Tag: Business EconomicsOsmania University b.com Notes

Cost and revenue are just like two different faces of the same coin. The costs and revenues of a firm determine its nature and the levels of profit. Cost refers to the expenses incurred by a producer for the production of a commodity. Revenue denotes the amount of income, which a firm receives by the sale of its output. The revenue concepts commonly used in economic are total revenue, average revenue and marginal revenue.

Total Revenue

Total revenue refers to the total sale proceeds of a firm by selling its total output at a given price.

Total revenue is the amount of money that a firm receives for the offer of goods and services in the market. A firm’s total revenue can be calculated as the quantity of goods sold multiplied by the price. The total revenue includes the product of the quantity sold and the price.

Total revenue=Total Quantity Sold × Unit Price

Mathematically,

TR = PQ

TR = Total Revenue

P = Price

Q = Quantity sold.

Average Revenue

Average revenue is the revenue per unit of the commodity sold. It is obtained by dividing the total revenue by the number of units sold.

Average revenue is used as price in a perfectly competitive market. This can be found by the ratio of the firm’s total revenue and the number of goods sold.

AR = Total Revenue/ Total Output Sold

Mathematically

AR = TR/Q;

Where,

AR = Average revenue

TR = Total revenue

Q = Quantity sold.

Marginal Revenue

Marginal revenue is the addition to total revenue by selling one more unit of the commodity.

Marginal revenue refers to the extra money received by selling one more additional unit of the commodity. It is an addition to the total revenue of a firm as new additional units are sold. By selling an additional unit, a firm earns additional revenue that adds to the total revenue and this addition to revenue is called marginal revenue.

Algebraically it is the total revenue earned by selling ‘n’ units of the commodity instead of n-1. Thus,

MRn = TRn – TRn-1; where MRn = Marginal revenue of the nth unit

TRn = Total revenue of n units

TRn-1 = Total revenue of n-1 units

N = Any given number of units sold.

Relationship:

Both AR and MR are Calculated from TR:

The average cost and marginal costs are calculated from total cost. In the same fashion, average revenue and marginal revenue can also be calculated from total revenue.

When AR and MR are Parallel to X-axis:

If average revenue and marginal revenue are parallel to horizontal axis then it means both AR and MR are equal to each other i.e. AR = MR.

When both AR and MR are Straight Lines:

Under imperfect competition, when AR falls, MR also falls and it is always below AR line because there are large numbers of buyers and sellers, products are not homogeneous and the firms can enter or exit the market.

If AR Curve is Rising Upward from Left to Right:

In case AR curve is rising upward from left to right, then MR curve will also move upward. It means MR will be greater than AR.

When AR and MR are Convex:

AR and MR curves are convex to the origin. It means as more and more units of a commodity are sold, average revenue falls at lower speed. MR curve also moves in the same direction. The convexity shows that MR falls but at a faster speed.

When AR and MR are Concave:

If AR is concave to the origin, MR will also be concave to the origin. It means average revenue is falling at a higher rate for each additional unit of a commodity sold. Similar would be the case for MR curve.

Revenue and Elasticity:

The elasticity of demand, average revenue and marginal revenue has a close relationship. If a firm knows any two of the three elements viz; average revenue and marginal revenue then it can easily find out the third element i.e. elasticity of demand.

The formula for the calculation is:

E = A / A-M

Where,

E = elasticity of demand

A = average revenue

M = marginal revenue

Returns to a factor refers to the behaviour of physical output owing to change in physical input of a variable factor, fixed factors remaining constant.

In economics, returns to scale describe what happens to long run returns as the scale of production increases, when all input levels including physical capital usage are variable (able to be set by the firm). The concept of returns to scale arises in the context of a firm’s production function. It explains the long run linkage of the rate of increase in output (production) relative to associated increases in the inputs (factors of production). In the long run, all factors of production are variable and subject to change in response to a given increase in production scale. While economies of scale show the effect of an increased output level on unit costs, returns to scale focus only on the relation between input and output quantities.

