1.

managerial economics is a multi

dimensional discipline explain

.Managerial Economics − Definition

To quote Mansfield, “Managerial economics is concerned with the
application of economic concepts and economic analysis to the problems
of formulating rational managerial decisions.

Spencer and Siegelman have defined the subject as “the integration of

economic theory with business practice for the purpose of facilitating
decision making and forward planning by management.”

Micro, Macro, and Managerial Economics

Relationship
Microeconomics studies the actions of individual consumers and
firms; managerial economics is an applied specialty of this
branch. Macroeconomics deals with the performance, structure, and
behavior of an economy as a whole. Managerial economics applies
microeconomic theories and techniques to management decisions. It is
more limited in scope as compared to microeconomics. Macroeconomists
study aggregate indicators such as GDP, unemployment rates to
understand the functions of the whole economy.

Microeconomics and managerial economics both encourage the use of

quantitative methods to analyze economic data. Businesses have finite
human and financial resources; managerial economic principles can aid
management decisions in allocating these resources efficiently.
Macroeconomics models and their estimates are used by the government
to assist in the development of economic policy.

Nature and Scope of Managerial Economics

The most important function in managerial economics is decision-making.
It involves the complete course of selecting the most suitable action from
two or more alternatives. The primary function is to make the most
profitable use of resources which are limited such as labor, capital, land
etc. A manager is very careful while taking decisions as the future is
uncertain; he ensures that the best possible plans are made in the most
effective manner to achieve the desired objective which is profit
maximization.

 Economic theory and economic analysis are used to solve the problems of
managerial economics.

 Economics basically comprises of two main divisions namely Micro economics

and Macro economics.

 Managerial economics covers both macroeconomics as well as

microeconomics, as both are equally important for decision making and
business analysis.

 Macroeconomics deals with the study of entire economy. It considers all the
factors such as government policies, business cycles, national income, etc.

 Microeconomics includes the analysis of small individual units of economy such

as individual firms, individual industry, or a single individual consumer.

All the economic theories, tools, and concepts are covered under the scope
of managerial economics to analyze the business environment. The scope
of managerial economics is a continual process, as it is a developing
science. Demand analysis and forecasting, profit management, and capital
management are also considered under the scope of managerial
economics.
Demand Analysis and Forecasting
Demand analysis and forecasting involves huge amount of decision-
making! Demand estimation is an integral part of decision making, an
assessment of future sales helps in strengthening the market position and
maximizing profit. In managerial economics, demand analysis and
forecasting holds a very important place.

Profit Management
Success of a firm depends on its primary measure and that is profit. Firms
are operated to earn long term profit which is generally the reward for risk
taking. Appropriate planning and measuring profit is the most important
and challenging area of managerial economics.

Capital Management
Capital management involves planning and controlling of expenses. There
are many problems related to capital investments which involve
considerable amount of time and labor. Cost of capital and rate of return
are important factors of capital management.

Demand for Managerial Economics

The demand for this subject has increased post liberalization and
globalization period primarily because of increasing use of economic logic,
concepts, tools and theories in the decision making process of large
multinationals.

Also, this can be attributed to increasing demand for professionally trained

management personnel, who can leverage limited resources available to
them and maximize returns with efficiency and effectiveness.
Role in Managerial Decision Making
Managerial economics leverages economic concepts and decision science
techniques to solve managerial problems. It provides optimal solutions to
managerial decision making issues.

2.Consumer Equilibrium
When consumers make choices about the quantity of goods and services to consume, it is presumed
that their objective is to maximize total utility. In maximizing total utility, the consumer faces a
number of constraints, the most important of which are the consumer's income and the prices of
the goods and services that the consumer wishes to consume. The consumer's effort to maximize
total utility, subject to these constraints, is referred to as the consumer's problem. The solution
to the consumer's problem, which entails decisions about how much the consumer will consume of
a number of goods and services, is referred to as consumer equilibrium.

Determination of consumer equilibrium. Consider the simple case of a consumer

who cares about consuming only two goods: good 1 and good 2. This consumer
knows the prices of goods 1 and 2 and has a fixed income or budget that can be
used to purchase quantities of goods 1 and 2. The consumer will purchase quantities
of goods 1 and 2 so as to completely exhaust the budget for such purchases. The
actual quantities purchased of each good are determined by the condition for
consumer equilibrium, which is

This condition states that the marginal utility per dollar spent on good 1 must equal
the marginal utility per dollar spent on good 2. If, for example, the marginal utility per
dollar spent on good 1 were higher than the marginal utility per dollar spent on good
2, then it would make sense for the consumer to purchase more of good 1 rather
than purchasing any more of good 2. After purchasing more and more of good 1, the
marginal utility of good 1 will eventually fall due to the law of diminishing marginal
utility, so that the marginal utility per dollar spent on good 1 will eventually equal that
of good 2. Of course, the amount purchased of goods 1 and 2 cannot be limitless
and will depend not only on the marginal utilities per dollar spent, but also on the
consumer's budget.

An example. To illustrate how the consumer equilibrium condition determines

the quantity of goods 1 and 2 that the consumer demands, suppose that the price of
good 1 is $2 per unit and the price of good 2 is $1 per unit. Suppose also that the
consumer has a budget of $5. The marginal utility ( MU) that the consumer receives
from consuming 1 to 4 units of goods 1 and 2 is reported in Table . Here, marginal
utility is measured in fictional units called utils, which serve to quantify the
consumer's additional utility or satisfaction from consuming different quantities of
goods 1 and 2. The larger the number of utils, the greater is the consumer's marginal
utility from consuming that unit of the good. Table also reports the ratio of the
consumer's marginal utility to the price of each good. For example, the consumer
receives 24 utils from consuming the first unit of good 1, and the price of good 1 is
$2. Hence, the ratio of the marginal utility of the first unit of good 1 to the price of
good 1 is 12.

The consumer equilibrium is found by comparing the marginal utility per dollar spent
(the ratio of the marginal utility to the price of a good) for goods 1 and 2, subject to
the constraint that the consumer does not exceed her budget of $5. The marginal
utility per dollar spent on the first unit of good 1 is greater than the marginal utility per
dollar spent on the first unit of good 2(12 utils > 9 utils). Because the price of good 1
is $2 per unit, the consumer can afford to purchase this first unit of good 1, and so
she does. She now has $5 − $2 = $3 remaining in her budget. The consumer's next
step is to compare the marginal utility per dollar spent on the second unit of good 1
with marginal utility per dollar spent on the first unit of good 2. Because these ratios
are both equal to 9 utils, the consumer is indifferent between purchasing the second
unit of good 1 and first unit of good 2, so she purchases both. She can afford to do
so because the second unit of good 1 costs $2 and the first unit of good 2 costs $1,
for a total of $3. At this point, the consumer has exhausted her budget of $5 and has
arrived at the consumer equilibrium, where the marginal utilities per dollar spent are
equal. The consumer's equilibrium choice is to purchase 2 units of good 1 and 1 unit
of good 2.

The condition for consumer equilibrium can be extended to the more realistic case
where the consumer must choose how much to consume of many different goods.
When there are N > 2 goods to choose from, the consumer equilibrium condition is to
equate all of the marginal utilities per dollar spent,

subject to the constraint that the consumer's purchases do not exceed her budget.

3. What is Consumer equilibrium how is it achieved?

The state of balance achieved by an end user of products that refers to the amount
of goods and services they can purchase given their present level of income and the
current level of prices. Consumer equilibrium allows a consumer to obtain the
most satisfaction possible from their income.

4. What is the meaning of consumer preferences?

These reflect the consumer's preferences. Theory of Consumer
Preferences.Consumer preferences are defined as the subjective (individual)
tastes, as measured by utility, of various bundles of goods. They permit
the consumer to rank these bundles of goods according to the levels of utility they
give the consumer.

5.Consumer Theory
What is 'Consumer Theory'
Consumer theory is the study of how people decide to spend their money,
given their preferences and budget constraints. A branch of microeconomics,
consumer theory shows how individuals make choices, given restrains, such
as their income and the prices of goods and services. Through consumer
theory, we are better able to understand how individuals’ tastes
and incomes influence the demand curve. These choices are among the most
critical factors, shaping the overall economy.
BREAKING DOWN 'Consumer Theory'
Consumers are able to choose different bundles of goods and services;
logically, they choose those that bring the greatest benefit (or maximizes
utility, in economic terms). Working through examples and/or cases, consumer
theory usually requires the following inputs:

 A full set of consumption options

 How much utility a consumer derives from each bundle in the set of
options
 A set of prices assigned to each bundle
 Any initial bundle the consumer currently holds

Example of Consumer Theory

For example, consider a consumer, Kyle, who has $200 (his budget
constraint), who must choose how to allocate his funds between pizza and
video games (the bundle of goods). If pizzas cost $10 and video games cost
$50, Kyle can purchase any combination of pizzas and video games that costs
no more than $200. He could buy 20 pizzas, or four video games, or
five pizzas and three video games, or he could keep all $200 in his pocket.
But how can an outsider predict how Kyle is most likely to spend his money?
Consumer theory can help give an answer to this question.

Limitations of Consumer Theory

Challenges to developing a practical formula for this situation are numerous.
People are not always rational, for example, and occasionally they are
indifferent to the choices available. Some decisions are particularly difficult to
make, because consumers are not familiar with the products, or the decision
has an emotional component that isn't able to be captured in an economic
function.

Consumer theory therefore makes several assumptions to simplify the

process. For example, in Kyle’s case (above), economics can assume he
understands his preferences for pizza and video games and can decide how
much of each he wants to purchase. It also assumes there are enough video
games and pizzas available for Kyle to choose the quantity of each he desires
6. What is elasticity in economics example?
Example of elastic goods and services include furniture, motor vehicles, instrument
engineering products, professional services, and transportation services. Inelastic
goods have fewer substitutes and price change doesn't affect quantity demanded as
much.

7.Types of Elasticity
What is elasticity?
Elasticity is a measure of the responsiveness of a variable when other
variable changes. It is the proportional change of the value in one
variable relative to the proportional change in the value of
another variable.

According to the function that we are analyzing, we can measure

the elasticity of demand or the elasticity of supply.

Elasticity of Demand
When we calculate the elasticity of demand, we are measuring the
relative change in the total amount of goods or services that are
demanded by the market or by an individual. The quantity demanded
depends on several factors. Some of the more important factors are the
price of the good or service, the price of other goods and services, the
income of the population or person and the preferences of
the consumers.
Movement along the demand: when the price increases, the quantity
demanded decreases

Elasticity of Supply
When we calculate the elasticity of supply, we are measuring the relative
change in the the total amount of goods or services that one or several
firms supply. The quantity supplied depends on several factors. Some of
the more important factors are the price of the good or service, the cost
of the input and the technology of production.

Movement along the supply: when the price increases, the quantity
supplied decreases
 As we have mentioned, the demand depends on several factors. We can
calculate the elasticity of demand according to each one of these inputs.

 If we calculate the elasticity of demand according to the price of the

good, we are calculating the price elasticity of demand.
 If we calculate the elasticity according to the price of other goods, we are
calculating the cross elasticity of demand.
 If we calculate the elasticity of the demand according to the income, we
are calculating the income elasticity of demand.

Price elasticity of demand

The price elasticity of demand is the proportional change in the quantity
demanded, relative to the proportional change in the price of the good.

Price elasticity of demand = Percentage change in quantity demanded /

percentage change in price = ΔQ/Q / ΔP/P

Cross elasticity of demand

The cross elasticity of demand is the proportional change in the quantity
demanded, relative to the proportional change in the price of
another good.
Cross elasticity of demand = Percentaje change in quantity demanded /
percentaje change in price of another good = ΔQ1/Q1 / ΔP2/P2

Looking at the chart, the change in the price of another good shifts the
demand curve to the left or to the right.

If the two goods are substitutes, the cross elasticity of demand is

positive.
If the two goods are complements, the cross elasticity of demand
is negative.

Income elasticity of demand

The income elasticity of demand is the proportional change in the
quantity demanded, relative to the proportional change in the income.

Income elasticity of demand = Percentaje change in quantity demanded

/ percentaje change in the income = ΔQ/Q / ΔI/I
Price elasticity of supply
The price elasticity of supply is the proportional change in the quantity
supplied, relative to the proportional change in the price of the good.

Price elasticity of supply = Percentaje change in quantity supplied /

percentaje change in price = ΔQs/Qs / ΔP/P

Cross elasticity of supply

The cross elasticity of supply is the proportional change in the quantity
supplied, relative to the proportional change in the price of
another good.
Cross elasticity of supply = Percentaje change in quantity supplied /
percentaje change in the price of another good = ΔQs1/Qs1 / ΔP2/P2

Complements in production goods are goods that must be

produced together. If the price of a complement in production good
increases (let’s call it “good B”), then the quantity produced of B usually
increases. As a result, the supply curve of the good we are analyzing (let’s
call it “good A”), shift to the right. Thus, the cross elasticity of
complements in production goods is positive.
Substitutes in production : goods that use the same resources for
production. Producing more of one good, requires producing less of the
other good. If the good B is a substitute in production of A, and the price
of B increases, then the supply of the good A shifts to the left. Thus, the
cross elasticity of substitutes in production goods is negative.

Up to here, we have pointed out different types of elasticity according to

the function we are analyzing, and according to the inputs we are
considering. Now we will see how the supply and the demand can be
classified according to the value of the elasticity.

Elasticity of Demand
Perfect elastic demand
Perfect Elastic Demand: The elasticity tends towards -∞.

Relatively elastic demand, unitary elasticity demand

and relatively inelastic demand

Relatively elastic demand: The elasticity is between -1 and -∞

Unitary elasticity demand: The elasticity is -1
Relatively inelastic demand: The elasticity is between 0 and -1.

Perfect inelastic demand

A perfect inelastic demand has an elasticity of 0.

Elasticity of Supply
Perfect elastic supply

An horizontal supply is a perfect elastic supply and has an elasticity

that tends towards ∞

Relatively elastic supply

A relatively elastic supply has an elasticity bigger than 1

Supply with unitary elasticity

An unitary elasticity supply has an elasticity of 1

Relatively inelastic supply

A relatively inelastic supply has an elasticity of less than 1

Perfect inelastic supply

A perfect inelastic supply has an elasticity of 0

Source: http://economicpoint.com/types-of-elasticity

8.Types of Price Elasticity of Demand

– Explained!
The extent of responsiveness of demand with change in the price is
not always the same.
The demand for a product can be elastic or inelastic, depending on
the rate of change in the demand with respect to change in price of a
product.

Elastic demand is the one when the response of demand is greater

with a small proportionate change in the price. On the other hand,
inelastic demand is the one when there is relatively a less change in
the demand with a greater change in the price.

ADVERTISEMENTS:

For better understanding the concepts of elastic and

inelastic demand, the price elasticity of demand has been
divided into five types, which are shown in Figure-1:

Let us discuss the different types of price elasticity of demand (as

shown in Figure-1).

1. Perfectly Elastic Demand:

When a small change in price of a product causes a major change in
its demand, it is said to be perfectly elastic demand. In perfectly
elastic demand, a small rise in price results in fall in demand to
zero, while a small fall in price causes increase in demand to
infinity. In such a case, the demand is perfectly elastic or ep = 00.
ADVERTISEMENTS:

The degree of elasticity of demand helps in defining the shape and

slope of a demand curve. Therefore, the elasticity of demand can be
determined by the slope of the demand curve. Flatter the slope of
the demand curve, higher the elasticity of demand.

In perfectly elastic demand, the demand curve is

represented as a horizontal straight line, which is shown
in Figure-2:
From Figure-2 it can be interpreted that at price OP, demand is
infinite; however, a slight rise in price would result in fall in
demand to zero. It can also be interpreted from Figure-2 that at
price P consumers are ready to buy as much quantity of the product
as they want. However, a small rise in price would resist consumers
to buy the product.

Though, perfectly elastic demand is a theoretical concept and

cannot be applied in the real situation. However, it can be applied in
cases, such as perfectly competitive market and homogeneity
products. In such cases, the demand for a product of an
organization is assumed to be perfectly elastic.

From an organization’s point of view, in a perfectly elastic demand

situation, the organization can sell as much as much as it wants as
consumers are ready to purchase a large quantity of product.
However, a slight increase in price would stop the demand.

2. Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change
produced in the demand of a product with change in its price. The
numerical value for perfectly inelastic demand is zero (ep=0).
In case of perfectly inelastic demand, demand curve is
represented as a straight vertical line, which is shown in
Figure-3:
It can be interpreted from Figure-3 that the movement in price from
OP1 to OP2 and OP2 to OP3 does not show any change in the
demand of a product (OQ). The demand remains constant for any
value of price. Perfectly inelastic demand is a theoretical concept
and cannot be applied in a practical situation. However, in case of
essential goods, such as salt, the demand does not change with
change in price. Therefore, the demand for essential goods is
perfectly inelastic.

3. Relatively Elastic Demand:

Relatively elastic demand refers to the demand when the
proportionate change produced in demand is greater than the
proportionate change in price of a product. The numerical value of
relatively elastic demand ranges between one to infinity.

Mathematically, relatively elastic demand is known as more than

unit elastic demand (ep>1). For example, if the price of a product
increases by 20% and the demand of the product decreases by 25%,
then the demand would be relatively elastic.
The demand curve of relatively elastic demand is
gradually sloping, as shown in Figure-4:

It can be interpreted from Figure-4 that the proportionate change in

demand from OQ1 to OQ2 is relatively larger than the proportionate
change in price from OP1 to OP2. Relatively elastic demand has a
practical application as demand for many of products respond in
the same manner with respect to change in their prices.

For example, the price of a particular brand of cold drink increases

from Rs. 15 to Rs. 20. In such a case, consumers may switch to
another brand of cold drink. However, some of the consumers still
consume the same brand. Therefore, a small change in price
produces a larger change in demand of the product.

