A COURSE MATERIAL ON

ABAJA11- BUSINESS ECONOMICS

BY

R.RAJA., MCOM., M.B.A., M.Phil.,

ASSISTANT PROFESSOR

DEPARTMENT OF COMMERCE AND MANAGEMENT STUDIES

PARVATHYS ARTS AND SCIENCE COLLEGE DINDIGUL

2018-2019

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BUSINESS ECONOMICS

Unit I:

Business Economics Meaning-Nature and scope of Business Economics -

Economics verses Business Economics - Fundamental Concepts - Role and

responsibility of Business Economist -Objectives of a modern business firm.

Unit II:

Demand Analysis- Law of demand - Demand determinants - Demand distinctions -

Elasticity of demand - Measurement of price elasticity of demand -Factors

determining elasticity of demand -Uses of Elasticity of demand.

Unit -III:

Demand Forecasting - Meaning. Objectives, importance and factors involved in

forecasting.Methods of forecasting - Features of a good forecasting method.

Unit -IV:

Market Structure- Classification -perfect Competition –Monopoly –Duopoly -

Oligopoly and Monopolistic competition.

Unit -V:

Profit analysis – Nature of profit – profit planning – Break event analysis –

Concepts – Uses and limitations – Profit forecasting.

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Unit - I

Meaning of Business Economics:

Business Economics, used synonymously with business economics. It is a branch of economics

that deals with the application of microeconomic analysis to decision-making techniques of

businesses and management units. It acts as the via media between economic theory and

pragmatic economics. Business economics bridges the gap between "theory and practice".

Nature of Business Economics:

Business Economics is a Science

Business Economics is an essential scholastic field. It can be compared to science in a sense that

it fulfils the criteria of being a science in following sense:

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

Business economics is also a science of making decisions with regard to scarce resources

with alternative applications. It is a body of knowledge that determines or observes the

internal and external environment for decision making.

In science any conclusion is arrived at after continuous experimentation. In Business

economics also policies are made after persistent testing and trailing. Though economic

environment consists of human variable, which is unpredictable, thus the policies made

are not rigid. Business economist takes decisions by utilizing his valuable past experience

and observations.

Science principles are universally applicable. Similarly policies of Business economics

are also universally applicable partially if not fully. The policies need to be changed from

time to time depending on the situation and attitude of individuals to those particular

situations. Policies are applicable universally but modifications are required periodically.

Business Economics requires Art

Business economist is required to have an art of utilising his capability, knowledge and

understanding to achieve the organizational objective. Business economist should have an art to

put in practice his theoretical knowledge regarding elements of economic environment.

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Business Economics for administration of organization

Business economics helps the management in decision making. These decisions are based on the

economic rationale and are valid in the existing economic environment.

Business economics is helpful in optimum resource allocation

The resources are scarce with alternative uses. Managers need to use these limited resources

optimally. Each resource has several uses. It is manager who decides with his knowledge of

economics that which one is the preeminent use of the resource.

Business Economics has components of micro economics

Managers study and manage the internal environment of the organization and work for the

profitable and long-term functioning of the organization. This aspect refers to the micro

economics study. The Business economics deals with the problems faced by the individual

organization such as main objective of the organization, demand for its product, price and output

determination of the organization, available substitute and complimentary goods, supply of

inputs and raw material, target or prospective consumers of its products etc.

Business Economics has components of macro economics

None of the organization works in isolation. They are affected by the external environment of the

economy in which it operates such as government policies, general price level, income and

employment levels in the economy, stage of business cycle in which economy is operating,

exchange rate, balance of payment, general expenditure, saving and investment patterns of the

consumers, market conditions etc. These aspects are related to macro economics.

Business Economics is dynamic in nature

Business Economics deals with human-beings (i.e. human resource, consumers, producers etc.).

The nature and attitude differs from person to person. Thus to cope up with dynamism and

vitality Business economics also changes itself over a period of time.

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Scope of Business Economics:

1. Demand Analysis and Forecasting:

The foremost aspect regarding its scope is in demand analysis and forecasting. A business firm is

an economic unit which transforms productive resources into saleable goods. Since all output is

meant to be sold, accurate estimates of demand help a firm in minimizing its costs of production

and storage.

A firm must decide its total output before preparing its production schedule and deciding on the

resources to be employed. Demand forecasts serves as a guide to the management for

maintaining its market share in competition with its rivals, thereby securing its profit. Thus,

demand analysis facilitates the identification of the various factors affecting the demand for a

firm‘s product. This, in turn helps the firm in manipulating the demand for its output.

In fact, demand forecasts are the starting point for a firm‘s planning and decision-making. This

deals with the basic tools of demand analysis i.e.; Demand Determinants, Demand Distinctions

and Demand Forecasting etc.

2. Cost and Production Analysis:

A firm‘s profitability depends much on its costs of production. A wise manager would prepare

cost estimates of a range of output, identify the factors causing variations in costs and choose the

cost minimising output level, taking also into consideration the degree of uncertainty in

production and cost calculations. Production processes are under the charge of engineers but the

business manager works to carry out the production function analysis in order to avoid wastages

of materials and time. Sound pricing policies depend much on cost control.

3. Pricing Decisions, Policies and Practices:

Another task before a business manager is the pricing of a product. Since a firm‘s income and

profit depend mainly on the price decision, the pricing policies and all such decisions are to be

taken after careful analysis of the nature of the market in which the firm operates. The important

topics covered in this field of study are: Market Structure Analysis, Pricing Practices and Price

Forecasting.

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4. Profit Management:

Each and every business firms are tended for earning profit; it is profit which provides the chief

measure of success of a firm in the long period. Economists tell us that profits are the reward for

uncertainty bearing and risk taking. A successful business manager is one who can form more or

less correct estimates of costs and revenues at different levels of output. The more successful a

manager is in reducing uncertainty, the higher are the profits earned by him. It is therefore,

profit-planning and profit measurement that constitutes the most challenging area of business

economics.

5. Capital Management:

Still another most challenging problem for a modern business manager is of planning capital

investment. Investments are made in the plant and machinery and buildings which are very high.

Therefore, capital management requires top-level decisions. It means capital management i.e.,

planning and control of capital expenditure. It deals with Cost of capital, Rate of Return and

Selection of projects.

Difference Between Business Economics And Economics:

Business economics involves application of economic principles to the problems of a

business firm whereas; economics deals with the study of these principles only.

Economics ignores the application of economic principles to the problems of a business

firm.

Business economics is micro-economic in character, however, Economics is both macro-

economic and micro-economic.

Business economics, though micro in character, deals only with a firm and has nothing to

do with an individual‘s economic problems. But microeconomics as a branch of

economics deals with both economics of the individual as well as economics of a firm.

Under microeconomics, the distribution theories, viz., wages, interest and profit, are also

dealt with. Business economics on the contrary is mainly concerned with profit theory

and does not consider other distribution theories. Thus, the scope of economics is wider

than that of Business economics.

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Economic theory assumes economic relationships and builds economic models. Business

economics adopts, modifies and reformulates the economic models to suit the specific

conditions and serves the specific problem solving process.

Economics involves the study of certain assumptions like in the law of proportion where

it is assumed that ―The variable input as applied, unit by unit is homogeneous or identical

in amount and quality‖. Business economics on the other hand, introduces certain

feedbacks. These feedbacks are in the form of objectives of the firm, multi-product nature

of manufacture, behavioral constraints, environmental aspects, legal constraints,

constraints on resource availability, etc. Thus Business economics, attempts to solve the

complexities in real life, which are assumed in economics. this is done with the help of

mathematics, statistics, econometrics, accounting, operations research, etc.

Fundamental Concepts of Business Economics:

1. The Incremental Concept:

The incremental concept is probably the most important concept in economics and is certainly

the most frequently used in Business Economics. Incremental concept is closely related to the

marginal cost and marginal revenues of economic theory.

The two major concepts in this analysis are incremental cost and incremental revenue.

Incremental cost denotes change in total cost, whereas incremental revenue means change in

total revenue resulting from a decision of the firm.

The incremental principle may be stated as follows:

A decision is clearly a profitable one if

(i) It increases revenue more than costs.

(ii) It decreases some cost to a greater extent than it increases others.

(iii) It increases some revenues more than it decreases others.

(iv) It reduces costs more than revenues.

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The concept is mainly used by the progressive concerns. Even though it is a widely followed

concept, it has certain limitations:

(a) The concept cannot be generalised because observed behaviour of the firm is always variable.

(b) The concept can be applied only when there is excess capacity in the concern.

(c) The concept is applicable only during the short period.

2. Concept of Time Perspective:

The time perspective concept states that the decision maker must give due consideration both to

the short run and long run effects of his decisions. He must give due emphasis to the various time

periods. It was Marshall who introduced time element in economic theory.

The economic concepts of the long run and the short run have become part of everyday

language. Business economists are also concerned with the short run and long run effects of

decisions on revenues as well as costs. The main problem in decision making is to establish the

right balance between long run and short run.

In the short period, the firm can change its output without changing its size. In the long period,

the firm can change its output by changing its size. In the short period, the output of the industry

is fixed because the firms cannot change their size of operation and they can vary only variable

factors. In the long period, the output of the industry is likely to be more because the firms have

enough time to increase their sizes and also use both variable and fixed factors.

In the short period, the average cost of a firm may be either more or less than its average

revenue. In the long period, the average cost of the firm will be equal to its average revenue. A

decision may be made on the basis of short run considerations, but may as time elapses have long

run repercussions which make it more or less profitable than it at first appeared.

3. The Opportunity Cost Concept:

Both micro and macro economics make abundant use of the fundamental concept of opportunity

cost. In everyday life, we apply the notion of opportunity cost even if we are unable to articulate

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its significance. In Business Economics, the opportunity cost concept is useful in decision

involving a choice between different alternative courses of action.

Resources are scarce, we cannot produce all the commodities. For the production of one com-

modity, we have to forego the production of another commodity. We cannot have everything we

want. We are, therefore, forced to make a choice.

Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice

of alternatives is involved when carrying out a decision requires using a resource that is limited

in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone

by pursuing one course of action rather than another.

4. Equi-Marginal Concept:

One of the widest known principles of economics is the equi-marginal principle. The principle

states that an input should be allocated so that value added by the last unit is the same in all

cases. This generalisation is popularly called the equi-marginal.

Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is

involved in five activities viz., А, В, C, D and E. The firm can increase any one of these

activities by employing more labour but only at the cost i.e., sacrifice of other activities.

An optimum allocation cannot be achieved if the value of the marginal product is greater in one

activity than in another. It would be, therefore, profitable to shift labour from low marginal value

activity to high marginal value activity, thus increasing the total value of all products taken

together.

ABCDE = Activities i.e., the value of the marginal product of labour employed in A is equal to

the value of the marginal product of the labour employed in В and so on. The equimarginal

principle is an extremely practical notion.

It is behind any rational budgetary procedure. The principle is also applied in investment

decisions and allocation of research expenditures. For a consumer, this concept implies that

money may be allocated over various commodities such that marginal utility derived from the

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use of each commodity is the same. Similarly, for a producer this concept implies that resources

be allocated in such a manner that the marginal product of the inputs is the same in all uses.

5. Discounting Concept:

This concept is an extension of the concept of time perspective. Since future is unknown and

incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is

worth more than a rupee will be two years from now. This appears similar to the saying that ―a

bird in hand is more worth than two in the bush.‖ This judgment is made not on account of the

uncertainty surrounding the future or the risk of inflation.

It is simply that in the intervening period a sum of money can earn a return which is ruled out if

the same sum is available only at the end of the period. In technical parlance, it is said that the

present value of one rupee available at the end of two years is the present value of one rupee

available today. The mathematical technique for adjusting for the time value of money and

computing present value is called ‗discounting‘.

6. Risk and Uncertainty:

Business decisions are actions of today which bear fruits in future which is unforeseen. Future is

uncertain and involves risk. 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 institution in

uncertain and unknown economic conditions in the future. Firms may be uncertain about

production, market prices, strategies of rivals, etc. Under uncertainty, 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 of 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.

Also dynamic changes are external to the firm, they are beyond the control of the firm. The result

is that the risks from unexpected changes in a firm‘s cost and revenue data cannot be estimated

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and therefore the risks from such changes cannot be insured. But products must attempt to

predict the future cost and revenue data of their firms and determine the output and price

policies.

The Business 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. The probabilities of future events are

influenced by the time horizon, the risk attitude and the rate of change of the environment.

Role of Business Economist :

1. He studies the economic patterns at macro-level and analysis it‘s significance to the

specific firm he is working in.

2. He has to consistently examine the probabilities of transforming an ever-changing

economic environment into profitable business avenues.

3. He assists the business planning process of a firm.

4. He also carries cost-benefit analysis.

5. He assists the management in the decisions pertaining to internal functioning of a firm

such as changes in price, investment plans, type of goods /services to be produced, inputs

to be used, techniques of production to be employed, expansion/ contraction of firm,

allocation of capital, location of new plants, quantity of output to be produced,

replacement of plant equipment, sales forecasting, inventory forecasting, etc.

6. In addition, a Business economist has to analyze changes in macro- economic indicators

such as national income, population, business cycles, and their possible effect on the

firm‘s functioning.

7. He is also involved in advising the management on public relations, foreign exchange,

and trade. He guides the firm on the likely impact of changes in monetary and fiscal

policy on the firm‘s functioning.

8. He also makes an economic analysis of the firms in competition. He has to collect

economic data and examine all crucial information about the environment in which the

firm operates.

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9. The most significant function of a Business economist is to conduct a detailed research

on industrial market.

10. In order to perform all these roles, a Business economist has to conduct an elaborate

statistical analysis.

11. He must be vigilant and must have ability to cope up with the pressures.

12. He also provides management with economic information such as tax rates, competitor‘s

price and product, etc. They give their valuable advice to government authorities as well.

13. At times, a Business economist has to prepare speeches for top management.

Responsibilities of Business Economist:

1. To make a reasonable profit on capital employed:

He must have a strong conviction that profits are essential and his main obligation is to assist the

management in earning reasonable profits on capital employed in the firm.

2. He must make successful forecasts by making in depth study of the internal and external

factors:

This will have influence over the profitability or the working of the firm. He must aim at

lessening if not fully eliminating the risks involved in uncertainties. He has a major

responsibility to alert management at the earliest possible time in case he discovers any error in

his forecast, so that the management can make necessary changes and adjustments in the policies

and programmes of the firm.

3. He must inform the management of all the economic trends:

A Business economist should keep himself in touch with the latest developments of national

economy and business environment so that he can keep the management informed with these

developments and expected trends of the economy.

4. He must establish and maintain contacts with individuals and data sources:

(i) To establish and maintain contacts:

A Business economist should establish and maintain contacts with individuals and data sources

in order to collect relevant and valuable information in the field.

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(ii) To develop personal relations:

To collect information he should develop personal relations with those having specialised

knowledge of the field.

(iii) To join professional associations and should take active part in their activities:

The success of this lies in how quickly he gathers additional information in the best interest of

the firm.

5. He must earn full status in the business and only then he can be helpful to the

management in good and successful decision-making:

For this:

(i) He must receive continuous support for himself and his professional ideas by performing his

function effectively.

(ii) He should express his ideas in simple and understandable language with the minimum use of

technical words, while communicating with his management executives.

Objectives of a modern business firm:

1. Profit Maximisation

In many firms, there is a separation of ownership and control. Those who own the

company (shareholders) often do not get involved in the day to day running of the company.

This is a problem because although the owners may want to maximise profits, the

managers have much less incentive to maximise profits because they do not get the same

rewards, (share dividends)

Therefore managers may create a minimum level of profit to keep the shareholders

happy, but then maximise other objectives, such as enjoying work, getting on with other workers.

(e.g. not sacking them) This is the problem of separation between owners and managers.

This ‗principal-agent‗ problem can be overcome, to some extent, by giving managers

share options and performance related pay although in some industries it is difficult to measure

performance.

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2. Sales maximisation

Firms often seek to increase their market share – even if it means less profit. This could occur for

various reasons:

Increased market share increases monopoly power and may enable the firm to put up

prices and make more profit in the long run.

Managers prefer to work for bigger companies as it leads to greater prestige and higher

salaries.

Increasing market share may force rivals out of business. E.g. the growth of supermarkets

have lead to the demise of many local shops. Some firms may actually engage in predatory

pricing which involves making a loss to force a rival out of business.

3. Growth maximisation

This is similar to sales maximisation and may involve mergers and takeovers. With this

objective, the firm may be willing to make lower levels of profit in order to increase in size and

gain more market share.

4. Long run profit maximisation

In some cases, firms may sacrifice profits in the short term to increase profits in the long run. For

example, by investing heavily in new capacity, firms may make a loss in the short run but enable

higher profits in the future.

5. Social/environmental concerns

A firm may incur extra expense to choose products which don‘t harm the environment or

products not tested on animals. Alternatively, firms may be concerned about local community /

charitable concerns.

Some firms may adopt social/environmental concerns into part of its branding. This can

ultimately help profitability as the brand becomes more attractive to consumers.

Some firms may adopt social/environmental concerns on principal alone – even if it does

little to improve sales/brand image.

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6. Co-operatives

Co-operatives may have completely different objectives to a typical PLC. A co-operative is run

to maximise the welfare of all stakeholders – especially workers. Any profit the co-operative

makes will be shared amongst all members.

Unit – II

Law of Demand:

The law of demand is a microeconomic law that states, all other factors being equal, as the

price of a good or service increases, consumer demand for the good or service will decrease, and

vice versa. The law of demand says that the higher the price, the lower the quantity demanded,

because consumers‘ opportunity cost to acquire that good or service increases, and they must

make more tradeoffs to acquire the more expensive product.

Determinants of Demand:

When price changes, quantity demanded will change. That is a movement along the same

demand curve. When factors other than price changes, demand curve will shift. These are the

determinants of the demand curve.

1. Income: A rise in a person‘s income will lead to an increase in demand (shift demand curve to

the right), a fall will lead to a decrease in demand for normal goods. Goods whose demand varies

inversely with income are called inferior goods (e.g. Hamburger Helper).

2. Consumer Preferences: Favorable change leads to an increase in demand, unfavorable change

lead to a decrease.

3. Number of Buyers: the more buyers lead to an increase in demand; fewer buyers lead to

decrease.

4. Price of related goods:

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a. Substitute goods (those that can be used to replace each other): price of substitute and demand

for the other good are directly related.

Example: If the price of coffee rises, the demand for tea should increase.

b. Complement goods (those that can be used together): price of complement and demand for the

other good are inversely related.

Example: if the price of ice cream rises, the demand for ice-cream toppings will decrease.

5. Expectation of future:

a. Future price: consumers‘ current demand will increase if they expect higher future prices; their

demand will decrease if they expect lower future prices.

b. Future income: consumers‘ current demand will increase if they expect higher future income;

their demand will decrease if they expect lower future income.

Demand Distinctions:

i. Individual and Market Demand:

The individual demand of a product is influenced by the price of a product, income of customers,

and their tastes and preferences. On the other hand, the total quantity demanded for a product by

all individuals at a given price and time is regarded as market demand.

In simple terms, market demand is the aggregate of individual demands of all the consumers of a

product over a period of time at a specific price, while other factors are constant.

ii. Organization and Industry Demand:

Refers to the classification of demand on the basis of market. The demand for the products of an

organization at given price over a point of time is known as organization demand. This is due to

the fact that in a highly competitive market, organizations have insignificant market share.

Therefore, the demand for an organization‘s product is of no importance. However, an

organization can forecast the demand for its products only by analyzing the industry demand.

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iii. Autonomous and Derived Demand:

Refers to the classification of demand on the basis of dependency on other products. The demand

for a product that is not associated with the demand of other products is known as autonomous or

direct demand. The autonomous demand arises due to the natural desire of an individual to

consume the product.

iv. Demand for Perishable and Durable Goods:

Refers to the classification of demand on the basis of usage of goods. The goods are divided into

two categories, perishable goods and durable goods. Perishable or non-durable goods refer to the

goods that have a single use. For example, cement, coal, fuel, and eatables. On the other hand,

durable goods refer to goods that can be used repeatedly.

For example, clothes, shoes, machines, and buildings. Perishable goods satisfy the present

demand of individuals. However, durable goods satisfy both present as well as future demand of

individuals. Therefore, consumers purchase durable items by considering its durability.

