NATURE AND SCOPE

Economics is defined as a social science. It deals with production,

distribution, and consumption of goods and services.
From a small shop to a nation’s economy, Economics plays a major role in
efficient running of both. No one can survive without applying principles of
economics.
Is Economics an art or a science?
Science deals with systematic studies that signify the cause and effect
relationship. In science, facts and figures are collected and are analyzed
systematically to arrive at any certain conclusion. For these attributes
Economics can be treated as science. However, economics is treated as a
social science for the following reasons:
1. It involves a systematic collection of facts and figures
2. Like in science, it is based on the formulation of theories and laws.
3. It deals with cause and effect relationship.

1. Just as in science, various economic theories are also based on logical

reasoning.
 NATURE AND SCOPE

Economics as an art: Economic theories are used to solve various economic problems
in society.
Thus, it can be inferred that besides science, it can also be called as an art.

Scope
Economists use different economic theories to solve various economic problems in
society. Its applicability is very vast. From small shops to multinational companies
Economic laws come into play. The scope of economics can be understood in following
ways:
Microeconomics: Microeconomics examines individual economic activities, industries
and their interaction. It studies topics like elasticity, theory of production, market
structures like monopoly, oligopoly.
Macroeconomics studies economy as a whole. It explains broad relationships and the
interactions top down. It studies topics like growth, employment, inflation and deflation
DEMAND AND SUPPLY
The amount of a commodity people buy depends on its price. The higher
the price of an article, other things held constant, the fewer units
consumers are willing to buy. The meaning of other things held constant
means we are varying the price without changing any of the other
determinants of demand like income, tastes.
There is a definite relationship between the market price of a good and
the quantity demanded of that good, other things held constant. This
relationship between price and quantity bought is called the demand
schedule or the demand curve. It is the graphical representation of the
demand schedule. The quantity demanded and price are inversely
related: as the price goes up the quantity goes down. This creates a
downward sloping demand curve.
Downward sloping demand
 Demand curve
• The negative slope of the demand curve illustrates the law of downward sloping
demand., which states –when the price of a commodity is raised (and other
things held constant), buyers tend to buy less of a commodity. Similarly, when
the price is lowered, other things being constant, quantity demanded increases.
• The quantity demanded tends to fall as price rises for two reasons:
• [Link] is the substitution effect, which occurs because a good becomes relatively
more expensive when its price rises. When the price of a good rises, it will
generally substitute other goods for it. If the price of meat rises, I can substitute
it with eating more chicken.
• 2.A higher price also reduces quantity demanded through the income effect.
This comes into play when a price goes up, I find myself somewhat poorer than
before. Like, when petrol price has gone up, I have in effect less income, I will
naturally reduce my consumption of petrol and other goods.
 Demand curve
• We have been talking about individual demand. The fundamental building
block for demand is individual preferences. When we talk of market
demand, we talk of the sum total of all individual demands. The market
demand curve is found by adding together the quantities demanded by all
the individuals at each price. The market demand curve also follows the
law of downward sloping demand. If prices drop, the lower prices attract
new customers through substitution effect. In addition, a price reduction
will induce extra purchases of goods by existing customers through both
income effect and substitution effects. A rise in prices will cause some of
us to buy less.
• What are the forces behind the demand curve?
• [Link] average level of income of consumers is a key determinant of
demand. As people’s income rise, individuals tend to buy more of almost
everything, even if prices do not change. Car , scooter purchases tend to
increase with higher levels of income.
 Shift in demand curve
• [Link] size of the market-measured by the total population affects the
market demand curve.
• [Link] prices and availability of related goods also influence the demand of
a commodity. This relationship exists among substitute goods—goods that
tend to perform the same function, like cornflakes and oatmeal, pen and
pencil, small cars and large cars.
• 4. There are subjective factors like tastes and preferences of consumers.
Tastes reflect genuine psychological or physiological needs, tradition or
religion.
• 5. Some special influences affect the demand for certain goods. Demand
for umbrellas , air conditioners or demand for cars where public transport
is plentiful.
 Shift in demand curve
• Shifts in demand
• Demand changes incessantly. Why does the demand curve shift? Other
than price, the demand can change due to income effect. The powerful
effect of income increase, will impact the demand for automobiles, white
goods, luxury goods etc. The net effect of changes in underlying influences
is called the increase in demand. An increase in demand in automobiles
will result in the rightward shift in the demand curve. This means more
cars and two wheelers will be bought at every price.
• When there are changes in factors other than a good’s own price which
affects the quantity purchased , we call these changes shifts in demand.
Demand increases or decreases when the quantity demanded at each
price increases or decreases.

White goods refer to major household appliances that are typically finished in white or other light colors. Examples of white goods
include: Refrigerators washing machines Air conditioners, Dishwashers, ovens and microwaves
Luxury goods are high-end products/services characterized by premium quality, craftsmanship, and exclusivity. Examples include
designer clothing (Gucci, Louis Vuitton, Chanel), luxury watches (Rolex, Patek Philippe, Omega), high-end jewelry (Tiffany & Co.,
Cartier, Bulgari), luxury automobiles (Mercedes-Benz, BMW, Ferrari), and private jets.
Shift in demand curve
 Supply schedule
• The supply side of the market involves the terms on which businesses
produce and sell their products. The supply schedule relates the quantity
supplied of a good to the market price, other things constant ( input
prices, prices of related goods, government policies. The supply schedule
or the supply curve for a commodity shows the relationship between its
market price and the amount of that commodity producers are willing to
produce and sell, other things held constant.
•
Supply schedule
 Supply curve
• Forces determining the supply curve :Producers supply
commodities for profit and not for charity. One major element underlying the
supply curve is the cost of production. When production costs of a good are low
relative to the market price, it is profitable for the suppliers to supply a great
deal. When production costs are high relative to price, firms produce less, switch
to production of other products or may go out of business.
• Production costs are determined by the prices of inputs and technological
advances. Prices of inputs like labour, energy ,machinery have an important
influence on the cost of production.
• Another important factor is technological advances which consist of changes
that lower the quantity of inputs needed to produce the same quantity of
output. Such advances include scientific breakthroughs, better application of
existing technologies etc. Manufacturers are becoming more and more efficient
over the years due to the technological advances. It enables car makers to
produce more cars at the same cost.
• Supply is also influenced by the prices of related goods, particularly goods that
are alternative outputs of the production process.
 Supply curve
• If the price of one production substitute rises, the supply of another
substitute will decrease.
• Government policies have an impact on the supply curve. Environmental
and health considerations determine what technologies can be used.
Taxes and minimum wage laws can affect input prices.
• Finally, special influences affect the supply curve. Like weather affects
agriculture and other supplies, market structure will affect supplies and
expectations of future prices.
• Shifts in supply: When changes in factors other than a good’s own price
affect the quantity supplied, we call these changes shifts in supply. Supply
increases or decreases when the amount supplied increases or decreases
at each market price.
Shifts in supply
 Supply curve
• As production costs fall, the supply of automobiles increases. At each
price, producers will supply more automobiles, and the supply curve shifts
to right.
• When automobile prices change, producers change their production and
the quantity supplied , but the supply and supply curve do not shift.
• But, when other influences affecting supply change, supply changes and
supply curve shifts.
• For example, supply of automobiles would increase if the introduction of
cost saving computerized design and manufacturing reduced the labor
required to produce cars or if the workers agree for a pay cut or if the
government replaced the environmental laws. Any of these will increase
the supply of automobiles to the market.
 Equilibrium of demand and supply
• So far, we have looked at demand and supply in isolation.
• We have seen consumers demand different amounts of goods as a
function of their prices.
• Similarly, producers willingly supply different amounts of goods depending
on their prices.
• How can we put both sides of the market together?
• This happens when the demand and supply interact to produce an
equilibrium price as well as quantities known as market equilibrium. The
market equilibrium comes at that price and quantity where the forces of
demand and supply are in balance. At that equilibrium price, the amount
that buyers want to buy is just equal to the amount that sellers want to
sell. Its called equilibrium because there is no reason for price rise or fall,
as long as other things remain unchanged.
• To find the market price and quantity, we find a price at which amounts
desired to be bought and sold just match.
 Equilibrium price
• A market equilibrium comes at the price at which quantity demanded
equals quantity supplied. T that price, there is no tendency for the price to
rise or fall. The equilibrium price is also called the market clearing price.
This denotes that all demand and supply orders are filled, the books are
cleared of orders both buyers and sellers are satisfied.
 Equilibrium
In this diagram, the demand and
supply curves are combined. We find
the market equilibrium by looking at
the price the quantity demanded
equals quantity supplied. The
equilibrium price is at the intersection
of the demand and supply curves at
point C.
Thus, equilibrium price and quantity
come where the amount willingly
supplied equals the amount willingly
demanded. There are no shortages or
surplus at the equilibrium price.
 Elasticity of demand
• We now know , certain forces increase or decrease demand .Some luxuries like travel and
tourism are sensitive to price changes . Other purchases like food, electricity which are
necessities for which consumer purchases respond very little to price changes. The
quantitative relationship between price and quantity purchased is analyzed using the concept of
elasticity.
• Price elasticity of demand measures how much the quantity demanded of a good changes when
its price [Link] is the percentage change in quantity demanded divided by percentage
change in price.
• Goods vary enormously in their price elasticity or sensitivity to price changes. When the price
elasticity of a good is high, we say the good has elastic demand meaning its quantity demanded
responds greatly to price changes. When the price elasticity is low ,it is inelastic and its quantity
demanded responds little to price changes.
• Goods that have ready substitutes have more elastic demand than those that have no
substitutes.
• The time taken by buyers to respond to price changes also plays a role . E.g petrol prices where
the buyers will respond to higher fuel prices over a long term. The ability to adjust consumption
patterns implies that demand elasticities are generally higher in the longer run than in the short
run. In the long run you can adjust your behaviour to higher fuel [Link] implies that demand
elasticities are generally higher in the long run than in short run.
•
 Elasticity of demand
• The price elasticities of demand for individual goods are determined by
the economic characteristics of demand. Price elasticities tend to be
higher when the goods are luxuries, when substitutes are available, and
when consumers have more time to adjust their behavior. By contrast,
elasticities are lower for necessities, for goods with few substitutes, and
for the short run.
• The precise definition of price elasticity is the percentage change in
quantity demanded divided by the percentage change in price. In terms of
a formula price elasticity of demand= ep=% change in quantity demanded/
% change in price.
• When 1% change in price leads to more than 1% change in quantity
demanded, the good has price elastic demand. If 1% increase in price
yields a 5% decrease in quantity demanded, the commodity has a highly
price elastic demand.
 Elasticity of demand
• When 1% change in price produces less than 1% change in quantity
demanded, the good has price-inelastic demand.
• Unit elasticity of demand means when the percentage change in quantity
is exactly the same as the percentage change in price. i.e. 1%nincrease in
price leads to 1% decrease in demand.
• To calculate price elasticity of a demand curve: The elasticity of a straight
line at a point is given by the ratio of the length of the line segment below
the point to the length of the line segment above the point.
• This is shown by a diagram.
Elasticity
 Elasticity
• To calculate the demand elasticity for a non-linear demand curve, first draw a
tangent line at the point .Then take the ratio of the length of the straight line
segment below the point to the length of the line segment above the point.
Here, at point B the elasticity is 3.
• Always remember not to confuse the elasticity of a curve with its slope. The
slope is not the same as elasticity because the demand curve’s slope depends
upon the changes in P and Q, whereas the elasticity depends upon the
percentage changes in P and Q. The only exceptions are polar cases of
completely elastic and inelastic demands.
• The general rule for elasticities is that the elasticity can be calculated as a ratio
of the length of the straight line or tangent below the demand point to the
length of the segment above the point.
• The concept of price elasticity is widely used in businesses by separating
customers into groups with different elasticities. This technique is extensively
used by [Link] well as other businesses which have a wide range of different
prices foe their products in order to exploit different elasticities.
 Elasticity
• Businesses want to know whether raising prices will raise or lower
revenues.
• Total revenue is equal to price times quantity.(PxQ).
• When demand is price-inelastic, a price decrease reduces total revenue.
• When demand is price-elastic, a price decrease increases total revenue.
• When we look at unit-elastic demand, a price decrease leads to no change
in total revenue.
 Consumer behavior