4. Relatively Inelastic Demand:

Relatively inelastic demand is one when the percentage change
produced in demand is less than the percentage change in the price
of a product. For example, if the price of a product increases by 30%
and the demand for the product decreases only by 10%, then the
demand would be called relatively inelastic. The numerical value of
relatively elastic demand ranges between zero to one (ep<1).
Marshall has termed relatively inelastic demand as elasticity being
less than unity.
The demand curve of relatively inelastic demand is rapidly
sloping, as shown in Figure-5:

It can be interpreted from Figure-5 that the proportionate change in

demand from OQ1 to OQ2 is relatively smaller than the
proportionate change in price from OP1 to OP2. Relatively inelastic
demand has a practical application as demand for many of products
respond in the same manner with respect to change in their prices.
Let us understand the implication of relatively inelastic demand
with the help of an example.

Example-3:
The demand schedule for milk is given in Table-3:
Calculate the price elasticity of demand and determine the type of
price elasticity.

Solution:
P= 15

Q = 100

P1 = 20

Q1 = 90

Therefore, change in the price of milk is:

∆P = P1 – P

∆P = 20 – 15

∆P = 5

Similarly, change in quantity demanded of milk is:

∆Q = Q1 – Q

∆Q = 90 – 100

∆Q = -10

The change in demand shows a negative sign, which can be ignored.

This is because of the reason that the relationship between price
and demand is inverse that can yield a negative value of price or
demand.

Price elasticity of demand for milk is:

ep = ∆Q/∆P * P/Q
ep = 10/5 * 15/100
ep = 0.3
The price elasticity of demand for milk is 0.3, which is less than one.
Therefore, in such a case, the demand for milk is relatively inelastic.
5. Unitary Elastic Demand:
When the proportionate change in demand produces the same
change in the price of the product, the demand is referred as unitary
elastic demand. The numerical value for unitary elastic demand is
equal to one (ep=1).
The demand curve for unitary elastic demand is
represented as a rectangular hyperbola, as shown in
Figure-6:

From Figure-6, it can be interpreted that change in price OP1 to

OP2 produces the same change in demand from OQ1 to OQ2.
Therefore, the demand is unitary elastic.

The different types of price elasticity of demand are

summarized in Table-4:
9. What do you mean by working capital requirement?
Working capital is calculated as current assets minus current liabilities. ...
Positiveworking capital is required to ensure that a firm is able to continue its
operations and that it has sufficient funds to satisfy both maturing short-term debt
and upcoming operational expenses.

12 Main Factors Affecting Working

Capital
Main factors affecting the working capital are as follows:

(1) Nature of Business:

ADVERTISEMENTS:

The requirement of working capital depends on the nature of

business. The nature of business is usually of two types:
Manufacturing Business and Trading Business. In the case of
manufacturing business it takes a lot of time in converting raw
material into finished goods. Therefore, capital remains invested for
a long time in raw material, semi-finished goods and the stocking of
the finished goods.

Consequently, more working capital is required. On the contrary, in

case of trading business the goods are sold immediately after
purchasing or sometimes the sale is affected even before the
purchase itself. Therefore, very little working capital is required.
Moreover, in case of service businesses, the working capital is
almost nil since there is nothing in stock.
 Image Courtesy : payablesplace.ardentpartners.com/wp-content/uploads/2013/06/000×500.jpg

(2) Scale of Operations:

ADVERTISEMENTS:

There is a direct link between the working capital and the scale of
operations. In other words, more working capital is required in case
of big organisations while less working capital is needed in case of
small organisations.

(3) Business Cycle:

The need for the working capital is affected by various stages of the
business cycle. During the boom period, the demand of a product
increases and sales also increase. Therefore, more working capital is
needed. On the contrary, during the period of depression, the
demand declines and it affects both the production and sales of
goods. Therefore, in such a situation less working capital is
required.

(4) Seasonal Factors:

Some goods are demanded throughout the year while others have
seasonal demand. Goods which have uniform demand the whole
year their production and sale are continuous. Consequently, such
enterprises need little working capital.

On the other hand, some goods have seasonal demand but the same
are produced almost the whole year so that their supply is available
readily when demanded.

Such enterprises have to maintain large stocks of raw material and

finished products and so they need large amount of working capital
for this purpose. Woolen mills are a good example of it.

(5) Production Cycle:

Production cycle means the time involved in converting raw
material into finished product. The longer this period, the more will
be the time for which the capital remains blocked in raw material
and semi-manufactured products.

ADVERTISEMENTS:

Thus, more working capital will be needed. On the contrary, where

period of production cycle is little, less working capital will be
needed.

(6) Credit Allowed:

Those enterprises which sell goods on cash payment basis need
little working capital but those who provide credit facilities to the
customers need more working capital.

(7) Credit Availed:

If raw material and other inputs are easily available on credit, less
working capital is needed. On the contrary, if these things are not
available on credit then to make cash payment quickly large amount
of working capital will be needed.

(8) Operating Efficiency:

Operating efficiency means efficiently completing the various
business operations. Operating efficiency of every organisation
happens to be different.

Some such examples are: (i) converting raw material into finished
goods at the earliest, (ii) selling the finished goods quickly, and (iii)
quickly getting payments from the debtors. A company which has a
better operating efficiency has to invest less in stock and the
debtors.

Therefore, it requires less working capital, while the case is different

in respect of companies with less operating efficiency.

(9) Availability of Raw Material:

Availability of raw material also influences the amount of working
capital. If the enterprise makes use of such raw material which is
available easily throughout the year, then less working capital will
be required, because there will be no need to stock it in large
quantity.
On the contrary, if the enterprise makes use of such raw material
which is available only in some particular months of the year
whereas for continuous production it is needed all the year round,
then large quantity of it will be stocked. Under the circumstances,
more working capital will be required.

(10) Growth Prospects:

Growth means the development of the scale of business operations
(production, sales, etc.). The organisations which have sufficient
possibilities of growth require more working capital, while the case
is different in respect of companies with less growth prospects.

(11) Level of Competition:

High level of competition increases the need for more working
capital. In order to face competition, more stock is required for
quick delivery and credit facility for a long period has to be made
available.

(12) Inflation:
Inflation means rise in prices. In such a situation more capital is
required than before in order to maintain the previous scale of
production and sales. Therefore, with the increasing rate of
inflation, there is a corresponding increase in the working capital.

10. Payback method

FacebookTwitterPrintEmailMore272

Under payback method, an investment project is accepted or rejected on the basis of

payback period. Payback period means the period of time that a project requires to
recover the money invested in it. It is mostly expressed in years.

Unlike net present value and internal rate of return method, payback method does not
take into account the time value of money.
According to payback method, the project that promises a quick recovery of initial
investment is considered desirable. If the payback period of a project is shorter than or
equal to the management’s maximum desired payback period, the project is accepted,
otherwise rejected. For example, if a company wants to recoup the cost of a machine
within 5 years of purchase, the maximum desired payback period of the company would
be 5 years. The purchase of machine would be desirable if it promises a payback period
of 5 years or less.

Payback period formula – even cash flow:

When net annual cash inflow is even (i.e., same cash flow every period), the payback
period of the project can be computed by applying the simple formula given below:

*The denominator of the formula becomes incremental cash flow if an old asset (e.g.,
machine or equipment) is replaced by a new one.

Example 1:
The Delta company is planning to purchase a machine known as machine X. Machine X
would cost $25,000 and would have a useful life of 10 years with zero salvage value.
The expected annual cash inflow of the machine is $10,000.

Required: Compute payback period of machine X and conclude whether or not the
machine would be purchased if the maximum desired payback period of Delta company
is 3 years.

Solution:

Since the annual cash inflow is even in this project, we can simply divide the initial
investment by the annual cash inflow to compute the payback period. It is shown below:

Payback period = $25,000/$10,000

= 2.5 years

According to payback period analysis, the purchase of machine X is desirable because

its payback period is 2.5 years which is shorter than the maximum payback period of the
company.

Example 2:
Due to increased demand, the management of Rani Beverage Company is considering
to purchase a new equipment to increase the production and revenues. The useful life of
the equipment is 10 years and the company’s maximum desired payback period is 4
years. The inflow and outflow of cash associated with the new equipment is given
below:

Initial cost of equipment: $37,500

Annual cash inflows:

Sales: $75,000

Annual cash Outflows:

Cost of ingredients: $45,000

Salaries expenses: $13,500

Maintenance expenses: $1,500

Non cash expenses:

Depreciation expense: $5,000

Required: Should Rani Beverage Company purchase the new equipment? Use
payback method for your answer.

Solution:

Step 1: In order to compute the payback period of the equipment, we need to workout
the net annual cash inflow by deducting the total of cash outflow from the total of cash
inflow associated with the equipment.

Computation of net annual cash inflow:

$75,000 – ($45,000 + $13,500 + $1,500)

= $15,000

Step 2: Now, the amount of investment required to purchase the equipment would be
divided by the amount of net annual cash inflow (computed in step 1) to find the payback
period of the equipment.

= $37,500/$15,000

=2.5 years

Depreciation is a non-cash expense and has therefore been ignored while

calculating the payback period of the project.

According to payback method, the equipment should be purchased because the

payback period of the equipment is 2.5 years which is shorter than the maximum desired
payback period of 4 years.
Comparison of two or more alternatives –
choosing from several alternative projects:
Where funds are limited and several alternative projects are being considered, the
project with the shortest payback period is preferred. It is explained with the help of the
following example:

Example 3:
The management of Health Supplement Inc. wants to reduce its labor cost by installing a
new machine. Two types of machines are available in the market – machine X and
machine Y. Machine X would cost $18,000 where as machine Y would cost $15,000.
Both the machines can reduce annual labor cost by $3,000.

Required: Which is the best machine to purchase according to payback method?

Solution:

Payback period of machine X: $18,000/$3,000 = 6 years

Payback period of machine y: $15,000/$3,000 = 5 years

According to payback method, machine Y is more desirable than machine X because it

has a shorter payback period than machine X.

Payback method with uneven cash flow:

In the above examples we have assumed that the projects generate even cash inflow
but many projects usually generate uneven cash flow. When projects generate
inconsistent or uneven cash inflow (different cash inflow in different periods), the
simple formula given above cannot be used to compute payback period. In such
situations, we need to compute the cumulative cash inflow and then apply the following
formula:

Example 4:
An investment of $200,000 is expected to generate the following cash inflows in six
years:

Year 1: $70,000
Year 2: $60,000

Year 3: $55,000

Year 4: $40,000

Year 5: $30,000

Year 6: $25,000

Required: Compute payback period of the investment. Should the investment be made
if management wants to recover the initial investment in 3 years or less?

Solution:

(1). Because the cash inflow is uneven, the payback period formula cannot be used to
compute the payback period. We can compute the payback period by computing the
cumulative net cash flow as follows:

Payback period = 3 + (15,000*/40,000)

= 3 + 0.375

= 3.375 Years

*Unrecovered investment at start of 4th year:

= Initial cost – Cumulative cash inflow at the end of 3rd year

= $200,000 – $185,000

= $15,000

The payback period for this project is 3.375 years which is longer than the maximum
desired payback period of the management (3 years). The investment in this project is
therefore not desirable.
Advantages and disadvantages of payback
method:
Some advantages and disadvantages of payback method are given below:

Advantages:

1. An investment project with a short payback period promises the quick inflow of
cash. It is therefore, a useful capital budgeting method for cash poor firms.
2. A project with short payback period can improve the liquidity position of the
business quickly. The payback period is important for the firms for which liquidity
is very important.
3. An investment with short payback period makes the funds available soon to
invest in another project.
4. A short payback period reduces the risk of loss caused by changing economic
conditions and other unavoidable reasons.
5. Payback period is very easy to compute.

Disadvantages:

1. The payback method does not take into account the time value of money.
2. It does not consider the useful life of the assets and inflow of cash after payback
period. For example, If two projects, project A and project B require an initial
investment of $5,000. Project A generates an annual cash inflow of $1,000 for 5
years whereas project B generates a cash inflow of $1,000 for 7 years. It is clear
that the project B is more profitable than project A. But according to payback
method, both the projects are equally desirable because both have a payback
period of 5 years ($5,000/$1,000).

11. payback period

the length of time required for an investment to recover its initial outlay in terms of
profits or savings.
"if insulation costs £110 and saves £55 a year, its payback period would be two
years"

12. Factors Affecting Demand Forecasting

For making a good forecast, it is essential to consider the
various factors governing demand forecasting. These
factors are summarized as follows.

1. Prevailing business conditions: While preparing demand

forecast it becomes necessary to study the general
economic conditions very carefully. These include the
price level changes, change in national income, per-capita
income, consumption pattern, savings and investment
habits, employment etc.

2. Conditions within the industry: Every business

enterprise is only a unit of a particular industry. Sales of
that business enterprise are only a part of the total sales of
that industry. Therefore, while preparing demand
forecasts for a particular business enterprise, it becomes
necessary to study the changes in the demand of the whole
industry, number of units within the industry, design and
quality of product, price policy, competition within the
industry etc.

3. Conditions within the firm: Internal factors of the firm

also affect the demand forecast. These factors include
plant capacity of the firm, quality of the product, price of
the product, advertising and distribution policies,
production policies, financial policies etc.

4. Factors affecting export trade: If a firm is engaged in

export trade also it should consider the factors affecting
the export trade. These factors include import and export
control, terms and conditions of export, exim policy,
export conditions, export finance etc.

5. Market behavior : While preparing demand forecast, it

is required to consider the market behavior which brings
about changes in demand.
 6. Sociological conditions:
Sociological factors have their own impact on demand
forecast of the company. These conditions relate to size of
population, density, change in age groups, size of family,
family life cycle, level of education, family income, social
awareness etc.

7. Psychological conditions:While estimating the demand

for the product, it becomes necessary to take into
consideration such factors as changes in consumer tastes,
habits, fashions, likes and dislikes, attitudes, perception,
life styles, cultural and religious bents etc.

8. Competitive conditions: The competitive conditions

within the industry may change.
Competitors may enter into market or go out of market.
A demand forecast prepared without considering the
activities of competitors may not be correct.
 5 Major Differences between
13.

Returns to Scale and Returns to

a factor Proportions
5 Major Differences between Returns to Scale and Returns to a
factor Proportions are listed below:
Returns to a factor:
1. Only one factor varies while all the rest are fixed.

2. The factor-proportion varies as more and more of the units of the variable factor
are employed to increase output.

4. Returns to a factor or to variable proportions end up in negative returns.

ADVERTISEMENTS:

3. It is a short-run phenomenon.
5. Returns to variable proportions are caused by indivisibility of certain fixed factors,
specialisation of certain variable factors, or sub-optimal factor proportions.

Returns to scale:
1. All or at least two factors vary.

2. Factor proportion called scale does not vary. Factors are increased in same
proportion to increase output.

3. It is a long-run phenomenon.

4. Returns to scale end up in decreasing returns.

5. Returns to scale can be attributed to economies and diseconomies of scale

caused by technical and/or managerial indivisibilities, exhaustibility of natural and
managerial resources, or depreciability of certain factors.
14. What is fix cost and variable cost?
Fixed costs often include rent, buildings, machinery, etc. Variable
costs are coststhat vary with output. Generally variable costs increase at a
constant rate relative to labor and capital. Variable costs may include wages,
utilities, materials used in production, etc.

What is the Difference

Between Variable Cost and
Fixed Cost in Economics?
In economics, variable cost and fixed cost are the two main costs a company
has when producing goods and services. A company's total cost is composed
of its total fixed costs and its total variable costs combined. Variable costs vary
with the amount produced. Fixed costs remain the same, no matter how much
output a company produces.

Variable Costs
A variable cost is a company's cost that is associated with the amount of
goods or services it produces. A company's variable cost increases and
decreases with the production volume. For example, suppose company ABC
produces ceramic mugs for a cost of $2 a mug. If the company produces 500
units, its variable cost will be $1,000. However, if the company does not
produce any units, it will not have any variable cost for producing the mugs.

Fixed Costs
On the other hand, a fixed cost does not vary with the volume of production.
A fixed cost does not change with the amount of goods or services a company
produces. It remains the same even if no goods or services are produced.
Using the same example above, suppose company ABC has a fixed cost of
$10,000 per month for the machine it uses to produce mugs. If the company
does not produce any mugs for the month, it would still have to pay $10,000
for the cost of renting the machine. On the other hand, if it produces 1 million
mugs, its fixed cost remains the same. The variable costs change from zero to
$2 million in this example.

15.define cost :
An amount that has to be paid or given up in order to get something.
In business, cost is usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time
and utilities consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery
of a good or service. All expenses are costs, but not all costs (such as those incurred in
acquisition of an income-generating asset) are expenses.

16. fixed capital and working capital

definition
What do you mean by fixed capital?
Fixed capital is a concept in economics and accounting, first theoretically analyzed
in some depth by the economist David Ricardo. It refers to any kind of real or
physical capital (fixed asset) that is not used up in the production of a product

What is the definition of working capital?

Working capital is the amount of a company's current assets minus the amount of
its current liabilities. For example, if a company's balance sheet dated June 30
reports total current assets of $323,000 and total current liabilities of $310,000 the
company's working capital on June 30 was $13,000.

What is the difference between working capital and fixed capital?

Fixed capital investments represent the acquisition and maintenance of long-
termassets. A fixed capital investment can be tangible asset, such as a building, or
an intangible asset, such as an intellectual property. Working capital refers to the
deployment of financial resources in the day-to-day business operations

Every organization requires money to carry on the business activities and the money required by
the organization is termed as CAPITAL. The capital is mainly divided into two types

1. Fixed Capital
2. Working Capital.

The modern finance manager has to take decisions to efficiently allocate the fixed capital and
working capital among the investments of fixed assets and current assets to ensure the smooth
running
of the organization in the long run.
The words of H. G. Guthmann clearly explain the importance of working capital. “Working
Capital is the lifeblood and nerve center of the business.”
In the words of Walker, “A firm’s profitability is determined in part by the way its working
capital is managed.”

FIXED CAPITAL
Fixed capital refers to the funds invested in fixed or permanent assets as land, building, and
machinery etc by the organization.Fixed capital is required for establishment of business. Fixed
capital invested in the long term assets is very important since it determines the value of firm
through the growth, profitability, and risk. Fixed capital also refers to investment in intangible
assets like copyrights, patents, goodwill, organization.

