Short Notes:

1. Adam Smith’s Invisible Hand Doctrine

The Idea of "invisible hand" was introduced by Adam Smith in his book Wealth of Nations first published in 1776. Smith uses this concept to describe a paradox of laizzes-faire or perfect competition, in which every person in an economy is working to achieve his own selfish goals, leads to benefit of all. The individual neither intends to promote the public nor he knows how much he is promoting it. Adam Smith compares this process as an invisible benevolent directing the whole process for benefit of all.

The theory of the Invisible Hand states that if each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell and how to produce it, the market will settle on a product distribution and prices that are beneficial to all the individual members of a community, and hence to the community as a whole. The reason for this is that self-interest drives actors to beneficial behavior. Efficient methods of production are adopted to maximize profits. Low prices are charged to maximize revenue through gain in market share by undercutting competitors. Investors invest in those industries most urgently needed to maximize returns, and withdraw capital from those less efficient in creating value. All these effects take place dynamically and automatically.

It also works as a balancing mechanism. For example, the inhabitants of a poor country will be willing to work very cheaply, so entrepreneurs can make great profits by building factories in poor countries. Because they increase the demand for labor, they will increase its price; further, because the new producers also become consumers, local businesses must hire more people to provide the things they want to consume. As this process continues, the labor prices eventually rise to the point where there is no advantage for the foreign countries doing business in the formerly poor country. Overall, this mechanism causes the local economy to function on its own.

Based on belief of effectiveness of this so called invisible hand, the doctrine of laissez-faire which recommends that government should interfere as little as possible in economic affairs, guided the action of governments in many countries. However, beginning from the twentieth century, there has been growing feeling that the theoretical assumption on which the action of invisible hand is dependent, do not exist in reality.

2. The Prisoners’ Dilemma Game

The prisoner's dilemma is a canonical example of a game analyzed in game theory that shows why two individuals might not cooperate, even if it appears that it is in their best interest to do so. It was originally framed by Merrill Flood and Melvin Dresher working at RAND in 1950. Albert W. Tucker formalized the game with prison sentence payoffs and gave it the "prisoner's dilemma" name (Poundstone, 1992). A classic example of the prisoner's dilemma (PD) is presented as follows:Two men are arrested, but the police do not possess enough information for a conviction. Following the separation of the two men, the police offer both a similar deal—if one testifies against his partner (defects/betrays), and the other remains silent (cooperates/assists), the betrayer goes free and the cooperator receives the full one-year sentence. If both remain silent, both are sentenced to only one month in jail for a minor charge. If each 'rats out' the other, each receives a three-month sentence. Each prisoner must choose either to betray or remain silent; the decision of each is kept quiet. What should they do?If it is supposed here that each player is only concerned with lessening his time in jail, the game becomes a non-zero sum game where the two players may either assist or betray the other. In the game, the sole worry of the prisoners seems to be increasing his own reward.

The interesting symmetry of this problem is that the logical decision leads each to betray the other, even though their individual ‘prize’ would be greater if they cooperated.In the regular version of this game, collaboration is dominated by betrayal, and as a result, the only possible outcome of the game is for both prisoners to betray the other. Regardless of what the other prisoner chooses, one will always gain a greater payoff by betraying the other. Because betrayal is always more beneficial than cooperation, all objective prisoners would seemingly betray the other.In the extended form game, the game is played over and over, and consequently, both prisoners continuously have an opportunity to penalize the other for the previous decision. If the number of times the game will be played is known, the finite aspect of the game means that by backward induction, the two prisoners will betray each other repeatedly.In casual usage, the label "prisoner's dilemma" may be applied to situations not strictly matching the formal criteria of the classic or iterative games, for instance, those in which two entities could gain important benefits from cooperating or suffer from the failure to do so, but find it merely difficult or expensive, not necessarily impossible, to coordinate their activities to achieve cooperation.

3. Circular Flow model

In economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers. In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households. More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports.Human wants are unlimited and are of recurring nature therefore, production process remains a continuous and demanding process. In this process, household sector provides various factors of production such as land, labor, capital and enterprise to producers who produce by goods and services by coordinating them. Producers or business sector in return makes payments in the form of rent, wages, interest and profits to the household sector. Again household sector spends this income to fulfill its wants in the form of consumption expenditure. Business sector supplies them goods and services produced and gets income in return of it. Thus expenditure of one sector becomes the income of the other and supply of goods and services by one section of the community becomes demand for the other. This process is unending and forms the circular flow of income, expenditure and production.A continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning nor an end. The circular flow of income involves two basic principles:-1. In any exchange process, the seller or producer receives the same amount what buyer or consumer spends.2. Goods and services flow in one direction and money payment to get these flow in return direction, causes a circular flow.

In this simplified image, the relationship between the decision-makers in the circular flow model is shown. Larger arrows show primary factors, whilst the red smaller arrows show subsequent or secondary factors.