In addition, durable goods need replacement because of their continuous use. The demand for

perishable goods depends on the current price of goods and customers‘ income, tastes, and

preferences and changes frequently, while the demand for durable goods changes over a longer

period of time.

v. Short-term and Long-term Demand:

Refers to the classification of demand on the basis of time period. Short-term demand refers to

the demand for products that are used for a shorter duration of time or for current period. This

demand depends on the current tastes and preferences of consumers.

For example, demand for umbrellas, raincoats, sweaters, long boots is short term and seasonal in

nature. On the other hand, long-term demand refers to the demand for products over a longer

period of time.

Generally, durable goods have long-term demand. The long-term demand of a product depends

on a number of factors, such as change in technology, type of competition, promotional

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activities, and availability of substitutes. The short-term and long-term concepts of demand are

essential for an organization to design a new product.

Elasticity of Demand:

Demand elasticity refers to how sensitive the demand for a good is to changes in other economic

variables, such as the prices and consumer income. Demand elasticity is calculated by taking the

percent change in quantity of a good demanded and dividing it by a percent change in another

economic variable. A higher demand elasticity for a particular economic variable means that

consumers are more responsive to changes in this variable, such as price or income.

Measurement of price elasticity of demand:

(1) The Percentage Method:

The price elasticity of demand is measured by its coefficient Ep. This coefficient Epmeasures the

percentage change in the quantity of a commodity demanded resulting from a given percentage

change in its price: Thus

Where q refers to quantity demanded, p to price and ∆ to change. If Ep> 1, demand is elastic. If

Ep < 1, demand is inelastic, it Ep = 1 demand is unitary elastic.

With this formula, we can compute price elasticities of demand on the basis of a demand

schedule.

Table 11.1: Demand Schedule:

Combination Price (Rs.)

per Kg. of

X

Quantity Kgs. of

X

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A 6 0

В 5 ————-► 10

С 4 20

D 3 ————-► 30

E 2 40

F 1 ————► 50

G 0 60

Let us first take combinations В and D.

(i) Suppose the price of commodity X falls from Rs. 5 per kg. to Rs. 3 per kg. and its quantity

demanded increases from 10 kgs. to 30 kgs. Then

This shows elastic demand or elasticity of demand greater than unitary.

Note: The formula can be understood like this:

∆q =q2 –q1 where <72 is the new quantity (30 kgs.) and q1 the original quantity (10 kgs.)

∆p – p2– P1 where p2 is the new price (Rs. 3) and <$Ep sub 1> the original price (Rs. 5)

In the formula, p refers to the original price (p,) and q to original quantity (q1). The opposite is

the case in example (ii) below, where Rs. 3 becomes the original price and 30 kgs. as the original

quantity.

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(ii) Let us measure elasticity by moving in the reverse direction. Suppose the price of X rises

from Rs. 3 per kg. to Rs. 5 per kg. and the quantity demanded decreases from 30 kgs. to 10 kgs.

Then

This shows unitary elasticity of demand.

Notice that the value of Ep in example (ii) differs from that in example (i) depending on the

direction in which we move. This difference in the elasticities is due to the use of a different base

in computing percentage changes in each case.

Now consider combinations D and F.

(iii) Suppose the price of commodity X falls from Rs. 3 per kg. to Re. 1 per kg. and its quantity

demanded increases from 30 kgs. to 50 kgs. Then

This is again unitary elasticity.

(iv) Take the reverse order when the price rises from Re. 1 per kg. to Rs. 3 per kg. and the

quantity demanded decreases from 50 kgs. to 30 kgs. Then

This shows inelastic demand or less than unitary.

The value of Ep again differs in this example than that given in example (iii) for the reason stated

above.

(2) The Point Method:

Prof. Marshall devised a geometrical method for measuring elasticity at a point on the demand

curve. Let RS be a straight line demand curve in Figure 11.2. If the price falls from PB(=OA) to

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MD(=OC). the quantity demanded increases from OB to OD. Elasticity at point P on the RS

demand curve according to the formula is: Ep = ∆q/∆p x p/q

Where ∆ q represents changes in quantity demanded, ∆p changes in price level while p and q are

initial price and quantity levels.

From Figure 11.2

∆ q = BD = QM

∆p = PQ

p = PB

q = OB

Substituting these values in the elasticity formula:

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With the help of the point method, it is easy to point out the elasticity at any point along a

demand curve. Suppose that the straight line demand curve DC in Figure 11.3 is 6 centimetres.

Five points L, M, N, P and Q are taken oh this demand curve. The elasticity of demand at each

point can be known with the help of the above method. Let point N be in the middle of the

demand curve. So elasticity of demand at point.

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We arrive at the conclusion that at the mid-point on the demand curve the elasticity of demand is

unity. Moving up the demand curve from the mid-point, elasticity becomes greater. When the

demand curve touches the Y-axis, elasticity is infinity. Ipso facto, any point below the mid-point

towards the X-axis will show elastic demand.

Elasticity becomes zero when the demand curve touches the X-axis.

(3) The Arc Method:

We have studied the measurement of elasticity at a point on a demand curve. But when elasticity

is measured between two points on the same demand curve, it is known as arc elasticity. In the

words of Prof. Baumol, ―Arc elasticity is a measure of the average responsiveness to price

change exhibited by a demand curve over some finite stretch of the curve.‖

Any two points on a demand curve make an arc. The area between P and M on the DD curve in

Figure 11.4 is an arc which measures elasticity over a certain range of price and quantities. On

any two points of a demand curve the elasticity coefficients are likely to be different depending

upon the method of computation. Consider the price-quantity combinations P and M as given in

Table 11.2.

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Table 11.2: Demand Schedule:

Point Price (Rs.) Quantity (Kg)

P 8 10

M 6 12

If we move from P to M, the elasticity of demand is:

If we move in the reverse direction from M to P, then

Thus the point method of measuring elasticity at two points on a demand curve gives different

elasticity coefficients because we used a different base in computing the percentage change in

each case.

To avoid this discrepancy, elasticity for the arc (PM in Figure 11.4) is calculated by taking the

average of the two prices [(p1, + p2 1/2] and the average of the two quantities [(p1, + q2) 1/2]. The

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formula for price elasticity of demand at the mid-point (C in Figure 11.4) of the arc on the

demand curve is

On the basis of this formula, we can measure arc elasticity of demand when there is a movement

either from point P to M or from M to P.

From P to M at P, p1 = 8, q1, =10, and at M, P2 = 6, q2 = 12

Applying these values, we get

Thus whether we move from M to P or P to M on the arc PM of the DD curve, the formula for

arc elasticity of demand gives the same numerical value. The closer the two points P and M are,

the more accurate is the measure of elasticity on the basis of this formula. If the two points which

form the arc on the demand curve are so close that they almost merge into each other, the

numerical value of arc elasticity equals the numerical value of point elasticity.

(4) The Total Outlay Method:

Marshall evolved the total outlay, total revenue or total expenditure method as a measure of

elasticity. By comparing the total expenditure of a purchaser both before and after the change in

price, it can be known whether his demand for a good is elastic, unity or less elastic. Total outlay

is price multiplied by the quantity of a good purchased: Total Outlay = Price x Quantity

Demanded. This is explained with the help of the demand schedule in Table 11.3.

(i) Elastic Demand:

Demand is elastic, when with the fall in price the total expenditure increases and with the rise in

price the total expenditure decreases. Table 11.3 shows that when the price falls from Rs. 9 to

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Rs. 8, the total expenditure increases from Rs. 180 to Rs. 240 and when price rises from Rs. 7 to

Rs. 8, the total expenditure falls from Rs. 280 to Rs. 240. Demand is elastic (Ep > 1) in this case.

(ii) Unitary Elastic Demand:

When with the fall or rise in price, the total expenditure remains unchanged; the elasticity of

demand is unity. This is shown in the Table when with the fall in price from Rs. 6 to Rs. 5 or

with the rise in price from Rs. 4 to Rs. 5, the total expenditure remains unchanged at Rs. 300,

i.e., Ep = 1.

(iii) Less Elastic Demand:

Demand is less elastic if with the fall in price the total expenditure falls and with the rise in price

the total expenditure rises. In the Table when the price falls from Rs. 3 to Rs. 2 total expenditure

falls from Rs. 240 to Rs. 180, and when the price rises from Re. 1 to Rs. 2 the total expenditure

also rises from Rs. 100 to Rs. 180. This is the case of inelastic or less elastic demand, Ep < 1.

Table 11.4 summaries these relationships:

Figure 11.5 illustrates the relation between elasticity of demand and total expenditure. The

rectangles show total expenditure: Price x quantity demanded. The figure shows that at the

midpoint of the demand curve, total expenditure is maximum in the range of unitary elasticity,

i.e. Rs. 6, Rs. 5 and Rs. 4 with quantities 50 kgs., 60 kgs. and 75 kgs.

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Total expenditure rises as price falls, in the elastic range of demand, i.e. Rs. 9, Rs. 8 and Rs. 7

with quantities 20 kgs., 30 kgs. and 40 kgs. Total expenditure falls as price falls in the elasticity

range, i.e. Rs.3, Rs. 2 and Re. 1 with quantities 80 kgs., 90 kgs. and 100 kgs. Thus elasticity of

demand is unitary in the AB range of DD, curve, elastic in the range AD above point A and less

elastic in the BD1 range below point B. The conclusion is that price elasticity of demand refers to

a movement along a specific demand curve.

Factors determining elasticity of demand:

1. Nature of the Commodity:

Generally, all commodities can be divided into three categories i.e.

(i) Necessaries of Life:

For necessaries of life the demand is inelastic because people buy the required amount of goods

whatever their price. For example, necessaries such as rice, salt, cloth are purchased whether

they are dear or cheap.

(ii) Conventional Necessaries:

The demand for conventional necessaries is less elastic or inelastic. People are accustomed to the

use of goods like intoxicants which they purchase at any price. For example, drunkards consider

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opium and wine almost as a necessity as food and water. Therefore, they buy the same amount

even when their prices are higher and highest.

(iii) Luxury Commodities:

The demand for luxury is usually elastic as people buy more of them at a lower price and less at

a higher price. For example, the demand of luxuries like silk, perfumes and ornaments increases

at a lower price and diminishes at a higher price. Here, we must keep in mind that luxury is a

relative term, which varies from person to person, place to place and from time to time. For

example, what is a luxury to a poor man is a necessity to the rich. The luxury of the past may

become a necessary of today. Similarly a commodity which is a necessity to one class may be a

luxury to another. Hence, the elasticity of demand in such cases should have to be carefully

expressed.