WORKING CAPITAL
working capital refers to the funds which are invested in materials, work in progress, finished
goods, receivables, and cash etc. Working capital is required to utilize fixed assets of the
company. Working capital plays a key role in a business enterprise. The efficiency of the business
enterprise largely depends on its ability to manage its working capital. Working Capital is
concerned with the management of firm’s current assets and current liabilities.

COMPARISON TABLE
There exist numerous differences between Fixed Capital and Working Capital, some of them are
as follows.

FIXED CAPITAL WORKING CAPITAL

Fixed capital may be defined as capital invested in long- Working capital may be defined as capital inves
term assets. current assets

Requirement

Working capital is required to utilize fixed assets

Fixed capital is required for establishment of business.
company.

Sources of Funds

The industrial units mobilize fixed capital from various The industrial units mobilize working capital fro
sources like shares, debentures, banks etc. which are to be commercial bank loans, profits retained, etc. wh
repaid over long time period. repayable before one year.

Conversion
 FIXED CAPITAL WORKING CAPITAL

The fixed capital which is used for fixed assets is not easily The working capital investments have high liquid
convertible into cash. can be easily convertible into cash.

Nature

Fixed capital is a one-time investment to purchase fixed Working capital is required constantly for day t
assets for starting a business or for expanding a business. business activities of the organization.

Duration

Fixed capital in long-term investment i.e it is invested at the Working capital is usually a short term investme
for long periods of time. running of businesses day to day operation

Returns

Working capital is generally focused on meeting t

Fixed capital aims at long-term return to the organization.
requirements for operational activities of the orga

Amount Required

Fixed capital constitute a very large amount of investments Working capital required is considerably less in
done by the organization. when compared to Fixed Capital of the organiz

Assets

Fixed capital invested in long-term fixed assets is studied Working capital invested in current assets is studi
under "Capital Budgeting". "Working Capital Management".
 17. What is current liabilities and examples?
Current Liabilities for Companies. Accounts payable - This is money owed to
suppliers. Accrued expenses - These are monies due to a third party but not yet
payable; for example, wages payable. Accrued Interest - This includes all interest
that has accrued since last paid.

Current Liabilities

Current (or short-term) liabilities are liabilities that a company is required to settle within the next
twelve months or which it expects to settle within its normal operating cycle.

Liabilities are financial obligations which require transfer of assets (mainly cash) for settlement.
They are classified into current and non-current liabilities based on the urgency of their settlement.
Comparison of current liabilities with current assets helps creditors, debt-holders and investors
assess a company’s liquidity position.

Here is a list of typical current liabilities:

 Accounts payable
 Salaries payable
 Short-term debt payable
 Short-term notes payable
 Current lease liability
 Interest payable
 Current tax payable
 Accrued expenses
 Dividends payable

Accounts payable, salaries payable, accrued expenses and current tax payable are classified as
current liabilities because they are expected to be paid off within a normal operating cycle. These
liabilities are reported as current even if the company expects them to be paid after 12 months.

Short-term debt payable, short-term notes payable and current lease liability represent that
portion of the relevant long-term liability which is due within next 12 months.

Interest payable is normally a current liability because it is due with 12 months.

Dividends payable is a current liability because corporate laws normally require them to be paid
within a certain period after declaration date.

Example
Classify the following liabilities of STU, Inc. into current and non-current as at 31 August 2015:

1. Trade payables of $220 million (of which $20 million are due on 15 October 2016)
2. Salaries payable of $45 million
3. Pension liability of $550 million (of which $10 million is payable within next 12 months)
4. Current tax payable of $12 million
5. Net deferred tax liability of $22 million
6. Total lease liability of $25 million (of which $4 million is the current portion of finance lease and
$3 million is related to operating lease payable within 12 months)
7. Dividends of $15 million declared on 14 August 2015 to be paid on 14 September 2015.
8. Long-term loan payable to banks of $500 million (of which $120 million is due in next 12
months which the company can’t reschedule on its own)
9. Notes payable of $40 million (10 million due within 12 months)

If the company’s total assets and non-current assets are $1,910 million and $1,400 million,
demonstrate how information about current liabilities help better assess liquidity and solvency of a
company.
Solution

All amount are USDs in million

Non-
Total Current
Item Current Explanation
Liabilities Liabilities
Liabilities

a 220 220 0 Trade payable is a current liability even if

payable after 12 months.

b 45 45 0 Salaries are due to be paid in a normal operating

cycle

c 550 10 540 Pension payable is a non-current liability except

the current portion.

d 12 12 0 Current tax is payable within normal operating

cycle

e 22 0 22 Accounting standards such as IFRS always classify

deferred tax liability as non-current.

f 25 7 18 Current portion = current portion of finance

lease + current operating lease rentals

g 15 15 0 Dividends are expected to be paid within 12

months

h 500 120 380 $120 million is the current portion because it is

'unconditionally' due within 12 months.

i 40 10 30 The amount due with in 12 months is classified

as current.

Total 1429 439 990

STU, Inc. current assets = total assets – non-current assets = $1,910 million – $1,400 = $510
million

Since current liabilities are $439 million against current assets of $510 million, the current ratio is
1.16. It means that the company has enough current assets (i.e. assets that are due to be
converted to cash in next 12 months) to pay-off its short-term liabilities.
Solvency is assessed by debt ratio which compares total assets with total liabilities. In case of STU,
Inc., debt ratio is 0.75 (= $1,429/$1,910) which shows that 75% of the company’s assets are
financed by debt and hence total assets are adequate to pay off liabilities in case of a crisis.

Information about timing of cash inflows and cash outflows is very critical particularly in the short-
term which is why liabilities and assets are categorized into current and non-current portion to
assess the financial position both in the short-term and long-term.
18. What is the meaning of redeemable shares?
Redeemable shares. These are shares issued on terms that the company will, or
may, buy them back at some future date. The date may be fixed (e.g. that
theshares will be redeemed five years after they are issued) or at the directors'
discretion. The redemption price is often the same as the issue price, but need not
be ..

What Are Redeemable Preference

Shares?
By Vikram Shah -

August 31, 2016

43226

Share on Facebook

Tweet on Twitter

Redeemable preference shares, as per Companies Act 2013, are those that can be redeemed
after a period of time (not exceeding twenty years). The Articles of Association must,
however, authorise the company to do so. Redeemable preference shares are only one among
many other types of preference shares, such as cumulative, participating and convertible
preference shares.

When can preference shares be redeemed?

There are certain provisions that need to be fulfilled, under Section 48 of the Companies Act,
2013, for preference shares to be redeemed.

1. The redeemable preference shares must be fully paid-up.

2. The redeemable preference shares can be redeemed only if the terms laid down at the time
of issuing are met.

However, on approval of shareholders and under the conditions laid down in Section 48 of
the Act, certain provisions can be altered/modified. These include redemption of shares at a
fixed time or during a particular time period or at the time the shareholders and/or the
company have approved and ratified.

The particular sum received after redemption of shares can be kept as Capital Reserve and
can be utilised for any bonus on the issue of shares. This sum, in the Capital Redemption
Reserve, is treated as Paid-up Capital by the company.

Process for Redemption of Preference Shares

These steps must be followed in order to redeem the preference shares:

1. A meeting of the general body needs to be called. A notice needs to be issued to the
directors and stakeholders regarding the meeting. This needs to be done at least seven days
prior to the meeting.

2. At the general body meeting, a resolution needs to be passed regarding the preference
shares, the rules agreed upon, the type of preference shares to be issued and also the number
of shares. Also, the resolution for issuing of preference share and a letter for redemption
needs to be passed during the meeting.
3. Within 30 days of the resolution, SH- 7 needs to be filed with the Registrar. The SH-7
should contain the minutes of the meeting (the General Board meeting where the resolution
was passed) and a true copy of the resolution signed by all the members of the board.

What are Preference Shares?

1. Preference shares can be allotted by companies to any investor, with the agreement that
whenever dividend is paid, the holders of the preference shares are the first to be paid.

2. Preference shares enjoy certain benefits as against the other shares.

3. The dividend of a preference share is fixed at a particular rate (or a fixed amount) even
before the dividend on equity shares.

4. The preference shares must be repaid before all other investors and shareholders in the
event of the winding up of the company.

5. The issue of preference share is done as per the rules prescribed under Section 48 of the
Companies Act, 2013.

Types of Preference Shares

There are eight types of preference shares. In case of dissolution of the company, any of the
eight types would be paid out before other types of equity. Let’s understand each of them:

Cumulative: As the word indicates, all dividends are carried forward until specified, and
paid out only at the end of the specified period.

Non-cumulative: The opposite of cumulative, obviously. Dividends are paid out of profits
for every year. There are no arrears carried over a time period to be paid at the end of the
term.

Redeemable: Such preference shares can be claimed after a fixed period or after giving due
notice.
Non-Redeemable: Such shares cannot be redeemed during the lifetime of the company, but
can only be obtained at the time of winding up (liquidation) of assets.

Convertible: The shares can be converted into equity shares after a time period, or as per the
conditions laid down in the terms.

Non-convertible: Non-convertible preference shares cannot be, at any time, converted into
equity shares.

Participating: Such shares have the right to participate in any additional profits, after paying
the equity shareholders. The surplus of profit is apart from the fixed dividend paid up for
preference shares.

Non-Participating: Non-participating preference shares do not possess any right to

participate in surplus profits or any surplus gained at the time of liquidation of the company.

20. naked debenture

a type of bond where a company borrows money without offeringsecurity

21. What do you mean by floating assets?

Asset that is continually changing in quantity and/or value, such as amount of
accounts receivable, cash, inventory, outstanding shares.

22. Duopoly
Duopoly is a form of oligopoly. In its purest form two firms control all of the
market, but in reality the term duopoly is used to describe any market where two
firms dominate

Examples of duopolistic markets: There are many examples of duopoly including

the following:

 Coca-Cola and Pepsi (soft drinks), Unilever and Proctor & Gamble
(detergents)

 Bloomberg and Reuters (Financial information services), Sotheby's and

Christie's (auctioneers of antiques/paintings)
  Airbus and Boeing (aircraft manufacturers)

 US diesel locomotive market is a duopoly of General Electric's GE

Transportation and Caterpillar's EMD

 Glencore and Trafigura form a duopoly that controls as much as 60 per cent
of some markets, such as zinc

 Construction and maintenance of UK road and rail networks is largely

undertaken by two companies Carillion and Costain

In these imperfectly competitive markets entry barriers are high although there are
usually smaller players in the market surviving successfully. The high entry barriers
in duopolies are usually based on one or more of the following: brand loyalty, product
differentiation and huge research economies of scale.

23. Concept: free entry and exit

Free entry is a term used by economists to describe a condition in which
can sellers freely enter the market for an economic good by establishing
production and beginning to sell the product. Along these same lines, free
exit occurs when a firm can exit the market without limit when economic
losses are being incurred

24.Marginal cost
Marginal cost is the additional cost incurred in the production of one more unit of a good or
service. It is derived from the variable cost of production, given that fixed costs do not
change as output changes, hence no additional fixed cost is incurred in producing another unit
of a good or service once production has already started.

Marginal cost is significant in economic theory because a profit maximising firm will
produce up to the point where marginal cost (MC) equals marginal revenue (MR).
Also, a firm’s supply curve is effectively the part of the MC curve above average variable
costs (from point B upwards, on the diagram below). A firm will not supply below this point
as it will not be covering its opportunity cost. Point B is also known as shut-down point.
Point A represents break-even point.

25. Isoquants:
Definition and Meaning:

The word 'iso' is of Greek origin and means equal or same and 'quant' means quantity.
An isoquant may be defined as:
"A curve showing all the various combinations of two factors that can produce a given level of output.
The isoquant shows the whole range of alternative ways of producing the same level of output".

The modern economists are using isoquant, or "ISO" product curves for determining the optimum
factor combination to produce certain units of a commodity at the least cost.

Schedule:

The concept of isoquant or equal product curve can be better explained with the help of schedule
given below:

Combinations Factor X Factor Y Total Output

A 1 14 100 METERS

B 2 10 100 METERS

C 3 7 100 METERS

D 4 5 100 METERS

E 5 4 100 METERS

In the table given above, it is shown that a producer employs two factors of production X and Y for
producing an output of 100 meters of cloth. There are five combinations which produce the same level
of output (100 meters of cloth).

The factor combination A using 1 unit of factor X and 14 units of factor Y produces 100 meters of
cloth. The combination B using 2 units of factor X and 10 units of factor Y produces 100 meters of
cloth. Similarly combinations C, U and E, employing 3 units of X and 7 units of Y, 4 units of X and 5
units of Y, 5 units of X and 4 units of Y produce 100 units of output, each. The producer, here., is
indifferent as to which combination of inputs he uses for producing the same amount of output.

Diagram/Graph:

The alternative techniques for producing a given level of output can be plotted on a graph.
The figure 12.1 shows y the 100 units isoquant plotted to ISO product schedule. The five factor
combinations of X and Y are plotted and are shown by points a, b, c, d and e. if we join these points, it
forms an 'isoquant'.

An isoquant therefore, is the graphic representation of an iso-product schedule. It may here be noted
that all the factor combinations of X and Y on an iso-product curve are technically efficient
combinations. The producer is indifferent as to which combination he uses for producing the same
level of output. It is in this way that an iso product curve is also called 'production indifference curve'.
In the figure 12.1, ISO product IP curve represents the various combinations of the two inputs which
produce the same level of output (100 meters of cloth).

Isoquant Map:
An isoquant map shows a set of iso-product curves. Each isoquant represents a different level of
output. A higher isoquant shows a higher level of output and a lower isoquant represents a lower level
of output.

Diagram/Graph:
In the figure 12.2, a family of three iso-product curves which produce various level of output is shown.
The iso product IQ1 yields 100 units of output by using quantities of inputs X and Y. So is also the
case with isoquant IQ3 yielding 300 units of output.

We conclude that an isoquant map includes a series, of iso-product curves. Each isoquant represents
a different level of output. The higher the isoquant output, the further right will be the isoquant.

26. AVERAGE PHYSICAL PRODUCT:

The quantity of total output produced per unit of a variable input, holding all other inputs
fixed. Average physical product, usually abbreviated APP, is found by dividing total
physical product by the quantity of the variable input. Average product, which more
often goes by the shorter name average product (AP), is one of two measures derived
from total physical product. The other is marginal physical product.
Average physical product is the output produced per unit of input used. Average physical
product is more often termed average product. The longer name, created by inserting
the word "physical" between "average" and "product," serves to distinguish average
PHYSICAL product from average REVENUE product. When no distinction is needed, the
simpler term "average product" is suitable. However, when analysis turns to marginal
productivity theory and factor markets, a distinction IS important.

Conceptually, average physical product is simply the arithmetic mean of total physical
product calculated for each variable input over a whole range of variable input
quantities. The formula for specifying and calculating average physical product from total
physical product is given as:

total physical product

average physical product =
variable input
Average Taco Production

The table at the right summarizes the hourly production by Waldo's TexMex Taco World
of Super Deluxe TexMex Gargantuan Tacos (with sour cream and jalapeno peppers). The
total product numbers presented can be used to derive
average physical product. Average Taco Product
The column on the left is the variable input, specifically the
number of workers employed by Waldo's TexMex Taco World,
which ranges from 0 to 10. The column to the right is the total
(physical) product, the total number of TexMex Gargantuan
Tacos produced each hour, which ranges from a low of 0 to a
high of 125 before declining to 110. Keep in mind that the taco
production from these workers depends on a given amount of
fixed inputs, Waldo's TexMex Taco World restaurant and all of
the capital that goes with it.

Missing from this table is any mention of average physical

product. This apparent oversight can be fixed with a few
button clicks.

 First, consider the average physical product for Waldo's

TexMex Taco World workforce if Waldo employs only
one worker. With one worker, total production is 20
Gargantuan Tacos each hour. Averaging this total production of 20 tacos over the
variable input of one worker, gives an average physical product of 20 Gargantuan
Tacos. Click the [One] button to display the average physical product for one
worker.

 Now consider the average physical product if Waldo's employs two workers. In
this case, the total hourly production is 50 Gargantuan Tacos. Dividing 50 tacos
by two workers gives an average physical product of 25 Gargantuan Tacos. Click
the [Two] button to display the average physical product for two workers.

 Consider one more calculation. If Waldo's employs three workers, the total hourly
production increases to 75 Gargantuan Tacos. Dividing 75 tacos by three workers
results in an average physical product of 25 Gargantuan Tacos. Click the [Three]
button to display the average physical product for three workers.

The remaining average physical product values can be derived in a similar manner. To
reveal the entire column of average physical product values, click the [Others] button.
Please feel free to spot check the math on a few of these numbers by dividing the total
product by the quantity of the variable input.

An observation or three about this column of numbers is in order.

 First, average physical product increases for the first two workers, reaches a peak
of 25 tacos per worker per hour with either two or three workers employed, then
declines thereafter.
  Second, this decline in average physical product is indirectly caused by the law of
diminishing marginal returns.

 Third, while it might not be obvious from this table, average physical product
continues to decline as Waldo's workforce expands, but average physical product
is NEVER negative. To have a negative average physical product, total product
must be negative, and that just does not make sense.

The Average Physical Product Curve

The average physical product curve is a Average Physical Product Curve

graphical representation of the relation between
average physical product and the variable input.
The average physical product curve for
Gargantuan Taco production is displayed to the
right.

The "general" slope of this curve is negative,

with per unit output lower for larger workforces.
However, the average physical product curve is
actually "hump" shaped, with a positive slope
giving way to a negative slope. Consistent with
the numbers in the table, the curve reaches a peak of 25 Gargantuan Tacos at both 2
and 3 workers, before declining.

Total and Marginal

Two related product measures are total physical product and average physical product.

 Total Physical Product: A longer name for total product, this is the total quantity
of output produced by a firm for a given quantity of inputs. Total physical product
is the foundation upon which the analysis of short-run production for a firm and
marginal productivity theory are based. It also provides the basis for calculating
average physical product.

