Explain the theoretical principles of production to explain the relative
substitution of one input for another occurring as a result of the increased price
of labour.
Answer. The production theory deals with quantitative relationships, i.e., technical and
technological relations, between inputs, especially labour and capital, and between
output and input.
The Laws of production
This law states the relationship between output and input. The traditional theory studies
the marginal input-output relationships under short run and long run. In the short run,
input – output relations are studied with one variable input, other inputs held constant>
the laws of production under these conditions are called ‘The laws of variable
proportions’. In the long run input-output relations are studies assuming all the inputs to
be variable. The long run relations are studies under ‘Laws of return to scale’.
Input Prices - Substitution Effect
Input prices do not remain constant. When input prices change, it changes the least
cost input-combination and also the level of output, given the total cost. If all the input
prices change in the same proportion, the relative prices of inputs remain unaffected.
But, when the prices change at different rates in the same direction, or change at
different rates in opposite direction or price o only one input changes while the price of
the other input remains constant, the relative prices of the inputs change. A change in
relative input-output prices changes both input-output-combination and the level of
output.
The change in the input-output combination results from the substitution effect of
change in relative prices of inputs. A change in relative prices of inputs implies that
some input has become cheaper in relation to the other. The cost minimizing firms,
therefore, substitute relatively cheaper input for the costlier one. This is known as
substitution effect of change in the relative input prices.
Substitution effect = Price effect – Budget effect
If the price of one input, say labour, increases, the firm will adjust the input mix by
substitution capital for labour. If the price of labour declines, thus making labour
relatively less expensive, labour will be substituted for capital. In general, if the relative
prices of inputs change, managers will respond by substituting the input that has
become relatively less expensive for the input that has become relatively more
expensive.
The isoquant – isocost framework can be used to demonstrate this principle. Let us
suppose the firm is currently operating at point a where 100 units of output are
produced using the resource combination (K = 10, L = 2). This is an efficient resource
mix because the 100 unit isoquant is tangent to the isocost line CC. If the firm’s goal is
to maximize production subject to a cost constraint (i.e., the firm is limited to resource
combinations on a given isocost function).
If the price of labour falls while the price of capital remains unchanged (i.e., labour has
become relatively less expensive), the isocost pivots to the right from CC to the isocost
CC1. The reduction in the price of labour means that the firm is able to increase the
rate of production. Hence the firm moves from point a to point b, which is a new
efficient resource combination. That is, the new isocost is tangent to the 120 –unit
isoquant at point b. Now 9 units of capital and 6 units of labour are employed/. At point
a, the efficient ratio of capital to labour was 5 : 1. Now the efficient ratio of two inputs is
3: 2. The reduction in the price of labour has caused the firm to substitute that relatively
less expensive input for capital.
Friday, June 12, 2009
Oligopolists are more likely to match the price-cut than a price increase by a competitor. Why?
Oligopolists are more likely to match the price-cut than a price
increase by a competitor. Why? Explain with the help of examples.
Oligopoly: Oligopoly is a situation in which only a few firms (sellers) are
competing in the market for a particular commodity. The distinguishing characteristics
of oligopoly are such that neither the theory of monopolistic competition nor the theory
of monopoly can explain the behaviour of oligopolistic firm.
These characteristics are briefly explained below:
Under oligopoly the number of competing firms being small, each firm controls an
important proportion of the total (industry) supply. Consequently, the effect of a
change in the price or output of one firm upon the sales of its rival firms is
noticeable and not insignificant. When any firm takes an action its rivals will in all
probability react to it. (i.e., retaliate). The behaviour of oligopolistic firms is
interdependent and not independent or automistic as in the case under perfect or
monopolistic competition.
The demand curve of an individual firm under oligopoly is not known and is
indeterminate because it depends upon the reaction of its rivals, which is
uncertain. Each theory of oligopoly therefore makes a specific assumption about
how rivals will (or will not) react to an individual firm’s action.
In view of the uncertainty about the reaction of rivals and interdependence of
behaviour, oligopolistic firms find its advantageous to co-ordinate their behaviour
through explicit agreement (cartel) or implicit, hidden, understanding (collusion).
Also because the number of firms is small, it is feasible for oligopolists to establish
a cartel or collusive arrangement. However, it is difficult as well as expensive to
monitor and enforce an agreement or understanding. Very few cartels last long
particularly when oligopolistic firms significantly differ in their cost conditions.
Under oligopoly, new entry is difficult. It is neither free nor barred. Hence the
condition of entry becomes an important factor determining the price or output
decisions of oligopolistic firms, and preventing or limiting entry an important
objective.
Given the indeterminacy of the individual firm’s demand and, therefore, the
marginal revenue curve, oligopolistic firms may not aim at maximization of profits.
Modern theories of oligopoly take into account the following alternative objectives
of the firm:
Sales maximization with profit constraint.
Target or "fair" rate of profit and long-run stability.
Maximization of the managerial utility function.
Limiting (preventing) new entry.
Achieving "satisfactory" profits, sales, etc. That is, the firm is a "satisficer" and not
"maximizer".
Maximization of joint (industry) profits rather than individual (firm) profits:
TWO UNIQUE ASPECTS OF OLIGOPOLY COMPETITION
In oligopoly industries, competition occurs in ways that are unique to these industries.
Two unique aspects of oligopoly competition are mutual interdependence and repeated
interaction.
MUTUAL INTERDEPENDENCE
Mutual interdependence exists when the actions of one firm has a major impact on the
other firms in the industry. For instance, if Coke decides to sell more of its product (and
to do so they reduce their prices), Pepsi will certainly notice that its sales fall. Coke's
behavior affects Pepsi: mutual interdependence exists with in the US soft drink market.
But, if a corn farmer in Kansas decides to plant another few more of corn, the sales of
other corn farmers in the US will not be affected. An individual corn farmers' output is a
very small part of US corn output; changes in output by one farmer will have no impact
on the corn market. Mutual interdependence does not exist in the corn market. Mutual
interdependence exists within an oligopoly industry because each of the oligopolists
has a sizable part of the market. As a consequence, when it changes its sales, its
prices, or its marketing strategies, this oligopoly firm will likely affect the sales of other
firms within the industry. An analogy is the following. If you are on a ocean liner that
holds 1,000 people you can stand up and jump up and down and have no effect on the
other passengers. This is because you are very, very small compared to the boat and
to the number of other passengers on the boat. But, if you are in a small rowboat with 2
other people and you stand up the other 2 people will instantly notice that the boat is
more unstable and, perhaps, threatens to capsize. They must actively shift their weight
to keep the small boat from tipping over. The 3 people in the small row boat are
mutually interdependent: what one person does can directly affect what happens to the
other people on the boat.
REPEATED INTERACTION
Often the oligopolists within an industry have been competing with one another for a
long time. For instance, Pepsi and Coke have competed within the same market for
decades. Ford, GM, and Chrysler have faced one another in the US auto market for a
very long time. Oligopolists in other markets might have competed with one another for
a much shorter period of time, perhaps only a few years. But, in each of these cases,
the oligopolists within these industries have experience with the others within the
industry. For instance, whenever Pepsi decides to lower the price of its products it
knows how Coke responded in the past to previous reductions in price by Pepsi.
Perhaps Coke matches a Pepsi price reduction 10 out of the past 12 times Pepsi
reduced its prices. In this case, Pepsi likely anticipates that when it lowers its prices
this time, the odds are that Coke will respond in kind. Coke, on its part, also remembers
what happened in its past competitive interactions with Pepsi. Coke and Pepsi
remember, and take into account, what happened in the past when they design their
current competitive strategies. The situation is characterizes as "repeated interaction."
OLIGOPOLISTS ARE MORE LIKELY TO MATCH THE PRICE-CUT THAN A PRICE
INCREASE BY A COMPETITOR - KINKED DEMAND CURVE
The kinked demand curve has features common to most oligopoly markets. The kinked
demand curve analysis does not deal with price and output determination. Rather, it
seeks to establish that once a price quantity combination is determined, an oligopoly
firm does not find it profitable to change its price even if there is a considerable change
in cost of production. The logic behind this proportion is as follows. An oligopoly firm
believes that if it reduces the price of its products, rival firms would follow and
neutralize the expected gain from price reduction. But, if it raises its prices, rival firms
would either maintain their prices or may even cut their prices down. In either case, the
price raising firm stands to lose, at least a part of its market share. This behavioural
assumption is made by all the firms with respect to others. The oligopoly firms,
therefore, find it more desirable to maintain their price and output at the existing level.