2. Substitutes:

Demand is elastic for those goods which have substitutes and inelastic for those goods which

have no substitutes. The availability of substitutes, thus, determines the elasticity of demand. For

instance, tea and coffee are substitutes. The change in the price of tea affects the demand for

coffee. Hence, the demand for coffee and tea is elastic.

3. Number of Uses:

Elasticity of demand for any commodity depends on its number of uses. Demand is elastic; if a

commodity has more uses and inelastic if it has only one use. As coal has multiple uses, if its

price falls, it will be demanded more for cooking, heating, industrial purposes etc. But if its price

rises, minimum will be demanded for every purpose.

4. Postponement:

Demand is more elastic for goods the use of which can be postponed. For example, if the price of

silk rises, its consumption can be postponed. The demand for silk is, therefore, elastic. Demand

is inelastic for those goods the use of which is urgent and, therefore, cannot be postponed. The

use of medicines cannot be put off. Hence‖, the demand for medicines is inelastic.

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5. Raw Materials and Finished Goods:

The demand for raw materials is inelastic but the demand for finished goods is elastic. For

instance, raw cotton has inelastic demand but cloth has elastic demand. In the same way, petrol

has inelastic demand but car itself has only elastic demand.

6. Price Level:

The demand is elastic for moderate prices but inelastic for lower and higher prices. The rich and

poor do not bother about the prices of the goods that they buy. For example, rich buy Banaras

silk and diamonds etc. at any price. But the poor buy coarse rice, cloth etc. whatever their prices

are.

7. Income Level:

The demand is inelastic for higher and lower income groups and elastic for middle income

groups. The rich people with their higher income do not bother about the price. They may

continue to buy the same amount whatever the price. The poor people with lower incomes buy

always only the minimum requirements and, therefore, they are induced neither to buy more at a

lower price nor less at a higher price. The middle income group is sensitive to the change in

price. Thus, they buy more at a lower price and less at higher price.

8. Habits:

If consumers are habituated of some commodities, the demand for such commodities will be

usually inelastic. It is because that the consumer will use them even their prices go up. For

example, a smoker, generally, does not smoke less when the price of cigarette goes up.

9. Nature of Expenditure:

The elasticity of demand for a commodity also depends as to how much part of the income is

spent on that particular commodity. The demand for such commodities where a small part of

income is spent is generally highly inelastic i.e. news paper, boot-polish etc. On the other hand,

the demand of such commodities where a significant part of income is spent, elasticity of

demand is very elastic.

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10. Distribution of Income:

If the income is uniformly distributed in the society, a small change in price will affect the

demand of the whole society and the demand will be elastic. In case of unequal distribution of

income and wealth, a change in price will hardly influence the poor section of the society and the

demand will be relatively inelastic.

11. Influence of Diminishing Marginal Utility:

We know that utility falls when we consume more and more units but not in a uniform way. In

case utility falls rapidly, it means that the consumer has no other near substitutes. As a result,

demand is inelastic. Conversely if the utility falls slowly, demand for such commodity would be

elastic and extend much for a fall in price.

12. Influence of Consumer’s Surplus:

There is relationship between elasticity of demand and consumer‘s surplus. Generally,

necessaries provide us more consumers‘ surplus. Whenever consumer‘s surplus is high, the

margin between the actual price and potential price is high and the consumer does not change the

demand so long the price increases within the margin. But in case of those commodities where

marginal utility is equal to price, and the consumer does not get any surplus. Therefore, the

consumer being on the margin easily changes the demand when there is change in price. Hence,

the elasticity of demand varies inversely with consumer‘s surplus.

13. Joint Demand:

In case of a commodity being demanded jointly such as car and petrol, its elasticity will be

directly governed by the elasticity of other commodities which are jointly demanded in the

market. For example, if the demand for car is inelastic, the demand for petrol will also be

inelastic.

14. Time:

The demand for a commodity is always related to some period of time. This implies that

elasticity of demand varies with the length of time periods. In case of long period, elasticity of

demand will be elastic while in the short period, it will be inelastic. This is due to the fact that

during short period, generally demand does not change immediately due to price changes.

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Moreover, changing of habits and changing of equipment‘s are not easy. However, it is possible

in the long period.

Thus from the above discussion, it is clear that in first place, it is difficult to know whether the

demand for any good is elastic or less elastic. It will depend on the range of prices, reaction of

the consumers and the time period in which the price changes. Secondly, the elasticity of demand

depends on the price of the commodity, proportion of income spent on the commodity,

availability of substitutes etc.

Uses of elasticity of demand:

1. Elasticity of demand in production

In a free capitalistic economy, production mainly depends on consumer demand and care should

be taken to adjust it to the extent of demand. Hence elasticity is a concept which enables all

producers to take correct decision regarding the quantum of output based on the demand.

2. Elasticity of demand in Price Fixation

Every seller under imperfect competition and monopoly has to consider the elasticity of demand

for his product when he fixes the price or contemplates to change the price. The seller has to take

into consideration the extent of response in demand due to change in price as the revenue

realized by him depends on the quantity demanded in the market.

In price fixation, this concept is made use of not only in imperfect competition, but also in

monopoly. A monopolist can fix the price only on the basis of elasticity of demand.

If the commodity enjoys inelastic demand, the monopolist can increase the price without losing

the quantity demanded. This will not in anyway affect the net monopoly revenue for him. In the

case of price discrimination, the markets are divided mainly on the basis of difference in

elasticity of demand for the same product in different markets.

In the case of perfect competition this may be an exception as the producer can expect perfectly

elastic curve for his product.

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3. Elasticity of demand in Distribution

The concept of elasticity of demand has an important role to play in the determination of the

rewards for factors of production in a price-enterprise economy.

For example if the demand for labour is very elastic, the efforts of Trade Unions to increase the

wages will not meet with success.

On the other hand if the demand for labour is inelastic, as there may be little scope for

automation; Trade Unions can succeed well in getting the wages raised. Rewards for other

factors of production also depends on their elasticity of demand.

4. Elasticity of demand in International Trade

The concept of elasticity of demand forms the basis of international trade, particularly the terms

of trade which implies the rate at which the domestic commodity is exchanged for foreign

commodities. So, while calculating terms of trade, the intensities of demand of the two countries

requiring the product of the other country should be considered.

The terms of trade depends upon the mutual elasticities of demand of the two countries for each

other‘s goods.

5. Elasticity of demand in foreign Exchange

In the field of foreign exchange, fixation of appropriate rate of exchang ebetween two currencies

of the two countries mainly depends on the elasticities of demand for imports and exports.

In deciding devaluation or revaluation of the domestic currency, the authorities should make a

careful study of the elasticity of demand for the country‘s exports and imports and accordingly

fix the exchange rate to correct the disequilibrium in the balance of payments.

6. Elasticity of demand in nationalizing an Industry

This concept of elasticity of demand is used to enable the government to decide whether an

Industry can be declared as public utility to be nationalized. If the demand is inelastic for the

product of a monopolistic concern, it is a clear case of declaring as public utility and the

government can nationalize the concern and operate it.

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7. Elasticity of demand in Public Finance

Elasticity of demand is of immense use to Finance Ministers to formulate taxation and economic

policies. In imposing a tax on a commodity, the elasticity of demand of the commodity should be

carefully studied to find out the effect of taxation.

The tax burden should be equally borne by all and at the same time the government should

realize adequate revenue from that commodity.

The problem of Incidence of taxation (bearing the burden of taxation) depends upon the elasticity

of demand and supply of the commodities taxed.

Further, in imposing statutory price — control for a commodity, the elasticity of demand for that

commodity has to be taken into consideration. In framing the budget, the concept of elasticity of

demand has a significant role in all matters relating to taxes and revenue.

In framing economic policies, the knowledge of elasticity of demand is required. For stabilizing

agricultural prices, the government may adopt either output control or purchase surpluses and

other similar operations.

In all cases, without knowing the trends of demand and elasticities of commodities and farm

products, the government cannot stabilize the prices properly. Thus Elasticity of demand is of

great significance in theory and practice.

Unit – III

Meaning of Demand Forecasting:

Demand forecasting is predicting future demand for the product. In other words, it refers to the

prediction of a future demand for a product or a service on the basis of the past events and

prevailing trends in the present.

Objectives of Demand Forecasting:

Demand forecasting constitutes an important part in making crucial business decisions.

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The objectives of demand forecasting are divided into short and long-term objectives,

which are shown in Figure-1:

The objectives of demand forecasting (as shown in Figure-1) are discussed as follows:

i. Short-term Objectives:

Include the following:

a. Formulating production policy:

Helps in covering the gap between the demand and supply of the product. The demand

forecasting helps in estimating the requirement of raw material in future, so that the regular

supply of raw material can be maintained. It further helps in maximum utilization of resources as

operations are planned according to forecasts. Similarly, human resource requirements are easily

met with the help of demand forecasting.

b. Formulating price policy:

Refers to one of the most important objectives of demand forecasting. An organization sets

prices of its products according to their demand. For example, if an economy enters into

depression or recession phase, the demand for products falls. In such a case, the organization sets

low prices of its products.

c. Controlling sales:

Helps in setting sales targets, which act as a basis for evaluating sales performance. An

organization make demand forecasts for different regions and fix sales targets for each region

accordingly.

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d. Arranging finance:

Implies that the financial requirements of the enterprise are estimated with the help of demand

forecasting. This helps in ensuring proper liquidity within the organization.

ii. Long-term Objectives:

Include the following:

a. Deciding the production capacity:

Implies that with the help of demand forecasting, an organization can determine the size of the

plant required for production. The size of the plant should conform to the sales requirement of

the organization.

b. Planning long-term activities:

Implies that demand forecasting helps in planning for long term. For example, if the forecasted

demand for the organization‘s products is high, then it may plan to invest in various expansion

and development projects in the long term.

