51892668 managerial economics dn dwivedi

Managerial economics

Economics is branch of knowledge that studies allocation of scarce resources among competing ends.

Managerial economics may be viewed as economics applied to problem solving at the level of a firm.

Managerial Economics

Study of economic theories, logics and tools of economic analysis that are used in business decision making.

Economic theories, techniques of economic analysis are applied to analyze business problems, evaluate the options and opportunities with a view to arriving at an appropriate business decision.

Managerial economics (contd)

Business decision making is essentially a process of selecting the best out of alternative opportunities open to the firm.

It involves four main phases:1. Determining and defining the objectives

to be achieved2. Collecting and analyzing information

regarding economic , social, political and technological environment and foreseeing the necessity and occasion for decision making

3. inventing, developing and analyzing possible courses of action

4. Selecting a particular course of action from available alternatives

Factors influencing Managerial decisions

While economic analysis contributes to a great deal to problem solving in a firm three other variables also influence choices and decisions by managers –

Human behavior Technological forces Environmental factors

Scope of Managerial Economics

Economics has two major branches

Micro economics and Macro economics

Both Micro and macro economics are applied to business analysis and decision making directly or indirectly – depending on the purpose of analysis.

Business issues are Operational or internal Environment or external

Microeconomics applied to Operational issues

Operational issues are of internal nature-include problems which arise within the business organization and fall within the purview and control of the management.- Choice of business and nature of products to produce, how much to produce (size of the firm), choosing the factors combination (technology), how to price, how to decide on new investments, how to manage profits and capital, how to manage inventory etc

Micro economic theories

Theory of Demand Production theory (Theory of firm) Pricing theory Profit analysis and Management Theory of Capital and investment

decisions

Macro economic applied

Macro economics issues is generally pertain to factors in the economic environment in which the business operates-

Type of economic system, General trends in production, employment, income, -

prices, savings and investments Structure & trends of working of the financial institutions Magnitude of and trends in foreign trade Govt’s economic policies Social factors Political environment-govt attitude towards business Degree of openness of the economy

National Income Analysis

National Income concepts

National Income is the final outcome of all economic activities of a nation, as a whole, in terms of money

National Income is the most important macroeconomic variable that determines the level of business and environment of a country.

Level of NI determines the level of aggregate demand for goods and services.

The distribution pattern determines the pattern of demand for goods and services i.e., how much of which good is demanded

The trend in national income determines the trend in aggregate demand for goods and services and therefore the business prospects.

Definition

Conceptually National income is the money value of the end result of all economic activities of the nation.

Economic activities – include all human activities that which create goods and services that can be valued at market price. Thus economic activities include production by farmers (whether for consumption or for market), production by firms and companies in the industrial sector,

Production of goods and services by Govt. enterprises, services produced by business intermediaries (wholesalers & retailers), banks and other financial organisations, universities, colleges, hospitals etc.

Non economic activities are those activities that produce goods and services that have no market / economic value.

These activities include spiritual , social and political services.

They also include hobbies, services of self, services of housewives, services of members of the family to other members and exchange of mutual services between neighbors.

National income from product flows

versus

National income at factor cost.

National income at factor cost

We have seen that economic activities generate flow of goods and services which are valued in terms of money.

These activities also generate money flows in the form of payments – wages, interest, rent, profits etc. (subject to certain adjustments like for subsidies and indirect taxes )

DEMAND ANALYSIS

AND

FORECASTING

DEMAND

Demand is one of the crucial requirement for the existence of any business enterprise.

A firm is interested in its own profit or sales both of which are partially depend on demand for its product or service.

While how much a firm can produce depends on the capacity, how much a firm must try to produce depends on the demand for its products.

The decisions which management makes with respect to production, advertising, cost allocation, pricing, inventory holding etc call for analysis of demand.

Once demand analysis is done the alternative ways of managing or manipulating can be determined.

Meaning of Demand

Demand in economics means desire to buy backed by purchasing power.

Mere desire to wish can not buy goods. It also needs ability and willingness to pay for it.

Unless a person has adequate purchasing power or resources and preparedness to spend his resources, his/ her desire for a commodity would not be considered as his/her demand for it.