Examples
In the cigarette business, as in many other American industries, we have what is known
as an oligopoly, where a few large firms dominate the market and by various more or
less legal means contrive to keep the prices for all brands uniform. Demand for
cigarettes in general is thought to be highly inelastic, meaning that people will buy
about the same number no what the price is; but demand for individual brands is highly
elastic--people are fickle, and will readily switch to another brand if it's priced
significantly lower. What this means is that if one manufacturer cuts his prices, he'll sell
a lot more cigarettes, but mainly at the expense of his competitors. Knowing this, the
competitors would immediately have to drop their own prices, and the upshot is that
everybody ends up selling about as many cigarettes as before, only at a lower profit
margin. For this reason the manufacturers try to avoid price competition if at all
possible.
Let’s take another example of Dell computers and Gateway. If either firm changes
prices, they generally expect the worse. If Dell increases prices, Gateway does nothing
and Dell gets hurt. If Dell reduces prices, Gateway responds by imposing their own
price cut and the ensuing price war likely hurts Dell. Why would Gateway do this?
Simply because these actions best help Gateway protect or increase its profit. If Dell
increases their prices and Gateway does not, then Gateway will experience a boost in
demand (Gateway computers and Dell computers are substitute products). As Dell
computers are now higher priced, more consumers will buy from Gateway (although
Gateway kept the same price as before). This can only help Gateway's sales, revenue,
and profits. It is rational, then, for Gateway to keep their prices the same when Dell
raises their prices. If Dell reduces their prices and Gateway does not, then Gateway will
find they lose many sales to the (now) lower-priced competitor, Dell. In this situation,
Gateway might find it is best to respond with their own price reduction in order to help
maintain their sales, revenues, and profits. It is likely rational for Gateway to reduce
prices when Dell reduces prices. As is clear, competition within this industry can be
very nasty as firms attempt to take advantage of other firms (if these other firms raise
their prices) or firms act to protect themselves by matching price reductions.
increase by a competitor. Why? Explain with the help of examples.
Oligopoly: Oligopoly is a situation in which only a few firms (sellers) are
competing in the market for a particular commodity. The distinguishing characteristics
of oligopoly are such that neither the theory of monopolistic competition nor the theory
of monopoly can explain the behaviour of oligopolistic firm.
These characteristics are briefly explained below:
Under oligopoly the number of competing firms being small, each firm controls an
important proportion of the total (industry) supply. Consequently, the effect of a
change in the price or output of one firm upon the sales of its rival firms is
noticeable and not insignificant. When any firm takes an action its rivals will in all
probability react to it. (i.e., retaliate). The behaviour of oligopolistic firms is
interdependent and not independent or automistic as in the case under perfect or
monopolistic competition.
The demand curve of an individual firm under oligopoly is not known and is
indeterminate because it depends upon the reaction of its rivals, which is
uncertain. Each theory of oligopoly therefore makes a specific assumption about
how rivals will (or will not) react to an individual firm’s action.
In view of the uncertainty about the reaction of rivals and interdependence of
behaviour, oligopolistic firms find its advantageous to co-ordinate their behaviour
through explicit agreement (cartel) or implicit, hidden, understanding (collusion).
Also because the number of firms is small, it is feasible for oligopolists to establish
a cartel or collusive arrangement. However, it is difficult as well as expensive to
monitor and enforce an agreement or understanding. Very few cartels last long
particularly when oligopolistic firms significantly differ in their cost conditions.
Under oligopoly, new entry is difficult. It is neither free nor barred. Hence the
condition of entry becomes an important factor determining the price or output
decisions of oligopolistic firms, and preventing or limiting entry an important
objective.
Given the indeterminacy of the individual firm’s demand and, therefore, the
marginal revenue curve, oligopolistic firms may not aim at maximization of profits.
Modern theories of oligopoly take into account the following alternative objectives
of the firm:
Sales maximization with profit constraint.
Target or "fair" rate of profit and long-run stability.
Maximization of the managerial utility function.
Limiting (preventing) new entry.
Achieving "satisfactory" profits, sales, etc. That is, the firm is a "satisficer" and not
"maximizer".
Maximization of joint (industry) profits rather than individual (firm) profits:
TWO UNIQUE ASPECTS OF OLIGOPOLY COMPETITION
In oligopoly industries, competition occurs in ways that are unique to these industries.
Two unique aspects of oligopoly competition are mutual interdependence and repeated
interaction.
MUTUAL INTERDEPENDENCE
Mutual interdependence exists when the actions of one firm has a major impact on the
other firms in the industry. For instance, if Coke decides to sell more of its product (and
to do so they reduce their prices), Pepsi will certainly notice that its sales fall. Coke's
behavior affects Pepsi: mutual interdependence exists with in the US soft drink market.
But, if a corn farmer in Kansas decides to plant another few more of corn, the sales of
other corn farmers in the US will not be affected. An individual corn farmers' output is a
very small part of US corn output; changes in output by one farmer will have no impact
on the corn market. Mutual interdependence does not exist in the corn market. Mutual
interdependence exists within an oligopoly industry because each of the oligopolists
has a sizable part of the market. As a consequence, when it changes its sales, its
prices, or its marketing strategies, this oligopoly firm will likely affect the sales of other
firms within the industry. An analogy is the following. If you are on a ocean liner that
holds 1,000 people you can stand up and jump up and down and have no effect on the
other passengers. This is because you are very, very small compared to the boat and
to the number of other passengers on the boat. But, if you are in a small rowboat with 2
other people and you stand up the other 2 people will instantly notice that the boat is
more unstable and, perhaps, threatens to capsize. They must actively shift their weight
to keep the small boat from tipping over. The 3 people in the small row boat are
mutually interdependent: what one person does can directly affect what happens to the
other people on the boat.
REPEATED INTERACTION
Often the oligopolists within an industry have been competing with one another for a
long time. For instance, Pepsi and Coke have competed within the same market for
decades. Ford, GM, and Chrysler have faced one another in the US auto market for a
very long time. Oligopolists in other markets might have competed with one another for
a much shorter period of time, perhaps only a few years. But, in each of these cases,
the oligopolists within these industries have experience with the others within the
industry. For instance, whenever Pepsi decides to lower the price of its products it
knows how Coke responded in the past to previous reductions in price by Pepsi.
Perhaps Coke matches a Pepsi price reduction 10 out of the past 12 times Pepsi
reduced its prices. In this case, Pepsi likely anticipates that when it lowers its prices
this time, the odds are that Coke will respond in kind. Coke, on its part, also remembers
what happened in its past competitive interactions with Pepsi. Coke and Pepsi
remember, and take into account, what happened in the past when they design their
current competitive strategies. The situation is characterizes as "repeated interaction."
OLIGOPOLISTS ARE MORE LIKELY TO MATCH THE PRICE-CUT THAN A PRICE
INCREASE BY A COMPETITOR - KINKED DEMAND CURVE
The kinked demand curve has features common to most oligopoly markets. The kinked
demand curve analysis does not deal with price and output determination. Rather, it
seeks to establish that once a price quantity combination is determined, an oligopoly
firm does not find it profitable to change its price even if there is a considerable change
in cost of production. The logic behind this proportion is as follows. An oligopoly firm
believes that if it reduces the price of its products, rival firms would follow and
neutralize the expected gain from price reduction. But, if it raises its prices, rival firms
would either maintain their prices or may even cut their prices down. In either case, the
price raising firm stands to lose, at least a part of its market share. This behavioural
assumption is made by all the firms with respect to others. The oligopoly firms,
therefore, find it more desirable to maintain their price and output at the existing level.
Examples
In the cigarette business, as in many other American industries, we have what is known
as an oligopoly, where a few large firms dominate the market and by various more or
less legal means contrive to keep the prices for all brands uniform. Demand for
cigarettes in general is thought to be highly inelastic, meaning that people will buy
about the same number no what the price is; but demand for individual brands is highly
elastic--people are fickle, and will readily switch to another brand if it's priced
significantly lower. What this means is that if one manufacturer cuts his prices, he'll sell
a lot more cigarettes, but mainly at the expense of his competitors. Knowing this, the
competitors would immediately have to drop their own prices, and the upshot is that
everybody ends up selling about as many cigarettes as before, only at a lower profit
margin. For this reason the manufacturers try to avoid price competition if at all
possible.
Let’s take another example of Dell computers and Gateway. If either firm changes
prices, they generally expect the worse. If Dell increases prices, Gateway does nothing
and Dell gets hurt. If Dell reduces prices, Gateway responds by imposing their own
price cut and the ensuing price war likely hurts Dell. Why would Gateway do this?
Simply because these actions best help Gateway protect or increase its profit. If Dell
increases their prices and Gateway does not, then Gateway will experience a boost in
demand (Gateway computers and Dell computers are substitute products). As Dell
computers are now higher priced, more consumers will buy from Gateway (although
Gateway kept the same price as before). This can only help Gateway's sales, revenue,
and profits. It is rational, then, for Gateway to keep their prices the same when Dell
raises their prices. If Dell reduces their prices and Gateway does not, then Gateway will
find they lose many sales to the (now) lower-priced competitor, Dell. In this situation,
Gateway might find it is best to respond with their own price reduction in order to help
maintain their sales, revenues, and profits. It is likely rational for Gateway to reduce
prices when Dell reduces prices. As is clear, competition within this industry can be
very nasty as firms attempt to take advantage of other firms (if these other firms raise
their prices) or firms act to protect themselves by matching price reductions.