Importance of Demand Forecasting:

i. Fulfilling objectives:

Implies that every business unit starts with certain pre-decided objectives. Demand forecasting

helps in fulfilling these objectives. An organization estimates the current demand for its products

and services in the market and move forward to achieve the set goals.

ii. Preparing the budget:

Plays a crucial role in making budget by estimating costs and expected revenues. For instance, an

organization has forecasted that the demand for its product, which is priced at Rs. 10, would be

10, 00, 00 units. In such a case, the total expected revenue would be 10* 100000 = Rs. 10, 00,

000. In this way, demand forecasting enables organizations to prepare their budget.

iii. Stabilizing employment and production:

Helps an organization to control its production and recruitment activities. Producing according to

the forecasted demand of products helps in avoiding the wastage of the resources of an

organization. This further helps an organization to hire human resource according to

36

requirement. For example, if an organization expects a rise in the demand for its products, it may

opt for extra labor to fulfill the increased demand.

iv. Expanding organizations:

Implies that demand forecasting helps in deciding about the expansion of the business of the

organization. If the expected demand for products is higher, then the organization may plan to

expand further. On the other hand, if the demand for products is expected to fall, the organization

may cut down the investment in the business.

v. Taking Management Decisions:

Helps in making critical decisions, such as deciding the plant capacity, determining the

requirement of raw material, and ensuring the availability of labor and capital.

vi. Evaluating Performance:

Helps in making corrections. For example, if the demand for an organization‘s products is less, it

may take corrective actions and improve the level of demand by enhancing the quality of its

products or spending more on advertisements.

vii. Helping Government:

Enables the government to coordinate import and export activities and plan international trade.

Factors Influencing Demand Forecasting:

Demand forecasting is a proactive process that helps in determining what products are needed

where, when, and in what quantities. There are a number of factors that affect demand

forecasting.

Some of the factors that influence demand forecasting are shown in Figure-2:

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The various factors that influence demand forecasting (“as shown in Figure-2) are

explained as follows:

i. Types of Goods:

Affect the demand forecasting process to a larger extent. Goods can be producer‘s goods,

consumer goods, or services. Apart from this, goods can be established and new goods.

Established goods are those goods which already exist in the market, whereas new goods are

those which are yet to be introduced in the market.

Information regarding the demand, substitutes and level of competition of goods is known only

in case of established goods. On the other hand, it is difficult to forecast demand for the new

goods. Therefore, forecasting is different for different types of goods.

ii. Competition Level:

Influence the process of demand forecasting. In a highly competitive market, demand for

products also depend on the number of competitors existing in the market. Moreover, in a highly

competitive market, there is always a risk of new entrants. In such a case, demand forecasting

becomes difficult and challenging.

iii. Price of Goods:

Acts as a major factor that influences the demand forecasting process. The demand forecasts of

organizations are highly affected by change in their pricing policies. In such a scenario, it is

difficult to estimate the exact demand of products.

iv. Level of Technology:

Constitutes an important factor in obtaining reliable demand forecasts. If there is a rapid change

in technology, the existing technology or products may become obsolete. For example, there is a

high decline in the demand of floppy disks with the introduction of compact disks (CDs) and pen

drives for saving data in computer. In such a case, it is difficult to forecast demand for existing

products in future.

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v. Economic Viewpoint:

Play a crucial role in obtaining demand forecasts. For example, if there is a positive development

in an economy, such as globalization and high level of investment, the demand forecasts of

organizations would also be positive.

Apart from aforementioned factors, following are some of the other important factors that

influence demand forecasting:

a. Time Period of Forecasts:

Act as a crucial factor that affect demand forecasting. The accuracy of demand forecasting

depends on its time period.

Forecasts can be of three types, which are explained as follows:

1. Short Period Forecasts:

Refer to the forecasts that are generally for one year and based upon the judgment of the

experienced staff. Short period forecasts are important for deciding the production policy, price

policy, credit policy, and distribution policy of the organization.

2. Long Period Forecasts:

Refer to the forecasts that are for a period of 5-10 years and based on scientific analysis and

statistical methods. The forecasts help in deciding about the introduction of a new product,

expansion of the business, or requirement of extra funds.

3. Very Long Period Forecasts:

Refer to the forecasts that are for a period of more than 10 years. These forecasts are carried to

determine the growth of population, development of the economy, political situation in a

country, and changes in international trade in future.

Among the aforementioned forecasts, short period forecast deals with deviation in long period

forecast. Therefore, short period forecasts are more accurate than long period forecasts.

4. Level of Forecasts:

Influences demand forecasting to a larger extent. A demand forecast can be carried at three

levels, namely, macro level, industry level, and firm level. At macro level, forecasts are

39

undertaken for general economic conditions, such as industrial production and allocation of

national income. At the industry level, forecasts are prepared by trade associations and based on

the statistical data.

Moreover, at the industry level, forecasts deal with products whose sales are dependent on the

specific policy of a particular industry. On the other hand, at the firm level, forecasts are done to

estimate the demand of those products whose sales depends on the specific policy of a particular

firm. A firm considers various factors, such as changes in income, consumer‘s tastes and

preferences, technology, and competitive strategies, while forecasting demand for its products.

5. Nature of Forecasts:

Constitutes an important factor that affects demand forecasting. A forecast can be specific or

general. A general forecast provides a global picture of business environment, while a specific

forecast provides an insight into the business environment in which an organization operates.

Generally, organizations opt for both the forecasts together because over-generalization restricts

accurate estimation of demand and too specific information provides an inadequate basis for

planning and execution.

Steps of Demand Forecasting:

The Demand forecasting process of an organization can be effective only when it is conducted

systematically and scientifically.

It involves a number of steps, which are shown in Figure-3:

The steps involved in demand forecasting (as shown in Figure-3) are explained as follows:

1. Setting the Objective:

Refers to first and foremost step of the demand forecasting process. An organization needs to

clearly state the purpose of demand forecasting before initiating it.

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Setting objective of demand forecasting involves the following:

a. Deciding the time period of forecasting whether an organization should opt for short-term

forecasting or long-term forecasting

b. Deciding whether to forecast the overall demand for a product in the market or only- for the

organizations own products

c. Deciding whether to forecast the demand for the whole market or for the segment of the

market

d. Deciding whether to forecast the market share of the organization

2. Determining Time Period:

Involves deciding the time perspective for demand forecasting. Demand can be forecasted for a

long period or short period. In the short run, determinants of demand may not change

significantly or may remain constant, whereas in the long run, there is a significant change in the

determinants of demand. Therefore, an organization determines the time period on the basis of its

set objectives.

3. Selecting a Method for Demand Forecasting:

Constitutes one of the most important steps of the demand forecasting process Demand can be

forecasted by using various methods. The method of demand forecasting differs from

organization to organization depending on the purpose of forecasting, time frame, and data

requirement and its availability. Selecting the suitable method is necessary for saving time and

cost and ensuring the reliability of the data.

4. Collecting Data:

Requires gathering primary or secondary data. Primary‘ data refers to the data that is collected by

researchers through observation, interviews, and questionnaires for a particular research. On the

other hand, secondary data refers to the data that is collected in the past; but can be utilized in the

present scenario/research work.

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5. Estimating Results:

Involves making an estimate of the forecasted demand for predetermined years. The results

should be easily interpreted and presented in a usable form. The results should be easy to

understand by the readers or management of the organization.

Methods of Demand Forecasting:

1. Survey of Buyer’s-Intentions:

This is a short-term method of knowing and estimating customer‘s demand. This is direct

method of estimating demand of customers as to what they intend to buy for the forthcoming

time—usually a year. By this the burden of forecasting goes to the buyer. This method is useful

for the producers who produce goods in bulk. Still their estimates should not entirely depend

upon it. This method does not hold good for household consumers because of their inability to

foresee their choice when they see the alternatives. Besides the household consumers there are

many which make this method costly and impracticable. It does not expose and measure the

variables under management control.

2. Collective Opinion or Sales Force Competitive Method:

Under this method, the salesman are nearest persons to the customers and are able to judge, their

minds and market. They better understand the reactions of the customers to the firms products

and their sales trends. The estimates of the different salesmen are collected and estimates sales

are predicted.

These estimates are revised from time to time with changes in sales price, product, designs,

publicity programmes, expected changes in competition, purchasing power, income distribution,

employment and population. It makes use of collective wisdom of salesmen, departmental heads

and top executives.

Advantages:

(1) It is simple, common sense method involving no mathematical calculations.

(2) It is based on the first-hand knowledge of salesman and the persons directly connected with

sales.

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(3) This method is particularly useful for sales of new product. It has the salesman‘s judgment.

Dis-advantages:

(1) It is a subjective approach.

(2) This method can be used only for short-term forecasting.

For long-term planning it is not useful.

3. Trend Projection or Time Trend of the Time Series:

This is the most popular method of analysing time series and is generally used to project the time

trend of the time series. A trend line can be filled through the series in visual or statistical way by

the method of least squares.

The analyst can make a plausible algebraic relation—may it be linear, a quadratic or logarithmic

between sales on one hand and independent variable time on the other. The trend line is then

projected into the future for purpose of extrapolation.

Advantages:

This method is most popular as it is simple and in-extensive and because of time series data often

Features of a good demand forecasting method:

i. Accuracy:

Implies that an organization should make forecasts close to real figures, so that the real picture of

demand can be determined. For example, there would be an increase in sales in the coming years

is an inaccurate forecast.

ii. Durability:

Implies that forecasts should be done in such a way that they can be used for long periods as

forecasts involves a lot of time, money, and efforts.

iii. Flexibility:

Implies that the forecasts should be adjustable and adaptable to changes. In today‘s uncertain

business environment, there is a rapid change in the tastes and preferences of consumers, which

43

affect the demand for products. Therefore, the demand forecasts made by an organization should

reflect those changes

iv. Acceptability:

Refers to one of the most important criterion of demand forecasting. An organization should

forecast its demand by using simple and easy methods. In addition, the methods should be such

that organizations do not face any complexities. However, organizations generally prefer

advanced statistical methods, which may prove difficult and complex.

v. Availability:

Implies that adequate and up-to-date data should be available for forecasts. The forecasts should

be done in timely manner so that necessary arrangements should be made related to the market

demand.

vi. Plausibility:

Implies that the demand forecasts should be reasonable, so that they are easily understood by

individuals who are using it.

vii. Economy:

Implies demand forecasting should be economically effective. The forecasting should be done in

such a manner that the costs should be minimized and benefits should be maximized.

Unit – IV

Features of a Perfect Competition:

1. Free and Perfect Competition:

In a perfect market, there are no checks either on the buyers or sellers. They are free to buy or to

sell to any person. It means there are no monopolies.

2. Cheap and Efficient Transport and Communication:

Uniform price for the commodity would not be possible if the changes in the prices are not

quickly adjusted or the commodity cannot be quickly transported. Thus cheap and efficient

means of transport and communication are must.

