Managerial Economics

Managerial Economics

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C HAPTER 1

Introduction to Managerial Economics

S ECTION 1

Introduction to Managerial Economics

Video 1.1.1: Introduction to Economics by Prof Dennis Meyers

Economics is the study of how economic agents, individually and collectively, make choices regarding the use of scarce resources that can often be put to different uses, in order to satisfy wants which are of relatively higher priority from among the unlimited wants they face. It is the study of how entities try to make the best possible use of the limited resources they have. Economic analysis, like any other scientific analysis, can be either positive or normative. The analysis is positive when it describes how things are and how things will be. It is normative when the focus is on how things ought to be. Positive economics explains economic phenomena according to their causes and effects. It says nothing about what is right or wrong; it is not concerned with moral judgments. On the other hand, normative economics involves making

value judgments. There is a desired end which is deemed to be subjectively better than the alternatives and normative economics is about using the right means to reach that desired end. A positive statement is based on facts. A normative statement involves ethical values. Economics can be broadly divided into microeconomics and macroeconomics. Microeconomics is the study of how individual economic units, be it an individual agent or household or firm, tries to optimize when faced with resource scarcity. Microeconomics studies economic decision-making from the perspective of households and firms; it focuses on the conduct of individual consumption and production units within a particular market structure. The broad framework of microeconomics revolves around the allocation of resources,

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Video 1.1.2: Micro Vs Macro Economicsproduction and distribution of goods and services and consumption. Broadly, microeconomics deals with the consumer behavior, theory of demand and supply, theory of firm, pricing and market structure, and theory of distribution. Microeconomics deals with consumption and production, and uses notions of surplus to explain a sense of economic wellbeing. Change in these measures are used to understand the overall implications of economic policies on the welfare of the people. Much of welfare economics is based on price theory as microeconomics also deals with how to minimize inefficiencies in allocation and production. When economic efficiency is improved, wastage of scarce resources is minimized, which has significant effects on improving economic welfare. Macroeconomics deals with the overall performance of the economic system; it focuses on issues such as unemployment, inflation, economic growth and other problems, which affect the economy as a whole. It deals with aggregates and the overall economic environment. The framework of macroeconomics broadly covers sustained economic growth, price stability, growth and development, balance of payment, etc.

Keynote 1.1.1: Differences Between Micro & Macro Economics

Managenomics

rial Eco-

Managerial economics is the application of economic theory and decision science tools and techniques to the problems of4

managerial decision-making. While microeconomics provides theoretical framework and tools that help optimally utilize the firms resources, macroeconomics plays an important role by providing an understanding of the economic environment in which managerial decision-making takes place. To that extent, one can say that managerial economics is the application of microeconomic theory by practicing managers in running their business and developing it. According to Dominic Salvatore, "Managerial Economics is the application of economic theory and the tools of analysis of decision science to examine how an organization can achieve its aim or objectives most efficiently. Spencer and Siegelman define Managerial Economics as "The integration of economic theory with business practice for t h e purpose of facilitating Keynote 1.1.2: Dimension of Managerial Economics decision making and forward planning b y

management" Managerial Economics is a discipline which integrates economic theory, decision science and fundamental areas of business administration. Managerial Economics thus serves as a bridge between economics and business management. Theories are important for any science. Theories provide a framework for explaining reality and making predictions. There are several economic theories. Consumption Theory and the Theory of the Firm are two of the most important components of microeconomic theory. A model is an abstraction or simplification of the real world, based on economic theory. A model with its assumptions is often analogous to the control experiments that are done in the basic sciences. These models may be explained in words, or with numerical tables, graphs or algebra. Models often make use of assumptions. Most microeconomic theories assume that economic agents are rational and other factors, not in consideration, remain unchanged (Ceterius paribus). Such assumptions often may not hold true. However, if the model retains its predictive capacity, the invalidity of assumptions are not a matter of concern. Even in basic sciences, by definition, control factors in laboratory experiments may not remain the same outside the laboratory environment, but this does not make the experiment irrelevant in any fashion. The science of economics renders a technical help to the manager in making optimal and rational economic decisions particularly in situation involving risk and uncertainty.5

Nature and the ScopeManagerial economics helps the consumers and managers of a firm in reaching various managerial decisions such as decisions on buying different combinations of goods and services, what products and services to be produced, producing a level of output by using different combinations of inputs and techniques of production, how much output to be produced and at what price output to be sold, etc. It also helps the managers in taking marketing decision, cost decisions, advertisement decisions, budgetary decisions and investment decisions. Managerial economics deals in detail with the below-mentioned managerial decision problems faced by consumers and firms. Thus managerial economics is the application of economic analysis in evaluating decisions having economic content and intent. Some of the business decisions which have economic content are as follows: Profit Decision: Profit maximization is assumed to be the most principal objective of any business firm. In reality, a firm may not aim for maximizing profit, but they do have a profit policy. The entrepreneur constantly examines the profit position of the company so as to take the corrective timely measures in an advance. Hence the decision concerning the level of profit and reinvestment of profit are relevant and in turn influences the business greatly. For instance, Managerial economics

explains rules for selecting the profit maximizing output for firms in all types of market structure - perfectly competitive market, monopoly, monopolistic competitive market, oligopoly market, etc. Demand Decisions Profits are functionally related to the volume of sales and the revenue earned thereby. Demand for the firms goods or services and revenues in turn depend on the nature of individual and market demand. Demand decision of the firm needs to take into account the nature and dynamics of demand for its goods or services and accordingly arrange the factor inputs to organize the production in efficient manner. As such, demand decisions which can be evaluated through an analysis of consumer behavior are crucial. Managerial economics helps an organization to understand how changes in price and income affect demand for their products and helps to take appropriate production decisions. Production Decisions Analysis of demand decisions is naturally followed by that of production decisions. Production function is a statement of technological relation between input and output. Any decision concerning output has, therefore, a natural bearing on the decisions concerning input. The business firm, whether it produces goods or services, has to decide about factor combinations and factor proportions. The choice of techniques of production, use of economies of scale and scope, and least cost combination constitutes the dimension of production decision. For an examination of such decisions,6

production analysis must be combined with loss analysis. Firms have to decide how much of each input to be used in producing its output given the resource constraint. Price-Output Decisions Profit decision depends on two attributes, i.e., cost of production and revenue received from the sale of the product. It can be further inferred from the cost of production attribute that at what price and in what quantity are the productive factors obtained from the factor market. From the second attribute we can infer the meaning that at what price and what quantity are the products sold in the commodity markets? Answers to such questions are possible through an analysis of the market structure, i.e., the form of competition which the business firm faces in the commodity and factor market. Investment decisions The investment decision is also part of the production and capital budgeting decision of the firm. If the firm is operating for the long haul, the firms capital needs to be arranged at the least cost so as to enjoy the financial economies of scale. The various types of economic decisions taken by a business enterprise can be evaluated only through an extensive use of various types of economic analysis. Thus the scope of managerial economics tends to be wide. The main objective of managerial economics is the analysis of business decision of a firm with the help of microeconomic concepts, tools and techniques.

Thus Managerial economics is the application of economic theory and decision science tools and techniques to the problems of managerial decision-making. It helps the firm in reaching various managerial decisions such as profit decisions, demand decisions, production decisions, priceoutput decisions, marketing decisions and investment decisions for achieving optimal solutions. The next chapter will throw light on the theory of demand and supply. References Positive and Normative Economics Macro and Micro Economics

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R EVIEW 1.1Question 1 of 4 Who among the following supplies the various factors of production?

A. Households B. Firms C. Industry D. Government

Check Answer

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S ECTION 2

Scarcity and ChoiceScarcity is what necessitates making choices. Problems of choice arise at all levels - at the individual level, at the household level, at the firm level and at the overall economy level. The challenge is to make choices that maximize the level of satisfaction, with the available resources. The allocation of scarce resources between competing requirements is the main economic problem in any society. The individual also faces similar problems of choice as multiple wants have to be satisfied with a limited amount of money. To e n s u r e e ff i c i e n t a l l o c a t i o n o f resources, microeconomics advocates a free-market economy where demand and supply determine the allocation of resources. If demand is high for a particular product, and supply is less than the demand, its price will increase. Producers in a market economy will automatically produce more of the product, to reap the profits from the higher price. Consequently, supply increases and prices drop till the point where there is neither shortage nor surplus in the market. Thus in a free market economy, there is no agency or intermediary planning or controlling the market or fixing the price. Instead, consumers and producers make their choices based on the market forces of demand and supply. In market economies, both consumers and producers face trade-offs; trade-offs between consuming more and saving more or between earning more money and having more leisure.