Issues related to pricing are very important regarding introduction of competition. Discuss some of the important pricing issues...
Issues related to pricing are very important regarding introduction of
competition. Discuss some of the important pricing issues with special reference
to the software industry.
Determination of prices is an important managerial function in all enterprises.
Price affects the profit, demand, revenue, cost. The quantity sold varies with variations
in the price. Thus pricing plays a vital role in profit planning. Banker is interested in
how to mobilize the resources. Fire fighters are interested in how to prevent the fire
rather than extinguish it. In the same manner every management attempts to maximize
the level of output, minimize the cost and thereby accrue maximum level of profit. This
could be best judged only by pricing. So setting up of an appropriate price is important
for every enterprise.
According to traditional economic theorists, the buyers and sellers alone determine the
price. But now-a-days the determination of prices and outputs of various products
depends upon the type of market structure in which they are produced, sold and
purchased.
Pricing theory under this hypothesis suggests that, given the demand and cost curves,
price and output are so determined that profit is maximized, i.e., at the level of output
where MR = MC. Some empiricists have however, produced the evidence, inadequate
through, that the firms follow a pricing rule other the one suggested by the marginality
rules. Besides, in a complex business world, business firms follow by them.
Competition
If a firm is not the market leader, competitive prices will influence the pricing of
products or services. Market leaders have often created a "pricing standard" against
which other product/service prices are compared. So if a firms product or service is
reasonably competitive with the market leader's offering then it can set a price that is
near the "standard". If the firm has the ability to price lower than the competition and
still be profitable, it may be able to capture a greater market share which can benefit it
over time.
The firm’s decision to compete with a lower price should not be made lightly. If the
competitor perceives that your low pricing has the potential of reducing their market
share or impacting their influence in the industry, they may respond with an even lower
price. Then, instead of increasing your market share, you could be faced with no
opportunity to profitably penetrate the market at all. It is always of value to know the
capabilities and tendencies of your competitors.
A different form of competition is the 'alternative solution'. The prospect's first
alternative is always, if the price is too high, a decision that they really don't need your
offering or any of your direct competitor's offerings. There may also be a variety of
ways for the prospect to solve their problem. For example, if you offer an airline
service, you are really in the business of transportation. So your prospect has the
option of your service versus trains, busses, rental vehicles, personal vehicles,
hitchhiking, bicycles, walking or (back to the first alternative) staying at home. The
availability of numerous alternative solutions will usually limit your pricing flexibility.
SOFTWARE PRICING
If you're a services company that's anxious to turn a reusable piece of code you
developed into a product, one of your greatest challenges will be determining an
appropriate price for your product. When you start thinking about how to determine the
price, you'll probably naturally move toward cost-based pricing (a formula that is related
to your development costs), or competition-based pricing (a formula related to what
your competitors charge). Before you settle on a price using either of those basic
pricing models, go back and reassess the opportunity for value-based pricing,
especially if your product has a strong vertical market affinity.
Value-based pricing requires that you be attuned to your potential customers and how
they'll really use your product. Your competitors may not have used a value-based
pricing model, so there may be an opportunity to define a new model that will mean
higher profits for your company. Using informal survey techniques at industry trade
shows, or even a focus group, you may find that your competitors' pricing models have
created substantial pockets of would-be users who cannot effectively relate to the
existing pricing model. For example, the product may be unaffordable for businesses
with a certain number of users, or a certain number of daily transactions. Perhaps the
up-front charges on the software are a barrier-to-entry for businesses of a certain size.
Perhaps there are many businesses who can't use 50% of the functions provided by
your competitors, and simply aren't willing to pay the price for functions they won't use.
It's not uncommon to discover that customers are willing to pay your company more,
maybe without even realizing it, as long as your fees match the structure or nature of
that particular business. Decision-making can often be linked to simple and realistic
calculations of the value that might be received by using a product.
There are a wide variety of approaches, some of which can be used in conjunction with
one another that can be used when you create a value-based pricing structure. These
include user-based licensing, usage- or transaction-based licensing, site licensing,
function-oriented fees, support-based fees, customization fees, customer revenuebased
fees, and even leasing options. Needless to say, the pricing analysis can be an
enlightening experience.
Pricing strategy relies on a good understanding of customer price sensitivity. The
Information and Communication Technology (ICT) sector, including the software
industry, is no different. Yet, some issues in this industry present unique challenges.
1) Software is often a substantial investment both in relative and absolute terms
Switching can be costly. Especially as time passes and more users become versed in
the software. Beyond direct cost, maintenance and support, indirect costs such as
training and implementation also make switching difficult. As a result, customers
typically ascribe high value to reliability of the product and expected availability of the
vendor for the long term. Reliability of the software and stability of the company will
attract a less price-sensitive customer. Estimating the impact of these two factors will
have a bearing on quantifying the price/value relationship.
2) Total Cost of Ownership (TCO)
A customer may be more interested in total price when assessing the investment in
software. Often a customer expects the vendor to assume some of the risks associated
with TCO. This has given rise to pricing structures such as subscription models, which
avoid high up-front prices, spreading them over a longer period of time.
3) Value perception among segments
No uniform formula exists for assessing the benefit of a particular software. Most
vendors try to provide an ROI that estimates and quantifies potential benefits. But real
value varies from one customer to another. Segmenting customers into a number of
distinct groups based on perceived value guarantees an understanding of price
sensitivity.
4) Shifting demand
The largest proportion of software license investments are a one-time deal. A company
buys a number of modules, and license seats for users to access the modules. Buyers
may add modules or seats. Industry growth, however, is expected from new sales.
Markets become saturated. The adoption of new software starts with large companies
and eventually trickles down to smaller customers. As a product matures, growth
opportunities come from smaller customers who are more price sensitive due to less
buying power. The subscription model emerged to address this challenge.
5) Software maturity
Software maturity results from the lack of differentiation among offerings. At this point
software vendors with greater brand recognition and larger market shares benefit. This
is due to their cost leadership and greater ability to compete on price. Here is one
illustration of a method for determining software price sensitivity.
Factor Attribute Direction of
price sensitivity
1) Investment
Quality/reliability/longevity of product
primarily perceived in relation to the
reputation of the vendor
Increased
2) TCO High TCO, increasing in relative terms as
market demand shifts downwards
Increased
3) Price structure Emergence of subscription models and
outsourcing
Increased
4) Value perception
Some functionalities perceived very
valuable, and some less valuable
depending on the industry
Depends
5) Demand Rapidly shifting down to mid-market and
low mid-market
Increasing
6) Differentiation Substitutes very easy to find; increased
number of new entrants
Increasing
competition. Discuss some of the important pricing issues with special reference
to the software industry.
Determination of prices is an important managerial function in all enterprises.
Price affects the profit, demand, revenue, cost. The quantity sold varies with variations
in the price. Thus pricing plays a vital role in profit planning. Banker is interested in
how to mobilize the resources. Fire fighters are interested in how to prevent the fire
rather than extinguish it. In the same manner every management attempts to maximize
the level of output, minimize the cost and thereby accrue maximum level of profit. This
could be best judged only by pricing. So setting up of an appropriate price is important
for every enterprise.
According to traditional economic theorists, the buyers and sellers alone determine the
price. But now-a-days the determination of prices and outputs of various products
depends upon the type of market structure in which they are produced, sold and
purchased.
Pricing theory under this hypothesis suggests that, given the demand and cost curves,
price and output are so determined that profit is maximized, i.e., at the level of output
where MR = MC. Some empiricists have however, produced the evidence, inadequate
through, that the firms follow a pricing rule other the one suggested by the marginality
rules. Besides, in a complex business world, business firms follow by them.
Competition
If a firm is not the market leader, competitive prices will influence the pricing of
products or services. Market leaders have often created a "pricing standard" against
which other product/service prices are compared. So if a firms product or service is
reasonably competitive with the market leader's offering then it can set a price that is
near the "standard". If the firm has the ability to price lower than the competition and
still be profitable, it may be able to capture a greater market share which can benefit it
over time.
The firm’s decision to compete with a lower price should not be made lightly. If the
competitor perceives that your low pricing has the potential of reducing their market
share or impacting their influence in the industry, they may respond with an even lower
price. Then, instead of increasing your market share, you could be faced with no
opportunity to profitably penetrate the market at all. It is always of value to know the
capabilities and tendencies of your competitors.