 Marginal Physical Product: This is the change in total physical product resulting
from a change in the number of workers. Marginal physical product indicates how
the total production of TexMex Gargantuan Tacos changes when an extra worker
is hired or fired. For example, hiring a fifth worker means that Waldo's TexMex
Taco World total physical product increases from 95 to 110 tacos. The addition of
fifth worker results in the production of an additional 15 TexMex Gargantuan
Tacos.
 Income Demand and Cross
27.
Demand for a Commodity
Article Shared by <="" div="" style="margin: 0px; padding: 0px; border:
0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width:
100%;">

ADVERTISEMENTS:

In this article we will discuss about the income and cross

demand for a commodity.
Income Demand:
Let us now study income demand which indicates the relationship
between income and the quantity of commodity demanded. It
relates to the various quantities of a commodity or service that will
be bought by the consumer at various levels of income in a given
period of time, other things being equal.

Things that are assumed to remain equal are the price of the
commodity in question, the prices of related commodities, and the
tastes, preferences and habits of the consumer for it. The income-
demand function for Quantity Demanded a commodity is written as
D = f (y).

ADVERTISEMENTS:

The Fig. 9 income-demand relationship is usually direct. The

demand for the commodity increases with the rise in income and
decreases with the fall in income, as shown in Figure 9. When
income is OI, the quantity demanded is OQ and when income rises
to OI1 the quantity demanded also increases to OQ1. The reverse
case can also be shown likewise. Thus, the income demand curve ID
has a positive slope. But this slope is in the case of normal goods.
Let us take the case of a consumer who is in the habit of consuming
an inferior good. So long as his income remains below a particular
level of his minimum subsistence, he will continue to buy more of
this inferior good even when his income increase by small
increments. But when his income starts rising above that level, he
reduces his demand for the inferior good.

In Figure 9(B), OI is the minimum subsistence level of income

where he buys IQ of the commodity. Upto this level, this commodity
is a normal good for him so that he increases its consumption when
his income rises gradually from OI1 to OI2.
ADVERTISEMENTS:

As his income rises above OI, he starts buying less of the

commodity. For instance, at OI3 income level, he buys I3Q3 which is
less than IQ. Thus, in the case of inferior foods, the income demand
curve ID is backward sloping.
Cross Demand:
Let us now take the case of related goods and how the change in the
price of one affects the demand of the other. This is known as cross
demand and is written as D = f (pr). Related goods are of two types,
substitutes and complementary. In the case of substitute or
competitive goods, a rise in the price of one good A raises the
demand for the other good B, the price of B remaining the same.

The opposite holds in the case of a fall in the price of A when the
demand for B falls. Figure 10 (A) illustrates it. When the price of
good A increases from OA to OA1 the quantity of good B also
increases from OB to OB1. The cross demand curve CD for
substitutes is positively sloping.
For with the rise in the price of A, the consumers will shift their
demand to B since the price of B remains unchanged. It is also
assumed here that the incomes, tastes, preferences, etc., of the
consumers do not change.

In case the two goods are complementary or jointly demanded, a

rise in the price of one good A will bring a fall in the demand for
good B. Conversely, a fall in the price of A will raise the demand for
B. This is illustrated in Figure 10 (B) where when the price of A falls
from OA1 to OA, the demand for B increases from OB to OB1. The
demand curve in the case of complementary goods is negatively
sloping like the ordinary demand curve.

If, however, the two goods are independent, a change in the price of
A will have no effect on the demand for B. We seldom study the
relation between two unrelated goods like wheat and chairs. Mostly
as consumers, we are concerned with the price-demand relation of
substitutes and complementary goods

28. Monopolistic competition

The model of monopolistic competition describes a common market structure in which firms
have many competitors, but each one sells a slightly different product.
 Monopolistic competition as a market
structure was first identified in the 1930s by American economist Edward Chamberlin, and
English economist Joan Robinson.

Many small businesses operate under conditions of monopolistic competition, including

independently owned and operated high-street stores and restaurants. In the case of
restaurants, each one offers something different and possesses an element of uniqueness, but
all are essentially competing for the same customers.

Characteristics
Monopolistically competitive markets exhibit the following characteristics:

1. Each firm makes independent decisions about price and output, based on its product,
its market, and its costs of production.
2. Knowledge is widely spread between participants, but it is unlikely to be perfect. For
example, diners can review all the menus available from restaurants in a town, before
they make their choice. Once inside the restaurant, they can view the menu again,
before ordering. However, they cannot fully appreciate the restaurant or the meal until
after they have dined.
3. The entrepreneur has a more significant role than in firms that are perfectly
competitive because of the increased risks associated with decision making.
4. There is freedom to enter or leave the market, as there are no major barriers to
entry or exit.
5. A central feature of monopolistic competition is that products are differentiated. There
are four main types of differentiation:

Physical product differentiation, where firms use size, design, colour, shape,
performance, and features to make their products different. For example,
consumer electronics can easily be physically differentiated.

Marketing differentiation, where firms try to differentiate their product by

distinctive packaging and other promotional techniques. For example,
breakfast cereals can easily be differentiated through packaging.
 Human capital differentiation, where the firm creates differences through the
skill of its employees, the level of training received, distinctive uniforms, and
so on.

Differentiation through distribution, including distribution via mail order or

through internet shopping, such as Amazon.com, which differentiates itself
from traditional bookstores by selling online.

6. Firms are price makers and are faced with a downward sloping demand curve.
Because each firm makes a unique product, it can charge a higher or lower price than
its rivals. The firm can set its own price and does not have to ‘take' it from the
industry as a whole, though the industry price may be a guideline, or becomes a
constraint. This also means that the demand curve will slope downwards.
7. Firms operating under monopolistic competition usually have to engage in
advertising. Firms are often in fierce competition with other (local) firms offering a
similar product or service, and may need to advertise on a local basis, to let customers
know their differences. Common methods of advertising for these firms are through
local press and radio, local cinema, posters, leaflets and special promotions.
8. Monopolistically competitive firms are assumed to be profit maximisers because
firms tend to be small with entrepreneurs actively involved in managing the business.
9. There are usually a large numbers of independent firms competing in the market.

Equilibrium under monopolistic

competition
In the short run supernormal profits are possible, but in the long run new firms are attracted
into the industry, because of low barriers to entry, good knowledge and an opportunity to
differentiate.

Monopolistic competition in the short run

At profit maximisation, MC = MR, and output is Q and price P. Given that price (AR) is
above ATC at Q, supernormal profits are possible (area PABC).
As new firms enter the market, demand for the existing firm’s products becomes
more elastic and the demand curve shifts to the left, driving down price. Eventually, all super-
normal profits are eroded away.

Monopolistic competition in the long run

Super-normal profits attract in new entrants, which shifts the demand curve for existing firm
to the left. New entrants continue until only normal profit is available. At this point, firms
have reached their long run equilibrium.
 Clearly, the firm benefits most when it is in its short run and will try to stay in the short run
by innovating, and further product differentiation.

Examples of monopolistic competition

Examples of monopolistic competition can be found in every high street.

Monopolistically competitive firms are most common in industries where differentiation is

possible, such as:

 The restaurant business

 Hotels and pubs
 General specialist retailing
 Consumer services, such as hairdressing

The survival of small firms

The existence of monopolistic competition partly explains the survival of small firms in
modern economies. The majority of small firms in the real world operate in markets that
could be said to be monopolistically competitive.

Evaluation
The advantages of monopolistic competition
Monopolistic competition can bring the following advantages:

1. There are no significant barriers to entry; therefore markets are relatively contestable.
2. Differentiation creates diversity, choice and utility. For example, a typical high street
in any town will have a number of different restaurants from which to choose.
3. The market is more efficient than monopoly but less efficient than perfect competition
- less allocatively and less productively efficient. However, they may be dynamically
efficient, innovative in terms of new production processes or new products. For
example, retailers often constantly have to develop new ways to attract and retain
local custom.

The disadvantages of monopolistic competition

There are several potential disadvantages associated with monopolistic competition,
including:

1. Some differentiation does not create utility but generates unnecessary waste, such as
excess packaging. Advertising may also be considered wasteful, though most is
informative rather than persuasive.
2. As the diagram illustrates, assuming profit maximisation, there is allocative
inefficiency in both the long and short run. This is because price is above marginal
cost in both cases. In the long run the firm is less allocatively inefficient, but it is still
inefficient.
Inefficiency
The firm is allocatively and productively inefficient in both the long and short run.

There is a tendency for excess capacity because firms can never fully exploit their fixed
factors because mass production is difficult. This means they are productively inefficient in
both the long and short run. However, this is may be outweighed by the advantages of
diversity and choice.

As an economic model of competition, monopolistic competition is more realistic than

perfect competition - many familiar and commonplace markets have many of the
characteristics of this model.
29. Difference Between Perfect Competition
and Monopolistic Competition
February 26, 2016 By Surbhi S 2 Comments

The term market

can be described as any place where buyers and sellers meet, directly or
through dealers, to conclude transactions. There are three types of market
structure, i.e. perfect competition, monopoly and imperfect competition.
Further imperfect competition can be of two types: Monopolistic competition
and oligopoly. In perfect competition, the product sold by different firms is
identical, but in monopolistic competition, the firms sold near substitute
products.

The equilibrium position of these market are reached in different

circumstances and are based on revenues earned and cost incurred. In the
article provided to you, we’ve simplified the differences between perfect
competition and monopolistic competition.
Content: Perfect Competition Vs Monopolistic
Competition
1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart

BASIS FOR
PERFECT COMPETITION MONOPOLISTIC COMPETITION
COMPARISON

Meaning A market structure, where there are Monopolistic Competition is a market

many sellers selling similar goods to structure, where there are numerous
the buyers, is perfect competition. sellers, selling close substitute goods to the
buyers.

Product Standardized Differentiated

Price Determined by demand and supply Every firm offer products to customers at
forces, for the whole industry. its own price.

Entry and Exit No barrier Few barriers

Demand Curve Horizontal, perfectly elastic. Downward sloping, relatively elastic.

slope

Relation between AR = MR AR > MR

AR and MR

Situation Unrealistic Realistic

Definition of Perfect Competition

The market structure in which there are numerous sellers in the market,
offering similar goods that are produced using a standard method and each
firm has complete information regarding the market and price, is known as a
perfectly competitive market. The entry and exit to such a market are free. It is
a theoretical situation of the market, where the competition is at its peak.

The firms are price takers in this market structure, and so, they do not have
their own pricing policy. The individual buyers and sellers have no control
over the prices. Therefore, the sellers have to accept the price ascertained by
the demand and supply forces of the market and sell the product, as much as
they can at the price prevailing in the market. As the product offered for sale is
identical in all respects, no firm can increase the price than that of prevailing
in the market, because if a firm increases its price, then it will lose all the
demand, to the competitors.

Definition of Monopolistic Competition

Monopolistic Competition refers to a type of market structure, where the

number of sellers selling similar but not exactly identical products, is large.
The product or service offered for sale in a monopolistic competition are close
substitutes for one another. Such a market contains the features of
both monopoly and perfect competition and is found in the real world
situation. The salient features of a monopolistic competition are given below:

 It is a non-price competition. The firms are price makers, and so every

firm has its own pricing policy, and thus the sellers are free to make
decisions regarding the price and output, on the basis of the product.
 The entry and exit, into and out of the industry are easy because of fewer
barriers.
 Product differentiation exists in a monopolistic competition, where the
products are distinguished from each other on the basis of brands.
 Highly elastic demand curve.

Key Differences Between Perfect Competition and

Monopolistic Competition
The basic differences between perfect competition and monopolistic
competition are indicated in the following points:

1. A market structure, where there are many sellers selling similar goods to
the buyers, is perfect competition. A market structure, where there
are numerous sellers, selling close substitute goods to the buyers, is
monopolistic competition.
2. In perfect competition, the product offered is standardised whereas in
monopolistic competition product differentiation is there.
3. In perfect competition, the demand and supply forces determine the
price for the whole industry and every firm sells its product at that price.
In monopolistic competition, every firm offers products at its own price.
 4. Entry and Exit are comparatively easy in perfect competition than in
monopolistic competition.
5. The slope of the demand curve is horizontal, which shows perfectly
elastic demand. On the other hand, in monopolistic competition, the
demand curve is downward sloping which represents the relatively
elastic demand.
6. Average revenue (AR) and marginal revenue (MR) curve coincide with
each other in perfect competition. Conversely, in monopolistic
competition, average revenue is greater than the marginal revenue, i.e.
to increase sales the firm has to lower down its price.
7. Perfect competition is an imaginary situation which does not exist in
reality. Unlike, monopolistic competition, that exists practically.

Conclusion

After reviewing the above points, it is quite clear that perfect competition and
monopolistic competition are different, where monopolistic competition has
features of both monopoly and perfect competition. The principal difference
between these two is that in the case of perfect competition the firms are price
takers, whereas in monopolistic competition the firms are price makers.

Perfect Competition and

30.
Monopolistic Competition |
Differences
Article Shared by <="" div="" style="margin: 0px; padding: 0px; border:
0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width:
100%;">

ADVERTISEMENTS:

Some of the main differences between perfect competition and

monopolistic competition are as follows:

1. Nature of Firms:
Under perfect competition an industry consists of a large number of
firms. Each firm in the industry has a very little share in the total
output.
The firms have to accept the price determined by the industry. On
the other hand, under monopolistic competition the number of
firms is limited.

ADVERTISEMENTS:

The firms can influence the market price by their individual actions.

2. Nature of Price and Output:

Under perfect competition price is equal to marginal cost as well as
marginal revenue whereas under imperfect competition it is not so.
Although, under monopolistic competition marginal cost and
marginal revenue are equal yet not equalizing the price.

3. Nature of Profits:
Under monopolistic competition firms get super normal profits only
in the short period. But, in the long run the existence of super-
normal profits disappears. It is so because in the long period price
becomes equal to average cost of production. In case of perfect
competition, the situation is slightly different.

4. Nature of Product:
Under perfect competition, firms produce homogeneous products.
The cross elasticity of demand among the goods is infinite. Under
imperfect competition, all the firms produce differentiated products
and the cross elasticity of demand among them is very small.

5. Selling Costs:
ADVERTISEMENTS:

Another point of difference between the monopolistic and perfect

competition is regarding the selling costs. Under perfect
competition, homogeneous goods are produced and are sold at
uniform prices. Thus, there arises no necessity of selling costs. On
the other side under monopolistic competition, all the firms
produce differentiated products, thus, each firm has to bear the
huge expenses on selling costs.
6. Slope of Demand Curves:
The demand curve of a firm under monopolistic competition slopes
downward. It is due to the reason that each firm has to reduce the
price, if it wishes to increase the sale (Fig 12). The situation under
perfect competition is not so. Under perfect competition the firm
can sell any amount of his output without lowering the price, thus,
the curve remains parallel to horizontal axis (Fig. 11).

7. Relation between AR and MR:

Under perfect competition, average revenue and marginal revenue
are equal, so both these curves coincide with each other. Under
monopolistic competition average revenue is more than marginal
revenue because the firm has to lower the price to increase sales.
Thus marginal revenue is less than average revenue i.e., AR > MR.

8. More Price in Monopolistic Competition:

Under monopolistic competition price is higher than price under
perfect competition in long period because a perfect competition
firm extends output up to the point where average cost is lowest i.e.,
there is optimum output in perfect competition.

However, in monopolistic competition firm stops the production

before it has attained the optimum output. It has been shown by
Fig. 13 (A) and 13 (B). In Fig. 13 A, perfect competition firm is in
equilibrium at point ‘M’ where MC is equal to MR. At this point AR
is also equal to LAC at its lowest point.

The equilibrium output is ON and equilibrium price is OP. In fig. 13

(B) a monopolistic competition firm is in equilibrium position at
point ‘K’ where MC=MR. The equilibrium output is ON1 and price is
OP. In the equilibrium position the firm is earning normal profit. If
we compare the equilibrium price under both market situations, it
is clear that price in monopolistic competition market is higher than
that of the price in perfect competition market.

9. More Output under Perfect Competition:

ADVERTISEMENTS:

In the perfect competition market output is more than the

monopolistic competition market output. In long period, under
perfect competition MC = MR = AC = AR in equilibrium position as
has been shown in Fig. 13 (A). Under monopolistic competition, in
the equilibrium position MC = MR but AR is more than MC or MR.

That is the reason that in monopolistic competition output is lower

than the output in perfect competition as is clear from Fig. 13 (A).
In the Fig 13 (B). Monopolistic competition output is ON/ and
perfect competition output is ON.

10. Perfect competition is an imaginary situation, whereas

monopolistic competition is a reality.

11. Under perfect competition, an inefficient firm cannot exist but

under monopolistic competition both efficient and inefficient firms
can exist because buyers have their irrational preferences for goods
in the market.
 31. What is an Oligopoly?
Home/Accounting Dictionary/What is an Oligopoly?
Definition: An oligopoly is a market form with limited competition in which a few producers
control the majority of the market share and typically produce similar or homogenous
products. Due to the small number of firms and lack of competition, this market structure
often allows for partnerships and collusion.

What Does Oligopoly Mean?

What is the definition of oligopoly? Oligopolistic firms are price setters that seek the best
partnership to define prices higher than their marginal cost, thus maximizing their profits.
Oligopoly is the result of lack of competition in the product price. If a firm lowers the price
of a product and achieves significant sales growth, competitive firms will enter a price war to
match the lower price; therefore, oligopolistic firms do not lower their prices, but they rather
spend significant amounts of money for advertising and research for the improvement of their
product.

Furthermore, the entrance of new firms in an oligopolistic industry is too difficult because the
existing oligopolies offer well-established products through solid distribution systems. Thus,
entering an oligopolistic industry requires substantial funds due to the economies of
scale almost ensuring the industry status quo will always stay the same.

Let’s look at an example.

Example
Company A and Company B are responsible for the 90% of the water produced in Orange
County. If Company B raises its prices, consumers most likely will shift to Company A for
their water provision. But, if Company A raises its prices too, then both Companies will
control the entire water market through their pricing setting ability.

The same is true for the U.S. cellular market where AT&T, Sprint Nextel, T-Mobile, and
Verizon control 90% of the industry. Barclays, Halifax, HSBC, Lloyds TSB and Natwest
control the U.K. banking sector. Boeing and Airbus dominate the airliner market. In all of
these industries, only a few firms control their respective markets and provide almost
indistinguishable goods and services. Thus, they can collude and set their prices.