• We make decisions all the time about how to allocate our scarce money
and time. The results of these individual choices are what underline the
demand curves and price elasticities.
• In explaining consumer behavior, economics relies on basic premise that
people choose those goods and services they value most highly. The
notion of utility was developed a century ago.
• Utility denotes satisfaction. It refers to how consumers rank different
goods and services. Utility is used by economists use to understand how
rational consumers make decisions. We derive consumer demand
functions from the assumption that people make decisions that give them
the greatest satisfaction or utility.
• In the theory of demand , we assume that people maximize their utility ,
which means that they choose the bundle of consumption goods that they
most prefer.
 Marginal utility

• How does utility apply to the theory of demand?

• Consuming the first unit of ice cream gives you a certain level of
satisfaction or utility. If you consume second unit, your total utility goes up
because the second unit gives you additional utility. If you eat the third
and the fourth unit, instead of adding to your satisfaction or utility, it
makes you sick.
• This leads us to the fundamental economic concept of marginal utility.
When you eat an additional unit of ice cream, you will get additional
satisfaction or utility. The increment to your utility is called marginal
utility.
• It means additional or extra. Marginal utility denotes the additional utility
you get from the consumption of additional unit of a commodity.
• One of the fundamental ideas behind the demand theory is the law of
diminishing marginal utility. It states that the amount of extra or marginal
utility declines as a person consumes more and more of a good.
 Marginal utility

• To understand this law, first remember that utility tends to increase as

you consume more and more of a good. As you consume more, your total
utility will grow at a slower and slower rate. This is the same thing as
saying that your marginal utility ( the extra utility added by the last unit
consumed of a good) diminishes as more of a good is consumed.
• The law of diminishing marginal utility states that , as the amount of a
good consumed increases, the marginal utility of that good tends to
decline.
Law of diminishing marginal utility
 Total and marginal utility

• From the figure , it can be seen that total utility of consuming a certain
amount is equal to the sum of marginal utilities up to that point.

• Consumer surplus
• The paradox of value emphasizes that the recorded monetary value of a
good ( measured by pxq) may be a misleading indicator of the total
economic value of that good. For example, the measured economic value
of air, water is zero or very small, yet their contribution to welfare is very
large.
• The gap between the total utility of a good and its total market value is
called consumer surplus.
• The surplus arises because we receive more than we pay for as a result of
the law of diminishing marginal utility.
 Consumer surplus

• We have consumer surplus because we pay the same amount for each
unit of a commodity that we buy, from the first to the last. We pay the
same price for each egg. Thus we pay for each unit what the last unit is
worth.
• But, by the law of diminishing marginal utility, the earlier units are worth
more to us than the last. Thus, we enjoy a surplus of utility on each of
these earlier units.
• Because consumers pay the same price of the last unit for all units
consumed, they enjoy a surplus of utility over cost. Consumer surplus
measures the extra value that consumers receive above what they pay for
a commodity.
• Applications of consumer surplus:
• This concept is very useful in evaluating many government decisions. For
example, how can the Govt. decide on the value of a building a new
highway or a bridge?
 Consumer surplus

• Being free to all, it will bring in no revenue. The value to users will be
found in time saved or in safer trips and can be measured by the individual
consumer surplus.
• Consumer surplus concept is used when performing a cost-benefit
analysis, which determines the costs and benefits of a Govt. program.
• The concept of consumer surplus points to the enormous privilege
enjoyed by the citizens. Each of us enjoy a vast array of enormously
valuable goods that can be bought at very low prices.
 Indifference curve analysis
• More advanced approach to deriving demand curves and consumer
behavior is called indifference curves.
• Let us assume you are a consumer who buys different combinations of
two commodities, say food and clothing, at a given set of prices.
• For each combination of the two goods, assume that you prefer one to
the other or are indifferent between the pair. For example, when asked to
choose between combination A of 1 unit of food and 6 units of clothing
and a combination B of 2 units of food and 3 units of clothing, you might
prefer A to B, or prefer B to A or be indifferent between A and B.
• Suppose A and B are equally good in your eyes –or you are indifferent as
to which of them you receive. There are many combinations of goods
about which you are indifferent. This can be shown diagrammatically.
Indifference curves
 Indifference curves

• The figure shows these diagrammatically. We measure units of clothing on

one axis and units of food on the other. Each of the foue combinations of
goods is shown by points A, B, C, D. But these four combinations are not
the only combinations among which you are indifferent. Other
combinations might be equal to A,B,C,D and many such combinations are
not shown.
• The curved contour in the figure, linking the four points is an indifferent
curve. The points on the curve represent consumption bundles among
which the consumer is indifferent i.e. all are equally desirable.
• LAW OF SUBSTITUTION
• Indifference curves are drawn as bowl-shaped or convex to the origin. As
you move downwards and to the right along the curve –a movement that
implies increasing the quantity of food and reducing the units of
clothing-the curve becomes flatter. The curve illustrates a property which
is often true in reality is called the law of substitution.
 Indifference curves

• The law states- the scarer a good, the greater its relative substitution value; its
marginal utility rises relative to the marginal utility of the good that has become
plentiful.
• Thus, in going from A to B in the figure, you would swap 3 units of your 6
clothing units for 1 extra food unit. From B to C, you would sacrifice only 1 unit
of your remaining clothing supply to obtain a third food unit –a 1 for 1 swap. For
a fourth unit of food, you would sacrifice only ½ unit of the clothing.
• If we join points A and B ,we find the slope of the resulting line has a value of 3..
From B to C the slope is 1; form C to D the slope is ½.
• These figures—3,1,1/2 are the substitution ratios called as marginal rate of
substation between two goods.
• The slope of the indifference curve is the measure of the goods’ relative
marginal utilities or of the substitution terms on which the consumer would be
willing to exchange a little less of one good in return for a little more of the
other.
 Indifference curves

• The indifference curve conforms to the law of substation. As the amount

of food you consume goes up, the quantity of clothing goes down-food
must become relatively cheaper in order for you to be persuaded to take a
little extra food in exchange for a little sacrifice of clothing.
• The shape and slope of the curve will vary from consumer to the next.
• THE INDIFFERENCE MAP:
• In the earlier diagram, we have seen one of an infinite number of possible
combinations. There could be different combinations that would bring the
consumer to a higher level of satisfaction. One such combination could be
with 2 units of food and 7 clothing units; another with 3 food units and 8
clothing units. All such combinations can be portrayed graphically, each
with a corresponding indifference curve.
Indifference curves
 The indifference curve

• The figure shows four such curves. A person who walks along the path
indicated by a particular height contour on such a map is neither climbing
nor descending ; similarly , the consumer who moves from one point
position to another along a single indifference curve enjoys neither
increasing nor decreasing satisfaction from the change in consumption.
• As we increase both goods thus move in a northeasterly direction across
the map, we are crossing successive indifference curves; hence, we are
reaching higher and higher levels satisfaction( assuming that the
consumer gets greater satisfaction from receiving increased quantities of
both goods). So curveU3 stands for a higher level of satisfaction than U2.
 Factors of production