A different form of competition is the 'alternative solution'. The prospect's first
alternative is always, if the price is too high, a decision that they really don't need your
offering or any of your direct competitor's offerings. There may also be a variety of
ways for the prospect to solve their problem. For example, if you offer an airline
service, you are really in the business of transportation. So your prospect has the
option of your service versus trains, busses, rental vehicles, personal vehicles,
hitchhiking, bicycles, walking or (back to the first alternative) staying at home. The
availability of numerous alternative solutions will usually limit your pricing flexibility.
SOFTWARE PRICING
If you're a services company that's anxious to turn a reusable piece of code you
developed into a product, one of your greatest challenges will be determining an
appropriate price for your product. When you start thinking about how to determine the
price, you'll probably naturally move toward cost-based pricing (a formula that is related
to your development costs), or competition-based pricing (a formula related to what
your competitors charge). Before you settle on a price using either of those basic
pricing models, go back and reassess the opportunity for value-based pricing,
especially if your product has a strong vertical market affinity.
Value-based pricing requires that you be attuned to your potential customers and how
they'll really use your product. Your competitors may not have used a value-based
pricing model, so there may be an opportunity to define a new model that will mean
higher profits for your company. Using informal survey techniques at industry trade
shows, or even a focus group, you may find that your competitors' pricing models have
created substantial pockets of would-be users who cannot effectively relate to the
existing pricing model. For example, the product may be unaffordable for businesses
with a certain number of users, or a certain number of daily transactions. Perhaps the
up-front charges on the software are a barrier-to-entry for businesses of a certain size.
Perhaps there are many businesses who can't use 50% of the functions provided by
your competitors, and simply aren't willing to pay the price for functions they won't use.
It's not uncommon to discover that customers are willing to pay your company more,
maybe without even realizing it, as long as your fees match the structure or nature of
that particular business. Decision-making can often be linked to simple and realistic
calculations of the value that might be received by using a product.
There are a wide variety of approaches, some of which can be used in conjunction with
one another that can be used when you create a value-based pricing structure. These
include user-based licensing, usage- or transaction-based licensing, site licensing,
function-oriented fees, support-based fees, customization fees, customer revenuebased
fees, and even leasing options. Needless to say, the pricing analysis can be an
enlightening experience.
Pricing strategy relies on a good understanding of customer price sensitivity. The
Information and Communication Technology (ICT) sector, including the software
industry, is no different. Yet, some issues in this industry present unique challenges.
1) Software is often a substantial investment both in relative and absolute terms
Switching can be costly. Especially as time passes and more users become versed in
the software. Beyond direct cost, maintenance and support, indirect costs such as
training and implementation also make switching difficult. As a result, customers
typically ascribe high value to reliability of the product and expected availability of the
vendor for the long term. Reliability of the software and stability of the company will
attract a less price-sensitive customer. Estimating the impact of these two factors will
have a bearing on quantifying the price/value relationship.
2) Total Cost of Ownership (TCO)
A customer may be more interested in total price when assessing the investment in
software. Often a customer expects the vendor to assume some of the risks associated
with TCO. This has given rise to pricing structures such as subscription models, which
avoid high up-front prices, spreading them over a longer period of time.
3) Value perception among segments
No uniform formula exists for assessing the benefit of a particular software. Most
vendors try to provide an ROI that estimates and quantifies potential benefits. But real
value varies from one customer to another. Segmenting customers into a number of
distinct groups based on perceived value guarantees an understanding of price
sensitivity.
4) Shifting demand
The largest proportion of software license investments are a one-time deal. A company
buys a number of modules, and license seats for users to access the modules. Buyers
may add modules or seats. Industry growth, however, is expected from new sales.
Markets become saturated. The adoption of new software starts with large companies
and eventually trickles down to smaller customers. As a product matures, growth
opportunities come from smaller customers who are more price sensitive due to less
buying power. The subscription model emerged to address this challenge.
5) Software maturity
Software maturity results from the lack of differentiation among offerings. At this point
software vendors with greater brand recognition and larger market shares benefit. This
is due to their cost leadership and greater ability to compete on price. Here is one
illustration of a method for determining software price sensitivity.
Factor Attribute Direction of
price sensitivity
1) Investment
Quality/reliability/longevity of product
primarily perceived in relation to the
reputation of the vendor
Increased
2) TCO High TCO, increasing in relative terms as
market demand shifts downwards
Increased
3) Price structure Emergence of subscription models and
outsourcing
Increased
4) Value perception
Some functionalities perceived very
valuable, and some less valuable
depending on the industry
Depends
5) Demand Rapidly shifting down to mid-market and
low mid-market
Increasing
6) Differentiation Substitutes very easy to find; increased
number of new entrants
Increasing
‘Price leadership is an alternative cooperative method used to avoid tough competition’. Comment.
‘Price leadership is an alternative cooperative method used to avoid
tough competition’. Comment.
Answer. Price leadership is an observation made of oligopolic business behavior in
which one company, usually the dominant competitor among several leads the way in
determining prices, the others soon following.
When business conditions permit, the price leader will raise prices with the expectation
that the others will follow. The practice of price leadership prevails in many industries:
automobiles, breakfast cereals, beer, steel and bank loans are among the many goods
and services that are usually priced in this manner.
On the surface, it looks as though the effect of price leadership is the same as the
effect of the fixing of prices by a cartel or a trust. But there is a fundamental difference.
The trust or cartel assigns production quotas to its members in order to keep
production down. Competition does not exist in any form. Oligopolies that follow a price
leader do not engage in price competition, but they still contest for market share with a
variety of forms of non-price competition. Pepsi and Coke each spend billions on TV
ads designed to entice the consumer to switch cola brands, but those expensive ads
never mention price.
An example. Company A has two principal competitors and a number of smaller niche
players. The niche players serve focused geographic areas or offer specialty products
or services to unique segments of the customer base. Company A is a premium priced
producer and is a price leader. Each time it raises or lowers prices, its competitors also
make a price move. If Company B has a current price which is 90% of Company A, then
when Company A lowers its price Company B will adjust proportionally. Thus Company
B will still have a price 90% of Company A. The reverse occurs when Company A takes
a price increase.
PRICE LEADERSHIP- AVOIDING TOUGH PRICE COMPETITION
Price Leadership: Changing a price is always a dangerous practice for an oligopoly. If
the firm lowers the price, its competitors are also likely to lower theirs, then all will
suffer from lower profits. On the other hand, raising prices may lead to a loss of market
share unless competitors also raise their prices. In many industries, one firm (usually
the largest) is accepted by the others as the price leader. The price leader will be the
first to adjust prices to new conditions (higher labor costs, lower raw materials costs,
etc.) and the others will fall into line. Of course this arrangement is entirely informal and
unwritten - since any actual agreement to follow such a practice would violate the
antitrust laws.
Price Setting: But on what basis does the price leader set prices? The interplay of
supply and demand forces so beloved by neoclassical economists loses its cogency as
a theory of prices when 1) there is too little competition to force prices to equal
marginal costs and marginal benefits through a Darwinian struggle; 2) costs per unit fall
with increased output as the firm is able to spread its fixed costs over a larger number
of units; and 3) demand is itself subject to manipulation by the firm through advertising.
Institutionalists and Post-Keynesians claim that the structure of oligopoly leads to a
form of administered pricing. The price leader will use its average cost as a basis for
price setting. Prices will be set at a level which achieves a target level of operating
profits. This target level will be sufficient to enable the firm to self-finance expansion
without the need to issue new stock or to borrow amounts of money that might threaten
the firm's independence. Rather than constantly move the price up and down in order
to sell as many units as the firm is capable of producing at a profit, the firm will normally
adjust its output in order to maintain its target price. When this form of administered
pricing is combined with the normal tendency of firms to expand, one result is that firms
will usually have more production capacity than they use. When demand increases,
they will increase output rather than prices.
Enforcement of Price Leadership In the economic as in the political arena, leadership
will occasionally be challenged. Sometimes the mere threat of lowering prices suffices.
In 1989, Miller and Coors tried to expand their market shares by discounting their
premium beers. Anheuser-Busch, with 41 percent of the U.S. beer market, simply
issued a press release:
We cannot permit a further slowing in our volume trend... [the company will take]
appropriate competitive pricing actions to support our long-term market share growth
strategy.
Actually the Anheuser statement is simply a warning to competitors that if they do not
stop discounting they will face a costly battle which they will certainly lose.
But sometimes actual price reductions are necessary. In the late 1960s, Chrysler tired
to break away from the pricing pattern then set by General Motors. But GM was a
larger and more efficient producer and was not about to abandon its price-leader role.
So GM lowered prices below the cost of production in those lines in which Chrysler was
competitive. Thus Chrysler was left with a lower margin per vehicle sold but was still
unable to expand its market share. When GM raised their prices again in 1971 Chrysler
quickly followed. Chrysler also filed suit charging GM (and Ford) with predatory pricing,
but Ford and GM were acquitted due to lack of evidence.