In a truly competitive market, all these companies would not be able to set their prices, but
they would rather be price takers to stay in business. Instead, under the oligopoly structure,
these companies are interested in increasing their long-term profits by monopolizing the
market and maintaining a competitive edge.
Most countries have laws put in place to prevent price fixing and other practices of collusion
for this reason.

Summary Definition
Define Oligopoly: An oligopoly in economics is a market that is dominated by a few
companies that produce standardized products.

32. difference between Money Market and Capital Market

Key Difference: Money market is a component of financial market where short-term
borrowing can be issued. This market includes assets that deal with short-term
borrowing, lending, buying and selling. A capital market is a component of a financial
market that allows long-term trading of debt and equity-backed securities. Long-term
borrowing or lending is done by investors or corporations that have large amounts of
wealth at their disposal.

When it comes to business, each business at a certain point has to

borrow money in order to keep running business. There are multiple ways that a company can
borrow money, including issuing bonds, shares or taking up a loan. There are two different
components of the financial market; known as Money Market and Capital Market. These
terms are more commonly come across in business and economics.

Money market is a component of financial market where short-term borrowing can be issued.
This market includes assets that deal with short-term borrowing, lending, buying and selling.
The short-term ensures that the borrowing and lending period has a lease of less than one
year. The lease can also be as short as a one hour, depending on the borrower and the lender.
According to The Global Money Markets, Trading is usually done over the counter using
instruments such as Treasury bills, commercial paper, bankers' acceptances, deposits,
certificates of deposit, bills of exchange, repurchase agreements, federal funds, and short-
lived mortgage-, and asset-backed securities. The money market was created as some
businesses has a surplus of cash, while the other businesses were looking for loans.

In the United States, all federal, state and local governments issue papers that are traded in
form of money. These include municipal paper and Treasury bills. The main functions of
Money market include: Transfer from parties with surplus funds to parties with a deficit,
transfer of large sums of money, help to implement monetary policies, determine short-term
interest rates and allow government to raise funds. The interest rates in a Money market are
also high as the borrowing time is low. Trading in the money markets are usually done by
banks or companies with high credit ratings.

A capital market is a component of a financial market

that allows long-term trading of debt and equity-backed securities. Long-term borrowing or
lending is done by investors or corporations that have large amounts of wealth at their
disposal. The most popular capital market is the NYSE or the New York Stock Exchange.
Huge financial regulators are responsible for overseeing the capital market to ensure that
companies do not defraud their investors. Trading can be done by a number of credit
instruments such as stocks, shares, equity, debentured, bonds, and securities. Much of the
trading is actually done online using a computer. There is no actual cash involved in trading.

Investments made in a capital market usually last longer than a year and can even last up to
25-30 years. Some investments may depend on the life of the company, with the investment
ending if the company shuts down. A benefit of this investment is that if need arises, the
investor can swiftly cash their investment. Capital market can be divided into two divisions:
stock markets and bond markets. In stock markets investors acquire the ownership of the
company they are investing in, while in bond markets investors are considered as creditors.
Investment done in capital markets are usually for acquiring physical capital goods that
would help increase its income. However, generating an income may take anywhere from a
couple of months to many years or could even fall through.

Money Market Capital Market

Is a component of the financial Is a component of financial

Definition markets where short-term markets where long-term
borrowing takes place borrowing takes place

Lasts for more than one year and

Lasts anywhere from 1 hour to
Maturity Period can also include life-time of a
90 days.
company.
 Certificate of deposit,
Repurchase agreements,
Commercial paper, Eurodollar
Stocks, Shares, Debentures,
deposit, Federal funds,
Credit Instruments bonds, Securities of the
Municipal notes, Treasury bills,
Government.
Money funds, Foreign Exchange
Swaps, short-lived mortgage and
asset-backed securities.

Homogenous. A lot of variety Heterogeneous. A lot of

Nature of Credit Instruments
causes problems for investors. varieties are required.

Long-term credit required to

Short-term credit required for establish business, expand
Purpose of Loan
small investments. business or purchase fixed
assets.

Basic Role Liquidity adjustment Putting capital to work

Stock exchanges, Commercial

Central banks, Commercial
banks and Nonbank institutions,
banks, Acceptance houses,
Institutions such as Insurance Companies,
Nonbank financial institutions,
Mortgage Banks, Building
Bill brokers, etc.
Societies, etc.

Risk Risk is small Risk is greater

Commercial banks are closely Institutions are regulated to keep

Market Regulation regulated to prevent occurrence them from defrauding
of a liquidity crisis. customers.

Indirectly related with central

Closely related to the central banks and feels fluctuations
Relation with Central Bank
banks of the country. depending on the policies of
central banks.
33. Difference Between Primary Market and Secondary
Market
May 13, 2015 By Surbhi S 4 Comments

Securities market can be defined as the market, whereby financial

instruments, obligations, and claims are available for sale. It is classified into
two interdependent segments, i.e. Primary Market and Secondary
Market. Market. The former is a market where securities are offered for the
first time for receiving public subscription while the latter is a place where pre-
issued securities are dealt between the investors.

While primary market offers avenues for selling new securities to the
investors, the secondary market is the market dealing in securities that are
already issued by the company. Before investing your hard-earned money in
financial assets like shares, debenture, commodities etc, one should know the
difference between primary market and secondary market, to have better
utilization of savings.

Content: Primary Market Vs Secondary Market

1. Comparison Chart
2. Definition
3. Key Differences
4. Video
5. Conclusion

Comparison Chart
 BASIS FOR
PRIMARY MARKET SECONDARY MARKET
COMPARISON

Meaning The market place for new shares is The place where formerly issued
called primary market. securities are traded is known as
Secondary Market.

Another name New Issue Market (NIM) After Market

Type of Purchasing Direct Indirect

Financing It supplies funds to budding enterprises It does not provide funding to

and also to existing companies for companies.
expansion and diversification.

How many times a Only once Multiple times

security can be sold?

Buying and Selling Company and Investors Investors

between

Who will gain the Company Investors

amount on the sale of
shares?

Intermediary Underwriters Brokers

Price Fixed price Fluctuates, depends on the

demand and supply force

Organizational Not rooted to any specific spot or It has physical existence.

difference geographical location.

Definition of Primary Market

A primary market is a place where companies bring a new issue of shares for
being subscribed by the general public for raising funds to fulfil their long-
term capital requirement like expanding the existing business or purchasing
new entity. It plays a catalytic role in the mobilisation of savings in the
economy.

Various types of an issue made by the corporation are a Public issue, Offer for
Sale, Right Issue, Bonus Issue, Issue of IDR, etc.

The company who brings the IPO is known as the issuer, and the process is
regarded as a public issue. The process includes many merchant
bankers (investment banks) and underwriters through which the shares,
debentures, and bonds can directly be sold to the investors. These investment
banks and underwriters need to be registered with SEBI (Securities Exchange
Board of India).

The public issue is of two types, they are:

 Initial Public Offer (IPO): Public issue made by an unlisted

company for the very first time, which after making issue lists its shares
on the securities exchange is known as the Initial Public Offer.
 Further Public Offer (FPO): Public issue made by a listed company,
for one more time is known as a follow-on offer.

Definition of Secondary Market

The secondary market is a type of capital market where existing shares,

debentures, bonds, options, commercial papers, treasury bills, etc. of
the corporates are traded amongst investors. The secondary market can either
be an auction market where trading of securities is done through the stock
exchange or a dealer market, popularly known as Over The Counter where
trading is done without using the platform of the stock exchange.

The securities are firstly offered in the primary market to the general public
for a subscription where the company receives the money from the investors
and the investors get the securities; thereafter they are listed on the stock
exchange for the purpose of trading. These stock exchanges are the
secondary market where maximum trading of the company is done. The top
two stock exchanges of India are Bombay Stock Exchange and National Stock
Exchange.

An investor can trade in securities through the stock exchange with the help of
brokers who provide assistance to their client for purchasing and selling. The
brokers are the registered members of the recognised stock exchange in which
the investor is trading his / her securities. The brokers are allowed to trade on
the advanced trading system. The SEBI issues a certificate of registration to
the member brokers through which an investor can identify whether a broker
is registered or not.
Key Differences Between Primary Market and
Secondary Market
The points given below are noteworthy, as far as the difference between
primary market and secondary market is concerned:

1. The securities are formerly issued in a market known as Primary

Market, which is then listed on a recognised stock exchange for trading,
which is known as a secondary market.
2. The prices in the primary market are fixed while the prices vary in the
secondary market depending upon the demand and supply of the
securities traded.
3. Primary market provides financing to new companies and also to old
companies for their expansion and diversification. On the contrary,
secondary market does not provide financing to companies, as they are
not involved in the transaction.
4. At the primary market, the investor can purchase shares directly from
the company. Unlike Secondary Market, when investors buy and sell the
stocks and bonds among themselves.
5. Investment bankers do the selling of securities in case of Primary
Market. Conversely, brokers act as intermediaries while trading is done
in the secondary market.
6. In the primary market, security can be sold only once, whereas it can be
done an infinite number of times in case of a secondary market.
7. The amount received from the securities are income of the company, but
same is the income of investors when it is the case of a secondary
market.
8. The primary market is rooted in a particular place and has no
geographical presence, as it has no organisational setup. Conversely, the
Secondary market is present physically, as stock exchnage, which is
situated in a particular geographical area.

Video

Conclusion

The two financial markets play a major role in the mobilisation of money in
the country’s economy. Primary Market encourages direct interaction between
the company and the investor while the secondary market is opposite where
brokers help out the investors to buy and sell the stocks among other
investors. In the primary market bulk purchasing of securities is not done
while secondary market promotes bulk buying.
34. Accounting Rate of Return (ARR)

Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting
profit of a project to the average investment made in the project. ARR is used in investment
appraisal.

Formula
Accounting Rate of Return is calculated using the following formula:

Average Accounting Profit

ARR =
Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned
during each year of the project's life time. Average investment may be calculated as the sum of
the beginning and ending book value of the project divided by 2. Another variation of ARR formula
uses initial investment instead of average investment.

Decision Rule
Accept the project only if its ARR is equal to or greater than the required accounting rate of return.
In case of mutually exclusive projects, accept the one with highest ARR.

Examples
Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of
$32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the
project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate of
return assuming that there are no other expenses on the project.
Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years
Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
Average Accounting Income = $32,000 − $19,917 = $12,083
Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%
Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash
flows and salvage values are in thousands of dollars. Use the straight line depreciation method.
Project A:

Year 0 1 2 3
Cash Outflow -220
Cash Inflow 91 130 105
Salvage Value 10
Project B:

Year 0 1 2 3
Cash Outflow -198
Cash Inflow 87 110 84
Salvage Value 18
Solution
Project A:

Step 1: Annual Depreciation = ( 220 − 10 ) / 3 = 70

Step 2: Year 1 2 3
Cash Inflow 91 130 105
Salvage Value 10
Depreciation* -70 -70 -70
Accounting Income 21 60 45
Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3
= 42
Step 4: Accounting Rate of Return = 42 / 220 = 19.1%
Project B:

Step 1: Annual Depreciation = ( 198 − 18 ) / 3 = 60

Step 2: Year 1 2 3
Cash Inflow 87 110 84
Salvage Value 18
Depreciation* -60 -60 -60
Accounting Income 27 50 42
Step 3: Average Accounting Income = ( 27 + 50 + 42 ) / 3
= 39.666
Step 4: Accounting Rate of Return = 39.666 / 198 ≈ 20.0%
Since the ARR of the project B is higher, it is more favorable than the project A.

Advantages and Disadvantages

Advantages
1. Like payback period, this method of investment appraisal is easy to calculate.
2. It recognizes the profitability factor of investment.
Disadvantages
1. It ignores time value of money. Suppose, if we use ARR to compare two projects having equal
initial investments. The project which has higher annual income in the latter years of its useful
life may rank higher than the one having higher annual income in the beginning years, even if
the present value of the income generated by the latter project is higher.
2. It can be calculated in different ways. Thus there is problem of consistency.
3. It uses accounting income rather than cash flow information. Thus it is not suitable for projects
which having high maintenance costs because their viability also depends upon timely cash
inflows.

The Law of Demand (With

35.
Diagram)
Article Shared by <="" div="" style="margin: 0px; padding: 0px; border:
0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width:
100%;">

ADVERTISEMENTS:
In this article we will discuss about:- 1. Introduction to the
Law of Demand 2. Assumptions of the Law of Demand 3.
Exceptions.
Introduction to the Law of Demand:
The law of demand expresses a relationship between the quantity
demanded and its price. It may be defined in Marshall’s words
as “the amount demanded increases with a fall in price,
and diminishes with a rise in price”. Thus it expresses an
inverse relation between price and demand. The law refers to the
direction in which quantity demanded changes with a change in
price.
On the figure, it is represented by the slope of the demand curve
which is normally negative throughout its length. The inverse price-
demand relationship is based on other things remaining equal. This
phrase points towards certain important assumptions on which this
law is based.

Assumptions of the Law of Demand:

ADVERTISEMENTS:

These assumptions are:

(i) There is no change in the tastes and preferences of the consumer;

(ii) The income of the consumer remains constant;

(iii) There is no change in customs;

ADVERTISEMENTS:

(iv) The commodity to be used should not confer distinction on the

consumer;

(v) There should not be any substitutes of the commodity;

(vi) There should not be any change in the prices of other products;

(vii) There should not be any possibility of change in the price of the
product being used;
(viii) There should not be any change in the quality of the product;
and

(ix) The habits of the consumers should remain unchanged. Given

these conditions, the law of demand operates. If there is change
even in one of these conditions, it will stop operating.

Given these assumptions, the law of demand is explained in terms

of Table 3 and Figure 7.

The above table shows that when the price of say, orange, is Rs. 5
per unit, 100 units are demanded. If the price falls to Rs.4, the
demand increases to 200 units. Similarly, when the price declines to
Re.1, the demand increases to 600 units. On the contrary, as the
price increases from Re. 1, the demand continues to decline from
600 units.

ADVERTISEMENTS:

In the figure, point P of the demand curve DD1 shows demand for
100 units at the Rs. 5. As the price falls to Rs. 4, Rs. 3, Rs. 2 and Re.
1, the demand rises to 200, 300, 400 and 600 units respectively.
This is clear from points Q, R, S, and T. Thus, the demand curve
DD1 shows increase in demand of orange when its price falls. This
indicates the inverse relation between price and demand.
Exceptions to the Law of Demand:
In certain cases, the demand curve slopes up from left to right, i.e.,
it has a positive slope. Under certain circumstances, consumers buy
more when the price of a commodity rises, and less when price falls,
as shown by the D curve in Figure 8. Many causes are attributed to
an upward sloping demand curve.

(i) War:
If shortage is feared in anticipation of war, people may start buying
for building stocks or for hoarding even when the price rises.

(ii) Depression:
During a depression, the prices of commodities are very low and the
demand for them is also less. This is because of the lack of
purchasing power with consumers.

(iii) Giffen Paradox:

If a commodity happens to be a necessity of life like wheat and its
price goes up, consumers are forced to curtail the consumption of
more expensive foods like meat and fish, and wheat being still the
cheapest food they will consume more of it. The Marshallian
example is applicable to developed economies.

In the case of an underdeveloped economy, with the fall in the price

of an inferior commodity like maize, consumers will start
consuming more of the superior commodity like wheat. As a result,
the demand for maize will fall. This is what Marshall called the
Giffen Paradox which makes the demand curve to have a positive
slope.

(iv) Demonstration Effect:

If consumers are affected by the principle of conspicuous consump-
tion or demonstration effect, they will like to buy more of those
commodities which confer distinction on the possessor, when their
prices rise. On the other hand, with the fall in the prices of such
articles, their demand falls, as is the case with diamonds.

(v) Ignorance Effect:

Consumers buy more at a higher price under the influence of the
“ignorance effect”, where a commodity may be mistaken for some
other commodity, due to deceptive packing, label, etc.

(vi) Speculation:
Marshall mentions speculation as one of the important exceptions
to the downward sloping demand curve. According to him, the law
of demand does not apply to the demand in a campaign between
groups of speculators. When a group unloads a great quantity of a
thing on to the market, the price falls and the other group begins
buying it. When it has raised the price of the thing, it arranges to
sell a great deal quietly. Thus when price rises, demand also
increases.

(vii) Necessities of Life:

Normally, the law of demand does not apply on necessities of life
such as food, cloth etc. Even the price of these goods increases, the
consumer does not reduce their demand. Rather, he purchases
them even the prices of these goods increase often by reducing the
demand for comfortable goods. This is also a reason that the
demand curve slopes upwards to the right.

36. What's the difference between increase of demand and

extension of demand?
Increase in demand at the same price due to change in other determinants of the
demand curve.. In such a case a shift takes place in the demand curve. An increases
in demand takes place due to following reasons :

1. when consumer income rises.

 2. the fashion for a good increase, or
3. tastes and preferences becomes more favourable for the good;
4. prices of the substitutes of the good in question have risen;
5. propensity to consume of the people has increased; or
6. owing to the increase in population and as a result of expansion of the
market, the number of consumers of the good has increased.

Expansion in Demand:

Expansion in demand refers to a rise in the quantity demanded due to a fall in the
price of commodity.

other factors remaining constant.

 It leads to a downward movement along the same demand curve.

37. What is a production function in economics?

In economics, a production function relates physical output of
a productionprocess to physical inputs or factors of production. It is a
mathematical functionthat relates the maximum amount of output that can be
obtained from a given number of inputs – generally capital and labor.
3 Types of Production Functions –
Explained!
Production function is the mathematical representation of
relationship between physical inputs and physical outputs of an
organization.

There are different types of production functions that can be

classified according to the degree of substitution of one input by the
other.

Figure-16 shows different types of production function:

ADVERTISEMENTS:

The different types of production function (as shown in Figure-16).

1. Cobb-Douglas Production Function:

Cobb-Douglas production function refers to the production function
in which one input can be substituted by other but to a limited
extent. For example, capital and labor can be used as a substitute of
each other, but to a limited extent only.