4. Law of Returns to Scale:

Definition and Explanation:

The law of returns are often confused with the law of returns to scale. The law of returns operates in the short period. It explains the production behavior of the firm with one factor variable while other factors are kept constant. Whereas the law of returns to scale operates in the long period. It explains the production behavior of the firm with all variable factors.There is no fixed factor of production in the long run. The law of returns to scale describes the relationship between variable inputs and output when all the inputs, or factors are increased in the same proportion. The law of returns to scale analysis the effects of scale on the level of output. Here we find out in what proportions the output changes when there is proportionate change in the quantities of all inputs. The answer to this question helps a firm to determine its scale or size in the long run.It has been observed that when there is a proportionate change in the amounts of inputs, the behavior of output varies. The output may increase by a great proportion, by in the same proportion or in a smaller proportion to its inputs. This behavior of output with the increase in scale of operation is termed as increasing returns to scale, constant returns to scale and diminishing returns to scale. These three laws of returns to scale are now explained, in brief, under separate heads.

(1) Increasing Returns to Scale:

If the output of a firm increases more than in proportion to an equal percentage increase in all inputs, the production is said to exhibit increasing returns to scale.

For example, if the amount of inputs are doubled and the output increases by more than double, it is said to be an increasing returns returns to scale. When there is an increase in the scale of production, it leads to lower average cost per unit produced as the firm enjoys economies of scale.

(2) Constant Returns to Scale:

When all inputs are increased by a certain percentage, the output increases by the same percentage, the production function is said to exhibit constant returns to scale.

For example, if a firm doubles inputs, it doubles output. In case, it triples output. The constant scale of production has no effect on average cost per unit produced.

(3) Diminishing Returns to Scale:

The term 'diminishing' returns to scale refers to scale where output increases in a smaller proportion than the increase in all inputs.

For example, if a firm increases inputs by 100% but the output decreases by less than 100%, the firm is said to exhibit decreasing returns to scale. In case of decreasing returns to scale, the firm faces diseconomies of scale. The firm's scale of production leads to higher average cost per unit produced.

Graph/Diagram:

The three laws of returns to scale are now explained with the help of a graph below:

The figure shows that when a firm uses one unit of labor and one unit of capital, point a, it produces 1 unit of quantity as is shown on the q = 1 isoquant. When the firm doubles its outputs by using 2 units of labor and 2 units of capital, it produces more than double from q = 1 to q = 3.So the production function has increasing returns to scale in this range. Another output from quantity 3 to quantity 6. At the last doubling point c to point d, the production function has decreasing returns to scale. The doubling of output from 4 units of input, causes output to increase from 6 to 8 units increases of two units only.

5. Survey techniques of demand forecasting

Survey methods help us in obtaining information about the future purchase plans of potential buyers through collecting the opinions of experts or by interviewing the consumers. These methods are extensively used in short run and estimating the demand for new products. There are different approaches under survey methods. They are:

A. Consumers’ interview method: Under this method, efforts are made to collect the relevant information directly from the consumers with regard to their future purchase plans.

In order to gather information from consumers, a number of alternative techniques are developed from time to time. Among them, the following are some of the important ones.

Survey of buyer’s intentions or preferences: It is one of the oldest methods of demand forecasting. It is also called as “Opinion surveys”. Under this method, consumer buyers are requested to indicate their preferences and willingness about particular products. They are asked to reveal their ‘future purchase plans with respect to specific items.

B. Direct Interview Method: Under this method, customers are directly contacted and interviewed. Direct and simple questions are asked to them.

i. Complete enumeration methodUnder this method, all potential customers are interviewed in a particular city or a region.ii. Sample survey method or the consumer panel methodUnder this method, different cross sections of customers that make up the bulk of the market are carefully chosen. Only such consumers selected from the relevant market through some sampling method are interviewed or surveyed.

C. Collective opinion method or opinion survey method: Under this method, sales representatives, professional experts and the market consultants and others are asked to express their considered opinions about the volume of sales expected in the future.

D. Delphi Method or Experts Opinion Method: Under this method, outside experts are appointed. They are supplied with all kinds of information and statistical data. The management requests the experts to express their considered opinions and views about the expected future sales of the company.

E. End Use or Input – Output Method: Under this method, the sale of the product under consideration is projected on the basis of demand surveys of the industries using the given product as an intermediate product.

6. Cross elasticity of demand

In economics, the cross elasticity of demand or cross-price elasticity of demand measures the responsiveness of the demand for a good to a change in the price of another good. It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticityof demand would be:-20%/10%=-2. A negative cross elasticity denotes two products that are complements, while a positive cross elasticity denotes two substitute products. These two key relationships go against one's intuition, but the reason behind them is fairly simple: assume products A and B are complements, meaning that an increase in the demand for A is caused by an increase in the quantity demanded for B. Therefore, if the price of product B decreases, then the demand curve for product A shifts to the right, increasing A's demand, resulting in a negative value for the cross elasticity of demand. The exact opposite reasoning holds for substitutes.

Formula

The formula used to calculate the coefficient cross elasticity of demand is

or:

Results for main types of goodsIn the example above, the two goods, fuel and cars (consists of fuel consumption), are complements; that is, one is used with the other. In these cases the cross elasticity of demand will be negative, as shown by the decrease in demand for cars when the price for fuel will rise. In the case of perfect substitutes, the cross elasticity of demand is equal to positive infinity. Where the two goods are independent, or, as described in consumer theory, if a good is independent in demand then the demand of that good is independent of the quantity consumed of all other goods available to the consumer, the cross elasticity of demand will be zero: as the price of one good changes, there will be no change in demand for the other good.

