Managerial economics book

MANAGERIAL ECONOMICS

BABASAB PATIL (BEC DOMS )


SYLLABUS

Unit 1 Managerial economics: Meaning, nature and scope;

Economic theory and managerial economic; Managerialeconomics and business decision making; Role ofmanagerial economics.

Unit 2 Demand Analysis: Meaning, types and determinants ofdemand.

Unit 3 Cost Concepts: Cost function and cost output

relationship; Economics and diseconomies of scale; Costcontrol and cost reduction.

Unit 4 Production Functions: Pricing and output decisionsunder competitive conditions; Government control overpricing; Price discrimination; Price discount and

differentials.Unit 5 Profit: Measurement of profit; Profit planning and

forecasting; Profit maximization; Cost volume profit

analysis; Investment analysis.Unit 6 National Income: Business cycle; Inflation and deflation;

Balance of payment; Their implications in managerialdecision.



CONTENTS

1. NATURE & SCOPE OF MANAGERIAL ECONOMICS

2. DEMAND ANALYSIS

3. COST CONCEPTS

4. PRODUCTION FUNCTION

5. PROFIT

6. NATIONAL INCOME



LESSON – 1

NATURE & SCOPE OF MANAGERIAL ECONOMICS

The terms Managerial Economics and Business Economics are oftenused interchangeably. However, the terms Managerial Economics has

become more popular and seems to displace Business Economics.

DECISION-MAKING AND FORWARD PLANNINGThe chief function of a management executive in a business firm isdecision-making and forward planning. Decision-making refers to the

process of selecting one action from two or more alternative coursesof action. Forward planning on the other hand is arranging plans forthe future. In the functioning of a firm the question of choice arises

because the available resources such as capital, land, labour andmanagement, are limited and can be employed in alternative uses. The

decision-making function thus involves making choices or decisionsthat will provide the most efficient means of attaining anorganisational objectives, for example profit maximization. Once a

decision is made about the particular goal to be achieved, plans for thefuture regarding production, pricing, capital, raw materials and labourare prepared. Forward planning thus goes hand in hand with

decision-making. The conditions in which firms work and takedecisions, is characterised with uncertainty. And this uncertainty not

only makes the function of decision-making and forward planningcomplicated but also adds a different dimension to it. If the knowledgeof the future were perfect, plans could be formulated without error

and hence without any need for subsequent revision. In the real world,however, the business manager rarely has complete information aboutthe future sales, costs, profits, capital conditions. etc. Hence, decisions

are made and plans are formulated on the basis of past data, currentinformation and the estimates about future that are predicted as

accurately as possible. While the plans are implemented over time,



more facts come into the knowledge of the businessman. Inaccordance with these facts the plans may have to be revised, and adifferent course of action needs to be adopted. Managers are thus

engaged n a continuous process of decision-making through anuncertain future and the overall problem that they deal with isadjusting to uncertainty.

To execute the function of ‘decision-making in an uncertainframe-work’, economic theory can be applied with considerable

advantage. Economic theory deals with a number of concepts andprinciples relating to profit, demand, cost, pricing, production,competition, business cycles and national income, which are aided by

allied disciplines like accounting. Statistics and Mathematics also canbe used to solve or at least throw some light upon the problems ofbusiness management. The way economic analysis can be used

towards solving business problems constitutes the subject matter ofManagerial Economics.

DEFINITIONAccording to McNair the Merriam, Managerial Economics consists of

the use of economic modes of thought to analyse business situations.Spencer and Siegelman have defined Managerial Economics as

“the integration of economic theory with business practice for the

purpose of facilitating decision-making and forward planning bymanagement.”

The above definitions suggest that Managerial economics is thediscipline, which deals with the application of economic theory tobusiness management. Managerial Economics thus lies on the margin

between economics and business management and serves as thebridge between the two disciplines. The following Figure 1.1 shows therelationship between economics, business management and

managerial economics.



APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT

The application of economics to business management or theintegration of economic theory with business practice, as Spencer andSiegelman have put it, has the following aspects :

Reconciling traditional theoretical concepts of economics inrelation to the actual business behavior and conditions: In

economic theory, the technique of analysis is that of modelbuilding. This involves making some assumptions and, drawingconclusions on the basis of the assumptions about the behavior

of the firms. The assumptions, however, make the theory of thefirm unrealistic since it fails to provide a satisfactory explanation

of what the firms actually do. Hence, there is need to reconcilethe theoretical principles based on simplified assumptions withactual business practice and develop appropriate extensions and

reformulation of economic theory. For example, it is usuallyassumed that firms aim at maximising profits. Based on this, thetheory of the firm suggests how much the firm will produce and

at what price it would sell. In practice, however, firms do notalways aim at maximum profits (as they may think of

diversifying or introducing new product etc.) To that extent, thetheory of the firm fails to provide a satisfactory explanation ofthe firm’s actual behavior. Moreover, in actual business



language, certain terms like profits and costs have accountingconcepts as distinguished from economic concepts. Inmanagerial economics, an attempt is made to merge the

accounting concepts with the economics, an attempt is made tomerge the accounting concepts with the economic concepts.This helps in a more effective use of financial data related to

profits and costs to suit the needs of decision-making andforward planning.

Estimating economic relationships: This involves the

measurement of various types of elasticities of demand such asprice elasticity, income elasticity, cross-elasticity, promotional

elasticity and cost-output relationships. The estimates of theseeconomic relationships are to be used for the purpose offorecasting.

Predicting relevant economic quantities: Economic quantitiessuch as profit, demand, production, costs, pricing and capital

are predicated in numerical terms together with theirprobabilities. As the business manager has to work in anenvironment of uncertainty, the future needs to be foreseen so

that in the light of the predicted estimates, decision-making andforward planning may be possible.

Using economic quantities in decision-making and forward

planning: This involves formulating business policies forestablishing future business plans. This nature of economic

forecasting indicates the degree of probability of variouspossible outcomes, i.e., losses or gains that will occur as a resultof following each one of the available strategies. Thus, a

quantified picture gets set up, that indicates the number ofcourses open, their possible outcomes and the quantified

probability of each outcome. Keeping this picture in view, thebusiness manager is able to decide about which strategy shouldbe chosen.



Understanding significant external forces: Applying economic

theory to business management also involves understanding theimportant external forces that constitute the business

environment and with which a business must adjust. Businesscycles, fluctuations in national income and government policiespertaining to taxation, foreign trade, labour relations,

antimonopoly measures, industrial licensing and price controlsare typical examples. The business manager has to appraise the

relevance and impact of these external forces in relation to theparticular business unit and its business policies.

CHARACTERISTICS OF MANAGERIAL ECONOMICSThere are certain chief characteristics of managerial economics, which

can help to understand the nature of the subject matter and help in aclear understanding of the following terms:

Managerial economics is micro-economic in character. This is

because the unit of study is a firm and its problems. Managerialeconomics does not deal with the entire economy as a unit of

study.

Managerial economics largely uses that body of economicconcepts and principles, which is known as Theory of the Firm or

Economics of the Firm. In addition, it also seeks to apply profittheory, which forms part of distribution theories in economics.