Video 1.2.1: Scarcity & Choice

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It is important to remember that, in reality, markets may be competitive or non-competitive. Most benefits of market economy are benefits derived from competition. Since not all markets are equally competitive, the degree of economic efficiency which exists in various markets are likely to differ. Opportunity Cost The opportunity cost of using a resource is the benefit that one could have got had the resource been put to its next best possible alternative use. The opportunity cost is an important concept; by making a choice to produce one type of good, the next best alternative good cannot be produced. For the consumer, deciding to spend a certain amount of money on a particular good is also about deciding not to spend that amount on another good which satisfies some want. It should be obvious that if scarcity was not there, opportunity cost would hardly matter. Consumers typically make their decisions based on two considerations - budget constraints and personal preferences. A budget constraint is the difficulty a person faces when he tries to satisfy his unlimited wants with a limited income. Since the budget constraint is a function of income and price, one can say that any purchase decision is based on income, price, and personal tastes and preferences. A consumer can have a choice of alternative products with a limited income if he can find a person with whom he can exchange goods or services. By means of such exchanges, he can increase his level of satisfaction.

Such exchanges are also possible for producers. Although two producers may both be capable of producing two products, each can also choose to produce the one product in which she has a comparative advantage over the other and exchange products.

Fundamental Economic ProblemsAll societies face three fundamental economic problems which arise out of scarcity. These are questions about choices related to the use of scarce economic resources. They are: What to produce? At the societal level, scarcity of land, labor and capital implies that all the wants in the economy cannot be satisfied. Since all wants cannot be satisfied, society must determine which wants are more important at a given point in time. Accordingly, they have to choose which goods and services are to be produced with the limited resources available. How to produce? This is about choosing the combination of resources and the quantity of each resource to be used to produce a certain quantity and quality of output. From a societal perspective, the best combination is one which fully employs the available resources to produce the maximum output. Depending on the resources available, techniques of production may be labor intensive or capital intensive.

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For whom to produce? This refers to the distribution of goods and services between different sections of the population. Scarce resources are to be used appropriately to cater to the needs of all income groups. These three questions are indeed interrelated. A society, which decides to produce more of highly sophisticated aircrafts and less of cycles, is also deciding to use more of capital and less of labor. In turn, since aircraft mechanics are likely to belong to a much higher income group than, say, cycle mechanics, the decision to produce more aircrafts has direct implications on the distribution question as well.

Decisions made by producers and consumers are influenced greatly by price. Any increase in the price of a product without a corresponding increase in cost increases profit; as a result, producers allocate more resources to that particular product. On the other hand, if consumers do not like to buy a product, supply would exceed demand and price would fall, resulting in a lower profit or even a loss to the producers. Thus price plays a major role in a market economy. The role of the government is negligible: consumers choose the goods they want and producers allocate their resources based on the market demand for different products. The United States of America is an example of a market economy. In the US, firms decide the type and quantity of goods to be made in response to consumer demand. An increase in the price of one good encourages producers to switch resources to the production of that item. Consumers decide the type and quantity of goods to be bought; a decrease in the price of one good encourages consumers to switch to buying that item. Command Economy In a command economy, answers to the three fundamental questions are decided by the government. So, what to produce, how to produce and for whom to produce are all decided by the people in power. The role of the government is all pervasive here, while consumer and producer choice is very limited. In this system, efficiency can be achieved only when demand is accurately forecasted and resources allocated accordingly. The former USSR was an example of a command economy. The government had complete control11

Economic SystemsHow these fundamental questions are answered will depend on the extent of government control on the economy. Based on the role of the government in addressing these questions, there are three broad types of economic systems in the world - the market economy, the command economy and the mixed economy. Market Economy In a market economy, the freedom of individuals as consumers and suppliers of resources, allows market forces to determine the allocation of scarce resources through the price mechanism. Based on market demand and supply, consumers are free to buy goods and services of their choice and producers allocate their resources based on the demand.

over the economy and consumers were just the price takers. The government set output targets and allocated the necessary resources. The biggest challenge for a command economy is the massive requirement of real-time economic data, far beyond the technological and infrastructural capabilities of any government anywhere today. Mixed Economy A mixed economy is an economic system, which combines the features of a free market economy and a command economy. While consumers and producers enjoy freedom and choice, the government usually sets limits to such freedom. Government controls price Video 1.2.2:Economic fluctuations beyond a range, Systems while interfering in the economy in order to achieve a few set national goals. Mixed economies often have some unregulated sectors and some highly regulated sectors. Governments in mixed economies generally attempt to plan the course of their countries development and use cost-benefit analyses to answer the fundamental economic problems of what, how and for whom to produce. In principle, decisions or projects affecting the economy as a whole are taken or accepted only when the social benefits from the decision of project are greater than the social costs. Theoretically, a cost benefit analysis helps to assess the full costs and benefits to society arising from a particular decision or project, but sometimes in practice, the cost of collecting

and processing the massive amount of information required results in lags and inefficiencies. In a mixed economy, often the government organizes the provision of certain goods and services such as education and health care, which are considered essential.

Production Possibility Curve

The production possibility curve (PPC) helps us understand the problem of scarcity better, by showing what can be produced with given resources and technology. The production possibility curve can be defined as a curve which shows the maximum combination of output that the economy can produce using all the available resources. Technology is the knowledge of how to produce goods and services. A PPC tells us that to increase the production of one item, we have to forgo the production of some units of the other item. As resources are scarce, producers deciding to produce a certain good have to sacrifice the next best alternative good that could have been produced with the same resources. The value of the good given up is the opportunity cost. Opportunity costs are a result of scarcity. There is always an opportunity cost when production choices are determined. Since the slope of the PPC shows how much of one good has to be sacrificed in order to produce another good, we can say that the curve explains the opportunity cost. If we concentrate on producing more and more of a particular12

good, the opportunity cost keeps on increasing. As a result, the PPC is concave to the origin. Let us look at an example of the production possibility curve. Consider the production of two goods, say rice and cloth. Figure 1.1 shows different combinations of the two goods that can be produced. From the figure, we can see that production possibility C, with the resources available, we can produce two tons of rice and 12,000 meters of cloth. However, if we want to increase the production of rice to three tons, resources have to be diverted to the production of rice from the production of cloth. As a result, the production of cloth will drop to 9000 meters. In fact, if we want to produce 5 tons of rice, all our resources will have to be utilized for this, which means that we will not be able to produce any cloth at all (production possibility F). Thus to increase the production of one item, we have to forgo the production of some units of the other item. Looking at the figure 1.1, we can Keynote 1.2.1: see that to increase Production Possibility Curve rice production by one ton (from two tons to three tons), we have to forgo the production of 3000 meters of cloth. In this case, the opportunity cost of the additional ton of rice is the value of the 3000 meters

of cloth forgone. An increase in the production or consumption of one good can be achieved only through the opportunity cost of the other good. From the figure, we can see that increasing the production of rice from one ton to two tons causes a fall of 2000 meters in cloth production; and moving from two tons to three tons of rice production results in a 3000 meter drop in cloth production. So the opportunity cost of the second additional ton of rice is greater than the the opportunity cost of the first additional ton.Video 1.2.3: Production Possibility Frontier with constant marginal opportunity cost

The PPC does not give the desirable point of production; it only indicates the possible combinations of the two goods that can be produced with the available resources. In other words, the PPC only helps us find out the combinations of outputs that can be produced with the available resources in an economy. All the points on the curve represent points at which13

the economy operates at its full productive capacity, that is, all the factors of production are fully employed. However, in any economy, actual production may fall short of the capability. In such a situation, we obtain a point inside the curve, which indicates that resources are not completely utilized, i.e., there is unemployment in the economy. The PPC illustrates the notion of scarcity by showing that, given the available resources and technology, production possibilities are limited; and at a given level of output of one good, once the maximum production possibility of the other good is reached, any increase in the production of the second good can come about only with a reduction of output of the first. In the long run, given increases in the availability of resources and improvements in technology, the PPC can shift outward. This outward shift of the curve represents growth of the economy. The three main sources of economic growth are: Increase in the quantities of economic resources available. Improvement in the quality of resources. Advances in technology. Technological developments enable higher productivity even with other factors of production remaining constant.

References Scarcity Opportunity Cost Market Economy Command Economy Mixed Economy Production Possibility Curve

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REVIEW 1.2.3Question 1 of 8 Opportunity costs are a result of

REVIEW 1.2.2Question 1 of 4 Which type of economy gives rise to the most efficient allocation of resources and capital in the standard microeconomics framework?

A. Scarcity A. Free market economy B. Overproduction B. Command economy C. Technology obsolescence C. Mixed economy D. Abundance of resources D. Marxist economy

Check Answer

Check Answer

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S ECTION 3

Case Study: Switzerland, Cuba and India: The Troika of Economic Problems in Three EconomiesAll the economies of the world face the problem of scarcity of resources, which limits the production activities. Scarcity of resources makes an economy face tradeoffs as producing more of one commodity means producing less of another commodity. Such trade-offs compel an economy to answer the three fundamental questions: What goods will be produced? How will the goods be produced? And for whom will the goods be produced? Economic Systems (Market, Command and Mixed) are the ways through which countries address these three fundamental posers. Each type of economic system has its own way of deciding what commodities are to be produced, how and for whom.