There are three possible types of returns to scale:

• Increasing returns to scale
• Constant returns to scale
• Diminishing (or decreasing) returns to scale

If output increases by the same proportional change as all inputs change then there are constant returns to scale (CRS). If output increases by less than the proportional change in all inputs, there are decreasing returns to scale (DRS). If output increases by more than the proportional change in all inputs, there are increasing returns to scale (IRS). A firm’s production function could exhibit different types of returns to scale in different ranges of output. Typically, there could be increasing returns at relatively low output levels, decreasing returns at relatively high output levels, and constant returns at some range of output levels between those extremes.

In mainstream microeconomics, the returns to scale faced by a firm are purely technologically imposed and are not influenced by economic decisions or by market conditions (i.e., conclusions about returns to scale are derived from the specific mathematical structure of the production function in isolation).

Returns to factors are also called factor productivities. Productivity is the ratio of output to the input. Factor productivity refers to the short-run relationship of input and output. The productivity of one unit of a factor of production will be equal to the output it can generate. The productivity of a particular factor is measured with the assumption that the other factors are not changed or remain unchanged. Only that particular factor under study is changed.

Returns to factors refer to the output or return generated as a result of change in one or more factors, keeping the other factors unchanged. Given a percentage of increase or decrease in a particular factor such as labour, is it yielding proportionate increase or decrease in production? This is analysed in ‘returns to factors.’

The change in productivity can be measured in terms of

• Average productivity the total physical product divided by the number units of that particular factor used yields average productivity.
• Total productivity the total output generated at varied levels of input of a particular factor (while other factors remain constant), is called total physical product.
• Marginal productivity the marginal physical product is the additional output generated by adding an additional unit of the factor under study, keeping the other factors constant.

The total physical product increases along with an increase in the inputs. However, the rate of increase is varied, not constant. The total physical product at first increases at an increasing rate because of the law of increasing return to scale, and later its rate of increase declines because of the law of decreasing returns to scale.

Assumptions:

• Labour is the variable factor and capital is the fixed factor.
• There are only two factors of production, labour and capital.
• The production function is homogeneous.
• Both factors are variable in returns to scale.

Differentiate an input and keep all the other inputs unchanged, then for different degrees of that input we get different degrees of output. This association between the variable input and output, keeping all the other inputs unchanged is often referred to as total product (TP) of the variable input. This is also sometimes termed as the total return or total physical product of the variable input. It will be helpful to elucidate the concepts of average product (AP) and marginal product (MP). They are useful in order to explain the contribution of the variable inputs to the production procedure.

The function that explains the relationship between physical inputs and physical output (final output) is called the production function. We normally denote the production function in the form:

Q = f(X1, X2)

Where,

Q Represents the final output.

X1 and X2 are inputs or factors of production.

Total Production

Total Product as the total volume or amount of final output produced by a firm using given inputs in a given period of time.

Total product of a factor is the amount of total output produced by a given amount of the factor, other factors held constant. As the amount of a factor increases, the total output increases.

Marginal Production

The additional output produced as a result of employing an additional unit of the variable factor input is called the Marginal Product. Thus, we can say that marginal product is the addition to Total Product when an extra factor input is used.

Marginal Product = Change in Output/ Change in Input

Average Production

It is defined as the output per unit of factor inputs or the average of the total product per unit of input and can be calculated by dividing the Total Product by the inputs (variable factors).

Average Product = Total Product/ Units of Variable Factor Input

Relationship between Average Product and Marginal Product

There exists an interesting relationship between Average Product and Marginal Product. We can summarize it as under:

• When Average Product is declining, Marginal Product lies below Average Product.
• When Average Product is rising, Marginal Product lies above Average Product.
• At the maximum of Average Product, Marginal and Average Product equal each other.

Relationship between Marginal Product and Total Product

The law of variable proportions is used to explain the relationship between Total Product and Marginal Product. It states that when only one variable factor input is allowed to increase and all other inputs are kept constant, the following can be observed:

• When the MP declines but remains positive, the Total Product is increasing but at a decreasing rate. This give ends the Total product curve a concave shape after the point of inflexion. This continues until the Total product curve reaches its maximum.
• When the Marginal Product (MP) increases, the Total Product is also increasing at an increasing rate. This gives the Total product curve a convex shape in the beginning as variable factor inputs increase. This continues to the point where the MP curve reaches its maximum.
• When the MP becomes zero, Total Product reaches its maximum.
• When the MP is declining and negative, the Total Product declines.

