RADA College

Distance Education Division

(Degree Programme)

Module for
Managerial Economics
(MGMT - 3171)

September, 2021
Addis Ababa, Ethiopia
Managerial Economics (MGMT - 3171)
© RADA College Distance Education Division September, 2021 Addis Ababa
Course Introduction

Dear Learners, you are well come to the study of the course Managerial Economics. The
subject matter in the study of Managerial Economics represents a blend of concepts from
different perspectives like: the role of economics to decision making, demand and supply,
optimization, pricing, production etc perspectives. Managerial Economics is relatively a
new subject matter. It has emerged and developed because of the complexity of the growing
business environment. Nowadays efficient resource utilization and effective goal
achievement are at the center of every managerial decision. However efficient and effective
utilization of resources highly depend on an understanding of the technical aspects of
decision makes including scientific method of decision making and decision makes models.

These decision-making approaches are rooted in economic theories, concepts and tools.
Thus economic theories and analytical tools, which are widely used in business decision-
making, have crystallized into a separate branch of management studies, called Managerial
Economics (MC). Different scholars use different expression to define managerial
economics. However, the common elements emphasized by each scholar are the use of
analytical tools and concepts to make decisions. In this global economy the application of
Managerial Economics as a tool of analysis and its contribution to the process of decision-
making has been widely recognized. Moreover, the appreciation of economic theories and
concepts not only increases the quality of decision outcomes but also improves the
confidence of decision-makers.

Throughout this course material the various economic theories which are demanded to
constitute Managerial Economics are discussed. So to understand the subject matter, you are
required to read this material very carefully. To acquire broader knowledge further readings
related to the course is strongly advisable.

Managerial Economics (MGMT - 3171)

© RADA College Distance Education Division September, 2021 Addis Ababa
Course Objectives: At the end of this course, learners should be able to:

 Define Managerial Economics;

 Enhance their knowledge on how theories and concepts in economics
influence; rationalized decision-making;
 Understand what the law of demand and supply states about;
 Apply the right decision-making models and tools for the right problems;
 Explain decision-making and planning approaches as and when applied;
 Clearly state what optimization, pricing, and decision making under risk and
uncertainty.

Managerial Economics (MGMT - 3171)

© RADA College Distance Education Division September, 2021 Addis Ababa
Module Introduction

Dear Learner! We are happy to present this Module to you. We hope that you are eager
to acquire knowledge in Managerial Economics, and related concepts. The Module contains
Seven (7) units each has different sub topics which focus on specific topic of the respective
units. The Module provides you with the information required to understand key concepts,
theories, principles, and process in Managerial Economics. As you go through, you will be
introduced many issues including the meaning of Managerial Economics, scope of
Managerial Economics, the role of Managerial Economics in decision making, meaning and
types of decision under risk and uncertainty, meaning and laws of demand and supply,
meaning and types optimization, meaning and types production, meaning and types pricing
etc. Every unit or section of the Module contains a variety of activities. These activities
help you to learn by doing and to think for yourself.

Module objectives

After completing this module, you will be able to:

 Understand the concepts of Managerial Economics;

 Understand implication of Managerial Economics for decision making;
 Identify demand and supply with their laws;
 Understand about optimization;
 Identify what does cost mean and help to analyze the different types of cost;
 Know what pricing mean and how to price a product in production.

Managerial Economics (MGMT - 3171)

© RADA College Distance Education Division September, 2021 Addis Ababa
Unit One: Managerial Economics - An Introduction

1. Introduction
Dear Learner! This is the first unit of the module Managerial Economics. In this unit we
are going to give you an overview of Managerial Economics. The aim of this unit is to
present you an over view of what is all about Managerial Economic and how Economic
models use to make decision. Managerial economics is about the criteria for rational
decision making by managers of business enterprises. The criteria elaborated here for
business enterprises can also be applied to non-commercial decision settings, including
government agencies, eleemosynary institutions, the home, and one's personal life. Before
we precede to an examination of these decision criteria, we shall review the essential
economic nature of decision making in order to establish the fundamental principles upon
which decision criteria may be based. As noted in a first Principle of Economics course, the
world is characterized by scarcity rather than abundance. Human beings need certain things
for survival, and they want to possess or consume a much larger variety of amenities. If all
of these things were abundantly available, each person could simply gather as much as he or
she wished, and still leave enough for everyone else to do likewise. Managerial decision
making would require little more than determining the time sequence of acquisition.

In regard to most of the things that humans consume, scarcity is the rule and abundance is
the exception. A scarcity of something means that the total of human wants for it exceeds the
quantity of it available for human consumption. As a result, one person simply cannot take
all that he or she might want without consequences for other persons. Something may be
said to be scarce when its price exceeds zero (P greater than 0). The price may be expressed
and paid in non-pecuniary terms as well as in money. There are a few things that have
essentially zero prices, e.g., common air and the water available from a water fountain. We
must make qualifications in regard to each of these examples. If someone wishes to breathe
air of any particular quality or purity, he or she will have to go to some lengths to acquire it,
and such pure air then is not a so-called "free good." The water that any one of us can
"freely" drink from a water fountain does in fact cost the larger society of which the drinker
is a member something to acquire it, to transport it to the site, and to cool it to a desirable
temperature.

Managerial Economics (MGMT - 3171)

© RADA College Distance Education Division September, 2021 Addis Ababa
Unit Objectives: After studying this unit, students will be able to:
 Define managerial economics and illustrate the typical issues encountered in the
field;
 Discuss the scope and methodology of managerial economics;
 Demonstrate the importance of economic analysis in managerial decision-
making;
 Explain how managerial economics helps managers to make an optimal
economic decision;
 Identify different types of Economic decisions;
 Understand decision making system and process.

1.1. Over view of Managerial Economics

What is Managerial Economics?

Dear learner, what do you think of the term Managerial Economics? (You can write
your response on the space left below):

Its name suggests its scope, content, the form and structure of the subject. Managerial
economics constitutes economic theories and analytical tools that are widely applied to
business decision. It is therefore first important to define what the word economics is?

Economics is a social science, it studies how nations make decision to allocate their
resources between competing needs of society so that economic welfare of the society can be
maximized. However, choice-making is not so simple as it looks because the economic work
is very complex and most economic decisions have to be taken under the conditions of
imperfect knowledge, risk uncertainly. Thus, economists in their endeavor to study the
complex decision making process have developed analytical tools, techniques and economic
theories with the aid of mathematics and statistics.

Managerial Economics is the discipline that deals with the application of economic
concepts, theories and methodologies to the practical problems of business in order to

Managerial Economics (MGMT - 3171)

© RADA College Distance Education Division September, 2021 Addis Ababa
formulate rational managerial decisions for solving the problems. With regard to the
problems, there are various problems related to the decision making process such as
production decisions (what, how much, and how to produce). Exchange decisions (what
price to charge and to whom to sell) and consumption decisions (what and how much to
consume).
In other words, managerial economics can be defined as the integration of economics
theory (application of economics theory) with business practice for the purpose of
facilitating decision making and forward planning by management.

It uses analytical tools and a set of concepts to provide effective ways of thinking about
decision problem. Thus, managerial economics is concerned with the application of
economic concepts and economic analysis to the problem of formulating rational managerial
decisions.

Managerial economics, therefore, is the study of how to direct scarce resources in the way
that most efficiently achieves a managerial goal. It is a very broad discipline in that it
describes methods useful for directing everything from the resources of a household to
maximize household welfare to the resources of a firm to maximize profits.
The business decision-making process has become increasingly complex due to ever
growing complexity of the business world. Experiences acquired through traditional training
are no longer sufficient to meet the managerial challenges. Thus, making an appropriate
business decision requires a clear understanding of market condition, market fundamentals
and the business environment.

As a result, the application of economic concepts, theories, logic and analytical tools in the
assessment and prediction of market conditions and business environment have proved to be
of great help in business decision making.

1.2. Importance of Managerial Economics for Managers

A manager is the people who organizes factors of production, introduce new ideas or
product or process, make the business decisions and is held accountable for success or
failure. Since managers in all types of enterprise face a common set of problems; these tools
of managerial economics can be applied by all managers in profit seeking firms, in the
public and not for profit sectors. In profit seeking firms the decision can be such as in
relation to customers including pricing, and advertizing; suppliers; competitors or the
Managerial Economics (MGMT - 3171)
© RADA College Distance Education Division September, 2021 Addis Ababa
internal working of the organization. And in the public and not-for-profit sectors of the
economy the same managerial economics principles is applied for example to allocate funds
among different programs. Moreover, these principles exist whether a market is local or
global.

The basic function of the managers of a business is to achieve the objective of the firm thus
to maximum profit with the limited resources placed at their disposal. Bearing this function
in mind, managerial economics helps managers in two ways.

 First, it provides a framework for evaluating whether resources are being allocated
efficiently within the firm. It helps to identify the alternative means of achieving the
given objectives, and then to select the alternative that accomplishes the objectives in
the most resources efficient manner. For example, to determine if profit could be
increased by substitute labor (variable cost) by technology (fixed cost).
 Second, these principles help managers to respond to various economic signals. For
example, an increase in prices of the output would be the appropriate signal to
increase an output.

1.3. Scope of Managerial Economics and the Business Environment

Business environment has reference to the broad characteristics of the economic system in
which the business firm operates. It includes the overall economic policies, social factors
and political atmosphere of the nation. Managerial economics, however, concerned with
only the economic environment, and in particular with those economic factors which form
the business climate. Micro economics focuses on individual economic behavior (individual
household) and firms and their interaction in the market where resources are costly,
example, how consumers respond to changes in prices and income, how business decide on
employment and sales. On the other hand, macroeconomics deals with the aggregate
economic variables or the economic system as a whole. It addresses question like the effect
of changes in investment, government spending, employment, exchange rates, inflation
unemployment, and import and export policies. It shows how fiscal monetary policies can
keep the aggregate system working well.

Many macro economic theories are based on micro economic principles and concepts.
Similarly micro economic behavior of many variables can be meaningfully explained only
with reference to macro economics environment. The scope of managerial economics to
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© RADA College Distance Education Division September, 2021 Addis Ababa
managerial issues is more limited to microeconomics. It should be thought with respect to
microeconomics focusing on those topics like demand, production, cost, pricing, and market
structure.

Accordingly, it has a wide scope to deal on the following issues:

 Estimation and analysis of demand for products;
 Determination of price of products;
 Planning of production and deciding input combination;
 Estimation and analysis of cost of production;
 Analysis of market structures and estimation of profit;
 Achieving other objectives of a business.

1.4. Decision Systems and Process

The ability to make good decisions is the key to successful managerial performance. The
success of every decision depends mainly on decision process. Decision process refers to the
procedure of making decision; it involves co-ordination on the time scale, present problem,
past date and future action. Decision process in each of those areas of decision shares a
number of common elements and basically it includes five steps. This five-step decision-
making process is illustrated in figure 1.1.

Figure 1.1 the Decision Making Process

Establish and/or identify objectives

Define the problem

Identify possible alternative solutions

Consider organizational Evaluate alternatives Consider organizational

and input constraints and select the best and input constraints

Implement and monitor the decision

Managerial Economics (MGMT - 3171)
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  First, the decision must establish or identify the objectives of the organization. The
failure to identify organizational objectives correctly can result in the complete
rejection of a well-convinced and well-implemented plan.
 Next, the decision maker must identify the problem requiring a solution.
 Third, once the source(s) of the problem is (are) identified, the manager can move to
an examination of potential solutions. To provide potential solutions collection of
data available facts and figures are important. If for example, the problem is the use
of technologically inefficient equipment, two possible solutions may be proposed
updating and replacing the plant's equipment or building a completely new plant.
The choice between these alternatives depends on the relative data on cost and
benefit, as well as other constraints that may make one alternative preferable to
another.
 Fourth, formulation of a model (a model is an analytical tool that helps for making
decision under different situation. After all alternatives have been identified and
evaluated the best alternatives have been chosen using the model.
 The final step in the process is the implementation of the decision. This phase often
requires constraint monitoring to ensure that results are as expected. If they are not,
corrective action needs to be taken when possible.

1.5. Nature of the Firm

A firm is an association of individuals who have organized themselves for the purpose of
turning inputs into output. The firm organizes the factors of production to produce goods and
services to fulfill the needs of the households. Each firm lays down its own objectives which
is fundamental to the existence of a firm.
The major objectives of the firm are:
 To achieve the Organizational Goal
 To maximize the Output
 To maximize the Sales
 To maximize the Profit of the Organization
 To maximize the Customer and Stakeholders Satisfaction
 To maximize Shareholder‟s Return on Investment
 To maximize the Growth of the Organization
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© RADA College Distance Education Division September, 2021 Addis Ababa
Firms are established to earn profit, to keep the shareholders happy. To increase their market
share, they try to maximize their sales. In the present business world firms try to produce
goods and services without harming the environment. Firms are not always able to operate at
a profit. They may be facing the operating loss also. Economists believe that firms maximize
their long run rather than their short run profit. So managers have to make enough profit to
satisfy the demands of their shareholders and to maximize their wealth through the company.

1.6. Identify Goals and Constraints

The first step in making sound decisions is to have well-defined goals because achieving
different goals entails making different decisions. If your goal is to maximize your grade in
this course rather than maximize your overall grade point average, your study habits will
differ accordingly. Similarly, if the goal of a food bank is to distribute food to needy people
in rural areas, its decisions and optimal distribution network will differ from those it would
use to distribute food to needy inner city residents. Notice that in both instances, the decision
maker faces constraints that affect the ability to achieve a goal. The 24-hour day affects your
ability to earn an A in this course; a budget affects the ability of the food bank to distribute
food to the needy. Constraints are an artifact of scarcity.

1.7. Circular Flow of Economic Activity

The individuals own or control resources which are necessary inputs for the firms in the
production process. These resources (factors of production) are classified into four types.
Land: It includes all natural resources on the earth and below the earth. Non- renewable
resources such as: oil, coal etc once used will never be replaced. It will not be available for
our children. Renewable resources can be used and replaced and is not depleted with use.
Labour: is the work force of an economy. The value of the worker is called as human
capital.
Capital: It is classified as working capital and fixed capital (not transformed into final
products)
Entrepreneurship: It refers to the individuals who organize production and take risks.

All these resources are allocated in an effective manner to achieve the objectives of
consumers (to maximize satisfaction), workers (to maximize wages), firms (to maximize the
output and profit) and government (to maximize the welfare of the society).
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The circular flows of economic activities are explained in a clockwise and counterclockwise
flow of goods and services. The four sectors namely households, business, government and
the rest of the world can also be considered to see the flow of economic activities. The
circular flow of activity is a chain in which production creates income, income generates
spending and spending in turn induces production.
The major four sectors of the economy are engaged in three economic activities of
production, consumption and exchange of goods and services. These sectors are as follows:
Households: Households fulfill their needs and wants through purchase of goods and
services from the firms. They are owners and suppliers of factors of production and in turn
they receive income in the form of rent, wages and interest.
Firms: Firms employ the input factors to produce various goods and services and make
payments to the households.
Government: The government purchases goods and services from firms and also factors of
production from households by making payments.
Foreign sector: Households, firms and government purchase goods and services (import)
from abroad and make payments. On the other hand all these sectors sell goods and services
to various countries (export) and in turn receive payments from abroad

1.8. Recognize the Nature and Importance of Profits

The overall goal of most firms is to maximize profits or the firm's value. Let us examine the
nature and importance of profits in an Economic versus Accounting Profits. When most
people hear the word profit, they think of accounting profits. Accounting profit is the total
amount of money taken in from sales (total revenue, or price times quantity sold) minus the
dollar cost of producing goods or services. Accounting profits are what show up on the
firm's income statement and are typically reported to the manager by the firm's accounting
department.
A more general way to define profits is in terms of what economists refer to as economic
profits. Economic profits are the difference between the total revenue and the total
opportunity cost of producing the firm's goods or services. The opportunity cost of using a
resource includes both the explicit (or accounting) cost of the resource and the implicit cost
of giving up the best alternative use of the resource. The opportunity cost of producing a
good or service generally is higher than accounting costs because it includes both the dollar
value of costs (explicit, or accounting, costs) and any implicit costs.

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Implicit costs are very hard to measure and therefore managers often overlook them.
Effective managers, however, continually seek out data from other sources to identify and
quantify implicit costs.

1.9. Optimization
Optimization deals with the determination of extreme values which can be maximum or
minimum for the objective variable. The objective variable may be one or multiple. For
example, the private firm might pursue profit maximization as single goal or the public
sector firm might aim at minimizing its average cost of production as the sole goal. In
contrast, the government undertaking might have twin goals, namely, maximization of profit
and maximization of employment of unskilled labor. Thus, below we will discuss
optimization problems of the firm.

Profit Maximization
If a firm‟s objective is profit maximization, it would have the power to control variables
such as total revenue and total cost which are variables related to profit. With regard to the
total cost, it is to mean the total economic cost which is the sum of implicit and explicit
costs. Explicit costs are costs directly incurred by the firm for the purchase of the inputs
from the supplier of inputs where as implicit costs are an indirect costs of the firm which are
related to depreciation of capital assets, employment of owner-supplied resources and
payments to the owner-manager for his/her services. Thus, the economic profit is the
difference between the total revenue and the total economic costs. So the firm maximizes its
profit when such difference comes with a possible maximum value.

Value Maximization
The value of the firm is the price for which the firm can be sold and that price is equal to the
present value of the future expected profit of the firm. The value of the firm is affected by
the risk associated with the future profit so that the value would depends up on the risk
premium, which is a discount rate to compensate investors for the risk they have faced due
to uncertainty on future profits. Thus, the value of a firm is computed as the present value of
the future economic profits expected to be generated by the firm so that the value of the firm
maximizes when the summation of the present value of the future economic profits over the
life time of the firm becomes at its maximum.

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 1 2 3 T T
t
Value of the firm     ... 
1  r  1  r 2
1  r 
3
1  r 
T
t 1 (1  r ) t

Where  t is the economic profit expected in period t, r is the risk-adjusted discount rate, and
T is the number of years in the life of the firm. The larger the risk associated with the future
profit, the higher the risk adjusted discount rate used to compute the value of the firm and
the lower will be the value of the firm. The reverse holds true if the risk associated with the
future profits is smaller.

Profit Maximization Vs Value Maximization

Profit maximization refers to maximization of a single period profit by considering only the
current revenue and cost conditions where as value maximization refers to maximization of
the present value of future profits expected to be generated by considering not only the
current revenue and cost conditions but also the future revenue and cost conditions.

The profit maximization and value maximization become equivalent and mean to the same
thing if the cost and revenue conditions in one time period are independent of the revenue
and costs in the future time period so a manager will maximize the value of the firm by
making the decision that maximize profit in every single time period. However, if there is
some dependency between the current and future condition of revenue and costs, say the
current production output has an effect on increasing costs in the future, profit maximization
in each (single) time period will not maximize the value of the firm.

Summary
Managerial Economics is concerned with the application of economics theory and
analytical tools to decision-making problems faced by private, not-for-profit and
public institutions. With the complexity of the growing business environment the
usefulness of economic theory as a tool of analysis in the assessment, and prediction
of market conditions have proved to be of great help in business decision-making.
Managerial Economics draws on microeconomic theory and macroeconomic models
however; the scope of managerial economics to managerial issues can be viewed as
an application of that part of microeconomics that focuses on such topics as demand
production, cost, pricing etc. Managerial economics helps managers in two ways.
First it provides a framework for evaluating whether resources are being allocated

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© RADA College Distance Education Division September, 2021 Addis Ababa
 efficiently within the firm. Second these principles help managers to respond to
various economic signals
Economic decisions or business decisions are numerous in number and forms
however; economic decision will be less risky to the extent the probability of the
occurrence of the future events is correctly estimated. The success of every decision
depends mainly on decision process. Decision process refers to the procedure of
making decision it involves co-ordination on the time scale, present problem, past
date and future action and basically it includes five steps.
Self Test Exercises 1:
Part I: Write “True” if the statement is correct and “False” if the statement is
incorrect.
1) Managerial economics is the study of how to direct scarce resources in the way that
most efficiently achieves a managerial goal.

2) The business decision-making process has become increasingly complex due to ever
growing complexity of the business world.

3) Managerial economics help managers to respond to various economic signals.

4) Managerial economics is concerned with only the economic environment, and in

particular with those economic factors which form the business climate.

5) The ability to make good decisions is the key to unsuccessful managerial

performance.

Part II: Choose the correct answer & encircle the letter of your choice.
1) _______studies how nations make decision to allocate their resources between
competing needs of society so that economic welfare of the society can be
maximized.

A. Management
B. Economics
C. Accounting
D. All
E. None

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 2) Of the following, one is not correct about managerial economics?

A. It is the discipline that deals with the application of economic concepts, theories and
methodologies to the practical problems of business in order to formulate rational
managerial decisions for solving the problems.
B. It is the integration of economics theory (application of economics theory) with
business practice for the purpose of facilitating decision making and forward
planning by management.
C. It uses analytical tools and a set of concepts to provide effective ways of thinking
about decision problem.
D. All
E. None

3) Which one of the following is not the objective of the firm?