Switzerland A Market Economy

Switzerland comes closest to the idea of market economy or capitalism. Private entrepreneurship forms the basis of the Swiss economic policy. By the year 2000, most of the government enterprises were privatised in Switzerland. Friedrich A. Hayek, the Austrian economist, opined, Private property is the most important guarantee of freedom.1 Property rights are important for the proper functioning of an economy. People in Switzerland are guaranteed

This case study was written by Hepsi Swarna under the direction of Akshaya Kumar Jena, IBSCDC . It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.

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private property rights, and they do not fear unjust dispossession. Switzerland has one of the best property rights regimes. It was ranked 8th out of 115 countries with a score of 8.2 in the 2009 International Property Rights Index (IPRI) .Table 1.3.1: Index of Economic Freedom (2009): Top 10 countries

Most of the countries figuring in the index, Hong Kong, Singapore, UK, US, Finland, Ireland, Denmark, Netherlands and Switzerland, are free market economies and these economies also have higher per capita income (Table 1.3.2). According to UNDPs 2008 statistical Table 1.3.2: Nations with high Per Capita Income, World Bank (revised in 2008) Rank1 4 5 6 9 10 12 13 17 19 24 25 31

Rank 1 2 3 4 5 6 7 8 9 10 12 17

Country Hong kong Singapore Australia Ireland New zealand US Canada Denmark Switzerland UK Netherlands Finland

Score 90.0 87.10 82.6 82.20 82.0 80.70 80.50 80.00 79.40 79.0 77 74.5

CountryLiechtenstein Kuwait Norway Brunei Darussalam Singapore US Hong kong, China Switzerland Netherlands Ireland Denmark Finland UK

Per capita Income (PPP* International $)63590 49970 53320 49900 48520 45850 44050 43870 39310 37090 36300 34550 33800

Compiled by the author from: 2009 index of economic freedom Ranking the Countries, http://www.heritage.org/Index/ Ranking.aspx

Switzerland is an international banking centre with many Multinational Corporations (MNCs). It is one of the worlds freest economies. Switzerland was ranked 9th (Table 1.3.1) with a score of 79.4 in the 2009 Index of Economic Freedom

*

Purchasing Power Parity. The most common way of presenting the per capita income data is PPP gures. Compiled by the author from: Gross national income per capita 2007, Atlas method and PPP, http:// siteresources.worldbank.org/DATASTATISTICS/Resources/ GNIPC.pdf, October 17th 2008

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update, Switzerlands GDP per capita for a population of 7.5 million people is $37,3962 . Switzerland has also some of the highest wages in the world. Thus, a high standard of living prevails in the country. The market economy of Switzerland has earned it a Human Development Index (HDI) of 0.9555, ranked 10th out of 179 countries3. In market economies, the means of production are owned by private individuals and most cost-efficient techniques of production are used. Holderbank, Switzerlands largest cement company, attributes its success to the best production technology and low production costs. Switzerlands market economy is based on international trade and banking. Swiss banks are known for very high standards of banking and financial services. The Swiss are the leaders in private banking. In 2003, it was reported that Switzerland with its 400 banks manage ... one-third of the worlds wealth that resides outside its country of origin.4 The Swiss banks are not subjected to any legal scrutiny. That is why the money (legal/ illegal) from the entire world is deposited in Swiss banks. In September 2008, the UBS of Switzerland revealed to the US that it held 47,000 secret accounts for Americans. Capitalism results in generation of wealth the Swiss banking business is an attestation to this fact. The Swiss are also known for their world-class watches, pharmaceuticals, electronics, chemicals, metals, precision instruments, chocolates, cheese and also for their ground breaking research and advances in organic agriculture and poultry production. Chemicals and engineering products are the biggest exports of Switzerland. Watches occupy third5

place in the countrys exports. About 95% of Switzerlands watches are exported and it stands as the world largest watch exporter in terms of value. In 2006, Swiss watch exports were valued at 13.7 billion francs6. The average export price of a Chinese watch in 2006 was $1, in Hong Kong it was $8, while Switzerlands export price of a watch was on an average $410.7 Switzerland has extremely well-developed infrastructure for scientific research. The Research Institute of Organic Agriculture is the worlds leading information and documentation centre for organic agriculture. Swiss companies spend a lot of money on Research and Development due to which they come up with very innovative products. Swatch, the famous Swiss watch company has always flirted with technology. Besides manufacturing watches, Swatch is into manufacturing microprocessors, smartcard technology, portable telephones, and other futureoriented designs, such as wristwatches that double as telephones, credit cards, even concert tickets.8

The innovation in the field of technology in Switzerland, along with other factors like first-rate infrastructure and efficient markets, has boosted Switzerlands global competitiveness, and it has been featuring among the top ten economies in the Global Competitive Index (GCI) for many years (Table 1.3.3). Switzerland was ranked as the second most competitive country in the global economy for the years 2007 and 2008. The other capitalist countries like UK, US, Finland, Denmark, Netherlands, Singapore and Hong Kong have also been featuring in top ten countries of the GCI index.18

Table 1.3.3: Global Competitiveness Index: 20002008Rank 1 2 3 4 5 6 7 8 9 10 2000 US Singapore 2001* Finland US 2002 US Finland Taiwan Singapore Sweden 2003 Finland US Sweden Denmark Taiwan 2004 Finland US Sweden Taiwan Denmark Norway 2005 Finland US Sweden Denmark Taiwan Singapore Iceland Norway Australia 2006 US UK Denmark 2007 US 2008 US

Switzerland Switzerland Denmark Denmark Sweden Singapore Finland Germany Netherlands Japan

Netherlands Canada Ireland Finland Canada Singapore Australia Norway

Switzerland Sweden Japan Finland Germany Sweden Germany Finland Singapore Japan UK

Switzerland Singapore

Hong Kong Taiwan Australia SAR UK Netherlands Canada Switzerland Sweden Taiwan New Zealand Norway Denmark

Switzerland Singapore Iceland Norway Australia Japan Iceland

Switzerland Switzerland Singapore

Hong Kong Netherlands Canada SAR

* Switzerland for the year 2001 ranked 15th Compiled by the author from Global Competitiveness Reports 20002008

Trade has been the key to Switzerlands prosperity and growth. It has very liberal trade and investment policies, with minimum trade barriers (Table 1.3.4). In Global Enabling Trade Index released by World Economic Forum for the very first time in 2008, Switzerland was ranked 9th among 118 countries signifying its business-friendly environment and openness to international trade and investment. Exports generate lot of income and bost the economic growth. The Swiss economy

earns roughly half of its corporate earnings from the export industry, and 62% of Swiss exports are destined for the EU market.9 Government has a very limited role to play in Switzerland. The new agricultural policy of Switzerland, which came into effect from January 1st 1999 began eliminating detailed market regulations and reducing direct government intervention in setting up of market prices . Most of the Swiss1910

government activities are confined to provision of public services like defence, railways, infrastructure and post office. The government policy aims at maintaining macro-economic stability in the country. Corruption is less in market economies than in command and mixed economies. Even though the US financial crisis was alleged to be a result of corruption and greed, most of the

of 180 countries in Transparency International Corruption Perceptions Index 2008 (Table 1.3.5). In contrast, command economy of Cuba was ranked 65th and the mixed economy of India was ranked 85th, which shows a very high level of corruption in these economies. The biggest drawback of Switzerland is that it is characterized by inequality of income and wealth. A study by the World Institute for Development Economics Research in 2006 using Table 1.3.4: Transparency International Corruption Perceptions Index* 2008 Country Rank 1 1 1 4 5 5 7 7 9 9 65 85 Country/ Territory Denmark Sweden New Zealand Singapore Finland Switzerland Iceland Netherlands Australia Canada Cuba India CPI Score 2008 9.3 9.3 9.3 9.2 9.0 9.0 8.9 8.9 8.7 8.7 4.3 3.4

Keynote 1.3.1: Trade Barriers-2008

Source: 2008 World Trade Indicators published by the World Bank, www.economist.com

market economies are characterized by low levels of corruption. In a market economy, the scope for corruption is pre- empted to a great extent. Switzerland was ranked 5th out

* A country or territorys CPI score indicates the degree of public sector corruption as perceived by business people and country analysts, and ranges between 10 (highly clean) and 0 (highly corrupt)Source: Transparency International Corruption Perceptions Index 2008, http://webcasts.acc.com/handouts/ TI_CP_Index_2008.pdf, pages 4 and 5

