumer goods and can also be used for final consumption. A commodity that is used for the production of some other finally consumable goods is also known as an intermediary good. While the demand for goods used for final consumption can be forecasted using any other methods, the end use method focuses on forecasting the demand for intermediary goods. Such goods can also be exported or imported besides being used for domestic production of other goods. For ex, milk is a commodity which can be used as an intermediary good for the production of ice-cream, paneer and other dairy products. Advantages : 1. 2. 3.

The method yields accurate predictions. It provide sector wise demand forecast from different industries. It is especially useful for producer‘s goods.

Disadvantages : 1.

It requires complex and diverse calculations. 2. It is costlier as compared to the other survey methods and is more time consuming. 3. Industry data may not be readily available.. Statistical techniques: These are forecasting techniques that make use of historical quantitative data. A statistical concept is applied to this existing data about the demand for a commodity over the past years, in order to generate the predicted demand in the forecast period. Due to this reason these

quantitative techniques are also known as statistical methods. Some important quantitative methods are as follows: Trend projection methods: This technique assumes that whatever has been the pattern of demand in the past , will continue to hold good in the future as well. Historical data can thus be used to predict the demand for a commodity in the future. In the trend projection method, historical data is collected and fitted into some kind of trend i.e, repetitive behavior pattern. This trend is then extrapolated into the future to get the demand for the forecast period. The trend could be linear or curvilinear or have any other complex shape. Future demand through the trend method can be found by either of two methods. • Graphical method • Algebraic method In the graphical method, the past data will be plotted on a graph and the identified trend will be extended further in the same pattern to ascertain the demand in the forecast period. The figure shows the past data in bold lines and the forecasted data in dotted lines. Advantages: a. b. c.

It is very simple The method provides reasonably accurate forecast. It is quick and inexpensive

Disadvantages: a. b.

Can be used only if past data is available It is not necessary that past trends may continue to hold good in the future as well. c. There is no analysis of causal relations between the demand and time series explaining the whys of it. Barometric techniques — It has been observed that despite erratic cyclical patterns in most economic time series, the movements of different economic variables exhibit quite a consistent relationship over time. Thus, there is always some time series which is closely correlated with a given time series. This correlation between two time series can be of 3 types either the second series data can move ahead or move behind or move aloud with first series data. Accordingly, when the second series moves ahead after fist series, the second series is known as the leading series while the first series is called the lagging series. The opposite holds true when the second series moves behind the first series, the series are called coincidence series if both of them move along with each other.

For example, the Bhuj earthquake in January 2001, lead to a massive destruction of property and building in Gujarat. This necessitated construction of buildings to rehabilitate the people of affected areas. The construction was followed by a spurt in the demand for cement, fans, tube lights, etc. Thus, one can say that the construction of buildings leads to the demand for cement. In this case, the construction of buildings is the leading indicator or the barometer. Forecasting technique that use the lead and lag relationship between economic variables for predicting the directional changes in the concerned variables are known as barometric techniques. This techniques requires ascertaining the lead lag relationship between two series and then keeping a track of the movement of leading indicator. Advantages : 1. 2.

It is a simple method. It predicts directional changes quite accurately.

Disadvantages : 1. 2. 3. 4.

It does not predict the magnitude of changes very well. Finding out a leading indicator for any series is not always feasible. The lead time is maintained consistently by a veryfew time series. The method can be used for short term forecasts only.

Econometric techniques —These techniques forecast demand on the basis of systematic analysis of economic relations by combining economic theory with mathematical and statistical tools. While economic theory is used to identify those variables on which other variables depend. The relationship between the dependent and causal variables is estimated through the mathematical tools. The most commonly used mathematical tool for estimation is the least square method, as discussed earlier. On the basis of both economic theory and mathematical tools, the equation that best describes the past causal relationship is selected. Regression method — Forecasting problems can often be adequately analyzed with single equation econometric models. This is also called the regression method. The relevant equation is : Dx = a + bPx + cI + dA – ePy Where a,b,c,d and e are constants. Dx is the demand X, Px is the price of X, I is the consumers income. A is the advertisement outlay and Px is the price of its substitute product Y. econometric modeling consists of expressing the economic relation in the form of an equation to be followed by estimating the parameters of the system i.e, the constants a,b,c,d and e. this usually done with the help of the least square method. Finally the equation is used to forecast the value of demand in the forecast period. Advantages:

1. 2. 3. 4. 5.

As the method is based on causal relationships it produces reliable and accurate results. Besides generating the forecast, it also explains the economic phenomenon. It is neither as subjective as the qualitative techniques nor as mechanistic as the quantitative ones. This method not only forecasts the direction but also the magnitude of the change. The method is quite consistent.

Disadvantages: 1. 2. 3.

The method uses complex calculations. It is costly and time consuming. It requires the use of some other forecasting technique for estimating the value of the causal variables.

Simultaneous equation method: When the inter relationship between the economic variables become complex, the use of single equation regression method become difficult. In such cases forecasting of demand is done using multiple simultaneous equations. This is a complex statistical method of forecasting where a complete model is developed explaining the behavior of all the economic variables. These variables are of two types. Variables whose values are determined within the system are called endogenous while those are determined outside the model are exogenous. The number of equations in such a model equals the number of endogenous variables. The model consists of two basic kinds of equations identities and behavioral equations. While the identity equations express relations that are true by definition, the behavioral equation. While the identify equation express relations that are true by definition. The behavioral equation reflects hypotheses about how the variables in a system interact with each other. These equations are solved through methods such as the two stages method. A detailed discussion of this method of forecasting is beyond the scope of this book.