Consumerism is the organized form of efforts from different individuals, groups, governments and various related organizations which helps to protect the consumer from unfair practices and to safeguard their rights.

The growth of consumerism has led to many organizations improving their services to the customer.

Consumer theory is the study of how people decide to spend their money based on their individual preferences and budget constraints. A branch of microeconomics, consumer theory shows how individuals make choices, subject to how much income they have available to spend and the prices of goods and services.

Understanding how consumers operate makes it easier for vendors to predict which of their products will sell more and enables economists to get a better grasp of the shape of the overall economy.

Determinants of Demand

The key determinants that affect the demand function are as follows:

Consumer Preferences: Favorable change leads to an increase in demand, unfavorable change leads to a decrease in demand.

Income: A rise in consumer’s income will tend to increase the demand curve (shift the demand curve to the right). A fall will tend to decrease the demand for normal goods.

Number of Buyers: More the number of buyers, more will be the demand. Fewer buyers lead to a decrease in demand.

Complementary Goods (goods that can be used together): The prices of complementary goods and their demand are inversely related.

Substitute Goods (goods that can be used to replace each other): The price of substitutes and demand for the other good are directly related.

Dimensions of Consumer Behavior

Consumer behavior is multidimensional in nature and it is influenced by the following subjects:

• Sociology is the study of groups. When individuals form groups, their actions are sometimes relatively different from the actions of those individuals when they are operating individually.
• Psychology is a discipline that deals with the study of mind and behavior. It helps in understanding individuals and groups by establishing general principles and researching specific cases. Psychology plays a vital role in understanding how consumers behave while making a purchase.
• Cultural Anthropology is the study of human beings in society. It explores the development of central beliefs, values and customs that individuals inherit from their parents, which influence their purchasing patterns.
• Social Psychology is a combination of sociology and psychology. It explains how an individual operates in a group. Group dynamics play an important role in purchasing decisions. Opinions of peers, reference groups, their families and opinion leaders influence individuals in their behavior.

Understanding Consumer Theory

Individuals have the freedom to choose between different bundles of goods and services. Consumer theory seeks to predict their purchasing patterns by making the following three basic assumptions about human behavior:

Nonsatiation: People are seldom satisfied with one trip to the shops and always want to consume more.

Utility maximization: Individuals are said to make calculated decisions when shopping, purchasing products that bring them the greatest benefit, otherwise known as maximum utility in economic terms.

Decreasing marginal utility: Consumers lose satisfaction in a product the more they consume it.

In the Determination of Gains from International Trade:

The gains from international trade depend, among others, on the elasticity of demand. A country will gain from international trade if it exports goods with less elasticity of demand and import those goods for which its demand is elastic.

The ‘terms of trade’ can be determined by measuring elasticity of demand in two countries for each other’s goods. In international trade, a country earns more profits by importing the commodities, which have elastic demand and exporting the ones, which have relatively less elasticities.

In the first case, it will be in a position to charge a high price for its products and in the latter case it will be paying less for the goods obtained from the other country. Thus, it gains both ways and shall be able to increase the volume of its exports and imports.

In the Determination of Government Policies:

The knowledge of elasticity of demand is also helpful for the government in determining its policies. Before imposing statutory price control on a product, the government must consider the elasticity of demand for that product.

The government decision to declare public utilities those industries whose products have inelastic demand and are in danger of being controlled by monopolist interests depends upon the elasticity of demand for their products.

In Dumping:

A firm enters foreign markets for dumping his product on the basis of elasticity of demand to face foreign competition.

In Price Determination of Factors of Production:

The concept of elasticity for demand is of great importance for determining prices of various factors of production. Factors of production are paid according to their elasticity of demand. In other words, if the demand of a factor is inelastic, its price will be high and if it is elastic, its price will be low.

In the Determination of Price:

The elasticity of demand for a product is the basis of its price determination. The ratio in which the demand for a product will fall with the rise in its price and vice versa can be known with the knowledge of elasticity of demand.