Two goods that complement each other show a negative cross elasticity of demand: as the price of good Y rises, the demand for good X falls

Two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y rises, the demand for good X rises

Two goods that are independent have a zero cross elasticity of demand: as the price of good Y rises, the demand for good X stays constant

7. Differentiate between Economic profit and Business (Accounting) profit

When it comes to profit, it is often assumed that the only kind of profit there is the amount that is left after the deduction of costs from the revenue, but this is not so. There exits two kinds or profits, accounting profit and economic profit which bear several differences from each other.

What is accounting profit?

The accounting profit can be defined as the difference between the total revenue and the total explicit cost which does not include the opportunity cost such as time and capital whatsoever. This is obtained by deducting the total amount of costs by the total revenue. For example, if a company has earned $50,000 one month and the total amount of costs for that month stands at $10,000 the accounting cost would be calculated as $40,000.

What is economic profit?

The economic profit can be defined as the difference between the sales revenue minus all implicit and explicit costs including the opportunity cost of equity capital, time and the owner’s own resources. This is done so because it is important that the revenue which these self employed resources could have brought in their best alternative uses should be worked at and added in the cost as well. Therefore, the economic profit is calculated by deducting the implicit and explicit costs from the total revenue. For example, if a company has earned $50,000 one month and the owner has invested $10,000 in the business and the amount of explicit costs stand at $10,000, the economic profit would be calculated at $30,000 that month.

What is the difference between economic and accounting profit?

While the accounting profit is calculated without deducting the opportunity cost from the revenue, the economic profit is calculated by deducting the explicit costs, opportunity cost and all implicit costs as well from the revenue. In calculating economic profit, in addition to explicit costs such as the production cost, etc, all other costs including the company’s own building, the owner’s own resources, the use of its own capital, the time dedicated are calculated and then deducted from the revenue. This is done so because it is considered important that one calculates what revenue these assets would have brought in if used in other projects other than this particular one. This is called the opportunity cost. Accounting

profit need not consider all those factors. And therefore, as a result, the economic profit is often much lower that the accounting profit.

Another difference would be as opposed to the accounting profit of a company which would be calculated every year; the economic profit of a company would be only produced ever leap year.

If the total revenue exceeds both explicit and implicit costs, it is considered that the firm has earned economic profit.

Summary

1. Accounting profit can be defined as the difference between the total revenue and the total explicit cost which does not include the opportunity cost.

2. Economic profit as opposed to accounting profit includes the opportunity cost in its calculations.

3. Economic profit is often lower than accounting profit.4. As opposed to accounting profit which is calculated for a certain period of time,

economic profit is only calculated every leap year.

8. Monopolistic Competition

Pure monopoly and perfect competition are two extreme cases of market structure. In reality, there are markets having large number of producers competing with each other in order to sell their product in the market. Thus, there is monopoly on one hand and perfect competition on other hand. Such a mixture of monopoly and perfect competition is called as monopolistic competition. It is a case of imperfect competition.

Monopolistic competition has been introduced by American economist Prof. Edward Chamberlin, in his book 'Theory of Monopolistic Competition' published in 1933.

Features of Monopolistic Competition ↓

The following are the features or characteristics of monopolistic competition:-

1. Large Number of Sellers

There are large number of sellers producing differentiated products. So, competition among them is very keen. Since number of sellers is large, each seller produces a very small part of market supply. So no seller is in a position to control price of product. Every firm is limited in its size.

2. Product Differentiation

It is one of the most important features of monopolistic competition. In perfect competition, products are homogeneous in nature. On the contrary, here, every producer tries to keep his product dissimilar than his rival's product in order to maintain his separate identity. This boosts up the competition in market. So, every firm acquires some monopoly power.

3. Freedom of Entry and Exit

This feature leads to stiff competition in market. Free entry into the market enables new firms to come with close substitutes. Free entry or exit maintains normal profit in the market for a longer span of time.

4. Selling Cost

It is a unique feature of monopolistic competition. In such type of market, due to product differentiation, every firm has to incur some additional expenditure in the form of selling cost. This cost includes sales promotion expenses, advertisement expenses, salaries of marketing staff, etc.

But on account of homogeneous product in perfect competition and zero competition in monopoly, selling cost does not exist there.

5. Absence of Interdependence

Large numbers of firms are different in their size. Each firm has its own production and marketing policy. So no firm is influenced by other firm. All are independent.

6. Two Dimensional Competition

Monopolistic competition has two types of competition aspects viz.

Price competition i.e. firms compete with each other on the basis of price. Non price competition i.e. firms compete on the basis of brand, product quality

advertisement.

7. Concept of Group

In place of Marshallian concept of industry, Chamberlin introduced the concept of Group under monopolistic competition. An industry means a number of firms producing identical product. A group means a number of firms producing differentiated products which are closely related.

8. Falling Demand Curve

In monopolistic competition, a firm is facing downward sloping demand curve i.e. elastic demand curve. It means one can sell more at lower price and vice versa.

Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a quantity where the firm's marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price based on the average revenue (AR)

curve. The difference between the firms average revenue and average cost, multiplied by the quantity sold (Qs), gives the total profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost and marginal revenue are equal; however, the demand curve (and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its goods above average cost and can no longer claim an economic profit

9. Quantitative tools used for Demand Forecasting

Quantitative Forecasting Methods

There are two forecasting models here – (1) the time series model and (2) the causal model. A time series is a s et of evenly spaced numerical data and is o btained by observing responses at regular time periods. In the time series model , the forecast is based only on past values and assumes that factors that influence the past, the present and the future sales of your products will continue.

On the other hand, t he causal model uses a mathematical technique known as the regression analysis that relates a dependent variable (for example, demand) to an independent variable (for example, price, advertisement, etc.) in the form of a linear equation. The time series forecasting methods are described below:

Time Series Forecasting Method

Description

Naïve Approach Assumes that demand in the next period is the same as demand in most recent period; demand pattern may not always be that stable

For example:

If July sales were 50, then Augusts sales will also be 50

Time Series Forecasting Method

Description

Moving Averages (MA)

MA is a series of arithmetic means and is used if little or no trend is present in the data; provides an overall impression of data over time

A simple moving average uses average demand for a fixed sequence of periods and is good for stable demand with no pronounced behavioral patterns.

Equation:

F 4 = [D 1 + D2 + D3] / 4

F – forecast, D – Demand, No. – Period

A weighted moving average adjusts the moving average method to reflect fluctuations more closely by assigning weights to the most recent data, meaning, that the older data is usually less important. The weights are based on intuition and lie between 0 and 1 for a total of 1.0

Equation:

WMA 4 = (W) (D3) + (W) (D2) + (W) (D1)

WMA – Weighted moving average, W – Weight, D – Demand, No. – Period

Exponential Smoothing

The exponential smoothing is an averaging method that reacts more strongly to recent changes in demand by assigning a smoothing constant to the most recent data more strongly; useful if recent changes in data are the results of actual change (e.g., seasonal pattern) instead of just random fluctuations

F t + 1 = a D t + (1 - a ) F t

Where

F t + 1 = the forecast for the next period

D t = actual demand in the present period

F t = the previously determined forecast for the present period

•  = a weighting factor referred to as the smoothing constant

Time Series Decomposition

The time series decomposition adjusts the seasonality by multiplying the normal forecast by a seasonal factor

10.Value Analysis

Value analysis is a systematic effort to improve upon cost and/or performance of products (services), either purchased or produced. It examines the materials, processes, information systems, and the flow of materials involved. Value Analysis efforts began in earnest during WW II. Value Analysis, also called Functional Analysis was created by L.D. Miles. In his search, Miles found that each material has unique properties that could enhance the product if the design was modified to take advantage of those properties.

The value of an item is how well the item does its function divided by the cost of the item (In value analysis value is not just another word for cost):

Value of an item = performance of its function / cost

If implemented diligently, value analysis can result in -   1.reduced material use and cost  2.reduced distribution costs   3.reduced waste  4.improved profit margins   5.increased customer satisfaction   6.increased employee morale

Value analysis should be a part of continuous improvement effort.

11.Factors hampering Cost Control

Steps taken by management to assure that the cost objectives set down in the

planning stage are attained and to assure that all segments of the organization

function in a manner consistent with its policies .For effective cost control, most

organizations use standard cost systems, in which the actual costs are compared

against standard costs for performance evaluation and the deviations are

investigated for remedial actions

Reducing costs can be damaging. Before making changes, check that your standards

will not be compromised and that your ability to meet objectives will not be harmed.

Reducing costs which directly affect employees is extremely difficult. Reducing costs

such as training and meeting times is often counterproductive in the longer term.

Poor condition, pay and benefits will not attract and hold good employees. Making

employees redundant brings short-term costs and the risk of possible employment

tribunal proceedings. It may also damage long-term morale

Almost every cost saving has a potential downside.

Production and marketing plans driven by cost-cutting considerations are unlikely to

meet customer requirements

Attempting to control fixed costs is itself a wasteful process

Tighter control of financing may leave you with no safety margin when cash flow is

unexpectedly poor

Cutting short-term ‘investment’ costs (e.g. training, advertising, equipment or new

product development) can lead to long-term weakness.

Introducing improved procedures can be difficult and expensive. Employees may

resist change, and may need extra training.

12.Production Possibilities’ Frontier

Under the field of macroeconomics, the production possibility frontier (PPF)

represents the point at which an economy is most efficiently producing its goods and

services and, therefore, allocating its resources in the best way possible. If the

economy is not producing the quantities indicated by the PPF, resources are being

managed inefficiently and the production of society will dwindle. The production

possibility frontier shows there are limits to production, so an economy, to achieve

efficiency, must decide what combination of goods and services can be produced

PPFs are normally drawn as bulging upwards ("concave") from the origin but can also

be represented as bulging downward or linear (straight), depending on a number of

factors. A PPF can be used to represent a number of economic concepts, such

as scarcity of resources (i.e., the fundamental economic problem all societies

face), opportunity cost (or marginal rate of transformation), productive

efficiency, allocation efficiency, and economies of scale. A PPF shows all possible

combinations of two goods that can be produced simultaneously during a given

period of time, ceteris paribus. The combination represented by the point on the PPF

where an economy operates shows the priorities or choices of the economy, such as

the choice between producing more capital goods and fewer consumer goods, or vice

versa.