Test Marketing: It is likely that opinions given by buyers, salesmen or other experts may be, at times, misleading. This is reason why most of the manufacturers favor to test their product or service in a limited market as test -run before they launch their products nationwide. Based on the results of test marketing, valuable lessons can be leant on how consumers react to the given product and necessary changes can be introduced to gain wider acceptability. To forecast the sales of an new product or the likely sales of an established product in a new channel of distribution or territory, it is customary to find test marketing in practice.

Automobile companies maintain a panel of consumers who give feedback on the style and design and specifications of the new models. Accordingly these companies make necessary changes, if any, and launch the product in the wider markets. In test marketing, the entire product and marketing programmer is tried out for the first time in a small number of well-chosen and authentic sale environment. The primary objective, here, is a know whether the customer will accept the product in the present form or not. If sales are not encouraging in the markets so tested, it is clear that the product has certain defects, which are to be looked into seriously. The company can work further to identify these defects, correct them and then test the product again, if necessary. One of the factors determining the success of the test marketing is the relevance of small market chosen. A small market representing all the features of the wide market constitutes an ideal place conduct test marketing for a given product or service. In other words, should be representative.

Control Experiments: Controlled experiment refer to such exercises where some of the major determinants of demand are manipulated to suit to the customers with different tastes and preferences income groups, and such others. It is further assumed that all other factors remain the same. In this method, the product is introduced with different packages, different prices in different markets or same markets to assess which combination appeals to the customer most. Regression equation can be built upon these price-quantity relationships of different markets. This method cannot provide better results unless these markets are homogeneous I terms of, tastes and preferences of the customers, their income and so on. This method is used to gauge the effect of a change in some demand determinant like price, product, design, advertisement, packaging, and so on. This method is still in the infancy sage and not much tried because of the following reasons: • • •

It is costly and time consuming. It involves elaborate process of studying different markets and different permutations and combinations that can push the product aggressively. If it fails in one market, it may affect other markets also.

Judgmental Approach: When none of the above methods are directly related to the given product or service, the management has no alternative other than using its own judgment. Even when the above methods are used, the forecasting process is supplemented with the factor of judgment for the following reasons; •

Historical data for significantly long period is not available

• • • •

Turning points in terms of policies or procedures or causal factors cannot be precisely determined Sales fluctuations are wide and significant The sophisticated statistical techniques such as regression and so on. May not cover all the significant factors such as new technology and so on, effecting demand The results of statistical methods are more reliable at the national level rather than firm or industry level. In such a case the management has to rely more on its judgment to assess the validity of such results.

4. How do you measure the Elasticity’s of Demand? Ans. Elasticity of demand:It is a technique to measure the responsiveness in the quantity demanded of a commodity to a change in anyone of the determinants in the demand function vise, price, income, expectations, advertising expenditure etc. This technique provides a quantitative value for the responsiveness of the quantity demanded to change in each of the determinants in the demand function. Definition: Elasticity of demand is defined as the percentage change in quantity demanded earned by one percent change in the demand determined under consideration, while the other determinants are held constant. The general equation for the measurement of elasticity of demand is Ed=

Percentage change in quantity demanded of Product X Percentage change in demand determinants

Elasticity’s: There are various types of elasticity‘s of demand. However, the importance ones are given below, 1. 2. 3. 4.

Income elasticity of demand Price elasticity of demand Cross elasticity of demand Promotional elasticity of demand

Income elasticity of demand: The income elasticity of demand is the measure of the percentage change in the demand for a commodity due to a one percent change in the consumer‘s income, ceteris paribus

Ei = percentage change in Quantity demand / Percentage change in income of consumer. In other words elasticity of demand is a measure of the responsiveness of demand to the change in the variables on which it depends. Demand elasticity shows how sensitive demand is to the change in the underlying factors in the demand function. Regardless of whether the underlying factor is within or outside the control of the firm, an effect of its change by a particular amount and in a particular direction is very useful in managerial decision making. With this knowledge of elasticity of demand, a manager can use the changes in the endogenous and exogenous variables to his advantage. Thus, the firm will be able to respond effectively to the changes in the environment.

From our discussion on the determinants of demand, we know that demand increases with a rise in consumers income for superior goods and decreases for inferior goods and vice versa. Likewise, the income elasticity of demand is positive for superior or normal goods and negative for inferior goods since a person may shift from inferior to superior goods with a rise in income. I

I

Inferior Superior

D

D

Demand and consumersincome: Further, the positive income elasticity of demand can be unity, more than unity or less than unity. It is more than one when the quantity demanded increases at a faster rate than the rise in consumers income or decrease at a faster rate than the fall in income. For positive income elasticity to be less than one, the relationship will be just the opposite. However when the rise in consumer‘s income leads to a proportionate increase in demand of the commodity income elasticity is said to be unity. Income elasticity : Luxury goods such as cars air conditioners mobile phones etc. are knows to take away a large share of the consumers income and the consumer buys more of these when his income increases necessity goods on the other hand becomes less important with rising income levels. This behavior can be seen in goods like foods and cloth. Semi luxury and comfort goods witness a direct and proportionate relationship between demand and income.