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3. Wide Extent:

Sometimes wide market is regarded as the same thing as the perfect market. For wide market, the

commodity should have permanent and universal demand. The commodity should be portable.

Means of transport and communication should be quick. There should be peace and security and

extensive division of labour.

4. Large number of firms:

In this market, a product is produced and sold by large number of firms. Since there are large

number of firms, therefore each firm is supplying only a small part of the total supply in the

market, thus no one firm has any market power. It implies that no firm can influence the price of

the product rather each must accept the price set by the forces of market demand and supply. The

firms are price-takers instead of price-makers.

5. Large number of buyers:

In a perfectly competitive market, there are large numbers of buyers each demanding a small part

of the total market supply of the product. As a result, no single buyer is in a position to influence

the market price determined by the forces of market demand and supply.

6. Homogeneous Product:

In a perfectly competitive market, all the firms produce and supply the identical products. It

means that the products of all the firms are perfect substitutes of each other. As a result of this,

the price elasticity of demand for a firm‘s product is infinite.

7. Free entry and exit:

In a perfectly competitive market, there are no restrictions on the entry of new firms into market

or on the exit of existing firms from the market.

8. Perfect knowledge:

In a perfectly competitive market, the firms and the buyers possess perfect information about the

market. It implies that no buyer or firm is ignorant about the price prevailing in the market.

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9. Perfect mobility of factors of production:

In a perfectly competitive market, the factors of production are completely mobile leading to

factor-price equalization throughout the market.

Meaning:

The word monopoly has been derived from the combination of two words i.e., ‗Mono‘ and

‗Poly‘. Mono refers to a single and poly to control.

In this way, monopoly refers to a market situation in which there is only one seller of a

commodity. There are no close substitutes for the commodity it produces and there are barriers to

entry. The single producer may be in the form of individual owner or a single partnership or a

joint stock company. In other words, under monopoly there is no difference between firm and

industry.

Monopolist has full control over the supply of commodity. Having control over the supply of the

commodity he possesses the market power to set the price. Thus, as a single seller, monopolist

may be a king without a crown. If there is to be monopoly, the cross elasticity of demand

between the product of the monopolist and the product of any other seller must be very small.

Definitions:

―Pure monopoly is represented by a market situation in which there is a single seller of a product

for which there are no substitutes; this single seller is unaffected by and does not affect the prices

and outputs of other products sold in the economy.‖ Bilas

―Monopoly is a market situation in which there is a single seller. There are no close substitutes of

the commodity it produces, there are barriers to entry‖. –Koutsoyiannis

―Under pure monopoly there is a single seller in the market. The monopolist demand is market

demand. The monopolist is a price-maker. Pure monopoly suggests no substitute situation‖. -A.

J. Braff

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―A pure monopoly exists when there is only one producer in the market. There are no dire

competitions.‖ -Ferguson

―Pure or absolute monopoly exists when a single firm is the sole producer for a product for

which there are no close substitutes.‖ -McConnel

Features:

We may state the features of monopoly as:

1. One Seller and Large Number of Buyers:

The monopolist‘s firm is the only firm; it is an industry. But the number of buyers is assumed to

be large.

2. No Close Substitutes:

There shall not be any close substitutes for the product sold by the monopolist. The cross

elasticity of demand between the product of the monopolist and others must be negligible or

zero.

3. Difficulty of Entry of New Firms:

There are either natural or artificial restrictions on the entry of firms into the industry, even when

the firm is making abnormal profits.

4. Monopoly is also an Industry:

Under monopoly there is only one firm which constitutes the industry. Difference between firm

and industry comes to an end.

5. Price Maker:

Under monopoly, monopolist has full control over the supply of the commodity. But due to large

number of buyers, demand of any one buyer constitutes an infinitely small part of the total

demand. Therefore, buyers have to pay the price fixed by the monopolist.

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Characteristics:

Important characteristics of the Monopoly market are as follows:

1. There is only one seller in the market and the products are homogeneous.

2. The product produced by the monopolist has no close substitutes.

3. The firm is the price-maker and not price taker i.e., the firm can sell more at lower price and

less at higher price.

4. Monopolist is guided by the motive of profit maximisation either by raising price or by

expanding the scale of production. Much would depend on his business objectives.

5. There are many buyers on the demand side but none is in a position to influence the price of

the product by his individual action. Thus, the price of the product is given for the consumer.

6. The monopolist treats all consumers alike and charges a uniform price for his product.

7. The monopoly price is uncontrolled. There are no restrictions on the power of the monopolist.

Kinds of Monopoly:

Monopoly is of following kinds:

1. Simple Monopoly and Discriminating Monopoly:

A simple monopoly firm charges a uniform price for its output sold to all the buyers. While a

discriminating monopoly firm charges different prices for the same product to different buyers.

A simple monopoly operates in a single market a discriminating monopoly operates in more than

one market.

2. Pure Monopoly and Imperfect Monopoly:

Pure monopoly is that type of monopoly in which a single firm which controls the supply of a

commodity which has no substitutes not even a remote one. It possesses an absolute Monopoly

power. Such a Monopoly is very rare. While imperfect monopoly means a limited degree of

Monopoly. It refers to a single firm which produces a commodity having no close substitutes.

The degree of Monopoly is less than perfect in this case and it relates to the availability of the

closeness of a substitute. In practice, there are many cases of such imperfect monopoly.

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3. Natural Monopoly:

When a Monopoly is established due to natural causes then it is called natural monopoly. To-day

India has got Monopoly in mica production and Canada has got Monopoly in nickel production.

These Monopoly natures has provided to these countries.

4. Legal Monopoly:

When anybody receives or acquires Monopoly due to legal provisions in the country.

5. Industrial Monopolies or Public Monopolies:

In the general interest of the nation, when a government nationalizes certain industries in the

public sector, whereby industrial or public monopolies are created. The Industrial Policy

Resolution 1956, in India, for instance, categorically lays down that certain fields like arms and

ammunition, atomic energy, railways and air transport will be the sole monopoly of the Central

Government. In this way industrial monopolies are created through statutory measures.

Duopoly

Duopoly (from the Greek «duo», two, and «polein», to sell) is a type of oligopoly. This kind

of imperfect competition is characterized by having only two firms in the market producing a

homogeneous good. For simplicity purposes, oligopolies are normally studied by analysing

duopolies. What strategies firms follow and their interactions are a key feature of this market

structure.

Oligopoly Market

Definition:

The Oligopoly Market characterized by few sellers, selling the homogeneous or differentiated

products. In other words, the Oligopoly market structure lies between the pure monopoly and

monopolistic competition, where few sellers dominate the market and have control over the price

of the product.

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Under the Oligopoly market, a firm either produces:

Homogeneous product: The firms producing the homogeneous products are called as

Pure or Perfect Oligopoly. It is found in the producers of industrial products such as aluminum,

copper, steel, zinc, iron, etc.

Heterogeneous Product: The firms producing the heterogeneous products are called as

Imperfect or Differentiated Oligopoly. Such type of Oligopoly is found in the producers of

consumer goods such as automobiles, soaps, detergents, television, refrigerators, etc.

There are five types of oligopoly market, for detailed description, click on the link below:

Types of Oligopoly Market

Features of Oligopoly Market

1. Few Sellers: Under the Oligopoly market, the sellers are few, and the customers are

many. Few firms dominating the market enjoys a considerable control over the price of the

product.

2. Interdependence: it is one of the most important features of an Oligopoly market,

wherein, the seller has to be cautious with respect to any action taken by the competing firms.

Since there are few sellers in the market, if any firm makes the change in the price or

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promotional scheme, all other firms in the industry have to comply with it, to remain in the

competition.

Thus, every firm remains alert to the actions of others and plan their counterattack beforehand, to

escape the turmoil. Hence, there is a complete interdependence among the sellers with respect to

their price-output policies.

3. Advertising: Under Oligopoly market, every firm advertises their products on a frequent

basis, with the intention to reach more and more customers and increase their customer base.This

is due to the advertising that makes the competition intense.

If any firm does a lot of advertisement while the other remained silent, then he will observe that

his customers are going to that firm who is continuously promoting its product. Thus, in order to

be in the race, each firm spends lots of money on advertisement activities.

4. Competition: It is genuine that with a few players in the market, there will be an intense

competition among the sellers. Any move taken by the firm will have a considerable impact on

its rivals. Thus, every seller keeps an eye over its rival and be ready with the counterattack.

5. Entry and Exit Barriers: The firms can easily exit the industry whenever it wants, but

has to face certain barriers to entering into it. These barriers could be Government license,

Patent, large firm‘s economies of scale, high capital requirement, complex technology, etc. Also,

sometimes the government regulations favor the existing large firms, thereby acting as a barrier

for the new entrants.

6. Lack of Uniformity: There is a lack of uniformity among the firms in terms of their size,

some are big, and some are small.

Since there are less number of firms, any action taken by one firm has a considerable effect on

the other. Thus, every firm must keep a close eye on its counterpart and plan the promotional

activities accordingly.

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Monopolistic Competition

Definition:

Under, the Monopolistic Competition, there are a large number of firms that produce

differentiated products which are close substitutes for each other. In other words, large sellers

selling the products that are similar, but not identical and compete with each other on other

factors besides price.

Features of Monopolistic Competition

1. Product Differentiation: This is one of the major features of the firms operating under

the monopolistic competition, that produces the product which is not identical but is slightly

different from each other. The products being slightly different from each other remain close

substitutes of each other and hence cannot be priced very differently from each other.

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2. Large number of firms: A large number of firms operate under the monopolistic

competition, and there is a stiff competition between the existing firms. Unlike the perfect

competition, the firms produce the differentiated products which are substitutes for each other,

thus make the competition among the firms a real and a tough one.

3. Free Entry and Exit: With an intense competition among the firms, the entity incurring

the loss can move out of the industry at any time it wants. Similarly, the new firms can enter into

the industry freely, provided it comes up with the unique feature and different variety of products

to outstand in the market and meet with the competition already existing in the industry.

4. Some control over price: Since, the products are close substitutes for each other, if a

firm lowers the price of its product, then the customers of other products will switch over to it.

Conversely, with the increase in the price of the product, it will lose its customers to others.

Thus, under the monopolistic competition, an individual firm is not a price taker but has some

influence over the price of its product.