Demand for a commodity therefore implies:

(a) desire to acquire it

(b) willingness to pay for it, and

(c) ability to pay for it

Any statement regarding demand for a commodity without reference to its price, time of purchase and place has no practical use for any business. e.g., demand for CTVs is 50,000 vs demand for TV sets @ Rs 15,000 each in Mangalore is 50,000 per annum

Basis of Consumer Demand

Consumers demand a commodity or product because they derive or expect to derive utility from that commodity or product.

What is utility?

From the product or commodity’s point of view it is the want or need satisfying property

Utility (contd)

From the consumer’s point of view utility is the psychological feeling of satisfaction, pleasure, happiness or wellbeing which a consumer derives from the consumption, use or possession of the product or commodity.

This is a subjective or relative concept – A product need not be useful for all e.g.,

cigarettes Utility varies from person to person A commodity need not have the same

utility for the same consumer at different points of time, different levels of consumption and in different moods of a consumer

Total Utility

Assuming that utility is measurable and additive, total utility may be defined as the sum of utilities derived by a consumer from the various units of goods and services he consumes.

Suppose a consumer consumes four units of a commodity X, at a time, and derives utility as u1,u2,u3 and u4,Total utility derived is

TUx = u1 + u2 + u3 + u4

If a consumer consumes n number of commodities, his total utility is

TUn = TUx + TUy + TUz

Marginal Utility may be defined as as the utility derived from the marginal unit consumed.

It may also be thought of as the addition to the total utility resulting from the consumption (or accumulation) of one additional unit.

MU= dTU / dQ

Law of Diminishing MU

As the quantity consumed of a commodity increases, the utility derived from the each successive unit decreases, consumption of all other commodities remaining the same.

When a person consumes more and more units of the a commodity per unit of time (say ice cream) keeping the consumption all other commodities constant, the utility which he drives from the successive units of consumption goes on diminishing.

Why does MU Decrease

The utility gained from a unit of commodity depends on the intensity of desire for it. When a person consumes successive units of the commodity his need is satisfied by degrees in the process of consumption and the intensity of his need goes on decreasing so also the utility. ( Ref table 6.1 and fig 6.1 page 106 Dwivedi)

Assumptions

1. Unit of good must be standard

2. Consumer taste or preference must remain same

3. There must be continuity in consumption

4. Mental condition must remain normal during the period of consumption

Market Demand

The quantity demanded of a product by an individual per unit of time, at a given price is known as individual demand for the product.

The aggregate of individual demands for the product is called the market demand for the product.

In other words, the total that all the consumers /users are willing to buy per unit of time at a given price, all other things remaining same, is called the market demand for the product.

Determinants of Demand

Demand for a commodity or product depends on several factors the main among them are:

Price of the product Price of related goods- substitutes,

complements and supplements Level of consumer’s income Consumers taste and preference

5.Advertisement for the product

6.Consumers’ expectations about the future price and supply position

7.Demnostration effect or band wagon effect

8. Consumer credit facility

9. Population and its distribution

10.National Income and its distribution pattern

The Law of Demand

Other things remaining same, the quantity of a commodity demanded is inversely proportion to its price.

In other words, the higher the price, lower the demand and vice versa, other things remaining same.

The main characteristics

Inverse relationship The relationship between price and quantity

demanded is inverse. i.e., if the price rises, the demand falls; the price falls, demand goes up.

Price is an independent variable, demand a dependent variable.

Under the law of demand it is the effect of price on demand that is examined and not the effect of demand on the price. When demand goes up price goes up and when demand falls price would fall. But the law of demand does not concern with this phenomenon.

The law of demand assumes that Other things remain the same

In other words there should be no change in other factors influencing demand except the price. Changes in income, substitutes’ prices, consumer tastes and preferences, advertising spend etc due to which the demand may rise even if price increases or demand may fall in spite of fall in prices

Factors Behind law of Demand

Substitution effect

Income effect

Utility maximizing behavior

Demand Curve

Graphical representation of law of demand

Demand curve is the locus of points showing alternative price quantity combinations

Demand curve shows the quantities of a commodity which a consumer will buy at different prices per unit of time, under the assumptions of the law of demand.