Helpful in Adopting the Policy of Protection:

The government considers the elasticity of demand of the products of those industries which apply for the grant of a subsidy or protection. Subsidy or protection is given to only those industries whose products have an elastic demand. As a consequence, they are unable to face foreign competition unless their prices are lowered through sub­sidy or by raising the prices of imported goods by imposing heavy duties on them.

In the Determination of Prices of Joint Products:

The concept of the elasticity of demand is of much use in the pricing of joint products, like wool and mutton, wheat and straw, cotton and cotton seeds, etc. In such cases, separate cost of production of each product is not known.

Therefore, the price of each is fixed on the basis of its elasticity of demand. That is why products like wool, wheat and cotton having an inelastic demand are priced very high as compared to their byproducts like mutton, straw and cotton seeds which have an elastic demand.

In Demand Forecasting:

The elasticity of demand is the basis of demand forecasting. The knowledge of income elasticity is essential for demand forecasting of producible goods in future. Long- term production planning and management depend more on the income elasticity because management can know the effect of changing income levels on the demand for his product.

In Price Discrimination by Monopolist:

Under monopoly discrimination the problem of pricing the same commodity in two different markets also depends on the elasticity of demand in each market. In the market with elastic demand for his commodity, the discriminating monopolist fixes a low price and in the market with less elastic demand, he charges a high price.

In the Determination of Output Level:

For making production profitable, it is essential that the quantity of goods and services should be produced corresponding to the demand for that product. Since the changes in demand is due to the change in price, the knowledge of elasticity of demand is necessary for determining the output level.

Business Economics is playing an important role in our daily economic life and business practices. In actual practice different types of business are existing and run by people so study of Business Economics become very useful for businessmen. Since the emergence of economic reforms in Indian economy the whole economic scenario regarding the business is changed.

Various new types of businesses are emerged, while taking the business decisions businessmen are using economic tools. Economic theories, economic principles, economic laws, equations economic concepts are used for decision making. On this ground students of commerce should know the importance of basic theories in actual business application. Hence the introduction of Business Economics becomes important to the students.

Professors H.C. Peterson and W.C. Lewis suggested that Business Economics must be considered as a part of applied microeconomics.

• In Business Economics, the primary importance upon the firm, the environment in which the firm finds itself and the business decision that the firm has to take.
• Business Economics is an application of microeconomics which focuses on the topics which are of much importance and interest. The topics include the theories of demand, production and cost, profit-maximising, the model of a firm, optimal prices of the advertising expenditures, government regulation etc.
• Business Economics seeks to investigate and analyse how and why a business behaves. It looks at the implications of action, policies of the firm in which they operate and the economy as a whole.

Broadly there are two main branches of economics “positive” economics and ‘normative’ economics. Positive economics deals with “description” while normative economics deals with ‘prescription’. By building up propositions on the basis of a set of assumptions, positive economics tries to explain economic phenomenon.

Normative economics comments on the desirability of that phenomenon and suggests policy measures. Value judgments are, thus, pronounced in normative economics. In the words of Profs. Mote, Paul and Gupta: “Managerial economics is a part of normative economics as its focus is more on prescribing choice and action and less on explaining what has happened. Managerial economics draws on positive economics by utilizing the relevant theories as a basis for prescribing choices.”

Business economics not only seeks to investigate and analyse how and why businesses behave as they do but also the implications of their actions and policies for the industry in which they operate and, finally, for the economy as a whole. In this business environment, both internal and external factors work.

Macro Analysis:

Macro economics which deals with the principles of economic behaviour for the economy as a whole is also useful for business economics. A business unit operates within some economic environment which is in turn shaped by the behaviour of the economy as a whole. Therefore, business manager must know the external forces working over his business environment.

Normative in Nature:

Business economics is also called normative economics which prescribes standards or norms for policy making. Business economics is prescriptive rather than descriptive in nature. In economic theory, we try to explain economic bahaviour: in business economics, we try to prescribe policies for a business manager which are most likely applied to achieve his objectives. In economic theory, we build ‘laws’ such as the law of Demand and the Law of Diminishing Returns. In business economics we apply these laws for policy planning at the level of a firm.