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the statistics for the year 2000 came up with the data on wealth distribution for the whole world. According to the study, Switzerland had the highest concentration of wealth in the top 10% of the adult population (Table 1.3.6). Other capitalist countries like US, Denmark, France, UK, Germany and Finland also have concentration of wealth in few hands. According a World Resources Institute report, Switzerlands Gini coefficient is 0.33. The percentage of total income earned by the richest 20% of the population in Switzerland is 40.3% and the percentage of total income earned by the poorest 20% of the population is 6.9%11. Table 1.3.5: Percentage of Wealth Held by the Top 10% of the Adult Population in Various Countries Country Switzerland US Denmark France Sweden UK Canada Norway Germany Finland Wealth Owned by the Top 10% 71.3% 69.8% 65.0% 61.0% 58.6% 56.0% 53.0% 50.5% 44.4% 42.3%

Cuba Command Economy

There is the Cuban joke that in the socialist paradise, there are only three minor economic problems left to solve: breakfast, lunch and dinner.12

Cuba, Iran, Libya and North Korea are some of the countries where command economy still exists. Around 90% of the Cuban economy with a population of 11.4 million people is controlled by the state. The government controls all means of production and determines prices for most of the goods in the economy. It interferes heavily in the day-to-day economic lives of the Cuban people. Private entrepreneurship is thoroughly discouraged in Cuba. Laws governing private property are very complex in Cuba. Even though the constitution of Cuba allows Cubans to hold private property, they cannot buy or sell property. This shows that Cuba does not have proper property rights in place and that could be one of the reasons why it did not feature in 2009 IPRI. The government controls all the spheres of life in Cuba. The governmental spending for the year 2008 equalled 72.6% of GDP13

.

Source: Domhoff William G., Wealth, Income, and Power, http:// sociology.ucsc.edu/whorulesamerica/power/wealth.html, September 2005 (Updated on December 2006)

Cuba, once a colony of US, gained its independence through the Cuban Revolution in 1959. Fidel Castro (Fidel) overthrew Fulgencio Batistas US-backed army and established his empire. On account of the ongoing friction between Cuba and US, in 1960, Cuba nationalised three US oil refineries namely, Texaco (on June 29th 1960), Esso (on July 1st1960) and Shell (on July 1st1960). Thus, on July 3rd 1960, US suspended trading sugar21

with Cuba, by passing the Sugar Act in the Congress. Nearly 80% of the Cuban sugar exports to US were cut off. Cuba retaliated by nationalising all US businesses and commercial property on July 5th 1960. The following day, the then US President Dwight David Eisenhower cancelled the 700,000 tonnes of sugar remaining in Cubas quota for 1960. USSR decided to buy the 700,000 tonnes of sugar cut by US, and thus the sugar-for-oil exchange between Cuba and USSR was born. It was estimated at that time that Cuba was doing 85% of its trade with USSR. In September 1960, Cuba nationalized all US banks. On October 13th 1960, Fidel nationalized local firms, which included large agricultural estates, sugar refineries, banks, mining firms, large industries and privately owned urban property. Following this, US imposed a trade and economic embargo on Cuba excluding food and medicine on October 19th 1960. Cuba defended itself against the US invasion at Bay of Pigs on April 17th 1961 and defeated the US army after 3 days of fighting government 14. Fidel established a centrally planned system and nationalised all means of production. Even after the imposition of US embargo, Cuban agricultural production remained high, with USSR buying sugar from it at more than the market price. But in early 1990s, as the USSR collapsed, so did Cuban economy and its agricultural production. Instead of choosing to open up its markets and agricultural production to the forces of free markets, Cuban government continued to control agricultural production and marketing. As a result of the socialist management, the sugar

production started falling, and hence the once prosperous sugar industry lost all its glory. It was opined, Inefficient planting and cultivation methods, poor management, shortages of spare parts, and poor transportation infrastructure combined to deter the recovery of the sector. Sugar industry fell from 8.1 million metric tonnes in 1989 to 3.5 million metric tonnes in 1995. In June 2002, Cuba announced it would have to close half of the countrys 156 decrepit sugar mills16. Shortages are common in Cuba, due to poorly run state factories and firms. Command economies result in the formation of shadow or black markets. Cubas black market has been flourishing because when the government controls the distribution of goods and services, producers start selling things illegally. Cubans have been increasingly buying the needed food and clothing from the black markets at very high prices. The black markets bypass all the government restrictions. Moreover, Cubans get to buy the very essential items which are not available at the government ration shops. In Cuba, government exercises control over employment issues. As per the Government statistics, about 75% of the labour force is employed by the state. The actual figure is however, closer to 93%17. A meagre 3% of the total workforce (4.87 million) is allowed to be self-employed. If a foreign company intends to hire workers, it can be done only through the recognised state agencies. Workers are paid only a fraction of the amount that is charged to foreign companies. Cuba has a very hostile business and investment environment characterised by dense regulations and impenetrable communist bureaucracy. Trade is non-transparent and the2215

government controls imports and exports. The non-tariff barriers to trade are very restrictive. All these put together are deterring foreign investment in Cuba. Most of the foreign investment in Cuba, takes place through joint ventures with state companies, which have majority of the ownership. A paper titled The Legal and Administrative Framework for Foreign Trade and Investment by European Companies in Cuba, given to the Cuban government by the European Union in July 2002 contained the problems that were encountered in the operations of joint ventures in Cuba. The paper pointed out the difficulty in obtaining work permits for foreign employees. It also complained that EU joint venture partners had no say in hiring employees and often they were forced by the Cuban government to hire employees who were professionally not suitable and securing finance was also very difficult18. The Cuban government did not respond. Cuba has been witnessing fall in foreign investment due to such difficult investment environment Of the 540 joint ventures formed since the Cuban Government issued the first legislation on foreign investment in 1982 ... 287 remained at the close of 2005 ... Foreign direct investment flows decreased from $448 million in 2000 to $39 million in 2001 and were at zero in 2002.19

ranked Cuba 177 out of 179 countries. The two countries ranked after it are Zimbabwe and North Korea; both of them are command economies. Command economies are characterized by equitable distribution of income and wealth. Cuba under Fidel in 1960s witnessed more equitable wages. The income gap between the farmers and the urban workers decreased as wages were controlled by the government. Fidelss agenda, employment for all, brought all the classes on the same platform. All Cuban children go to school and even a remote village has a school in Cuba. It has a literacy rate of 99.8%. Cubans also enjoy a good healthcare, and they have achieved many breakthroughs in the field of biotechnology. And that is why HDI ranked Cuba 48th out of 179 countries (Table 1.3.7). By 1986, Cubas Gini coefficient of 0.25 was among the lowest in the world. Cuba has set an example of an egalitarian economy. But in 1990s, following the collapse of USSR, Cuban economy was in a deep crisis. To alleviate the crisis, Cuba introduced some market reforms, like legalisation of dollar, allowing foreign investment, opening of the country for tourism, legalisation of some private enterprises and self-employment for 150 occupations. Following the legalisation of dollar, the Cuban Peso became worthless and inequalities between the Cubans rose. The Cubans who had access to dollars earned higher incomes. Jobs like driving taxis and working at restaurants which earned salaries/tips in dollars from foreign businesses and tourists became highly desirable. Cubas Gini coefficient of 0.40 in 1999 turned up similar to US. The Cuban government23

The citizens of Cuba are denied the freedom of expression the freedom of speech and press. Cuban jails contain prisoners of conscience, who have been detained just because of their beliefs. Cubans are denied the right to change their government. Assembly of more than three persons is punishable under the law in Cuba. Access to internet and outside media is heavily controlled. It is illegal in Cuba to own a TV satellite dish. The 2009 Index of Economic Freedom,

tightly controlled the small private sector that evolved during 1990s. Fidel in his Cuba established Soviet-style rationing of housing, goods and food20. Cubas rationing system started in 1962,which severely limited the quantity and choice of Cuban consumers. People of Cuba for many decades have been surviving on ration books that provide limited amount of essential products like rice and beans. Cuban parents can buy subsidised milk powder (which comes to one glass a day) for children less than 7 years of age. Once a child turns 8 years old, it is not available. Fresh fruits and meat are scarce and beyond the reach of ordinary Cubans. the ration, which the Table 1.3.6: Cubas Human Development Index 2006 Life expectancy at birth (years) 2006 Combined GDP primary, per secondary and capita tertiary gross (PPP in enrolment ratio $) 2006 (%) 2006

provisions for the remaining half of the month in the expensive Cuban black markets. In October 2008, it was reported that the Cuban government was putting a limit on how much fruits and vegetables Cuban people can buy in farmers market. Lettuce was limited to two pounds per person21. Command economies have a very low unemployment rate compared to market and mixed economies. Cuban government has been committed to provide employment to each of its citizen. Cuba also has a moderate level of inflation (Table 1.3.8). There are very few markets in Cuba and many of the farmers are prohibited from selling their extra produce in the markets. In February 2008, Fidel Castros nearly five decades of rule came to an end when his brother Raul Castro (Raul) was appointed the President of Cuba. President Raul in 2008 announced that farmers will be allowed to sell their extra produce in local markets and also, there will be large scale distribution of land to private farmers. However, farmers still face rules about what and how much they can plant, and risk losing their land if they fail to meet government production quotas. They are also required by law to sell any surplus to farmers markets.22