Managerial economics is concrete and realistic. I avoids difficult

abstract issues of economic theory. But it also involvescomplications ignored in economic theory in order to face the

overall situation in which decisions are made. Economic theoryignores the variety of backgrounds and training found inindividual firms. Conversely, managerial economics is concerned



more with the particular environment that influencesdecision-making.

Managerial economics belongs to normative economics rather

than positive economics. Normative economy is the branch ofeconomics in which judgments about the desirability of variouspolicies are made. Positive economics describes how the

economy behaves and predicts how it might change. In otherwords, managerial economics is prescriptive rather than

descriptive. It remains confined to descriptive hypothesis.

Managerial economics also simplifies the relations amongdifferent variables without judging what is desirable or

undesirable. For instance, the law of demand states that as priceincreases, demand goes down or vice-versa but this statement

does not imply if the result is desirable or not. Managerialeconomics, however, is concerned with what decisions ought tobe made and hence involves value judgments. This further has

two aspects: first, it tells what aims and objectives a firm shouldpursue; and secondly, how best to achieve these aims inparticular situations. Managerial economics, therefore, has been

described as normative microeconomics of the firm.

Macroeconomics is also useful to managerial economics since it

provides an intelligent understanding of the businessenvironment. This understanding enables a business executiveto adjust with the external forces that are beyond the

management’s control but which play a crucial role in the wellbeing of the firm. The important forces are: business cycles,national income accounting, and economic policies of the

government like those relating to taxation foreign trade,anti-monopoly measures and labour relations.

DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICSThe difference between managerial economics and economics can be

understood with the help of the following points:



Managerial economics involves application of economic

principles to the problems of a business firm whereas;economics deals with the study of these principles only.

Economics ignores the application of economic principles to theproblems of a business firm.

Managerial economics is micro-economic in character, however,

Economics is both macro-economic and micro-economic.

Managerial economics, though micro in character, deals only

with a firm and has nothing to do with an individual’s economicproblems. But microeconomics as a branch of economics dealswith both economics of the individual as well as economics of a

firm.

Under microeconomics, the distribution theories, viz., wages,

interest and profit, are also dealt with. Managerial economics onthe contrary is mainly concerned with profit theory and does notconsider other distribution theories. Thus, the scope of

economics is wider than that of managerial economics.

Economic theory assumes economic relationships and builds

economic models. Managerial economics adopts, modifies andreformulates the economic models to suit the specific conditionsand serves the specific problem solving process. Thus,

economics gives the simplified model, whereas managerialeconomics modifies and enlarges it.

Economics involves the study of certain assumptions like in the

law of proportion where it is assumed that “The variable input asapplied, unit by unit is homogeneous or identical in amount and

quality”. Managerial economics on the other hand, introducescertain feedbacks. These feedbacks are in the form of objectivesof the firm, multi-product nature of manufacture, behavioral

constraints, environmental aspects, legal constraints, constraintson resource availability, etc. Thus managerial economics,

attempts to solve the complexities in real life, which areassumed in economics. this is done with the help of



mathematics, statistics, econometrics, accounting, operationsresearch, etc.

OTHER TERMS FOR MANAGERIAL ECONOMICSCertain other expressions like economic analysis for businessdecisions and economics of business management have also been

used instead of managerial economics but they are not so popular.Sometimes expressions like ‘Economics of the Enterprise’, ‘Theory of

the Firm’ or ‘Economics of the Firm’ have also been used formanagerial economics. It is, however, not appropriate t use thesesterms because managerial economics, though primarily related to the

economics of the firm, differs from it in the following respects:

First, ‘Economics of the Firm’ deals with the theory of the firm,which is a body of economic principles relating to the firm alone.

Managerial economics on the other hand deals with the,application of the same principles to business.

Secondly, the term ‘Economics of the firm’ is too simple in its

assumptions whereas managerial economics has to reckon withactual business behaviour, which is much more complex.

SCOPE OF MANAGERIAL ECONOMICS

As regards the scope of managerial economics, there is no generaluniform pattern. However, the following aspects may be said to beinclusive under managerial economics:

Demand analysis and forecasting.

Cost and production analysis.

Pricing decisions, policies and practices.

Profit management.

Capital management.

These aspects may also be defined as the ‘Subject-Matter ofManagerial Economics’. In recent years, there is a trend towards

integrations of managerial economics and operations research. Hence,



techniques such as linear programming, inventory models and theoryof games have also been regarded as a part of managerial economics.

Demand Analysis and ForecastingA business firm is an economic Organisation, which transformsproductive resources into goods that are to be sold in a market. A

major part of managerial decision-making depends on accurateestimates of demand. This is because before production schedules can

be prepared and resources are employed, a forecast of future sales isessential. This forecast can also guide the management in maintainingor strengthening the market position and enlarging profits. The

demand analysis helps to identify the various factors influencingdemand for a firm’s product and thus provides guidelines tomanipulate demand. Demand analysis and forecasting, thus, is

essential for business planning and occupies a strategic place inmanagerial economics. It comprises of discovering the forces

determining sales and their measurement. The chief topics covered inthis are:

Demand determinants

Demand distinctions

Demand forecasting.

Cost and Production AnalysisA study of economic costs, combined with the data drawn from the

firm’s accounting records, can yield significant cost estimates. Theseestimates are useful for management decisions. The factors causingvariations in costs must be recognised and thereby should be used for

taking management decisions. This facilitates the management toarrive at cost estimates, which are significant for planning purposes.

An element of cost uncertainty exists in this because all the factorsdetermining costs are not always known or controllable. Therefore, itis essential to discover economic costs and measure them for effective

profit planning, cost control and sound pricing practices. Production



analysis is narrower in scope than cost analysis. The chief topicscovered under cost and production analysis are:

Cost concepts and classifications

Cost-output relationships

Economics of scale

Production functions

Cost control.Pricing Decisions, Policies and Practices

Pricing is a very important area of managerial economics. In fact priceis the origin of the revenue of a firm. As such the success of a usiness

firm largely depends on the accuracy of price decisions of that firm.The important aspects dealt under area, are as follows:

Price determination in various market forms

Pricing methods

Differential pricing product-line pricing and price forecasting.

Profit ManagementBusiness firms are generally organised with the purpose of makingprofits. In the long run, profits provide the chief measure of success.

In this connection, an important point worth considering is theelement of uncertainty existing about profits. This uncertainty occursbecause of variations in costs and revenues. These are caused by

factors such as internal and external. If knowledge about the futurewere perfect, profit analysis would have been a very easy task.

However, in a world of uncertainty, expectations are not alwaysrealised. Thus profit planning and measurement make up the difficultarea of managerial economics. The important aspects covered under

this area are:

Nature and measurement of profit.

Profit policies and techniques of profit planning.