Demand change

At a particular price say Rs 10 people

were buying100 nos of product X. They may buy 90 nos for two reasons:

Price may rise to Rs 12 or one of the factors assumed to be constant may change e.g. price of a substitute product has reduced or income has gone down.

In the first case there is only change in the quantity demanded.

In the second case the demand has changed – new combination of price and quantity has resulted.

This is also called Demand shift

Reasons for shift in Demand

1. Increase in consumer Income

2. Price of substitute rises/falls – substitution effect

3. Price of a complement falls

4. Advertisement by the producer changing the consumer’s tastes and preferences

Exceptions to Law of Demand

While the Law of demand holds good for most of the goods, there are exceptions:

Snob appeal –goods purchased not for direct or indirect benefit but for the impressions they create on other people examples – curios and diamonds

Speculative markets – shares are bought when price increases

Giffen case of potatoes in the 19th century Ireland

Elasticity of Demand

The degree of responsiveness of demand to the changes in its determinants is called the elasticity of demand.

Price elasticity Income elasticity Cross elasticity Advertising or promotion elasticity

Price Elasticity of Demand

Defined as the responsiveness or sensitiveness of demand for a commodity to the changes in its price.

It is also the percentage change in demand as a result of one percent change in the price of the commodity

Ep= (Q1- Q2)/Q1x100/(P1- P2)/P1 x100

=dQ/dPx P1/Q1

Determinants of Price elasticity

Availability of substitutes Nature of commodity- essentials,

luxuries Weight age in the total consumption –if

the commodity purchase accounts for a very small percentage of total income then less elastic

Time factor in adjustment of consumption pattern

Range of use of commodity

Income elasticity of Demand

Measures the responsiveness of demand foe a commodity to changes in consumer income.

Income Elasticity of demand depends on the type of goods:

Essential consumer goods

Inferior goods

Normal goods

Luxury and prestige goods (page 153 Dwivedi)

Cross elasticity of Demand

Describes the responsiveness of demand for good X to changes in the price of good Y

Demand Distinctions(Types of Demand)

Producer goods & Consumer goods Durable & non durable Derived and autonomous demand Industry demand and firm’s demand Short run and long run Individual and market demand

(Refer chapter 5 pp59 Varshney & Maheshwari)

Demand Forecasting

Forecast is a predication or estimation of a future situation.

Demand forecasting is the estimation of the demand for a particular good in a future period of time.

Accurate demand forecasting is essential for a firm to enable it to produce the required quantities at the right time and to arrange in advance for the various inputs

Passive and active forecasts by a firm

Purposes of Forecasting

Sort term forecasting: Appropriate production scheduling – to

avoid over production and shortages Help reduce cost of acquiring inputs &

finance Determining appropriate price policies Setting sales targets, establishing controls

and incentive schemes Evolving suitable promotional

programmes

Long term Forecasting:

Planning of a new unit or expansions Planning long term financial

requirements Planning man power requirements

Factors involved in Demand forecasting

1. How far ahead ? Long term 10 to 20 yrs short term - quarterly, half yearly and yearly

2.Level of forecasting: Macro level Industry level Firm level

Factors (continued)

3. General or specific Commodity or product wise, nationwide

or area wise. 4. New products vs established products 5. Type of products – consumer goods, producer goods, durable goods, non durable goods etc. 6. Factors specific to particular goods

SUPPLY ANALYSIS

Meaning of Supply

The Supply of a commodity means the amount of that commodity which the producers are able and willing to offer for sale at a given price.

Supply is related to scarcity. Only scarce goods have a supply price;

goods which are freely available have no supply price

Supply Schedule

Supply schedule is a tabular representation of the data on the quantity supplied and the price of that commodity or product.

As the price increases, a firm supplies greater quantity of output and vice versa. The quantity supplied and the price both move in the same direction.

Supply curve

The graphical representation of the Supply schedule is called the supply curve.

Each point on the supply curve shows the price- quantity supplied combination of a firm.