A. To achieve the D. To maximize the Profit of
Organizational Goal the Organization
B. To maximize the Output E. All
C. To maximize the Sales F. None

4) Of the following, one is not the importance of Managerial economics for business
managers?
A. It provides a framework for evaluating whether resources are being allocated
efficiently within the firm.
B. It helps to identify the alternative means of achieving the given objectives
C. To determine if profit could be increased by substitute labor (variable cost) by
technology (fixed cost).
D. None

5) ____ is an association of individuals who have organized themselves for the purpose
of turning inputs into output.
A. Firm C. Business
B. Output D. Organization

Part III: Fill In the Blank Space

1. ________ deals with the determination of extreme values which can be

maximum or minimum for the objective variable.

2. ________ is the total amount of money taken in from sales (total revenue, or
price times quantity sold) minus the dollar cost of producing goods or services.

3. ______, ________, _______ and _______ are considered as factors of production.

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 Unit Two: Demand and Supply

Introduction
Dear Learners, The aim of this unit is to introduce you the concept of demand, elasticity
and factors affecting them. The success or failure of a business depends primarily on its
ability to generate revenues by satisfying the demands of consumers. By identifying and
analyzing the basic determinants of consumer needs and wants, demand theory and analysis
provides many useful insights for business decisions. These decisions include pricing
decisions, forecast sales and formulating marketing strategies. Demand analysis is concerned
with understanding consumer behavior, measuring and characterizing the market response to
a change in price or incomes or other economic variables. It also derives the demand side
information necessary to make sound business decisions.

The unit begins with providing the meaning of demand with respect to individual versus
market demand and the discussion of determinants of demand will follow. The focus then
shifts to the concept of elasticity, it discusses how elasticity is measured and their relevance
to business decision. In our previous discussion it is said that human want by its nature has
unlimited character. However this unlimited want is affected by existing limited resources.
Many of the consumers would like to drive a car, eating at the best restaurants; however, the
purchasing power of most consumers is constrained by their income. The term demand, of
course, refers a desire for goods and services but this desire should be backed by ability and
willingness to buy. For example if a man wants to buy a car but he does not have sufficient
money to buy it, his want is not his demand for the car. And if a rich miserly person wants
to buy a car but is not willing to pay for his desire, too his want is not his demand for a car.
Therefore, the term demand is always defined in combination with desire with adequate
purchasing power and willingness to pay.

Unit Objectives: After learning this unit, students will be able to:

 Understand the difference between individual and market demands;

 Know factors that determine the market demand of a commodity;
 Measure the response of market demand to changes in the determinants such as
price and income;

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  Explain the reaction of consumers to changes in their incomes, their preference,
the price they face, and other economic variables;
 Understand how demand side information is necessary to make sound business
decision.

2. Meaning of Demand
Dear Learners, what do you mean Demand to you?
___________________________________________________________

Demand is one of the crucial requirements for the existence of any business enterprise. A
firm is interested in its profit and/or sales, both of which depend partially upon the demand
for its product. The decision which management makes with respect to production,
advertising, cost allocation, pricing etc. call for an analysis of demand.

In Managerial Economics we are concerned with demand for a commodity faced by the firm.
This depends upon the size of the total market or industry demand for the commodity, which
in turn is the sum of the demands for the commodity of the individual consumers in the
market. Thus, we begin by examining the theory of consumer demand in order to learn about
the market demand on which the demand for the product faced by a particular firm depends.

Demand for a commodity refers to the quantity of the commodity which an individual
household is willing to purchase per unit of time at a particular price. In other words, the
amount of a good or service that consumers in a market are willing and able to purchase
during a given period of time (example, a week, a month) is called Quantity Demanded.
Hence, demand for a commodity implies:
(a) Desire to acquire it,
(b) Willingness to pay for it, and
(c) Ability to pay for it.

Demand has a specific meaning. Mere desire to buy a product is not demand. Mere desire
and ability to pay for a car is not demand because he does not have the necessary will to pay
for it. Similarly a poor man‟s desire and his willingness to pay for a car is not demand
because he lacks the necessary purchasing power. One can also conceive of a person who

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possesses both the will and purchasing power to pay for a commodity, yet this is not demand
for that commodity if he does not have desire to have that commodity.

2.1. Law of Demand

The assumption of profit-maximizing behavior assumes that owners and managers know the
demand for the firm‟s good or service. The demand function asserts that there is a
measurable relationship between the price that a company charges for its product and the
number of units that buyers are willing and able to purchase during a specified time period.
Economists refer to this behavioral relationship as the law of demand, which is sometimes
called the first fundamental law of economics.

Definition: The law of demand states the functional relationships between price and
quantity demanded. According to this law, there is an inverse relationship between price and
quantity demanded of a commodity, other things hold constant.

2.1.2 Determinants of Demand

Although price is the important determinant of demand, there are also various factors which
determine demand. Some of these include:
1. Price of a commodity: as the law of demand describes, the relationship between the
price of the commodity and the quantity demanded is inverse. I.e., as one increases the
other decreases and vice versa.
2. Price of related commodities: the two goods are related either being substituted or
complemented each other. The two goods are said to be substituted if they are
independent in usage but substitute for each other. For such goods changes in the price of
one affects the demand for other in the same direction. Example, tea and coffee, Pepsi
and coca. However, the two goods are said to be complementary if they goes together in
uses and complement of each other. For such goods changes in price of one affects the
demand for other in the different direction. Example, tea and sugar, car and tire, camera
and film.

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3. Income of the consumer: usually people want to spend more at higher income level
than at lower income level. But for a detailed analysis of income-demand relationship the
type of good taking into consideration will result different outcomes.
a. Necessity or basic goods: these are goods essentially consumed by the society
such as food grains, vegetables and sugar etc. So the demand of such goods
increases with the increase in income.
b. Inferior goods: goods which has been given less value by the society. The demand
for such goods may initially increase with increase in income up to a certain limit.
But it decreases when income increases beyond that limit.
c. Normal goods: normal goods are goods like clothing and furniture whose demand
increases as income increase.
d. Prestige or luxury goods: these are goods demanded for luxury purposes usually
by the rich. Demand for these goods a rise beyond a certain level of consumer‟s
income. Example, Luxury cars and jewelers.
4. Taste and preference of consumers: it also has an effect on demand of a
consumer due to the existence of different social, cultural, religious values which
changes the taste and preference of consumers towards a given commodity.
5. Expectation about future price of commodities and income of
consumers: there exist positive relationship between the expected price and demand,
that is, as the expected price in the future time increases, the today‟s consumers‟
consumption (or demand) increases and vice versa. Also we will obtain the same result
in the case of expected income of the consumer.

2.1.3. Shift in Demand Vs Change in Quantity Demanded

Demand is represented by the entire demand curve while quantity demanded is represented
by a single point on the demand curve. Thus, the shift in demand causes the entire curve to
move and this is due to changes in the determinants of demand other than its own price. In
contrast, the change in quantity demand referred the movement on the curve from one point
to another point and caused by changes in its own price, other things held constant.
Price (dollars)

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 P

Qd
Quantity
Figure 2.1 Quantity Demanded

2.1.4 Demand Schedule, Curve and Function

Under ceteris paribus assumption, the law of demand can be illustrated through the concept
of demand schedule, curve and function.
Demand schedule: tabular representation of a series of price of a commodity and the
corresponding quantity demanded.
Price Quantity demanded

1 20

2 15

3 12

4 10

5 9

Demand curve: it is a graphical representation of law of demand and caused by changes in

its own price, other things held constant.

D2 D3
D1
Price (dollars)

Qd
Quantity
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Figure 2.2 Shifts in Demand

Demand function: the mathematical representation of relationship between demand and its
determinants given the factors such as price of commodity x (Px), price of commodity y (Py)-
as a related commodity, income of the consumer (I) and taste and preference of the
consumer (T), the quantity demanded of a commodity (Qx) becomes a function of all the
above stated determinants. Qx = f(Px, Py, I, T). In the case of law of demand, the function
will be reduced to Qx= f(Px).

Relation: An increase in demand means that, at each price, more is demanded; a decrease in
demand means that, at each price, less is demanded, &Demand changes or shifts when one
of the determinant of demand changes.

2.1.5 Demand Distinctions: Types of Demand

Demand may be defined as the quantity of goods or services desired by an individual,
backed by the ability and willingness to pay.

Some of the types of Demand:

1. Direct and Indirect Demand: (or) Producers‟ goods and consumers‟ goods:
demand for goods that are directly used for consumption by the ultimate consumer is known
as direct demand (example: Demand for T shirts). On the other hand demand for goods that
are used by producers for producing goods and services. (Example: Demand for cotton by a
textile mill)
2. Derived Demand and Autonomous Demand: when a produce derives its usage
from the use of some primary product it is known as derived demand. (Example: demand
for tyres derived from demand for car). Autonomous demand is the demand for a product
that can be independently used.
(Example: demand for a washing machine)
3. Durable and Nondurable Goods Demand: durable goods are those that can be
used more than once, over a period of time (example: Microwave oven). Nondurable goods
can be used only once. (Example: vegetables)

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4. Joint Demand and Composite Demand: when two goods are demanded in
conjunction with one another at the same time to satisfy a single want; it is called as joint or
complementary demand. (Example: demand for petrol and two wheelers). A composite
demand is one in which a good is wanted for several different uses. (Example: demand for
iron rods for various purposes)

2.1.6. Exceptional Demand Curve

The demand curve slopes from left to right upward if despite the increase in price of the
commodity, people tend to buy more due to reasons like fear of shortages or it may be an
absolutely essential good.
The law of demand does not apply in every case and situation. The circumstances when the
law of demand becomes ineffective are known as exceptions of the law. Some of these
important exceptions are as under.
1. Giffen Goods:
Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties
millets like cheaper vegetables like potato etc come under this category. Sir Robert Giffen of
Ireland first observed that people used to spend more of their income on inferior goods like
potato and less of their income on meat. After purchasing potato the staple food, they did not
have staple food potato surplus to buy meat. So the rise in price of potato compelled people
to buy more potato and thus raised the demand for potato. This is against the law of
demand. This is also known as Giffen paradox.
2. Conspicuous Consumption / Veblen Effect:
This exception to the law of demand is associated with the doctrine propounded by Thorsten
Veblen. A few goods like diamonds etc are purchased by the rich and wealthy sections of
society. The prices of these goods are so high that they are beyond the reach of the common
man. The higher the price of the diamond, the higher it‟s prestige value. So, when price of
these goods falls, the consumers think that the prestige value of these goods comes down. So
quantity demanded of these goods falls with fall in their price. So the law of demand does
not hold good here.

3. Conspicuous Necessities:

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Certain things become the necessities of modern life. So we have to purchase them despite
their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone
down in spite of the increase in their price. These things have become the symbol of status.
So they are purchased despite their rising price.
4. Emergencies:
During emergencies like war, famine etc, households behave in an abnormal way.
Households accentuate scarcities and induce further price rise by making increased
purchases even at higher prices because of the apprehension that they may not be available.
5. Future Changes in Prices:
Households also act as speculators. When the prices are rising households tend to purchase
large quantities of the commodity out of the apprehension that prices may still go up. When
prices are expected to fall further, they wait to buy goods in future at still lower prices. So
quantity demanded falls when prices are falling.
6. Change in Fashion:
A change in fashion and tastes affects the market for a commodity. When a digital camera
replaces a normal manual camera, no amount of reduction in the price of the latter(Manual
camera) is sufficient to clear the stocks. Digital cameras on the other hand, will have more
customers even though its price may be going up. The law of demand becomes ineffective.
7. Demonstration Effect:
It refers to a tendency of low income groups to imitate the consumption pattern of high
income groups. They will buy a commodity to imitate the consumption of their neighbors
even if they do not have the purchasing power.
8. Snob Effect:
Some buyers have a desire to own unusual or unique products to show that they are different
from others. In this situation even when the price rises the demand for the commodity will
be more.
9. Speculative Goods/ Outdated Goods/ Seasonal Goods:
Speculative goods such as shares do not follow the law of demand. Whenever the prices rise,
the traders expect the prices to rise further so they buy more.
Goods that go out of use due to advancement in the underlying technology are called
outdated goods. The demand for such goods does not rise even with fall in prices

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Seasonal Goods: Goods which are not used during the off-season (seasonal goods) will also
be subject to similar demand behavior.

10. Goods in Short Supply:

Goods that are available in limited quantity or whose future availability is uncertain also
violate the law of demand.

2.2 Meaning of Supply

Supply refers to the producer‟s attitude towards a commodity to produce and sell a given
commodity at a given price per time period. So it is the willingness and ability of a producer
to produce and offer a commodity to the market. The amount of a good or service offered for
sale in a market during a given period of time (example, a week, a month) is called quantity
supplied, which we denote as QS.

2.2.1 Law of supply

The law of supply states that the price and quantity of a commodity are positively related.
Implying that the supply of a commodity increases with increase in its price and it decreases
in its price, ceteris paribus.

2.2.2 Determinants of Supply

1. Price of a commodity: as the law of supply describes, the relationship between the price
of the commodity and the quantity supplied is positively related.
2. Cost of inputs: the cost of inputs has an indirect effect on the supply of a commodity.
That is, when the cost of inputs used to produce a commodity increase/decreases the
supply of the commodity decreases/increases respectively.
3. Technology and productivity: the technology applied to the production process and the
productivity has a direct effect on supply of a commodity by reducing the cost of
production and increasing efficiency.
4. Price of alternative products: the alternative products may be a substitute or
complement. An increase in the price of the substitute product causes a reduction in
supply of the commodity and vice versa, however, an increase in the price of a
complementary product causes an increase in supply of the commodity. Thus, the
substitute inversely affects supply where as the complement directly affects supply.

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5. Number of firms in the industry: the size of the industry affects the supply in the same
direction. Increase/decrease in the number of producers causes the supply to
increase/decrease. Moreover, a grant/subsidy to the producers affects the supply
positively while the tax on producers affects supply negatively.

Note that: the conceptual explanations presented on the demand theory with regard to
difference between demand and quantity demanded and the representation of relationship
between demand and its determinant through schedule, curve and function would also have
analogous conceptual explanations in the supply theory under the lessons of difference
between supply and quaintly supplied and supply schedule, curve and function.

2.3 Market Equilibrium

Demand and supply provide an analytical framework for the analysis of the behavior of
buyers and sellers in markets. Demand shows how buyers respond to changes in price and
other variables that determine quantities buyers are willing and able to purchase. Supply
shows how sellers respond to changes in price and other variables that determine quantities
offered for sale. The interaction of buyers and sellers in the marketplace leads market
equilibrium. Market equilibrium is a situation in which, at the prevailing price, consumers
can buy all of a good they wish and producers can sell all of the good they wish.

In other words, market equilibrium refers to equilibrium of demand and supply in which
the quantity demanded of a commodity equals the quantity supplied of a commodity.
Consequently, such equilibrium brings the equilibrium price and quantity. The equilibrium
price is also known as a market clearing price, because at this price the market is clear in a
sense that there is no unsold stock and no unsupplied demand, instead the supply equals the
demand.

(1)Price (2)S0 (2)D0 (4)Excess supply (+) or excess

demand (-)
Quantity supplied Quantity demanded
(QS - Qd)
(QS = 100 + 10P) (Qd= 1,300 -20P)

$65 750 0 +750

60 700 100 +600

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 50 600 300 +300

40 500 500 0

30 400 700 -300

20 300 900 -600

10 200 1,100 -900

Table 2.1 Market Equilibrium

To illustrate how market equilibrium is achieved, we can use the demand and supply
concepts in the preceding sections. As the table 2.1 shows, equilibrium in the market occurs
when price is $40 and both quantities demanded and quantities supplied are equal to 500
units. At every price above $40, quantity supplied is greater than quantity demanded. Excess
supply or a surplus exists when the quantity supplied exceeds the quantity demanded. At
every price below $40, quantity supplied is less than quantity demanded. A situation in
which quantity demanded exceeds quantity supplied is called excess demand or a shortage.
Excess demand and excess supply equal zero only in equilibrium. In equilibrium the market
"clears" in the sense that buyers can purchase all they want and sellers can sell all they want
at the equilibrium price. Because of this clearing of the market, equilibrium price is
sometimes called the market clearing price.

Example 1: The demand equation is Qd = 1,300 - 20P and the supply equation is Qs = 100 +
10P. Since equilibrium requires that Qd = Qs, in equilibrium,
1,300 - 20P = 100 + 10P
Solving this equation for equilibrium price,
1,200 = 30P
P = $40

Figure 2.3 Market Equilibrium

At the market clearing price of $40,
Qd = 1,300 - (20 * 40) = 500
Qs= 100 + (10 * 40) = 500
As expected, these mathematically derived results are identical to those presented in Table
2.1.
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According to Table 2.1, when price is $50, there is a surplus of 300 units. Using the demand
and supply equations, when P = 50,
Qd = 1,300 - (20 * 50) = 300
Qs= 100 + (10 * 50) = 600
Therefore, when price is $50,
QS- Qd= 600 - 300 = 300, which is the result shown in column 4.

To express the equilibrium solution graphically, Figure 2.3 shows the demand curve D0 and
the supply S0 associated with the schedules in Table 2.1. Clearly, $40 and 500 units are the
equilibrium price and quantity. Only at a price of $40 does quantity demanded equal
quantity supplied.

Market forces will drive price toward $40. If price is $50, producers want to supply 600
units while consumers only demand 300 units. An excess supply of 300 units develops.
Producers must lower price in order to keep from accumulating unwanted inventories. At
any price above $40, excess supply results, and producers will lower price.

If the price is $20, consumers are willing and able to purchase 900 units, while producers
offer only 300 units for sale. An excess demand of 600 units results. Since their demands are
not satisfied, consumers bid the price up. Any price below $40 leads to an excess demand,
and the shortage induces consumers to bid up the price. Given no outside influences that
prevent price from being bid up or down, an equilibrium price and quantity are attained. This
equilibrium price is the price that clears the market; both excess demand and excess supply
are zero in equilibrium.

Example 2: Given the demand and supply functions, the equilibrium price and quantity can
be computed algebraically using the concept of market equilibrium. Suppose the demand
and supply functions for a commodity x be given as Qd= 150 –5Px and Qs = 10Px
respectively. Thus, the equilibrium P and Q will be computed as:For market equilibrium
DD  SS
150  5 Px  10 Px Q  10 Px
150  15 Px Q  10 x10
Px  10 Q  100
Therefore, the equilibrium price and quantity are 10 and 100 respectively.

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2.4 Elasticity
Elasticity is the responsiveness of a consumer/producer to the change in the quantity
demanded/quantity supplied of a commodity.

2.4.1 Price Elasticity of Demand

It is the responsiveness or sensitiveness of a consumer to the price change and price
elasticity of demand, d , is given by

percentage change in quantity demanded x / x.100

d  
percentage change in price p / p.100
where x, p are quantity and price respectively. It can be also written as:
x / x x p x p x p
d   .  .  .
p / p x p p x p x
 d is the coefficient of elasticity of demand that lie between 0 and  . Thus, depending up
on the proportional change in quantity demanded (Qx) and price (p), there are various types
of elasticity‟s.
i. Perfectly elastic demand (  d   ): change in price leads the quantity demanded to
be very high so that the consumer is highly responsible.
ii. Elastic demand ( 1   d   ): proportional change in quantity demanded greater
than that of price so that the consumer is more responsible.
iii. Unitary elastic demand (  d  1 ): proportionate change in quantity demanded and
price are equal so that the consumer responds by the same magnitude of the price
change.
iv. Inelastic demand ( 0   d  1 ): proportionate change in quantity demanded is less
than that of the price so that the consumer is less responsive.
v. Perfectly inelastic demand (  d  0 ): it refers to whatever the price change there is
no change in quantity demanded so that the consumer is not responsive for the price
change.

The arc price elasticity of demand calculates price elasticity between two prices and
indicates the effect on the demand.
 d = Q - Q .P + P
2 1 2 1

P2 - P1 Q2 + Q1
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Example 1: Consider the following demand schedule.

Price P ($ /unit) Quantity sold, QD

20 12

19 14

18 16

17 18

16 20

Table 2.1 Demand schedule

Calculate the price elasticity between an original price $20 (12 units are demanded) and a
new price of $19.
Given:
P1 = 20, Q1 = 12
P2 = 19, Q2 = 14
 d = Q - Q . P + P = 14- 12 .19 + 20 = 2 . 39 = 78 = -3
2 1 2 1
P2 - P1 Q2 + Q1 19 – 20 14 + 12 -1 26 -26

Interpretation: A price elasticity of demand coefficient of -3 means that a 1 percent

decrease in price can be expected to result in a 3 percent increase in quantity demanded,
other things remain constant.

Example 2: Suppose that the price and quantity demanded for a good are $5 and 20 units,
respectively. Suppose further that the price of the product increases to $20 and the quantity
demanded falls to 5 units. Calculate the price elasticity of demand.
Solution: Since we are given two price–quantity combinations, the price elasticity of
demand may be calculated using the midpoint formula.