Capital ManagementAmong the various types and classes of business problems, the most

complex and troublesome for the business manager are those relatingto the firm’s capital investments. Capital management implies



planning and control and capital expenditure. In this procedure,relatively large sums are involved and the problems are so complexthat their disposal not only requires considerable time and labour but

also top-level decisions. The main elements dealt with costmanagement are:

Cost of capital

Rate of return and selection of projects.The various aspects outlined above represent the major

uncertainties, which a business firm has to consider viz., demanduncertainty, cost uncertainty, price uncertainty, profit uncertainty andcapital uncertainty. We can, therefore, conclude that managerial

economics is mainly concerned with applying economic principles andconcepts to adjust with the various uncertainties faced by a business

firm.MANAGERIAL ECONOMICS AND OTHER SUBJECTSYet another useful method of explaining the nature and scope of

managerial economics is to examine its relationship with othersubjects. The following discussion helps to understand relationshipbetween managerial economics and economics, statistics, mathematics,

accounting and operations research.

Managerial Economics and EconomicsManagerial economics is defined as a subdivision of economics thatdeals with decision-making. It may be viewed as a special branch of

economics bridging the gulf between pure economic theory andmanagerial practice. Economics has two maindivisions-microeconomics and Macroeconomics. Microeconomics has

been defined as that branch where the unit of study is an individual ora firm. It is also called “price theory” (or Marshallian economics) and is

the main source of concepts and analytical tools for managerialeconomics. To illustrate, various micro-economic concepts such aselasticity of demand, marginal cost, the short and the long runs,



various market forms, etc., are all of great significance to managerialeconomics.

Macroeconomics, on the other hand, is aggregative in character

and has the entire economy as a unit of study. The chief contributionof macroeconomics to managerial economics is in the area offorecasting. The modern theory of income and employment has direct

implications for forecasting general business conditions. As theprospects of an individual firm often depend greatly on general

business conditions, individual firm forecasts rely on general businessforecasts.

A survey in the U.K. has shown that business economists have

found the following economic concepts quite useful and of frequentapplication:

Price elasticity of demand

Income elasticity of demand

Opportunity cost

Multiplier

Propensity to consume

Marginal revenue product

Speculative motive

Production function

Liquidity preference

Business economists have also found the following main areas

of economics as useful in their work. Demand theory

Theory of firms – price, output and investment decisions

Business financing

Public finance and fiscal policy

Money and banking

National income and social accounting

Theory of international trade

Economies of developing countries.

Thus, it is obvious that Managerial Economics is very closelyrelated to Economics.



Managerial Economics and StatisticsStatistics is important to managerial economics in several ways.

Managerial economics calls for the organising quantitative data andderiving a useful measure of appropriate functional relationshipsinvolved in decision-making. For instance, in order to base its pricing

decisions on demand and cost considerations, a firm should havestatistically derived or calculated demand and cost functions.

Managerial economics also employs statistical methods forexperimental testing of economic generalisations. The generalisationscan be accepted in practice only when they are checked against the

data from the world of reality and are found valid. Managers do nothave exact information about the variables affecting decisions andhave to deal with the uncertainty of future events. The theory of

probability, upon which statistics is based, provides logic for dealingwith such uncertainties.

Managerial Economics and MathematicsMathematics is yet another important subject closely related to

managerial economics. This is because managerial economics ismathematical in character, as it involves estimating various economicrelationships, predicting relevant economic quantities and using them

in decision-making and forward planning. Knowledge of geometry,trigonometry ad algebra is not only essential but also certain

mathematical tools and concepts such as logarithms and exponential,vectors, determinants, matrix, algebra, calculus, differential as well asintegral, are the most commonly used devices. Further, operations

research, which is closely related to managerial economics, ismathematical in character. It provides and analyses data ad developsmodels, benefiting from the experiences of experts drawn from

different disciplines, viz., psychology, sociology, statistics andengineering.



MANAGERIAL ECONOMICS AND ACCOUNTINGManagerial economics is also closely related to accounting, which isconcerned with recording the financial operations of a business firm.

In fact, a managerial economist depends chiefly on the accountinginformation as an important source of data required for hisdecision-making purpose. for instance, the profit and loss statement

of a firm shows how well the firm has done and whether theinformation it contains can be used by managerial economist to throw

significant light on the future course of action that is whether the firmshould improve its productivity or close down. Therefore, accountingdata require careful interpretation, reconstruction and adjustments

before they can be used safely and effectively. It is in this context thatthe link between management accounting and managerial economicsdeserves special mention. The main task of management accounting is

to provide the sort of data, which managers need if they are to applythe ideas of managerial economics to solve business problems

correctly. The accounting data should be provided in such a form thatthey fit easily into the concepts and analysis of managerial economics.

Managerial Economics and Operations ResearchOperations research is a subject field that emerged during the SecondWorld War and the years thereafter. A good deal of interdisciplinary

research was done in the USA. as well as other western countries tosolve the complex operational problems of planning and resource

allocation in defence and basic industries. Several experts likemathematicians, statisticians, engineers and others teamed uptogether and developed models and analytical tools leading to the

emergence of this specialised subject. Much of the development oftechniques and concepts, such as linear programming, inventorymodels, game theory, etc., emerged from the working of the operation

researchers. Several problems of managerial economics are solved bythe operation research techniques. These highlight the significant



relationship between managerial economics and operations research.The problems solved by operation research are as follows:

Allocation problems: An allocation problem confronts with the

issue that men, machines and other resources are scarce, relatedto the number sand size of the jobs that need to be completed.The examples are production programming and transportation

problems.

Competitive problems: competitive problems deal with

situations where managerial decision-making is to be made inthe face of competitive action. That is, one of the factors to beconsidered is: “What will competitors do if certain steps are

taken?” Price reduction, for example, will not lead to increasedmarket share if rivals follow suit.

Waiting line problems : Waiting line problems arise when a firm

wants to know how many machines it should install in order toensure that the amount of ‘work-in-progress’ waiting to be

machined is neither too small nor too large. Such situationsarise when for example, a post office, or a bank wants to knowhow many cash desks or counter clerks it should employ in

order to balance the business lost through long guesses againstthe cost of installing more equipment or hiring more labour.

Inventory problems: Inventory problems deal with the principal

question: “What is the optimum level of stocks of raw-materials,components or finished goods for the firm to hold?”

The above discussion explains that the managerial economics isclosely related to certain subjects such as economics, statistics,

mathematics and accounting. A trained managerial economistcombines concepts and methods from all these subjects by bringingthem together to solve business problems. In particular, operations

research and management accounting are getting very close tomanagerial economics.

USES OF MANAGERIAL ECONOMICS



Managerial economics achieves several objectives. The principalobjectives are as follows:

It presents those aspects of traditional economics, which are

relevant for business decision-making in real life. For thispurpose, it picks from economic theory those concepts,principles and techniques of analysis, which are concerned with

the decision-making process. These are adapted or modified insuch a way that it enables the manager to take better decisions.

Thus, managerial economics attains the objective of building asuitable tool kit from traditional economics.

Managerial economics also incorporates useful ideas from other

disciplines such as psychology, sociology, etc. If they are foundrelevant for decision-making. In fact, managerial economics

takes the aid of other academic disciplines that are concernedwith the business decisions of a manager in view of the variousexplicit and implicit constraints subject to which resource

allocation is to be optimised.