The supply curve shows the minimum price which a firm is prepared to receive for different quantities or it shows the max quantity the firm is willing to sell at each possible price.

Law of Supply

Other things remaining the same, as the price of a commodity rises, its supply increases and as the price falls its supply declines.

An increase in the price generally implies higher profits leading producers to offer increased quantities. Again,

In the long run, due to higher profitability new producers may enter the market leading to an increased output offered for sale.

Limitations

1. Future price: When price rises seller expects the price to rise further and in order to get more profits in future he may sell less now.

Likewise when the price declines, the seller may anticipate further decline and to make the best of the situation he may offer to sell more, thus increasing the supply.

2. Agricultural output: In case of agricultural commodities, as their

production can not increase at once when the price increases.

3. Subsistence farmers: In underdeveloped countries where agriculture is

characterized with subsistence farmers, as food grain price increases marketable surplus of food grains, farmers can get the required amount of income by selling less and keep the remaining for their own consumption.

4. OTHER FACTORS not remaining same

If prices of other commodities rise the quantity supplied will fall at a given price.

Change in technology can bring about change in quantity supplied even if the price of the commodity does not undergo change

Elasticity of Supply

Degree of responsiveness of supply to a given change in price

Es = dQ/Q1 /dP/P1

= Percentage Change in Quantity Supplied

Percentage Change in price

Cross Elasticity of Supply

Proportionate change in quantity supplied

Proportionate change in he price of Other

commodity

Factors influencing supply

1. The supply depends on the goals of the company.

2. Depends on the price of the commodity

3. Depends on the price of other commodities

4. Depends on the prices of factors of production

5.The State of Technology 6.Time factor can also determine the

elasticity of Supply 7.Supply may be consciously decreased

by agreement among producers. 8.Supply destroyed to raise price 9.Taxation and imports 10.Political disturbances/wars creating

scarcity

COST ANALYSIS

Cost concepts

Cost concepts used for accounting purposes

Analytical Cost Concepts used in economic analysis for business activities.

Opportunity Cost and Actual cost Opportunity cost also called alternative

cost is the expected return from the next best use of the resource(s) which are foregone due to scarcity of resources.

Actual costs are those which are actually incurred by the firm in payment for inputs – labor, materials, plant, bldg, advertising, transport, traveling etc.

Business costs and Full costs. Business cost includes all expenses

incurred to carry out the business – include all payments and contractual obligations made together with book cost of depreciation.

Full costs include business costs, opportunity costs and normal profits.

Explicit cost and implicit (imputed) cost

Production Function

Meaning of Production

A process by which resources (men, matl, time etc) are transformed into a different more useful commodity or service.

Inputs --> Production Outputs

function

Production Function

A production function refers to the relationship between the output of a commodity and its inputs.

Traditional Economics considers factors of production – land, labor, capital, organization /management (and technology)

Output X= f( Ld, L,K,M,T) Y= f ( X1,X2,X3, etc)

In a specific situation, one or other of the inputs may not be important – relative importance varies from product to product.

In the production of agricultural product land is importance while in steel production, land is not that important but Capital is.

For easier understanding of production decision problems, it is convenient to work with two input factors for an output – labour and Capital

Production function, x = f ( L,K) 3 variables - output of commodity X (x),

units of labor (L) and units of capital (K)For any given value of x, there will be

alternative combinations of L and K. These combinations of L & K, vary with variations in x. K and L are to a certain extent are substitutes to each other.

Isoquants

Isoquant is the locus of all those combinations of labour and capital that yield the same output. (sometimes called iso-product curves)

Geometric representation of a production function

Isoquants shape(a) they are falling- one input decreases while the

other decreases(b) the higher the isoquant the higher the output it

represents(c) they do not intersect each other(d) they are convex – lesser and lesser unit of the

second input is used while increasing the quantity of the first input

Least- cost combination of inputs

The production function indicates alternative combinations of inputs or factors of production which can produce a given output.

Of these an entrepreneur would like to choose that combination of inputs which costs him the least.

There are two ways to determine the least cost combination of inputs for given output.

Find the cost of each combination and find out the one that gives the least value arithmetically.