13.Utility

Utility is a term used by economists to describe the measurement of "useful-

ness" that a consumer obtains from any good. Utility may measure how much one

enjoys a movie, or the sense of security one gets from buying a deadbolt. The utility

of any object or circumstance can be considered. Some examples include the utility

from eating an apple, from living in a certain house, from voting for a specific

candidate, from having a given wireless phone plan. In fact, every decision that an

individual makes in their daily life can be viewed as a comparison between the utility

gained from pursuing one option or another.

Total utility is the aggregate sum of satisfaction or benefit that an individual

gains from consuming a given amount of goods or services in an economy. Usually,

the more the person consumes, the larger his or her total utility will be. Marginal

utility is the additional satisfaction, or amount of utility, gained from each extra unit

of consumption. Utility is usually applied by economists in such constructs as

the indifference curve, which plot the combination of commodities that an individual

or a society would accept to maintain a given level of satisfaction. Individual utility

and social utility can be construed as the value of a utility function and a social

welfare function respectively.

14.Actual Cost

Actual cost is the total amount of materials, labor costs, and any directly

associated overhead costs that can be charged to a specific project. The actual cost

is different from the standard cost, although both approaches are often used to

evaluate the profitability of a given project. With actual costs, the goal is to break

down the specifics of the costs involved with the project and determine if the

production process associated with the project is in fact working at optimum

efficiency.

Determining the actual cost is very important when it comes to judging the

profitability of any production process. Knowing how much it actually costs to engage

in that production for a specific period, such as a month, makes it easier to compare

the revenue that is generated for the same period. If the actual cost was exceeded

by the amount of revenue received during the same period, then the company is

operating at a profit. If not, this calculation of the actual cost can motivate business

owners to take a closer look at each expense involved with the manufacturing

process and identify ways to cut costs and increase the chance of becoming

profitable.

Comparing the actual cost of production from a given period to previous

periods can also help identify situations where the cost of production is increasing for

some reason. For example, an investigation may uncover the fact that an excessive

amount of overtime is the reason for the higher production costs. If this is the case,

the business can look closely for the reasons why the overtime took place, and

determine if there is any better way to arrange the use of labor to offset this

increase.

15.3Cs framework of Pricing

Pricing is the process of determining what a company will receive in

exchange for its products. Pricing factors are manufacturing cost, market place,

competition, market condition, and quality of product. Pricing is the manual or

automatic process of applying prices to purchase and sales orders, based on factors

such as: a fixed amount, quantity break, promotion or sales campaign, specific

vendor quote etc.

The 3Cs model suggests that defining the right place is a difficult balancing

exercise that uses three main references as follows:

a) Cost: Cost shows the minimal price, i.e. if you want to be profitable. Cost can be a tough one to calculate though, since cost can depend on scale of production, efficiency of production, etc

b) Customer: Customer based pricing is not a specific approach. It is the value perceived in the eyes of the customer. The more value one adds to the customer, the higher one could price its offering. Value-based pricing aims at this reference, and is seen as both difficult to calculate and difficult to sell/obtain. In this case, the retailer sets the prices according to what they think the customer can afford. This requires that they know what the customer affords which is not easy. Polls sometimes help with finding out.

c) Competition: Competition based pricing is an approach where the retailer sets the prices according to the competition. This is an easy way to lose millions without noticing. the price the customer could obtain from the competitor sets a reference framework in the industry. This reference framework obliges a higher price to correspond to a higher value. Lower price is always easier to sell, but then there is value given away.

16.Different theories of Profit

There are various theories of profit which have been advanced from time to

time regarding the nature of profit in a competitive economy. Almost all of them

differ basically from one another and are inadequate to explain the actual role of

profit in the operation of free economy. The most important theories are:

a) Dynamic theory of profit: The dynamic theory of profit was given by J.B. Clark. According to him profit accrues because the society is dynamic by nature. Since the dynamic nature of society makes future uncertain and any act, the result of which has to come in future, involves risk. Thus profit is the price of risk taking and risk bearing. It arises only in a dynamic society which means in a society where changes does not occur i.e. it is static by nature the risk element disappears and hence the profit element does not exist there.