Cobb-Douglas production function can be expressed as

follows:
ADVERTISEMENTS:

Q = AKaLb
Where, A = positive constant

a and b = positive fractions

b=1–a
Therefore, Cobb- Douglas production function can also be
expressed as follows:
Q = akaL1-a
The characteristics of Cobb- Douglas production function
are as follows:
i. Makes it possible to change the algebraic form in log linear form,
represented as follows:

log Q = log A + a log K + b log L

ADVERTISEMENTS:

This production function has been estimated with the help of linear
regression analysis.

ii. Makes it possible to change the algebraic form in log linear form,
represented as follows:

log Q = log A + a log K + b log L

This production function has been estimated with the help of linear
regression analysis.

iii. Acts as a homogeneous production function, whose degree can

be calculated by the value obtained after adding values of a and b. If
the resultant value of a + b is 1, it implies that the degree of
homogeneity is 1 and indicates the constant returns to scale.

iv. Makes use of parameters a and b, which signifies the elasticity’

coefficients of output for inputs, labor and capital, respectively.
Output elasticity coefficient refers to the change produced in output
due to change in capital while keeping labor at constant.

v. Represents that there would be no production at zero cost.

2. Leontief Production Function:

Leontief production function uses fixed proportion of inputs having
no substitutability between them. It is regarded as the limiting case
for constant elasticity of substitution.
The production function can be expressed as follows:
q= min (z1/a, Z2/b)
Where, q = quantity of output produced

Z1 = utilized quantity of input 1

Z2 = utilized quantity of input 2
a and b = constants

For example, tyres and steering wheels are used for producing cars.
In such case, the production function can be as follows:

Q = min (z1/a, Z2/b)

Q = min (number of tyres used, number of steering used).

3. CES Production Function:

CES stands for constant elasticity substitution. CES production
function shows a constant change produced in the output due to
change in input of production.

It can be represented as follows:

Q = A [aKβ + (1-a) L-β]-1/β
Or,

Q = A [aL-β + (1-a) K-β]-1/β

CES has the homogeneity degree of 1 that implies that output would
be increased with the increase in inputs. For example, labor and
capital has increased by constant factor m.

In such a case, production function can be represented as

follows:
Q’ = A [a (mK)-β + (1-a) (mL)-β]-1/β
Q’ = A [m-β {aK-β + (1-a) L-β}]-1/β
Q’ = (m-β)-1/β .A [aK-β + (1-a) L-β)-1/β
Because, Q = A [aK-β + (1-a) L-β]-1/β
Therefore, Q’ = mQ

This implies that CES production function is homogeneous with

degree one.
Production Function: Meaning,
Definitions and Features
Article Shared by <="" div="" style="margin: 0px; padding: 0px; border:
0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width:
100%;">

ADVERTISEMENTS:

Production Function: Meaning, Definitions and Features!

Production is the result of co-operation of four factors of production
viz., land, labour, capital and organization.

This is evident from the fact that no single commodity can be

produced without the help of any one of these four factors of
production.

ADVERTISEMENTS:

Therefore, the producer combines all the four factors of production

in a technical proportion. The aim of the producer is to maximize
his profit. For this sake, he decides to maximize the production at
minimum cost by means of the best combination of factors of
production.

The producer secures the best combination by applying the

principles of equi-marginal returns and substitution. According to
the principle of equi-marginal returns, any producer can have
maximum production only when the marginal returns of all the
factors of production are equal to one another. For instance, when
the marginal product of the land is equal to that of labour, capital
and organisation, the production becomes maximum.

Meaning of Production Function:

In simple words, production function refers to the functional
relationship between the quantity of a good produced (output) and
factors of production (inputs).
“The production function is purely a technical relation which
connects factor inputs and output.” Prof. Koutsoyiannis

ADVERTISEMENTS:

Defined production function as “the relation between a firm’s

physical production (output) and the material factors of production
(inputs).” Prof. Watson

In this way, production function reflects how much output we can

expect if we have so much of labour and so much of capital as well
as of labour etc. In other words, we can say that production function
is an indicator of the physical relationship between the inputs and
output of a firm.

The reason behind physical relationship is that money prices do not

appear in it. However, here one thing that becomes most important
to quote is that like demand function a production function is for a
definite period.

It shows the flow of inputs resulting into a flow of output during

some time. The production function of a firm depends on the state
of technology. With every development in technology the
production function of the firm undergoes a change.

The new production function brought about by developing

technology displays same inputs and more output or the same
output with lesser inputs. Sometimes a new production function of
the firm may be adverse as it takes more inputs to produce the same
output.

Mathematically, such a basic relationship between inputs and

outputs may be expressed as:

Q = f( L, C, N )

Where Q = Quantity of output

L = Labour
ADVERTISEMENTS:

C = Capital

N = Land.

Hence, the level of output (Q), depends on the quantities of

different inputs (L, C, N) available to the firm. In the simplest case,
where there are only two inputs, labour (L) and capital (C) and one
output (Q), the production function becomes.

Q =f (L, C)

Definitions:
“The production function is a technical or engineering relation
between input and output. As long as the natural laws of technology
remain unchanged, the production function remains unchanged.”
Prof. L.R. Klein

“Production function is the relationship between inputs of

productive services per unit of time and outputs of product per unit
of time.” Prof. George J. Stigler

“The relationship between inputs and outputs is summarized in

what is called the production function. This is a technological
relation showing for a given state of technological knowledge how
much can be produced with given amounts of inputs.” Prof. Richard
J. Lipsey

Thus, from the above definitions, we can conclude that production

function shows for a given state of technological knowledge, the
relation between physical quantities of inputs and outputs achieved
per period of time.

Features of Production Function:

Following are the main features of production function:
1. Substitutability:
The factors of production or inputs are substitutes of one another
which make it possible to vary the total output by changing the
quantity of one or a few inputs, while the quantities of all other
inputs are held constant. It is the substitutability of the factors of
production that gives rise to the laws of variable proportions.

2. Complementarity:
The factors of production are also complementary to one another,
that is, the two or more inputs are to be used together as nothing
will be produced if the quantity of either of the inputs used in the
production process is zero.

The principles of returns to scale is another manifestation of

complementarity of inputs as it reveals that the quantity of all
inputs are to be increased simultaneously in order to attain a higher
scale of total output.

3. Specificity:
It reveals that the inputs are specific to the production of a
particular product. Machines and equipment’s, specialized workers
and raw materials are a few examples of the specificity of factors of
production. The specificity may not be complete as factors may be
used for production of other commodities too. This reveals that in
the production process none of the factors can be ignored and in
some cases ignorance to even slightest extent is not possible if the
factors are perfectly specific.

Production involves time; hence, the way the inputs are combined is
determined to a large extent by the time period under
consideration. The greater the time period, the greater the freedom
the producer has to vary the quantities of various inputs used in the
production process.

In the production function, variation in total output by varying the

quantities of all inputs is possible only in the long run whereas the
variation in total output by varying the quantity of single input may
be possible even in the short run.
38. Law of Variable Proportions (With
Diagrams)
Article Shared by <="" div="" style="margin: 0px; padding: 0px; border:
0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width:
100%;">

ADVERTISEMENTS:

Law of Variable Proportions: Assumptions, Explanation ,

Stages , Causes of Applicability and Applicability of the
Law of Variable Proportions!
Law of Variable Proportions occupies an important place in
economic theory. This law is also known as Law of Proportionality.

Keeping other factors fixed, the law explains the production

function with one factor variable. In the short run when output of a
commodity is sought to be increased, the law of variable
proportions comes into operation.

ADVERTISEMENTS:

Therefore, when the number of one factor is increased or decreased,

while other factors are constant, the proportion between the factors
is altered. For instance, there are two factors of production viz., land
and labour.

Land is a fixed factor whereas labour is a variable factor. Now,

suppose we have a land measuring 5 hectares. We grow wheat on it
with the help of variable factor i.e., labour. Accordingly, the
proportion between land and labour will be 1: 5. If the number of
laborers is increased to 2, the new proportion between labour and
land will be 2: 5. Due to change in the proportion of factors there
will also emerge a change in total output at different rates. This
tendency in the theory of production called the Law of Variable
Proportion.

Definitions:
“As the proportion of the factor in a combination of factors is
increased after a point, first the marginal and then the average
product of that factor will diminish.” Benham

“An increase in some inputs relative to other fixed inputs will in a

given state of technology cause output to increase, but after a point
the extra output resulting from the same additions of extra inputs
will become less and less.” Samuelson

ADVERTISEMENTS:

“The law of variable proportion states that if the inputs of one

resource is increased by equal increment per unit of time while the
inputs of other resources are held constant, total output will
increase, but beyond some point the resulting output increases will
become smaller and smaller.” Leftwitch

Assumptions:
Law of variable proportions is based on following
assumptions:
(i) Constant Technology:
The state of technology is assumed to be given and constant. If there
is an improvement in technology the production function will move
upward.

(ii) Factor Proportions are Variable:

The law assumes that factor proportions are variable. If factors of
production are to be combined in a fixed proportion, the law has no
validity.

(iii) Homogeneous Factor Units:

The units of variable factor are homogeneous. Each unit is identical
in quality and amount with every other unit.

(iv) Short-Run:
The law operates in the short-run when it is not possible to vary all
factor inputs.

Explanation of the Law:

In order to understand the law of variable proportions we take the
example of agriculture. Suppose land and labour are the only two
factors of production.

By keeping land as a fixed factor, the production of

variable factor i.e., labour can be shown with the help of
the following table:

From the table 1 it is clear that there are three stages of the law of
variable proportion. In the first stage average production increases
as there are more and more doses of labour and capital employed
with fixed factors (land). We see that total product, average product,
and marginal product increases but average product and marginal
product increases up to 40 units. Later on, both start decreasing
because proportion of workers to land was sufficient and land is not
properly used. This is the end of the first stage.

ADVERTISEMENTS:

The second stage starts from where the first stage ends or where
AP=MP. In this stage, average product and marginal product start
falling. We should note that marginal product falls at a faster rate
than the average product. Here, total product increases at a
diminishing rate. It is also maximum at 70 units of labour where
marginal product becomes zero while average product is never zero
or negative.

The third stage begins where second stage ends. This starts from
8th unit. Here, marginal product is negative and total product falls
but average product is still positive. At this stage, any additional
dose leads to positive nuisance because additional dose leads to
negative marginal product.

Graphic Presentation:
In fig. 1, on OX axis, we have measured number of labourers while
quantity of product is shown on OY axis. TP is total product curve.
Up to point ‘E’, total product is increasing at increasing rate.
Between points E and G it is increasing at the decreasing rate. Here
marginal product has started falling. At point ‘G’ i.e., when 7 units
of labourers are employed, total product is maximum while,
marginal product is zero. Thereafter, it begins to diminish
corresponding to negative marginal product. In the lower part of the
figure MP is marginal product curve.

Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3

units of labourers are employed, it is maximum. After that,
marginal product begins to decrease. Before point ‘I’ marginal
product becomes zero at point C and it turns negative. AP curve
represents average product. Before point ‘I’, average product is less
than marginal product. At point ‘I’ average product is maximum. Up
to point T, average product increases but after that it starts to
diminish.

Three Stages of the Law:

1. First Stage:
First stage starts from point ‘O’ and ends up to point F. At point F
average product is maximum and is equal to marginal product. In
this stage, total product increases initially at increasing rate up to
point E. between ‘E’ and ‘F’ it increases at diminishing rate.
Similarly marginal product also increases initially and reaches its
maximum at point ‘H’. Later on, it begins to diminish and becomes
equal to average product at point T. In this stage, marginal product
exceeds average product (MP > AP).

2. Second Stage:
It begins from the point F. In this stage, total product increases at
diminishing rate and is at its maximum at point ‘G’ correspondingly
marginal product diminishes rapidly and becomes ‘zero’ at point ‘C’.
Average product is maximum at point ‘I’ and thereafter it begins to
decrease. In this stage, marginal product is less than average
product (MP < AP).

3. Third Stage:
This stage begins beyond point ‘G’. Here total product starts
diminishing. Average product also declines. Marginal product turns
negative. Law of diminishing returns firmly manifests itself. In this
stage, no firm will produce anything. This happens because
marginal product of the labour becomes negative. The employer will
suffer losses by employing more units of labourers. However, of the
three stages, a firm will like to produce up to any given point in the
second stage only.
In Which Stage Rational Decision is Possible:
To make the things simple, let us suppose that, a is variable factor
and b is the fixed factor. And a1, a2 , a3….are units of a and b1 b2b3……
are unit of b.
Stage I is characterized by increasing AP, so that the total product
must also be increasing. This means that the efficiency of the
variable factor of production is increasing i.e., output per unit of a is
increasing. The efficiency of b, the fixed factor, is also increasing,
since the total product with b1 is increasing.
The stage II is characterized by decreasing AP and a decreasing MP,
but with MP not negative. Thus, the efficiency of the variable factor
is falling, while the efficiency of b, the fixed factor, is increasing,
since the TP with b1 continues to increase.
Finally, stage III is characterized by falling AP and MP, and further
by negative MP. Thus, the efficiency of both the fixed and variable
factor is decreasing.

Rational Decision:
Stage II becomes the relevant and important stage of production.
Production will not take place in either of the other two stages. It
means production will not take place in stage III and stage I. Thus, a
rational producer will operate in stage II.

Suppose b were a free resource; i.e., it commanded no price. An

entrepreneur would want to achieve the greatest efficiency possible
from the factor for which he is paying, i.e., from factor a. Thus, he
would want to produce where AP is maximum or at the boundary
between stage I and II.

If on the other hand, a were the free resource, then he would want
to employ b to its most efficient point; this is the boundary between
stage II and III.

Obviously, if both resources commanded a price, he would produce

somewhere in stage II. At what place in this stage production takes
place would depend upon the relative prices of a and b.

Condition or Causes of Applicability:

There are many causes which are responsible for the application of
the law of variable proportions.

They are as follows:

1. Under Utilization of Fixed Factor:
In initial stage of production, fixed factors of production like land or
machine, is under-utilized. More units of variable factor, like
labour, are needed for its proper utilization. As a result of
employment of additional units of variable factors there is proper
utilization of fixed factor. In short, increasing returns to a factor
begins to manifest itself in the first stage.

2. Fixed Factors of Production.

The foremost cause of the operation of this law is that some of the
factors of production are fixed during the short period. When the
fixed factor is used with variable factor, then its ratio compared to
variable factor falls. Production is the result of the co-operation of
all factors. When an additional unit of a variable factor has to
produce with the help of relatively fixed factor, then the marginal
return of variable factor begins to decline.

3. Optimum Production:
After making the optimum use of a fixed factor, then the marginal
return of such variable factor begins to diminish. The simple reason
is that after the optimum use, the ratio of fixed and variable factors
become defective. Let us suppose a machine is a fixed factor of
production. It is put to optimum use when 4 labourers are
employed on it. If 5 labourers are put on it, then total production
increases very little and the marginal product diminishes.

4. Imperfect Substitutes:
Mrs. Joan Robinson has put the argument that imperfect
substitution of factors is mainly responsible for the operation of the
law of diminishing returns. One factor cannot be used in place of
the other factor. After optimum use of fixed factors, variable factors
are increased and the amount of fixed factor could be increased by
its substitutes.

Such a substitution would increase the production in the same

proportion as earlier. But in real practice factors are imperfect
substitutes. However, after the optimum use of a fixed factor, it
cannot be substituted by another factor.

Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields
of production. This law applies to any field of production where
some factors are fixed and others are variable. That is why it is
called the law of universal application.

The main cause of application of this law is the fixity of any one
factor. Land, mines, fisheries, and house building etc. are not the
only examples of fixed factors. Machines, raw materials may also
become fixed in the short period. Therefore, this law holds good in
all activities of production etc. agriculture, mining, manufacturing
industries.

1. Application to Agriculture:
With a view of raising agricultural production, labour and capital
can be increased to any extent but not the land, being fixed factor.
Thus when more and more units of variable factors like labour and
capital are applied to a fixed factor then their marginal product
starts to diminish and this law becomes operative.

2. Application to Industries:
In order to increase production of manufactured goods, factors of
production has to be increased. It can be increased as desired for a
long period, being variable factors. Thus, law of increasing returns
operates in industries for a long period. But, this situation arises
when additional units of labour, capital and enterprise are of
inferior quality or are available at higher cost.

As a result, after a point, marginal product increases less

proportionately than increase in the units of labour and capital. In
this way, the law is equally valid in industries.

Postponement of the Law:

The postponement of the law of variable proportions is
possible under following conditions:
(i) Improvement in Technique of Production:
The operation of the law can be postponed in case variable factors
techniques of production are improved.

(ii) Perfect Substitute:

The law of variable proportion can also be postponed in case factors
of production are made perfect substitutes i.e., when one factor can
be substituted for the other.

Demand Forecasting: Concept,

39.
Significance, Objectives and Factors
Article Shared by <="" div="" style="margin: 0px; padding: 0px; border:
0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width:
100%;">

ADVERTISEMENTS:

An organization faces several internal and external risks, such as

high competition, failure of technology, labor unrest, inflation,
recession, and change in government laws.

Therefore, most of the business decisions of an organization are

made under the conditions of risk and uncertainty.
An organization can lessen the adverse effects of risks by
determining the demand or sales prospects for its products and
services in future. Demand forecasting is a systematic process that
involves anticipating the demand for the product and services of an
organization in future under a set of uncontrollable and competitive
forces.

ADVERTISEMENTS:

Some of the popular definitions of demand forecasting are

as follows:
According to Evan J. Douglas, “Demand estimation (forecasting)
may be defined as a process of finding values for demand in future
time periods.”

In the words of Cundiff and Still, “Demand forecasting is an

estimate of sales during a specified future period based on proposed
marketing plan and a set of particular uncontrollable and
competitive forces.”

Demand forecasting enables an organization to take various

business decisions, such as planning the production process,
purchasing raw materials, managing funds, and deciding the price
of the product. An organization can forecast demand by making
own estimates called guess estimate or taking the help of specialized
consultants or market research agencies. Let us discuss the
significance of demand forecasting in the next section.