The concept of income elasticity of demand is very useful in studying the effects of the changes in national income on the demand for the firm‘s products. Companies whose products have high income elasticity will grow faster when the economy will expand. Such firms are very sensitive to the level of business activity. The performance of firms having low income elasticity on the other hand will be less affected by economics changes. Price elasticity of demand — Price elasticity of demand measures the responsiveness of demand for products to changes in the price of the products, when all other variables are constant. Thus the price elasticity of demand is ep = percentage changes in demand for a commodity / percentages change in price of commodity ep = ∆Dx\Dx ∆px \ px = ∆Dx \∆Px* Px\Dx Where DDx and DPx are the changes in demand and price of the commodity X while Dx and Px are the demand and price of the commodity X at a given point on the demand curve. But for goods that are exceptions to the laws of the demand the price of demand is negative for all goods. This is because of the facts that the demand for a commodity varies inversely with its own price and vice versa .

Price elasticity varies between 0 and - a, which will be the respective conditions when the goods is completely inelastic or perfectly elastic. Between these two extremes the values of the price elasticity of demand can be clubbed into three ranges using its absolute values. Thus we can have ep> 1 i .e ep lies between -1 and –a (elastic) ep =1 ,i.eep=-1 (unitary ) and ep 0, TP will be rising as L increases. The TP curve begins at the origin, increases at an increasing rate over the range 0 to 3, and then increases at a decreasing rate. The MP reaches a maximum at 3, which corresponds to an inflection point (x) on the TP curve. At the inflection point, the TP curve changes from increasing at an increasing rate to increasing at a decreasing rate. b) If MP = 0, TP will be constant as L increases. The TP is constant between workers 6 and 7.

c) If MP < 0, TP will be declining as L increases. The TP declines beyond 7. Also, the TP curve reaches a maximum when MP = 0 and then starts declining when MP < 0.2. MP intersects AP (MP = AP) at the maximum point on the AP curve. This occurs at labour input rate 4.5. Also, observe that whenever MP > AP, the AP is rising (up to number of workers 4.5) — it makes no difference whether MP is rising or falling. When MP < AP (from number of workers 4.5), the AP is falling. Therefore, the intersection must occur at the maximum point of AP. It is important to understand why. The key is that AP increases as long as the MP is greater than AP. and AP decreases as long as MP is less than AP. Since AP is positively or negatively sloped depending on whether MP is above or below AP, it follows that MP = AP at the highest point on the AP curve. This relationship between MP and AP is not unique to economics. Consider a cricket batsman, say Sachin Tendulkar, who is averaging 50 runs in 10 innings. In his next innings he scores a 100. His marginal score is 100 and his average will now be above 50. More precisely, it is 54 i.e. (50 * 10 + 100)/(10+1) = 600/11. This means when the marginal score is above the average, the average must increase. In case he had scored zero, his marginal score would be below the average, and his average would fall to 45.5 i.e. 500/11 is 45.45. Only if he had scored 50 would the average remain constant, and the marginal score would be equal to the average.

4. Explain the law of diminishing marginal returns. The slope of the MP curve in figure illustrates an important principle, the law of diminishing marginal returns. As the number of units of the variable input increases, the other inputs held constant (fixed), there exists a point beyond which the MP of the variable input declines. Table illustrates this law. Observe that MP was increasing up to the addition of 4th worker (input)beyond this the MP decreases. What this law says is that MP may rise or stay constant for some time, but as we keep increasing the units of variable input, MP should start falling. It may keep falling and turn negative, or may stay positive all the time. Consider another example for clarity. Single application of fertilizers may increase the output by 50%, a second application by another 30% and the third by 20% and so on. However, if you were to apply fertilizer five to six times in a year, the output may drop to zero. Three things should be noted concerning the law of diminishing marginal returns. 1. This law is an empirical generalization, not a deduction from physical orbiological laws. 2. It is assumed that technology remains fixed. The law of diminishing marginal returns cannot predict the effect of an additional unit of input when technology is allowed to change.

3. It is assumed that there is at least one input whose quantity is being heldconstant (fixed). In other words, the law of diminishing marginal returnsdoes not applies to cases where all inputs are variable. Stages of Production Based on the behaviour of MP and AP, economists have classified productioninto three stages: Stage 1: MP > 0, AP rising. Thus, MP > AP. Stage 2: MP > 0, but AP is falling. MP < AP but TP is increasing (becauseMP > 0). Stage 3: MP < 0. In this case TP is falling. These results are illustrated in Figure. No profit-maximizing producer would produce in stages I or III. In stage I, by adding one more unit of labour, the producer can increase the AP of all units. Thus, it would be unwise on the part of the producer to stop the production in this stage. As for stage III, it does not pay the producer to be in this region because by reducing the labour input the total output can be increased and the cost of a unit of labour can be saved. Thus, the economically meaningful range is given by stage II. In Figure at the point of inflection (x), we saw earlier that MP is maximised. At point y, since AP is maximized, we have AP = MP. At point z, TP reaches a maximum. Thus, MP = 0 at this point. If the variable input is free then the optimum level of output is at point z where TP is maximized. 5. Explain production function with two variable inputs. Suggested Answer Output is a function of labour and capital.Capital is also varying with output.Generally in long run these two inputs vary.Also these two inputs are substitutable.These inputs are used in different combinations to produce a level of output.Q=f(L,K). Production Isoquants A production isoquant (equal output curve) is the locus of all those combinations of two inputs which yields a given level of output. With two variable inputs, capital and labour, the isoquant gives the different combinations of capital and labour, that produces the same level of output. For example, 5 units of output can be produced using either 15 units of capital (K) or 2 units of labour (L) or K=10 and L=3 or K=5 and L=5 or K=3 and L=7. These four combinations of capital and labour are four points on the isoquant associated with 5 units of output as shown in Figure and if we assume that capital and labour are continuously divisible, therewould be many more combinations on this isoquant. Production Isoquant: This isoquant shows various combinations of capital and labour inputs that can produce 5 units of output.