Given:
P1 = 5, Q1 = 20
P2 = 20, Q2 = 5

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 d = Q - Q .P + P = 5- 20.20 + 5 = -15 .25= -1.
2 1 2 1
P2 - P1Q2 + Q120 - 520 + 5 15 25

2.4.2Income Elasticity of Demand

Income is among the variables that strongly affect demand. Income elasticity of demand
measures the responsiveness of a change in quantity demanded of some commodity to a
change in income.
EY = % QD
% Y

Where, EY = Income elasticity

QD = Change in quantity demand,
Y = Change in income

Arc income elasticity is used when relatively large changes in income are being considered
and defined as:
EY = Q2 - Q1.Y2 + Y1
Y2 - Y1Q2 + Q1

Example 1: What is the income elasticity of automobiles as per capital income increases
from $10,000 to $11,000? The demand for automobiles as a function of income per capital is
given by the equation; Q = 50,000 + 5(y).
Solution: First find Q1 and Q2 by substituting Y1 = $10,000 and Y2 = 11,000 in the demand
equation respectively.
Q1 = 50,000 + 5(10,000)
= 50,000 + 50,000
Q1 = 100,000 cars

Q2 = 50,000 + 5(11,000)
= 50,000 + 55,000
Q2 = 105,000 cars

Thus, EY = 105,000 - 100,000 .11,000 + 10,000= 0.512.

11,000 - 10,000 105,000 + 100,000

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The result can be interpreted as over the income range $10,000 to $11,000 each 1 percent
increase in income causes about 0.51 increases in quantity demanded.

2.4.3 Cross Elasticity of Demand

Another variable that often affects the demand for a product is the price of a related product
(Substitute or Complementary). Cross elasticity denoted as EX and it is a measure of the
responsiveness of change in the quantity demanded (QDA) of product A to price changes for
product B (PB).

EX = % QDA, ceteris paribus

% PB

Where, % QDA= change in quantity demanded of product A

% PB= change in price of product B

As we did previously arc cross elasticity uses to compute cross elasticity between two price
levels. It is calculated as follows:
EX = QA2 - QA1 .PB2 + PB1
PB2 - PB1QA2 + QA1

Where, QA2 = quantity demanded of A after a price change in B

QA1 = original quantity demanded of A
PB2 = new price for product B
PB1 = original price for product B

Example 1: Suppose at a local grocery store the price of butter increase from $1 to $1.50 per
pound. As a result, the quantity demanded of margarine QA increases from 500 pounds to
600 pounds per a month. Compute the arc cross elasticity of demand.
Solution: Substituting the relevant data into the above equation,

EX = 600 - 500 .$1.50 + 1.00

$1.50 - $1.00 600 + 500
EX = 0.45.

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The result can be interpreted as follows a 1 percent increase in the price of butter will lead to
a 0.45 percent increase in the quantity demanded of margarine, which is, of course, a butter
substitute, ceteris paribus.

2.4.4 Price Elasticity of Supply

Price elasticity of supply,  s , is the responsiveness of a producer to the price change and it is

percentage change in quantity sup plied x / x.100

given by  s  
percentage change in price p / p.100
Like the price elasticity of demand, the price elasticity of supply can also be classified in
five types of price elasticity which will be explained in brief as follows:
i. Perfectly elastic supply:  s  

ii. Elastic supply: 1   s  

iii. Unitary elastic supply:  s  1

iv. Inelastic supply: 0   s  1

v. Perfectly inelastic supply:  s  0

Exercise: Suppose that the price of salt rises from 15 cents to 17 cents a pound. The quantity
demanded decrease from 25 pounds to 20 pound per month and the quantity supplied
increases from 525 pounds to 600 pounds per month
A. Calculate the price elasticity of demand for salt
B. Is the demand for salt price elastic or price inelastic?
C. Calculate the price elasticity of supply for salt
D. Is the supply for salt price elastic or price inelastic?

2.5 The Marginal Analysis

Marginal analysis is an analytical technique used for solving optimization problem and
arrives at optimal decision. Although there are various maximization or minimization
decision to solve the optimization problems, all optimization problems can be solved using
analytical technique called marginal analysis. The marginal analysis involves changing the
value/s of the variables that determine the objective function (i.e., choice variables) by a
small amount to see if the objective function can be further increased (in the case of
maximization problems) or further decreased (in the case of minimization problems). The

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manager continues to make incremental adjustment on the choice variables until no further
improvements are possible.

The change on a choice variable also refers to an activity that decision makers might wish to
undertake will generate both benefits and costs. Consequently, the decision makers will want
to obtain a maximum possible net benefit from the activity where the net benefit (NB)
associated with a specific amount or level of activity (A) is the difference between the total
benefit (TB) and total cost (TC) of the activity. NB = TB - TC. This net benefit helps to
maximize the objective function.

Regarding the marginal analysis the marginal benefit (MB) and the marginal cost (MC)
helps to analyze the optimization problem. MB is a change in total benefit caused by an
incremental change in the level of an activity and MC is a change in total cost caused by an
incremental change in the level of activity. MB and MC can be expressed mathematically as:
change in total benefit TB change in total cos t TC
MB   MC  
change in activity A change in activity A

Principle: If, at a given level of activity, a small increase or decrease in activity causes net
benefit to increase, then this level of the activity is not optimal. The activity must then be
increased (if marginal benefit exceeds marginal cost, MB > MC) or decreased (if marginal cost
exceeds marginal benefit, MB < MC) to reach the highest net benefit. The optimal level of the
activity- the level that maximizes net benefit- is obtained when no further increases in net benefit
are possible for any changes in the activity, which occurs at the activity level for which marginal
benefit equals marginal cost: MB = MC.

2.6 The Time Value of Money

People generally earn money because they want to spend it. If they save it, rather than spend
it in the period in which it was earned, it is usually because they want it to spend in the
future. However, for most people present consumption is more desirable than future
consumption if only because the future is so uncertain. "Live and be merry, for tomorrow we
may die," is a rationale used over the ages to justify the urge to buy now rather than

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deferring gratification to the future. For this reason, most of us would rather have a dollar
today than a dollar a year from today, and must be given something extra to get us to defer
gratification.

Looking at the transaction from the borrower's perspective, there are consumers and
businesses (not to mention the deficit-ridden government) who really need that dollar today
and who are willing to promise to pay back more than that dollar in the future. Businesses
can invest borrowed funds in capital to create profits which are (hopefully) more than
sufficient to repay the borrowed funds (principal) plus interest. Consumers and governments
borrow for various reasons but are expected to have income in the future sufficient to repay
principal and interest. Simply put, the basic concept of time value of money is that money
has time value. That is, a bird at hand worth two in the forest.

Discounting principle: Discounting principle states that when a decision affects costs and
revenue at future dates, it is necessary to discount those costs and revenues to present values
before a valid comparison of alternatives is possible. This is because money has time value,
that is Birr 1 to be received in the future does not worth Birr 1 today. Therefore, it is
necessary to have techniques for measuring the value today (i.e., the present value) of money
to be received or paid at different points in future.

Example: What is the present value of Birr 1 to be received in 4 years if the interest rate is
0.10?
Solution: P = A =1 = 1 = Birr 0.683
n 4
(1 + i) (1 + 0.10) 1.4641
In other words, the present value is Birr 68.3 cents. Similarly, we can calculate the present
value for longer periods.

Summary
The aggregate of individual demand for a product results the market demand. The
analysis of market demand plays a crucial role in business decision making.
Increasing demand for a product offers a high business prospects in the future and
decreasing demand for a product reduces the business prospect. The law of demand
states that the demand for a commodity increases when its price decreases and falls
when its price increases. The demand curve is typically downward sloping,
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 indicating that consumers are willing to purchase more units of a good or service at
lower prices.

Some of the factors that determine the market demand are changes in the income
level of consumers, the price of substitute and complementary goods, level of
advertising, competitor advertising expenditures, population, consumer preferences,
and price expectations. Changes in price result in movement along the demand curve,
whereas changes in any of the other variables in the demand function result in shifts
of the entire demand curve. Demand is said to be relatively price elastic if a given
percentage change in price results in a greater percentage change in a quantity
demanded. Demand is said to be relatively price inelastic if a given percentage
change in price results in a lesser percentage change in a quantity demanded.

When demand is elastic, an increase (decrease) in price will result in a decrease

(increase) in total revenue. When demand is inelastic, an increase (decrease) in price
will result in an increase (decrease) in total revenue. When demand is unit elastic,
marginal revenue equals zero and total revenue is unaffected. An understanding of
the magnitude of various elasticity measures for a product can be extremely helpful
when forecasting demand for the product.

Self Test Exercise 2:

Part I: Write “True” if the statement is correct and “False” if the statement is
incorrect.
1) Demand is one of the crucial requirements for the existence of any business
enterprise.

2) The decision which management makes with respect to production,

advertising, cost allocation, pricing etc. call for an analysis of demand.

3) The law of demand states, there is a direct relationship between price and
quantity demanded of a commodity, other things hold constant.

4) An increase in the price of the substitute product causes a reduction in supply

of the commodity and vice versa

5) Market equilibrium is a situation in which, at the prevailing price, consumers

can buy all of a good they wish and producers can sell all of the good they
wish.

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 6) Excess supply or a surplus exists when the quantity supplied exceeds the
quantity demanded.

Part II: Choose the correct answer & encircle the letter of your choice.

1) _____ Goods are goods which has been given less value by the society
A. Inferior goods
B. Normal goods
C. luxury goods
D. All
E. None

2) Demand for a commodity implies:

A. Desire to acquire it
B. Willingness to pay for it
C. Ability to pay for it.
D. All
E. None

3) The amount of a good or service that consumers in a market are willing and
able to purchase during a given period of time (example, a week, a month) is
called ___
A. Quantity supplied
B. Quantity demanded
C. Demand and supply
D. All
E. None

4) The term demand refers a desire for goods and services but this desire should
be backed by:
A. ability
B. Willingness to buy
C. Simply having a desire for the product
D. All except „C‟
E. None

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 5) ______refers to the producer‟s attitude towards a commodity to produce and
sell a given commodity at a given price per time period
A. Demand
B. Supply
C. Quantity Supply
D. Quantity demand
6) From the following, one is not the Determinants of Supply?
A. Price of a commodity
B. Cost of inputs
C. Technology and productivity
D. Price of alternative product
E. All
F. None
Part III: Fill In the Blank Space

1. The amount of a good or service that consumers in a market are willing and able
to purchase during a given period of time (example, a week, a month) is called
________
2. ________ states that the functional relationships between price and quantity
demanded.
3. ______ refers to the producer‟s attitude towards a commodity to produce and sell
a given commodity at a given price per time period.

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Unit Three: Optimization Techniques

Introduction

Dear learners, this is the second unit of the course managerial economics. In this unit,
you are going to study about optimization. An optimization technique is a technique of
maximizing or minimizing a function. In simple words, it is a technique of finding the value
of the independent variable(s) that maximizes or minimizes the value of the dependent
variable. For example, some firms may be interested in finding the level of output that
maximizes their total revenue; some firms facing a constant price may want to find the level
of output that would minimize the average cost; and most important of all, most firms may
be interested in finding the level of output that maximizes their profits.
Unit Objectives: After learning this unit, students will be able to:

 Understand what optimization means;

 Know the concept of differentiation;

 Identify the different types derivatives;

 Know how to Maximize Total Revenue.

3. The Rules of Differentiation

The nature of functions that are encountered in managerial decisions are (i) function of a
constant, (ii) power function, (iii) function as a sum or difference of two functions, (iv)
function as a product of two functions, (v) function of a function. For describing the rules of
differentiation, we will use the alphabet Y as the dependent variable, alphabet X as the
independent variable, and alphabets a, b, and c as constraints.
1. Derivative of a Constant Function
The derivative of a constant function equals zero. For example,
If Y = f(X) = a (where a is constant)......................(3.2.1)
Then Y =0
X

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The reason is that a constant function implies that whatever the value of X, the value of Y
remains constant. That is, even if the value of X changes, the value of Y does not change. For
example, if the optimum level of capital-labor ratio has been reached and capital is constant,
then the production function can be expressed as
Y = f(X) = 500
Where Y is output and X is labor. Given this function, output will remain constant whatever
the number of workers employed.

2. Derivative of a Power Function

A power function takes the following form.
Y = f(X) = aXb......................(3.2.2)
Where a and b are constants, a being the coefficient of X and b power of X.
The derivative of Y with respect to X is power b times a times X raised to the power b - 1.
That is, Y =baXb - 1......................(3.2.3)
X
Example:
(a) If Y = 5X3
then Y = 3 * 5 * X3 - 1= 15X2
X
(b) If Y = 4X2
then Y = 2 * 4 * X2 - 1= 8X
X
(c) If Y = 2X
then Y = 1 * 2 * X1 - 1= 2 X0 = 2
X
(d) If Y=X
then Y = X1 - 1= 1
X

3. Derivative of Functions of Sum and Difference of Functions

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A dependent variable Y may be the function of the sum (or difference) of two different
functions of the same independent variable X or of a sum (or difference) of two other
variables which are functions of X. The derivatives of such functions are given below.
Y = f(X) + g(X)
Where f(X) and g(X) denote two different functional relationships between Y and X
The derivative function can be expressed as
Y = f(X)+ g(X)
X X X
And if Y = f(X) - g(X)
(Where f(X) and g(X) denote two different functions)
Then Y = f(X)- g(X)
X X X

Example:
(i) If Y = 5X + 2X3
then Y = 5X1 - 1 + 2 * 3X3 - 1 = 5 + 6X2
X
(ii) If Y = 5X2 - 2X4
then Y = 2 * 5 X2 - 1 - 4 * 2 X4 - 1 = 10X - 8X3
X
(iii) If Y = 4X3 - 3X2 + 3
then Y = 3 * 4 X3 - 1 - 2 * 3 X2 - 1 + 0 = 12X2 - 6X
X

4. Derivative of a Function as a Product of Two Functions

The derivative of a function as a product of two functions is equal to the first term (or
function) multiplied by derivative of the second function plus second term (or function)
multiplied by the derivative of the first function. For example, suppose Y is the function of
two different functions of the same independent variable, X, i.e.,
Y = f(X) x g(X)
Where f(X) and g(X) denote two different functional relationships between Y and X
The derivative function can be expressed as
Y = f(X) x g(X) + g(X) x f(X)

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 X X X

5. Derivative a Quotient
If a function is in the form of a quotient, then the derivative of the function is equal to the
denominator times the derivative of the numerator minus the numerator times the derivative
of the denominator, whole divided by the square of the denominator. For example, suppose
Y =f(X)......................(3.2.4)
g(X)
Then Y =g(X) x f(X)-f(X) x g(X)......................(3.2.45
X X X
[g(X)2
Consider another example. Suppose
Y =5X + 4
2X + 3

Then the derivative of the function is given as

Y =(2X + 3) (5) - (5X + 4) (2)
X (2X + 3)2

=(10X + 15) - (10X + 8)

(2X + 3)2
=7
(2X + 3)2

6. Chain Rule

If Y is a function of Z and again Z is a function of X, then

Y= Y Z = Y
X Z X X

Y = 5Z + 2Z2 and Z= 2X + 10X2

Then and = 2+20X

Now = (5+4Z) (2+20X)

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3.2.1 The Partial Derivative
Functions with Several Independent Variables: Many functions used in economic and
business analysis have more than one independent variable. Some common examples of
such functions are demand function, production function and cost function.
Demand function: Dx = f (Px, Ps, Pc, Rd, A, T, ... etc.)
Where, Dx = demand for commodity X,
Px = price of X,
Ps = price of substitutes,
Pc = price of complements,
Rd = disposable resources (income),
A = advertisement of expenditure by producers,
T = tastes and preferences etc.

Production function: Q = f (K, L)

Where, Q = quantity produced,
K = quantity of capital,
L = number of workers.
Cost function: C = f (K, r, L, w)
Where, C = total cost,
K = capital,
r = rental rent,
L = number of workers,
w = wage rate.

Rules of Partial Differentiation: We will describe the rules of partial differentiation in

terms of Y, as dependent variable and X and Z as two independent variables. Suppose Y = f
(X, Z) and the functional relationship between Y (the dependent variable) and the
independent variables, X and Z, is given as
Y = X3 + 4XZ + 5Z2......................(3.2.4)

The rules of partial differentiation can be stated as follows:

(i) Only one of the independent variables is allowed to change at a time and all other
independent variables are held constant.
(ii) For differentiating the dependent variable with respect to one independent variable, the
rule of differentiation is followed.
Based on these rules, the derivatives of Y with respect to X and Z in equation (3.2.4) are
given below.
(i) Derivative of Y with respect to X with Z held constant,
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 Y = 3X3 - 1 + 4Z = 3X2 + 4Z
X
(ii) Derivative of Y with respect to Z with X remaining constant,
Y = 4X + 2 x 5Z2 - 1 = 4X + 10Z
Z
In case a function with two (or more) independent variables is in the multiplier form such as
Y = aXbZc
then the derivative of Y with respect to X is
Y =baXb - 1Zc
X
and the derivative of Ywith respect to Z is
Y =aXbcZc - 1 = acXb Z c - 1
Z

3.3 Technique of Maximizing Total Revenue

The total revenue (TR) of a firm is defined as:
TR = P.Q ...................... (3.1)
Where P = price and Q = quantity sold.
Suppose a price function is given as
P = 500 -5Q ...................... (3.2)
By substituting equation (3.2) into equation (3.1), we get TR as follows.
TR = (500 - 5Q)Q
= 500Q - 5Q2 ...................... (3.3)
Now the problem is to find the value of Q that maximizes total revenue.

3.3.1 The Rule of Total Revenue Maximization

The rule of maximization of total sales revenue is that, the total revenue is maximum
at the level of sales (Q) at which MR = 0, that is, the marginal revenue (MR), i.e.,
the revenue from the sale of the marginal unit of the product, must be equal to zero.
MR is given by the first derivative of the TR function. So, to find the value Q that
maximizes TR, we need to find the derivative of the TR function (3.3) with respect

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to Q; set it equal to zero and solve it for Q, as shown below. Given the TR function in
Equation (3.3), the first derivative of the TR function can be obtained as follows.
TR = 500 - 10 Q...................... (3.4)

By setting equation (3.4) equal to zero and solving for Q, we get

500 - 10Q = 0
- 10 Q = - 500
Q = 50...................... (3.5)
Equation (3.5) shows that Q = 50 maximizes the total revenue.

The maximum TR can be obtained by substituting 50 for Q in the TR function (3.3). Thus,
TR = 500 - (50) - 5 (50)2...................... (3.6)
= 25,000 - 12,500
= 12,500
Let us now check the result. Whether TR = Rs. 12,500 is maximum can be checked can be
checked by increasing and decreasing Q by one unit and then comparing TR at Q = 51 and at
Q = 49 with TR at Q = 50.
TR (at Q = 51) = 500 (51) - 5 (51)2
= 25,500 - 13,005
= 12,495
TR (at Q = 49) = 500 (49) - 5 (49)2
= 24,500 - 12,005
= 12,495
The calculation made above show that if sales are increased above 50 units or reduced below
50 units, TR decreases in both the cases. Thus, it is proved that Q = 50 maximizes TR.

3.4 Technique of Optimizing Output: Minimizing Average Cost

The optimum size of the firm is one that minimizes the average cost of production. It is also
called the most efficient size of the firm. A prior knowledge of the optimum size of the firm
is very important for future planning under at least three conditions.

One, a businessman planning to set up a new production unit would like to know the
optimum size of the plant for future planning. This problem arises because, as the theory of

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production tells us, the advantage cost of production in most productive activities decreases
to a certain level of output and then begins to increase.

Two, the firms planning to expand their scale of production would like to know the most
efficient level of the economies of scale so that they are able to plan the marketing of the
product accordingly.

Three, businessmen working in a competitive market are often faced with a given market
price. Their profit then depends on their ability to reduce their unit cost of production. Given
the technology and input prices, the prospect of reducing the unit cost of production depends
invariably on the size or production. The problem that decision makers might face in this
regard is how to find the optimum level of output, i.e., the level of output that minimizes the
average of production.

As already mentioned, under the general production conditions, the optimum level of output
is the one that minimizes the average cost. The average cost (AC) can be obtained by
dividing total cost (TC) by the quantity produced (Q).
That is, AC = TC...................... (3.7)
Q
Suppose the TC function of a firm is given as
TC = 100 + 60Q + 4Q2...................... (3.8)
Then AC = 100 + 60Q + 4Q2
Q
= 100/Q + 60 + 4Q= 100Q-1 + 60 + 4Q...................... (3.9)
Now the problem is how to find the value of Q that minimizes AC.
The Rule of Minimization: Like the rule of maximization, the rule of minimizing a function is
that its derivative must be equal to zero. So the value of Q that minimizes AC can be
obtained by finding the derivative of the AC function and setting it equal to zero and solving
it for Q.

The derivative of the AC function (3.9) is given as

AC = - 100/Q2 + 4...................... (3.10)
Q
Be setting equation (3.10) equal to zero, we get
- 100/Q2 + 4 = 0
- 100/Q2 = - 4
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 Q2 = - 100/- 4 = 25...................... (3.11)
Q=5
The result shows that Q = 5 minimizes the average cost. In other words, the optimum size of
the output is 5 units. Any other output will increase the average cost of production.

3.5 Maximization of Profit

Profit maximization is the most common objective of business firms.
= TR - TC ...................... (3.12)
Total profit ( will be maximum when TR - TC is maximum. Therefore, a profit
maximizing firms tries to maximize TR - TC. Recall that both TR and TC are positive
functions of the same variable, Q. The problem that decision-makers face is 'how to
determine the level of output (Q) which maximizes profit'. The technique of differentiation is
of great help in finding the answer to this problem. There are two alternative ways of finding
ways of finding Q at which profit is maximum: (i) going by the rules of profit maximization,
and (ii) maximizing the profit function.