• Another term for inputs is factors of production. These are classified into
three broad categories—land, labor, capital.
• Land or generally the natural resources are the gift of nature to the
society. It consists of land used for farming, building houses, factories,
roads, energy resources like petrol, coal etc,as well as minerals like iron,
aluminium, sand.
• Labor consists of human time spent in production—working in offices and
factories, teaching etc. Thousands of occupations and skills used by
humans which are crucial for industrial development.
• Capital resources from the durable goods of an economy, produced in
order to produce more other goods. Capital goods include machines,
computers, software, steel mills etc. The production and accumulation of
capital goods is essential for the economic development of a country.
 Production function

• One of the most important measures of economic performance is

productivity. Productivity is a concept measuring the ratio of total output
to a weighted average of inputs.
• Two important variants are labor productivity , which measures the
amount per unit of labor, and the total factor productivity , which
measures output per unit of total inputs( of capital and labor).
• We have seen inputs like land, labor and outputs like foodgrains, machines
and numerous products for consumption.
• If you have a fixed amount of inputs, how much output can you get?
• Given the available technical knowledge, land, machinery, capital, only a
certain quantity of goods can be obtained from a given amount of labor.
The relationship between the amount of input required and the amount of
output that can be obtained is called the production function.
 Production function

• The production function specifies the maximum output that can be

produced with a given quantity of inputs. It is defined for a given state of
engineering and technical knowledge.
• For example, look at production function for electricity generation. One
way is electricity based on gas turbine, another is based on thermal or coal
based plants, third is solar based plants, fourth is hydel plants. Taken
together, they constitute the production function for electricity
generation.
• There are millions of different production functions- one for each and
every product or service. In areas where technology is changing rapidly,
like in software and biotechnology, production functions may become
obsolete soon after they are used. The concept of production function is
useful way of describing the productive capabilities of a firm.
 Law of variable proportions

• The law of variable proportions or Returns to a factor shows the short run
production functions in which one factor varies while the others are fixed.
• The law concerns itself with the way output changes when you increase
the number of units of a variable factor. It refers to the effect of changing
factor ratio on the output.
• The law exhibits the relationship between the units of a variable factor
and the amount of output in the short term. This is assuming that all other
factors are constant. This relationship is called returns to a variable factor.
• The law states that keeping other factors constant, when you increase the
variable factor, the total product initially increases at an increasing rate,
and eventually starts declining.
• As one input varies and all others remain constant, the factor ratio or
factor proportion varies.
Law of variable proportions
 Law of variable proportions

• In this example, the land is a fixed factor and labor is a variable factor. The table
shows the different amounts of output when you apply different units of labor
to one acre of land, which is a fixed factor.
• To explain, we draw two curves-Total Physical Produce(TPP) and Marginal
Physical Product (MPP) curves against the variable input labor.
• The TPP increases at an increasing rate and the MPP increases too. The MPP
increases with an increase in the units of variable factor. Therefore, it is also
called the stage of increasing returns. Stage 1
• In stage 2 the TPP continues to increase but at a diminishing rate. The increase
is positive. The MPP decreases with an increase in the number of units of the
variable factor. So, its called the stage of diminishing returns.(Between points L
and M). This stage reaches a point where TPP is maximum and MPP becomes
zero.
• In stage 3, TPP starts declining. MPP decreases and becomes negative.
Therefore, it is called the stage of negative returns.(From point M onwards).
 Law of variable proportions

• Let’s understand with an example. In this, land is a fixed factor and labor is
a variable factor. The table shows different amounts of output when you
apply different units of labor to one acre of land which is fixed.
 Law of variable proportions

• Significance of the stages:

• In stage 1, marginal product increases with an increase in the variable
factor. So, the producer can employ more units of the variable factor to
efficiently utilize fixed factors. Hence, he will not stop at stage 1 but will
expand further.
• Producer will prefer stage 2 of the operation as it is most relevant to him.
This stage id of diminishing returns.
• In stage 3, there is a decline in total product and the marginal product
becomes negative. In order to increase the output, producer will reduce
the amount of variable factor. However, in stage 3 he incurs higher costs
and also gets lesser revenue thereby getting reduced profits.
 Total, average and marginal product

• There are three important production concepts-total, average and

marginal product.
• Total product is the total amount of output produced, in physical units
such as kgs of wheat or tons of steel. The total product starts at zero for
zero labor and then increases as additional units of labor are applied. It
shows how total product responds as the amount of labor applied is
increased.
• Once we know the total product, we can derive marginal product. The
marginal product of an input is the extra output produced by 1 additional
unit of that input while other inputs are held constant. For example,
assume that we are holding land, machinery , and all other inputs
constant. Then labor’s marginal product is the extra output obtained by
adding 1 unit of labor.
• Average product is equal to total output divided by total units of input.
 Law of diminishing returns
• Under the law of diminishing returns, a firm will get less and less extra
output when it adds additional units of an input while holding other inputs
fixed. In other words, the marginal product of each unit of input will
decline as the amount of that input increases, holding all other inputs
constant.
• Its expresses a very basic relationship. As more of an input such as labor is
added to a fixed amount of land, machinery and other inputs, the labor
has less and less of the other factors to work with. The land gets more
crowded, machinery overworked, and the marginal product of labor
declines.
• RETURNS TO SCALE
• Diminishing returns and marginal products refer to the response of output
to an increase of a single input when all other inputs are held constant.
 Returns to scale

• Diminishing returns and marginal products refer to the response of output to an

increase of a single input when all other inputs are held constant. Sometimes we are
also interested to see the effect of increasing all inputs. What would happen to wheat
production if land, labor, and other inputs are increased by the same proportion? What
would happen to the car production if the quantities of labor, computers, steel,
components, factory space were all doubled?
• These questions refer to returns to scale , or the effects of scale increases of inputs on
the quantity produced. There can be three distinct possibilities:
• 1. CONSTANT RETURNS TO SCALE: A case where a change in all inputs leads to a
proportional change in output. For example, if labor , land capital and other inputs are
doubled, then under constant returns to scale output would also double.
• [Link] RETURNS TO SCALE: (Also called economies of scale) arise when an
increase in all inputs leads to a more than proportional increase in the level of output.
A small manufacturing unit will find that increase in labor, capital , and materials by
10% will increase the total output by more than 10%.Many manufacturing processes
enjoy modestly increasing returns to scale for plants up to the largest size used today.
 Returns to scale

• DECREASING RETURNS TO SCALE: occur when a balanced increase of all

inputs leads to a less than proportional increase in total output. In many
manufacturing processes scaling up may eventually reach a point beyond
which inefficiencies set in. These might arise because of the cost of
management or control become large. In certain cases, when plant size
becomes too large risks of plant failure grow.
• Production shows increasing, decreasing or constant returns to scale when
a balanced increase in all inputs lead to a more than proportional, less
than proportional, or just proportional increase in output.
• Modern mass production techniques require that factories be of a certain
minimum size. Large scale production allows intensive use of specialized
capital equipment , automation and computerized design and
manufacturing to perform simple and repetitive tasks quickly.
Productivity and aggregate production function

• One of the most important measures of economic performance is productivity.

Productivity is a concept measuring the ratio of total output to a weighed
average of inputs. Two important variants are labour productivity, which
calculates the amount of output per unit of labor, and factor productivity , which
measures output per unit o total inputs( typically of capital and labor)
• A central concept in economics is productivity, a term denoting the ratio of
output to inputs.
• Total factor productivity is output divided by an index of all inputs(labor, capital,
materials). Labor productivity measures output per unit of labor (such as hours
worked). When output is growing faster than inputs, this represents productivity
growth.
• Productivity grows because of technological advances process and product
innovations.
• A process innovation occurs when new engineering knowledge improves
production techniques for existing products. Product innovation occurs when
new or improved products are introduced in the market.
 Productivity

• For example, a process innovation allows firms to produce more output with the
same inputs or to produce the same output with fewer inputs. A process
innovation is equivalent to a shift in the production function.
• Productivity also grows because of economies of scale and scope.
• Economies of scale and mass production have been important elements of
productivity growth. Most production processes are many times larger than
they were during the nineteenth century.
• If increasing returns to scale prevail, the larger scale of inputs and production
would lead to greater productivity.
• A different kind of efficiency arises when there are economies of scope. They
occur when a number of different products can be produced more efficiently
together than apart. For example, software programs often incorporate
additional features as they evolve. This shows economies of scope because the
different modules can be more inexpensively produced , packaged and used
together than separately. Economies of scope are like the specialization and
division of labor that increase productivity as economies become larger and
more diversified.
 Productivity

• Increasing returns to scale and scope are potentially large in many sectors,
at some point decreasing returns to scale and scope may take place. As
firms becomes larger and larger, the problems of management and
coordination become increasingly difficult. In order to make more profits,
a firm may find itself expanding into more geographic markets or product
lines than it can effectively manage. A firm can have only one CEO, one
FO, and one board of directors. With less time to study each market and
spend on each decision, top management become insulated and begin to
make mistakes. Such firms find themselves vulnerable to invasion by small
er and more agile firms.
 Isoquant analysis

• A firm’s objective is profit maximization. In the short run, its total output
will remain fixed due to capacity constraint, its total revenue will remain
fixed. Therefore, the only way to maximize profits in the short run is to
minimize costs. Thus, profit maximization and cost minimization are the
two sides of a coin. The most important determinant of a firm’s
price-output decision is its cost of production.
• Its costs depend on two important factors:
• 1. Its technical relation between inputs and output(how output varies as
inputs vary)
• [Link] prices( price of labor i.e. wages and price of capital i.e. interest)
• The long-run production function of a firm involving usage of these two
factors –labor and capital-is represented by equal product curve or
isoquant. The curve is also known as producer’s indifference curve. An
isoquant traces out the combination of any two inputs which yield the
same level of output.
 Isoquant analysis
• This combinations must be the most efficient ones-i.e. any point on an
isoquant shows the minimum quantities of inputs required to produce a
given output. Isoquants are convex to the origin.
• An isoquant is a locus of points showing all the technically efficient ways
of combining factors of production to produce a fixed level of output. It is
also known as the equal product curve. In case of two variable factors-
labor and capital- isoquant appears as a curve on a graph where the
quantities of two factors are measured on the two axes The curve shows
the efficient alternative techniques of production or alternative
combinations of two factors that can produce a fixed level of output.
Isoquant analysis
 Isoquant analysis