5. Heavy expenditure on Advertisement and other Selling Costs: Under the

monopolistic competition, the firms incur a huge cost on advertisements and other selling costs

to promote the sale of their products. Since the products are different and are close substitutes for

each other; the firms need to undertake the promotional activities to capture a larger market

share.

6. Product Variation: Under the monopolistic competition, there is a variation in the

products offered by several firms. To meet the needs of the customers, each firm tries to adjust

its product accordingly. The changes could be in the form of new design, better quality, new

packages or container, better materials, etc. Thus, the amount of product a firm is selling in the

market depends on the uniqueness of its product and the extent to which it differs from the other

products.

The monopolistic competition is also called as imperfect competition because this market

structure lies between the pure monopoly and the pure competition.

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Pricing Methods

Cost-based Pricing:

Cost-based pricing refers to a pricing method in which some percentage of desired profit margins

is added to the cost of the product to obtain the final price. In other words, cost-based pricing can

be defined as a pricing method in which a certain percentage of the total cost of production is

added to the cost of the product to determine its selling price. Cost-based pricing can be of two

types, namely, cost-plus pricing and markup pricing.

These two types of cost-based pricing are as follows:

i. Cost-plus Pricing:

Refers to the simplest method of determining the price of a product. In cost-plus pricing method,

a fixed percentage, also called mark-up percentage, of the total cost (as a profit) is added to the

total cost to set the price. For example, XYZ organization bears the total cost of Rs. 100 per unit

for producing a product. It adds Rs. 50 per unit to the price of product as‘ profit. In such a case,

the final price of a product of the organization would be Rs. 150.

Cost-plus pricing is also known as average cost pricing. This is the most commonly used method

in manufacturing organizations.

In economics, the general formula given for setting price in case of cost-plus pricing is as

follows:

P = AVC + AVC (M)

AVC= Average Variable Cost

M = Mark-up percentage

AVC (m) = Gross profit margin

Mark-up percentage (M) is fixed in which AFC and net profit margin (NPM) are covered.

AVC (m) = AFC+ NPM

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ii. For determining average variable cost, the first step is to fix prices. This is done by estimating

the volume of the output for a given period of time. The planned output or normal level of

production is taken into account to estimate the output.

The second step is to calculate Total Variable Cost (TVC) of the output. TVC includes direct

costs, such as cost incurred in labor, electricity, and transportation. Once TVC is calculated,

AVC is obtained by dividing TVC by output, Q. [AVC= TVC/Q]. The price is then fixed by

adding the mark-up of some percentage of AVC to the profit [P = AVC + AVC (m)].

iii. The advantages of cost-plus pricing method are as follows:

a. Requires minimum information

b. Involves simplicity of calculation

c. Insures sellers against the unexpected changes in costs

The disadvantages of cost-plus pricing method are as follows:

a. Ignores price strategies of competitors

b. Ignores the role of customers

iv. Markup Pricing:

Refers to a pricing method in which the fixed amount or the percentage of cost of the product is

added to product‘s price to get the selling price of the product. Markup pricing is more common

in retailing in which a retailer sells the product to earn profit. For example, if a retailer has taken

a product from the wholesaler for Rs. 100, then he/she might add up a markup of Rs. 20 to gain

profit.

It is mostly expressed by the following formulae:

a. Markup as the percentage of cost= (Markup/Cost) *100

b. Markup as the percentage of selling price= (Markup/ Selling Price)*100

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c. For example, the product is sold for Rs. 500 whose cost was Rs. 400. The mark up as a

percentage to cost is equal to (100/400)*100 =25. The mark up as a percentage of the selling

price equals (100/500)*100= 20.

Demand-based Pricing:

Demand-based pricing refers to a pricing method in which the price of a product is finalized

according to its demand. If the demand of a product is more, an organization prefers to set high

prices for products to gain profit; whereas, if the demand of a product is less, the low prices are

charged to attract the customers.

The success of demand-based pricing depends on the ability of marketers to analyze the demand.

This type of pricing can be seen in the hospitality and travel industries. For instance, airlines

during the period of low demand charge less rates as compared to the period of high demand.

Demand-based pricing helps the organization to earn more profit if the customers accept the

product at the price more than its cost.

Competition-based Pricing:

Competition-based pricing refers to a method in which an organization considers the prices of

competitors‘ products to set the prices of its own products. The organization may charge higher,

lower, or equal prices as compared to the prices of its competitors.

The aviation industry is the best example of competition-based pricing where airlines charge the

same or fewer prices for same routes as charged by their competitors. In addition, the

introductory prices charged by publishing organizations for textbooks are determined according

to the competitors‘ prices.

Other Pricing Methods:

In addition to the pricing methods, there are other methods that are discussed as follows:

i. Value Pricing:

Implies a method in which an organization tries to win loyal customers by charging low prices

for their high- quality products. The organization aims to become a low cost producer without

sacrificing the quality. It can deliver high- quality products at low prices by improving its

research and development process. Value pricing is also called value-optimized pricing.

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ii. Target Return Pricing:

Helps in achieving the required rate of return on investment done for a product. In other words,

the price of a product is fixed on the basis of expected profit.

iii. Going Rate Pricing:

Implies a method in which an organization sets the price of a product according to the prevailing

price trends in the market. Thus, the pricing strategy adopted by the organization can be same or

similar to other organizations. However, in this type of pricing, the prices set by the market

leaders are followed by all the organizations in the industry.

iv. Transfer Pricing:

Involves selling of goods and services within the departments of the organization. It is done to

manage the profit and loss ratios of different departments within the organization. One

department of an organization can sell its products to other departments at low prices.

Sometimes, transfer pricing is used to show higher profits in the organization by showing fake

sales of products within departments.

Unit – V

1. Nature of Profits:

To understand the theory of the firm, it is necessary to know the nature of profits. How do profits

arise, what determines the volume of profits or stream of expected future profits are important

issues that require explanation in this regard. Profits or expected profit stream from a productive

activity or an investment play a crucial role in decision making by managers.

Therefore, it is necessary to first explain the difference between business profits and economic

profits. Business profits are an accounting concept and represent the residual sales revenue to the

owners of the firm after making payments to all other factors or resources the firm uses.

These payments to hired factors include the wages to hired labour, interest on borrowed capital,

rent on land and factory buildings and expenditure on raw materials used by the firm. The

expenditures on these factors or resources hired or purchased by the firms are call explicit costs.

Business profit refers to the sales revenue of the firm minus its explicit costs. Thus

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Business profits = Total sales revenue – Explicit costs

It is the concept of business profits that is generally used by the business community and

accountants.

Therefore, it is necessary to first explain the difference between business profits and economic

profits. Business profits are an accounting concept and represent the residual sales revenue to the

owners of the firm after making payments to all other factors or resources the firm uses.

These payments to hired factors include the wages to hired labour, interest on borrowed capital,

rent on land and factory buildings and expenditure on raw materials used by the firm. The

expenditures on these factors or resources hired or purchased by the firms are call explicit costs.

Business profit refers to the sales revenue of the firm minus its explicit costs. Thus

Business profits = Total sales revenue – Explicit costs

It is the concept of business profits that is generally used by the business community and

accountants.

In their calculation of economic profit, the economists deduct not only explicit costs but also

implicit costs from the sales revenue of the firm. The implicit costs refer to the opportunity costs

of the resources provided by the firm‘s owners themselves including capital and entrepreneurial

ability.

These self-owned factors must be paid if they are too employed by the firm in its own production

process otherwise they will be employed elsewhere on hired basis. Thus, economists take into

account the normal rate of return on capital used by the owner of the firm in its own business and

the transfer earnings of the owner-entrepreneur as costs of doing business.

The risk adjusted rate of return on capital is the minimum return that is necessary to attract or

retain it in business and is equal to what the owner could earn from investing in other firms.

Similarly, the opportunity cost of the entrepreneurial effort made by the owner entrepreneur is

the salary that he could earn in his next best activity (say, as the manager of another firm).

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Likewise, the opportunity costs of other self-owned factors or inputs such as land, buildings used

by the owner-entrepreneur in his own business will be counted as implicit costs.

The economic profit represents the sales revenue of the firm in excess of both explicit and

implicit costs.

Economic profits = Sales revenue – Explicit costs – implicit costs.

While explaining maximisation of short-run profits or present value of the stream of expected

profits in the future, economists assume that it is economic profits that owner- entrepreneur or

managers of corporations seek to maximise. The concept of economic profits brings into sharp

focus the question why such profits which is over and above the normal rate of return on equity

capital and reward for entrepreneurial ability in case of owner-entrepreneur, exists and what is its

role in a free enterprise system.

In long-run equilibrium economic profits will be zero if all firms work in perfectly competitive

market. Then, how does an economic profit, positive or negative, come into existence.

2. Role and Functions of Profits:

Profits play an important role in a free market economy. Profits perform two important primary

roles in such an economy.

First, profits serve as a signal to change the rate of output or for the firms to enter or leave the

industry.

Second, profits play a critical role in providing incentive to introduce innovations and increase

productive efficiency and take risks.

Thus, high economic profits being earned in an industry serve as a signal that consumers want

more of the commodity being produced by that industry. These profits indicate to the firm to

expend output of the commodity and for the new firms to enter the industry to gain a share of

economic profits that exist in the industry. As a result, more resources will be allocated to the

output of that industry.

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On the other hand, below normal profits in an industry serve as a signal that either less output of

the industry is demanded by the consumers or inefficient production methods are being used by

the firms. In response to the lower demand for the product the firms will reduce their output and

also some firms will leave the industry.

Profit motive drives a free-market economy. Although it has been observed that sometimes

managers and entrepreneurs in a free market system are swayed by greed and avarice, and break

laws to make money or profits by exploiting the consumers or workers but in general profits

perform useful function of sending signals for changing levels of output of various products and

for reallocation of resources among them.

Secondly, above normal rate of profits in a free enterprise system is an essential reward for

introducing innovations and taking risks. No entrepreneur will introduce new products or more

efficient of production methods or undertake investment in risky projects unless there is prospect

of making profits. Some firms continue to earn above-normal rate of profit year after year as they

are continually introducing new products, new production methods and providing good customer

services.

In the economy changes in demand for the product often occur due to cyclical and structural

changes. Besides, new strategies of rival firms also affect the demand for the product of a firm.

All these uncertain and unanticipated changes involve a good deal of risk. An important function

of economic profits is to reward entrepreneurs for taking these risks involved in making

investment and organising factors for the production of products.