3.5.1 Profit Maximization Conditions

There are two conditions of profit maximization: (i) the necessary or the first order
condition, and (ii) the supplementary or the second order condition.
(i) The necessary or the first order condition requires that MC must be equal to MR. This
means that for profit to be maximum;
MR = MC
The first order condition can be written as:
=

or = = 0 ...................... (3.13)

It means that the first derivative of the TR function must be equal to the first derivative of
the TC function or their difference must be equal to zero.

(ii) The supplementary or the second order condition requires that the difference between
the second derivative of the TR function and the second derivatives of the two functions must

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be equal. Incidentally, the derivative of the first derivative of a function is called the second
derivative. The second order condition requires that
2 2 2 2
TR< TC or TR + TC<0 ............... (3.14)
2 2 2 2
Q Q Q Q

Now let us apply these conditions to the TR and TC functions and find (a) the profit
maximizing output, (b) the maximum profit, and (c) proof that profit is maximum.

Suppose that the TR and TC functions are given, respectively, as follows.

TR = 600Q - 3Q2........................... (3.15)
TC = 1000 + 100Q +2Q2............... (3.16)
Given the TR and TC functions as in equation (3.15) and (3.16), respectively, MR and MC
can be obtained as follows.
MR = TR= 600 - 6Q........................... (3.17)
Q
and MC = TC = 100 + 4Q........................... (3.18)
Q

By applying the first order condition of profit maximization, we get maximum profit where
MR = MC
600 - 6Q = 100 + 4Q ........................... (3.19)
- 6Q - 4Q = - 600 + 100
- 10Q = - 500
Q = 50
The first order condition of profit maximization reveals that, given the TR and TC functions,
the total profit is maximum at Q = 50.

Let us now apply the second order condition. Given the first order derivative of the TR
function in equation (3.17) and that of the TC function in Equation (3.18), the second
derivatives of the TR and TC functions are presented below.
2
TR = MR = - 6
Q2 Q
2
and TC = MC = 4
2
Q Q
Note that the second derivative of the TR function equals - 6 and the second derivative of the
TC function equals 4. The sum of the two second derivatives, i.e., - 6 + 4 = - 2 and - 2 < 0.
So the second order condition of profit maximization is also satisfied at Q = 50.

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Is Total Profit Maximum at Q = 50? This can be checked by comparing profits at Q = 50,
at Q> 50 and Q< 50. By substituting these numbers by turn into profit function, we can get
the total profit at three levels of output. Let us first work out the profit at Q = 50.
Total profit (at Q = 50) = TR - TC
= (600Q - 3Q2) - (1000 + 100Q + 2Q2)
= {600 (50) - 3 (50)2} - {1000 + 100 (50) + 2 (50)2}
= 22,500 - 11,000 = 11,500
Total profit (at Q = 51) = TR - TC
= {600 (51) - 3 (51)2} - {1000 + 100 (51) + 2 (51)2}
= 22,797 - 11,302 = 11,495
Total profit (at Q = 49) = TR - TC
= {600 (49) - 3 (49)2} - {1000 + 100 (49) + 2 (49)2}
= 22,197 - 10,702 = 11,495
The foregoing calculations show that at Q = 50 profits equal Rs. 11,500. And, if Q is
increased or decreased even by a single unit, the total profit decreases by Rs. 5 in either case.
This proves that profit is maximized at 50 units of output.

3.5.2 Maximization of Profit Function

Profit function is given as = TR - TC;
= 600Q - 3Q2 - (1000 + 100Q + 2Q2)
= 600Q - 3Q2 - 1000 - 100Q - 2Q2
= - 1000 + 500Q - 5Q2........................... (3.20)
Going by the maximization rule, for profit to be maximum, the derivative of the profit
function (3.20) must be equal to zero. The derivative of the profit function is

= 500 - 10Q........................... (3.21)

Q
For profit to be maximum, the first derivative of the profit function must be equal to zero.
That is,
500 - 10Q = 0
Q = 50
Note that the profit to be maximizing output obtained by the alternative methods is the same,
i.e., Q = 50.

Optimization of a Multivariate Profit Function: We have so far discussed the

optimization (maximization and minimization) of a function with one independent variable.
Most decision makers deal with functions with more than one independent variable. For

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example, output is the function of two independent variable inputs, labor and capital; total
revenue is not the function of quantity alone but also the advertisement expenditure; in case
of firms producing more than one commodity that is, the multi-product firms, profit is
function of all the products. In this section, we will explain the technique of optimization of
a multivariate function assuming a simple case of independent variables. One common case
is that of profit maximization by a firm which produces two commodities. We will,
therefore, explain here the profit maximization technique assuming a case of two products.
In this case, the problem is to find the outputs of both products that maximize the profit.

The profit function in the case of two products, say X and Y, can then be expressed as
= f(X, Y)
Suppose that the profit function is given as follows.
= 100X - 2X2 - XY + 180Y - 4Y2........................... (3.22)
Maximization of a multivariate profit function (3.22) requires that (i) partial derivative of
with respect to X and (ii) partial derivative of with respect to Y are each set equal to zero
and solved for X and Y.
The partial derivative of with respect to X, holding Y constant, is
= 100 - 4X - Y ........................... (3.23)

and partial derivative of with respect to Y, holding X constant, is

= 180 - X - 8Y ........................... (3.24)

Setting each of the partial derivative given in Equations (3.23) and (3.24) equal to zero, we
get
(i) 100 - 4X - Y = 0
(ii) 180 - X - 8Y = 0

Note that setting each partial derivative equal to zero results in two simultaneous equations.
By solving these equations we can find the values of X and Y that maximize the profit
function. To solve the equations, we need to eliminate one of the variables (say, X). For this,
let us multiply equation (ii) by 4 and subtract the product from equation (i). Thus, we have
(iii) 100 - 4X - Y = 0 (equation (iii) is the same as equation (i))
(iv) 720 - 4X - 32Y = 0
By subtracting equation (iv) from equation (iii), we get

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 - 620 + 31Y = 0
Y = 20
By substituting 20 for Y in equation (i) we can obtain the value of X.
100 - 4X - 20= 0
- 4X = - 80
X = 20

The forgoing calculations show that the firm can maximize its profit function by producing
20 units each of its products X and Y. The maximum profit can be worked out by substituting
the values of X and Y in the profit function.
= 100(20)- 2 (20)2 - (20) (20) + 180 (20) - 4 (20)2
= 2000 - 800 - 400 + 3600 - 1600
= 2,800
Any other combination of X and Y will reduce the profit. Whether the profit is maximum can
be checked by substituting any value other than 20 for X and Y.

3.6 Constrained Optimization

The maximization techniques discussed above can be called unconstrained optimization
techniques, in the sense that they assume that firms operate under no constraints on their
activity. For example, in the case output maximization, firms face no resource constraints:
they possess unlimited resources and can acquire all the inputs, finance, capital equipment,
men and raw materials that they need to maximize output. Same is the case with cost
minimization technique. The firms have all the resources to carry out production activity
until average cost is minimized or cost for a given output is minimized. In the real business
world, however, the managers face serious resource constraints. For example, they need to
maximize output with given quantity of capital and labor time. The technique that is used to
optimize the business objective(s) under constraints is called constrained optimization
techniques. There are three very common techniques of constrained optimization, linear
programming, and constrained optimization by substitution and Lagrangian multiplier. The
linear programming technique has a wide range of application and is a subject in itself.

3.6.1 Constrained Optimization by Substitution Technique

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(i) Constrained Profit Maximization: Let us recall our earlier example of profit
maximization.
= 100X - 2X2 - XY + 180Y - 4Y2........................... (3.25)
We have illustrated above maximization of this profit function without any constraint. That
is, the independent variables, X and Y, were free to take any value in the profit maximization
solution.

Here we illustrate the maximization of the same profit function with a constraint on output
that the sum of X and Y must be equal to 30 (instead of 40 as in the solution without
constraints). That is,
X + Y = 30........................... (3.26)
A constrained problem of this kind can be solved by substituting method as illustrated
below. The process of solution involves two steps: (i) express one of the variables in terms
of the other and solve the constraint equation for one of the variables (X or Y) and (ii)
substitute the solution into the objective function to be maximized and solve it for the other
variable.

Given the constraint equation (3.26), the values of X and Y can be expressed in terms of one
another as follows.
X = 30 - Y
or Y = 30 - X
We can now substitute the value of X (or Y), in to equation (3.25) and find the maximization
solution.
By substituting the value of X, the profit function (3.25) can be expressed as
= 100(30 - Y)- 2 (30 - Y)2 - (30 - Y) Y + 180Y - 4Y2
= 3000- 100Y - 2 (900 - 60Y +Y2) - 30Y+ Y2+ 180Y - 4Y2
= 3000- 100Y - 1800 + 120Y - 2Y2 - 30Y+ Y2+ 180Y - 4Y2
= 1200 + 170Y - 5Y2........................... (3.27)
Note that the substitution method converts a constrained problem into an unconstrained one.
Equation 3.27 can now be maximized by obtaining its derivative and setting it equal to zero
and solving it or Y.
Thus, = 170 - 10 Y ........................... (3.28)
Y
Be setting equation (3.28) equal to zero, we get
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 170 - 10 Y = 0
Y = 17
By substituting 17 for Y in constant equation (3.26), we get
X + 17 = 30
X = 13

Thus, the optimal solution of the profit maximization problem is X = 13 and Y = 17. These
values of X and Y satisfy the constraint. In simple words, we get the optimization solution
that the firm maximizes its profit by producing 13 units of X and 17 units of Y. The answer
will be the same if we substitute 30 - X for Y in equation (3.25) and solve the equation for X.

Now let us compute the maximized profit under constraints. This can be done by substituting
the values of X and Y into the profit function (3.25). By substitution, we get
= 100(13) - 2 (13)2 - (13) (17) + 180 (17) - 4 (17)2
= 2,645
Note that maximum profit (2,645) under constraint is less than the maximum profit under no
constraint (2800).

(ii) Constrained Cost Minimization: Let us now apply the substitution method of
optimization to a problem of constrained cost minimization. Suppose that the cost function
of a firm producing two goods, X and Y, is given as
TC = 2X2 - XY + 3Y2
and the firm has to meet a combined order of 36 units of the two goods. The manager's
problem is to find an optimum combination of X and Y that minimizes the cost of
production. The problem can be restated formally as
Minimize TC = 2X2 - XY + 3Y2........................... (3.29)
Subject to: X + Y = 36 ........................... (3.30)

Substitution method requires that the constraint equation (3.30) is expressed in terms of any
one of the two goods and then substituted into the objective function (3.29). By expressing X
in terms of Y, we get
X = 36 - Y........................... (3.31)
By substituting equation (3.31) for X in the objective function (3.29), we get
TC = 2 (36 - Y)2- (36 - Y)Y + 3Y2
= 2 (1296 - 72Y + Y2) - 36Y + Y2 + 3Y2
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 = 2592 - 144Y +2Y2 - 36Y + Y2 + 3Y2
= 2592 - 180 Y + 6 Y2........................... (3.32)

For the objective function (3.32) to be minimized, its first derivative must be set to zero.
Thus,
TC = - 180 + 12 Y = 0 ........................... (3.33)
Y
Solving equation (3.33) for Y, we get
12 Y = 180
Y = 15
By substituting the value of Y in the constraint equation (3.30) we get
X + 15 = 36
X = 21
Thus, we get the optimum solution that X = 21 and Y = 15 minimize the cost of meeting the
order. The minimum cost of producing 21 units of X and 15 units of Y can be obtained by
substituting these values in cost function (3.29).
Minimum cost = 2 (21)2 - (21) (15) + 3 (15)2
= 882 - 315 + 675
= 1,242

3.6.2 Constrained Optimization by Lagrangian Multiplier Method

This method is used to solve the optimization problems of a complex nature and those which
cannot be solved by the substitution method. We will, however, illustrate the Lagrangian
multiplier method in respect of
(i) a constrained profit maximization problem, and
(ii) a constrained cost minimization problem.
(i) Constrained Profit Maximization
Let us restate the problem as
Maximize = 100X - 2X2 - XY + 180Y - 4Y2........................... (3.34)
Subject to the constraint X + Y = 30 ........................... (3.35)

The basic approach of the Lagrangian multiplier method is to form a Lagrangian function by
combining the objective function and the constraint equation and then solve it by the partial

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derivative method. There is a simple technique of formulating the Lagrangian function. First,
set the constraint equation (3.35) equal to zero, i.e.,
X + Y - 30 = 0
Second, multiply the resulting equation by  (the Greek letter "lambda'), i.e.,
(X + Y - 30) = X + Y - 30
And, finally add the resulting equation to the objective function. Thus, the Lagrangian
function is formed as
L = 100X- 2X2 -XY + 180Y - 4Y2 + (X + Y- 30).............
(3.36)
Equation (3.36) is the unconstrained Lagrangian function with three unknowns, X, Yand .
The values of X, Y and  that maximize L maximize also: The Greek letter  is the
Lagrangian multiplier. It gives the measure of a small change in the constraint on the
objective function.

What we need to do to maximize the L function (3.36) is to obtain the partial derivative of

L with respect to X, Y and and set each of them equal to zero. This will give us the first
order condition of profit maximization in the form of three simultaneous equations, as shown
below.
= 100 - 4X - Y +  = 0........................... (3.37)
X
= - X + 180 - 8Y +  = 0........................... (3.38)
Y
TC= X + Y - 30 = 0........................... (3.39)


By solving the simultaneous equations, we get the values of X, Y and  that maximize the
objective function (3.36). In order to solve these equations for X, Y and , we need to reduce
the three simultaneous equations, (3.37), (3.38) and (3.39) to two equations. To do this, let
us rearrange the terms of equations (3.38) and subtract it from equation (3.37). By
subtracting we get,
100 - 4X - Y +  = 0
180 - X - 8Y +  = 0
- 80 - 3X + 7Y = 0 ........................... (3.40)

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Now we have two simultaneous equations (3.40) and (3.39). Using the method of solving the
simultaneous equations, we multiply equation (3.39) by 3 and add it to equation (3.40). Then
we get,
3X + 3Y - 90 = 0
- 3X+7Y- 80 = 0
10Y - 170 = 0
Y = 17
By substituting 17 for Y in the constraint equation (3.35), we get the value of X as
X + 17 = 30
or X = 13
Note that the values of X and Y are the same as computed above.

The value of  can be obtained by substituting the values of X and Y in equation (3.37) or in
equation (3.38). Using equation (3.38), we get,
- 13 + 180 - 8 (17) +  = 0
 = - 31

The value of  has an important economic interpretation. It gives the measure of the change
in the total profit when the output constraint is changed by 1 unit. For example, if output is
increased by 1 unit, i.e., from 30 to 31 units, profit will increase by about 31 and if output is
decreased by 1 unit, i.e., from 30 to 29 units, the profit will decrease by about 31.

(ii) Constrained Cost Minimization: Suppose Josef Carpets, a carpet manufacturing and
exporting firm, has to supply an order for 500 pieces of woolen carpets of two varieties X
and Y to a German buyer. The joint cost function for the two varieties of carpets is given as
C = 100 X2 + 150 Y2........................... (3.41)

The quantity of X and Y are not specified in the order. So the firm is free to supply X and Y
in any combination. The firm's problem is to find the combination of X and Y that minimizes
the cost of production subject to the constraint X + Y = 500. The problem can be restated
formally as
Minimize C = 100 X2 + 150 Y2
Subject to X + Y = 500........................... (3.42)

In order to solve the cost minimization problem by Lagrangian multiplier method, the
problem has to be converted into a Lagrangian function. The procedure is to set the
constraint equation (3.42) equal to zero, multiply it by  and add the result to the objective
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function. The cost minimization problem converted into the Lagrangian function is given
below.
Minimize LC = 100 X2 + 150 Y2 +  (500 - X - Y) ...................... (3.43)
Subject to 500- X - Y = 0

The objective here is to minimize equation (3.43) subject to X + Y = 500. The first order
condition of the solution requires that the derivative of LC with respect to X, Y and  is set
equal to zero. Thus,
C= 200X -  = 0........................... (3.44)
X
C= 300Y -  = 0........................... (3.45)
Y
C= 500 - X - Y = 0........................ (3.46)

By subtracting equation (3.45) from equation (3.44), we get
200X -  - (300 Y - ) = 0
200X = 300Y
X = 1.5Y

By substituting 1.5 Y for X in equation (3.46), we get

500 - 1.5 Y - Y = 0
500 = 2.5Y
Y = 200
By substituting the value of Y with 200 in the constraint equation (3.42), we get
X + 200 = 500
X = 300

Thus, the solution to the cost minimization problem is that X = 300 and Y = 200 minimize
the cost of producing 500 pieces of woolen carpets. The minimum cost can be worked out as
follows
C = 100 X2 + 150 Y2
= 100 (300)2 + 150 (200)2
= 9,000,000 + 6,000,000
= 15,000,000

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Thus, the minimum cost of supplying 500 pieces if woolen carpets works out to Rs. 15
million. This is minimum cost because any other combination of X and Y varieties of carpets
will make the cost exceed Rs. 15 million.

Summary
Optimization is the act of choosing the best alternative out of the available ones. It
describes how decisions or choices among alternatives are taken or should be made.
All such optimization problems have 3 elements: Decision Variables: These are
variables whose optimal values have to be determined. For example, a production
manager wants to know at what level to set output in order to achieve maximum
profit or maximum sales revenue. Here, output is the decision or choice variable.
Similarly labour, machine, time and raw materials are choice variables if a works
manager wants to know what amount of these are to be used so as to produce a given
output level at minimum cost. The quantity of any choice variable must be
measurable (20kg, 5 laborers, 10 hours, etc.). The Objective Function: It is a
mathematical relationship between the choice variables and some variables whose
values are to be maximized or minimized. For example, the objective function could
relate profit to level of output or cost to amount of labour, machine, time, raw
materials, etc. in the above example. The Feasible Set: The available set of
alternatives is called a feasible set.

Total revenue (TR) generated by the firm indicates whether the firm doing well or
not. Ranking of firm‟s size and growth are usually expressed on the basis of total
revenue. To achieve the maximum profit the firm should consider its price and level
of output. Marginal analysis is the convenient concept to find the highest-profit
equilibrium of the firm; we need to measure the impact of selling an extra unit of
output on total revenue. The relationship between the price elasticity of demand and
marginal revenue is essential for decision making. Marginal revenue is positive when
demand is elastic, zero when demand is unit-elastic and negative when demand is
inelastic. The rule of total revenue maximization states the total revenue is
maximized at the level of sales (Q) at which MR=0, that is, the marginal revenue

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 (MR), i.e. the revenue from the sale of the marginal unit of the product must be equal
to zero.

Self Test Exercise 3:

Part I: Write “True” if the statement is correct and “False” if the statement is
incorrect.

1) An optimization technique is a technique of finding the value of the independent

variable(s) that maximizes or minimizes the value of the dependent variable.
2) The optimum size of the firm is one that minimizes the average cost of production.
3) The rule of maximization, like the rule of minimizing a function, is that its derivative
must be equal to zero.
4) Profit maximization is the most common objective of business firms.
5) Total revenue (TR) generated by the firm indicates whether the firm doing well or
not.

Part II: Choose the correct answer & encircle the letter of your choice.
1) A prior knowledge of the optimum size of the firm is very important for future
planning under all of the following conditions except one;
A. A business man planning to set up a new production unit would like to know the
optimum size of the plant for future planning.
B. The firms planning to expand their scale of production would like to know the most
efficient level of the economies of scale
C. A business men working in a competitive market are often faced with a given market
price
D. All
E. None

2) ______ is variables whose optimal values have to be determined.

A. Decision Variables
B. Constant variable
C. Constrained variable
D. None
3) _______ is a mathematical relationship between the choice variables and some
variables whose values are to be maximized or minimized.

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 A. Objective Function
B. Decision function
C. Alternative function
D. All
E. None

Part III: Fill in the Blank Space

1. The two conditions of profit maximization are ____________________ and

_______________

2. ______, _______ and ______ are the three elements of optimization problems

3. _______ is the convenient concept to find the highest-profit equilibrium of the firm

Unit Four: Demand and Demand Forecasting

Introduction

Dear learners, this is the fourth unit of the module managerial economics. In this unit,
you are going to see about demand and demand forecasting. Managers use forecasts for
budgeting purposes. A forecast aids in determining volume of production, inventory needs,
labor hours required, cash requirements, and financing needs. A variety of forecasting
methods are available. However, consideration has to be given to cost, preparation time,
accuracy, and time period. The manager must understand clearly the assumptions on which
a particular forecast method is based to obtain maximum benefit.
Management in both private and public organizations typically operates under conditions of
uncertainty or risk. Probably the most important function of business is forecasting, which is
a starting point for planning and budgeting. The objective of forecasting is to reduce risk in
decision making.
Unit Objectives: By studying this unit, you should be able to:
 Identify a wide range of demand estimation and forecasting methods;
 Apply these methods and to understand the meaning of the results;

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  Understand the nature of a demand function;
 Identify the strengths and weaknesses of the different methods;
 Understand that demand estimation and forecasting is about minimizing risk.