• The table illustrates by using hypothetical numbers, seven alternative

methods of producing six units of output. These alternatives are shown in
the curve diagram where Q=6. Thus the firm could choose combination
a(18k+2L), combination g(2k=18L), or any other combination shown in the
table.
Isoquant curves
 Isoquant curves

• Figure 5 also shows two other isoquants, each corresponding to a

particular, fixed level of output—Q=8, Q=10. Each curve shows the
alternative combinations of labor and capital that would produce 8 and 10
units of output respectively. We could draw as many isoquants as we like.
• An isoquant shows what a firm is desirous of producing. But the desire to
produce a commodity is not enough. The producer must have sufficient
capacity to buy necessary factor inputs to be able to reach its desired
production level. The capacity of the producer is shown by his monetary
resources, i.e. his cost outlay or how much money he is capable of
spending on capital and labor, the prices of which are taken as constant
given the market place.
• Thus, like a consumer, a producer has to operate under the budget
constraints. This is shown by the budget line called the isoquant line. To
find the least cost combination of inputs to produce a given output, we
need to construct such equal cost lines or isoquant lines.
 Market structure

• Perfect competition is an idealized market of atomic or small firms who

are price takers. Such firms are hard to find. When you buy a car or
computer or food items you are dealing with firms large enough to affect
the market price. Most markets in the economy are dominated by large
firms, often two or three or more.
• A perfectly competitive market is one in which no firm is large enough to
affect the market price.
• In real world, for a given technology, prices are higher and outputs are
lower under imperfect competition than under perfect competition. So,
we need to study how imperfectly competitive markets work.
• Looking at all the possible goods available in the market, most of the firms
show imperfect competition as they fail the simple test of perfect
competition—most firms in the industry can affect the market price by
changing the quantity they sell . Thus, they have some control over the
price of their output.
 Market structure

• Imperfect competition.
• If a firm can affect the market price of its output, it is classified as imperfect
competition. Imperfect competition prevails in an industry whenever individual
sellers can affect the price of their output. The major kinds of imperfect
competition are monopoly, oligopoly and monopolistic competition.
• Imperfect competition does not imply that a firm has absolute control over price
of its product. Coca-cola, Pepsi together have the major share of the market,
thus imperfect compaction prevails. None of these giants can price their
products too high or too lower than the market price, but can be lower than the
others and still be able to make huge profits. So, imperfect competition has
some but not complete discretion over its prices.
• The amount of discretion over price will differ from industry to industry. In some
imperfectly competitive industries, the degree of monopoly power is small. In
retail computer market, more than a few percent difference in price will usually
have a significant effect upon a firm’s sales. Whereas, in computer operating
systems, Microsoft has a virtual monopoly and has great discretion about the
price of Windows software.
Market structure
 Market structure

• The horizontal demand curve in the first figure indicates that a firm can sell all it wants
at the going market price. In contrast, an imperfect competitor facing a downward
sloping demand curve, shows that if an imperfectly competitive firm increases its sales,
it will depress the market price of its output as it moves down its dd demand curve.
• Another difference between the two is by looking at the price elasticity of demand.
• For perfect competition., demand is perfectly elastic , for an imperfect competitor,
demand has a finite elasticity. The fact that demand curves of imperfect competitors
slope downwards implies that imperfect competitors are price-makers not price-takers.
They must decide on the price of their product , while perfect competitors take the
price as given.
• The imperfectly competitive market is classified into three different market structures:
• Monopoly: At one end of competitive spectrum is perfect competition with a vast
multitude of firms. At the other end is monopoly, which is a single seller with complete
control over an industry. A monopolist is the only firm producing in the industry. There
is no other industry producing a close substitute.
 Market structure

• Monopolies are rare today. Most monopolies exist because of some form
of government protection.
• Another example is that of a pharma firm which discovers a life saving
drug may be granted a patient , which gives it monopoly control over that
drug for a number of years.
• Another example is that of franchised local utility, such as a firm providing
water supply or electricity. In this case, there is a single seller with no
other substitute.
• Microsoft Windows is an example of a monopoly without government
license. The company has achieved this position due to its large
investments in in R&D, rapid innovations, network economies, and tough
tactics against competitors.
• But monopolies must be always looking for their potential competitors. In
the long run, no monopoly is completely secure from attack by
competitors.
 Market structure

• Oligopoly: It means few sellers. The number can be as small as 2 or as

large as 10to15. The important feature is that each individual firm can
affect the market price. In airline industry, the decision of a single airline
to lower fares can set off price war which brings down the fares charged
by all its competitors.
• Monopolistic competition: In this situation a large number of sellers
produce differentiated products. As there are many sellers , this market
structure resembles perfect competition , where none of the sellers have
a large share of the market. It also differs from perfect competition in that
the products sold by different firms are not identical. Differentiated
products are the ones whose important characteristics vary. Personal
computers or smart phones have differing characteristics such as speed,
memory, hard disk, size, weight etc. Because computers , smart phones
are differentiated, they can sell at different prices.
 Market structure

• Most personal computers can run the same software, and there are many
manufacturers. Yet, the personal computer industry is a monopolistically
competitive industry because computers differ in speed, size, memory,
repair services etc.
 Costs

Wherever there is production, there are costs. Firms must pay for their
inputs: raw materials, software, labor, computers etc.
Costs affect input choices, investment decisions, even decisions to stay in
business. Is it cheaper to hire a new labor or to pay overtime? To open a
new factory or expand a new one? To invest in new machinery
domestically or to outsource production abroad?
Businesses want to choose those methods of production that are most
efficient and produce output at the lowest costs.
TOTAL COST: FIXED AND VARIABLE
Fixed costs are expenses that must be paid even if the firm produces zero
output. They are also called overheads or sunk costs. They consist of
items such as rent for factory or office space, interest payment on debts,
salaries of employees, etc. They are fixed because they do not change if
the output changes. FC is the amount that must be paid regardless of the
level of output and remains constant.
Costs
 Costs

• Variable costs do vary as output changes. Examples are materials required

to produce output, workers, electricity , fuel and power, etc.
• VC begins at zero when q is zero. VC is a part of TC that grows with output.
• In short, total costs represent the lowest rupee expense needed to
produce each level of output q. TC rises as q rises. Total costs represents
the total expense that is paid out even when no output is produced; fixed
cost is unaffected by any variation in the quantity of output.
• Variable cost represents expenses that vary with the level of output and
includes all costs that are not fixed. Thus TC=FC+VC.
• Marginal cost—MC– denotes the extra or additional cost of producing 1
extra unit of output. Sometimes, the marginal cost of producing an extra
unit of output can be quite low. For example, for an airline flying with lots
of empty seats , the added cost of another passenger can be literally
peanuts, as no additional capital or labor is necessary. It can be quite high
in other cases.
 Costs

• For example, for an electric utility, under normal conditions, it can

generate enough power using its lowest cost, most efficient plants. But,
during summers, when the power demand shoots up, the power plant
may be forced to turn on its high cost , old and inefficient generators. This
added power comes at a high marginal cost to the utility.
 Costs

• Average cost or Unit cost:

• Average cost is the total cost divided by the total number of units
produced, or
• Average cost =total cost/ output=TC/q=AC.
• Average cost is a widely used concept in in business.
• By comparing average cost with price or average revenue businesses can
determine whether or not they are making a profit.
 Costs

• Average fixed and variable costs:

• We can further break average cost into fixed and variable components.
Average fixed cost(AFC) is defined as FC/q. Since total fixed cost is
constant, dividing it by an increasing output gives a steadily falling
average fixed cost .In other words, as a firm sells more output , it can
spread its overhead cost over more and more units.
• Average variable cost(AVC) is variable cost divided by output or AVC= VC/q
• Relation between average cost and marginal cost:
• [Link] marginal cost is below average cost, it is pulling average cost
down.
• When MC is above AC, it is pulling up AC.
• [Link] MC equals AC, AC is constant
 Cost

• If MC or marginal cost is below AC, this means that the last unit produced
costs less than the average cost of all the previous units produced. This
implies that the new AC –the AC including the last unit—must be less than
the old AC , so C must be falling.
• We can see from the table that the AC of the first unit is 85. The MC of the
second unit is 25. This implies that the AC of the first two units is
(85+25/2=55) because MC was below AC ,implying AC is falling.
• The second rule is illustrated by the case of sixth unit. The AC of 5 units is
42, and MC between 5 and 6 units is 70. MC is pulling up AC as we see by
the AC of the sixth unit , which is 46 and2/3.