Predatory Pricing A large or diverse firm that can stand temporary losses can cut its
prices below the cost of production until it runs competitors out of business or
establishes its price leadership. Then it can raise prices again. This is illegal. But it is
very hard to prove, since normal competitive pressures can lead to prices set
temporarily below the cost of production.
SOME PRICE LEADERSHIP MODELS
Barometric price leadership: The barometric price leadership is not a dominant firm.
One firm in a group of firms of more or less comparable size comes to pay the role of
price leader, not because of its dominant position in the market but because other firms
regard its actions as a suitable barometer of changing market conditions. They are
willing to follow its policies in the belief that competitive disturbances are minimized by
so doing. But the actual powers of a barometric price leader are greatly restricted by its
realization that other firms will follow him only with reasonable limits.
Two simplified models of price leadership:
Suppose there are only firms in the industry and they have assigned half of the market.
Furthermore, suppose that they are producing homogeneous products, but one firm
has lower costs that the other. The price and output policies of the two firms differ
because of the different cost of the two firms.
This can be illustrated with the following figure:
DD presents the market demand curve and dd represents the firms demand curve. The
firm 1 fixes the price at op 1 and its level of output is OM1 where as the firm 2 fixes its
price at op 2 and produces OM2 amount of output. The firm 2 has comparatively
advantageous position than the firm 1 because of its lower cost. Hence, the firm 2
becomes the price leader.
tough competition’. Comment.
Answer. Price leadership is an observation made of oligopolic business behavior in
which one company, usually the dominant competitor among several leads the way in
determining prices, the others soon following.
When business conditions permit, the price leader will raise prices with the expectation
that the others will follow. The practice of price leadership prevails in many industries:
automobiles, breakfast cereals, beer, steel and bank loans are among the many goods
and services that are usually priced in this manner.
On the surface, it looks as though the effect of price leadership is the same as the
effect of the fixing of prices by a cartel or a trust. But there is a fundamental difference.
The trust or cartel assigns production quotas to its members in order to keep
production down. Competition does not exist in any form. Oligopolies that follow a price
leader do not engage in price competition, but they still contest for market share with a
variety of forms of non-price competition. Pepsi and Coke each spend billions on TV
ads designed to entice the consumer to switch cola brands, but those expensive ads
never mention price.
An example. Company A has two principal competitors and a number of smaller niche
players. The niche players serve focused geographic areas or offer specialty products
or services to unique segments of the customer base. Company A is a premium priced
producer and is a price leader. Each time it raises or lowers prices, its competitors also
make a price move. If Company B has a current price which is 90% of Company A, then
when Company A lowers its price Company B will adjust proportionally. Thus Company
B will still have a price 90% of Company A. The reverse occurs when Company A takes
a price increase.
PRICE LEADERSHIP- AVOIDING TOUGH PRICE COMPETITION
Price Leadership: Changing a price is always a dangerous practice for an oligopoly. If
the firm lowers the price, its competitors are also likely to lower theirs, then all will
suffer from lower profits. On the other hand, raising prices may lead to a loss of market
share unless competitors also raise their prices. In many industries, one firm (usually
the largest) is accepted by the others as the price leader. The price leader will be the
first to adjust prices to new conditions (higher labor costs, lower raw materials costs,
etc.) and the others will fall into line. Of course this arrangement is entirely informal and
unwritten - since any actual agreement to follow such a practice would violate the
antitrust laws.
Price Setting: But on what basis does the price leader set prices? The interplay of
supply and demand forces so beloved by neoclassical economists loses its cogency as
a theory of prices when 1) there is too little competition to force prices to equal
marginal costs and marginal benefits through a Darwinian struggle; 2) costs per unit fall
with increased output as the firm is able to spread its fixed costs over a larger number
of units; and 3) demand is itself subject to manipulation by the firm through advertising.
Institutionalists and Post-Keynesians claim that the structure of oligopoly leads to a
form of administered pricing. The price leader will use its average cost as a basis for
price setting. Prices will be set at a level which achieves a target level of operating
profits. This target level will be sufficient to enable the firm to self-finance expansion
without the need to issue new stock or to borrow amounts of money that might threaten
the firm's independence. Rather than constantly move the price up and down in order
to sell as many units as the firm is capable of producing at a profit, the firm will normally
adjust its output in order to maintain its target price. When this form of administered
pricing is combined with the normal tendency of firms to expand, one result is that firms
will usually have more production capacity than they use. When demand increases,
they will increase output rather than prices.
Enforcement of Price Leadership In the economic as in the political arena, leadership
will occasionally be challenged. Sometimes the mere threat of lowering prices suffices.
In 1989, Miller and Coors tried to expand their market shares by discounting their
premium beers. Anheuser-Busch, with 41 percent of the U.S. beer market, simply
issued a press release:
We cannot permit a further slowing in our volume trend... [the company will take]
appropriate competitive pricing actions to support our long-term market share growth
strategy.
Actually the Anheuser statement is simply a warning to competitors that if they do not
stop discounting they will face a costly battle which they will certainly lose.
But sometimes actual price reductions are necessary. In the late 1960s, Chrysler tired
to break away from the pricing pattern then set by General Motors. But GM was a
larger and more efficient producer and was not about to abandon its price-leader role.
So GM lowered prices below the cost of production in those lines in which Chrysler was
competitive. Thus Chrysler was left with a lower margin per vehicle sold but was still
unable to expand its market share. When GM raised their prices again in 1971 Chrysler
quickly followed. Chrysler also filed suit charging GM (and Ford) with predatory pricing,
but Ford and GM were acquitted due to lack of evidence.
Predatory Pricing A large or diverse firm that can stand temporary losses can cut its
prices below the cost of production until it runs competitors out of business or
establishes its price leadership. Then it can raise prices again. This is illegal. But it is
very hard to prove, since normal competitive pressures can lead to prices set
temporarily below the cost of production.
SOME PRICE LEADERSHIP MODELS
Barometric price leadership: The barometric price leadership is not a dominant firm.
One firm in a group of firms of more or less comparable size comes to pay the role of
price leader, not because of its dominant position in the market but because other firms
regard its actions as a suitable barometer of changing market conditions. They are
willing to follow its policies in the belief that competitive disturbances are minimized by
so doing. But the actual powers of a barometric price leader are greatly restricted by its
realization that other firms will follow him only with reasonable limits.
Two simplified models of price leadership:
Suppose there are only firms in the industry and they have assigned half of the market.
Furthermore, suppose that they are producing homogeneous products, but one firm
has lower costs that the other. The price and output policies of the two firms differ
because of the different cost of the two firms.
This can be illustrated with the following figure:
DD presents the market demand curve and dd represents the firms demand curve. The
firm 1 fixes the price at op 1 and its level of output is OM1 where as the firm 2 fixes its
price at op 2 and produces OM2 amount of output. The firm 2 has comparatively
advantageous position than the firm 1 because of its lower cost. Hence, the firm 2
becomes the price leader.
Differentiate between Accounting profit and economic profit.
Differentiate between Accounting profit and economic profit.
Illustrate with the help of examples.
Profit is defined as the residual value gained from business operations.
However, the exact method of calculation differs between accountants and economists.
Political economists may define profit in still other ways. Sidney Hook defined it as the
cash value of unpaid labor, i.e. the value of all production after the breakeven point.
This avoids deeply vague terms like "residual" and "gained." Economists and
accountants measure profit in slightly different ways, profit will only be the same when
all the factors of production have been credited their full opportunity cost.
Economic profit
Economists usually define profits as revenues less the opportunity costs of labor,
capital, and materials. Furthermore, profits are divided into two types:
Normal profits are the salaries paid to executives in exchange for their
entrepreneurial skills.
Economic profits are what remain after normal profits are subtracted. It is the
economic profit that economists see as the incentive for firms to enter or leave a
market.
Some economists define further types of profit:
Abnormal (or supernormal profit)
Subnormal
monopoly profit
Economic profit is calculated as:
where:
p = profit
P = price per unit
Q = quantity of units sold
AVC = average variable cost
F = total fixed costs
Economic profit can also be calculated by
where C(q) is the cost function with respect to quantity.
The derivative of the cost function is the marginal cost, and the value of the cost
function with quantity 0 are the total fixed costs.
Accounting profit
In the accounting sense of the term, net profit (before tax) is the residual after
deduction of all money costs such as; wages, rent, fuel, raw materials, interest on loans
and depreciation. Gross profit is profit before depreciation and interest, Net profit after
tax is after the deduction of either corporate tax (for a company) or income tax (for an
individual). Operating profit is a measure of a company's earning power from ongoing
operations, equal to earnings before the deduction of interest payments and income
taxes.
Another definition of accounting profit is the total revenue minus costs properly
chargeable against the goods sold.