Pragmatic in Approach:

Business economics is pragmatic in its approach. It does not involve itself with the theoretical controversies of economics. Yet it does not relegate the realities of business decision-making to the background by bringing in abstract assumptions. While economic theory abstracts from realities of the individual business units to build up its theories, managerial economics takes proper note of the particular economic environment in which a firm works.

Basis of Theory of Markets and Private Enterprises:

Business economics largely uses the theory of markets and private enterprise. It uses the theory of the firm and resource allocation of private enterprise economy.

Micro in Nature:

Business economics is micro-economics in nature. This is due to the study of business economics mainly at the level of the firm.

Generally, a business manager is concerned with problems of his own business unit. He does not study the economic problems of an economy as a whole.

The vital role which business firms play in increasing social welfare is quite clear. It is due to the working of business firms that a high rate of economic growth has been achieved in the United States and other western countries.

Benefits of this economic growth have been widely shared. The high rate of economic growth has resulted in improving social well-being and removing poverty. To put in the words of Adam Smith, the father of economics, business firms have greatly increased the ‘wealth of nations’ (that is, the volume of output of goods and services) in the capitalist world.

The social benefits conferred by business firms on the communities are despite the fact that businesses work to maximise their profits or maximise the value of their firms. In their bid to maximise profits, business firms organise the work of production by engaging and combining the various productive resources and bringing about coordination between them. The suppliers of capital, labour, raw materials and other resources receive rewards from the firms for their contribution to the production of goods and services.

These business firms generate income and employment for labour, the owners of capital, land and other resources. This has greatly benefited them and contributed to their well-being. Besides, consumers too have gained from increasing quantity of goods and services produced by business firms for their consumption.

Apart from the gain to the resource owners and consumers, business firms contribute a good deal of revenue to the government. Taxes on profits (i.e. income of business firms), excise duties on their production, sales tax on the goods produced by them and other such taxes yield a lot of public revenue which are used by the Government to expand the services provided by it and to increase public investment for economic growth.

All the above mentioned contributions of business firms to economic growth and social well-being depend on the efficiency with which they use national resources and allocate them among products and services, A fundamental question that has been often raised is how business firms, which in their productive activities are guided by maximisation of private profits, work to increase social welfare.

The answer to this question was provided by Adam Smith, the author of now well-known classic ‘Wealth of Nations’. Advocating for a free-market system he clarifies the role of business in promoting social well-being despite the fact that it pursues the goal of profit maximisation.

Adam Smith argues that it is the profit-driven market system (also called price mechanism) that drives business firms to promise welfare though they work for private’s gain. It is worth quoting him. “Every individual endeveavours to employ his capital so that its produce may be of greatest value. He generally neither intends to promote the public interest, nor knows how much he is promoting it.

He intends only his own security, only his own gain. And he is in this led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest, he frequently promotes that of society more effectively than when the realty intends to promote it.

Business economist applies economics in decision­-making. He uses the tools of economic analysis in clarifying problems, in organizing and evaluating information and in comparing alternative courses of action. He is concerned with analytical tools that are useful, that have proven themselves in practice or that promise to improve decision-making in the future.

The economist is an expert model builder and this is the most important thing which the economic theorist can contribute to the work of management science. In management science it is important to be able to recognize the structure of a managed problem. The second way in which economic theory can help management science is to provide a set of analytical methods.

A managerial economist can become a far more helpful member of a management group by virtue of his studies of economic analysis, primarily because there he learns to become an effective model builder and because there he acquires a very rich body of tools and techniques which can help him to deal with the problems of the firm in a far more rigorous a far more proving an a far deeper manner.

The economic department is a relatively recent addition to corporate management in most developed countries of the world the business economist is an important member of the management group. This is possible so because he has developed a technique which can help the company to manage its business more efficiently.

Modern business is a very complex affair because organizations have become vast in size and they can be run only with a well coordinated management cadre specialized in different aspects of business. In the words of Prof. Galbraith it is management by technically.

A managerial economist is an important piece in this zig saw puzzle. In countries like ours businesses are small but the management is no more a one man show. It consists of a number of specialized personnel and the managerial economist has now become a familiar face.