It helps in reaching a variety of business decisions even in acomplicated environment. Certain examples of such decisions

are those decisions concerned with:o The products and services to be produced

o The inputs and production techniques to be usedo The quantity of output to be produced and the sellingprices to be subscribed

o The best sizes and locations of new plantso Time of replacing the equipmento Allocation of the available capital

Managerial economics helps a manager to become a morecompetent model builder. Thus, he can pick out the essential

relationships, which characterise a situation and leave out theother unwanted details and minor relationships.

At the level of the firm, functional specialists or functional

departments exist, e.g., finance, marketing, personnel,



production etc. For these various functional areas, managerialeconomics serves as an integrating agent by co-ordinating thedifferent areas. It then applies the decisions of each department

or specialist, those implications, which are pertaining to otherfunctional areas. Thus managerial economics enables businessdecision-making to operate not with an inflexible and rigid but

with an integrated perspective. This integration is importantbecause the functional departments or specialists often enjoy

considerable autonomy and achieve conflicting goals.Managerialeconomics keeps in mind the interaction between the firm andsociety and accomplishes the key role of business as an agent

in attaining social economic welfare. There is a growingawareness that besides its obligations to shareholders, businessenterprise has certain social obligations as well. Managerial

economics focuses on these social obligations while takingbusiness decisions. By doing so, it serves as an instrument of

furthering the economic welfare of the society through sociallyoriented business decisions.

Thus, it is evident that the applicability and usefulness of

managerial economics is obtained by performing the followingactivates:

Borrowing and adopting the tool-kit from economic theory.

Incorporating relevant ideas from other disciplines to achievebetter business decisions.

Serving as a catalytic agent in the course of decision-making by

different functional departments/specialists at the firm’s level.

Accomplishing a social purpose by adjusting business decisions

to social obligations.

ECONOMIC THEORY AND MANAGERIAL ECONOMICSEconomic theory offers a variety of concepts and analytical tools thatcan assist the manager in the decision-making practices. Problem

solving in business has, however, found that there exists a wide



disparity between the economic theory of a firm and actual observedpractice, thus necessitating the use of many skills and be quite usefulto examine two aspects in this regard:

The basic tools of managerial economics which it has borrowed

from economics, and

The nature and extent of gap between the economic theory of

the firm and the managerial theory of the firm.Basic Economic Tools in Managerial Economics

The most significant contribution of economics to managerialeconomics lies in certain principles, which are basic to the entire rangeof managerial economics. The basic principles may be identified as

follows:

1. Opportunity Cost PrincipleThe opportunity cost of a decision means the sacrifice of alternativesrequired by that decision. This can be best understood with the help of

a few illustrations, which are as follows:

The opportunity cost of the funds employed in one’s ownbusiness is equal to the interest that could be earned on those

funds if they were employed in other ventures.

The opportunity cost of the time as an entrepreneur devotes to

his own business is equal to the salary he could earn by seekingemployment.

The opportunity cost of using a machine to produce one product

is equal to the earnings forgone which would have been possiblefrom other products.

The opportunity cost of using a machine that is useless for any

other purpose is zero since its use requires no sacrifice of otheropportunities.

If a machine can produce either X or Y, the opportunity cost ofproducing a given quantity of X is equal to the quantity of Y,

which it would have produced. If that machine can produce 10



units of X or 20 units of Y, the opportunity cost of 1 X is equalto 2 Y.

If no information is provided about quantities produced, except

about their prices then the opportunity cost can be computed interms of the ratio of their respective prices, say Px/Py.

The opportunity cost of holding Rs. 500 as cash in hand for one

year is equal to the 10% rate of interest, which would have beenearned had the money been kept as fixed deposit in a bank.

Thus, it is clear that opportunity costs require the ascertainingof sacrifices. If a decision involves no sacrifice, its opportunitycost is nil.

For decision-making, opportunity costs are the only relevantcosts. The opportunity cost principle may be stated as under:

“The cost involved in any decision consists of the sacrifices ofalternatives required by that decision. If there are no sacrifices, thereis no cost.”

Thus in macro sense, the opportunity cost of more guns in aneconomy is less butter. That is the expenditure to national fund forbuying armour has cost the nation of losing an opportunity of buying

more butter. Similarly, a continued diversion of funds towards defencespending, amounts to a heavy tax on alternative spending required for

growth and development.2. Incremental PrincipleThe incremental concept is closely related to the marginal costs and

marginal revenues of economic theory. Incremental concept involvestwo important activities which are as follows:

Estimating the impact of decision alternatives on costs and

revenues.

Emphasising the changes in total cost and total cost and total

revenue resulting from changes in prices, products, procedures,investments or whatever may be at stake in the decision.

The two basic components of incremental reasoning are as follows:



Incremental cost: Incremental cost may be defined as the change

in total cost resulting from a particular decision.

Incremental revenue: Incremental revenue means the change in

total revenue resulting from a particular decision.The incremental principle may be stated as under:

A decision is obviously a profitable one if:o It increases revenue more than costso It decreases some costs to a greater extent than it

increases other costso It increases some revenues more than it decreases otherrevenues

o It reduces costs more that revenues.Some businessmen hold the view that to make an overall profit,

they must make a profit on every job. Consequently, they refuseorders that do not cover full cost (labour, materials and overhead) plusa provision for profit. Incremental reasoning indicates that this rule

may be inconsistent with profit maximisation in the short run. Arefusal to accept business below full cost may mean rejection of apossibility of adding more to revenue than cost. The relevant cost is

not the full cost but rather the incremental cost. A simple problem willillustrate this point.

IIIustrationSuppose a new order is estimated to bring in additional revenue of Rs.5,000. The costs are estimated as under:

Labour Rs. 1,500Material Rs. 2,000Overhead (Allocated at 120% of labour cost) Rs. 1,800

Selling administrative expenses(Allocated at 20% of labour and material cost) Rs. 700

Total Cost Rs. 6,000

The order at first appears to be unprofitable. However, suppose,

if there is idle capacity, which can be, utilised to execute this order



then the order can be accepted. If the order adds only Rs. 500 ofoverhead (that is, the added use of heat, power and light, the addedwear and tear on machinery, the added costs of supervision, and so

on), Rs. 1,000 by way of labour cost because some of the idle workersalready on the payroll will be deployed without added pay and no extraselling and administrative cost then the incremental cost of accepting

the order will be as follows.Labour Rs. 1,500

Material Rs. 2,000Overhead Rs. 500

Total Incremental Cost Rs. 3,500

While it appeared in the first instance that the order will result in

a loss of Rs. 1,000, it now appears that it will lead to an addition of Rs.1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does notmean that the firm should accept all orders at prices, which cover

merely their incremental costs. The acceptance of the Rs. 5,000 orderdepends upon the existence of idle capacity and labour that would gounutilised in the absence of more profitable opportunities. Earley’s

study of “excellently managed” large firms suggests that progressivecorporations do make formal use of incremental analysis. It is,

however, impossible to generalise on the use of incremental principle,since the observed behaviour is variable.

3. Principle of Time PerspectiveThe economic concepts of the long run and the short run have become

part of everyday language. Managerial economists are also concernedwith the short-run and long-run effects of decisions on revenues aswell as on costs. The actual problem in decision-making is to maintain

the right balance between the long-run and short-run considerations.A decision may be made on the basis of short-run considerations, butmay in the course of time offer long-run repercussions, which make it



more or less profitable than it appeared at first. An illustration willmake this point clear.