Isoquant Map: These isoquants shows various combinations of capital and labour inputs that can produce 10, 15, and 20 units of output.

6.What is marginal rate of technical substitution? Suggested answer The production function can be written as Q = f (K,L) The rate, at which one input can be substituted for another input, if output remains constant, is called the marginal rate of technical substitution (MRTS). It is defined in case of two inputs, capital and labour, as the amount of capital that can be replaced by an extra unit of labour, without affecting total output.

The MRTS of labour for capital between points a and b is equal to WK/WL = (4–8) / (4–2)= – 4/2 = –2 or | 2 |. Between points b and c, the MRTS is equal to –2/4 = –½ or | ½ |. The MRTS has decreased because capital and labour are not perfect substitutes for each other. Therefore, as more of labour is added, less of capital can be used (in exchange for another unit of labour) while keeping the output level constant. Marginal Rate of Technical Substitution

Not at all substitutable,perfectly substitutable,imperfectly substitutable products

7. How do you determine the optimal combination of inputs? Suggested answer Any desired level of output can be produced using a number of different combinations of inputs. As said earlier in the introduction of this unit one of the decision problems that concerns a production process manager is, which input combination to use. That is, what is the optimal input combination? While all the input combinations are technically efficient, the final decision to employ a particular input combination is purely an economic decision and rests on cost (expenditure). Thus, the production manager can make either of the following two input choice decisions: 1. Choose the input combination that yields the maximum level of output with a given level of expenditure. 2. Choose the input combination that leads to the lowest cost of producing agiven level of output. Isocost Lines Isocosts are different combinations of inputs which cost the producer same amount of money. Optimal Combination of Inputs: This is obtained by superimposing the isocost curve on the corresponding isoquant for a given level of output.

So for an output 50 optimal combination is at Z.for output 100 optimal combination is at Q 8. What is expansion path of the firm? Suggested answer; In addition to above answer, the firm expands through least cost points ie ZQS 9. What are returns to scale? Suggested answer Another important attribute of production function is how output responds in the long run to changes in the scale of the firm i.e. when all inputs are increased in the same proportion (by say 10%), how does output change. Clearly, there are 3 possibilities. If output increases by more than an increase in inputs (i.e. by more than 10%), then the situation is one of increasing returns to scale (IRS). If output increases by less than the increase in inputs, then it is a case of decreasing returns to scale (DRS). Lastly, output may increase by exactly the same proportion as inputs. For example a doubling of inputs may lead to a doubling of output. This is a case of constant returns to scale (CRS).

10.What are Economies and diseconomies of scale (Reasons for returns to scale)? Suggested answer The advantages of large scale production that result in lower unit (average) costs (cost per unit) is known as economies of scale.  

AC = TC / Q Economies of scale – spreads total costs over a greater range of output

Types Pecuniary Economies: Economies realized from paying lower prices for the factor used in production and distribution of the product, due to bulk buying by the firm as its size increases Real Economies: Associated with a reduction in the physical quantity of inputs, raw materials, various types of labor and various types of capital.    

Production Economies Selling and Marketing Economies Managerial Economies Transport and Storage Economies

Production Economies  

It may arise from the factor 1. Labor 2. Fixed capital 3. Inventory requirement of firm Production Economies Labor Economies



1.Specialization 2.Time saving 3.Automation of Production process 4.Cumulative volume Economies

Technical economies   

At large scale production the firm becomes capital intensive uses sophisticated equipment and technology which results in decrease in average cost. Selling and Marketing Economies Good relations with dealers and customers will decrease average cost

Managerial Economies Managerial efficiencies like effective planning decrease average cost of production and selling. Cost of management decreases with increase in scale up to a certain point. Transport and Storage Economies Transport cost and storage cost decrease with increase in scale. External Economies of Scale The advantages firms can gain as a result of the growth of the industry – normally associated with a particular area.     

Supply of skilled labour Reputation Local knowledge and skills Infrastructure Training facilities

Diseconomies of scale Business can become too large. Unit costs can then tend to rise. Causes: Communication 

Hierarchical structure, information overload, formal methods, less face to face, language.



Co-ordination



Different departments must work towards same goals.



Motivation



Being a small fish in a big pond syndrome. Less contact with senior managers.



Technical diseconomies



If a large machine breaks down production costs can rise.

Problems of management 

Lack of effective communication, lack of coordination, demotivation of staff, no understanding between ownership and management

11.What is Cobb Douglas Production function? Suggested Answer Cobb Douglus Production function is a production function representing constant returns to scale.Mathematically it is represented as Q=bLaK1-a Where Q is total output, L is labour employed K is fixed capital employed A and 1-a are labour and capital elasticities of production A function with values is given below. Q=1.01L 0.75K 0.25 Here if labour and capital change by 100%,q also changes by 100%.ie if L becomes 2L,K BECOMES 2K,Q becomes 2Q.