4.1. What Is Demand Forecasting

In business, forecasts form the basis for planning capacity, production and inventory,
manpower, sales and market share, finances and budgeting, research and development, and
top management‟s strategy. Sales forecasts are especially crucial aspects of many financial
management activities, including budgets, profit planning, capital expenditure analysis, and
acquisition and merger analysis. Forecasting is done both for the long run as well as short
run. In a short run forecast, seasonal patterns are of prime importance such a forecast help in
preparing suitable sales policy and proper scheduling of output in order to avoid over –
stocking or cost delay in meeting the orders. Besides, given an idea of likely demand short
run forecasts also help in arriving at suitable price for the product and in deciding about
necessary modifications in advertising and sales techniques. Short run forecasts are needed
to evolve suitable production policy, controlling inventory and cost of raw materials,
determining suitable price policy, setting sales targets and planning future financial
requirements. Long run forecasts are helpful in proper capital planning. Long term help in
saving the wastages in raw materials, man-hours, variables like population, age group
pattern, consumption pattern etc. are included. Long run forecasting usually used for ―new
planning, long run financial requirements etc.

4.2 Market Demand Analysis

Companies use market demand analysis to understand how much consumer demand exists
for a product or service. This analysis helps management determine if the company can
successfully enter a market and generate enough profits to advance its business operations.
While several methods of demand analysis may be used, they usually contain a review of the
basic components of an economic market.

Market Identification

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The first step of market analysis is to define and identify the specific market to target with
new products or services. Companies will use market surveys or consumer feedback to
determine their satisfaction with current products and services. Comments indicating
dissatisfaction will lead businesses to develop new products or services to meet this
consumer demand. While companies will usually identify markets close to their current
product line, new industries may be tested for business expansion possibilities.

Business Cycle
Once a potential market is identified, companies will assess what stage of the business cycle
the market is in. Three stages exist in the business cycle: emerging, plateau and declining.
Markets in the emerging stage indicate higher consumer demand and low supply of current
products or services. The plateau stage is the break-even level of the market, where the
supply of goods meets current market demand. Declining stages indicate lagging consumer
demand for the goods or services supplied by businesses.

Product Niche
Once markets and business cycles are reviewed, companies will develop a product that
meets a specific niche in the market. Products must be differentiated from others in the
market so they meet a specific need of consumer demand, creating higher demand for their
product or service. Many companies will conduct tests in sample markets to determine
which of their potential product styles is most preferred by consumers. Companies will also
develop their goods so that competitors cannot easily duplicate their product.

Growth Potential
While every market has an initial level of consumer demand, specialized products or goods
can create a sense of usefulness, which will increase demand. Examples of specialized
products are iPods or iPhones, which entered the personal electronics market and increased
demand through their perceived usefulness by consumers. This type of demand quickly
increases the demand for current markets, allowing companies to increase profits through
new consumer demand.

Competition

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An important factor of market analysis is determining the number of competitors and their
current market share. Markets in the emerging stage of the business cycle tend to have fewer
competitors, meaning a higher profit margin may be earned by companies. Once a market
becomes saturated with competing companies and products, fewer profits are achieved and
companies will begin to lose money. As markets enter the declining business cycle,
companies will conduct a new market analysis to find more profitable markets.

4.3 Demand Function

A demand function that represents the behavior of buyers can be constructed for an
individual or a group of buyers in a market. The market demand function is the horizontal
summation of the individuals' demand functions. In models of firm behavior, the demand for
a firm's product can be constructed.
The nature of the "demand function" depends on the nature of the good considered and the
relationship being modeled. In most cases the demand relationship is based on an inverse or
negative relationship between the price and quantity of a good purchased. The demand for
purely competitive firm's output is usually depicted as horizontal (or perfectly elastic). In
rare cases, under extreme conditions, a "Giffen good" may result in a positively sloped
demand function. These Giffen goods rarely occur.

Individual Demand Function

The behavior of a buyer is influenced by many factors; the price of the good, the prices of
related goods (compliments and substitutes), incomes of the buyer, the tastes and preferences
of the buyer, the period of time and a variety of other possible variables. The quantity that a
buyer is willing and able to purchase is a function of these variables.

Market Demand Function

When property rights are no attenuated (exclusive, enforceable and transferable) the
individual's demand functions can be summed horizontally to obtain the market demand
function.

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4.4 Demand Forecasting

Forecasts are needed for marketing, production, purchasing, manpower, and financial
planning. Further, top management needs forecasts for planning and implementing long-term
strategic objectives and planning for capital expenditures.

More specifically, here are who and why they need to forecast:

Marketing managers – They use sales forecasts to determine optimal sales force
allocations, set sales goals, and plan promotions and advertising. Market share, prices, and
trends in new product development are also required.

Production planners – They need forecasts in order to: schedule production activities, order
materials, establish inventory levels and plan shipments. Other areas that need forecasts
include material requirements (purchasing and procurement), labor scheduling, equipment
purchases, maintenance requirements, and plant capacity planning.

The personnel department – It requires a number of forecasts in planning for human

resources. Workers must be hired, trained, and provided with benefits that are competitive
with those available in the firm‟s labor market. Also, trends that affect such variables as
labor turnover, retirement age, absenteeism, and tardiness need to be forecast for planning
and decision making.

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The bank – Banks have to forecast too. Demands of various loans and deposits Money and
credit conditions so that it can determine the cost of money it lends

4.4.1 Qualitative Forecasting Methods

The qualitative (or judgmental) approach can be useful in formulating short-term forecasts
and can also supplement the projections based on the use of any of the quantitative methods.

Four of the better-known qualitative forecasting methods are executive opinions, the Delphi
method, sales-force polling, and consumer surveys:

1. Executive Opinions

The subjective views of executives or experts from sales, production, finance, purchasing,
and administration are averaged to generate a forecast about future sales. Usually this
method is used in conjunction with some quantitative method, such as trend extrapolation.
The management team modifies the resulting forecast, based on their expectations.

The advantage of this approach: The forecasting is done quickly and easily, without need
of elaborate statistics. Also, the jury of executive opinions may be the only means of
forecasting feasible in the absence of adequate data.

The disadvantage: This, however, is that of group-think. This is a set of problems inherent
to those who meet as a group. Foremost among these are high cohesiveness, strong
leadership, and insulation of the group. With high cohesiveness, the group becomes
increasingly conforming through group pressure that helps stifle dissension and critical
thought. Strong leadership fosters group pressure for unanimous opinion. Insulation of the
group tends to separate the group from outside opinions, if given.

2. Delphi Method

This is a group technique in which a panel of experts is questioned individually about their
perceptions of future events. The experts do not meet as a group, in order to reduce the
possibility that consensus is reached because of dominant personality factors. Instead, the
forecasts and accompanying arguments are summarized by an outside party and returned to
the experts along with further questions. This continues until a consensus is reached.
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Advantages: This type of method is useful and quite effective for long-range forecasting.
The technique is done by questionnaire format and eliminates the disadvantages of group
think. There is no committee or debate. The experts are not influenced by peer pressure to
forecast a certain way, as the answer is not intended to be reached by consensus or
unanimity.

Disadvantages: Low reliability is cited as the main disadvantage of the Delphi method, as
well as lack of consensus from the returns.

3. Sales Force Polling

Some companies use as a forecast source salespeople who have continual contacts with
customers. They believe that the salespeople who are closest to the ultimate customers may
have significant insights regarding the state of the future market. Forecasts based on sales
force polling may be averaged to develop a future forecast. Or they may be used to modify
other quantitative and/or qualitative forecasts that have been generated internally in the
company.

The advantages of this forecast are:

 It is simple to use and understand.

 It uses the specialized knowledge of those closest to the action.
 It can place responsibility for attaining the forecast in the hands of those who most
affect the actual results.
 The information can be broken down easily by territory, product, customer, or
salesperson.

The disadvantages include: salespeople‟s being overly optimistic or pessimistic regarding

their predictions and inaccuracies due to broader economic events that are largely beyond
their control.

4. Consumer Surveys

Some companies conduct their own market surveys regarding specific consumer purchases.
Surveys may consist of telephone contacts, personal interviews, or questionnaires as a means

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 of obtaining data. Extensive statistical analysis usually is applied to survey results in order to
test hypotheses regarding consumer behavior.

Common Features and Assumptions Inherent in Forecasting

As pointed out, forecasting techniques are quite different from each other. But four features
and assumptions underlie the business of forecasting. They are:

 Forecasting techniques generally assume that the same underlying causal relationship
that existed in the past will continue to prevail in the future. In other words, most of our
techniques are based on historical data.
 Forecasts are rarely perfect. Therefore, for planning purposes, allowances should be
made for inaccuracies. For example, the company should always maintain a safety stock in
anticipation of a sudden depletion of inventory.
 Forecast accuracy decreases as the time period covered by the forecast (i.e., the time
horizon) increases. Generally speaking, a long-term forecast tends to be more inaccurate
than a short-term forecast because of the greater uncertainty.
 Forecasts for groups of items tend to be more accurate than forecasts for individual
items, because forecasting errors among items in a group tend to cancel each other out. For
example, industry forecasting is more accurate than individual firm forecasting.

4.4.2 Quantitative Forecasting

Quantitative forecasting models are used to forecast future data as a function of past data.
They are appropriate to use when past numerical data is available and when it is reasonable
to assume that some of the patterns in the data are expected to continue into the future.

Some of the quantitative methods:

A. Historical data forecasts – Grouped under historical data forecasts are the
followings:

 Naive methods/approach

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Naïve forecasts are the most cost-effective forecasting model, and provide a benchmark
against which more sophisticated models can be compared. In time series data, using naive
approach would produce forecasts that are equal to the last observed value. This method
works quite well for economic and financial time series, which often have patterns that are
difficult to reliably and accurately predict. If the time series is believed to have seasonality,
seasonal naive approach may be more appropriate where the forecasts are equal to the value
from last season.

Moving Average

 Simple moving averages

 Weighted moving average
When using a moving average method described before, each of the observations used to
compute the forecasted value is weighted equally. In certain cases, it might be beneficial to
put more weight on the observations that are closer to the time period being forecast. When
this is done, this is known as a weighted moving average technique. The weights in a
weighted Moving average must sum to 1.

Weighted MA(3) = Ft+1 = wt1(Dt) + wt2(Dt-1) + wt3(Dt-2)

The demand for defense machinery for a certain project is given each month as follows:

Month 1 2 3 4 5 6 7 8 9 10

Demand 120 110 90 115 125 117 121 126 132 128

The defense officer is asked to forecast the demand for the 11th month using three period
moving average techniques.
The defense officer has decided to use a weighting scheme of 0.5, 0.3, and 0.2 and calculated
the weighted moving average for the 11th month as follows.

Weighted MA (3): F11 = 0.5(128) + 0.3(132) + 0.2(126) = 64 + 39.6 + 25.2 = 128.2

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 B. Associative (causal) forecasts – Grouped under the associative forecasts are the
followings:

Simple regression

The linear trend is the most commonly used method of time series analysis. The following
are various trend projections used under various circumstances.

linear trend Y= a+bX

quadratic trend Y = a + bX + cX2
cubic trend Y = a + bX + cX2 + dX3
exponential trend Y= a e b/x
double log trend Y= a Xb

Linear Trend Equation:

Y = a + b X, Y = demand
X = time period and a,b constant values representing intercept and slope of the line. To
calculate Y for any value of X we have to solve the following equations,
(i) and (ii). We can derive the values of „a‟ and „b‟ through solving these equations and by
substituting the same in the above given linear trend equation we can forecast demand for
„X‟ time period.

∑Y = na + b∑X ----- (i)

∑XY = a∑X + b∑X2 ----- (ii)

Example:
Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Sales 22734 24731 31489 44685 55319 91021 146234 107887 127483 97275

Estimate the sales for 2012, 2015 and fit a linear regression equation and draw a trend line.

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 Year X Sales (Y) XY X2
2002 1 22734 22734 1
2003 2 24731 49462 4
2004 3 31489 94467 9
2005 4 44685 178740 16
2006 5 55319 276595 25
2007 6 91021 546126 36
2008 7 146234 1023638 49
2009 8 107887 863096 64
2010 9 127483 1147347 81
2011 10 97275 972750 100

∑X = 55 ∑Y= 748858 ∑XY= 5174955 ∑X2= 385

∑Y = na + b∑X ----- (i)

∑XY = a∑X + b∑X2 ----- (ii)

748858 = 10a + 55b ----- (i)

5174955 = 55a + 385 b ----- (ii)
Equation (i) x 3 5242006 = 70a + 385 b ----- (iii)
Equation (iii) –
(ii) 67051 = 15a

4470.07 =a

Substitute value of „a‟ in equation (i)

748858 = 44700 + 55 b
55b = 748858 – 44700

b =12802.8

Y = a+bX
Y = 4470.07 + 12802.8X

Sales for 2012 =4470.07 + 12802.8(11) = 145300.87

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Sales for 2015 =4470.07 + 12802.8(14) = 183709.27

Summery
Demand forecasting is a prediction or estimation of the future demand. In this chapter we
have looked at a range of demand estimation and forecasting techniques which can be used
by the firm either singly or in combination in order to predict the level of demand for their
product(s). The choice of technique will depend upon the resources at the firm‟s disposal,
the cost to the firm of insufficient knowledge of the market(s) in which it operates and the
ease with which information can be obtained. Each of the methods we have considered has
its own advantages and disadvantages in its use and there is no „right‟ or „wrong‟ approach
in any given situation. It is for the decision maker to choose the technique(s) which are most
appropriate to the firm‟s needs. As a general principle, however, the more, and the more
accurate, information the firm has the better able it will be to take the best decisions
possible for the firm‟s efficient operation. Thus the firm can substantially reduce the risk to
which it will be exposed, particularly in rapidly changing markets.
Sales forecasts can be developed using qualitative methods, such as expert opinion, the
Delphi method, or market surveys or by using quantitative models, such as exponential
smoothing, time series decomposition, or multiple regression analysis. In many cases, firms
use a combination of qualitative and quantitative forecasting techniques. The use of more
than one sales forecast method is advisable because doing so can reduce errors in the final
forecast. Forecasting, on the other hand, attempts to predict the overall level of future
demand rather than looking at specific linkages. For this reason the set of techniques used
may differ, although there will be some overlap between the two.
In general, an estimation technique can be used to forecast demand but a forecasting
technique cannot be used to estimate demand. A manager who wishes to know how high
demand is likely to be in two years‟ time might use a forecasting technique. A manager who
wishes to know how the firm‟s pricing policy could be used to generate a given increase in
demand would use an estimation technique.
The firm needs to have information about likely future demand in order to pursue optimal
pricing strategy. It can only charge a price that the market will bear if it is to sell the
product. On one hand, over-optimistic estimates of demand may lead to an excessively high

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price and lost sales. On the other hand, over-pessimistic estimates of demand may lead to a
price which is set too low resulting in lost profits. The more accurate, information the firm
has, the less likely it is to take a decision which will have a negative impact on its operations
and profitability. The level of demand for a product will influence decisions, which the firm
will take regarding the non-price factors that form part of its overall competitive strategy.
For example, the level of advertising it carries out will be determined by the perceived need
to stimulate demand for the product. As advertising expenditure represents an additional
cost to the firm, unnecessary spending in this area needs to be avoided. If the firm‟s
expectations about demand are too low it may try to compensate by spending large sums on
advertising, money which in this instance may be, at least, partly wasted. Alternatively it
may decide to redesign the product in response to this, thus incurring unnecessary
additional costs in the form of research and development expenditure.

Self Test Exercise 4:

Part I: Write “True” if the statement is correct and “False” if the statement is
incorrect.

1) The manager must understand clearly the assumptions on which a particular

forecast method is based to obtain maximum benefit.

2) Forecasting is done both for only long run.

3) The first step of market analysis is to define and identify the specific market
to target with new products or services.

4) An important factor of market analysis is determining the number of

competitors and their current market share.

5) The quantitative (or judgmental) approach can be useful in formulating short-

term forecasts

6) Naïve forecasts are the most cost-effective forecasting model, and provide a
benchmark against which more sophisticated models can be compared.

7) The firm needs to have information about likely future demand in order to
pursue optimal pricing strategy.

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Part II: Choose the correct answer & encircle the letter of your choice.

1) Forecasts are needed for all but not one?

A. Marketing
B. Production
C. Purchasing
D. manpower and financial planning
E. All
F. None
2) Products must be differentiated from others in the market because of ____

A. To meet a specific need of consumer demand

B. Creating higher demand for their service.
C. Creating higher demand for their product.
D. To Niche in the market
E. All
F. None

3) A forecast aids for all of the following purpose except one;

A. Determining volume of production
B. Determining inventory needs
C. Determining labor hours required
D. Determining cash requirements, and financing needs.
E. All
F. None
4) Management in both private and public organizations typically operates under
conditions of _______
A. Uncertainty
B. Risk.
C. Certainty
D. A and B
E. None
5) One of the following is not features and assumptions underlie the business of
forecasting.
A. Forecasting techniques generally assume that the same underlying causal
relationship that existed in the past will continue to prevail in the future.
B. Forecasts are rarely perfect.
C. Forecast accuracy decreases as the time period covered by the forecast (i.e.,
the time horizon) increases.
D. All
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 E. None

Part III: Fill in the Blank Space

1. _______ is making a prediction or estimation about the future.

2. _____ is a group technique in which a panel of experts is questioned individually about
their perceptions of future events. The experts do not meet as a group.

Unit Five: Decision Making Under Risk and Uncertainty

Introduction
Dear learners, this is the fifth unit of the course Managerial economics. In this unit you
are going to look about Decision making mainly Under Risk and Uncertainty. Hundreds of
decisions are made every day in the operations activity. Each minor decision determines the
company's success or failure. It ranges from simple judgmental to complex analysis which
can also involve judgment (past experience and common sense). They involve a way of
blending objective and subjective data to arrive at a choice. The use of quantitative methods
of analysis adds to the objectivity of such decisions. Quantitative approaches to problem

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 solving often embody an attempt to obtain mathematically optimum solutions to managerial
problems. The functions are commonly used quantitative approaches like, linear
programming, Queuing techniques, Inventory models, Forecasting techniques, Statistical
models. Operation decision become more complex when: it involves many variables, the
variable are highly interdependent or related, and the data describing the variables are
incomplete or uncertain. The necessity of working with incomplete and uncertain data has
always been a problem for decision maker. The following figure depicts the information
environment decisions.

Unit Objectives: At the end of this unit, you will be able to:
 Know about the nature of decision making;

 Understand what does decision under the condition of risk mean;

 Understand what decision under the condition of uncertainty means.

5.1 The Nature of Decision Making

Making effective decisions, as well as recognizing when a bad decision has been made and
quickly responding to mistakes, is a key ingredient in organizational effectiveness. Some
experts believe that decision making is the most basic and fundamental of all managerial
activities. Decision making is most closely linked with the planning function. However, it is
also part of organizing, leading and controlling.

5.1.1 Types of Decisions

Programmed decision is one that is fairly structured or recurs with some frequency (or both).
Non programmed decision is one that is unstructured and occurs much less often than a
programmed decision.

5.1.2 Decision-Making Conditions

[Link] Decision Making Under Certainty

A state of certainty exists when a decision maker knows, with reasonable certainty, what the
alternatives are and what conditions are associated with each alternative. Very few
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organizational decisions, however, are made under these conditions. The complex and
turbulent environment in which businesses exist rarely allows for such decisions.

[Link] Decision Making Under Risk

A state of risk exists when a decision maker makes decisions under a condition in which the
availability of each alternative and its potential payoffs and costs are all associated with
probability estimate. Decisions such as these are based on past experiences, relevant
information, the advice of others and one‟s own judgment. Decision is „calculated‟ on the
basis of which alternative has the highest probability of working effectively.

[Link] Decision Making Under Uncertainty

A state of uncertainty exists when a decision maker does not know all of the alternatives, the
risks associated with each, or the consequences each alternative is likely to have. Most of the
major decision making in today‟s organizations is done under these conditions. To make
effective decisions under these conditions, managers must secure as much relevant
information as possible and approach the situation from a logical and rational view. Intuition,
judgment and experience always play major roles in the decision-making process under these
conditions.

5.2 Meaning of Risk and Uncertainty

When one is examining the decision-making process under conditions of imperfect
information, it is important to distinguish between the closely related concepts of risk and
uncertainty. Risky situations involve multiple outcomes (or payoffs), where the probability of
each outcome is known or can be estimated. An example of a risky situation is the flipping of
a fair coin. The probability that either a head or a tail will result from flipping a fair coin is
50%. Investing in the stock market is another risky situation. While the investor cannot know
with certainty the rate of return on the investment, it is possible to estimate an expected rate of
return based on a company‟s past performance.

Definitions: Risk involves choices. Involves multiple possible outcomes in which the
probability of each outcome is known or may be estimated.
Uncertainty also involves multiple-outcomes situations. What distinguishes risk from
uncertainty, however, is that with uncertainty the probability of each outcome is unknown and

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cannot be estimated. In many cases, these probabilities cannot be estimated because of the
absence of historical evidence about the event. Nevertheless, there is a fine line between
decision making under conditions of risk and of uncertainty.