Geometric method by drawing isocost curves and superimposing them on the isoquant curves.(Ref pp53-55 Mote et al)

Factor Productivities

Production function is a relationship between the output and inputs or factors of production.

The short term relationship between inputs and outputs are denoted by productivity of a factor of production

There are three productivities – total product, average and marginal product

The Total Product (TP) of a factor of production is defined as the total production we obtain by employing different amount of that factor, keeping all other factors constant.

Average Product (AP) of a factor is the total product divided by the quantity of that factor, with all other factors held constant

The Marginal Product (MP) of a factor of production is the extra physical product we obtain by adding an extra unit of that factor, with all other factors held constant

Law of Diminishing Returns

When more and more units of a variable input is applied to a given quantity of fixed inputs, the total output may initially increase at an increasing rate and then at a constant rate but eventually increase at diminishing rate.

Stages of Production

Stage I :TP increases in increasing rate,

MP increases, AP increases

Stage II: TP increases at diminishing rate till reaches a maximum level, MP diminishes and becomes zero, AP starts diminishing

Stage III:

TP starts declining, MP becomes negative

Continues to decline

Return to Scale

Returns to scale explains what happens to the output rate when each input is increased by the same proportion.

If out put increases by larger percentage than the in each of the inputs we have the case of increasing returns to scale; increases by smaller percentage then diminishing return to scale and if the increase is by the same proportion we have the case of constant return to scale.

If one increases all inputs in equal proportions, one moves along a ray from the origin in the graph.

If a 10% increase in all inputs yields more than a 10% increase in out put , the production function has an increasing return to scale. If it yields less than 10%increase in the output, there is decreasing return to scale. If it yields exactly 10% increase in output it has a constant return to scale

Return to scale concept is important for determining how many firms will populate an industry.

When increasing returns to scale exist, one large firm will produce more cheaply than two smaller firms. Small firms have a tendency to merge to increase profits while those which do not merge will eventually fail.

If an industry has decreasing returns to scale, a merger of two units will produce a larger firm which will reduce output, raise average cost and lower profits. In such industry it is better to have many small firms than a larger ones.

Cost Analysis

Theory of cost deals with behavior of cost in relation to a change in output.

In other words cost theory deals with cost – output relations

Short run cost analysis

Total cost (TC) is the actual cost that must be incurred to produce a given quantity of output

Average Cost (AC) is the cost per unit of output. Obtained by dividing TC by Quantity produced (Q)

Marginal Cost (MC) is the extra cost of producing one additional unit of output.

In practice however it may not be possible to determine the extra cost of producing one extra unit, say one extra metre of cloth, in large scale production say in textile manufacturing. In this case one can determine the incremental cost of producing additional 100 metres and then divide the incremental total cost by the additional units

Fixed and Variable costs

Fixed costs are those which remain the same at a given capacity and do not vary with the output. These costs exist even if there is no output .

Variable costs vary directly as output changes

Short run Cost output Relationship

This refers to a particular scale of operation i.e., to a fixed capacity plant.

It indicates the variations in cost over output of a given capacity .This relationship will vary with plants of different capacity.

TC = f (x) + A Total cost = Total VC + Total Fixed cost

Fixed cost and output

By definition Fixed cost does not vary with output. Total fixed cost curve is horizontal line (.Rs 176 at all output levels).

The larger the quantity produced the lower will be the fixed cost per unit. The Average Fixed Cost =TFC/ quantity of output declines as output increases.

AFC=176 at output 1,88 at output 2,12 at out 15 etc. AFC curve is falling continuously (shape is rectangular hyperbola).

This relationship is same for types of business.

Variable cost and output

Total Variable cost increases as output increases.

In the beginning, as the output increases, TVC increases at a decreasing rate, then at a constant rate and eventually at an increasing rate. Increase in TVC goes on diminishing up to a certain level of output, then constant over a range ,finally starts rising.

Reasons ? Need for variable factor input for increased

output behaves in a similar fashion and the operation of the law of diminishing returns. While this behaviour pattern generally holds

good in all situations the exact behavior may vary from product to product. For capital intensive products the first phase may be longer than for labour intensive products.