12. Explain concept of cost and various cost concepts. Suggested answer Cost Analysis Analysis of cost is very important. Profit can be made not only by maximizing revenue but also minimizing cost. So controlling cost is important. Analysis of cost is to •

Understand concept of cost

•

Classification of costs

•

Cost output relationship in short run and cost output relationship in long run.

Cost involves some type of sacrifice ie to get some benefit some thing is be spent. Cost is the expenditure incurred in producing a good or a service.Eg.;We go to hotel.We eat food.We incur some expenditure. Various costs Category of cost  

Concepts used for accounting purposes; and, Analytical cost concepts used in economic analysis of business activities.

Accounting Cost Concepts Opportunity Cost and Actual or Explicit Cost Opportunity cost can be seen as the expected returns from the second best use of an economic resource which is foregone due to the scarcity of the resources

Opportunity Cost and Actual or Explicit Cost The actual or explicit costs are those out-of-pocket costs of labour, materials, machine, plant building and other factors of production. Explicit and Implicit/Imputed Costs These are costs falling under business costs and are those entered in the books of accounts. Payments for wages and salaries, materials, insurance premium, depreciation charges are examples of explicit costs. These costs involve cash payments and are recorded in accounting practices. Implicit/Imputed Costs Those costs that do not involve cash outlays or payments and do not appear in the business accounting system are referred to as implicit or imputed costs. Implicit costs are not taken into account while calculating the loss or gains of the business The explicit and implicit costs together (explicit +implicit costs) form the economic cost. Out-of-Pocket and Book Costs Expenditure items that involve cash payments or cash transfers, both recurring and nonrecurring, are referred to in economics as out-of pocket costs. All the explicit costs including wages, rent, interest, cost of materials, maintenance, transport expenditures, and the like are in this classification. Some actual business costs which do not involve cash payments, but a provision is made in the books of account and they are taken into account while finalizing the profit and loss accounts. Such costs are known as book costs. These are somehow, payments made by a firm to itself. Fixed and Variable Costs Costs that are fixed in volume for a certain level of output. They do not vary with output. They remain constant regardless of the level of output. Fixed costs include: i.

Cost of managerial and administrative staff; (ii) Depreciation of machinery; (iii) Land, maintenance. Fixed costs are normally short-term concepts because, in the long-run, all costs must vary.

Variable Costs are those that vary with variations in output. It includes: (i) Cost of raw materials; (ii) Running costs of fixed capital, such as fuel, repairs, routine maintenance expenditure, direct labour charges associated with output levels; and (iii) The Costs of all other inputs that may vary with the level of output. Total, Average, and Marginal Costs The Total Cost (TC) refers to the total expenditure on the production of goods and services. Total cost includes fixed cost and variable cost.(TC=FC+VC) The Average cost (AC) is obtained by dividing total cost (TC) by total output (Q). AC = TC/Q

Marginal Cost (MC) is the addition to total cost on account of producing one additional unit of a product. It is the cost of the marginal unit produced. MC = Change in TC/ Change in Q = ΔTC/ ΔQ Short-Run and Long-Run Costs Short-Run Costs are costs which change as desired output changes, size of the firm remaining constant. These costs are often referred to as variable costs. Long-Run costs, on the other hand are costs incurred on the firm‘s fixed assets, such as plant, machinery, building, and the like. Incremental Costs and Sunk Costs Refers to the total additional cost associated with the decision to expand output or to add a new variety of product. The concept of incremental cost is based on the fact that, in the real world, it is not practicable to employ factors for each unit of output separately due to lack of perfect divisibility of inputs. It also arise as a result of change in product line, addition or introduction of a new product, replacement of worn out plant and machinery, replacement of old technique of production with a new one, and the like The Sunk costs are those costs that cannot be altered, increased or decreased, by varying the rate of output. once management decides to make incremental investment expenditure and the funds are allocated and spent, all preceding costs are considered to be the sunk costs since they accord to the prior commitment and cannot be reversed or recovered when there is a change in market conditions or a change in business decisions. Historical and Replacement Costs Historical cost refers to the cost an asset acquired in the past, whereas, replacement cost refers to the outlay made for replacing an old asset. Private and Social Costs Private and social costs are those costs which arise as a result of the functioning of a firm, but neither are normally reflected in the business decisions nor are explicitly borne by the firm Examples of such social costs include:  

water pollution from oil refineries, air pollution costs by mills and factories located near a city etc

13. Explain short-run cost functions The distinction between fixed and variable costs is of great significance to the business manager. Variable costs are those costs, which the business manager can control or alter in the short run by changing levels of production. On the other hand, fixed costs are clearly beyond business manager‘s control, such costs are incurred in the short run and must be paid regardless of output. Cost Output Relationship A cost function is a symbolic statement of the technological relationship between the cost and output. C = TC = f(Q), and ΔQ > 0, The specific form of the cost function depends on the time framework for cost analysis: in short-or long-run.