Uncertainty involves choices involving multiple possible outcomes in which the probability of
each outcome is unknown and cannot be estimated.
When one is considering the different ways in which manager‟s deal with uncertain outcomes,
it is important to distinguish between two types of uncertainty. In situations of complete
ignorance, the decision maker is unable to make any assumptions about the probabilities of
alternative outcomes under different states of nature. In these situations, the decision maker
may adopt any of a number of rational criteria to facilitate the decision-making process.
Situations involving partial ignorance, on the other hand, assume that the decision maker is
able to assign subjective probabilities to multiple outcomes. Whenever the decision maker is
able to use personal knowledge, intuition, and experience to assign subjective probabilities to
outcomes, then decision making under uncertainty is effectively transformed into decision
making under risk.
The procedures for evaluating outcomes of decisions made under conditions of risk, or
uncertainty involving partial ignorance, are identical, the process of evaluating outcomes
under conditions of complete ignorance requires alternative approaches to the decision-making
process.

5.3 Measuring Risk: Mean, Variance and Coefficient of Variation

Mean (Expected Value)

The manager must know the possible outcomes of a particular event, action or decision. The
manager must be aware of the probability of risks in business. (Probability means likelihood
that a given outcome will occur).
For example; a purchase of share may lead to three probable results i.e. either the price will
increase, decrease or it can be the same. Objective interpretation relies on the frequency with
which certain events tend to occur. Out of 100 shares, if 25 have increased and 75 have
remained in the same level in the market then the probability of incurring profit is ¼. If there
is no past experience then we go for subjective probability and based on our perception of
occurrence we may measure the probability. But manager‟s perceptions differ therefore they
make different choices. In general probabilities are measured in two ways they are expected
value and variability.
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Expected value: The probable payoffs associated with all possible outcomes are called as
expected value.

The most commonly used summary measures of risky, random payoffs are the mean and the
variance. These random payoffs may refer to profits, capital gains, prices, unit sales, and so
on. In risky situations, the expected value of these random payoffs is called the mean. The
mean is the weighted average of all possible random outcomes, with the weights being the
probability of each outcome. For discrete random variables, the expected value may be
calculated using Equation (5.1)

(x)= (5.1)

Where xi is the value of the outcome, pi is the probability of its occurrence.

When the probability of each outcome is the same as the probability of every other outcome,
then the expected value is the sum of the outcomes divided by the number of observations. In
this case, the expected value of a set of uncertain outcomes may be calculated using Equation
(5.2)

(x)= (5.2)

Definition: The mean is the expected value of a set of random outcomes. The mean is the sum
of the products of each outcome and the probability of its occurrence. When the probability of
the occurrence of each outcome is the same as the probability of every other outcome, the
mean is the sum of the outcomes divided by the number of observations.

[Link] that the chief economist of Silver Zephyr Ltd. believes that there is a 40%
(p1 = 0.4) probability of a recession in the next operating period and a 60% (p2 = 0.6)
probability that a recession will not occur. The COO of Silver Zephyr believes that the firm
will earn profits of p1 = $100 in the event of a recession and p2 = $1,000 otherwise. What are
Silver Zephyr‟s expected profits?

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Solution: Silver Zephyr‟s expected profits are:

(
0.4
40+600 =640
Thus, Silver Zephyr‟s expected profits for the next operating period are$640.

Variance (Variability): The extent to which the possible outcomes of an uncertain situation
differ. This difference is called as deviation; it means difference between expected outcome
and the actual outcome.
The strength of the mean is its simplicity. In a single number, the mean (expected value)
summarizes important information about the most likely outcome of a set of random payoffs.
Unfortunately, this strength hides other important information that is valuable to the decision
maker. For example, suppose that an individual is offered the following fair wager. If the
individual flips a coin and it comes up heads, then the individual wins $10. On the other hand,
if the coin comes up tails, then the individual loses $[Link] reader should verify that the
expected value of the wager is $0. Suppose, on the other hand the payoffs were $1,000 and -
$1,000 for a head and tail, respectively. Once again, the reader will verify that the expected
value of the wager is $[Link] the expected values of the two wagers are the same, clearly the
wagers themselves are different While the potential payoff is much greater than in the second
scenario, so too is the potential loss. While the individual may be prepared to accept the first
bet, that person may not be willing to accept the second because the possibility of such a large
loss may be unacceptable. For this individual, the second wager may simply be too risky.
The second wager is riskier because the spread, or dispersion, of the possible payoffs is
greater. Each has the same expected value, but the swing between a gain and a loss is
considerably greater. It is this dispersion in the possible payoffs that is the distinguishing
characteristic of risk. The most commonly used measure of the dispersion of a set of random
outcomes is the variance.
The variance is the weighted average of the squared deviations of all possible random
outcomes from its mean, with the weights being the probability of each outcome. The variance
of a set of random payoffs may be calculated by using Equation (5.3).
( = = ( pi (5.3)

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When the probability of each outcome is the same, then the variance is simply the sum of the
squared deviations divided by the number of outcomes.

( = = ( (5.4)

Definition: The variance of a set of random outcomes is the expected value of the squared
deviations of an outcome from its mean. The variance is a measure of the dispersion of a data
series around its expected value.
The greater the dispersion, the greater the value of the variance. The variance is the sum of the
products of the square of the deviation of each outcome from its mean and the probability of
the occurrence of the outcome. When the probability of the occurrence of each outcome is the
same as the probability of the occurrence of every other outcome, the mean is the sum of the
squared deviations divided by the number of outcomes.
Denoting a win and a loss as x1 and x2, respectively, the variances of the two wagers,

= ( = 100

=(
0.5(1,000,000) +0.5(1,000,000)=1,000,000

> , then the second wager is riskier than the first.

An alternative way to express the riskiness of a set of random outcomes is the standard
deviation. The standard deviation is simply the square root of the variance, s.

Definition: The standard deviation is the square root of the variance

For the foregoing wagers the standard deviations are =

since the standard deviation is a monotonic

transformation of the variance, the ordering of relative risks of the wagers is preserved. Thus,
since > the second wager is riskier than the first.

Coefficient of Variation (CV)

Unfortunately, neither the variance nor the standard deviation can be used to compare the
riskiness involving two or more risky situations with different expected values. The reason for

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this is that neither measure is independent of the units of measurement. To measure the
relative riskiness of two or more outcomes, we may use the coefficient of variation, which
maybe calculated by using Equation (5.5). The coefficient of variation allows us to compare
the riskiness of alternative projects by “normalizing” the standard deviation of each by its
expected value.

Cv= (5.5)

Definition: The coefficient of variation is a dimensionless number that is used to compare

risk involving two or more outcomes involving different expected values. It is calculated as
the ratio of the standard deviation to the mean.
Problem2. Suppose that capital investment project A has an expected value of $100,000
and a standard deviation of A = $30,000. Additionally, suppose that project B has an
expected value = $150,000 and a standard deviation of = $40,[Link] is the
relatively riskier project?
Solution: From Equation (14.6) the relative riskiness of projects A and B are

CVA= = = 0.3

CVB= = = 0.267

Thus, although project B has the larger standard deviation, it is the relativelyless risky project.

5.4 Types of Risks

Economic Risk: Choice of loss due the fact that all possible outcomes and their probability of
occurrence is unknown.
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 Uncertainty: When the outcomes of managerial decisions cannot be predicted with absolute
accuracy but all possibilities and their associated probabilities of occurrence are known.
Business risk: Chance of loss associated with a given managerial decision.
Market risk: Chance that a portfolio of investments can lose money due to volatility in the
financial market.
Inflation risk: A general increase in the price level will undermine the real economic value of
any legal agreement that involves a fixed promise to pay over an extended period.
Interest rate risk: The changing interest rates affect the value of any agreement that involves
a fixed promise to pay over a specified period.
Credit risk: May arise when the other party fails to abide by the contractual obligations.
Liquidity risk: Difficulty of selling corporate assets and investments.

Derivative risk: Chance that volatile financial derivatives could create losses on investments
by increasing price volatility.
Cultural risk: Risk may arise due to loss of markets differences due to distinctive social
customs.
Currency risk: Is the probable loss due to changes in the domestic currency value in terms of
expected foreign currency.
Government policy risk: Chance of loss because of domestic and foreign government
policies.

The above listed various types of risks are involved in business. Therefore it is essential for the
manager to understand the type of risk and strategies to overcome the same Preference towards
risk

Manager‟s attitudes toward risk affect the decision making. The preference towards risk is
classified as, risk loving, risk aversion and risk neutral.

1. Risk loving: Arises when the payoff is greater than the expected value.

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2. Risk Aversion: Is the behavior of the mangers when the payoff is less than the expected value.

3. Risk neutral: Behavior takes place when the expected value is equal to thepayoff.

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Decision under Uncertainty:
1. The maximax rule: Deals with selecting the best possible outcomefor each decision
and choosing the decision with the maximum payoff for all the best outcomes.
2. The Maximin rule: Deals with selecting a worst outcome for eachinvestment
decision and choosing the decision with the maximum worst payoff.
3. The Minimax rule: Deals with determining the worst potential regret associated
with each, decision, then choosing the decision with the minimum worst potential
regret.

5.5 Decision Making Under Uncertainty with Complete Ignorance

It was mentioned earlier that whenever the decision maker is able to use personal knowledge,
intuition, and experience to assign subjective probabilities to outcomes, decision making under
uncertainty is transformed in to decision making under risk. These situations were described as
decision making under conditions of uncertainty with partial ignorance. When managers are
unable to assign probabilities to alternative outcomes, some other rational decision-making
criteria must be used. As mentioned earlier, this is referred to as decision making under
conditions of uncertainty with complete ignorance. In this section we will examine four such
rational decision criteria: the Laplace criterion, the Wald (maximin) criterion, the Hurwicz
criterion, and the Savage (minimax regret) criterion. No single decision rule is appropriate for all
decision-making situations. The choice of the criterion should be appropriate to the
circumstances and consistent with organizational objectives and philosophy.

Laplace Decision Criterion

Under conditions of risk or partial ignorance, however, the decision maker may be able to assign
objective or subjective probabilities to the different states of the economy. These probabilities (in
parentheses), and the expected values of the payoffs from each strategy, (Si) = , are
summarized in Figure 5.2. As in the Slumlords‟ Dilemma, if management decides to adopt the
pricing strategy with the highest expected rate of return, then the best strategy is to “raise price.”
The most significant draw- back of this decision is that it fails to consider management‟s attitude
toward risk.
Economy
Expansion Stability Contraction
25 15 -10
Strategy Raise price
15 20 -5
No change 15 0 5

Lower price

Fig. 5.1 Payoff matrix for pricing strategies under alternative state of nature

If the manager estimates the probability of the occurrence of expansion, stability and contraction
of the economy as 35%, 50% and 15% respectively, then the as follows:

Economy
Expansion Stability Contraction

Raise price 25(0.35) 15(0.5) -10(0.15) 14.75 11.34

Strategy
15(0.35) 20(0.5) -5(0.15) 9.5 9.86
No change 15(0.35) 0(0.5) 5(0.15) 6 6.8

Lower price

Fig. 5.2 Decision making under risk: expected values and standard deviations of returns for each
pricing strategy with different probabilistic outcomes.

Definition: The Laplace decision criterion transforms decision making under complete
ignorance to decision making under risk by assuming that all possible outcomes are equally
likely.
 Economy
Expansion Stability Contraction

Raise price 25(0.333) 15(0.333) -10(0.333) 10 14.71

Strategy
15(0.333) 20(0.333) -5(0.333) 10 10.79
No change 15(0.333) 0(0.333) 5(0.333) 6.67 6.23

Lower price

Fig. 5.3 Laplace decision criteria: expected values and standard deviations for each pricing
strategy assuming equal probabilistic outcomes.

Definition: The Wald (maximin) decision criterion is a decision-making approach in the

presence of complete ignorance that involves the selection of the largest payoff from among the
worst possible payoffs.
The Wald decision criterion represents an extremely risk-averse approach to decision making in
the presence of complete ignorance. In essence, the Wald decision criterion attempts to
maximize management‟s feelings of security; in Figure 5.4 the indicated solution is a “lower
price” strategy with a maximin payoff of 0, which stands in contrast to the selection of a “no
change” pricing strategy obtained by using the Laplace decision criterion.

Economy
Expansion Stability Contraction
25 15 -10 -10 25*
Strategy Raise price
15 20 -5 -5 20
No change 15 0 5 0* 15

Lower price
Fig. 5.4Wald (maxmin) decision criterion

While the maximin strategy represents an extremely pessimistic approach to the decision-making
process, a maximax strategy by contrast is extremely optimistic. Managers who use this
approach will select as optimal that strategy that promises the best of the best of all possible
outcomes.
In the situation depicted in Figure 5.4, the decision to raise price represents one such maximax
strategy. But, how likely is it that this, or any, firm would knowingly adopt such a strategy? The
selection of a maximax strategy suggests that managers are risk lovers who are willing to
gamblewith the firm‟s assets in the hope of a big payoff, which in Figure 5.4occurs with
economic expansion. Under the other two phases of the business cycle, this firm will earn the
lowest possible payoff. Since managers are ultimately responsible to the shareholders, it is very
unlikely that such a strategy would ever be adopted. So why is it presented here? Minimax and
maximax decision criteria are two extreme examples of the Hurwicz decision criteria.
The Savage decision criterion, which is sometimes referred to as the minimax regret criterion, is
based on the opportunity cost (or regret) of selecting an incorrect strategy. In this instance,
opportunity costs are measured as the absolute difference between the payoffs for each strategy
and the strategy that yields the highest payoff from each state of nature. Once these opportunity
costs have been estimated, the manager will select the strategy that results in the minimum of all
maximum opportunity costs.
Definition: The Savage decision criterion is used to determine the strategy that results in the
minimum of all maximum opportunity costs associated with the selection of an incorrect
strategy.
Figure 5.5 illustrates the calculations of the opportunity costs for the payoffs summarized in
Figure 5.1 For example; the maximum possible payoff during an economic expansion is 25 for a
“raise price” strategy. The absolute difference between the maximum payoff and the payoffs
from each strategy during an economic expansion are calculated and summarized in each cell of
the matrix. Figure 5.5 summarizes the maximum regret (opportunity cost) from each strategy.
The minimum of these maximum opportunity costs, which is identified with an asterisk, is the
strategy that will be selected by means of the Savage decision criterion.
Neither overly optimistic nor overly pessimistic, the Savage decision criterion is most
appropriate when management is interested in earning a satisfactory rate of return with moderate
levels of risk over the long term.
Thus, the Savage decision criterion may be more appropriate for long-term capital investment
projects.
Economy
Expansion Stability Contraction
=0 =5 =15 15
Strategy Raise price
=10 =0 =10 10*
No change
= 10 =20 =10 20
Lower price
Fig. 5.5 Savage regret matrix

There are four ways to manage the risk and uncertainty:

1. Insurance ( Business risks are transferred through Insurance Policies)
2. Hedging is a mechanism whereby the expected loss is to be offset by an expected profit
from another contract.
3. Diversification is a method of managing the risk where the risk is spread to various
investments and thus the risk is minimized to each investment.
4. Adjusting risk is the mechanism whereby the provision is made to offset the expected
loss.
 Summary
In the decision rules discussed so far, an assumption of certainty has been developed in
which the manager is certain about the marginal benefits and marginal costs associated with
the decision he/she has taken. However, decision can also be undertaken under the condition
of risk and uncertainty. For instance, although a manager does not know the marginal
benefits and marginal costs in advance, he/she may decide to invest in a new production
facility with the expectation that the new technology will reduce production cost. As a result,
there are basic rules that the decision makers can used to make decision under risk and
uncertainty. Before dealing with decision making rules under risk and uncertainty, it is better
to define the terms risk and uncertainty. Accordingly, Risk is a decision making condition
under which a manager can list all outcomes and assign probabilities to each outcome.
Uncertainty is a decision making condition under which a manager cannot list all possible
outcomes and/or cannot assign probabilities to the various outcomes.
Expected value rule: since the costs and benefits are not known in advance, the decision
is based on expectation. So the decision with the maximum or highest expected value would be
chosen. Coefficient of variation rule: the expected value rule only focuses on a decision which
gives maximum expected value regardless of the level of risk associated with the decision but this
rule considers both the expected value and the coefficient of variation for risk which directly
related with the level risk. Thus, according to this rule the decision to be chosen should be the
one with the higher expected value, smallest coefficient of variation, and low level of risk. Note
that if we consider the managers‟ attitude towards risk-risk averse, risk loving and risk neutral-
these attitudes become directly related to the marginal utility for profit. Thus, the marginal
utilities for profit of the risk averse, risk lover and risk neutral decision makers will be
diminishing, increasing and constant respectively. This phenomenon is known as the expected
utility theory of decision under risk.
 Self Test Exercise 5:
Part I: Write “True” if the statement is correct and “False” if the statement is
incorrect.

1) Since decision can mainly be made under risk and uncertainty, each minor
decision determines the company's success or failure.

2) Quantitative approaches to problem solving often embody an attempt to obtain

mathematically optimum solutions to managerial problems.

3) Making effective decisions, as well as recognizing when a bad decision has been
made and quickly responding to mistakes, is a key ingredient in organizational
effectiveness.
4) The most commonly used summary measures of risky, random payoffs are the
mean and the variance.

5) The manager must be aware of the probability of risks in business.

Part II: Choose the correct answer & encircle the letter of your choice.

1) From the following, one is not true about Decision Making under Certainty

A. A state of certainty exists when a decision maker knows, with reasonable certainty,
what the alternatives are and what conditions are associated with each alternative.
B. Very few organizational decisions, however, are made under these conditions.
C. The complex and turbulent environment in which businesses exist rarely allows
for such decisions.
D. All
E. None
2) _____ Can exists when a decision maker makes decisions under a condition in
which the availability of each alternative and its potential payoffs and costs are all
associated with probability estimate.
A. Decision Making under Certainty exists
B. Decision Making under uncertainty exists
C. Decision Making under risk exists
 D. When all exists
E. None

3) The probable payoffs associated with all possible outcomes are called as____
A. Expected Value
B. Variance
C. Standard deviation
D. None
4) ______ is the extent to which the possible outcomes of an uncertain situation differ.
A. Variance
B. Mean
C. Variability
D. A and C
E. All
5) _______is a dimensionless number that is used to compare risk involving two or
more outcomes involving different expected values
A. Coefficient of Variation
B. Variance
C. Standard Deviation
D. None

6) ____ is a Chance that a portfolio of investments can lose money due to volatility in
the financial market.
A. Market risk D. Uncertainty
B. Business risk E. None
C. Economic Risk
Part III: Fill In the Blank Space
1. ______ Decision is one that is unstructured and occurs much less often than a
programmed decision.

2. _______involves multiple possible outcomes in which the probability of each outcome is

known or may be estimated.

3. ________involves choices involving multiple possible outcomes in which the probability

of each outcome is unknown and cannot be estimated.
 Unit Six: Theory of Production
Introduction
Production process involves the transformation of inputs into output. The inputs could be land,
labour, capital, entrepreneurship etc. and the output could be goods or services. In a production
process managers take four types of decisions: (a) whether to produce or not, (b) how much
output to produce, (c) what input combination to use, and (d) what type of technology to use.
This Unit deals with the analysis of managers‟ decision rules concerning (c) and (d) above. In
this unit, we shall begin with a general discussion of the concept of production function. The
analysis of this unit mainly focuses on the firms that produce a single product. Analysis on
decisions related to multiproduct firms is also given briefly. The nature of production when there
is only one variable input is taken up first. We then move on to the problem of finding optimum
combination of inputs for producing a particular level of output when there are two or more
variable inputs. You will learn various functional forms of production frequently used by
economists and their empirical estimation. The unit concludes with the production decisions in
case of product mix of multiproduct firms.

Unit Objectives: At the end of this unit, you will be able to:
 Familiarize with the concepts and rules relevant for production decision analysis;
 Understand the economics of production;
 Understand the set of conditions required for efficient production.

6.1 Some Basic Concepts of Production Theory

6.1.1 Production Defined
Dear learners, what does production mean to you? (Use the space provided below to write
your view)
______________________________________________________________________________
_____________________________________________________________________________
This unit examines the theory of producer behavior which is the supply side of the market.
In this theory of production, firms organize/combine resources or inputs such as labor, capital,
land and entrepreneurship and so on, to produce final goods and services. Thus, production refers
to the process of converting inputs into outputs. In other words, production is the creation of
goods and services from inputs or resources, such as labor, machinery and other capital
equipment, land, raw materials, and so on.

Examples: when a company such as Ford makes a truck or car or when Exxon refines a gallon of
gasoline, the activity is production. But production goes much further than that. A doctor
produces medical services, a teacher produces education, and a singer produces entertainment.
So production involves services as well as making the goods people buy. Production is also
undertaken by governments and non-profit organizations. A city police department produces
protection, a public school produces education, and a hospital produces health care.

The following points are worth noting about the notion of production:
 Production may not involve physical conversion of raw materials into tangible goods.
Some kinds of production may involve an intangible input to produce an intangible output.
For example, in the production of legal, medical, social and consultancy services both input
and output are intangible. Lawyers, doctors, social workers, consultants, hairdressers,
musicians, orchestra players are all engaged in producing intangible goods.
 Production process may take a variety of forms other than manufacturing. For example,
transporting a commodity from one place to another where it can be used is production. Such
activities too are 'production'. Storing a commodity for future sale or consumption is also
'production'. Wholesaling, retailing, packaging, assembling are all productive activities.
These activities are just as good examples of production as manufacturing.
6.1.2 An Input
An input is a good or service that goes into the process of production. In other words, an input is
simply anything which the firm buys for use in its production or other process for sale.
Inputs can be classified into
1. Labor (including entrepreneurial talent);
2. Capital;
3. Land or natural resources;
4. Raw materials;
 5. Times

Inputs are also classified as (i) fixed inputs (ii) variable inputs. A fixed input is one for which
the level of usage cannot readily be changed. To be sure, no input is ever absolutely fixed, no
matter how short the period of time under consideration. However, the cost of immediately
varying the use of an input may be so great that, for all practical purposes, the input is fixed. For
example, buildings, major pieces of machinery, and managerial personnel are inputs that
generally cannot be rapidly augmented or diminished. A variable input, on the other hand, is
one for which the level of usage may be changed quite readily in response to desired changes in
output. Many types of labor services as well as certain raw and processed materials would be this
category.