• In the case of fourth unit , the AC is exactly equal to MC at a cost of 40. So

, the new AC is exactly equal to the old AC and is equal to MC.
Cost
 cost

• What are the factors that determine the cost curves? The key elements are
factor prices and the firm’s production function.
• Prices of inputs like labor and land are important ingredients of costs. Higher
rents and higher wages mean higher costs. But, costs also depend on the firm’s
technological opportunities. If technological improvements allow the firm to
produce the same output with fewer inputs, the firm’s costs will fall.
• Diminishing returns and U shaped cost curves
• Often cost curves are like the letter “U”. For U shaped cost curve, costs fall in the
initial phase, reaches a minimum point, and then begins to rise. Lets consider
the reasons :
• In the short run—the period of time that is long enough to adjust variable
inputs, such as materials and labor, but too short to allow all inputs to be
changed. In the short run, fixed or overhead factors such as plant and
equipment cannot be fully modified or adjusted. Therefore, in the short run,
labor and material costs are typically variable costs, while capital costs are fixed.
 Cost

• In the long run, all inputs can be adjusted including labor, materials, and
capital. Hence in the long run, all costs are variable and none are fixed. For
example, the number of planes an airline owns is a fixed cost. But, over
the long run the airline can control its fleet size by either buying or selling
planes.
• In the short run, we will consider capital to be the fixed cost and labor to
be the variable cost.
• Why is the cost curve U shaped? In the short run in which capital is fixed
and labor variable. In this situation, there are diminishing returns to the
variable factor- labor-because each additional unit of labor has less capital
to work with. As a result, the marginal cost of output will rise because the
extra output produces by each extra labor unit is going down. In other
words, the diminishing returns to the variable factor will imply an
increasing short run marginal cost. This shows why diminishing returns
lead to rising marginal costs.
 Cost

• The figure bellow illustrates the point. It shows that the region of
increasing marginal product corresponds to falling marginal costs, while
the region of diminishing returns implies rising marginal costs.
 Cost

• In the short run, when factors like capital are fixed, variable factors tend
to show an initial phase of increasing marginal product followed by
diminishing marginal product. The corresponding cost curves show an
initial phase of declining marginal costs, followed by increasing marginal
costs after diminishing returns have set in.
• OPTIMAL COMBINATION OF FACTOR INPUTS:
• Every firm must decide how to produce its output. Should electricity be
produced by using oil, coal, nuclear energy or hydel energy? Should a firm
hire more employees or outsource the job?
• To find this, we will make an assumption that firms minimize their costs of
production. The cost minimization assumption holds good for not only
perfectly competitive markets, but for monopoly and other market
structures. It states that a firm should strive to produce its output at the
lowest possible cost and thereby have the maximum amount of revenue
left over as profits.
 Costs

• For example, let us see how a firm can decide between different input
combinations.
• The desired level of output of say 9 units can be produced with two possible
options. In both cases the energy costs Rs. 2 per unit, labor costs Rs. 5 per hour.
Under option 1, the input mix is energy=10 and labor-2. In option 2, energy=Rs.4
and labor=Rs.5. Which is the preferred option for the firm? At the given market
prices of inputs, total production costs for option 1 are (2x10)+(5x2)= Rs.30.
Option 2 will cost (2x4)+(5x5)=Rs.33. Therefore. Option 1 would be the preferred
low cost combination of inputs.
• In reality, there are more options of input combinations. Then how does a firm
decide on the least-cost combination?
• It is done by calculating the marginal product of each input , then divide the
marginal product of each input by its factor price. This gives you the marginal
product per rupee of input. The cost minimizing combination of inputs comes
when marginal product per rupee of input is equal for all inputs. That is the
marginal contribution to output of each rupee’s worth of labor, land, etc. must
be the same.
 Costs

• Thus, a firm will minimize its total cost of production when the marginal
product per rupee of input is equalized for each factor of production. This
is called the least cost rule. To produce a given level of output at least
cost, a firm should buy inputs until it has equalized the marginal product
per rupee spent on each input.
• Marginal product of L /Price of L=Marginal product of A /Price of A=…..
• The corollary of the least-cost rule is the substitution rule: If the price of
one factor falls while all other factor prices remain the same, firms will
profit by substituting the now cheaper factor for the other factors until
the marginal products per rupee are equal for all inputs.
• OPPORTUNITY COSTS:
• We have seen that in Economics one of the cardinal tenets is that
resources are scarce. That means every time we choose to use a resource
one way, we have given up the opportunity to utilize it another way. We
have to constantly decide what to do with our limited time and income.
 Costs

• Making choice costs us the opportunity to do something else. The value of

the best alternative foregone is called the opportunity cost. The
opportunity costs of a decision include all its consequences, whether they
reflect monetary transactions or not.
• Decisions have opportunity costs because choosing one thing in a world of
scarcity means giving up something else. The opportunity cost is the value
of the most valuable good or service foregone.
• Business decisions have opportunity costs too. There are several
important opportunity costs that do not show up on income statements or
profit and loss statement. For example, in small businesses, the owner and
his family may put in many unpaid hours , which are not accounted as
accounting costs. Business accounts do not account for capital charge for
owner’s financial contribution or the environmental damage that occurs
when a business dumps toxic wastes in to a stream. But from an economic
point of view, each of these is a genuine cost to the economy.
 Costs

• In well functioning markets, when all costs are included , price equals
opportunity cost. If, for example, a farmer brings his wheat to market, he
will receive a number of bids from different buyers. He will pick up the
best available price to sell his wheat. The opportunity cost of this sale is
the value of the best available alternative—that is the second best bid
which is the closest to the price that is accepted. In competitive markets,
numerous buyers compete to the point where price is bid pp to the best
alternative and is therefore equal to the opportunity cost.
• During exams, time has a very high opportunity cost. After exams, time
has a lower opportunity cost. Thus, the concept of opportunity cost is
crucial when you analyze transactions that take place outside markets. For
example, how do you measure the value of a road, bridge or a park?
• Opportunity cost , is a measure of what has been given up when we make
a decision.
 Costs

• There are implicit and explicit costs. Explicit costs are those which are
directly paid to other parties by an entrepreneur or a company running a
business.--e.g. cost of labor, raw materials, machinery purchased etc.
• Implicit costs are those for which there is no direct payment but indirectly
there is cost involved. Example-If you are using your own house on the
ground floor for your own business and stay on the first floor, you are
effectively losing the rent income for your ground floor. This is an implicit
cost of your business. This does not show directly in your accounts.
• Explicit costs are also called as accounting costs. Explicit costs and implicit
costs reflect the true costs of running a business and are called as
economic costs.
 Break even analysis

• Break even analysis tells you how many units of a product must be sold to cover
the variable and fixed costs of production. The break-even point is considered as
a measure of the margin of safety.
• This analysis entails calculating and examining the margin of safety for an entity
based on the revenues collected and the associated costs. The analysis shows
how many sales it takes to pay for the cost of doing a business. Analysing
different price levels relating to various levels of demand the break even analysis
determines what level of sales are necessary to cover the company’s total fixed
costs.
• How it is used:
• It is useful in determining the level of production or a targeted desired sales mix.
It calculated by using a break even point. The break even point is calculated by
dividing the total fixed costs of production by the price per individual unit less
the variable costs of production.
• Break even analysis looks at the level of fixed costs relative to profit earned by
each individual unit produced and sold. In general, a company with lower fixed
costs will have a lower break even point of sale.
 Break even analysis

• The concept of break even analysis is concerned with contribution margin

of a product. The contribution margin is the excess between the selling
price of a product and the total variable costs.

• REVENUE, MARGINAL REVENUE

• Revenue is the income generated from normal business operations. It is
the gross income figure from which costs are deducted to determine net
income figure.
• Sales revenue= sales price x no of units sold
• Net revenue ,also known as the bottom line, is revenues minus expenses.
There is profit when revenue exceeds expenses. To increase profits, a
company can either increase price and thus increase revenues or reduce
expenses. It is possible for net income to grow while revenues remain
stagnant due to cost cutting.
 Revenue

• Revenue can be divided into operating revenue—sales from a company’s

core business—and non-operating revenue which is derived from
secondary sources. As these non- operating sources are often
unpredictable or non-recurring , they can be said to be one time gains. For
example, a windfall from a one time sale of an asset, or money awarded in
legal litigation.
• In case of Govt; revenue is the money received through taxation, fees,
fines, securities sales etc.
• Revenue is the money a company earns through sale of its products and
services. Whereas cash flow is the net amount of cash being transferred
into and out of a company. Revenue provides a measure of effectiveness
of a company’s sales and marketing, whereas cash flow is more of a
liquidity indicator. Both revenue and cash flow should be analyzed to
know a company’s financial health.
 Revenue

• In Economics, types of revenue are total revenue, average revenue and

marginal revenue.
• Total revenue is the income earned by a seller or producer after selling
output.
• Average revenue refers to the revenue obtained by a seller by selling the
per unit commodity. It is calculated by dividing the total revenue by total
units sold.
• Marginal revenue is the change in revenue that is generated by an
additional unit of [Link] can be either positive or negative.
• Relationship between revenue and price elasticity:
• What is the relationship between marginal revenue and price elasticity of
demand? Marginal revenue is positive when demand is elastic , zero when
demand is unit elastic, and negative when demand is inelastic.
 Revenue

• We have seen that demand is elastic when a price decrease leads to a

revenue increase. In such a situation, a price decrease raises output
demanded so much that revenues rise, so marginal revenue is positive.
• What happens when demand is unit elastic? A percentage price cut then
just matches the percentage output increase, and marginal revenue is
therefore, zero.
• Marginal revenue is negative when demand is inelastic.
 Revenue

• Important points to understand are:

• Marginal revenue(MR)is the change in revenue that is generated by an additional unit
of sales.
• Price=average revenue(P=AR)
• With downward sloping demand curve, P> MR=P-reduced revenue on all previous units
• Marginal revenue is positive when demand is elastic, zero when
• demand unit elastic, and negative when demand is inelastic.
• For perfect competition P=MR=AR
• Pricing and profit maximizing:
• Now, let us see how a monopolist should set its price and quantity if it wants to
maximize profits. Total profits equals total revenue minus total costs. TP=TR-TC= (P X
q)-TC.
• As long as each additional unit of output provides more revenue than it costs, the firm’s
profit will increase as output increases. So the firm should continue to increase its
output as long as MR>MC. Thus, maximum profit will occur when output is at that level
where the firm’s marginal revenue is equal to its marginal cost.
 Revenue