Short Run Costs       

Total Variable cost (TVC) Total amount paid for variable inputs Increases as output increases Total Fixed Cost (TFC) Total amount paid for fixed inputs Does not vary with output Total Cost (TC) = TVC + TFC

Short-Run Total Cost Schedules

Total Cost Curves

Average Costs AVC= TVC/Q AFC =TFC/Q ATC=TC/Q=AFC+AVC Short Run Marginal Cost Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies SMC=TC/Q=TVC/Q Average & Marginal Cost Schedules

Average & Marginal Cost Curves

Behaviour of Costs in Short Run 1. TFC‘s are fixed irrespective of increase or decrease in production activity. 2. AFC per unit declines as the volume of production increases. Fixed costs are spread over a greater number of units. Thus FC per unit will fall. The relationship between FC per unit and volume of production is inverse. 3. Total variable cost increases proportionately with production. However the rate of increase is not constant. 4. TC increases with volume of production. 5. Average total cost decrease up to a certain level of production. After this level it increases sharply. If represented graphically it will result in a flat U-Shaped curve. The lowest point of average total cost curve denotes the ideal level of production. 6. Marginal cost is the change in total cost resulting from one unit change in output. 7. Marginal cost also decreases up to a certain level and thereafter steeply rises 8. Marginal cost curve cuts ATC and AVC curves at their lowest points. Relationship between Average cost and Marginal Cost   

Marginal cost is less than average cost when the average cost is falling. When the average cost is rising, the marginal cost is less than the average cost. When the average cost is constant, marginal cost is also constant and equals average cost.

MC

AC

AC

MC

Output

Output

(MCAC)

AC=MC

Output (AC=MC)

14.Explain Costs in long run Suggested answer Long run is a period, during which all inputs are variable including the one, which are fixes in the short-run. In the long run a firm can change its output according to its demand. Over a long period, the size of the plant can be changed, unwanted buildings can be sold staff can be increased or reduced. The long run enables the firms to expand and scale of their operation by bringing or purchasing larger quantities of all the inputs. Thus in the long run all factors become variable.      

Long run costs are incurred by a firm as it Expands its production Upgrades its production facilities Enter in to new markets Initiate necessary changes in the labour force Import technology Undertake research and development

Hence long run costs refer to costs of producing different levels of output by changing the scale of production. In the long run a firm has a number of alternatives in regards to the scale of operations. For each scale of production or plant size, the firm has an appropriate short-run average cost curves. The short-run average cost (SAC) curve applies to only one plant whereas the long-run average cost (LAC) curve takes in to consideration many plants. The long-run cost-output relationship is shown graphically with the help of ―LCA‘ curve.

To draw on ‗LAC‘ curve we have to start with a number of ‗SAC‘ curves. In the above figure it is assumed that technologically there are only three sizes of plants – small, medium and large, ‗SAC‘, for the small size, ‗SAC2‘ for the medium size plant and ‗SAC3‘ for the large size plant. If the firm wants to produce ‗OP‘ units of output, it will choose the smallest plant. For an output beyond ‗OQ‘ the firm wills optimum for medium size plant. It does not mean that the OQ production is not possible with small plant. Rather it implies that cost of production will be more with small plant compared to the medium plant. For an output ‗OR‘ the firm will choose the largest plant as the cost of production will be more with medium plant. Thus the firm has a series of ‗SAC‘ curves. The ‗LCA‘ curve drawn will be tangential to the entire family of ‗SAC‘ curves i.e. the ‗LAC‘ curve touches each ‗SAC‘ curve at one point, and thus it is known as envelope curve. It is also known as planning curve as it serves as guide to the entrepreneur in his planning to expand the production in future. With the help of ‗LAC‘ the firm determines the size of plant which yields the lowest average cost of producing a given volume of output it anticipates. Optimum Plant Size and Long-Run Cost Curves. The optimum size of the firm is one which ensures the most efficient utilization of the resources. The optimum size of a firm is one in which the long-run average cost (LAC) is minimised.   

Before optimum point Economies of scale >Diseconomies of scale At optimum point Economies of scale=Diseconomies of scale Beyond optimum Economies of scale Minimum Desired Rate of return – Accept the Project ARR < Minimum Desired Rate of return – Reject the Project For Mutually Exclusive Projects The ARR of the projects will be compared and the project with higher ARR will be accepted. Pay Back Period The Pay back period measures the time required for a project to repay the initial investment. It is the period in which the Cash Flows After Tax (CFAT) generated by the project equals to the initial investment. The pay back period is computed as under For projects generating uniform CFAT Pay Back Period =

Initial Investment Annual Uniform CFAT

Discounting Cash Flow (DCF) Techniques These techniques take into consideration the time value of money for evaluating the capital budgeting proposals. This category of techniques include (i) Net Present Value (ii) Internal Rate of Return and (iii) Profitability index

Net Present Value The Net Present Value (NPV) is the difference between the present value of cash inflows and present value of cash outflows. NPV = PV of cash inflows – PV of cash outflows It can also be represented as

 CF1 CF3 CFn  CF2 CF4   CF0     .......... .......... .....  NPV =  1 2 3 4 n  ( 1  k ) ( 1  k ) ( 1  k ) ( 1  k ) ( 1  k )   Where CF0 represents initial cash outlay/ cash outflow CF1, CF2, CF3, CF4……………………. CFn represents CFAT generated by the project at the end of year 1, 2, 3, 4…………..n respectively. n represents life of project in years k represents the cost of capital Accept – Reject Criteria For Single Proposal If the NPV of the project is greater than zero, the project has to be accepted. And if the NPV of the project is less than zero, the project will be rejected. NPV > 0 – Accept the Project NPV < 0 – Reject the Project NPV = 0, the project may be accepted or rejected. For Mutually Exclusive Projects The NPV of the projects will be compared and the project with higher NPV will be accepted. Internal Rate of Return The Internal Rate of Return (IRR) is the rate of return generated by the project. It can also be defined as the discount rate which equates the present value of cash inflows and present value of cash outflows (or) it is the discount rate where NPV of the project is zero.