Total Cost and Output

Total cost increases as out put increases. As one of the components of TC, the TFC

remains constant at all output levels, the behavior of TC follows the behavior of TVC. The TC curve is parallel to TVC curve.

Average Total Cost ATC or Average Cost first falls as output increases ,remains constant and eventually rises – U shaped

Summary of Relationships

1.AVC, ATC and MC first fall, then remain

constant and then rise as output increases.

2.AC falls for a longer range of output than AVC.

3. AVC = MC when AVC is the least

4. AC = MC when AC is the least

(page 73 Mote et al)

Long Run Cost Output Relationship

In the long run there is no fixed factor of production and therefore no fixed cost.

TC = f (x, k) where k=plant size.

As k changes, TC changes.

Q: What Is TC at a given output? It is small for a small size plant compared to a large one, when the output is small. Large size plant capacity remains unutilized, whereas for large outputs small size plant may be insufficient/ inadequate.

Managerial use of Production Function

MARKET STRUCTURE

AND

PRICING DECISIONS

Type of Market Structure

1. Perfect Competition

2. Imperfect Competition

a. Monopoly

b. Oligopoly

c. Monopolistic competition

Perfect Competition

1. There are many small firms, each producing an identical product and each is too small to affect the market price. It is a price taker. No control over price.

2. The firm faces a completely elastic demand.

3. Extra revenue earned from extra unit sold by the firm is the market price.

4. Free entry and exit from industry.

Imperfect Competition

Imperfect competition prevails in an industry where individual sellers have some measure of control over the price of their output.

Demand has a finite elasticity

Monopoly

Most extreme case of imperfect competition.

Greek : Mono – one ; polist- seller

It is the only firm producing in its industry and there is no industry producing a close substitute. (examples: Microsoft windows, patented drugs, franchise monopolies, public utilities)

Very good control over the price of its product. (nowadays regulated by govt)

Monoplolies are rare today.

Monopsony

There is only one buyer of goods or services

Rivalry from buyers who offer substitute outlet is so remote as to be insignificant.

Buyers are in a position to determine the price

Oligopoly

Oligopoly in Greek means “few sellers”

- 2 to 10 or 15.

Products- no difference in products like steel chemicals etc

Or some differentiation like cars,word processing softwares

Each firm can affect market price.

Monopolist Competition

Many producers

Real or perceived difference in products. products are not identical.

Resembles perfect competition in that there are large number of producers, none have large market share.

Barriers to entry

PRICING POLICIES

AND

PRICING METHODS

General considerations in formulating pricing policy

1. Objectives of the business

2. Competitive situation

3. Product and promotional policies

4. Price Sensitivity

5. Interests of Manufacturers and middlemen

6. Influence of Non business entities on price determination

Objectives of Pricing Policy

1. Profit maximization of product line

2. Promoting long term welfare of the firm – discouraging competitor entry

3. Adaptation of prices to diverse competitive situations for products

4. Flexibility to changes in economic conditions

5. Stabilization of prices and margins

Market penetration Market skimming Early cash recovery Satisfactory ROI

Professional Managers’ motives also can determine objectives (p 236 V&M)

PRICING METHODS

Cost Oriented

1. Cost- plus or Full cost pricing

2. Pricing for return or target pricing

3. Marginal cost pricing

Competition Oriented

1. Going rate pricing

2. Customary pricing

3. Sealed bid pricing

Full cost or Cost plus pricing

Most common method used.

Cost set to cover variable and fixed

costs including overheads plus a pre

determined percentage for profit margin.

(Margin varies from industry to industry)

Fair and plausible prices determined for all products with ease and speed.

Full cost prices look factual and precise and defensible on moral grounds.

Firms preferring stability use full cost pricing in a market with insufficient info and knowledge.

Fixed costs are covered even in short run

Managements know the costs better than the market forces to set prices.

Full cost pricing is used in: Public utility pricing Monopsony buying situations Tailor made products Product (cost) tailoring to price when

selling price is predetermined - (HLL challenge cost concept)

Pricing for a Rate of return

Price adjusted to changes in costs.