6.1.3 An Output
On the other hand, is any good or service that comes out of production process.
 The output of a firm can be a final commodity (such as home automobile) or an intermediate
product, such as semiconductors (which are used in the production of computers and other
goods).
 The output can be a service rather than a good. Examples of services are education, medicine,
banking, communication, transportation, and many others.

6.1.4 Short-run and Long-run

The short-run refers to a period of time in which the supply of certain inputs (example, plant,
building, and machines, etc.) is fixed or inelastic. In the short-run, therefore, production of a
commodity can be increased by increasing the use of only variable inputs, like labor and raw
materials. Long-run refers to a period of time in which the supply of all the inputs is elastic, but
not enough to permit a change in technology. That is, in the long run, all the inputs are variable.
Therefore, in the long-run production of a commodity can be increased by employing more or
both, variable and fixed, inputs. To sum up, it can be said that the firm operates in the short-run
and plans increases or reductions in its scale of operation in the long run.
6.2 Production Function
A production function is the link between levels of input usage and attainable levels of output.
That is, the production formally describes the relation between physical rates of output and
physical rates of input usage. A production function is a schedule (or table or mathematical
equation) showing the maximum amount of output that can be produced from any specified set
of inputs, given the existing technology or state of the art of production.
Q  f ( X 1 , X 2 ,..., X n )
For the sake of illustration, let‟s consider the simple case of production function in which only
two inputs are involved in the production process (usually labor and capital).
Q  f ( L, K )

Where, Q = Quantity produced;

L = Labor
K = Capital
However, we must stress that the principles to be developed apply to situations with more than
two points and, as well, to inputs other than capital and labor.

6.2.1 Technical Efficiency and Economic Efficiency

Technical efficiency is achieved when the maximum possible amount of output is being
produced with a given combination of inputs. The definition of a production function assumes
that technical efficiency is being achieved because the production function gives the maximum
output level that can be achieved for any particular combination of inputs. Thus, technical
efficiency is implied by the production function.

Economic efficiency is achieved when the firm is producing a given amount of output at the
lowest possible cost. One should be careful about labeling a particular production process
inefficient. Certainly a process would be technically inefficient if another process can produce
the same amount of output using less or one or more inputs and the same amounts of all others.
If, however, the second process uses less of some inputs but more of others, the economically
efficient method of producing a given level of output depends on the prices of the inputs. Even
when both are technically efficient, one process might cost less- be economically efficient- under
one set of input prices while the other may be economically efficient at other input prices.
6.3 Production Function in the Short Run (Optimization in the Case of one
Variable Input)
The supply of the fixed inputs remained unchanged (i.e., supply inelastic) so that there are only
one variable input and one fixed input Thus, production of a commodity increased by using more
of the variable inputs. In the short run, the firm faces a decision problem on how much of
variable inputs should be employed with a given employment of fixed inputs. To address this
issue, one needs a clear understanding of relationship among the total, average, and marginal
productivity of factors.

Total Product (TP): the total amount of output produced as a result of employing all the inputs.
TP  Q  f ( L, K )  f ( L)
Suppose a firm with a production function of the form Q = f (L, K) can, in the long run, choose
levels of both labor and capital between 0 and 10 units. A production function giving the
maximum amount of output that can be produced from every possible combination of labor and
capital is shown in Table 6.1. For example, from the table, 4 units of labor combined with 3 units
of capital can produce a maximum of 325 units of output; 6 labor and 6 capital can produce a
maximum of 655 units of output; and so on. Note that with 0 capital, no output can be produced
regardless of the level of labor usage. Likewise, with 0 labor, there can be no output.

Once the level of capital is fixed, the firm is in the short run, and output can be changed only by
varying the amount of labor employed. Assume now that the capital stock is fixed at 2 units of
capital. The firm is in the short run and can vary output only by varying the usage of labor (the
variable input). The column in Table 6.1 under 2 units of capital gives the total output, or total
product of labor, for 0 through 10 workers. This column, for which K = 2, represents the short-
run production function when capital is fixed at 2 units.

These total products are reproduced in column 2 of Table 6.1 for each level of labor usage in
column 1. Thus, columns 1 and 2 in Table 6.2 define a production function of the form
Q  f ( L, K ) , where K = 2. In this example, total product (Q) rises with increases in labor up to

a point (9 workers) and then declines. While total product does eventually fall as more workers if
they knew output would fall. A manager can hire either 8 workers or 10 workers to produce 314
units of output. Obviously, the economically efficient amount of labor to hire to produce 314
units is eight workers.

Average Product (AP): the total product per unit of variable input.
AP  TP / L  Q / L
In our example, average product, shown in column 3, first rises, reaches a maximum at 56.7, then
declines thereafter.
Marginal Product (MP): is the additional output attributable to using one additional worker
with the use of all other inputs fixed (in this case, at 2 units of capital). That is,
MP  TP / L  Q / L where means "the change in." The marginal product schedule
associated with the production function in Table 6.2 is shown in column 4 of the table. Because
no output can be produced with 0 workers, the first worker adds 52 units of output; the second
adds 60 units (i.e., increase output from 52 to 112); and so on.

Units of capital (K)

0 1 2 3 4 5 6 7 8 9 1
0

0 0 0 0 0 0 0 0 0 0 0 0

1 120
0 2 5 7 9 1 1 1 120
1 1
5 2 4 0 0 0 1 1 2
Units of labor (L)

0 8 4 8 1

2 0 5 1 1 1 2 2 2 2 2 2
5 1 6 9 2 4 5 5 6 6
2 2 8 4 2 2 8 2 4

3 0 8 1 2 3 3 3 3 3 4 4
3 7 4 0 4 6 8 9 0 0
0 7 3 2 9 4 4 0 3
 4 0 1 2 3 4 4 4 5 5 5 5
0 2 2 0 5 8 1 2 3 4
8 0 5 0 3 8 1 7 5 0

5 0 1 2 3 4 5 5 6 6 6 6
2 5 9 7 4 9 3 5 6 7
5 8 0 8 3 0 1 3 3 0

6 0 1 2 4 5 5 6 7 7 7 7
3 8 2 2 9 5 0 3 4 5
7 6 5 3 8 5 4 2 4 3

7 0 1 3 4 5 6 7 7 8 8 8
4 0 5 5 4 0 6 0 1 2
1 4 3 9 3 8 6 0 4 5

8 0 1 3 4 5 6 7 8 8 8 8
4 1 7 8 7 5 1 5 7 8
3 4 4 7 9 3 8 7 3 5

9 0 1 3 4 6 7 7 8 9 9 9
4 1 8 0 0 8 6 0 2 3
1 8 8 9 8 9 1 5 2 5

1 0 1 3 4 6 7 8 8 9 9 9
0 3 1 9 1 2 0 8 3 5 6
7 4 2 7 2 9 7 5 3 7

Table 6.1 A Production Function

 (1) (2) (3) (4)

Number of Total Average Marginal

workers (L) product (Q) product product

(AP = Q/L) (MP = Q/ L)

0 0 - -

1 52 52 52

2 112 56 60

3 170 56.7 58

4 220 55 50

5 258 51.6 38

6 286 47.7 28

7 304 43.4 18

8 314 39.3 10

9 318 35.3 4

10 314 31.4 -4

Table 6.2 Total, Average, and Marginal Products of Labor (with capital fixed at 2 units)

Note that increasing the amount of labor from 9 to 10 actually decreases output from 318 to 314.
Thus, the marginal product of the 10th worker is negative. In this example, marginal product first
increases as the amount of labor increases, then decreases, and finally becomes negative. This is
a pattern frequently assumed in economic analysis.

Figure 6.1 shows graphically the relations among the total, average, and marginal products set
forth in Table 6.2. In Panel A, total product increases up to 9 workers, then decreases. Panel B
incorporates a common assumption made in production theory: Average product first rises then
falls. When average product is increasing, marginal product is greater than average product (after
the first worker, at which they are equal). When average product is decreasing, marginal product
is less than average product. This result is not peculiar to this production function; it occurs for
any production function for which average product first increases then decreases.

An example might help demonstrate that for any average and marginal schedule, the average
must increase when the marginal is above the average and decrease when the marginal is below
the average. If you have taken two tests and made grades of 70 and 80, your average grade is 75.
If your third test grade is higher than 75, the marginal grade is above the average the average, so
your average grade increases. Conversely, if your third grade is less than 75- the marginal grade
is below the average- your average falls. In production theory, if each additional worker adds
more than the average, average product rises; if each additional worker adds less than the
average, average product falls.

As shown in Figure 6.1, marginal product first increases then decreases, becoming negative after
9 workers. The maximum marginal product occurs before the maximum average product is
attained. When marginal product is increasing, total product increases at an increasing rate.
When marginal product begins to increase at a decreasing rate. When marginal product becomes
negative (10 workers), total product declines.

We can derive the following important relationship between TP, AP and MP:
AP  when MP  AP
AP  when MP  AP
AP reaches max imum when AP  MP
MP  0 when TP reaches max imum
MP reaches max imum before AP

MATHEMATICAL RELATIONSHIP BETWEENAPL AND MPL

The mathematical relationship between the average product of labor (or any average concept)
and the marginal product of labor (or any related marginal concept) may be illustrated by the use
of optimization analysis.
Consider again the definition of the average product of labor
 TPL QL f ( K 0, L)
APL= = =
L L L

Taking the first derivative with respect to labor and setting the results equal to zero yields

∂APL L(∂QL∂L)- QL(∂L ∂L)

= =0
2
∂L L

∂APL L(MPL)- QL(1)

= =0
∂L L2

- = - = (MPL-APL) =0

(MPL-APL) = 0 when AP is maximum, then MPL= APL

(MPL-APL) = +ve when AP is rising, then MPL= APL +(+ve)

Meaning MPL> APL

(MPL-APL) = -ve when AP is declining, then MPL= APL - (+ve)

Meaning MPL< APL

Figure 6.1 A
 Figure 6.1 B

6.3.1 The Law of Diminishing Marginal Returns (LDMR)

When an increasing amount of variable inputs is combined with a specified amount of fixed
input in the short run, the resulting increase in output diminishes. In other words, as more and
more units of labor is added to a given fixed input, the marginal product of labor diminishes after
some point. When the amount of the variable input is small relative to the fixed inputs, more
intensive utilization of fixed inputs by variable inputs may initially increase the marginal product
of the variable input as this input is increased. Nonetheless, a point is reached beyond which an
increase in the use of the variable input yields progressively less additional output. Each
additional unit has, on average, fewer units of the fixed inputs with which to work.

Thus, the point here is that as a manager we need to know the levels of inputs where the LDMR
exists and all the above stated relationship between TP, AP, and MP.

When the first order derivative of production function is zero, total output reaches maximum
When the second order derivative of production function is zero, that level of unit (labor) is the
point where DMR starts to operate.
The optimization rule states that the marginal revenue product of an input (in this case labor) is
equal to the price of the input. MRPL  PL

MPL * PL = MRPL
Marginal cost of labor means price of each additional labor
M L = MRPL - MCL

At optimum level M L= 0 so
0 = MRPL - MC , MRPL = MC =P
L L L

Labor should be increased until the marginal revenue product equals to the marginal cost of
labor. Increasing the labor force any further will be unprofitable.

6.4 Production Function in the Long Run (Optimization in the Case of

Multiple Variable Inputs)
In the long run all inputs are variable inputs and thus the firm can produce a certain output by
using more and more of these variable inputs (labor and capital).
Q  f ( L, K )
Managers are, therefore, trying to find and exploit opportunities to change the fixed inputs in the
short run into variable inputs by adding new products: changing the type and amount of inputs,
restructuring the size of the firm and the production capacity.

6.4.1 Production Isoquants and Isocosts

The terms 'isoquant' has been derived from the Greek word 'iso' meaning 'equal' and Latin word
quantus meaning 'quantity'. The 'isoquant curve' is therefore also known as 'Equal Product
Curve'. Production in the case of two variable inputs (i.e., the long run production) is studied
with the help of isoquant and [Link] isoquantis a curve (or locus of points) showing all
possible combinations of the inputs physically capable of producing a given (fixed) level of
output. Each point on an isoquant is technically efficient; that is, for each combination on the
isoquant, the maximum possible output is that associated with the given isoquant. The concept of
an isoquant implies that it is possible to substitute some amount of one input for some of the
other, say, labor for capital, while keeping output constant.
To understand the concept of an isoquant, return for a moment to Table 6.1 in the preceding
section. This table shows the maximum output that can be produced by combining different
levels of labor and capital. Now note that several levels of output in this table can be produced in
two ways. For example, 108 units of output can be produced using either 6 units of capital and 1
worker or 1 unit of capital and 4 workers. Thus, these two combinations of labor and capital are
two points on the isoquant associated with 108 units of output. And if we assumed that labor and
capital were continuously divisible, there would be many more combinations of this isoquant.

Other input combinations in Table 6.1 that can produce the same level of output are:
Q = 285: using K = 2, L = 5, or K = 8, L = 2
Q = 400: using K = 9, L = 3, or K = 4, L = 4
Q = 453: using K = 5, L = 4, or K = 3, L = 7
Q = 708: using K = 6, L = 7, or K = 5, L = 9
Q = 753: using K = 10, L = 6, or K = 6, L = 8

Figure 6.2 Typical Isoquants

K I

MPKX¥K

MPK= Q= MPK. K

MPL = Q= MPL. L
In isoquant output is constant. So Q = Q

MPK. K = MPL. L

= as it is technical substitution between two products its slope is negative

= - this value indicates the rate of capital given up to increase one unit of

labor.

Characteristics of Isoquants
We now set forth the typically assumed characteristics of isoquants when labor, capital, and
output are continuously divisible.
 The isoquant curves never cross each other or they do not intersect.
 The higher the isoquant the more the output level in the isoquant map.
 The slope of the isoquant, that is, the marginal rate of technical substitution (MRTS) is
negative.
 The isoquant curve is convex to the origin.

6.4.2 Marginal Rate of Technical Substitution (MRTS)

As depicted in Figure 6.2, isoquants slope downward over the relevant range of production. This
negative slope indicates that if the firm decreases the amount of capital employed, more labor
must be added in order to keep the rate of output constant. Or if labor use is decreased, capital
usage must be increased to keep outside constant. Thus, the two inputs can be substituted for one
another to maintain a constant level of output. This rate at which one input is substituted for
another along an isoquant is called the marginal rate of technical substitution (MRTS) and is
defined as:
MRTS  K / L This can clearly show the rate of substitution of any two ordered pairs of
capital and labor.
The minus sign is added to make MRTS a positive number, since K / L , the slope of the

isoquant, is negative.
Over the relevant range of production, the marginal rate of technical substitution diminishes.
That is, as more and more labor is substituted for capital while holding output constant, the
absolute value of K/ decreases. This can be seen in Figure 4.2. If capital is reduced from 50
to 40 (a decrease of 10 units), labor must be increased by 5 units (from 15 to 20) in order to keep
the level of output at 100 units. That is, when capital is plentiful relative to labor, the firm can
discharge 10 units of capital but must substitute only 5 units of labor in order to keep output at
100. The marginal rate of technical substitution in this case is - K/ = -(-10)/5 = 2, meaning
that for every unit of labor added, 2 units of capital can be discharged in order to keep the level
of output constant. However, consider a combination where capital is more scarce and labor
more plentiful. For example, if capital is decreased from 20 to 10 (again a decrease of 10 units),
labor must be increased by 35 units (from 40 to 75) to keep output at 100 units. In this case the
MRTS is 10/35, indicating that for each unit of labor added, capital can be reduced by slightly
more than one-quarter of a unit.

Isocost Curves
Producers must consider relative input prices in order to find the least-cost combination of inputs
to produce a given level of output. An isocost curve shows all combinations of inputs that may
be purchased for a given level of total expenditure at a given input prices. For most managers,
the price of each input is determined in the market for that input by the intersection of the
demand for the input and the supply of the input.

The role of managers in the concepts of isoquant and isocost is to reduce the costs. For instance,
the managers may be large enough buyers of the resources that they can bargain with the sellers
of the resources to get better prices. Considering the quantities of labor and capital as L and K
and their respective prices as wages (w) and rent (r), the total cost, C, is given by: C  wL  rK
Slope the isocost line: C  wL  rK  rK  C  wL  K  C / r  (w / r ) L
The slope of the isocost curve is equal to the negative of the relative input price ratio, - w/r. This
ratio is important because it tells the manager how much capital must be given up if one or more
unit of labor is purchased. As illustrated in Figure 4.3, - w/r = - $25/$50 = -1/2. If the manager
wishes to purchase 1 more unit of labor at $25, 1/2 unit of capital, which costs $50, must be
given up to keep the total cost of the input combination constant. If the price of labor happens to
rise to $50 per unit, r remaining constant, the slope of the isocost curve is -$50/$50 = -1, which
means the manager must give up 1 unit of capital for each additional unit of labor purchased in
order to keep total cost constant.

Figure 6.3 an Isocost Curve (w = $25 and r = $50)

[Link] Determining the Optimal Combination of Inputs

A manager who wishes to maximize profit must first decide how much output to produce and
then how to produce that amount at the lowest possible total cost. The optimal combination of
inputs or the producer‟s equilibrium is achieved at point where the slope of isoquant (MRTSLK)
is equal to the slope of the isocost line (w/r = PL/PK)
MRTS LK  K / L  MPL / MPk  PL / PK  w / r

Thus, at optimization: MPL / w  MPK / r

And in the multiple input case with X1, X2, ..., Xn inputs:
MPX 1 / PX 1  MPX 2 / PX 2  ...  MPXn / PXn

Example: production function of Q= 40L – L2 +54K-1.5K2

Given price of labor is 10 and capital is 15
Total cost = 120
How many combinations of labor and capital used to produce maximum output given 120 as
total cost?
This is because at the cost of 120 different units of output can be produced. Meaning with
different combinations of labor and capital that has same cost, different levels of output can be
produced. So what is that maximum level of output with this cost? It is the tangency point of
isoquant curves and isocost lines.

6.5The Law of Returns to Scale

We will now describe the effect of a proportional increase in all inputs on the level of output
produced. For example, if the firm's usage of all inputs doubles, output would increase. The
question is: By how much? The answer to this question depends upon the concept of returns to
scale. The law of returns to scale shows: how output is changing when inputs such as labor and
capital are proportionately and simultaneously changed in the long run. This law is called the
long run production function. There are three possible ways in which output may be increase
when all inputs are proportionally increased.
 Increasing returns to scale (IRS): increase in output (30%) is more than proportionate to
increase in inputs (20%).
 Decreasing returns to scale (DRS): increase in output (30%) is less than proportionate to
increase in inputs (40%).
 Constant returns to scale (CRS): increase in output (30%) is equal to the proportional
change in inputs (30%)

Summery

A production function specifies the maximum output that can be produced with a given set of
inputs. In order to achieve maximum profits the production manager has to use optimum input-
output combination for a given cost. In this unit, we have shown how a production manager
minimizes the cost for a given output in order to maximize the profit. Also, we have shown how to
maximize the output at a given level of cost.
The law of diminishing marginal returns states that as equal increments of variable input are
added to fixed input, a point will eventually be reached where corresponding increments to
output begin to decline. We have also seen the relations between the marginal product, average
product, and total product. There are three stages of production. Stage I is characterized by
MP>0 and MP>AP. Stage II is characterized by MP>0 and MP<AP. Stage III is characterized
by MP<0. The economically meaningful range is Stage II. The production manager maximizes
the profit at a point where the value of marginal product equals the price of the output.
A production isoquant consists of all the combinations of two inputs that will yield the same
maximum output. The marginal rate of technical substitution is WK/WL, holding output constant.
The law of diminishing marginal rate of substitution implies the rate at which one input can be
substituted for another input, if output remains constant. An isocost line consists of all the
combinations of inputs which have the same total cost. The absolute slope of the isocost line is
the input price ratio. Returns to scale, a long run concept, involves the effect on output of
changing all inputs by same proportion and in the same direction.

Self Test Exercise 6:

Part I: Write “True” if the statement is correct and “False” if the statement is
incorrect.

1) Production process involves the transformation of inputs into output.

2) A fixed input is one for which the level of usage cannot readily be changed.
3) Output is any good or service that comes out of production process.
4) In the short-run, production of a commodity can be increased by increasing the use of
only variable inputs, like labor and raw materials.
5) Economic efficiency can be achieved when the firm is producing a given amount of
output at the lowest possible cost.
6) Once the level of capital is fixed, the firm is in the short run, and output can be changed
only by varying the amount of labor employed.