The IRR can be represented by ‗k‘ where

 CF1 CF3 CFn CF2 CF4 CF0       .........................  1 2 3 4 (1  k ) (1  k ) (1  k ) (1  k ) n  (1  k )

  

(or)

 CF1 CF3 CFn CF2 CF4      .........................  1 2 3 4 (1  k ) (1  k ) (1  k ) (1  k ) n  (1  k )

   CF0 = 0 

where CF0 represents initial cash outlay/ cash outflow CF1, CF2, CF3, CF4……………………. CFn represents CFAT generated by the project at the end of year 1, 2, 3, 4…………..n respectively. n represents life of project in years k represents the internal rate of return Computation of IRR The following steps are to be adopted for computing IRR of the project. Step 1: Calculate NPV at some assumed discount rate. Step 2 : If NPV is positive, calculate NPV at a higher discount rate and if NPV is negative, calculate NPV at a lesser discount rate. Step 3 : By using the technique of interpolation, IRR will be computed. Accept – Reject Criteria For Single Proposal If the IRR of the project is greater than cost of capital, the project has to be accepted. And if the IRR of the project is less than cost of capital, the project will be rejected. IRR > Cost of Capital

– Accept the Project

IRR < Cost of Capital – Reject the Project IRR = Cost of Capital, the project may be accepted or rejected. For Mutually Exclusive Projects

The IRR of the projects will be compared and the project with higher IRR will be accepted.

Profitability Index It is also called as Benefit – Cost Ratio. It is the ratio between the present value of cash inflows and present value of cash outflows. Profitability Index ( PI) =

Present Value of Cash Inflows Present Value of Cash Outflows

Accept – Reject Criteria For Single Proposal If the PI of the project is greater than one, the project has to be accepted. And if the PI of the project is less than one, the project will be rejected. PI > 1

– Accept the Project

PI < 1

– Reject the Project

PI = 1, the project may be accepted or rejected. For Mutually Exclusive Projects The PI of the projects will be compared and the project with higher PI will be accepted. 7. A company is considering an investment proposal which has in investment outlay of Rs.50,000. The project has a life of 6 years with a salvage value of Rs.4,000. The Project is expected to generate profit after tax (PAT) of Rs.5,000, Rs.8,000, Rs.9,000, Rs.8,000 and Rs.7,000 at the end of year 1, 2, 3, 4 and 5 respectively. Advise the firm whether the project has to be accepted or not if the firm adopts ARR technique for evaluating capital budgeting proposals. Assume the firm’s minimum expected rate of return is 15% Solution Average Profit after Taxes =

Total Expected Profit after Taxes during life of the project Life of the project (in years)

Average Profit after taxes

=

5,000  8,000  9,000  8,000  7,000 5

= Rs. 7,400

Average Investment

= Salvage Value +

1 (Initial Investment - Salvage Value) 2

1 (50,000-4,000) 2 = Rs. 27,000

= 4,000 +

ARR

=

ARR

=

Average Profit After Tax  100 Average Investment

7,400  100 27,000 = 27.40%

Decision : As the ARR of the project (27.40%) is higher than the minimum required rate of return (15%) the project has to be accepted.

8. A project requires an investment of Rs. 1,00,000 and has zero scrap value after 4 years. The project is expected to yield profit after taxes amounting to Rs. 12,000, Rs. 15,000, Rs. 18,000 and Rs.23,000 at the end of year 1, 2, 3 and 4 respectively. Compute the ARR of the project. Solution Average Profit after Taxes =

Average Profit after taxes =

Total Expected Profit after Taxes during life of the project Life of the project (in years) 12,000  15,000  18,000  23,000 4

= Rs. 17,000 Average Investment

= Salvage Value +

1 (Initial Investment - Salvage Value) 2

1 (1,00,000-0) 2 = Rs. 50,000

=0+

ARR

ARR

=

Average Profit After Tax  100 Average Investment

17,000  100 50,000 = 34% =

9. A project requires an initial investment of Rs.50,000 and is expected to generate annual Cash Flows After Tax (CFAT) of Rs.20,000 for five years. Compute Pay back period. Solution Pay Back Period =

Initial Investment Annual Uniform CFAT

50,000 20,000

= =

2.5 years

For projects generating uniform CFAT The pay back period will be the time period where the cumulative CFAT will become equal to the initial investment. 10. A company is considering two mutually exclusive projects A and B which requires an initial investment of Rs. 50,000 each. Project A is expected to generate annual CFAT of Rs. 10,000 for 8 years and Project B is expected to generate CFAT of Rs. 12,500 for 8 years. Advise the firm which project has to be accepted if the firm adopts Pay back period technique for evaluating capital budgeting proposals. Solution: Project A Initial Investment Annual Uniform CFAT 50,000 10,000 5 years

Pay Back Period = = = Project B

Initial Investment Annual Uniform CFAT 50,000 12,500 4 years

Pay Back Period = = =

Decision : As the pay back period of project B is less than project A, the project B has to be accepted.