TR = Total Revenue
TC = Total Cost
AR = Average Revenue
AC = Average Cost
Q = Quantity demanded/sold
Profit = TR - TC
Profit = (AR * Q) - (AC * Q)
Profit = Q * (AR - AC)
TR = TC results in normal profit.
TR > TC results in supernormal profit.
Economic profit versus Accounting profit
In calculating economic profit, opportunity costs are deducted from revenues earned.
Opportunity costs are the alternative returns foregone by using the chosen inputs. As a
result, you can have a significant accounting profit with little to no economic profit.
For example, say you invest $100,000 to start a business, and in that year you earn
$120,000 in profits. Your accounting profit would be $20,000. However, say that same
year you could have earned an income of $45,000 had you been employed. Therefore,
you have an economic loss of $25,000 (120,000 - 100,000 - 45,000).
Illustrate with the help of examples.
Profit is defined as the residual value gained from business operations.
However, the exact method of calculation differs between accountants and economists.
Political economists may define profit in still other ways. Sidney Hook defined it as the
cash value of unpaid labor, i.e. the value of all production after the breakeven point.
This avoids deeply vague terms like "residual" and "gained." Economists and
accountants measure profit in slightly different ways, profit will only be the same when
all the factors of production have been credited their full opportunity cost.
Economic profit
Economists usually define profits as revenues less the opportunity costs of labor,
capital, and materials. Furthermore, profits are divided into two types:
Normal profits are the salaries paid to executives in exchange for their
entrepreneurial skills.
Economic profits are what remain after normal profits are subtracted. It is the
economic profit that economists see as the incentive for firms to enter or leave a
market.
Some economists define further types of profit:
Abnormal (or supernormal profit)
Subnormal
monopoly profit
Economic profit is calculated as:
where:
p = profit
P = price per unit
Q = quantity of units sold
AVC = average variable cost
F = total fixed costs
Economic profit can also be calculated by
where C(q) is the cost function with respect to quantity.
The derivative of the cost function is the marginal cost, and the value of the cost
function with quantity 0 are the total fixed costs.
Accounting profit
In the accounting sense of the term, net profit (before tax) is the residual after
deduction of all money costs such as; wages, rent, fuel, raw materials, interest on loans
and depreciation. Gross profit is profit before depreciation and interest, Net profit after
tax is after the deduction of either corporate tax (for a company) or income tax (for an
individual). Operating profit is a measure of a company's earning power from ongoing
operations, equal to earnings before the deduction of interest payments and income
taxes.
Another definition of accounting profit is the total revenue minus costs properly
chargeable against the goods sold.
TR = Total Revenue
TC = Total Cost
AR = Average Revenue
AC = Average Cost
Q = Quantity demanded/sold
Profit = TR - TC
Profit = (AR * Q) - (AC * Q)
Profit = Q * (AR - AC)
TR = TC results in normal profit.
TR > TC results in supernormal profit.
Economic profit versus Accounting profit
In calculating economic profit, opportunity costs are deducted from revenues earned.
Opportunity costs are the alternative returns foregone by using the chosen inputs. As a
result, you can have a significant accounting profit with little to no economic profit.
For example, say you invest $100,000 to start a business, and in that year you earn
$120,000 in profits. Your accounting profit would be $20,000. However, say that same
year you could have earned an income of $45,000 had you been employed. Therefore,
you have an economic loss of $25,000 (120,000 - 100,000 - 45,000).
What do you understand by demand forecasting?
What do you understand by demand forecasting? Survey method is
one of the techniques of demand forecasting. Discuss its different types.
Demand forecasting is predicting future demand for a product. The
information regarding future demand is essential for planning and scheduling
production, purchase of raw materials, acquisition of finance and advertising. It is much
more where large-scale production is being planned and production involves a long
gestation period.
TYPES OF DEMAND FORECASTING
There are two broad categories of forecasting. They are:
Short-term forecasting
Long –term forecasting
Short-term Forecasting
Forecasts for short periods normally do not exceed a year. There are number of
purposes for which short term forecasts may be used. They are:
In most companies knowledge of condition in the immediate future is essential for
evolving a suitable sales policy. Production schedules have to be geared to expected
sales, rather than to actual sales. If the firm assumes that prevailing conditions
continue in the next year also, then it only has to face the problem of over production or
short supply. Evolving suitable production policy is necessary to avoid the problem of
over –production and the problem of short supply.
Knowledge of near future conditions is important in purchasing. If prices of materials
are expected to rise or shortages are expected, businessman may take advantage of
the rise by easier buying. Proper price forecasting may, thus, help the firm in reducing
costs of operation.
Sales forecasting is useful to the businessman in determining appropriate price policy.
An increase of price is avoided when future market conditions are not expected to be
strong and the lowering of prices is avoided when costs and sales levels are likely to
rise substantially.
Many companies use forecasting for setting sales targets and for establishing controls
and incentives. If targets are set too high, they will be discouraging salesman who fail
to achieve them. If set too low, the targets will be achieved easily and hence incentives
will prove meaningless.
Short term sales forecasting will be of assistance. In short term financial forecasting
cash requirements depend on sales levels and production operators. Moreover it takes
time to arrange for funds on reasonable terms. Neglect of sales forecasting will
therefore complicate financial planning of the company.
Long-term Forecasting
In short term forecasting, a company is concerned only about the use if its existing
production capacity. But in the long term, capacity can be expanded or reduced. If the
capacity is too limited some orders can not be filled and potential business is lost. In
order to minimize these errors, the businessman must know something about long term
demand for his product.
Forecasts are important for several aspects of long term planning. They are as follows:
Planning of a new unit as expansion of an existing unit must start with an analysis of
the long-term demand potential of the products of the firm. A multi product firm must
ascertain not only the total demand situations, but also the demand for different terms.
If a company has better knowledge than its rivals of the growth trends of the aggregate
demand and of the distribution of the demand, its competitive position would be much
better. Once the demand potential is assessed it will easier for company to engage in
long term financial planning. Planning for raising funds require considerable advance
notice.
Man power requirement in existing as will as new firms must be based on long-term
forecasts of the company’s growth. Man power planning requires considerable lead
time as training and personnel development are long term prepositions.
1. Opinion Poll Methods
a. Expert’s opinion survey method: Obtaining views from a group of specialists
outside the firm has the possible advantages of speed and cheapness. This method is
best suited in situations where intractable changes are occurring. Example: forecasting
future technological states. It is possible that in cases where basic data are lacking
experts may give divergent views, but even then it is possible for the manager to adapt
his thinking on the basis of these views. Although this method is simple and
inexpensive, it has its own limitations. First, estimates provided by the sales
representatives or professional experts are reliable only to an extent depending on
their skill to analyze the market and their experience. Second, demand estimates may
involve the subjective judgement of the assessor that may lead to over or under
estimation. Finally, the assessment of market demand is usually based on inadequate
information available to the sales representatives they have only a narrow view of
market.
b. Delphi Method: This method is an extension of the simple expert opinion poll
method. At its simplest, panel members are asked by letters to give their predictions of
the likelihood of occurrence of specified events. Postal anonymity from other panel
members minimizes the impact of personal inhibitions on the making of speculations
about the future. Panel members are then informed by letters of the outcome and
particulars of the consensus. Those who dissent are invited to give reasons or else
modify their forecasts. This process may be repeated and the final range of outcome is
regarded as a probabilistic forecast.
c. Market Studies and Experiments: An alternative method of collecting necessary
information regarding demand is to carry out market studies and experiments on
consumer’s behaviour under actual, though controlled, market conditions. This method
is known in common parlance as market experiment method. Under this method, forms
first select some areas of representative markets- three or four cities having similar
features, viz., population, income levels, etc. Then they carry out market experiments
by changing prices, advertisement expenditure and other controllable variables in the
demand function under the assumption that other things remain same. The controllable
variables may be changed over time. After such changes are introduced, the
consequent changes in the demand over a period of time are recorded. On the basis of
data collected, elasticity coefficients are computed. These coefficients are then used
along with the variables of the demand function to assess the demand for the product.
2. Consumers survey method
This method uses the most direct approach to demand forecasting by directly asking
the consumers about their future consumption plan. It is of three types:
Complete Enumeration Survey
Sample Survey
End-use Method
a. Complete Enumeration survey: In the complete enumeration survey, the probable
demands of all the consumers for the forecast period are summed up to have the sales
forecast for the forecast period. For example, if there are n consumers and their
probable demands for commodity X in the forecast period are x1, x2, x3…………… xn, the
sales forecast would be
?X = X1 + X2 + X3 + X4
The advantages of this method are:
it gives an unbiased information
if all consumers expect accurately. The forecast will be accurate.
However, the disadvantages are:
contact with a large number of consumers
tedious and cumbersome
the authenticity of data is doubtful.