Part II: Choose the correct answer & encircle the letter of your choice.
1) _______ is the link between levels of input usage and attainable levels of output.
A. Production Function
B. Supply Function
C. Quantity Demand Function
D. Quantity Supply Function
 2) One of the following is not input for production?
A. Land
B. Labor
C. Capital
D. Entrepreneurship
E. None
3) In production process, managers take any of the following decisions except one;
A. Whether to produce or not D. What type of technology to use
B. How much output to produce E. All
C. What input combination to use F. None
4) Identify the incorrect statement;
A. In this theory of production, firms organize/combine resources or inputs such as labor,
capital, land and entrepreneurship and so on, to produce final goods and services
B. Production refers to the process of converting inputs into outputs.
C. Production is the creation of goods and services from inputs or resources.
D. All are correct
E. All are not correct
5) ____ is a good or service that goes into the process of production
A. Input C. Process
B. Output D. Conversion

Part III: Fill in the Blank Space

1. _____ involves the transformation of inputs into output.
2. ________ And ______ are the two types of Inputs
3. ______efficiency can be achieved when the firm is producing a given amount of output at
the lowest possible cost.
Unit Seven: Theory of Cost

Introduction
Dear learners, this is the seventh unit of the course managerial economics. In this unit, you
are going to deal about cost and its theory. The analysis of cost is important in the study of
managerial economics because it provides a basis for two important decisions made by
managers: (a) whether to produce or not and (b) how much to produce when a decision is taken
to produce. In this Unit, we shall discuss some important cost concepts that are relevant for
managerial decisions. We analyze the basic differences between these cost concepts and also,
examine how accountants and economists differ on treating different cost concepts. Actual costs
are those costs, which a firm incurs while producing or acquiring a good or service like raw
materials, labor, rent, etc. The economists called this cost as accounting costs because
traditionally accountants have been primarily connected with collection of historical data (that
is the costs actually incurred) in reporting a firm‟s financial position and in calculating its taxes.
Sometimes the actual costs are also called acquisition costs or outlay costs. On the other hand,
opportunity cost is defined as the value of a resource in its next best use.

Unit Objectives: At the end of this unit, you will be able to:
 Understand some of the cost concepts that are frequently used in the Managerial
decision making process;
 Differentiate between different cost concepts;
 Distinguish between economic costs and accounting costs;
 Analyze the behavior of costs both in short run and long run;
 Comprehend the different sources of economies of scale;
 Apply cost concepts and analysis in managerial decision-making.

7.1 Concepts and Types of Costs

The theory of production shows the relationship between inputs and outputs in physical terms
while the theory of cost deals the money value of inputs (i.e., costs of production) and the money
value of outputs (i.e., revenue). The excess of revenue over cost yields profit which is the
primary objective of firms. To achieve the profit goal of the firm a manager would make a
decision on costs and outputs. Since managerial decisions are affected by the types of costs the
manager should understand the different types of costs so as to focus on a relevant cost for a
particular decision making. And also understand the relationship between cost and output both in
the short run and long run.

7.1.1 Types of Costs

Actual and Opportunity Cost
Costs that are actually incurred in acquiring or producing a good or service is known as actual
cost. The opportunity cost, on the other hand, refers to the foregoing of opportunities to produce
an alternative good or service. Because of the fundamental economic problem of scarce
resources the manager forced to choose the best out of the available alternative. Thus, the value
that must be forgone in the second/next best alternative as a result of putting resources on the
first best alternative. For example, a firm with Birr 100 can either make a fixed deposit with a
bank or earn an interest of 10% per annum or can purchase factors of production for producing t-
shirts. Let the costs of land, labor, capital and management be Birr 20, 35, 30 and 10
respectively. Thus, the actual cost is Birr 95 while the opportunity cost is Birr 10.

Explicit and Implicit Costs

Explicit costs are monetary payments, that is out of pocket or cash expenditures, which a firm
make to those “out-sider” who supply labor and other raw materials. The costs related to the firm
use of certain resources which they own are called explicit or imputed costs. While the wages
and other costs of raw materials constitute explicit costs, depreciation, salary of owner manager
and other costs of self owned/self sponsored resources are implicit costs.
Incremental and Sunk Costs
Costs which depend on decision and relevant for decision making are incremental costs while
costs which do not depend on decision and irrelevant on decision making are sunk costs. For
illustration, consider a university as a firm which going to start an evening program on
commercial basis beyond its regular program which runs in the day time.

The evening program is intended to use the time of academic as well as administrative staff for
whom extra payments would have to be made for their services. In addition, there will be some
costs on electricity, chalk etc. Besides, the classroom and blackboard of the university would be
utilized for the purpose. With this regard, the costs of the time of the staff and the amount spent
on electricity bill and chalk etc are incremental costs while the cost of the use of classroom and
blackboard are the sunk cost. Other types of costs, but not part of this chapter, includes:
economic and accounting costs, private and social costs, separable and common cost, historical
and replacement cost.

7.1.2 Short Run and Long Run Costs

Short-run and long-run cost concepts are related to variable and fixed costs, respectively, and
often figure in economic analysis interchangeably.

Short-run costs are the costs which vary with the variation in output, the size of the firm
remaining the same. In other words, short-run costs are the same as variable costs. Long-run
costs, on the other hand, are the costs which are incurred on the fixed assets like plant, building,
machinery, etc. Such costs have long-run implication in the sense that these are not used up in
the single 'batch of production'.

Long-run costs are, by implication, the same as fixed costs. In the long-run, however, even the
fixed costs become variable costs as the size of the firm or sale of production increases. Broadly
speaking, 'the short-run costs are those associated with variables in the utilization of fixed plant
or other facilities whereas long-run costs are associated with the changes in the size and kind of
plant.

Production Cost in the Short-Run

In the short run, the relationship between the TC and per unit costs (average & marginal costs)
can be displayed using tabular and graphical illustration.

Fixed and Variable Costs

Total Fixed Costs (TFC): are costs of a firm that do not vary with the change in output so
that firm‟s might incur costs even if no output is produced. Example: cost of firm‟s plant and
machinery, rent of building and factory etc. Total Variable Cost (TVC) is the sum of the
amounts spent for each of the variable inputs used. Total variable cost increases as output
increases. Example, costs of raw materials and wages. Total Cost (TC) is the sum of total fixed
cost and total variable cost. Total cost increases with increases in output (TC = TVC + TFC).
Table 7.1 Short-Run Total Cost Schedules
(1) (2) (3) (4)

Output Total fixed Total variable Total cost

cost cost (TC)
(Q)
(TFC) (TVC) TC = TFC +
TVC

0 $6,000 $ 0 $6,000

100 6,000 4,000 10,000

200 6,000 6,000 12,000

300 6,000 9,000 15,000

400 6,000 14,000 20,000

500 6,000 22,000 28,000

600 6,000 34,000 40,000

Figure 7.1 Total Cost Curves

Average and Marginal Costs
Average Fixed Cost (AFC): is total fixed cost divided by output:
AFC = TFC/Q
Average fixed cost is obtained by dividing the fixed cost (in this case $6,000) by output. Thus,
AFC is high at relatively low levels of output; since the denominator increases as output
increases, AFC decreases over the entire range of output. If output were to continue increasing,
AFC would approach 0 as output became extremely large.

Average Variable Cost (AVC): is total variable cost divided by output:

AVC = TVC/Q
The average variable cost first falls to $30, then increases thereafter.
Average Total Cost (ATC): it is the per unit cost of the total cost and computed as the sum
of average variable cost (AVC) and average fixed cost (AFC).
ATC = TC/Q = (TVC + TFC)/Q = AVC + AFC
Marginal Cost (MC): it is the change in TC due to the production of one additional unit of
output. In other word, the change in either total variable cost or total cost per unit change in
output.
MC = TC/Q

Table 7.2 Average and Marginal Cost Schedules

(1) (2) (3) (4) (5)

Output Average Average Average Marginal

fixed cost variable total cost cost (MC)
(Q)
(AFC) cost (ATC)
MC =
(AVC)
AFC = ATC = TC/Q
TFC/Q AVC = TC/Q
TVC/Q

0 - - - $40
 100 $60 $40 $100 20

200 30 30 60 30

300 20 30 50 50

400 15 35 50 80

500 12 44 56 120

600 10 56.7 66.7

Figure 7.2 Average and Marginal Cost Curves

The average total cost first declines, reaches a minimum at $50, and then increases thereafter.
The minimum AFC is attained at a larger output (between 300 and 400) than that at which AVC
attains its minimum (between 200 and 300). This result is not peculiar to the cost schedules
given above.

It can be seen that MC first declines, reaches a minimum of $20, then rises. Note that minimum
marginal cost is attained at an output (between 100 and 200) below that at which either AVC or
ATC attains its minimum. Marginal cost equals AVC and ATC at their respective minimum
levels.

The average and marginal cost schedules in columns 3, 4, and 5 are shown graphically in Figure
7.2. Average fixed cost is not graphed because it is a curve that simply declines over the entire
range of output and because, as you will see, it is irrelevant for decision making. All three curves
decline at first and then rise. Marginal cost equals AVC and ATC when they are declining and
above them when they are increasing. Since AFC decreases over the entire range of output and
since ATC = AVC + AFC, ATC becomes increasingly close to AVC as output increases. These are
the general properties of typically assumed average and marginal cost curves.

 Relations: (1) AFC declines continuously, approaching both axes asymptotically (as shown
by the decreasing distance between ATC and AVC). (2) AVC first declines, reaches a
minimum at Q2, and then rises thereafter. When AVC is at its minimum, short-run marginal
cost equals AVC. (3) ATC first declines, reaches a minimum at Q3, and then rises
thereafter. When ATC is at its minimum, short-run marginal cost equals ATC. (4) Short-run
marginal cost first declines, reaches a minimum at Q1, and rises thereafter. Short-run
marginal cost equals both AVC and ATC when these curves are at their minimum values.
Furthermore, short-run marginal cost lies below both AVC and ATC over the range for
which this curve declines; Short-run marginal cost lies above them when they are rising.

In general, the reason marginal cost crosses AVC and ATC at their respective minimum points
follows from the definitions of the cost curves. If marginal cost is below average variable cost,
each additional unit of output adds less to cost than the average variable cost of that unit. Thus,
average variable cost must decline over this range. When short-run marginal cost is above AVC,
each additional unit f output adds more to cost than AVC. In this case AVC must rise.

Mathematical relationships between AC and MC

AC= TC/Q =VC/Q + FC/Q (by using derivative of a quotient)

= +
 = +

= +

= - +

= (

= (MC-AVC-AFC)

1. If = 0 when AC is minimum, then

(MC-AVC-AFC) = 0

MC = AVC+AFC, MC= AC
2. If = + ve (when AC is rising)

(MC-AVC-AFC) = + ve

(MC-AVC-AFC) = + ve(Q)

MC = AVC+AFC (+ ve)(Q)

MC = AC(+ ve)(Q), So MC > AC

3. If = (- ve )(when AC is decling)

(MC-AVC-AFC) = (- ve)
 (MC-AVC-AFC) = (- ve)Q

MC = AVC+AFC +(- ve)Q

MC = AC+(- ve)Q, So MC < AC

Figure 7.3 Graph – Optimum Cost And Output

Production Cost in the Long-Run

To analyze the production costs in the long run it is good to deal above the long run cost curves
which are a guide for an entrepreneur in his/her decision to plan future expansion of the firm‟s
output. Due to this circumstance, the long run curves are known as a „planning curve‟ or
sometimes called the „planning horizon‟. The most important long run costs are the long run
average cost (LAC) and long run marginal cost (LMC) and these curves are derived from their
respective short run cost curves as depicted in the following graphs.

The LAC is derived from the short run average costs SAC1, SAC2& SAC3 which are associated
with the three different plant sizes as small, medium and large plants respectively. The firm
produces OX1 at the minimum point of its short run average cost, SAC1. By installing a medium
size plant, the firm can increase its output to OX2 at a reduced cost of BX2 at the minimum level
of its short run average cost, SAC2, as well as the minimum of LAC. This production of more
output at lower cost is due to economics of scale which could be achieved through specialization
and factor productivity. If the firm wishes to increase its size by installing a large plant the output
might increase to OX3 but the cost, CX3, rising compared to that of small plant size. This
production of more output at higher cost resulted from diseconomies of scale in this situation the
firm becomes less efficient as its size gets large and large. Because the system of management
becomes complex so that the managers are overworked and thus less efficient.

Figure 7.4 The LAC Curve

The LAC is, therefore, derived by joining then points on falling part of SAC1 (which is on the
left of its minimum indicating underutilization of the firm), the minimum of SAC 2, and the rising
part of SAC3 ( which is on the right of its minimum indicating overutilization of the firm). In
traditional theory of firms the LAC is U-shaped and it is often called the envelope Curve because
it envelops the SAC curves.

Note: The SAC curve of the medium plant size is an optimal plant size. This is because all
possible economies of scale are fully exploited. At this point more output is produced at lower
cost in which both the SAC and LAC are at their minimum levels. An optimal scale of the firm
(or the firm‟s long run equilibrium) is achieved at the point where SAC2 = LAC = LMC = SMC2
and the equilibrium level of output is X2.
7.2 Scale and Scope Economies
Economies and diseconomies of scale are a phenomenon relating to the long run cost-output
relationship while economies of scope is a phenomenon relating to the comparison of the long
run costs between the joint and separate production process.
Economies of scale: it refers to range of output over which LAC falls as output increases by
increasing the plant size. It is represented by the range of output between point 0 and M2 on the
LAC curve in Figure 6.7. In other words, economies of scale are referred to the production
ofmore outputs at lower costs by increasing the size of the plant. Better facilities operative
system, training and R & D are main factors causing the economies of scale.

Diseconomies of scale: it refers to a range of output over which LAC rises as output rises by
further increasing the plant size. It is represented by the range of output on the right of M 2 on the
LAC curve in figure 6.7. In other words, diseconomies of scale are referred to the production of
more output at higher costs by further increasing the size of the plant. Difficulties in rising funds
and difficulties in team-work and coordination are main factor causing diseconomies of scale.

Figure 7.5 – Economies of Scale and Diseconomies of scale

Economies of scope: it is a situation in which the joint cost of producing two or more goods by a
single firm is less than the sum of separate costs of producing the same level of output for each
goods by separate firms.

7.3 Cost Function

The cost of production (C) is a function of three main factors the total output produced (q), the
price of inputs (p) and the efficiency of inputs (e). I.e., C = f (q, p, e).
There are various functional forms of cost function. The most important function forms are
linear, quadratic and cubic forms of cost functions.
Linear: C  a  bQ

Quadratic: C  a  bQ  cQ 2

Cubic: C  a  bQ  cQ 2  dQ 3

Summery
Cost concepts are important for decision-making but neither the accounting approach nor
the economic approach is completely acceptable when decision making is involved. Costs
must be considered in various ways, depending on the decision at hand. Both traditional
economists and traditional accountants have tended to be fairly dogmatic in their definitions
of costs. On the other hand, managerial economists want a flexible approach. All the cost
concepts need to be considered in such a way so as to help make sound decisions. The
 decision maker should try to discover the “relevant” costs by asking what costs are relevant
to a particular decision at hand, and the decision maker is not necessarily bound by
traditional concepts constructed for other purposes. In this unit the basic cost concepts have
been covered to give a fair view about the understanding of costs.
To make wise decisions concerning how much to produce and what prices to charge, a manager
must understand the relationship between firm‟s output rate and its costs. The profit-oriented
firm‟s manager must consider both opportunity costs and explicit costs in order to use all the
resources most economically. Although it is difficult to have accurate information on its costs, a
firm should have reliable estimates of its fixed costs, how its costs vary with respect to output
over the relevant range of production, and whether or not its costs would be lower with a larger
plant size. In short run, the total cost consists of fixed and variable costs. A firm‟s marginal cost
is the additional variable cost associated with each additional unit of output. The average
variable cost is the total variable cost divided by the number of units of output. When there is a
single variable input, the presence of diminishing returns determines the shape of cost curves.
In particular, there is an inverse relationship between the marginal product of the variable
input and the marginal cost of production. The average variable cost and average total cost
curves are U-shaped. The short run marginal cost curve increases beyond a certain point, and
cuts both average total cost curve and average variable cost curve from below at their minimum
points.
In the long run, all inputs to the production process are variable. Thus, in the long run, total
costs are identical to variable costs. The long run average cost function shows the minimum cost
for each output level when a desired scale of plant can be built. The long run average cost curve
is important to managers because it shows the extent to which larger plants have cost
advantages over smaller ones.
Economies or diseconomies of scale arise either due to the internal factors pertaining to the
expansion of output by a firm, or due to the external factors such as industry expansion. In
contrast, economies of scope result from product diversification. Thus the scale-economies have
reference to an increase in volume of production, whereas the scope-economies have reference
to an improvement in the variety of products from the existing plant and equipment. These cost
concepts and analysis have a lot of applications in real world decision-making process such as
optimum output, optimum product-mix, breakeven output, profit contribution, operating
leverage, etc.

Self Test Exercise 7:

Part I: Write “True” if the statement is correct and “False” if the statement is
incorrect.

1) The theory of production shows the relationship between inputs and outputs in physical
terms while the theory of cost deals the money value of inputs (i.e., costs of production)
and the money value of outputs (i.e., revenue).
2) Since managerial decisions are affected by the types of costs the manager should
understand the different types of costs so as to focus on a relevant cost for a particular
decision making.
3) Because of the fundamental economic problem of scarce resources, the manager should be
forced to choose the best out of the available alternative.
4) Explicit costs are monetary payments, that is out of pocket or cash expenditures, which a
firm make to those “out-sider” who supply labor and other raw materials.
5) Costs which depends on the decision and relevant for decision making are incremental
costs.
6) In the long run, all inputs to the production process are variable.

Part II: Choose the correct answer & encircle the letter of your choice.

1) Costs that are actually incurred in acquiring or producing a good or service is

known as ______
A. Actual Cost
B. Total Cost
C. Variable Cost
D. Fixed Cost
 2) The wages and other costs of raw materials constitute explicit costs, depreciation,
salary of owner manager and other costs of self owned/self sponsored resources
are _____
A. Implicit Costs
B. Explicit
C. Imputed Costs
D. All
E. None

3) Costs which do not depend on decision and irrelevant on decision making are
_____
A. Incremental cost
B. Fixed cost
C. Sunk cost
D. All
E. None

4) _______ are costs which are incurred on the fixed assets like plant, building,
machinery, etc.
A. Short-run costs
B. Long-run costs
C. Intermediate costs
D. None

5) Identify the incorrect statement;

A. Long-run costs are, by implication, the same as fixed costs.

B. In the long-run, even the fixed costs become variable costs as the size of the firm or sale
of production increases.

C. The short-run costs are those associated with variables in the utilization of fixed plant or
other facilities

D. Long-run costs are associated with the changes in the size and kind of plant.
 E. All

F. None

6) ______are costs of a firm that do not vary with the change in output

A. Total Fixed Costs

B. Total variable Costs

C. Total Costs

D. Total revenue

Part III: Fill in the Blank Space

1. Costs that are actually incurred in acquiring or producing a good or service is known as
________

2. Depreciation, salary of owner manager and other costs of self owned/self sponsored
resources are _________ costs.
Answer Key for Self Test Exercise

Self Test Exercise One

True/False

1. True

2. True

3. True

4. True

5. False

Multiple Choices

1. B

2. E

3. F

4. D

5. A

Fill In the Blank Space

1. Optimization

2. Accounting profit

3. Land, labor, capital and entrepreneurship

Self Test Exercise Two

True/False

1. True

2. True

3. False

4. True

5. True

6. True

Multiple Choices

1. A

2. D

3. B

4. D

5. C

6. F

Fill In the Blank Space

1. Quantity Demanded.

2. Law of Demand

3. Supply

Self Test Exercise Three

True/False

1. True

2. True

3. True

4. True

5. True

Multiple Choices

1. E

2. A

3. A

Fill In the Blank Space

1. The necessary or the first order condition and the supplementary or the
second order condition.

2. Decision Variable, objective function and Feasible Set

3. Marginal analysis

Self Test Exercise Four

True/False

1. True

2. False

3. True

4. True
 5. False

6. True

7. True

Multiple Choices

1. F

2. E

3. F

4. D

5. E

Fill In the Blank Space

1. Forecasting

2. Delphi Method

Self Test Exercise Five

True/False

1. True

2. True

3. True

4. True

5. True
Multiple Choices

1. E

2. C

3. A

4. D

5. A

6. A

Fill In the Blank Space

1. Non programmed decision

2. Risk

3. Uncertainty

Self Test Exercise Six

True/False

1. True

2. True

3. True

4. True

5. True

6. True
Multiple Choices

1. A

2. E

3. F

4. D

5. A

Fill In the Blank Space

1. Production

2. Economic efficiency

Self Test Exercise Seven

True/False

1. True

2. True

3. True

4. True

5. True

6. True
Multiple Choices

1. A

2. A

3. C

4. B

5. F

6. A

Fill In the Blank Space

1. Actual cost

2. Implicit costs.
REFERENCES

 D.N. Dwivedi, Managerial Economics, Vikas Publishing House Pvt Ltd., New Delhi,
1989.
 Maurice, Thomas, and Smithson. Managerial Economics, 4th ed. Richard D. Irwin,
Boston. 1992.
 McGuigan and Moyer. Managerial Economics, 5th ed. West Publishing Company.1989.
 Michael R. Baye, Managerial Economics, McGraw Hill, New York 2000.

 Pappas and Hirschey. Managerial Economics, 6thed. The Dryden press 1990.