HDI value 2006

Adult literacy rate (ages 15 and above (%)) 2006

0.855

77.9

99.8

94.8

6876

Source: 2008 statisical update Cuba

government provides, lasts only 10-15 days and many Cuban women, in a desperate attempt to feed their families, have turned to prostitution so that they get enough money to buy

With the coming of Raul to power, some are hoping that Cuba may open up and witness some changes in the economic realm. But many analysts believe Cubas transition to a market economy is not possible as long as Fidel is alive. However, to make a start in loosening the Cuban economy, Raul in February 2008 made some announcements (Table 1.3.9). Countries like Canada, Spain, China and Russia are emerging as prominent foreign investors in Cuba. Many analysts agree with the notion24

that Cuba will slowly make a transition to a conventional market economy. Jawaharlal Nehru, Indias first Prime Minister introduced the concept of mixed economy in India. He intended to incorporate the best features of market and command economy in India. Till 1990s, the government occupied a very important role in the economy and private sector was severely regulated and thoroughly discouraged by excessive bureaucratic controls. State was actively involved in providing for healthcare, education, defence and development of infrastructure in the country. All the other major industries like mining, banking and Table 1.3.7: Inflation and Unemployment Figures of Switzerland, Cuba and India-2008 Country Switzerland Cuba India Inflation (CPI) (%) 0.9 3.6 6.4 Unemployment Rate (%) 2.5 1.8 7.2

Airlines, Air Deccan, Go Air, Jet Airways, Kingfisher Airlines, etc. Private sectors also started having a firm grip on educational and healthcare sectors. Indias financial sectors have (as on 2009), 28 state-owned banks controlling about 71% of commercial banking, 29 private banks, and 31 foreign banks23. In the recent times, development of infrastructure has been opened to private sectors also. There is private property in India, but it needs improvement in the area of protection of Table 1.3.8: Announcements made by Raul Castro (february 2008)

Expanding access to public land for private farmers Permitting some Cubans to own their homes Increasing wages and retirement pensions Licensing private taxis to operate Limited deregulation of the construction industry Expanding access to certain previously restricted consumer goods (like cell phones, computers, microwaves, toasters, DVD players, motorcycles, air conditioners, electric ovens, agricultural supplies and tools) Launching a new 24-hr television station to include mostly foreign produced content.

insurance, communications, transportation, manufacturing and construction were also under government control. In 1990s, there was a paradigm shift in the Indian economic policy. Private sector was invited to take on sectors like education, communications, civil aviation, healthcare, banking and insurance. As a result, government and private players were present in most of the sectors simultaneously. In the civil aviation sector, there have been governments Indian Airlines and Air India, co-existing with private airlines like East West

Compiled by the author from Background Note: Cuba,http://www.state.gov/r/pa/ei/ bgn/2886htm, August 2008

25

property rights. India was ranked 46th in 2009 IPRI with a score of 5.6. The private sectors role in the economy has raised overall production and efficiency. Telecommunication sector, after the entry of private players became very efficient and costeffective. The advent of private sector in civil aviation increased the comfort in travelling and the airfares got slashed due to the healthy competition between the air carriers. Private sector in India has set very high India Mixed Economy standards in the education, healthcare, banking and tourism segments. Since private sectors aim is maximisation of profit, they venture only into those avenues which will increase their revenues. Therefore, the government provides services to rural and low-income people who are largely untouched by the private sector. Indian government has retained the ownership over the strategic sectors like defence and artillery, maintenance of law and order and railways. Thus, in India, government controls the sectors which are important for its growth and stability. The total government expenditure in India is moderate, equalling 27.2% of GDP24. India has a huge consumer base. It is the second largest consumer market in terms of population. While production of goods and services are carried by both private individuals and government, the decision about consumption of goods and service rests entirely on the consumers. Indian consumers decide what to buy out of all the choices given.

And incomes of the consumers and prices of goods and services also play an important role in determining consumption. In the recent years, Indian consumers have become environment friendly and eighty-eight percent of Indian consumers are prepared to pay more for goods that are environmental friendly25. Prices in Indian markets are determined by the interaction of demand and supply forces of goods and services. Even though Indian government does not tell people what to buy or sell, it is actively involved in regulating the market. Corruption is very highly prevalent in India (Table 1.3.6). In India, the difference between the public and private sector is clearly visible. Public sector undertakings have become the property of a few politicians. Despite being run by the government, Indian economy is characterised by a great disparity between the rich and the poor. Indias Gini coefficient is 0.38 where 46.1% of the total income is earned by the richest 20% of the population, and just 8.1% of the income is earned by the poorest 20% of the population26. Compared to market economies, mixed economies have a low standard of living measured in terms of HDI and per capita GDP. Indias HDI value is 0.609 with a rank of 132nd and its GDP per capita28 is $2,489. India is ranked 123rd in the 2009 Index of Economic Freedom. Out of all the three economies, Switzerland is the freest economy followed by India and Cuba (Table 1.3.9) Most of the market economies of the world like Switzerland, US, Singapore, Hong Kong have relatively open market systems in their respective countries. Neither market2627

economy nor command economy exists in pure form. The basic difference between the two is that while in a market economy buyers and sellers decide the three basic questions of the economy, in a command economy the government pulls the string. In some degree or other, all the economies of the world are mixed economies, with market features and government controls existing simultaneously. The question that remains to be answered is how much mixed an economy should be?

TABLE 1.3.9: 2009 INDEX OF ECONOMIC FREEDOM OF CUBA, INDIA AND SWITZERLAND A COMPARATIVE ANALYSIS Country Name Cuba India Overall Score 27.9 54.4 Business Trade Fiscal freedom freedom freedom 10 54.4 64.4 51 45.9 73.8 Governm ent Size Monetary freedom Investment Freedom Financial freedom 10 40 Property rights 10 50 Freedom from corruption 42 35 Labour freedom 20 62.3

Switzerland

79.4

82.9

85.4

67.5

COUNTRY NAME 67 10 OVERALL SCORE BUSINESS FREEDOM 77.8 69.3 30 TRADE FREEDOM FISCAL FREEDOM GOVERNMENT 65.3 83.9SIZE 70 MONETARY FREEDOM INVESTMENT FREEDOM

80

90

90

79.2

27

Footnotes 1.Dedigama C. Anne, INTERNATIONAL PROPERTY RIGHTS INDEX (IPRI) 2009 Report, http:// www.internationalpropertyrightsindex.org./atr_Final1.pdf, page 11 2.2008 Statistical Update Switzerland, http://hdrstats.un dp.org/2008/countries/country_fact_sheets/cty_fs_CHE.html , December 18th 2008 3.2008 Statistical Update Switzerland, op.cit 4.Beng Kim Phar, Capitalisms Mistress: Private Banking, http://www.globalpolicy.org/socecon /crisis/2003/0625 mistress .htm, June 25th 2003. 5.A i y a r S h a n k k a r , M i n t i n g p o l i t i c a l c a p i t a l , http://in.elections.yahoo.com/articles.html?feed=http://in.ne ws.yahoo.com/ 248/20090422/1585/tnl- mintingpolitical-capital_1.html, April 22nd 2009. 6.The Swiss watch industry, http://www.swiss world.org /en/ switzerland/ swiss_ specials/swiss _watches/ the_swiss_watch_industry/ 7.Ibid. 8. T h e S w a t c h G r o u p S A , h t t p : / / w w w. f u n d i n g universe.com/company - histories/ The-Swatch-Group-SACompany- History.html 9. Background Note: Switzerland, http://www.state.gov/ r/pa/ ei/b gn/3431.htm, January 2009.