Criticism

This theory completely ignores the future or uncertainty. According to Prof. Knight

only those changes, which cannot be foreseen, and which cannot be provided in

advance will yield profits and not others. Also this theory often gives a misleading

conclusion regarding the competition.

b) Marginal productivity theory: According to this theory, profit always equals to the marginal productivity of the entrepreneur. The marginal productivity of the entrepreneur cannot be evaluated in the case of the firm because there is only one entrepreneur in a firm. It is however can be easily done in an industry where the number of the firms can be calculated and hence the marginal productivity of various entrepreneurs can be measured. According to this theory the profit depends upon the marginal production. Greater the marginal production greater will be the profit.

c) Uncertainty breaking theory of Profit: According to Prof. Knight “Profit is the

reward for uncertainty bearing and not the risk bearing”. Prof. Knight has

regarded uncertainty bearing as a factor of production. Knight’s theory classifies

the position that profit arises because of the joint action of uncertainty bearing

and capital.

d) Risk bearing theory of Profit: This risk bearing theory of profit is associated with

the name of F.B. Hawley. According to him: "Profit is the reward of risk taking in

a business. During the conduct of any business activity, all other factors of

production, i.e., land, labor and capital have their guaranteed incomes from the

entrepreneur. They are least concerned whether the entrepreneur makes profit or

undergoes tosses". Profit is a payment or a reward for the assumption of risks by

the entrepreneur. The 'greater the risk, the higher must be the profits. It is

because if the return on risky enterprise is at the same level as that obtained

from the safe investment, then not a single entrepreneur will invest his capital in

a risky enterprise.

e) Monopoly Theory of Profit: There is no doubt that profits arise from dynamic

changes, innovations and from making a correct estimate of future economic

conditions. Another view point of profit is that monopolistic and monopolistic

competition in the market also gives rise to profits. The firms under monopoly or

monopolistic competition have greater control over the price of the product. They

are the price makers rather than the price takers. As such they raise prices by

restricting the level of output and thus keep profit at higher level. Monopoly

power, thus, is the basic sources of business profits.

However, it can be concluded that all these theories are defective in one way or

the other. The basic defect with these theories is that they particularize certain

aspects of the function of an entrepreneur to the neglect of others.

17.Superior and Inferior goods

Superior goods make up a larger proportion of consumption as income rises, and therefore are a type of normal goods in consumer theory. Such a good must possess two economic characteristics: it must be scarce, and, along with that, it must have a high price. The scarcity of the good can be natural or artificial; however, the general population (i.e., consumers) must recognize the good as distinguishably better. Possession of such a good usually signifies "superiority" in resources, and usually is accompanied by prestige.

The prestige-value of some superior goods is so high that a price decline would lower demand; these are Veblen goods.

The income elasticity of a superior good is above one by definition, because it raises the expenditure share as income rises. A superior good also may be a luxury good that is not purchased at all below a certain level of income. Examples would include smoked salmon and caviar, and most other delicacies. On the other hand, superior goods may have a wide

quality distribution, such as wine and holidays; however, though the number of such goods consumed may stay constant even with rising wealth, the level of spending will go up, to secure a better experience.

Inferior goods: In consumer theory, an inferior good is a good that decreases in demand when consumer income rises, unlike normal goods, for which the opposite is observed.[1] Normal goods are those for which consumers' demand increases when their income increases. Inferiority, in this sense, is an observable fact relating to affordability rather than a statement about the quality of the good. As a rule, these goods are affordable and adequately fulfil their purpose, but as more costly substitutes that offer more pleasure (or at least variety) become available, the use of the inferior goods diminishes.

Depending on consumer or market indifference curves, the amount of a good bought can either increase, decrease, or stay the same when income increases.

Good Y is a normal good since the amount purchased increases from Y1 to Y2 as the budget

constraint shifts from BC1 to the higher income BC2. Good X is an inferior good since the

amount bought decreases from X1 to X2 as income increases.

18.Isoquants & MRTS

In economics, an isoquant is a contour line drawn through the set of points at which

the same quantity of output is produced while changing the quantities of two or more

inputs. While an indifference curve mapping helps to solve the utility-maximizing

problem of consumers, the isoquant mapping deals with the cost-minimization

problem of producers. Isoquants are typically drawn on capital-labor graphs, showing

the technological tradeoff between capital and labor in the production function, and

the decreasing marginal returns of both inputs. Adding one input while holding the

other constant eventually leads to decreasing marginal output, and this is reflected in

the shape of the isoquant. Isoquants may take a wide variety of forms. When we

draw a "typical" one we usually assume that it is smooth and convex to the origin, as

in the following figure.

In economic theory, the Marginal Rate of Technical Substitution (MRTS) - or Technical Rate of Substitution (TRS) - is the amount by which the quantity of one input has to be

reduced ( ) when one extra unit of another input is used ( ), so that output

remains constant ( ).

Where    and   are the marginal products of input 1 and input 2, respectively,

and   is Marginal Rate of Technical Substitution of the input    for . Along an isoquant, the MRTS shows the rate at which one input (e.g. capital or labor) may be substituted for another, while maintaining the same level of output. The MRTS can also be seen as the slope of an isoquant at the point in question.

For a typical production function, with isoquants convex to the origin, the MRTS diminishes as more of input 1 is used. We say that such a production function has a diminishing marginal rate of technical substitution.

The marginal rate of technical substitution (MRTS) measures the slope of an isoquant. As such, it measures the amount by which capital can be reduced if another unit of labor is added and still maintain a constant level of production.It turns out that MRTS is equal to the negative of the ratio of the marginal product of labor to the marginal product of capital (i.e., MRTS=-MPL/MPK). Note that if MPL and MPK are constant, then MRTS is also constant, so it is not necessarily true that MRTS changes along an isoquant.In many production processes, however, it is reasonable to assume that the ratio of MPL/MPK is very large when a firm is using a lot of capital relative to its labor input. On the other hand, MPL/MPK becomes very small when the firm uses a lot of labor and very little capital. In such instances the slope of an isoquant gets flatter and flatter as more labor is

substituted for capital, since the productivity of labor relative to the productivity of capital keeps falling.