11. A Petroleum company is considering purchase of new machine for its future expansion. The new machine requires an investment outlay of Rs.2,00,000. The machine has an expected life of 5 years. The machine is expected to generate CFAT of Rs. 40,000, Rs. 50,000, Rs. 60,000, Rs. 80,000 and Rs. 90,000 at the end of year1, 2, 3,4 and 5 respectively. If the firm’s cost of capital is 12%, advise the company whether to purchase the machine or not. Solution

Calculation of present value of cash inflows Year CFAT

PVIF @ 12% PV of CFAT

1 40,000

0.893

35,720

2 50,000

0.797

39,850

3 60,000

0.712

42,720

4 80,000

0.636

50,880

5 90,000

0.567

51,030

Present value of Cash Inflows

2,20,200

PVIF : Present Value Interest Factor NPV = PV of cash inflows – PV of cash outflows = 2,20,200 – 2,00,000 = Rs. 20,200 Decision : As the NPV of the project is greater than zero, the company should purchase the new machine. 12. A company is considering two mutually exclusive projects. The following information is available related to the two projects. Project A

Project B

Initial Investment

Rs. 5,00,000

Rs. 5,00,000

CFAT at the end of Year 1

Rs.

50,000

Rs. 3,00,000

2

Rs. 1,00,000

Rs. 2,50,000

3

Rs. 2,00,000

Rs. 2,00,000

4

Rs. 2,50,000

Rs. 1,00,000

5

Rs. 3,00,000

Rs.

50,000

If the firm‘s minimum expected rate of return is 10%, advise the company which project has to be accepted.

Solution: Calculation of NPV of Project A Year

CFAT

PVIF @ 10%

PV of CFAT

0 (5,00,000)

1.000

(500000)

1

50,000

0.909

45450

2

100,000

0.826

82600

3

200,000

0.751

150200

4

250,000

0.683

170750

5

300,000

0.621

186300

NPV =

135300

Calculation of NPV of Project B Year CFAT

PVIF @ 10%

PV of CFAT

0 (5,00,000)

1.000

(500000)

1

300,000

0.909

272700

2

250,000

0.826

206500

3

200,000

0.751

150200

4

100,000

0.683

68300

5

50,000

0.621

31050

NPV =

228750

Decision : As the NPV of Project B is higher than Project A, Project B should be accepted. 12. PQR Ltd is planning to purchase a new machine to meet the increasing demand for its products. The new machine costs Rs. 1,00,000 and has a salvage value of Rs.10,000. The expected life of the machine is 6 years. The new machine is expected to generate additional CFAT of Rs. 20,000, Rs. 30,000, Rs. 45,000, Rs. 32,000, Rs. 25,000 and Rs.15,000 at the end of the year 1,2,3,4,5 and 6 respectively. The company’s cost of capital is 12%. Advise the

firm whether to purchase the new machine or not if the company adopts IRR technique for evaluating capital budgeting proposals. Solution:

Calculation of NPV at 10% discount rate : Year

CFAT

PVIF @ 10%

PV of CFAT

0

(1,00,000)

1.000

(100000)

1

20,000

0.909

18180

2

30,000

0.826

24780

3

45,000

0.751

33795

4

32,000

0.683

21856

5

25,000

0.621

15525

6

15,000

0.564

8460

6 (Salvage Value)

10,000

0.564

5640

NPV =

28236

As NPV >0 at 10% discount rate, let us calculate NPV a higher discount rate i.e. at 12%. Year

CFAT

PVIF @ 12%

PV of CFAT

0

(1,00,000)

1.000

(100000)

1

20,000

0.893

17,860

2

30,000

0.797

23,910

3

45,000

0.712

32,040

4

32,000

0.636

20,352

5

25,000

0.567

14,175

6

15,000

0.507

7,605

6 (Salvage Value)

10,000

0.507

5,070

NPV = Calculation of NPV at 12% discount rate :

21,012

By using the technique of Interpolation : At 10 % : NPV = Rs. 28,236 At 12% : NPV = Rs. 21,012 2 % Change – Change in NPV is 7,224 ? % change – Change in NPV will be 28,236 % Change

=

28,236 x 2 7224

= 7.82 % So, IRR = 10+7.82 = 17.82 % Decision : As the IRR of the new machine (17.82%) is greater than the cost of capital (12%), the company should be purchase the new machine.

13. The Great India Ltd is planning to replace its old machine with a new machine. The new machine costs Rs. 1,00,000 and the machine has an expected economic life of 5 years with zero salvage value. The new machine is expected to generate CFAT of Rs. 10,000, Rs. 20,000, Rs. 25,000, Rs. 40,000 and Rs.50,000 at the end of the year 1,2,3,4 and 5 respectively. If the Company’s cost of capital is 13% advise the company whether to purchase the new machine or not if the company adopts PI technique for evaluating capital budgeting proposals. Solution: Calculation of Present Value of Cash Inflows Year CFAT

PVIF @ 13%

PV of CFAT

1

10,000

0.885

8,850

2

20,000

0.783

15,660

3

25,000

0.693

17,325

4

40,000

0.613

24,520

5

50,000

0.543

27,150

Present Value of Cash Inflows =

93,505

Profitability Index ( PI) =

Present Value of Cash Inflows Present Value of Cash Outflows

93,505 1,00,000 = 0.935 =

Decision: As the PI