10. S w i t z e r l a n d , h t t p : / / w w w . u s t r . g o v / a s s e t s / D ocument_Library/Reports_Publications/2003/ 2003_NTE_Report/ asset_ upload_file346_6225.pdf, page 354 11.Economics, Business, and the Environment, http://earth trends.w ri.org/te xt/economics - business/country-profile174.html 12.Roberts M. James, Cubas Phony Transition: Fidel Resigns, Raul Reigns, http://www.heritage.org/Research/ LatinAmerica/wm1820.cfm, February19th 2008. 13.Cuba, http://www.heritage.org/Index/Country/Cuba 14.JohnsonStephen,TimeForConsensusOnCuba,http:// www.heritage.org/research/latinamerica/bg1579.cfm,Augus t 30th 2002. 15.Cubas Phony Transition: Fidel Resigns, Raul Reigns, op.cit 16. Ibid. 17.Background Note: Cuba, http://www.state.gov /r/pa/ei/bgn/2886.htm, August 2008 18.Ibid. 19.Ibid 20.Cubas Phony Transition: Fidel Resigns, Raul Reigns, op.cit

28

21.Garcia Anne-Marie, Cuba Begins Rationing Food, http://www.infowars.com/cuba-begins-rationing-food/, October 12th 2008. 22. C u b a g i v i n g l a n d t o p r i v a t e f a r m e r s , http://economictimes.indiatimes. com/articleshow/msid-2929895,prtpage-1.cms, April 6th 2008. 23.India, http://www.heritage.org/Index/Country/India, 2009. 24.Ibid. 25.Indian consumers favour eco-friendly products: study, http://www.thaindian.com/ne wspo rtal/business/indian26.c o n s u m e r s - f a v o u r - e c o - f r i e n d l y - p r o d u c t s - s t udy_100129834.htmlCountry Profile India, http://earth trends.wri.org/text/economics business/country-profile-85.html 27.2008 Statistical Update India, http://hdrstats.u ndp.org /2008/countries/ country_fact_sheets/cty_fs_IND.html, December 18th 2008 28.Ibid

29

C HAPTER 2

Theory of Demand and Supply

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S ECTION 1

Introduction to Demand & Supply

Multinational companies such as McDonalds and Kelloggs entered the Indian market in mid 1990s. Initially, McDonalds offered products which were not customized to the Indian tastes. The company seemed to have overestimated the demand for its products and hence almost all its operations ran into losses. McDonalds was able to capture a reasonable market share in the Indian fast-food segment when the company made some changes in its menu during the late 1990s, which were more suited to the tastes andhttp://www.truckertotrucker.com/wp-content/uploads/2011/03/gas-1.png

preferences of the Indian customers. Similarly, Kelloggs planned to replace heavier Indian breakfast with an alternative like cornflakes. However, the company was not able to estimate the right demand for its products. Kelloggs was unsuccessful due to wrong demand forecasting and premium pricing of its products. In the case of both McDonalds and Kelloggs, there were cheaper alternatives available. This was one of the reasons

31

why the Indian customers did not readily switch to the products offered by the multinationals. The above examples suggest the significance of analyzing the forces of demand and supply of any goods or service. The objective of a firm is to maximize its profits. The demand for its product(s) plays a major role to achieve this objective. Those firms whose products have inadequate demand are not able to generate sufficient revenues, and hence, are forced to close down their operations. Therefore, demand analysis is very important for a firm to determine the price of a product and the quantities to be produced. Firms market entry decision hinges crucially on profit. The demand for the goods is not the only factor that ensures firms profit, but the price of the input factors as well as the price of the output of the firm are also equally important. Therefore, supply analysis is also very important for a firm to optimally and efficiently produce the output so as to compete in the market. This chapter will extensively discuss the theory of demand and supply. First segment of the chapter will discuss the basic concepts and laws associated with demand and supply, key determinants of demand and supply. The second section will throw light on market equilibrium and the government intervention in the market. Measurement of elasticities of demand and supply will be covered in the third section of this chapter.

32

S ECTION 2

Theory of DemandIn economic theory, demand and supply has a great significance since the wants are unlimited and resources are limited. In economics the demand is defined as desire backed by ability and willingness to buy a product or service at alternative prices other things being constant. Law of Demand The law of demand explains the relationship between the price and the quantity demanded in a particular period. The law refers to the direction in which the quantity demanded changes with change in price. The law of demand states that other things being constant (ceteris paribus) the quantity demanded increases with a fall in price and quantity demanded decreases with a rise in price. The quantity demanded of the product not only depends on the price of the product alone, but also a host of other factors which determine the quantity demanded of the product, such as the taste and preferences of the consumer, seasonal changes, income of the consumer, price of alternative product and services, etc. Demand Schedule Listing of the various quantities that the consumer is willing to buy at different prices in a given period of time in a tabular form is called the demand schedule. The demand schedule is usually represented in a tabular form where it depicts the alternative prices of the product and the corresponding quantities demanded at a given period of time (Table 2.2.1).

Video 2.2.1:Theory of Demand

33

Table 2.2.1 DEMAND SCHEDULE FOR CHOCOLATES PRICE 10 12 14 16 18 20 Demand Curve When we represent the demand schedule in the form of a graph we get the demand curve. In the figure below, we have plotted the data given in the demand schedule. Here, it is a typical downward-sloping demand curve. The following diagram shows that at very low price, the consumers want to purchase higher quantities of chocolates, keeping other factors unchanged and vice versa. Demand Function Demand function: A function that depicts the relationship between how much of a good will be demanded at alternative prices of that good and alternative values of other non price variables affecting demand. The demand function for the good X can be written mathematically as: Qx= f( Px , Py, Y, e ) QUANTITY DEMANDED 20 18 16 14 12 10

Where, Qx: quantity demanded of good X Px: own price of good X Py: prices of the related goods Y Y: income of the consumer e: Other non-price factors that influence demand. The nature of the demand function differs from goods to goods. However, the simplest form of demand function is the linear demand function. The linear demand function is a function where the demand of a good is a linear function of its own price and other variables influencing demand. Factors determining demand There are wide array of factors which influence demand. Price is considered to be the most important factor that determines demand. There are also many no-price factors which influence demand. Some of the non-price factors which influence demand are discussed hereunder: Income of the Consumer: Other things being constant, if the income of the consumer increases the demand for the product increases and vice versa.

34

Price of Substitutes Other things being equal if the price of the product increases the demand for that product decreases and the demand for the substitute product increases and vice versa. Changes in government Policy The demand for a product may also depend upon government policies. For instance, if the government increases taxes on products, prices increase and hence the quantity demanded decreases in the short run. Government may also prohibit the consumption of a product or set limits on its consumption. Tastes and Preferences of the consumer The tastes and preferences of the consumer also affect the demand for a product. To an extent, prevailing fashion, advertising and an overall increase in standard of living influence consumer tastes. For example, when multinational Quick Service Restaurant (QSR) chains like Pizza Hut and McDonalds entered India, they found that their products did not cater to the Indian tastes. These companies had to not only change their pricing, but they also had to alter their menu to make it more suitable to the tastes and preferences of Indian consumers. Expectation Regarding Future Price Changes If a consumer expects a fall in the price of a product in the near future, the present consumption of that product may come down. This, however, depends on the nature of the product. If the product is essential or perishable, the consumer cannot postpone the purchase of that product. Even if the price of

a staple food like rice (or wheat) was expected to fall, there is a limit to the consumers ability to postpone its consumption. Special Influence Demand may also be influenced by other factors like climate change, demographic changes, population migration and technological progress. Change in quantity demanded vs Change in demand There is a need to understand the difference between change in quantity demanded and change in demand. Change in quantity demanded The change in quantity demanded indicates the relationship between price and quantity demanded which is the movement along the demand curve, keeping other things being constant. Ceteris paribus, higher is the price, lower is the quantity demanded and vice versa. Change in quantity demanded is also known as variations in demand (shown in the following Keynote 2.2.1) Change in demand The non-price factors will have an influence over the demand for the product. These factors may cause shift in the demand curve either rightward or leftward. Some of the non-price factors are discussed below. A change in demand, whether an increase or a decrease, refers to the shift in the demandcurve, towards the right or towards the left, caused by a change in any of the non-price determinants of demand (shown in the Keynote 2.2.1).35

tity demanded. The sign ofKeynote 2.2.1 Change in quantity demanded V/s Change in Demand

depends on goods X and Y, If both

whether they are complements or substitutes. the goods are substitutes and plements. The sign of modities. If

, if both goods are com-

depends on the nature of the com,

, the good X is a normal good and if

the good X is an inferior good. The nature of the goods will be discussed in detail under the indifference curve analysis. However, the following diagram is showing the shape of different goods with relation to the change in the income of the consumer (Keynote 2.2.2). Nature of Demand The nature of demand differs from goods to goods. The simplest form of demand function is the linear demand function through which an attempt is made hereunder to demonstrate how the factors influence demand. Linear demand function shows the linear functional relation between the quantity demanded of good X (Qx) and own price of good X (Px), prices of the related goods(Py,), income (Y) and other non price factors (O) that determines demand. The linear demand function can be presented as follows: 1. Normal good: Goods for which demand goes up when income is higher and for which demand goes down when income is lower. 2. Inferior goods: Goods for which demand tends to fall when income increases. 3. Substitutes: Goods that can serve as replacements for one another; when the price of one increases, demand for the other goes up. 4. Complementary goods: Goods that go together; a decrease in the price of one results in an increase in demand for the other and vice versa. 5. Giffen good: When the price of a commodity increases the demand for this type of good will increase and vice versa. Giffen good is also treated as an inferior good, but all inferior36

The signs of of demand,

depict how the changes in determinants 1), it is said to be relatively elastic, implying that the resultant change in x is greater than the change in y which caused it. When elasticity is less than one (E < 1), it is said to be relatively inelastic, indicating that the resultant change in x is less than the change in y. When elasticity is equal to zero (E = 0), it is said to be perfectly inelastic and changes in y will have no effect on x. Elasticity can be infinity (E = infinity) or perfectly elastic when a unit change in y will have infinite effect on x.