Nevertheless, sales forecasts for products having a few consumers may be attempted
by this method.
b. Sample Survey: Under the sample survey method, the probable demand expressed
by each selected unit is summed up to get the total demand of sample units in the
forecast period. It is then blown up to find the total demand in the market. That is, the
total sample demand id multiplied by the ratio of number of consuming units in the
population to the number of consuming units in the sample.
This method when carefully applied gives good results especially for new products and
brands. Care should be taken is choosing a sample size which should not be too small
(it will have high sampling error) or too big (it will have little error but will be costly and
tedious). The advantages of sample survey over complete enumeration method are:
less tedious
less costly
less data error
c. End use method: The sale of the product under consideration is projected on the
basis of demand survey of the industries using this product as an intermediate product.
Demand for the final product is the end-use demand of the intermediate product used
in the production of this final product. However, an intermediate product may have may
end-uses (like steel can be used in agricultural machinery, construction, etc). It may
have demand in both domestic and international markets. The demands for final
consumption and exports net of imports are estimated through some other forecasting
method and its demand for intermediate use is estimated through survey of its user
industries regarding their production plans and input-output coefficient. Then the sum
of final consumption demand and exports net of imports of any commodity can be
obtained with the help of an input-output coefficient. Then the sum of final consumption
demand and exports demand net of imports of any commodity can be obtained with the
help of an input-output model.
Such a method is feasible for national planning organizations only and not industry.
The weaknesses of this method are:
(i) It requires every industry to furnish its plan of production correctly and well-ahead of
time.
(ii) Individual industry will have to rely on some other method to estimate the future
demand of its product for final consumption.
(iii) Only the intermediate demand or the input demand part of total demand for a
commodity can be predicted.
The advantages of this method are:
(i) Provides use-wise or sector-wise demand forecasts.
(ii) Does not require any historical data.
(iii) If the number of end users of a product is limited, it will be convenient to use this
method.
one of the techniques of demand forecasting. Discuss its different types.
Demand forecasting is predicting future demand for a product. The
information regarding future demand is essential for planning and scheduling
production, purchase of raw materials, acquisition of finance and advertising. It is much
more where large-scale production is being planned and production involves a long
gestation period.
TYPES OF DEMAND FORECASTING
There are two broad categories of forecasting. They are:
Short-term forecasting
Long –term forecasting
Short-term Forecasting
Forecasts for short periods normally do not exceed a year. There are number of
purposes for which short term forecasts may be used. They are:
In most companies knowledge of condition in the immediate future is essential for
evolving a suitable sales policy. Production schedules have to be geared to expected
sales, rather than to actual sales. If the firm assumes that prevailing conditions
continue in the next year also, then it only has to face the problem of over production or
short supply. Evolving suitable production policy is necessary to avoid the problem of
over –production and the problem of short supply.
Knowledge of near future conditions is important in purchasing. If prices of materials
are expected to rise or shortages are expected, businessman may take advantage of
the rise by easier buying. Proper price forecasting may, thus, help the firm in reducing
costs of operation.
Sales forecasting is useful to the businessman in determining appropriate price policy.
An increase of price is avoided when future market conditions are not expected to be
strong and the lowering of prices is avoided when costs and sales levels are likely to
rise substantially.
Many companies use forecasting for setting sales targets and for establishing controls
and incentives. If targets are set too high, they will be discouraging salesman who fail
to achieve them. If set too low, the targets will be achieved easily and hence incentives
will prove meaningless.
Short term sales forecasting will be of assistance. In short term financial forecasting
cash requirements depend on sales levels and production operators. Moreover it takes
time to arrange for funds on reasonable terms. Neglect of sales forecasting will
therefore complicate financial planning of the company.
Long-term Forecasting
In short term forecasting, a company is concerned only about the use if its existing
production capacity. But in the long term, capacity can be expanded or reduced. If the
capacity is too limited some orders can not be filled and potential business is lost. In
order to minimize these errors, the businessman must know something about long term
demand for his product.
Forecasts are important for several aspects of long term planning. They are as follows:
Planning of a new unit as expansion of an existing unit must start with an analysis of
the long-term demand potential of the products of the firm. A multi product firm must
ascertain not only the total demand situations, but also the demand for different terms.
If a company has better knowledge than its rivals of the growth trends of the aggregate
demand and of the distribution of the demand, its competitive position would be much
better. Once the demand potential is assessed it will easier for company to engage in
long term financial planning. Planning for raising funds require considerable advance
notice.
Man power requirement in existing as will as new firms must be based on long-term
forecasts of the company’s growth. Man power planning requires considerable lead
time as training and personnel development are long term prepositions.
1. Opinion Poll Methods
a. Expert’s opinion survey method: Obtaining views from a group of specialists
outside the firm has the possible advantages of speed and cheapness. This method is
best suited in situations where intractable changes are occurring. Example: forecasting
future technological states. It is possible that in cases where basic data are lacking
experts may give divergent views, but even then it is possible for the manager to adapt
his thinking on the basis of these views. Although this method is simple and
inexpensive, it has its own limitations. First, estimates provided by the sales
representatives or professional experts are reliable only to an extent depending on
their skill to analyze the market and their experience. Second, demand estimates may
involve the subjective judgement of the assessor that may lead to over or under
estimation. Finally, the assessment of market demand is usually based on inadequate
information available to the sales representatives they have only a narrow view of
market.
b. Delphi Method: This method is an extension of the simple expert opinion poll
method. At its simplest, panel members are asked by letters to give their predictions of
the likelihood of occurrence of specified events. Postal anonymity from other panel
members minimizes the impact of personal inhibitions on the making of speculations
about the future. Panel members are then informed by letters of the outcome and
particulars of the consensus. Those who dissent are invited to give reasons or else
modify their forecasts. This process may be repeated and the final range of outcome is
regarded as a probabilistic forecast.
c. Market Studies and Experiments: An alternative method of collecting necessary
information regarding demand is to carry out market studies and experiments on
consumer’s behaviour under actual, though controlled, market conditions. This method
is known in common parlance as market experiment method. Under this method, forms
first select some areas of representative markets- three or four cities having similar
features, viz., population, income levels, etc. Then they carry out market experiments
by changing prices, advertisement expenditure and other controllable variables in the
demand function under the assumption that other things remain same. The controllable
variables may be changed over time. After such changes are introduced, the
consequent changes in the demand over a period of time are recorded. On the basis of
data collected, elasticity coefficients are computed. These coefficients are then used
along with the variables of the demand function to assess the demand for the product.
2. Consumers survey method
This method uses the most direct approach to demand forecasting by directly asking
the consumers about their future consumption plan. It is of three types:
Complete Enumeration Survey
Sample Survey
End-use Method
a. Complete Enumeration survey: In the complete enumeration survey, the probable
demands of all the consumers for the forecast period are summed up to have the sales
forecast for the forecast period. For example, if there are n consumers and their
probable demands for commodity X in the forecast period are x1, x2, x3…………… xn, the
sales forecast would be
?X = X1 + X2 + X3 + X4
The advantages of this method are:
it gives an unbiased information
if all consumers expect accurately. The forecast will be accurate.
However, the disadvantages are:
contact with a large number of consumers
tedious and cumbersome
the authenticity of data is doubtful.
Nevertheless, sales forecasts for products having a few consumers may be attempted
by this method.
b. Sample Survey: Under the sample survey method, the probable demand expressed
by each selected unit is summed up to get the total demand of sample units in the
forecast period. It is then blown up to find the total demand in the market. That is, the
total sample demand id multiplied by the ratio of number of consuming units in the
population to the number of consuming units in the sample.
This method when carefully applied gives good results especially for new products and
brands. Care should be taken is choosing a sample size which should not be too small
(it will have high sampling error) or too big (it will have little error but will be costly and
tedious). The advantages of sample survey over complete enumeration method are:
less tedious
less costly
less data error
c. End use method: The sale of the product under consideration is projected on the
basis of demand survey of the industries using this product as an intermediate product.
Demand for the final product is the end-use demand of the intermediate product used
in the production of this final product. However, an intermediate product may have may
end-uses (like steel can be used in agricultural machinery, construction, etc). It may
have demand in both domestic and international markets. The demands for final
consumption and exports net of imports are estimated through some other forecasting
method and its demand for intermediate use is estimated through survey of its user
industries regarding their production plans and input-output coefficient. Then the sum
of final consumption demand and exports net of imports of any commodity can be
obtained with the help of an input-output coefficient. Then the sum of final consumption
demand and exports demand net of imports of any commodity can be obtained with the
help of an input-output model.
Such a method is feasible for national planning organizations only and not industry.
The weaknesses of this method are:
(i) It requires every industry to furnish its plan of production correctly and well-ahead of
time.
(ii) Individual industry will have to rely on some other method to estimate the future
demand of its product for final consumption.
(iii) Only the intermediate demand or the input demand part of total demand for a
commodity can be predicted.