Significance of Demand Forecasting:

Demand plays a crucial role in the management of every business. It
helps an organization to reduce risks involved in business activities
and make important business decisions. Apart from this, demand
forecasting provides an insight into the organization’s capital
investment and expansion decisions.

ADVERTISEMENTS:

The significance of demand forecasting is shown in the

following points:
i. Fulfilling objectives:
Implies that every business unit starts with certain pre-decided
objectives. Demand forecasting helps in fulfilling these objectives.
An organization estimates the current demand for its products and
services in the market and move forward to achieve the set goals.

For example, an organization has set a target of selling 50, 000

units of its products. In such a case, the organization would perform
demand forecasting for its products. If the demand for the
organization’s products is low, the organization would take
corrective actions, so that the set objective can be achieved.

ii. Preparing the budget:

Plays a crucial role in making budget by estimating costs and
expected revenues. For instance, an organization has forecasted that
the demand for its product, which is priced at Rs. 10, would be 10,
00, 00 units. In such a case, the total expected revenue would be
10* 100000 = Rs. 10, 00, 000. In this way, demand forecasting
enables organizations to prepare their budget.

iii. Stabilizing employment and production:

Helps an organization to control its production and recruitment
activities. Producing according to the forecasted demand of
products helps in avoiding the wastage of the resources of an
organization. This further helps an organization to hire human
resource according to requirement. For example, if an organization
expects a rise in the demand for its products, it may opt for extra
labor to fulfill the increased demand.

ADVERTISEMENTS:

iv. Expanding organizations:

Implies that demand forecasting helps in deciding about the
expansion of the business of the organization. If the expected
demand for products is higher, then the organization may plan to
expand further. On the other hand, if the demand for products is
expected to fall, the organization may cut down the investment in
the business.

v. Taking Management Decisions:

Helps in making critical decisions, such as deciding the plant
capacity, determining the requirement of raw material, and
ensuring the availability of labor and capital.

vi. Evaluating Performance:

Helps in making corrections. For example, if the demand for an
organization’s products is less, it may take corrective actions and
improve the level of demand by enhancing the quality of its
products or spending more on advertisements.

vii. Helping Government:

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

Objectives of Demand Forecasting:

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

The objectives of demand forecasting are divided into

short and long-term objectives, which are shown in
Figure-1:

The objectives of demand forecasting (as shown in Figure-

1) are discussed as follows:
i. Short-term Objectives:
Include the following:
a. Formulating production policy:
Helps in covering the gap between the demand and supply of the
product. The demand forecasting helps in estimating the
requirement of raw material in future, so that the regular supply of
raw material can be maintained. It further helps in maximum
utilization of resources as operations are planned according to
forecasts. Similarly, human resource requirements are easily met
with the help of demand forecasting.

b. Formulating price policy:

Refers to one of the most important objectives of demand
forecasting. An organization sets prices of its products according to
their demand. For example, if an economy enters into depression or
recession phase, the demand for products falls. In such a case, the
organization sets low prices of its products.

c. Controlling sales:
Helps in setting sales targets, which act as a basis for evaluating
sales performance. An organization make demand forecasts for
different regions and fix sales targets for each region accordingly.

d. Arranging finance:
Implies that the financial requirements of the enterprise are
estimated with the help of demand forecasting. This helps in
ensuring proper liquidity within the organization.

ii. Long-term Objectives:

Include the following:
a. Deciding the production capacity:
Implies that with the help of demand forecasting, an organization
can determine the size of the plant required for production. The size
of the plant should conform to the sales requirement of the
organization.

b. Planning long-term activities:

Implies that demand forecasting helps in planning for long term.
For example, if the forecasted demand for the organization’s
products is high, then it may plan to invest in various expansion and
development projects in the long term.

Factors Influencing Demand Forecasting:

Demand forecasting is a proactive process that helps in determining
what products are needed where, when, and in what quantities.
There are a number of factors that affect demand forecasting.
Some of the factors that influence demand forecasting are
shown in Figure-2:

The various factors that influence demand forecasting

(“as shown in Figure-2) are explained as follows:
i. Types of Goods:
Affect the demand forecasting process to a larger extent. Goods can
be producer’s goods, consumer goods, or services. Apart from this,
goods can be established and new goods. Established goods are
those goods which already exist in the market, whereas new goods
are those which are yet to be introduced in the market.

Information regarding the demand, substitutes and level of

competition of goods is known only in case of established goods. On
the other hand, it is difficult to forecast demand for the new goods.
Therefore, forecasting is different for different types of goods.

ii. Competition Level:

Influence the process of demand forecasting. In a highly
competitive market, demand for products also depend on the
number of competitors existing in the market. Moreover, in a highly
competitive market, there is always a risk of new entrants. In such a
case, demand forecasting becomes difficult and challenging.

iii. Price of Goods:

Acts as a major factor that influences the demand forecasting
process. The demand forecasts of organizations are highly affected
by change in their pricing policies. In such a scenario, it is difficult
to estimate the exact demand of products.

iv. Level of Technology:

Constitutes an important factor in obtaining reliable demand
forecasts. If there is a rapid change in technology, the existing
technology or products may become obsolete. For example, there is
a high decline in the demand of floppy disks with the introduction
of compact disks (CDs) and pen drives for saving data in computer.
In such a case, it is difficult to forecast demand for existing products
in future.

v. Economic Viewpoint:
Play a crucial role in obtaining demand forecasts. For example, if
there is a positive development in an economy, such as globalization
and high level of investment, the demand forecasts of organizations
would also be positive.

Apart from aforementioned factors, following are some of

the other important factors that influence demand
forecasting:
a. Time Period of Forecasts:
Act as a crucial factor that affect demand forecasting. The accuracy
of demand forecasting depends on its time period.

Forecasts can be of three types, which are explained as

follows:
1. Short Period Forecasts:
Refer to the forecasts that are generally for one year and based upon
the judgment of the experienced staff. Short period forecasts are
important for deciding the production policy, price policy, credit
policy, and distribution policy of the organization.

2. Long Period Forecasts:

Refer to the forecasts that are for a period of 5-10 years and based
on scientific analysis and statistical methods. The forecasts help in
deciding about the introduction of a new product, expansion of the
business, or requirement of extra funds.

3. Very Long Period Forecasts:

Refer to the forecasts that are for a period of more than 10 years.
These forecasts are carried to determine the growth of population,
development of the economy, political situation in a country, and
changes in international trade in future.
Among the aforementioned forecasts, short period forecast deals
with deviation in long period forecast. Therefore, short period
forecasts are more accurate than long period forecasts.

4. Level of Forecasts:
Influences demand forecasting to a larger extent. A demand forecast
can be carried at three levels, namely, macro level, industry level,
and firm level. At macro level, forecasts are undertaken for general
economic conditions, such as industrial production and allocation
of national income. At the industry level, forecasts are prepared by
trade associations and based on the statistical data.

Moreover, at the industry level, forecasts deal with products whose

sales are dependent on the specific policy of a particular industry.
On the other hand, at the firm level, forecasts are done to estimate
the demand of those products whose sales depends on the specific
policy of a particular firm. A firm considers various factors, such as
changes in income, consumer’s tastes and preferences, technology,
and competitive strategies, while forecasting demand for its
products.

5. Nature of Forecasts:
Constitutes an important factor that affects demand forecasting. A
forecast can be specific or general. A general forecast provides a
global picture of business environment, while a specific forecast
provides an insight into the business environment in which an
organization operates. Generally, organizations opt for both the
forecasts together because over-generalization restricts accurate
estimation of demand and too specific information provides an
inadequate basis for planning and execution.

Steps of Demand Forecasting:

The Demand forecasting process of an organization can be effective
only when it is conducted systematically and scientifically.

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

3:
The steps involved in demand forecasting (as shown in
Figure-3) are explained as follows:
1. Setting the Objective:
Refers to first and foremost step of the demand forecasting process.
An organization needs to clearly state the purpose of demand
forecasting before initiating it.

Setting objective of demand forecasting involves the

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

b. Deciding whether to forecast the overall demand for a product in

the market or only- for the organizations own products

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

for the segment of the market

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

2. Determining Time Period:

Involves deciding the time perspective for demand forecasting.
Demand can be forecasted for a long period or short period. In the
short run, determinants of demand may not change significantly or
may remain constant, whereas in the long run, there is a significant
change in the determinants of demand. Therefore, an organization
determines the time period on the basis of its set objectives.

3. Selecting a Method for Demand Forecasting:

Constitutes one of the most important steps of the demand
forecasting process Demand can be forecasted by using various
methods. The method of demand forecasting differs from
organization to organization depending on the purpose of
forecasting, time frame, and data requirement and its availability.
Selecting the suitable method is necessary for saving time and cost
and ensuring the reliability of the data.
4. Collecting Data:
Requires gathering primary or secondary data. Primary’ data refers
to the data that is collected by researchers through observation,
interviews, and questionnaires for a particular research. On the
other hand, secondary data refers to the data that is collected in the
past; but can be utilized in the present scenario/research work.

5. Estimating Results:
Involves making an estimate of the forecasted demand for
predetermined years. The results should be easily interpreted and
presented in a usable form. The results should be easy to
understand by the readers or management of the
organization.
40. What is price discrimination and examples?
Price discrimination occurs when identical goods or services are sold at
differentprices from the same provider. ... Examples of forms of price
discriminationinclude coupons, age discounts, occupational discounts, retail
incentives, gender based pricing, financial aid, and haggling.

Price Discrimination
This involves charging a different price to different groups of people for the same good. For
example – student discounts, off peak fares cheaper than peak fares.
 Cut price fuel on
Tuesdays and Thursdays is a form of price discrimination.

Different Types of Price Discrimination

1. First Degree Price Discrimination

This involves charging consumers the maximum price that they are willing to pay. There will
be no consumer surplus.

2. Second Degree Price Discrimination

This involves charging different prices depending upon the quantity consumed. For example:

 After 10 minutes phone calls become cheaper.

 Electricity is more expensive for the first number of units. For a higher quantity of electricity
consumed the marginal cost is lower.
 Loyalty cards reward frequent buyers with discounts on future products.

3. Third Degree Price Discrimination – ‘Group price discrimination’

This involves charging different prices to different groups of people. For example:

 Student discounts,
 Senior citizen rail card
 Peak travel/ off-peak travel
 Cheaper prices by the time of the day (e.g. happy hour’s in pubs – usually earlier on in evening where
demand is lower.

More on third-degree price discrimination

Product versioning

One way firms practise price discrimination is to offer slightly different products as a way to
discriminate between consumers ability to pay. For example:
 Priority boarding tickets. Same flight but for a premium, you get a shorter queue.
 Organic coffee / fair trade coffee
 Extra leg room on airplanes
 First class/second class

This is a form of indirect segmentation. By offering slightly different choices, the firm is able
to separate consumers who are willing to pay higher prices.

Conditions necessary for price discrimination

1. Firm a price maker. The firm must operate in imperfect competition; it must be a price
maker with a downwardly sloping demand curve.

2. Separate markets. The firm must be able to separate markets and prevent resale. E.g.
stopping an adults using a child’s ticket. Prevent business travellers buying discount tickets.

3. Different elasticities of demand. Different consumer groups must have elasticities of

demand. E.g. students with low income will be more price elastic and sensitive to price.
Business travellers will have more inelastic demand.

4. Low admin costs. It must be relatively cheap to separate markets and implement price discrimination.

Simple diagram for Price Discrimination

 Without
price discrimination, the firm charges one price £7 * 100 = £700 revenue

WIth price discrimination, the firm can charge two different prices:

 £10 * 35 = £350
 £4 * 120 = £480

Total revenue = £830. Therefore, the firm makes more revenue under price
discrimination.

Profit maximisation under Price Discrimination

To maximise profits a firm sets output and price where MR=MC. If there are two sub markets
with different elasticities of demand. The firm will increase profits by setting different prices
depending upon the slope of the demand curve.

 Therefore for a group, such as adults, PED is inelastic – the price will be higher
 For groups like students, prices will be lower because their demand is elastic

Diagram of Price Discrimination

 Profit is maximised where MR=MC. WIthout price discrimination, there would just be one
price set for the whole market (A+B). There would be a price of P3.

 However, price discrimination allows the firm to set different prices for segment A (inelastic demand)
and segment B (elastic demand)
 Because demand is price inelastic, segment (A) will have a higher profit maximising price (P1)
 In segment (B) demand is price elastic, so the profit maximising price is lower.

Advantages of price discrimination

1. Firms will be able to increase revenue. Price discrimination will enable some firms to stay
in business who otherwise would have made a loss. For example price discrimination is
important for train companies who offer different prices for peak and off peak. Without price
discrimination, they may go out of business or be unable to provide off-peak services.

2. Increased investment. These increased revenues can be used for research and development
which benefit consumers

3. Lower prices for some. Some consumers will benefit from lower fares. For example, old
people benefit from lower train companies; old people are more likely to be poor. Also,
customers willing to spend time in researching ‘special offers’ and travelling at awkward
times will be rewarded with lower prices.

4. Manages demand. Airlines can use price discrimination to encourage people to travel at unpopular
times (early in morning) This helps avoid over-crowding and helps to spread out demand.

Disadvantages of Price Discrimination

1. Higher prices for some. Under price discrimination, some consumers will end up paying
higher prices (e.g. people who have to travel at busy times). These higher prices are likely to
be allocatively inefficient because P > MC.
2. Decline in consumer surplus. Price discrimination enables a transfer of money from
consumers to firms – contributing to increased inequality.

3. Potentially unfair. Those who pay higher prices may not be the poorest. For example, adults
paying full price could be unemployed, senior citizens can be very well off.

4. Administration costs. There will be administration costs in separating the markets, which
could lead to higher prices.

5. Predatory pricing. Profits from price discrimination could be used to finance predatory
pricing.

Importance of marginal cost in price discrimination

In markets where the marginal cost of an extra passenger is very low, the firm has an
incentive to use price discrimination to sell all the tickets. This is why sometimes prices for
airlines can be very low just before their date. Once the company is due to fly the MC of an
extra passenger will be very low. Therefore this justifies selling the remaining tickets at a low
price.

Examples of price discrimination

1. Student discounts on trains

2. Discounts for buying train tickets in advance
3. Discounts for travelling at off peak time
4. Lower unit cost price for buying high quantity.
5. Phone deals which give 100 texts free.
41. What is the concept of opportunity cost?
When economists refer to the “opportunity cost” of a resource, they mean the value
of the next-highest-valued alternative use of that resource. If, for example, you spend
time and money going to a movie, you cannot spend that time at home reading a
book, and you cannot spend the money on something else.

Top 13 Types of Cost in Cost

42.
Concept Analysis
Article Shared by <="" div="" style="margin: 0px; padding: 0px; border:
0px; outline: 0px; font-size: 14px; vertical-align: bottom; background: transparent; max-width:
100%;">

ADVERTISEMENTS:

The following points highlight the top thirteen types of cost in cost
concept analysis.
Some of the types are: 1. Private Cost and Social Cost2. Actual Cost
and Opportunity Cost 3. Past Cost and Future Cost 4. Explicit Cost
and Implicit Cost 5. Incremental Costs and Sunk Costs 6. Short-run
Costs and Long-run Costs and Others.

Type of Cost # 1. Private Cost:

Social Cost:
ADVERTISEMENTS:

Private cost refers to the cost of Production to an individual

producer. Social Cost refers to the cost of producing commodity to
society in the form of resources that are used to produce it.

From the social point of view, the economy has a certain volume of
resources in the form of capital, land etc., which it would be like to
put to the best uses.

This depends upon the efficient and full utilisation of resources and
also the specific list of commodities to be produced. It would be
ideal if the social cost coincided with the private costs of producing
commodity.

Type of Cost # 2. Actual Cost and Opportunity Cost:

Actual Costs or Outlay Costs or Absolute Costs mean the actual
amount of expenses incurred for producing or acquiring a good or
service. These are the costs which are generally recorded in the
books of accounts for cost or financial purposes such as payment for
wages, raw-materials purchased, other expenses paid etc.

ADVERTISEMENTS:

Opportunity Cost or Alternative Costs:

The Cost of production of any unit of a commodity A’ is the value of
the factors of production used in producing the unit.

The value of these factors of production is measured by the best

alternative use to which they might have been put had a unit of ‘A’
not been produced.

This concept of cost has been popularized by the American writers.

Type of Cost # 3. Past Costs and Future Costs:
Past Costs:
Actual costs or historical costs are records of past costs.

Future costs are based on forecasts. The costs relevant for most
managerial decisions are forecasts of future costs or comparative
conjunctions concerning future situations.

Forecasting of future costs is required for expense control,

projection of future income statements; appraisal of capital
expenditures, decision on new projects and on an expansion
programme and pricing.

For Policy Decisions on Price:

ADVERTISEMENTS:

The business enterprise depends upon future cost and not on Past
Cost. Past cost or historical cost is relevant only under the
assumption that, the cost conditions of the previous period would
be duplicated in the future too.

Type of Cost # 4. Explicit Cost and Implicit Cost:

“The total cost of production of any particular goods can
be said to include expenditure or explicit costs and non-
expenditure or implicit costs.” Expenditure or Outlay or
Explicit Costs are those costs which are paid by the employer to the
owners of the factor units which do not belong to the employer
itself.
These costs are in the nature of contractual payments and they
consist of wages and salaries paid; payments for raw materials,
interest on borrowed capital funds, rent on hired land and the taxes
paid to the Government.

Non-expenditure or Implicit Costs arise when factor units are

owned by the employer himself. The employer is not obligated to
anyone in order to obtain these factors. Expenditure costs are
explicit; since they are paid to factors outside the firm while non-
expenditure or implicit costs are imputed costs.
But the latter are costs in the real sense of the term, since the factor
units owned by the organizer himself can be supplied to other
producers for a contractual sum if they are not used in the business
of the organizer.

Type of Cost # 5. Incremental Costs or (Differential Costs) and

Sunk Costs:
Incremental Cost:
Is the additional cost due to change in the level or nature of
business activity.

The change may take several forms e.g.,:

(i) Addition of new product line,

(ii) Changing the channel of distribution,

(iii) Adding a new machine,

(iv) Replacing a machine by a better one, and

(v) The expansion into additional markets etc.