19.Multiple Regression Analysis

In statistics, regression analysis includes many techniques for modeling and analyzing several variables, when the focus is on the relationship between a dependent variable and one or more independent variables. More specifically, regression analysis helps one understand how the typical value of the dependent variable changes when any one of the independent variables is varied, while the other independent variables are held fixed.

Multiple regression analysis is a technique used to establish the relationship between quantifiable variables in which data on dependent and independent variables is plotted on a scatter graph or diagram, and trends are indicated through a line of best fit, using two or more independent variables. Multiple Regression analysis is more amenable to ceteris paribus analysis because it allows us to explicitly control for many other factors that simultaneously affect the dependent variable. This is important both for testing economic theories and for evaluating policy effects when we must reply on non-experimental data. Because MR models can accommodate many explanatory variables that may be correlated, we can hope to infer causality in cases where simple regression analysis would be misleading. MRA is also useful for generalizing functional relationships between variables.

Examples: Total factory overhead (the dependent variable) is related to both labor-hours and machine-hours (the independent variables). Sales of a popular soft drink ( the dependent variable) is a function of various factors, such as its price, advertising, taste, and the prices of its major competitors (the independent variables).

20.Firm & its Objectives

A business firm is an economic unit.  It is a producing unit. It converts inputs in to outputs. It is a legal entity on the basis of ownership and contractual relationship organized for production and sale of goods and services.  All business units are set  up and managed by  people  and are called by various names like shops, firms, enterprise, production and business concerns etc. They can take several  forms  like sole  trader,  partnership  concern,  Joint  Stock  Company,  cooperatives  or even public utilities.  They produce and supply different goods and services for the direct satisfaction of consumers for producing other final goods and services. Each

firm lays down its own objectives. They are fundamental to the very existence of a firm.  They are the endpoint towards rational activity.  They indicate the very existence of a firm and guide the actions of a firm. They indicate how a firm has to organize its activities and perform its functions. A modem business unit has multiple objectives and they are multi-dimensional in their nature.  Some of  them are competitive while others are supplementary in nature.  A few other objectives are mutually interconnected and a few others are opposing in nature.  These objectives are determined by various factors and forces like corporate environment, socio-economic conditions, and the nature of power in the organization and extraneous conditions, and constraints  under which  a firm operates. Each business unit defines its own objectives which may have to satisfy the needs of those groups whose cooperation makes the continued existence of the business e.g. the shareholders, management, employees,  suppliers  and consumers  etc.  Thus, we come across multiple and diversified objectives.

a) Profit Maximization: Profit maximization is the process of obtaining the highest possible level of profit through the production and sale of goods and services. This is the guiding principle underlying the analysis of short-run production by a firm. In particular, economic analysis is assumed that firms undertake actions and make the decisions that increase profit.

b) Sales Maximization: A reasonable and often pursued objective of firms is to maximize sales, that is, to sell as much output as possible. Clearly sales lead to revenue, meaning that maximizing sales is also bound to maximize revenue. But as the analysis of short-run production indicates, maximizing sales does NOT necessarily maximize profit.

c) Growth maximization : This is similar to sales maximization and may involve mergers and takeovers.

d) Pursuit of Personal Welfare: The people who make decisions for a business are, in fact, people. They have likes and dislikes. They have personal goals and aspirations just like people who do not make decisions for firms. On occasion these people use the firm to pursue their own personal welfare. When they do, their actions could enhance the firm's profit maximization or, in many cases, prevent profit maximization.

e) Pursuit of social welfare: The people who make decisions for firms also have social consciences. Part of their likes and dislikes might be related to the overall state of society. As such, they might use the firm to pursue social welfare, which could enhance or prevent the firm's profit maximization.

Natural Selection: Whichever objective a firm pursues on a day-to-day basis, the notion of natural selection suggests that successful firms intentionally or unintentionally maximize profit. That is, the firms best suited to the economic environment, and thus generate the most profit, are the ones that tend to survive.

21.Input Output Analysis

Input-output analysis is an economics term that refers to the study of the effects that different sectors have on the economy as a whole, for a particular nation or region. This type of economic analysis was originally developed by Wassily Leontief (1905 – 1999), who later won the Nobel Memorial Prize in Economic Sciences for his work on this model. Input-output analysis allows the various relationships within an economic system to be analyzed as a whole, rather than individual components.

Because the input-output model is fundamentally linear in nature, it lends itself well to rapid computation as well as flexibility in computing the effects of changes in demand.

The structure of the input-output model has been incorporated into national accounting in many developed countries, and as such forms an important part of measures such as GDP.

In addition to studying the structure of national economies, input-output economics has been used to study regional economies within a nation, and as a tool for national and regional economic planning. Indeed a main use of input-output analysis is for measuring the economic impacts of events as well as public investments or programs But it is also used to identify economically related industry clusters and also so-called "key" or "target" industries-- that are most likely to enhance the internal coherence of a specified economy. By linking industrial output to satellite accounts articulating energy use, effluent production, space needs, and so on, input-output analysts have extended the approaches application to a wide variety of uses.