1. Profit as a percentage over costs

2. Profit as a percentage on sales

3. Profit as a percentage on Capital employed.

(worked out example p 253 V & M)

Marginal Cost Pricing

Fixed costs are ignored and prices are

determined on the basis of marginal cost.

The firm uses only those costs that are directly attributable to the output of a specific product.

Each product is considered in isolation

and price fixed at a level to maximize

contribution to the fixed cost and profits.

Assumptions:

1. It is able to segregate its markets to charge higher price in one and lower in others.

2. No legal restriction for the above.

Advantages: Prices are never rendered uncompetitive unless

by virtue of higher variable cost which are controllable.

Permits manufacturer far more aggressive pricing policy than full cost pricing

Helps in pricing over product life cycle where short run relevant fixed costs and MC are isolated

Going - Rate pricing

Emphasis is on the market.

The firm adjusts its pricing policy to the general pricing structure of the industry.

This

Customary pricing

Sealed Bid Pricing

Profit

What is Profit ?Profit is essentially a residual sum.Net profit is a sum over and above theordinary costs including contractual outlaysLand ,labor and capital are frequently usedunder contracts whereby they receive pre

determined return. Nobody contracts to the entrepreneur the

residual sum - profits

Business is faced with a number of uncertainties:

Technical uncertainties

Cost uncertainties

Demand uncertainties

Market uncertainties

Profit is the reward to entrepreneur for combining

factors of production to meet the economic needs

of the world and successfully managing the risks

and uncertainties in the process.

Accounting Profit and Economic Profit

In the accounting sense profit is revenue realised during the period minus the explicit or actual cost and expenses incurred in producing the revenue – the residual concept.

The economic profit also calls for deduction of imputed costs –

Entrepreneur’s wages (which he could earn by working for others)

Rental income from self owned land and buildings (he would got by renting to others)

Interest on self owned capital (which he would earned by investing elsewhere)

Economic Profit = Accounting profit – imputed costsFrom the managerial point of vieweconomic profits are more important thanaccounting profits as the former reflect thetrue profitability of the business. A firm

incurring economic loss but making accounting profit may have to withdraw

from business in the long run.

Functions of profit

The basic function of profit is to provide businessmen with an incentive to produce what the consumers want, when and where they want at the lowest feasible cost.

Profits also serve these main purposes:

1. Measure of performance

2. Premium to cover cost of staying in business

3. Ensuring supply of future capital

Profit as measure of performance

Profits measure the net effectiveness and soundness of business effort.

A higher profit is an indicator that business is run successfully and effectively. Profit is probably the best indicator of the general efficiency of a firm and only one which allows a quick and easy comparison of performance of various firms

Profit measure has following advantages:

1. It provides a single criterion that can be used to compare future courses of action.

2. It permits a quantitative analysis of proposals where benefits can be directly compared with costs

3. It provides a single broad measure of performance

4. It facilitates decentralization

5. It permits comparison of performances of responsibility centers with dissimilar functions.

Premium to cover Costs of staying in business

Costs of staying in business - replacement, obsolescence, market and technical risks & uncertainties. Management of business has to provide adequately for these by generating sufficient profit. (In this sense there is no such thing called profit but only costs of staying in business)

Ensuring supply of future capital

Profits ensure supply of future additional capital either directly (self financing through Retained profits) or indirectly through inducement of new external capital to optimize the company’s capital structure and minimize cost of capital.

A firm must have growth because it is the only way it can perpetuate itself and profits are natural concomitant of growth

Profiteering Vs profit earning

Profiteering is a case when the amount of profits made exceeds acceptable limit by questionable means. Profiteering is often done by creating artificial shortages through hoarding and curtailing production.

Profit policies

Business firm aims at making profits; . volume of profit is the primary measure of its success.

In economic theory the basic assumption is that the firm aims at maximizing profits. However this may not be true always – we see that there are many reasons for this.

1. Attainment of Industry leadership2. Forestalling potential competition3. Preventing Govt intervention4. Maintaining consumer goodwill5. Restraining demand for wage increases6. Accent on liquidity of the firm7. Risk avoidance8. Changed business structure – entrepreneur

to professional managers with different focuses – other stake holders also considered.