The question of this type of cost, would not arise when a business
has to be set up a fresh. It arises only when a change is
contemplated in the existing business.

Sunk Cost:
Is one which is not affected or altered by a change in the level or
nature of business activity. It will remain the same whatever the
level of activity may be.

For Example:
The amortization of past expenses e.g., depreciation.

Distinction between the Sunk Cost and Incremental Cost:

It assumes importance in evaluating alternatives. Incremental costs
will be different in the case of different alternatives. The
incremental costs are relevant to the management in the analysis
for decision-making. Sunk costs on the other-hand will remain the
same irrespective of the alternatives selected.
Thus, it need not be considered by the management in costs
evaluating the alternatives as they are common to all of them.

Type of Cost # 6. Short-Run and Long-Run Costs:

Short-run Costs are costs that vary with output or sales when fixed
plant and capital equipment remain the same.

Long-run Costs are those which vary with output when all output
factors including plant and equipment vary.

Short-run costs become relevant when a firm has to decide whether

to produce more or not in the immediate future and when setting up
of a new plant in ruled out and the firm has to manage with the
existing plant.

Long-run costs become relevant when the firm has to decide

whether to set up a new plant or not. Long-run cost can help the
businessman in planning the best scale of plant or the best size of
the firm for his purposes.

Thus, long-run costs can be helpful both in the initiation of new

enterprises as well as the expansion of existing ones.

Type of Cost # 7. Fixed and Variable Costs:

Fixed Costs remain constant in total regardless of changes in
volume of production and sales, up to certain level of output. There
is an inverse relationship between volume and fixed costs per unit.
If volume of production increases, the fixed costs per unit decreases.
Thus, total fixed costs do not change with a change in volume but
vary per unit of volume inversely.

Variable Costs vary in total in direct proportion to changes in

volume. An increase in the volume means a proportionate increase
in the total variable costs and a decrease in volume results in a
proportionate decline in the total variable costs.

There is a linear relationship between volume and variable costs.

They are constant per unit. Many costs fall between these two
extremes. They are called as semi-variable costs. They are neither
perfectly variable nor absolutely fixed in relation to changes in
volume.

They change in the same direction as volume but not in direct

proportion there to. For Example— Electricity bills often include
both fixed charge and a charge based on consumption.

This is known as two part Tariff:

Distinction:
The distinction between fixed and variable cost is very important in
forecasting the effect of short-run changes in the volume upon costs
and profits. This distinction has given rise to the concepts of Break-
Even chart; Direct costing and Flexible Budgets.

Type of Cost # 8. Direct and Indirect Costs or Traceable and

Common Costs:
A Direct or Traceable Cost is one which can be identified easily and
indisputably with a unit of operation, i.e., costing unit/cost centre.
Indirect or Common Costs are not traceable to any plant,
department or operation as well as those that are not traceable to
indirect final products.

For example:
The salary of a Divisional Manager, when a Division is a costing
unit, will be a direct cost. The monthly salary of the General Manger
when one of the divisions is a costing unit would be an indirect cost.

Cost of Multiple Products:

In some manufacturing enterprises two or more different products
emerge from a single raw material.

For example:
A variety of petroleum products are derived from the refining of
crude oil. In a cigarette factory different parts of the tobacco leaves
are used for different qualities and products. They are identifiable
as separate products only at the conclusion of common processing
generally known as the SPLIT OFF POINT.

Common Costs:
The costs incurred up to the Split off Point are common costs. Costs
which cannot be traced to separate products in any direct or logical
manner. These costs should not be identified with individual
products if it is not meaningful and useful to identify them.

In this existing product line some common costs are unaffected by

the change that how to be decided upon i.e., cost of factory building.
Fixed common costs need not be allocated since they are irrelevant
for any decision and will remain constant. Common costs that vary
with the decision must be allocated to individual products.

Type of Cost # 9. Sunk, Shut-Down and Abandonment Costs:

(i) Sunk Cost:
A Past Cost resulting from a decision which can no more be revised
is called a Sank Cost. It is usually associated with the commitment
of funds to specialised equipment or other facilities not readily
adaptable to present or future e.g., brewing plant in times of
prohibition.

(ii) Shut-down Costs:

Are these costs which would be incurred in the event of suspension
of the plant operation and which would have been saved if the
operations had continued, e.g., for storing exposed property.
Further additional expenses may have to be incurred when
operations are re-started.

(iii) Abandonment Costs:

Are the costs of retiring altogether a plant from service.
Abandonment arises when there is complete cessation of activities.
These costs become important when management is faced with the
alternatives of either continuing the existing plant or suspending its
operation or abandoning it altogether.

Type of Cost # 10. Out of Pocket and Book Cost:

Out of Pocket Costs:
Refer to costs that involve current cash payments to outsiders. On
the other hand book costs such as depreciation, do not require
current cash payments. Book costs can be converted into out of
pocket costs by selling the assets and having them on hire. Rent
would then replace depreciation and interest, while understanding
expansion; book costs do not come into the picture until the assets
are purchased.

Type of Cost # 11. Historical Costs and Replacement Costs:

Historical Costs:
Mean the cost of an asset or the price originally paid for it.
Replacement cost means the price that would have to be paid
currently for acquiring the same plant. The assets are usually shown
in the conventional financial accounts at their historical costs.

But during the period of changing price levels historical costs may
not be correct basis for projecting future costs. Historical costs must
be adjusted to reflect current or future price levels.

Type of Cost # 12. Controllable and Non-Controllable Costs:

A Controllable Cost is one which is reasonably subject to regulation
by the executive with whose responsibility that cost is being
identified.

Un-controllable Cost:
Un-controllable cost is that cost which is uncontrollable at one level
of responsibility may be regarded as controllable at some other
higher level. The controllability of certain costs may be shared by
two or more executives. The distinction is important for controlling
the expenses and efficiency.

Type of Cost # 13. Average Cost, Marginal Cost and Total Cost:
(i) Average Cost is the total cost divided by the total quantity
produced.

(ii) Marginal Cost is the extra cost of producing one additional unit.
It may at times be impossible to measure marginal cost. For
example, if a firm produces 10,000 metres of cloth, it can become
impossible to determine the change in cost involved in producing
10,001 metres of cloth. The difficulty can be solved by taking units
of significant size. In general, economist’s marginal cost is cost
account cost.
(iii) The Total Costs of a firm are the sum of total fixed costs and
total variable costs.

Symbolically:
Total Cost or TC = TFC + TVC

Average Cost or AC = TC + TQ

Marginal Cost or MC = TCn -TCn-1

 Difference between Avoidable Cost
42.
and Unavoidable Cost

What is avoidable cost?

It is the cost incurred only if firm takes a decision related to
production or investment is taken. This kind of cost is variable and
depends on level of output and by external inputs where firm can
take choice depending in a cost of opportunity of multiple decisions
and incentives.

The avoidable cost can be separated in two types:

 Variable cost: It is respective costs related with velocity of
production. If firm choose minimize cost based on quantity to
production can be reduced to 0 or based on a minimization criteria.
 Stepped fixed Cost: It represent costs that depend of multiple levels
of production beyond current threshold of production.
 The decision of firm of reduce avoidable cost is result of cost of
opportunity of getting inputs with a relative price more economic.
Inputs required in production are traded in domestic and
international markets, where can be exchanged with a better price if
real exchange rate is appreciated or comparative costs abroad
countries, divided in three main cases:
 Labor costs
 Raw Material
 Advanced machinery
 Capital lending and interest rates swap

Also, firm can take choice of reduce avoidable cost as result of

changes in their industry, where size of production is reduced as
result of shortfall of demand and firms require to reduce prices to
compensate reduction of price of market and avoid losses.

What is unavoidable cost?

It is the cost that still incurred for firm even if decision of producing
is not taken. These costs are as result of risk taken by firms in their
industries for maintaining in the market and cover uncertainty of
 decisions of production. The fixed cost are the main representation
of unavoidable cost for firms, as result of firm to install capacity,
administrative workforce and tools, require an initial investment
that can be used or maybe not.

Additional fixed costs that are unavoidable for firm can be shown as
follows:

Cost of capital: Represent the cost of expected return of investment

provided by owners of firm, that does not depend on production but
opportunity cost between another investment choices different than
current industry where money was invested.

Sunk cost: There are the multiple costs associated to start business
that cannot be recovered in balance sheet until firm is producing
benefits, such as regulation costs, startup firm costs, building
improvement costs and training costs.

Examples of unavoidable costs refer cases where quality depends on

a single provider of an input with a unique quality of product impact
over costs of firm. This kind of cost cannot be controlled by firm and
avoided unless firm get new providers and switch it as an avoidable
cost.

Additional examples of unavoidable costs happen when systematic

risk of taking a position of financial assets impact negatively over
return of firm, and cannot be covered with diversification of
investment.

Difference between avoidable cost and unavoidable

cost
1. Velocity of production
 Avoidable cost

The usage of labor, capital and raw material inputs depend of level
of production decided to undertake for firm.

Unavoidable cost

The unavoidable costs do not depend on velocity of production, but

it occurs as an initial investment to function the firm.

2. Separation of costs
Avoidable cost

Avoidable cost can be separated in variable costs, represented in

inputs of labor, capital and raw material, and stepped fixed costs,
represented in investment required to change total level of output of
firm.

Unavoidable cost

Unavoidable costs are separated in cost resulted of systematic risk

and changes in capital cost for valuating business.

3. Managing costs
Avoidable cost

These cost can be controlled by firm due to it depends on a level of

output defined by an optimization criterion, being profit
maximization or minimize costs.

Unavoidable cost

The firm cannot control it as result of exogenous variables occurred

at macroeconomic and industrial level.
4. Swap of costs
Avoidable cost

Firms can switch avoidable costs in a market, using local or

international providers of inputs required to create final product.

Unavoidable cost

The firm cannot switch unavoidable costs in a market as result it

does not have immediate substitutes, but valuating the changes
generated in the costs.

5. Revenue short fall

Avoidable cost

If firm cannot achieve a maximization profit, can choose move

towards a position of minimize costs and avoid cost related to
production, where average cost and marginal cost have same value.

Unavoidable cost

As result of reduction of benefits generated by business,

unavoidable cost related capital cost, systematic risk, default risk
and coverage of adversity cost may increase.

Avoidable Cost versus

Unavoidable Cost
It can be excluded as result of velocity of production.

These are direct costs for firm.

There are controlled by firm.

 Costs can be obtained and switched in a market of multiple providers from domestic and abroad origins.

Costs related to inputs for production.

Summary
 Avoidable and unavoidable costs are related to organization´s
theory for valuation and undertake decision of production of firm.
 Avoidable costs represent the inputs where firm can change it
depending on multiple levels of production.
 Unavoidable costs represent costs where it does not depend on
velocity of production and firm cannot control by systematic risk
and economic conditions.
 Avoidable cost are divided in variable cost that changes on discrete
values and stepped fixed cost that changes on firms decision to
increase installed capacity and levels of output beyond its limit.
 The main representations of avoidable cost are represented in labor
cost, raw material costs and capital costs that can buy in local or
international markets depending on relative price of inputs.
 Unavoidable costs are exogenous to firm and there are result of
systematic risk cost of capital, and industrial performance.
 Sunk costs are an example of unavoidable costs, where it does not
depend on production but there are necessary to start production by
firm.
 Avoidable and unavoidable costs can be valuated at current prices
and differentiate them, to investment decision and profitability of
business.

What is a 43.

Replacement Cost?
Home/Accounting Dictionary/What is a Replacement Cost?
Definition: Replacement cost is the amount of money required to replace an existing asset
with an equally valued or similar asset at the current market price. In other words, it is the
cost of purchasing a substitute asset for the current asset being used by a company.
What Does Replacement Cost Mean?
This concept is important to businesses because most assets wear out and need to be replaced
eventually. Take a car for example. After 5-10 years, the vehicle will no longer work and will
need to be retired and a new one will need to be purchased. Most likely the replacement will
cost more than the price paid for the original vehicle. Another thing to keep in mind is that
the replacement cost must include any other cost incurred for the new asset to be fully
available and operational.

When a company is evaluating the scenario of replacing an asset it is very important to

consider the profitability of the purchase at the new cost. Since the newly purchased asset
might be more expensive than the old asset, the new purchase must be evaluated carefully to
see if the net present value of the investment stays positive considering the new price of the
asset.

This concept is also important for company valuations. If a company’s asset has a historical
cost that differs widely from its current market price, the replacement cost might increase the
value of the company. For instance, if the company purchased a building 20 years ago in an
up-and-coming area, the historical cost of the building is much less than its replacement cost.
Thus, making the company more valuable than its balance sheet lets on.

Here’s another example.

Example
Big Trucks INC. is a company that provides car rental services. The company’s fleet is
mostly made up of big trucks for people in the construction business. The company has to
replace one of his cars because it is too old and clients don’t want to lease it anymore. The
truck was initially bought at $20,000, but the current market price of a similar truck is
$23,000.

In this situation, it would cost the company $23,000 to purchase a similar asset to the one
they current have in order to replace it. Thus, $23,000 is the replacement cost of the $20,000
truck because this is how much it would cost to buy that same truck today.

44. The historical cost concept

also known as cost principle of accounting) states that the assets and liabilities of a
business should be presented in accounting records at their historical cost.

Historical cost is the amount that is originally paid to acquire the asset and may
be different from the current market value of the asset. Let us assume, for example, that
a herbal medicine company purchases a piece of land for growing herbs on it, paying
$25,000 in cash. The company will enter $25,000 as the cost of the land in its
accounting records. In a booming real estate market, the fair market value of the land
five years later might be $35,000. Although the market price of the land has significantly
increased, the amount entered in the balance sheet and other accounting records would
continue unchanged at the cost of $25,000.

A similar presentation is also required for liabilities. Companies issue various liabilities
(such as accounts payable, bills payable, notes payable, bonds payable etc.) in
exchange for goods and services. These liabilities are normally reported at their cost.
For example, a company acquires a tract of land at an agreed price of $12,000 and
issues a note payable amounting to $12,000 for the full payment. The cost of note
payable to be entered in accounting records would be $12,000.

Importance of historical cost concept

An important advantage of historical cost concept is that the records kept on the basis of
it are considered consistent, comparable, verifiable and reliable.

Any valuation basis other than historical cost may create serious issues for companies.
For example, if a company uses current market value or sales value rather than
historical cost, each member of accounting department is likely to suggest a different
value for each asset of the company.

Further, current market or sales value is not appropriate for entities that prepare their
financial statements more than once a year. For example, companies computing net
income or preparing balance sheet on monthly basis would have to establish a new
sales value for inventory and other assets at the end of each month which is usually
inconvenient.

Exceptions to cost principle

When a company prepares its balance sheet, most of the assets are listed at their
historical cost. However, some highly liquid assets are subject to exception of historical
cost concept. For example, investments in debt or equity instruments of other
enterprises that are expected to be converted into cash in near future are shown in the
balance sheet at their current market value. Similarly, accounts receivable are
presented in the balance sheet at their net realizable value. Net realizable value is the
approximate amount of cash that a company expects to receive from receivables at the
time of their collection.

The logic behind deviation of current market value and net realizable value from
historical cost concept in reporting some liquid assets is to provide a more reliable
information for predicting future cash inflows of the company and facilitating the users of
financial statements in decision making.

Examples of historical cost concept or cost

principle
 1. The Washington Company constructed a building at a cost of $45,000 in 2005.
On December 31, 2017, the fair market value of the building is $65,000 but still
stands on the balance sheet at its original cost of $45,000.
2. The New York Company purchased a tract of land for $50,000 on January 1,
2010. Today the fair market value of the land is $65,000. Although the economic
value or market price of the land has increased, the company would continue
reporting it at its historical cost of $50,000.
3. The Lasani Stone Crushing Company purchased a piece of equipment for
$10,000 several years ago. Today, the worth of equipment is only $2,500 but the
company would still report it at original cost less accumulated depreciation.
4. Mexico Trading Company purchased 1,000 units of an item last quarter for $1 per
unit . The current price of inventory is $1.25 per unit. The company would report
inventory at purchase price of $1,000 and not at $1,250.

Difference between Economic

46.

Cost and Accounting Cost

Learn about the difference between Economic cost and
Accounting cost.
An economist thinks of cost differently from an accountant, who is
concerned with the financial statements.

Accountants tend to take a retrospective look at a firm’s finances as

they have to keep track of assets and liabilities and evaluate past
performance.

ADVERTISEMENTS:

Accounting costs include actual expenses and depreciation expenses

for capital equipment, which are determine for tax purposes.

Economists, on the other hand, take a forward-looking view of the

firm. They are concerned with what costs are expected to be in the
future, and how the firm would be able to rearrange its resources to
lower its costs and improve its profitability. They must, thus, be
concerned with opportunity costs.

For example, consider a firm that owns a building, and, therefore,

pays no rent for office space. Does this mean that the cost of office
space is zero for the firm? Though an accountant might treat this
cost as zero, an economist would consider the rent that the firm
could have earned by leasing the office space to another company.
This foregone rent is an opportunity cost of utilizing the office space
and should be included as part of the economic cost of doing
business.

ADVERTISEMENTS:

Accountants and economists both include actual outlays, called

explicit costs, in their calculations. Explicit costs include wages,
salaries, etc. For accountants, explicit costs are important because
they involve direct payments by a company. These costs are relevant
for the economists because the costs of wages and materials
represent money that could have been usefully spent elsewhere.

Explicit costs involve opportunity cost as well; for example, wages

are the opportunity costs for labour inputs purchased in a
competitive market.

Let us look at how economic costs can differ from accounting costs
in the treatment of wages and depreciation. For example, consider
an owner who manages his own firm but chooses not to pay himself
a salary, the business none the less incurs an opportunity cost
because the owner could have earned a competitive salary by
working elsewhere.

Accountants and economists also treat depreciation differently.

When estimating the future profitability of a business, an economist
is concerned with the capital cost of plant and machinery. This
involves not only the explicit cost of buying and running the
machinery, but also cost associated with wear and tear.

Accountants use tax rules to determine allowable depreciation in

their cost and profit calculations. But these depreciation allowances
need not reflect the actual wear and tear on the equipment.
47.