The ultimate goal of the Input-Output Analysis technique is to generate a Total Requirements Table that shows the flows of rupees between industries in the production of output for a given sector.

To arrive at this final result, IO Analysis requires two earlier steps:

1) Transactions table: Contains basic data on the flows of goods and services among suppliers and purchasers during a study year.

2) Direct requirements table: Derived from the transactions table, this shows the inputs required directly from different suppliers by each intermediate purchaser for each unit of output that purchaser produces.

Problems with Input – Output Analysis

• Practical issues: Data needs and complexity: IO models are tremendously complex and very data hungry. This typically places these models in the hands of experts.

• Theoretical issues:

- Time/Data issues: Usually a single year’s data are used to develop the Total Requirements Table. But 1) purchases may actually reflect a longer term investment and 2) short term trends may impact the data.

- IO assumes a linear relationship between increasing demand for inputs and outputs: This assumes away 1) externalities and 2) increasing/ decreasing returns to scale.

- Industrial categorization: IO models still assume that each industry 1) has a single, homogeneous production function and 2) each produces one product. These assumptions do not reflect the real economy very well.

22.Derived Demand

Derived demand is a term in economics, where demand for one good or service occurs as a result of the demand for another intermediate/ final good or service. This may occur as the former is a part of production of the second. For example, demand for coal leads to derived demand for mining, as coal must be mined for coal to be consumed. As the demand for coal increases, so does its price. The increase in price leads to a higher demand for the resources involved in mining coal. And therefore:

Where MRP is the marginal revenue product of labor, MPP is the marginal physical product of labor, and P is the price of the physical product of labor.

Derived demand applies to both consumers and producers. Producers have a derived demand for employees. The employees themselves are not demanded; rather, the skills and productivity that they bring are. This is similar to the concept of joint demand or complimentary goods. One good or service is the compliment of another.

23. Industry Demand & Firm Demand and Autonomous Demand

Industry demand and Company demand:Industry demand has reference to the total demand for the products of a particular industry, e.g. the demand for textiles. Company demand has reference to the demand for the product of a particular company which is a part of that industry, e.g., the demand for textiles produced by the DCM. The company demand may be expressed as a percentage of industry demand. The percentage so calculated would indicate the market share of the company. The market-share of the company normally depends on the nature of competition and the market structure. Under monopoly where a single firm constitutes the industry, company-demand and industry-demand will be same. Under non – monopoly situation, the market share will depend on factors like price spread (i.e., the difference between the price charged by one company and the price charged by another company), product improvement, promotional expenditure like advertisement, and governmental interference like protection. The study of industry demand is useful guide to analysis and forecasting of company demand.

Autonomous Demand:

When a particular commodity is demanded for its own sake it is known as autonomous demand. Unless a product is totally independent of the use of other products, it is difficult to talk about autonomous demand. In the present world of dependence, there is hardly any autonomous demand. Nobody today consumes just a single commodity; everybody consumes a bundle of commodities. Even then, all direct demand may be loosely called autonomous.

24. Breakeven Analysis and its link to economic concepts

It is based on categorising production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point").

The Break-Even ChartIn its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.Fixed CostsFixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business.Variable CostsVariable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission.A distinction is often made between "Direct" variable costs and "Indirect" variable costs.Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples.Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs.

Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of categorizing business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed.

A firm's break-even point occurs when at a point where total revenue equals total costs. Break-even analysis depends on the following variables:

1. Selling Price per Unit: The amount of money charged to the customer for each unit of a product or service.

2. Total Fixed Costs: The sum of all costs required to produce the first unit of a product. This amount does not vary as production increases or decreases, until new capital expenditures are needed.

3. Variable Unit Cost: Costs that vary directly with the production of one additional unit. Total Variable Cost The product of expected unit sales and variable unit cost, i.e., expected unit sales times the variable unit cost.

4. Forecasted Net Profit: Total revenue minus total cost. Enter Zero (0) if you wish to find out the number of units that must be sold in order to produce a profit of zero (but will recover all associated costs)

Each of these variables is interdependent on the break-even point analysis. If any of the variables changes, the results may change. Total Cost: The sum of the fixed cost and total variable cost for any given level of production, i.e., fixed cost plus total variable cost. Total Revenue: The product of forecasted unit sales and unit price, i.e., forecasted unit sales times unit price. Break-Even Point: Number of units that must be sold in order to produce a profit of zero (but will recover all associated costs). In other words, the break-even point is the point at which your product stops costing you money to produce and sell, and starts to generate a profit for your company.

The graphic method of analysis (below) helps in understanding the concept of the break-even point. However, the break-even point is found faster and more accurately with the following formula:

Q = FC / (UP - VC) where:

Q = Break-even Point, i.e., Units of production (Q), FC = Fixed Costs, VC = Variable Costs per Unit UP = Unit Price Therefore,

Break-Even Point Q = Fixed Cost / (Unit Price - Variable Unit Cost)