Since price and quantity are Video 2.6.1: Elasticity of inversely related as per the law Demand of demand, the coefficient of the price elasticity of demand is a negative number. Thus to avoid the negative value, a minus sign is often introduced into the formula of the price elasticity of demand. Hence the absolute value of the price elasticity of demand can be greater than 1 or less than one. The own point price elasticity of demand for a good X is mathematically expressed as:

59

The formula of the Arc Price Elasticity of demand is given hereunder:

Keynote 2.6.1: Type of Price Elasticity

Type of Price Elasticity of Demand (see also Interactive 2.6.1) Perfectly price elastic demand (ed = ): The demand is said to be perfectly price elastic if the the absolute value of own price price elasticity is infinite. Relatively Price elastic demand (ed > 1) : The demand is said to be relatively price elastic if the the absolute value of own price price elasticity is greater than one. Unitary Price elastic demand (ed= 1) : The demand is said to be unitary price elastic if the the absolute value of own price price elasticity is equal to one. Relatively price inelastic demand (ed < 1):The demand is said to be relatively price inelastic if the the absolute value of own price elasticity is less than one. Perfectly price inelastic demand (ed = 0): The demand is said to be perfectly price inelastic if the absolute value of own price price elasticity is zero. Example: 18,000 duplexes were sold in Hyderabad at Rs. 30,00,000 per unit in March 2012. Two months later, price of duplex in Hyderabad surged to Rs.32,00,000 per unit. As a result, the number of duplexes sold declined to 16,000 units. During the above period, all the determinants of demand for housing in Hyderabad city were stable. Given the above information, estimate the point price elasticity of demand and arc price elasticity of demand. In the above example P1=30,00,000 P2=32,00,000 Q1=18,000 Q2=16,000 Q= -2000 P=2,00,000 Inputting the above values in the point price elasticity formula, we have,

60

Point price elasticity of demand=

( 6 )

Keynote 2.6.3: Price elasticity and Revenue Relationship

product and habit formation (Keynote 2.6.2).

Inputting the above values in the arc price elasticity formula, we have, Arc Price Elasticity=

Factors Determining Price Elasticity of Demand There are a Keynote 2.6.2: Factors Determining wide array of Price Elasticity of Demand factors determining price elasticity of demand. The major factors which are affecting the price elasticity of demand are: (1) availability of substitutes (2) Closeness of substitutes (3) Proportion of income spend on the product (4) time period (5) uses of theTABLE 2.6.1:RELATIONSHIP BETWEEN PRICE ELASTICITY OF DEMAND AND TOTAL REVENUE PRICE ELASTICIT Y Elastic Demand Unitary Elastic Demand Inelastic Demand DIRECTION OF PRICE CHANGE Increase Decrease Increase Decrease Increase Decrease EFFECT ON TOTAL REVENUE Decrease Increase Remains Unchanged Remains Unchanged Increase Decrease REASONS MR>0 MR>0 MR=0 MR=0 MRP, that is, the tax burden of the consumer is greater in case of a more elastic supply curve (given the market demand). In the limiting case of a market-supply curve with infinite elasticity, the increase in price is equal to the specific tax and the entire tax is borne by the consumer. In Figure 6.11, the demand is the same as in Figures 5.2.4(a) and 5.2.4(b), but the supply curve is parallel to the horizontal axis, showing infinite price elasticity.172

Output Marginal Margin & revenue al cost Sales / Price 1 2 3 4 5 6 7 8 9 10 10 10 10 10 10 10 10 10 10 10 4 3 2 2.5 3 4 6.5 10 16 24.5

Averag e total cost 34 18.5 13 10.38 8.9 8.8 7.86 8.12 9 10.5

Unit profit -24 -8.5 -3 -0.38 1.1 1.92 2.14 1.88 1 -0.5

Total profit -24 -17 -9 -1.5 5.5 11.5 15 15 9 -5

the firm, will shift upwards to the left and the amount produced at the prevailing price will be reduced. The market supply curve will shift upward to the left and price will rise. The important question here is by how much will the

Figure 5.2.4(a): Lesser Elasticity of Supply

Figure 5.2.4(b): Greater Elasticity of Supply

Keynote 5.2.1 Short-run Equilibrium in Perfect Competition

The imposition of a specific tax equal to ab (same as before) leads to an equal increase in the price: P2 = ab. If the supply curve has a negative slope (Figure 5.2.5) the imposition of a specific tax results in an increase in the price which is greater than the tax. In Figure 5.2.5, the demand is identical as in the above cases, but the supply is negatively sloping (with its slope smaller than the slope of the DD curve). Under these conditions, a specific tax of ab leads to an increase in the market price, equals to P3 which is obviously larger than the unit tax. Figure 5.2.5

173

REVIEW 5.2.1Question 1 of 5 Which of the following is not a characteristic of a perfectly competitive market?

A. Large number of buyers and sellers B. Homogeneous product C. Free entry and exit of firms D. Presence of high transportation costs

Check Answer

174

S ECTION 3

Case study: Perfect Competition under eBay: A Fact or a Factoid?

Figure 5.3.1:ebay page live

The online auction giant eBay is an American website, headquartered in San Jose, California. It is the worlds online marketplace facilitating largescale trade of varied items ranging from cars, real estate to collectibles, clothing, DVDs, and artwork. eBay was founded in September 1995 by Pierre Omidyar (Pierre), a software developer. Earlier, he had worked in Claris, a spin-off of the famed Apple Computers. eBay started in lines of something like a garage sale and the first product that it sold was a broken laser pointer. Pierre knew that he had created something big,

when the broken laser pointer sold for $14.83. When the winning bidder was contacted to check if he understood that the laser pointer was broken, the buyer replied that he was a collector of broken laser pointers! Pierre, a French-born IranianAmerican, acknowledged that he alone cannot put eBay into the corporate big leagues. In 1996, Jeffrey Skoll, with a MBA from Stanford, was hired. Soon in 1998, Meg Whitman (Meg), a Harvard Business School graduate, followed as the president and CEO. Meg had

This case study was written by Nitu Gupta under the guidance of Akshaya Kumar Jena, IBSCDC. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.175

learned the crucial importance of branding from her enriched association with Hasbro, a worldwide leader in childrens and family leisure time products and services. She took the company public (Exhibit I), expanded it and successfully exceeded earnings predictions. Exhibit I: eBays IPO Information Date went public Proposed Offer Price Actual Offer Price First Day OpenFirst Day Close

September 24th 1998 $14.00 to $16.00 $18.00 $53.50 $47.38 3.5 $62.8 Goldman Sachs & Co The Marketplaces segment of eBay comprises online commerce platforms that allow buyers and sellers to interact and trade with one another globally. It intends to bring them together from any place in the world at any time through fully automated online websites, available 24/7. The platforms have as a feature, software tools and services, some of which are available free of cost and others for a fee to ensure efficient trading. The Marketplaces segments core online commerce platform is eBay.com and its local counterparts are in 39 countries. Its adjacent platforms consist of eBays classifieds website, as well as Half.com, Rent.com, Shopping.com and StubHub. The revenue for eBays Marketplaces platforms are raised from the fee paid by sellers for listing, feature,176

Shares Offered (million) Offering Amount (million) Underwriters

Compiled from the author from eBay reignites IPO market with 197% surge at opening, find articles.com

Meg created an experienced management team by gathering her senior staff from companies such as Pepsico and Disney, and built a strong vision for the company. eBay intended to be a company that is in the business of connecting people. eBay has three business segments: Marketplaces, Payments and Communications (Exhibit II).

subscription and final value fee. Apart from this, there are lead referral fee, transaction fee, advertising fee, etc., which act as the source of revenue. eBay.com had initially followed only its traditional auction-style format. However, when it realised that an obscure website called Half.com with its fixed-price system could become a potential threat to its floating-price auction model, it bought the company and brought into being, the latters fixed-price formats. In the traditional auction-style format, a seller is allowed to set a reserve price for the item the minimum price at which the seller is willing to sell the item. In the fixed-price format, buyers and sellers experience an accelerated transaction process in comparison to traditional auction-style format, which necessitates waiting for the auction period to expire. eBay introduced fixed-price option to its auction listings with items with a Buy It Now logo, which can be bought immediately for a set price. eBays classifieds website are designed to help people meet, share ideas and trade on a local level, and are available in lot of cities and regions of the world. Rent.com concerning rental-housing industry is a US listing website, aimed at bringing together apartment seekers and apartment managers. Shopping.com, which features products from thousands of merchants across the Internet, is a comparison shopping destination. StubHub is a US ticket marketplace, which facilitates fans to buy and sell tickets of various sports, entertainment events, etc. eBays Payments segment, PayPal, allows individuals and businesses to send as well as receive payments online. Its Communications segment, Skype Technologies S.A. (Skype), enables Voice over Internet Protocol (VoIP) communications

and offers low-cost connectivity to traditional fixed- line and mobile telephones. In November 2008, eBay acquired USbased online payments business, Bill Me Later.