• If, on the other hand, MR is less than the MC at a given output, it means that
increasing output lowers profits, so the firm should cut back on output. So, the
best profit point comes where marginal revenue exactly equals marginal cost.
The maximum profit price (P) and quantity (q) of a monopolist come when the
firm’s marginal revenue equals its marginal cost.
• Thus, when MR exceeds MC, additional profits can be made by increasing
output; when MC exceeds MR, additional profits can be made by decreasing q.
Only when MR=MC can the firm maximize profits, because there are no
additional profits to be made by changing its output level.
• We have applied the MR=MC rule to monopolists who desire to maximize
profits, this rule is equally applicable to a profit-maximizing perfect competition.
• MR FOR PERFECT COMPETITOR:What is MR for a perfect competitor? For a
perfect competitor, the sale of extra units will never depress price, and the lost
revenue on all previous q is therefore equal to zero. Thus, price and marginal
revenue are identical for perfect competitors.
 Revenue

• Under perfect competition, price equals revenue equals marginal revenue

• (P=AR=MA). A perfect competitor’s dd curve and coincide as horizontal lines.
• MR=P=MC for a perfect competitor: the logic of profit maximization for
monopolists applies equally well to perfect competitors, but the result is little
different. As per the economic logic profits are maximized at that output level
where MC equals MR. But we have seen earlier that for a perfect competitor,
MR equals P. Therefore, the MR=MC profit=maximization condition becomes
the special case of P=MC.
• Because a perfect competitor can sell all it wants at the market price, MR=P=MC
at the maximum profit level of output.
• So, one of the most important lessons of economics is that you should look at
the marginal costs and marginal benefits of decisions and ignore past or sunk
costs.
• Leave the past , don’t look backward. Make a realistic decision based on
calculation of extra costs you will incur by any decision, and weigh these against
its extra advantages. Make a decision based on marginal costs and marginal
benefits.
 Revenue

• This is the marginal principle, which means that people will maximize their
incomes and profits or satisfactions by counting only the marginal costs
and marginal benefits of a decision. The marginal principle of equating
marginal cost and marginal revenue is the rule for profit maximization by
firms.

• PRICING POLICIES:
• We have studied perfect and imperfect market structures. The extreme
cases of perfect competition and complete monopoly are rare. Most
industries lie in between these two extremes and are populated by a small
number of frims competing with each other. How do these intermediate
types of imperfect competitors set their prices and output? How do we
measure the power of firms in an industry to control price and output?
 Pricing

• Market power of a firm signifies the degree of control that a single firm or a
small number of firms have over the price and production decisions in an
industry.
• The most common measure of market power is the concentration ratio for an
industry. The four firm concentration ratio measures the fraction of the market
or industry accounted for by the four largest firms. The market is measured by
domestic sales, shipments or output. In pure monopoly , the four firm
concentration ratio would be 100% and under perfect competition the ratio
would be close to zero because even the largest firms produce only a tiny
fraction of industry output.
• As a result of high prices, oligopolistic industries have supernormal profits. For
example, tobacco and pharma sector firms.
• Oligopoly(collusive): The degree of imperfect competition in a market is
influenced not just by number and size of firms but by their behaviour. With only
a few firms in the market , they see what their rivals are doing and react.
Example, two airlines operating the same route and one raises its fare, the other
must decide whether to match the increase or stay with old fare.
 Pricing

• Strategic interaction describes how each firm’s business strategy depends

upon its rivals’ behavior. When there are only a small number of firms in a
market, they have a choice between cooperative and non-cooperative
behavior. Firms act noncooperatively when they act on their own without
any explicit or implicit agreements with other firms. That produces price
wars. Firms operate in a cooperative mode when they try to minimize
competition(explain). When firms in an oligopoly actively cooperate with
each other , they engage in collusion. A situation when two or more firms
jointly set their prices or outputs , divide the market among themselves,
or make other business decisions jointly.
• Firms are tempted to engage in tacit collusion, when they refrain from
competition without explicit agreements. A cartel is is an organization of
independent firms , producing similar products, that work together to
raise prices and restrict output.(explain). They form a collusive oligopoly
and set their prices which maximize their joint profits.
 Pricing

• When oligopolists collude to maximize their joint profits, taking into

consideration their mutual interdependence, they will produce the
monopoly output and price and earn the monopoly profit.
• The classic example of an international cartel is OPEC which is in existence
since 1973.
• Monopolistic competition: It resembles perfect competition as there are
many buyers and sellers, entry and exit are easy, and firms take other
firms’s prices as given. The difference is that products are identical under
perfect competition, while under monopolistic competition they are
differentiated. Within each product group , products or services are
different, but close enough to compete with each other.
• Each seller has some freedom to raise or lower prices because of product
differentiation.
 Pricing

• Rivalry among few:

• A market where only a few firms compete. Here, instead of focusing on
collusion, we consider a case where firms have a strategic interaction with
each other. Here, each business must ask how its rival will react to
changes in key business decisions like pricing, production, technology,
product differentiation, sales and ad. Strategy , new product introduction
etc.
• Such strategic interactions are found in many industries like television,
automobiles, personal computers, etc. Different cost and demand
structures, different industries, will lead to different strategic interactions
and to differing pricing strategies.
• Competition among the few introduces a completely new feature into
economic life as it forces firms to take into account competitors’ reactions
to price and output decisions and bring strategic considerations into their
markets.
 Pricing

• When firms have market power, they can increase their profits through
price discrimination. Price discrimination occurs when the same product is
sold to different consumers for different prices.
• For example, a firm selling financial programs can differentiate the price of
the same product to its existing and potential new customers. As its
existing customers or users have more price-inelastic demand than
potential new customers( as they are locked into your program as they
keep their records using the program), the firm can increase the price to
its existing users and offer a discounted price to attract its potential new
customers.
• GAME THEORY analyzes the ways in which two or more players choose
strategies that jointly affect each other. It has been used to study the
interaction of oligopolists, union-management disputes, trade and militaty
policies etc.
 Pricing

• When considering the pricing and price setting strategies, a firm has to
consider the reactions and counterreactions of rivals. If one firm cuts its
price, the other rivals are likely to follow suit as they don’t want to loose
their market. If such price cutting continues, it will end in mutual end at
price zero. Only the shortsighted firms will think that they can undercut
each other for long. Soon they will have to think what their rival will do if I
cut my price or raise it or keep it . Once you begin to consider how others
will react to your actions, you have entered the realm of game theory.
 Management

• The objectives of any technology management function is to help plan,

implement and maintain a stable technical infrastructure to support an
organization’s business processes. Management of technology links engineering,
science, and management disciplines to plan, develop ,and implement
technological capabilities to shape and accomplish strategic and operational
objectives of an organization.
• MoT is also defined as the art and science of creating value by using technology
together with other resources of an organization.
• MoT involves technological strategy and planning, technological forecasting,
management of innovation, implementation of technology, technology transfer,
requires a science perspective, technical competency, and managerial ability.
• The scope of MoT is very broad and diverse. For some, it relates to scientific
research and the development of new concepts. MoT means engineering design
and development, manufacturing or operations management. With increasing
complexity of our business environment, MoT focuses strongly on managing the
organizational processes and the people affiliated with them.s
 Management

• The technology leaders of today and future need to know a host of

multi-disciplinary topics such as current emerging technologies, project
and process management, organizational leadership, human behavior,
leadership of multifunctional teams, development of practical technical
knowledge, understanding social and economic issues, etc.
• Some of the most crucial functions of management are: planning,
organizing, staffing, directing, controlling , co-ordination and cooperation.
• Management is the process of getting things done through others. This
process needs some of the identified functions performed by managers to
accomplish their organizational goals. Management in an organization
plays a dominant role to achieve the targeted goals of profit maximization
and increased market share. The main aim of any management is to
achieve the organizational goals while using the organizational resources
most effectively.
 Management

• Management is what management does. To achieve their goals, the manager

performs some fundamental functions as mentioned earlier.
• [Link]: Planning is concerned with the determination of objectives to be
achieved and the course of action to be followed to achieve them. Before taking
any action, one has to decide how the work will be performed. Thus planning
involves decision making as to what is to be done, how it is to be done, when it
is to be done and by whom it is to be done. Planning helps in achieving the
objectives effectively and efficiently. Planning involves selecting of objectives
and strategies, policies and programs and procedures for achieving them.
• Planning function is performed by managers at every level because planning
may either be for the entire enterprise or for any section or department thereof.
Planning pervades the entire gamut of managerial activity, and also it is
continuous and never ending. Managers at the top level spend more time on
planning, managers at the lower level follow the policies, programs and
procedures laid down by the top management.
 Management functions
• For any business activity, planning is a prerequisite for doing anything and also to
ensure the proper utilization of resources of the firm to achieve the desired goals. Plans
can be classified into standing plans and single use plans. Standing plans includes
objectives, policies and procedures, methods and rules and single -use plans include
budgets, policies, strategies, programs and projects.
• [Link]: To organize a business is to provide it with everything useful to its
functioning– raw materials, tools, capital and personnel. Thus organizing involves
bringing together the manpower and material resources for achievement of objectives
laid down by the enterprise. It involves following processes:
• A) Determining and defining the activities involved in achieving the objectives laid down
by the management.
• B) Grouping the activities in logical pattern
• C) Assigning the activities to specific people and the positions and
• D) Delegating the authorities to their positions and people so as to enable them to
perform the activities assigned to them.
• Organizing function helps in increasing the efficiency of enterprise. By avoiding
repetition and duplication activities, it reduces the operation cost of the enterprise.
 Management functions

• 3) Staffing: Every enterprise is very much concerned with the quality of

the people, especially its managers. Staffing function is concerned with
this aspect. It involves manning the organizational structure through
proper and effective selection, appraisal and development of personnel to
fill the roles designed in the structure. The function involves:
• A) Proper selection of candidates for the positions
• B) Proper remuneration
• C) Proper training and development of the people so as to discharge their
organizational functions effectively
• D) Proper evaluation of personnel
• This function is performed by every manager of the organization as he is
actively associated with the selection, appraisal, training of his
subordinates.
 Managerial functions