IIIustrationSuppose there is a firm with temporary idle capacity. An order for5,000 units comes to management’s attention. The customer is willing

to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more.The short-run incremental cost (ignoring the fixed cost) is only Rs.

3.00. Therefore, the contribution to overhead and profit is Re. 1.00 perunit (Rs. 5,000 for the lot. However, the long-run repercussions of theorder ought to be taken into account are as follows:

If the management commits itself with too much of business at

lower prices or with a small contribution, it may not havesufficient capacity to take up business with higher contributions

when the opportunity arises. The management may becompelled to consider the question of expansion of capacity

and in such cases; even the so-called fixed costs may becomevariable.

If any particular set of customers come to know about this low

price, they may demand a similar low price. Such customersmay complain of being treated unfairly and feel discriminated.

In response, they may opt to patronise manufacturers withmore decent views on pricing. The reduction or prices underconditions of excess capacity may adversely affect the image of

the company in the minds of its clientele, which will in turnaffect its sales.It is, therefore, important to give due consideration to the time

perspective. The principle of time perspective may be stated as under:‘A decision should take into account both the short-run and long-run

effects on revenues and costs and maintain the right balance betweenthe long-run and short-run perspectives.”

Haynes, Mote and Paul have cited the case of a printing company.

This company pursued the policy of never quoting prices below full



cost though it often experienced idle capacity and the managementwas fully aware that the incremental cost was far below full cost. Thiswas because the management realised that the long-run repercussions

of pricing below full cost would make up for any short-run gain. Themanagement felt that the reduction in rates for some customers mighthave an undesirable effect on customer goodwill particularly among

regular customers not benefiting from price reductions. It wanted toavoid crating such an “image” of the firm that it exploited the market

when demand was favorable but which was willing to negotiate pricesdownward when demand was unfavorable.4. Discounting Principle

One of the fundamental ideas in economics is that a rupee tomorrow isworth less than a rupee today. This seems similar to the saying that abird in hand is worth two in the bush. A simple example would make

this point clear. Suppose a person is offered a choice to make betweena gift of Rs. 100 today or Rs. 100 next year. Naturally he will choose

the Rs. 100 today.This is true for two reasons. First, the future is uncertain and

there may be uncertainty in getting Rs. 100 if the present opportunity

is not availed of. Secondly, even if he is sure to receive the gift infuture, today’s Rs. 100 can be invested so as to earn interest, say, at 8percent so that. one year after the Rs. 100 of today will become Rs.

108 whereas if he does not accept Rs. 100 today, he will get Rs. 100only in the next year. Naturally, he would prefer the first alternative

because he is likely to gain by Rs. 8 in future. Another way of sayingthe same thing is that the value of Rs. 100 after one year is not equalto the value of Rs. 100 of today but less than that. To find out how

much money today is equal to Rs. 100 would earn if one decides toinvest the money. Suppose the rate of interest is 8 percent. Then weshall have to discount Rs. 100 at 8 per cent in order to ascertain how

much money today will become Rs. 100 one year after. The formula is:

V =

Rs. 100

1 + i



where,V = present valuei = rate of interest.

Now, applying the formula, we get

V =Rs. 100

1 + i

=100

1.08

If we multiply Rs. 92.59 by 1.08, we shall get the amount of money,which will accumulate at 8 per cent after one year.

92.59 x 1.08 = 99.0072= 1.00

The same reasoning applies to longer periods. A sum of Rs. 100two years from now is worth:

V =

Rs. 100

=

Rs. 100

=

Rs. 100

(1+i)2 (1.08)2 1.1664

Similarly, we can also check by computing how much thecumulative interest will be after two years. The principle involved inthe above discussion is called the discounting principle and is stated

as follows: “If a decision affects costs and revenues at future dates, itis necessary to discount those costs and revenues to present valuesbefore a valid comparison of alternatives is possible.”

5. Equi-marginal Principle

This principle deals with the allocation of the available resource amongthe alternative activities. According to this principle, an input shouldbe allocated in such a way that the value added by the last unit is the

same in all cases. This generalisation is called the equi-marginalprinciple.

Suppose a firm has 100 units of labour at its disposal. The firm

is engaged in four activities, which need labour services, viz., A, B, C



and D. It can enhance any one of these activities by adding morelabour but sacrificing in return the cost of other activities. If the valueof the marginal product is higher in one activity than another, then it

should be assumed that an optimum allocation has not been attained.Hence it would, be profitable to shift labour from low marginal valueactivity to high marginal value activity, thus increasing the total value

of all products taken together. For example, if the values of certaintwo activities are as follows:

Value of Marginal Product of labourActivity A = Rs. 20Activity B = Rs. 30

In this case it will be profitable to shift labour from A to activityB thereby expanding activity B and reducing activity A. The optimumwill be reach when the value of the marginal product is equal in all the

four activities or, when in symbolic terms:VMPLA = VMPLB= VMPLC= VMPLDWhere the subscripts indicate labour in respective activities.Certain aspects of the equi-marginal principle need clarifications,

which are as follows:

First, the values of marginal products are net of incremental

costs. In activity B, we may add one unit of labour with an

increase in physical output of 100 units. Each unit is worth 50paise so that the 100 units will sell for Rs. 50. But the increasedoutput consumes raw materials, fuel and other inputs so that

variable costs in activity B (not counting the labour cost) arehigher. Let us say that the incremental costs are Rs. 30 leaving anet addition of Rs. 20. The value of the marginal product

relevant for our purpose is thus Rs. 20.

Secondly, if the revenues resulting from the addition of labour

are to occur in future, these revenues should be discountedbefore comparisons in the alternative activities are possible.Activity A may produce revenue immediately but activities B, C



and D may take 2, 3 and 5 years respectively. Here thediscounting of these revenues will make them equivalent.

Thirdly, the measurement of value of the marginal product may

have to be corrected if the expansion of an activity requires analternative reduction in the prices of the output. If activity Brepresents the production of radios and it is not possible to sell

more radios without a reduction in price, it is necessary to makeadjustment for the fall in price.

Fourthly, the equi-marginal principle may break under

sociological pressures. For instance, du to inertia, activities arecontinued simply because they exist. Similarly, due to their

empire building ambitions, managers may keep on expandingactivities to fulfil their desire for power. Department, which are

already over-budgeted often, use some of their excessresources to build up propaganda machines (public relationsoffices) to win additional support. Governmental agencies are

more prone to bureaucratic self-perpetuation and inertia.

Gaps between Theory of the Firm and managerial EconomicsThe theory of the firm is a body of theory, which contains certain

assumptions, theorems and conclusions. These theorems deal with theway in which businessmen make decisions about pricing, and

production under prescribed market conditions. It is concerned withthe study of the optimisation process.