eBay and Perfect CompetitioneBay is a place to buy, sell and window-shop. The products on the website are available at prices better than those one can find in traditional or online stores. Though there may be a few instances of bad deals on eBay, but careful buyers can always gain from this. Hence, there are large numbers of buyers on eBay. Individual seller, small retailer, or a big company anyone can sell nearly anything by listing their items on eBay, if they are flexible enough regarding the price. eBays global approach ensures saleability of unusual items that arent in demand in their vicinity. This facilitates large number of sellers. eBay serves as one of the best places in the world to window- shop and compare. As huge variety of things are available with enormous details like what each one sold or is selling for, photos, detailed descriptions, owner experiences, etc., a lot of information is gained about the items offered at eBay. At eBay, transaction by individual buyer and seller is very small compared to the total volume of transactions. Both buyers and sellers at eBay are price takers. No individual buyer and seller can do anything to change that price. The eBay user agreement limits each user to 10 simultaneous listings for identical goods. Thus, there is no possibility for economies of scale, which has the potential to turn the largest firm into a monopoly. As of December 31st 2008, eBays Marketplaces had around 86.3 million active users globally.177

On eBay, every second, $2,000 worth of goods are traded by users across the world. In Q4-2008, 732 million new listings were added to eBay.com worldwide. About 113 million existing listings are available on eBay worldwide, and approximately 7.1 million additional listings per day, are freshly included.2 In the eBay market, competitive advertising does not occur because the products are categorised and sub-categorised into homogeneous ones. Competitive advertising would be simply redundant. However, generic advertising bereft of brand names, benefiting the industry as a whole, often does occur. Though within the different categories of goods available there are subcategories where the items are homogeneous, product differentiation is inherent in used goods. Goods are differentiated by wear. Entry or exit as a business in eBay is quite easy. Anyone who is computer literate and knows how to use Internet and has the desire, can sell or buy product from eBay. Several sellers of common products and several potential buyers are features of eBay. No cost is entailed for browsing and bidding on auctions, but sellers are to pay two kinds of charges. In order to list an item on eBay, a non-refundable insertion fee is charged. For optional upgrades to boost the listing such as premium picture services and format enhancements through bold subtitles and highlighting additional charges are levied. These are included in the insertion fee. A final value fee is charged if the listing ends

with a winning bid. No final value fee is charged if there are no bids on an item, or if the reserve price is not met. Information costs are trivial under eBay. Comparison of prices by visiting different internet sites is quite easy. There are no browsing costs for buyers and the eBay fee schedule ensures identical selling costs for all sellers. Shipping and handling charges, signifying the travel costs generally differ depending on the good. However, in some instances, travel costs are cheaper than local sales taxes. Auctions under eBay, however, can be highly unpredictable instigating strange buyer behaviour. For instance, in late 2006, the new PlayStation 3 video-game system attracted a huge mass queuing for days outside retail stores to purchase it. For people who bought the playstation from stores and sold it on eBay, it fetched thousands of dollars for the $600 machines. However, resale prices of Apples iPhone, which drew similar crowds in mid-2007, were not lucrative enough on eBay.3 Ulrike Malmendier (Malmendier), an economist at the University of California at Berkeley, conducted quite an extensive research on eBay to reveal the mystery of such contrasting consumer behaviour. For example, she picked CashFlow 101, a personalfinance-themed board game, and tracked 166 auctions offering. Prior to this, during the 7-month trial, the game was sold online for $195 by the game designer. The researcher observed that eBay sellers offered an opening price of about $45 and buy it now price of about $125, which may be interpreted as a cool deal for the buyers. But some bidders grew so excited about winning the auction that instead of paying less than retail, to end the auction immediately or bidding in the hope of fetching an178

even lower price, they sometimes ended up paying more than $185. In 43% of the auctions, the bidders apparently paid more than the buy it now price. The economist found similar result in her extended research as well. Malmendier and her co-author, Stanford University economist Hanh Lee, refer to such buyer behaviour as bidders curse. The Romans term it as calor licitantis meaning bidders heat.4 eBay simulates many important features of perfect competition like large number of buyers and sellers, information symmetry, low barriers to entry and sub-categorisation of products on the basis of homogeneity. eBay is often cited as an eminently apt real world example of a perfectly competitive market. However, critics point out that products sub- categorised on the basis of homogeneity are strictly not homogenous products because of variation in period of original use as well as degree of wear and tear. Moreover, the products transacted under eBay do not affect resource allocation, the way the products usually do when they are produced to address the original demand. Prices, therefore, do not truly dictate the supply of products listed on eBay. While there are all these hair-splitting nobody has come up with a better instance of perfect competition that would comprise a host of items touching modern life.

References: 1. 2. 3. Our History, http://news.ebay.com/history.cfm,1995 eBay India Fast Facts,http://pages.ebay.in/community/ aboutebay/news/infastfacts.html, December 31st 2008 Gaylord Chris,Economists puzzled by irrational eBay buyers,http://www.usatoday.com/tech/techinvestor/ 2007-07-17-economists- study-ebay-buyers_N.htm, July 17th 2007 . Gaylord Chris,Economists puzzled by irrational eBay buyers,http://www.usatoday.com/tech/techinvestor/ 2007-07-17-economists- study-ebay-buyers_N.htm, July 17th 2007.

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S ECTION 4

Case study: Should Energy be Subsidized?

The Dutch government will renew subsidies for green energy next year but only for producers that can prove their energy is really green and does not deprive people of food.1 - Jacqueline Cramer, the Environment Minister of Netherlands, in May, 2007.

Jacqueline Cramer

http://www.rnw.nl/english/article/sceptical-mps-try-deraildutch-climate-policy

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INTRODUCTION Not only should global economies end energy subsidies which encourage excessive use of energy, they should also agree on a common higher price for energy.2 - Lawrence H Summers, Former US Treasury Secretary, in April, 2007. Awrence H Summers In January 2007, the US House of Representatives passed legislation seeking to cut US$ 14 billion in oil and gas subsidies over the next ten years and instead to pass on the amount to companies engaged in the development of renewable energy technology and the production of renewable energy.4 However, as of June 2007, the bill was still languishing in the US Senate, with lobbyists working hard to ensure that it did not become law. If the bill did become law, it was expected to give a boost to the renewable energy industry. Some analysts were, however, apprehensive that this step might have a negative impact on the domestic oil industry in the US. A reduction in oil subsidies was expected to lead to an increase in the domestic price of oil, forcing the government to increase oil imports. Analysts also argued that in order to maintain their competitiveness, US oil companies would look to cut costs, including through layoffs, and this would have a negative impact on employment in the oil sector. The increase in international energy prices in 2006-07 brought energy subsidies into focus. According to economists, energy subsidies resulted in inefficient use and over-consumption of energy in addition to being a drain on the exchequer. They felt that while it was true that subsidies allowed the poor access to energy, the government would have to keep in mind the longterm impact of extending these subsidies on the economy and on the environment. Even so, around the world, there were many countries that continued with subsidies which promoted the indiscriminate use of non-renewable energy. This not only affected the finances of these countries but also caused harm to the environment.181

http://www.harvard.edu/history/presidents /summers

Encouraging reforms of subsidies that have considerable negative effects on the environment and are incompatible with sustainable development, inter alia by establishing a list of criteria allowing such environmentally negative subsidies to be recorded, with a view to gradually eliminating them.3 - An action suggested in the Sixth Environment Action Program 4, in July, 2002.

In this context, proposals to shift subsidies from the nonrenewable energy sector to the renewable energy sector were gaining currency. Some analysts were of the view that giving subsidies to develop energy from renewable sources would not only help save the environment but also improve the finances of many oil-importing countries, besides providing energy security. However, others felt that diverting subsidies from the non-renewable energy sector (especially fossil fuels) was not a good idea as it would lead to sudden increases in the price of fuel. Considering that the per unit cost of generating energy from renewable sources was higher than the cost of generation from non-renewable sources, the social cost of removing energy subsidies would be high, with reduced access to energy for the poor and increase in unemployment, they said. On the other hand, with climate change becoming an important issue, analysts felt that there was an urgent need to control greenhouse gas (GHG) emissions. It was argued that the money that was being used to subsidize non-renewable energy could now be effectively used to develop more efficient forms of renewable energy (Refer Exhibit I for a brief note on renewable energy). However, even as of 2007, renewable energy continued to be expensive vis--vis fossil fuels. Also, there were experts who felt that renewable energy too had certain