• 4) Directing : It is the art and the process of getting things done. While other
function are preparations for doing the work, directing function actually starts
the work.
• Directing is concerned with the actuating the members of the organization to
work efficiently and effectively to achieve the organizational goals. Directing
involves the manager telling his subordinates how they have to perform the jobs
assigned to them. It involves guiding, supervising, and motivating the
subordinates for achieving the enterprise objectives. It concerns the manner in
which the manager the actions of his subordinates. It is the final action of a
manager in getting others to act after all preparations have been completed.
Functions involve:
• A) Communication or issuing orders and instructions to subordinates—what to
do, how to do, when to do.
• B) Guiding, leading, energizing subordinates to perform work systematically and
to build up among workers confidence and zeal in the work to be performed.
• C) Inspiring the subordinates to do the work with interest and enthusiasm for
the accomplishment of company’s objectives.
 Managerial functions

• D) Exercising supervision over the subordinates to ensure that the work done by
them is in conformity with the objectives that are determined.
• 4) Controlling : It is related to all other management functions. It is concerned
with in seeing whether the objectives have been performed in conformity with
the plans. It is a process of checking to determine whether or not proper
progress is being made towards the objectives and goals and acting if necessary
to correct any deviation. It is the measurement and correction of the
performance and activities of subordinates in order to make sure that the
organization’s objectives and plans devised to achieve them are being
accomplished.
• Thus, controlling function has following sub-functions:
• A)Determination of standards for measuring work performance
• B) Measurement of actual work performance
• C)Comparing actual work performance with standards
• D)Finding variances between the two and the reasons
• E) Taking corrective action to ensure attainment of objectives
 Management

• Scientific management is a theory of management that analyzes and

synthesizes the work flows. Its main objective is to provide economic
efficiency. Most of its themes are still important parts of industrial
engineering and management. It was pioneered by Fredrick Taylor in early
part of last century. These include: analysis, synthesis, logic, rationality,
efficiency, elimination of waste, standardization of best practices,
transformation of craft production into mass production knowledge
transfer between workers and from workers into toos, processes and
documentation.
• It uses scientific methods to determine and standardize the one best way
of doing a job. A clear vision of tasks and responsibilities, high pay for high
performing employees. Under this, both workers and management are
equally interested in attaining maximum output.
• The scientific management is based on five principles:
 Scientific management

• 1. Replacement of old rule of thumb methods: scientific investigation

should be used for taking managerial decisions instead of basing decisions
on opinions, rule of thumb or intuition. The principle of use of science for
rule of thumb is the starting point.
• 2. Scientific selection and training of workers: Selection of workers should
be designed scientifically in order to eliminate errors which might prove
costly later on. Selected workers should be trained for the jobs.
• 3. Co-operation between labor and management: It requires change in
mental attitude of both the workers and management towards each
other. They do not quarrel but turn their attention towards profit
maximization.
• 4. Maximum output; Both the parties should try to achieve maximum
output.
• [Link] division of responsibility: Management should be responsible for
planning and organizing work and workers for executing the work.
 Strategic management
• A strategy describes a framework for charting a course
of action– an approach for the company that builds on
its strengths and is a good fit with firm’s external
environment.
• It’s a guide for managers who implement it.
• By explaining how the firm intends to succeed in the
context it faces, the strategy alerts the management
to the assumptions about the firm’s context that are
essential for the strategy’s success.
• This information enables them to interpret contextual
changes, anticipating how these changes might affect
the firm’s performance.
 Understanding Vocabulary
• Strategic management is a broader term than strategy
and is a process that includes top management’s
analysis of the environment in which the organization
operates prior to formulating a strategy, as well as the
plan for implementation and control of the strategy.
• The difference between a strategy and the strategic
management process is that strategic management
includes the analysis that must be done before a
strategy should be formulated through assessing
whether or not the strategy was successful.
 Understanding vocabulary

• Strategy refers to top management’s plans to develop & sustain

competitive advantage so that an organization’s mission is fulfilled.(
mission statement for an orgn.)
• This definition assumes that an organization has a plan, its competitive
advantage is understood, and that its management understands the
reason for its existence.
• Strategic management is a broader term than strategy and is a process
that includes top management’s analysis of the environment in which it
operates before formulating its strategy as well as a plan for
implementation and control of the strategy.
• The difference between strategy and strategic management process is
that the latter includes the analysis that must be done before a strategy
should be formulated through assessing whether or not the strategy was
successful.
• It’s the study of the strategies of companies & how they are formulated,
implemented, and evaluated.
 Vocabulary…
• Strategy is the direction and scope of an organization over long term,
which achieves advantages for an organization through its configuration of
resources within challenging environment.
• It deals with issues regarding the overall organization, its business-
needing long range perspectives- the long term strategies are broken
down in medium range tactics, short term methods and daily activities.
• Corporate strategies provide directions & destinations to short term
activities.
• Its about identification of strategies that managers can carry out so as to
achieve better performance & competitive advantage for their
organization.( i.e. higher profitability than the average profitability for all
companies in the industry)
• Various decisions & actions which managers undertake impacts the result
of a firm’s performance. Hence the need to understand the general and
competitive organizational environment so as to take right decisions.
• Its also about planning for predictable and unpredictable contingencies.
 Vocabulary…
• Strategy at different levels of business:
• Corporate strategy: is concerned with overall purpose & scope of the business to
meet shareholder expectations. Corporate strategy is often stated explicitly in a
mission statement. For example, Coca-Cola has followed the growth strategy by
acquisition. It has acquired local bottling units to emerge as the market leader.
• Business Unit strategy: is concerned with how a business competes successfully in a
particular market. It is about strategic decisions about a) choice of products
b)meeting needs of customers c) gaining advantage over competitors d) exploiting
or creating new opportunities( example- Apple Computers uses a differentiation
competitive strategy that emphasizes innovative product with creative design)
• Operational strategy: is concerned with how each part of the business is organized
to deliver the corporate & business unit level strategic direction. It focuses on a)
resources b) processes c) people.
• Financial strategy is the approach by a functional area to achieve corporate &
business unit objectives & strategies by maximizing resource productivity. Its
concerned with developing & nurturing a distinctive competence to provide a firm
with competitive advantage. Example –P&G, HUL spend money on advertisements
to create consumer demand.
 Vocabulary..
• The strategic management process can be summarized in six
steps:
• [Link] analysis: Analyze the opportunities and threats and the
constraints that exist in the organization’s external environment;
including industry and macro-environmental forces.
• 2. Internal analysis; Analyze the organization’s strengths &
weaknesses in its internal environmental( orgn mission &
direction)
• [Link] & direction: Reassess the organization’s goals and
mission in the light of the previous two steps.
• 4. Strategy formulation: Formulate strategies that build and
sustain competitive advantage by matching organization’s
strengths & weaknesses with the environment’s opportunities and
threats.( defense production after new govt).
• [Link] implementation: Implementation the strategies that
have been developed.
 Vocabulary..

• 6. Strategic control: Engage in strategic control activities when the

strategies are not producing the desired results.
• (The PDCA cycle)
• Changes in one stage- modifications due to environmental or
organizational conditions changing-will affect other stages as well.
• As these steps are interrelated, they should be treated as an integrated,
ongoing process.
• Example: Strategic management process at a food chain restaurant, top
managers will assess changes in consumer taste preferences &food
preparation, analyzing competitor activities, working to overcome firm
weaknesses, implementing a strategy formulated months earlier and
formulating strategic plans for future. These processes occur
simultaneously as they are linked.
• An appreciation of an organization’s strategy helps all its members-top,
middle, lower level- to relate their work more closely to the direction of
the organization.
 Vocabulary..
• Core competencies are the firm’s capabilities and collective
learning skills that are fundamental to its strategy,
performance, and long-term profitability.
• Core competence is a strategic concept that defines an
organization’s capabilities- what you are particularly good
at.
• Each organization has some capabilities in which it excels
and the business should focus on the opportunities in that
area, letting others go or outsourcing them.
• Core competencies are difficult to duplicate, as it involves
skills and coordination of people across a variety of
functional areas.
 Classification of companies

• Companies are primarily classified as private and public. Private limited

companies are those companies that are closely held and have less than
200 shareholders. Public companies are limited companies that have more
than 200 shareholders and are listed on the stock exchange.
• There can be a sole proprietor company or single person company
requiring only one person with limited liability.
• Classification on the basis of control, companies are divided into holding
company and associate company.
• The relationship of holding company or associate company is established
either with the control of board of directors or control of share capital.
• A company will be a holding company of another if it controls composition
of the board of directors of other company or exercises or controls more
than 50% of the total share capital either on its own or together one or
more of its subsidiary companies.
 Classification of companies

• If a company has significant influence over another company, the latter will be
the Associate company of the former. Such significant control is acquired from
control of at least 20% of the total share capital either on its own or together
with one of its subsidiary companies.
• Classification on the basis of liability:
• Company limited by shares: companies usually have limited liability of members
unless specified otherwise in the memorandum and articles of association. In
this case, the liability of the members is limited to the extent of the face value of
shares and premium payable on shares. A limited company can be private or
public company.
• Company limited by guarantee: Refers to a company having the liability of its
members limited by the memorandum to an amount the members may
respectively undertake to contribute to the assets of the company in the event
of it being wound up.
• Unlimited liability company: is a company which does not have any limit on the
liability of its members. The liability of members will not cease until the final
payment.
 Classification of companies

• Classification on the basis of access to capital:

• Unlisted company: When the securities of a private or public company are
not listed on any of the stock exchanges, it is an unlisted company. Such
companies cannot raise funds from public at large by issuing prospects.
However, an unlisted company may issue shares on private placement
basis or to raise private equity funding.
• A listed company is a kind of a company whose securities are listed on at
least one of the stock exchanges. It must comply with the provisions of the
listing.
• Small company : Companies whose paid -up share capital does not exceed
fifty lakh rupees or any prescribed amount not exceeding Rs. 5 crore
rupees, and its turnover as per its latest profit and loss account is limited
to Rs. 2 crore or any prescribed amount not exceeding Rs, 20 crores, is
considered as a small company. A public company can never be a small
company. A holding or subsidiary company will not be a small company.
 Classification of companies

• Classification on the basis of objects:

• Not for profit company: company whose sole objective is to promote
commerce, art, science, education, research, welfare, religion, charity,
protection of environment, or any other useful purpose and not having
any profit motive is termed as a not for profit company. Such a company
must apply its profits and other incomes in promoting its objects. It musn’t
make any payment or dividend to its members.
• Classification on the basis of holding of shares:
• Government company is a kind of a company in which not less than 51%
of the paid up capital is held by the central or state government, or partly
by the state and central governments, and includes any company which is
a subsidiary of a government company.
• A foreign company is any company or body corporate incorporated
outside India which has a place of business in India,and conducts any
business activity in India.
 Sources of capital

• There are many sources of capital. Baiscally they fall into two main
categories– debt funding or financing which means you borrow money
and repay with interest. Equity financing is where money is invested in
your business in exchange for part ownership.
• Money comes from banks, or bond issues equity participation of investors
or venture capital funds, debenture notes.
• External sources of finance include equity capital, preferred stocks,
debentures, term loans, venture capital, leasing, hire purchase, trade
credit, bank overdraft.

• Share capital is the money a company raises by issuing a common or

preferred stock. The amount of share capital or equity financing a
company has can change over time by offering additional capital.
 Sources of capital

• Types of share capital

• Authorized share capital: Before raising share capital, a company must it must
obtain permission to execute the sale of stock. The company must specify the
total amount of equity it wants to raise and the base value of the shares, called
the par value.
• The maximum amount of share capital a company is allowed to raise is called
the authorized capital. It dos not limit the number of shares a company can issue
but it puts a ceiling on the total amount of money that can be raised by the sale
of those shares.
• Issued share capital : The total value of the shares a company elects to sell to
investors is called its issued share capital. The par value of the total issued share
capital cannot exceed the value of the authorized share capital.
• The accounting definition of share capital is the par value of all the equity
securities, including common and preferred stock, sold to shareholders.
• The difference between the par value and the real sale price, called paid up
capital, is usually considerable. It is not technically included in share capital or
capped by authorized capital limits.
 Sources of capital

• Share capital is reported by a company on its balance sheet in the shareholder’s

equity section. The information may be listed in separate line items depending
on the source of the funds. These usually include a line for common stock,
another for preferred stock, third for additional paid up capital.
• Common stock and preferred stock shares are reported at their par value at the
time of sale. The par value or face value is a nominal figure. The actual amount
received by a company in excess of par value is reported as additional paid up
capital.
• Common stock and preferred stock shares are reported at their par value at the
time of sale. The amount of share capital reported by a company includes only
payments for purchases made directly from the company. The later sales or
purchases of the shares and the rise and fall in their prices on the open market
have no effect on the company’s share capital.
• A company may opt to have more then one public offering after initial public
offering(IPO). The proceeds of those later sales would increase the share capital
on its balance sheet.
 Sources of capital

• Venture capital is a form of early stage financing sought by companies

with high growth ambitions. It is provided by venture capital companies or
institutional investors. It has stricter payback terms.
• Venture capital investors seek equity ownership in the companies they
fund, in the form of stocks or securities. Their goal is to sell that equity at a
later date for substantial profits. Companies seeking VC cannot access
funding they need through debt financing. But they must be comfortable
having outside investors who will take an active role in their management
and who may want to exit quickly.
• VSs typically stay invested 7 to 10 years, they offer companies expertise,
networking connections in addition to money. They also help attract new
investors and board members who can assist with strategic and financial
planning and corporate governance.
• VCs tend to invest in companies that are well positioned in high growth
marker, have good management teams.
 Sources of capital

• VC is not necessarily for all entrepreneurs. Venture capitalists are looking

for technology driven businesses and companies with high growth
potential in sectors like information technology, communications,
biotechnology. They expect a healthy rate of return on their investment
when they start selling their shares to the public.
• Angles are generally wealthy individuals or retired company executives
who invest in small firms owned by others. They are often leaders in their
own field who contribute their experience and network of contacts,
technical knowledge, management knowledge. Angels tend to finance
early stages of business.
• Bank loans are the most commonly used source of funding for small and
medium scale businesses. Banks offer various advantages like pesonalized
service, customized repayment. One can shop around to get the banking
service most suitable to one’s needs.
 Sources of finance

• Banks are also looking for companies with a sound track record and excellent
credit. One must have a sound business plan and start up loan will require a
personal guarantee from entrepreneurs.
• COST OF CAPITAL
• It is the required return necessary to make a capital budgeting project such as
building a new factory worthwhile. It refers to the cost of equity if the business
is largely financed through equity and to the cost of debt.
• Cost of capital is the standard of comparison for making different business
decisions. Its an accounting tool that companies and investors use to make
better decisions on how they allocate their money. It has great importance in
financial decision making.
• The cost of capital represents the minimum desired rate of return.(A weighted
average cost of debt and equity capital).
• The cost of capital is the return a company must earn on its investment projects
to maintain its market value. The components of the cost of capital are a) debt
b) preferred stock c) common stock
 Sources of capital

• Thus, the cost of capital is a composite cost of individual sources of funds

including equity shares, preference shares, debt and retained earnings.
• The overall cost of capital depends on the cost of each source and the and
the proportion of each source.
• The coat of debt capital is the total cost or the rate of interest paid by an
organization in raising debt capital. However, in real situation, the total
interest paid for raising debt capital is not considered as cost because the
total interest is treated as an expense and is deducted from tax, reducing
tax liability of an organization.
• Cost of preference capital is the sum of dividend paid and the expenses
incurred for raising preference shares.
• Equity shareholders do not receive a fixed amount of dividend. The
dividend on equity shares varies depending on the profit earned by the
company.
 Capital budgeting

• Capital budgeting is made up of capital and budget. Capital expenditure is

the spending of funds for large expenditures like purchasing fixed assets
and equipment, repairs to fixed assets and equipment, R&D, expansion
etc. Budgeting is setting targets for projects to ensure maximum
profitability.
• Capital budgeting is a process of evaluating investments and large
expenses in order to obtain the best returns on investment. An
organization is often faced with the challenges of selecting between two
projects or investments or the buy versus repair decision, Ideally an
organization would like to invest in all profitable projects but due to the
limitation of availability of resources, it has to choose between different
projects/ investments.
• As capital expenditures are huge and have a long term impact, a company
has to look for following important objectives:
 Capital budgeting

• 1. Selecting profitable projects: It needs to select the right mix of

profitable projects that will increase its shareholders’ wealth.
• 2. Capital expenditure control: Selecting the most profitable investment is
the main objective of capital budgeting. Controlling capital costs is equally
important objective. Forecasting capital expenditure requirements and
budgeting for it, and ensuring no investment opportunities are lost is the
crux of budgeting.
• Finding the right sources of funds: Determining the right quantum of funds
and the sources for procuring them is very important objective of capital
budgeting. Finding the balance between the cost of borrowing and returns
on investment is an important goal of capital budgeting.
 Capital budgeting process

• 1. Identifying investment opportunities: Any organization needs to identify

investment opportunities. An investment opportunity can be anything
from a new business line to product expansion to purchasing a new asset.
A company can find new products to add to its existing product line. It can
look for expansion of existing product lines based on the feedback from
market. Ny new product line or expansion of existing line may require
additional investments in new plans, additional capital equipments,
manpower etc.
• [Link] investment proposals: Once an investment opportunity has
been identified an organization needs to evaluate its options for
investment. Once it decides to add new product/ products to the product
line, the next step would be how to acquire these products. There might
be multiple ways of acquiring them like a) manufacture in house b)
outsourcing and getting them manufactured from outside c) purchase
from the market
 Capital budgeting process

• 3. Choosing a profitable investment: Once the investment opportunities are

identified and all proposals evaluated, an organization has to select the most
profitable investment and select it. While selecting a particular project it may
use the technique of capital rationing to rank the projects as per returns and
select the best option available. Manufacturing in house or outsourcing from
outside.
• 4. Capital budgeting and apportionment: Once a project is selected it has to be
funded. To fund the project it needs to identify the sources of funds and allocate
accordingly. The sources of these funds could be reserves, investments, loans or
any other available channel.
• 5. Performance review: The last step in capital budgeting is to review the
investment. Any investment proposal is selected for its expected returns. So
now the company will have to review the investment’s expected performance to
actual performance. Once the investment is made , products are released in the
market, profits are earned from its sales which need to be compared with the
expected returns. This will help in the performance review.
 Capital budgeting techniques

• To assist the organization in selecting the best investment there are various techniques
available based on the comparison of cash inflows to cash outflows. They are:
• 1. Payback period method: Here, the company calculates the time period required to
earn the initial investment of the project.
• 2. Net present value: It is calculated by taking the difference between the present value
of cash inflows and the present value of cash outflow over a period of time. Investment
with positive NPV will be considered.
• [Link] rate of return: In this method, the total net income of the investment is
divided by the initial or average investment to derive at the most profitable investment.
• [Link] rate of return: For NPV calculation a discount rate is used IRR is the rate at
which the NPV becomes zero. Net present value is the present value of future cash
flows compared with the initial investments.
• 5. Profitability index: Is the ratio of present value of future cashflow of the project to
the initial investment required for the project.
• Right decisions can lead the company to great heights. A wrong decision can lead to a
shut down as the funds involves are very large.
Sources of capital
 Costs

• /
Market structure