For optimality to exist profit must be maximised and this can

occur only when marginal cost equals marginal revenue. Thus, theoptimum position of the firm is that which maximises net revenue.Managerial economics, on the other hand, aims at developing a

managerial theory of the firm and for the purpose it takes the help ofeconomic theory of the firm. However, there are certain difficulties in

using economic theory as an aid to the study of decision-making atthe level of the firm. This is because for the purposes of business



decision-making it fails to provide sufficient analytical tools that areuseful to managers. Some of the reasons are as follows:

Underlying all economic theory is the assumption that the

decision-maker is omniscient and rational or simply that he isan economic man. Thus being omniscient means that he knowsthe alternatives that are available to him as well as the outcome

of any action he chooses. The model of “economic man”however as an omniscient person who is confronted with a

compete set of known or probabilistic outcomes is a distortedrepresentation of reality. The typical business decision-makerusually has limited information at his disposal, limited

computing ability and a limited number of feasible alternativesinvolving varying degrees of risk. Further, the net revenuefunction, which he is expected to maximise, and the marginal

cost and marginal revenue functions, which he is expected toequate, require excessive knowledge of information, which is

not known and cannot be obtained even by the most carefulanalysis. Hence, it is absurd to expect a manager to maximiseand equalise certain critical functional relationships, which he

does not know and cannot find out.

In micro-economic theory, the most profitable output is where

marginal cost (MC) and marginal revenue (MR) are equal. InFigure 1.2, the most profitable output will be at ON whereMR=MC. This is the point at which the slope of the profit

function or marginal profit is zero. This is highlighted in Figure1.3 where the most profitable output will be again at ON. Ineconomic theory, the decision-maker has to identify this unique

output level, which maximises profit.



In real world, however, a complexity often arises, viz., certain

resource limitations exist. As a result, it is not possible to attain themaximum output level (ON). In practical terms the maximum output

possible as a result of resource limitations is, say, OM. Now theproblem before the decision-maker is to find out whether the output,which maximises profit, is OM or some other level of output to the left

of OM. It is obvious that economic theory is of no help for ON level ofoutput because it is not relevant in view of the resource limitations. Amanagerial economist here has to take the aid of linear programming,

which enables the manager to optimise or search for the best valueswithin the limits set by inequality conditions.

Another central assumption in the economic theory of the

firm is that the entrepreneur strives to maximise his residualshare, or profit. Several criticisms of this assumption have

been made:



o The theory is ambiguous, as it doesn’t clarify. Whetherit is short or long run profit that is to be maximised.For example, in the short run, profits could be

maximised by firing all research and developmentpersonnel and thereby eliminating considerableimmediate expenses. This decision would, however,

have a substantial impact on long-run profitability.o Certain questions create some confusion around the

concept of profit maximisation. Should the firm seek tomaximise the amount of profit or the rate of profit?What is the rate of profit? Is it profit in relation to total

capital or profit in relation to shareholders’ equity?o There is no allowance for the existence of “psychicincome” (Income other than monetary, power, prestige,

or fame), which the entrepreneur might obtain from thefirm, quite apart from his monetary income.

o The theory does not recognise that under modernconditions, owners and managers are separate anddistinct groups of people and the latter may not be

motivated to maximise profits.o Under imperfect competition, maximisation is anambiguous goal, because actions that are optimal for

one will depend on the actions of the other firms.o The entrepreneur may not care to receive maximum

profits but may simply want to earn “satisfactoryprofits”. This last point is particularly relevant from thebehavioural science standpoint because it introduces a

concept of satiation. The notion of satiation plays norole in classical economic theory. To explain businessbehaviour in terms of this theory, it is necessary to

assume that the firm’s goals are not concerned withmaximising profit, but with attaining a certain level or

rate of profit, holding a certain share of the market or a



certain level of sales. Firms would try to satisfy ratherthan maximise. But according to Simon the satisfyingmodel damages all the conclusions that can be derived

concerning resource allocation under perfectcompetition. It focuses on the fact that the classicaltheory of the firm is empirically incorrect as a

description of the decision-making process. Based onthis notion of satiation, it appears that one of the main

strengths of classical economic theory has beenseriously weakened.

Most corporate undertakings involve the investment of funds,

which are expect to produce revenues over a number of years.The profit maximisation criterion provides no basis forcomparing alternatives that can promise varying flows of

revenue and expenditure over time.

The practical application of profit maximisation concept also

has another limitation. It provides no explicit way ofconsidering the risk associated with alternative decisions.Two projects generating similar expected revenues in the

future and requiring similar outlays might differ vastly asregarding the degree of uncertainty with which the benefits

to be generated. The greater the uncertainty associated withthe benefits, the greater the risk associated with the project.

Baumol on the other hand is of the view that firms do not

devote all their energies to maximising profit. Rather acompany will seek to maximise its sales revenue as long as asatisfactory level of profit is maintained. Thus Baumol has

substituted “Total sales revenue” for profits. Also, twodecision criteria or objectives have been advanced viz., a

satisfactory level of profit and the highest sales possible. Inother words, the firm is no longer viewed as working towardsone objective alone. Instead, it is portrayed as aiming at

balancing two competing and non-consistent goals. Baumol’s



model is based on the view that managers’ salaries, theirstatus and other rewards often appear as closely related tothe companies’ size in which they work and is measured by

sales revenue rather than their profitability. As such,managers may be more concerned to increased size thanprofits. And the firm’s objective thus becomes sales

maximisation rather than profits maximisation.

Empirical studies of pricing behaviour also give results that

differ from those of the economic theory of firm as can beseen from the following examples:o Several studies of the pricing practices of business

firms have indicated that managers tend to set pricesby applying some sort of a standard mark-up oncosts. They do not attempt to estimate marginal costs,

marginal revenues or demand elasticities, even ifthese could be accurately measured.

o For many firms, prices are more often set to attain, aparticular target return on investment, say, 10 percent, than to maximise short or long-run profits.

o There is some evidence that firms experiencingdeclining market shares in their industry strive more

vigorously to increase their sales than do competingfirms, which are experiencing steady or increasingmarket shares.

An alternative model to profit maximisation is the concept of

wealth maximisation, which assumes that firms seek tomaximise the present value of expected net revenues over all

periods within the forecasted future.

As pointed out by Haynes and Henry, a study of the

behaviour of actual firms shows that their decisions are notcompletely determined by the market. These firms have somefreedom to develop decisions, strategies or rules, which

become part of the decision-making system within the firm.



This gap in economic theory has led to what has come to beknown as ‘Behavioural Theory of the Firm’. This theory,however, does not replace the former but rather powerfully

supplements it. The behavioural theory represents the firm asan adoptive institution. It learns from experience and has amemory. Organisational behaviour, is embodies into decision

rules and standard operating procedures. These may bealtered over long run as the firm reacts to “feedback” from

experience. However, in the short run, decisions of theorganisation are dominated by its rules of thumb andstandard methods.

CONCLUSIONThe various gaps between the economic theory of the firm and the

actual decision-making process at the firm level are many in number.They do, however, stress that economic theory seriously needs major

fixing up and substantial changes are in progress for creating betterand different models. Thus the classical economic concepts like thoseof rational man is undergoing important changes; the notion of

satisfying is pushing aside the aim of maximisation and newer linesand patterns of thoughts are being developed for finding improvedapplications to managerial decision-making. A strong emphasis is laid

on quantitative model building, experimentation and empiricalinvestigation and newer techniques and concepts, such as linear

programming, game theory, statistical decision-making, etc., arebeing applied to revolutionise the approaches to problem solving inbusiness and economics.

MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIESA managerial economist can play a very important role by assisting the

management in using the increasingly specialised skills andsophisticated techniques, required to solve the difficult problems of

successful decision-making and forward planning. In business



concerns, the importance of the managerial economist is thereforerecognised a lot today. In advanced countries like the USA, largecompanies employ one or more economists. In our country too, big

industrial houses have understood the need for managerial economists.Such business firms like the Tatas, DCM and Hindustan Lever employeconomists. A managerial economist can contribute to

decision-making in business in specific terms. In this connection, twoimportant questions need be considered:

1. What role does he play in business, that is, what particularmanagement problems lend themselves to solution througheconomic analysis?

2. How can the managerial economist best serve management, thatis, what are the responsibilities of a successful managerialeconomist?

Role of a Managerial Economist

One of the principal objectives of any management in itsdecision-making process is to determine the key factors, which willinfluence the business over the period ahead. In general, these factors

can be divided into two categories:

External

Internal

The external factors lie outside the control of managementbecause they are external to the firm and are said to constitute

business environment. The internal factors lie within the scope andoperations of a firm and hence within the control of management, andthey are known as business operations. To illustrate, a business firm is

free to take decisions about what to invest, where to invest, how muchlabour to employ and what to pay for it, how to price its products, and

so on. But all these decisions are taken within the framework of aparticular business environment, and the firm’s degree of freedomdepends on such factors as the government’s economic policy, the

actions of its competitors and the like.



Environmental Studies of a Business FirmAn analysis and forecast of external factors constituting general

business conditions, for example, prices, national income and output,volume of trade, etc., are of great significance since they affect everybusiness firm. Certain important relevant factors to be considered in

this connection are as follows:

The outlook for the national economy, the most important local,

regional or worldwide economic trends, the nature of phase ofthe business cycle that lies immediately ahead.

Population shifts and the resultant ups and downs in regional

purchasing power.

The demand prospects in new as well as established markets.

Impact of changes in social behaviour and fashions, i.e., whetherthey will tend to expand or limit the sales of a company’sproducts, or possibly make the products obsolete?

The areas in which the market and customer opportunities are

likely to expand or contract most rapidly.

Whether overseas markets expand or contract and the affect of

new foreign government legislations on the operation of theoverseas plants?

Whether the availability and cost of credit tend to increase or

decrease buying, and whether money or credit conditions ahead

are likely to easy or tight?

The prices of raw materials and finished products.

Whether the competition will increase or decrease.

The main components of the five-year plan, the areas where

outlays have been increased and the segments, which have

suffered a cut in their outlays.

The outlook to government’s economic policies and regulationsand changes in defence expenditure, tax rates tariffs and import

restrictions.



Whether the Reserve Bank’s decisions will stimulate or depress

industrial production and consumer spending and how will thesedecisions affect the company’s cost, credit, sales and profits.

Reasonably accurate data regarding these factors can enable themanagement to chalk out the scope and direction of their ownbusiness plans effectively. It will also help them to determine the

timing of their specific actions. And it is these factors, which presentsome of the areas where a managerial economist can make effective

contribution. The managerial economist has not only to study theeconomic trends at the micro-level but also must interpret theirrelevance to the particular industry or firm where he works. He has to

digest the ever-growing economic literature and advise topmanagement by means of short, business-like practical notes. Inmixed economy like that of India, the managerial economist

pragmatically interprets the intentions of controls and evaluates theirimpact. He acts as a bridge between the government and the industry,

translating the government’s intentions and transmitting the reactionsof the industry. In fact, the government policies emerge out of theperformance of industry, the expectations of the people and political

expediency.

Business OperationsA managerial economist can also be helpful to the management inmaking decisions relating to the internal operations of a firm in

respect of such problems as price, rate of operations, investment,expansion or contraction. Certain relevant questions in this contextwould be as follows:

What will be a reasonable sales and profit budget for the nextyear?

What will be the most appropriate production schedules and

inventory policies for the next six months?

What changes in wage and price policies should be made now?



How much cash will be available next month and how should

it be invested?

Specific FunctionsThe managerial economists can play a further role, which can coverthe following specific functions as revealed by a survey pertaining to

Brittain conducted by K.J.W. Alexander and Alexander G. Kemp:

Sales forecasting.

Industrial market research.

Economic analysis of competing companies.

Pricing problems of industry.

Capital projects.

Production programmes.

Security / Investment analysis and forecasts.

Advice on trade and public relations.

Advice on primary commodities.

Advice on foreign exchange.

Economic analysis of agriculture.

Analysis of underdeveloped economics.

Environmental forecasting.

The managerial economist has to gather economic data, analyse allrelevant information about the business environment and prepare

position papers on issues facing the firm and the industry. In the caseof industries prone to rapid theological advances, the manager may

have to make continuous assessment of tl1e impact of changingtechnology. The manager' may need to evaluate the capital budget inthe light of short and long-range financial, profit and market

potentialities. Very often, he also needs to prepare speeches for thecorporate executives. It is thus clear that in practice, managerial

economists perform many and various functions. However, of all these,the marketing functions, i.e., sales force listing an industrial market



research, are the most important.For this purpose, the managers may collect statistical records of

the sales performance of their own business and those rehiring to

their rivals, carry out analysis of these records and report on trends indemand, their market shares, and the relative efficiency of their retailoutlets. Thus, while carrying out heir functions, the managers may

have to undertake detailed statistical analysis. There are, of course,differences in the relative importance of· the various functions

performed from firm to firm and in the degree of sophistication of themethods used in performing these functions. But there is no doubtthat the job of a managerial economist requires alertness and the

ability to work uriderpressure.

Economic Intelligence

Besides these functions involving sophisticated analysis, managerialeconomist may also provide general intelligence service. Thus theeconomist may supply the management with economic information of

general interest such as competitorsprices and products, tax rates, tariff rates, etc.

Participating in Public Debates

Many well-known business economists participate in public debates.The government and society alike are seeking their advice and views.

Their practical experience in business and industry adds prestige totheir views. Their public recognition enhances their protégé in the .firm itself.

Indian Context

In the Indian context, a managerial economist is expected to performthe following functions:

Macro-forecasting for demand and supply.

Production planning at macro and micro levels.

Capacity planning and product-mix determination.



Economics of various production lines.

Economic feasibility of new production lines / processes andprojects.

Assistance in preparation of overall development plans.

Preparation of periodical economic reports bearing on various

matters such as the company's product-lines, future growthopportunities, market pricing situation, general business,. andvarious national/international factors affecting industry and

business.

Preparing briefs; speeches, articles and papers for top

management for various chambers, Committees, Seminars,Conferences, etcKeeping management informed of various national and

International Developments on economic/industrial matters.

With the adoption of the new economic policy, themacro-economic environment is changing fast and these changes

have tremendous implications for business. The managerialeconomists have to playa much more significant role. They ha'1e to

constantly measure the possibilities of translating the rapidly changingeconomic scenario into workable business opportunities. As Indiamarches towards globalisation, the managerial economists will have to

interpret the global economic events and find out how the firm canavail itself of the various export opportunities or of establishing plantsabroad either wholly owned or in association with local partners.