The advantages of this method are:
(i) Provides use-wise or sector-wise demand forecasts.
(ii) Does not require any historical data.
(iii) If the number of end users of a product is limited, it will be convenient to use this
method.
Opportunity cost principle, Equi-marginal principle
Write short notes on:
a. Opportunity cost principle
b. Equi-marginal principle
Illustrate your answers with examples.
(a) Opportunity cost principle
Opportunity costs are cash outflows prevented by taking one course of action instead
of another. They include returns, which the entrepreneur could have earned in
alternative use of his services and capital.
The concept of opportunity cost occupies a very important place in modern economic
analysis. The opportunity costs or alternative costs are the return from the second best
use of the firm’s resources which the firm forgoes in order to avail itself of the return
from the best use of the resources. To take an example, a farmer who is producing
wheat can also produce potatoes with the same factors. Therefore, the opportunity cost
of a quintal of wheat is the amount of the output of potatoes given up. Thus we find that
opportunity cost of anything is the next best alternative that could be produced instead
by the same factors or by an equivalent group of factors, costing the same amount of
money. Two points must be noted in this definition. Firstly, the opportunity cost of
anything is only the next best alternative foregone. Secondly, in the above definition is
the addition of the qualification or by an equivalent group of factors costing the same
amount of money.
The alternative or opportunity cost of a good can be given a money value. In order to
produce a good the producer has to employ various factors of production and have to
pay them sufficient prices to get their services. These factors have alternative uses.
The factor must be paid atleast the price they are able to obtain in the alternative uses.
Suppose a businessman can buy either a washing machine or a press machine with his
limited resources and suppose that he can earn annually Rs. 40,000 and 60,000
respectively from the two alternatives. A rational businessman will certainly buy a press
machine that gives him a higher return. But, in the process of earning Rs. 60,000 he
has foregone the opportunity to earn Rs. 40,000 annually from the washing machine.
Thus, Rs. 40,000 is his opportunity cost or alternative cost. The difference between
actual and opportunity costs is called economic rent or economic rent or economic
profit. For example, economic profit from press machine in the above case is Rs.
60,000 –Rs. 4000 = Rs. 20,000. So long as economic profit is above zero, it is rational
to invest resources in press machine.
(b) Equi-marginal principle
The equi-marginal principle was originally associated with consumption theory and the
law is called ‘the law of equi-marginal utility’. The law of equi-marginal utility states that
a utility maximizing consumer distributes his consumption expenditure between various
goods and services he/she consumes in such a way that the marginal utility derived
from each unit of expenditure on various goods and services is the same. The pattern
of consumer’s expenditure maximizes a consumer’s total utility.
The law of equi-marginal principle has been applied to the allocation of resources
between their alternative uses with a view to maximizing profit in case a firm carries out
more than one business activity. This principle suggests that available resources
(inputs) should be so allocated between the alternative options that the marginal
productivity gain (MP) from the various activities are equalized. For example, suppose
a firm has a total capital of Rs. 100 million which it has the option of spending on three
projects, A, B, and C. Each of these projects requires a unit expenditure of Rs. 10
million. Suppose also that the marginal productivity schedule of each unit of
expenditure on the three projects is given as shown in the following table.
Units of Expenditure Marginal Productivity (MP)
(Rs. 10 million) Project A Project B Project C
1st 501 403 354
2nd 452 305 306
3rd 357 208 209
4th 2010 10 15
5th 10 0 12
Going by the equi-marginal principle, the firm will allocate its total resource (Rs. 100
million) among the projects A, B and C in such a way that marginal product of each
project is the same i.e., MpA = MPB = MPC. It can be seen from the above table that
going, by this rule, the firm will spend 1st, 2nd, 7th, and 10th unit of finance on project A,
3rd, 5th, and 8th unit on Project B, and 4th, 6th, and 9th unit on project C. In all, it puts 4
units of its finances in project A, 3 units each in projects n and C. In other words, of the
total finances of Rs. 100 million, a profit maximization firm would invest rs. 40 million in
project A, Rs. 30 million each in projects B and C. This pattern of investment maximizes
the form’s productivity gains. No other pattern will ensure this objective.
The equi-marginal principle suggests that a profit maximizing firms allocates
MpA = MPB = MPC = … = MPN
If cost of project (COP) varies from project to project, then resources are so allocated
that MP per unit of COP is the same. That is, resources are are allocated in such
proportions that
The equi-marginal principle can be applied only where (i) firms have limited investible
resources, (ii) resources have alternative uses, and (iii) the investment in various
alternative uses is subject to diminishing marginal productivity or returns.
a. Opportunity cost principle
b. Equi-marginal principle
Illustrate your answers with examples.
(a) Opportunity cost principle
Opportunity costs are cash outflows prevented by taking one course of action instead
of another. They include returns, which the entrepreneur could have earned in
alternative use of his services and capital.
The concept of opportunity cost occupies a very important place in modern economic
analysis. The opportunity costs or alternative costs are the return from the second best
use of the firm’s resources which the firm forgoes in order to avail itself of the return
from the best use of the resources. To take an example, a farmer who is producing
wheat can also produce potatoes with the same factors. Therefore, the opportunity cost
of a quintal of wheat is the amount of the output of potatoes given up. Thus we find that
opportunity cost of anything is the next best alternative that could be produced instead
by the same factors or by an equivalent group of factors, costing the same amount of
money. Two points must be noted in this definition. Firstly, the opportunity cost of
anything is only the next best alternative foregone. Secondly, in the above definition is
the addition of the qualification or by an equivalent group of factors costing the same
amount of money.
The alternative or opportunity cost of a good can be given a money value. In order to
produce a good the producer has to employ various factors of production and have to
pay them sufficient prices to get their services. These factors have alternative uses.
The factor must be paid atleast the price they are able to obtain in the alternative uses.
Suppose a businessman can buy either a washing machine or a press machine with his
limited resources and suppose that he can earn annually Rs. 40,000 and 60,000
respectively from the two alternatives. A rational businessman will certainly buy a press
machine that gives him a higher return. But, in the process of earning Rs. 60,000 he
has foregone the opportunity to earn Rs. 40,000 annually from the washing machine.
Thus, Rs. 40,000 is his opportunity cost or alternative cost. The difference between
actual and opportunity costs is called economic rent or economic rent or economic
profit. For example, economic profit from press machine in the above case is Rs.
60,000 –Rs. 4000 = Rs. 20,000. So long as economic profit is above zero, it is rational
to invest resources in press machine.
(b) Equi-marginal principle
The equi-marginal principle was originally associated with consumption theory and the
law is called ‘the law of equi-marginal utility’. The law of equi-marginal utility states that
a utility maximizing consumer distributes his consumption expenditure between various
goods and services he/she consumes in such a way that the marginal utility derived
from each unit of expenditure on various goods and services is the same. The pattern
of consumer’s expenditure maximizes a consumer’s total utility.
The law of equi-marginal principle has been applied to the allocation of resources
between their alternative uses with a view to maximizing profit in case a firm carries out
more than one business activity. This principle suggests that available resources
(inputs) should be so allocated between the alternative options that the marginal
productivity gain (MP) from the various activities are equalized. For example, suppose
a firm has a total capital of Rs. 100 million which it has the option of spending on three
projects, A, B, and C. Each of these projects requires a unit expenditure of Rs. 10
million. Suppose also that the marginal productivity schedule of each unit of
expenditure on the three projects is given as shown in the following table.
Units of Expenditure Marginal Productivity (MP)
(Rs. 10 million) Project A Project B Project C
1st 501 403 354
2nd 452 305 306
3rd 357 208 209
4th 2010 10 15
5th 10 0 12
Going by the equi-marginal principle, the firm will allocate its total resource (Rs. 100
million) among the projects A, B and C in such a way that marginal product of each
project is the same i.e., MpA = MPB = MPC. It can be seen from the above table that
going, by this rule, the firm will spend 1st, 2nd, 7th, and 10th unit of finance on project A,
3rd, 5th, and 8th unit on Project B, and 4th, 6th, and 9th unit on project C. In all, it puts 4
units of its finances in project A, 3 units each in projects n and C. In other words, of the
total finances of Rs. 100 million, a profit maximization firm would invest rs. 40 million in
project A, Rs. 30 million each in projects B and C. This pattern of investment maximizes
the form’s productivity gains. No other pattern will ensure this objective.
The equi-marginal principle suggests that a profit maximizing firms allocates
MpA = MPB = MPC = … = MPN
If cost of project (COP) varies from project to project, then resources are so allocated
that MP per unit of COP is the same. That is, resources are are allocated in such
proportions that
The equi-marginal principle can be applied only where (i) firms have limited investible
resources, (ii) resources have alternative uses, and (iii) the investment in various
alternative uses is subject to diminishing marginal productivity or returns.
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