These enable the monopoly firms to charges higher prices and thereby make large economic

profits. Therefore, even in free-market economies steps are taken to prevent the emergence of

monopolies through anti-trust laws or Competition Acts as recently enacted in India. Of course,

monopolies are legally permitted if they are needed in public interest. For example, in several

cities Government grants license to some firms to provide public utility services such electricity,

gas, telephone etc.

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In these cases of legal monopolies government regulates them and fix reasonable prices to be

charged by them from the public but at the same time ensures fair return or normal profits to

them on their investment.

Process of Profit Planning and Control

Profit is considered as a significant element of a business activity. According to Peter Drucker,

―profit is a condition of survival.

It is the cost of the future, the cost of staying in a business.‖ Thus, profit should be planned and

managed properly.

An organization should plan profits by taking into consideration its capabilities and resources.

Profit planning lays foundation for the future income statement of the organization. The profit

planning process begins with the forecasting of Les and estimating the desired level of profit

taking in view the market conditions.

Figure-6 shows the steps involved in the profit planning process:

The steps involved in profit planning process (as shown in Figure-6) are explained as

follows:

1. Establishing profit goals:

Implies that profit goals should be set in alignment with the strategic plans of the organization.

Moreover, the profit goals of an organization should be realistic in nature based on the

capabilities and resources of the organization.

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2. Determining expected sales volume:

Constitutes the most important step of the profit planning process. An organization needs to

forecast its sales volume so that it can achieve its profit goals. The sales volume can be

anticipated by taking into account the market and industry trends and performing competitive

analysis.

3. Estimating expenses:

Requires that an organization needs to estimate its expenses for the planned sales volume.

Expenses can be determined from the past data. If an organization is new, then the data of similar

organization in same industry can be taken. The expense forecasts should be adjusted to the

economic conditions of the country.

4. Determining profit:

Helps in estimating the exact value of sales.

It is calculated as:

Estimated Profit = Projected Sales Income – Expected Expenses

After planning profit successfully, an organization needs to control profit. Profit control involves

measuring the gap between the estimated level and actual level of profit achieved by an

organization. If there is any deviation, the necessary actions are taken by the organization.

Profit control involves two steps, which are as follows:

1. Comparing estimates with the goal:

Involves comparing the estimated profit with the expected profit. If there is a large gap between

the estimated profits and the expected profits, the measures should be taken.

2. Using alternatives to achieve the desired profit:

Includes the following:

a. Making changes in planned sales volume by increasing sales promotion, improving product

quality, providing better service, and providing after sales support to customers.

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b. Reducing planned expenses by minimizing losses, implementing better control systems,

improving product quality, and increasing the productivity of human resource and machines.

Concept Of Break-Even Analysis And Break-Even Ratio

Break-Even Analysis

Break-even analysis is that part of Cost-Volume-Profit Analysis which tells us about the level of

sales at which revenues equals expenses thus showing a zero net income more precisely, such a

sales point is called Break-Even Point. CVP analysis is sometimes referred to simply as break-

even analysis. This is unfortunate because break-even analysis is just one part of the

entire CVP analysis. Yet, it is always taken as an important part of profit planning as it gives the

planner many insights into the data with which he or she is working. Profit planning of each firm

begins with break-even analysis.

Introduction to Break-Even Analysis:

Break-even analysis is of vital importance in determining the practical application of cost func-

tions. It is a function of three factors, i.e., sales volume, cost and profit. It aims at classifying the

dynamic relationship existing between total cost and sale volume of a company.

Hence it is also known as ―cost-volume-profit analysis‖. It helps to know the operating condition

that exists when a company ‗breaks-even‘, that is when sales reach a point equal to all expenses

incurred in attaining that level of sales.

Assumptions of Break-Even Analysis:

The break-even analysis is based on the following set of assumptions:

(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.

(ii) The cost and revenue functions remain linear.

(iii) The price of the product is assumed to be constant.

(iv) The volume of sales and volume of production are equal.

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(v) The fixed costs remain constant over the volume under consideration.

(vi) It assumes constant rate of increase in variable cost.

(vii) It assumes constant technology and no improvement in labour efficiency.

(viii) The price of the product is assumed to be constant.

(ix) The factor price remains unaltered.

(x) Changes in input prices are ruled out.

(xi) In the case of multi-product firm, the product mix is stable.

Business Uses of Break-Even Analysis:

1. Safety Margin:

The break-even chart helps the management to know at a glance the profits generated at the

various levels of sales. The safety margin refers to the extent to which the firm can afford a

decline before it starts incurring losses.

2. Target Profit:

The break-even analysis can be utilised for the purpose of calculating the volume of sales

3. Change in Price:

The management is often faced with a problem of whether to reduce prices or not. Before taking

a decision on this question, the management will have to consider a profit. A reduction in price

leads to a reduction in the contribution margin.

This means that the volume of sales will have to be increased even to maintain the previous level

of profit. The higher the reduction in the contribution margin, the higher is the increase in sales

needed to ensure the previous profit.

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4. Change in Costs:

When costs undergo change, the selling price and the quantity produced and sold also undergo

changes.

Changes in cost can be in two ways:

(i) Change in variable cost, and

(ii) Change in fixed cost.

(i) Variable Cost Change:

An increase in variable costs leads to a reduction in the contribution margin. This reduction in

the contribution margin will shift the break-even point downward. Conversely, with the fall in

the proportion of variable costs, contribution margins increase and break-even point moves

(ii) Fixed Cost Change:

An increase in fixed cost of a firm may be caused either due to a tax on assets or due to an

increase in remuneration of management, etc. It will increase the contribution margin and thus

push the break-even point upwards. Again to maintain the earlier level of profits, a new level of

sales volume or new price has to be found out.

New Sales Volume = Present Sale Volume + (New Fixed Cost + Present Fixed Costs)/(Present

Selling Price-Present Variable Cost)

New Sale Price = Present Sale Price + (New Fixed Costs – Present Fixed Costs)/Present Sale

Volume

5. Decision on Choice of Technique of Production:

A firm has to decide about the most economical production process both at the planning and

expansion stages. There are many techniques available to produce a product. These techniques

will differ in terms of capacity and costs.

The breakeven analysis is the most simple and helpful in the case of decision on a choice of

technique of production. For example, for low levels of output, some conventional methods may

be most probable as they require minimum fixed cost.

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For high levels of output, only automatic machines may be most profitable. By showing the cost

of different alternative techniques at different levels of output, the break-even analysis helps the

decision of the choice among these techniques.

6. Make or Buy Decision:

Firms often have the option of making certain components or for purchasing them from outside

the concern. Break-even analysis can enable the firm to decide whether to make or buy.

7. Plant Expansion Decisions:

The break-even analysis may be adopted to reveal the effect of an actual or proposed change in

operation condition. This may be illustrated by showing the impact of a proposed plant on

expansion on costs, volume and profits. Through the break-even analysis, it would be possible to

examine the various implications of this proposal.

8. Plant Shut Down Decisions:

In the shut-down decisions, a distinction should be made between out of pocket and sunk costs.

Out of pocket costs include all the variable costs plus the fixed cost which do not vary with

output. Sunk fixed costs are the expenditures previously made but from which benefits still

remain to be obtained e.g., depreciation.

9. Advertising and Promotion Mix Decisions:

The main objective of advertisement is to stimulate or increase sales to all customers—former,

present and future. If there is keen competition, the firm has to undertake vigorous campaign of

advertisement. The management has to examine those marketing activities that stimulate

consumer purchasing and dealer effectiveness.

The break-even point concept helps the management to know about the circumstances. It enables

him not only to take appropriate decision but by showing how these additional fixed cost would

influence BEPs. The advertisement cost pushes up the total cost curve by the amount of

advertisement expenditure.

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10. Decision Regarding Addition or Deletion of Product Line:

If a product has outlived its utility in the market immediately, the production must be abandoned

by the management and examined what would be its consequent effect on revenue and cost.

Alternatively, the management may like to add a product to its existing product line because it

expects the product as a potential profit spinner. The break-even analysis helps in such a

decision.

Limitations of Break-Even Analysis:

1. In the break-even analysis, we keep everything constant. The selling price is assumed to be

constant and the cost function is linear. In practice, it will not be so.

2. In the break-even analysis since we keep the function constant, we project the future with the

help of past functions. This is not correct.

3. The assumption that the cost-revenue-output relationship is linear is true only over a small

range of output. It is not an effective tool for long-range use.

4. Profits are a function of not only output, but also of other factors like technological change,

improvement in the art of management, etc., which have been overlooked in this analysis.

5. When break-even analysis is based on accounting data, as it usually happens, it may suffer

from various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates

and inappropriate allocation of overheads. It can be sound and useful only if the firm in question

maintains a good accounting system.

6. Selling costs are specially difficult to handle break-even analysis. This is because changes in

selling costs are a cause and not a result of changes in output and sales.

7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate

income tax.

8. It usually assumes that the price of the output is given . In other words, it assumes a horizontal

demand curve that is realistic under the conditions of perfect competition.

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9. Matching cost with output imposes another limitation on break-even analysis. Cost in a

particular period need not be the result of the output in that period.

10. Because of so many restrictive assumptions underlying the technique, computation of a

breakeven point is considered an approximation rather than a reality.

Profit Forecasting in Business Economics

Profit planning cannot be done without proper profit forecasting. Profit forecasting means

projection of future earnings after considering all the factors affecting the size of business

profits, such as firm‘s pricing policies, costing policies, depreciation policy, and so on.

Approaches to Profit Forecasting in Business Economics

According to Joel Dean, a famous economist, there are three approaches to profit forecasting,

which are as follows:

1. Spot Projection: Spot projection includes projecting the profit and loss statement of a

business firm for a specified future period. Projecting of profit land loss statement means

forecasting each important element separately. Forecasts are made about sales volume, prices

and costs of producing the expected sales. The prediction of profits of a firm is subject to wide

margins of error, from forecasting revenues to the inter-relation of the various components of

the income statement.

2. Break-Even Analysis: It helps in identifying functional relations of both revenues and

costs to output rate, keeping in consideration the way in which output is related to the profits.

It also helps in doing so by relating profits to output directly by the usual data used in break-

even analysis.

3. Environmental Analysis: It helps in relating the company‘s profits to key variable, in

the economic environment such as the general business activity and the general price level.

These variables are not considered by a business firm.

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