Responsibilities of a Managerial Economist

Besides considering the opportunities that lie before a managerial

economist it is necessary to take into account the services that areexpected by the management. For this, it is necessary for amanagerial economist to thoroughly recognise the responsibilities

and obligations. A managerial economist can serve the mana¬gementbest by recognising that the main objective of the business, is tomake a profit on its invested capital. Academic training and the



critical comments from people outside the business may lead amanagerial economist to adopt an apologetic or defensive attitudetowards profits. There should be a strong personal conviction on part

of the managerial economist that profits are essential and it isnecessary to help enhance the ability of the firm to make profits.Otherwise it is difficult to succeed in serving management.

Most management decisions necessarily concern the future, whichis rather uncertain. It is, therefore, absolutely essential that a

managerial economist recognises his responsibility to makesuccessful forecast. By making the best possible forecasts andthrough constant efforts to improve, a managerial' ng, the risks

involved in uncertainties. This enables the management to· follow amore orderly course of business planning. At times, it is required forthe managerial economist to reassure the management that an

important trend will continue. In other cases, it is necessary to pointout the probabilities of a turning point in some activity of importance

to management. In any case, managerial economist must be willing tomake fairly positive statements about impending economicdevelopments. These can be based upon the best possible

information and analysis. The management's confidence in amanagerial economist increases more quickly and thoroughly witha record of successful forecasts, well documented in advance and

modestly evaluated when the actual results become available.A few consequences to the above proposition need also be

emphasised here.

First, a managerial economist has a major responsibility to alertmana¬gelI1ent at the earliest possible moment in' case there is

an err6r' in his forecast. This will assist the mallagement inmaking appropriate adjustment in policies and programmes and

strengthen his oWn position as a member of the managementteam by keeplrighis fingers on the economic pulse of thebusiness.

Secondly, a managerial economist must establish and maintain



many contacts with individuals and data sources: which wouldnot be imme¬diately available to the other members of themanagement. Extensive familiarity with reference sources and

material is essential. It is still more important that the knownindividuals who are specialists in particular fields have a bearingon tpe managerial economist's work. For this purpose, it is

required that managerial economist joins professionalassociations and tak~ active part in them. In fact, one of the best

means of determining the quality of a managerial economist is toevaluate his ability to obtain information quickly by personalcontacts rather than by lengthy research from either readily

available or obscure reference sources. Within any business,there' may be a wealth of knowledge and experience but themanagerial economist would be really useful ifit is possible pn

his part to supplement the existing know-how with additionalinformation and in the quickest possible manner.

Again, if a managerial economist is to be really helpful to themanagement in successful decision-making and forward planning, itis necessary'" to able to earn full status on the business team.

Readiness to take up special assignments, be that in study teams,committees or special projects is another important requirement. Thisis because it is necessary for the managerial economist to win

continuing support for himself and his professional ideas. Clarity ofexpression and attempting to minimise the use of technical

terminology while communJcating his ideas to management executivesis also an essential role so as to win approval.

To conclude, a managerial economist has a very important role to

play by helping management in successful decision-making andforward planning. But to discharge his role successfully, it is necessaryto recognise the 'relevant responsibilities and obligations. To some

business executives, however, a managerial economist is still a luxuryor perhaps even a necessary evil. It is not surprising, therefore, to find

that while tneir status is improving and their impor;ance is gradually



rising, managerial economists in certain firms still 'feel quite insecure.Nevertheless, there is a definite and growing realisation that they cancontribute significantly to the profitable growth of firms and effective

solution oftMir problems, and this' promises them a positive future.

REVIEW QUESTIONS1. What is managerial economics? How does it differ from

traditional economics?2. Discuss the nature and scopeofmanagerial economics.

3. Show the significance of economic analysis in business decisions.4. Managerial Economics is perspective rather than descriptive incharacter? Examine this statement.

5. Assess the contribution and limitations of economic analysis tobusiness decision-making.

6. Briefly explain the five principles, which are basic to the entire

gamut of managerial economics.

7. Explain the role of marginal analysis in determining optimalsolution if managerial economics. How does it compare with

break-even analysis?

9.Discuss some of the important economic concepts and

techniques that help busirless management.

10.Explain the various functions of a managerial economist. Howcan he best serve the management?



LESSON – 2

DEMAND ANALYSIS

Demand is one of the crucial requirements for the existence of anybusiness firm. Firms are interested in their profit and sales, both

of which depend partially upon the demand for the product. Thedecisions, which management makes with respect to production,advertising, cost allocation, pricing, inventory holdings, etc. call

for an analysis of demand. While how much a firm can producedepends upon its capacity and demand for its products. If there isno demand for a product, its production is unworthy. If demand

falls short of production, one way to balance the two is to createnew demand through more and better advertisements. The more

the future demand for a product, the more inventories the firmwould hold. The larger the demand for a firm's product, the higheris the price it can charge.

Demand analysis seeks to identify and measure the forces thatdetermine sales. Once this is done the alternative ways ofmanipulating or managing demand can easily be inferred.

Although, demand for a finri's product reflects what theconsumers buy, this can be influenced through manipulating thefactors on which consumers base their demands. Demand analysis

attempts to estiinate the demand for a product in future, whichfurther helps to plan production based on the estimated demand.

MEANING OF DEMAND

Demand for a good implies the desire of an individual to acquire theproduct. It also includes willingness and ability of ail individual to

pay for the product. For example, a miser's desire for and his abilityto pay for a car is not demand, for he does not have the necessarywill to pay for the car. Similarly, a poor person's desire for· and his

willingness to pay for a car is not demand because he lacks the



necessary purchasing power. One can also imagine an individual,who possesses both the will and the purchasing power to pay for agood. But this purchasing power is not the demand for that good,

this is because he does not have the desire to buy that product.Therefore, demand is successful when there are all the three factors:desire, willingness and ability. It should also be noted that demand

for any goods or services has no meaning unless it is stated withreference to time, price, competing product, consumer's incomes,

tastes and preferences. This is because demand varies withfluctuations in these factors. For example, the demand for anAmbassador car in India is 40,000 is meaningless unless it is stated

that this was the demand ·in 1976 when an Ambassador car's pricewas around thirty thousand rupees. The price of the competing cars’prices were around the same, a Bajaj scooter's price was around five

thousand rupees and petrol price was around three and a half rupeesper litre. In 1977, the demand for Ambassador cars could be

different if any of the above factors happened to be different.Furthermore, it should be noted that a product is defined withreference to its particular quality. If its quality changes it can be

deemed as another product. Thus, the demand for any product is thedesire, wi1lihigness and ability to buy the product with reference toa partkular time and given values of variables on which it depends.

TYPES OF DEMAND

The demand for various kinds of goods is generally classified on the

basis of kinds of consumers, suppliers of goods, nature of goods,duration of consumption goods, interdependence of demand,

period of demand and nature of use of goods (intermediate or final),The major classifications of demand are as follows:

Individual and market demand

Demand for firm's prodtictand industry's products

Autonomous and derived demand

Demand for durable and non-durable goods



Short-term and long-term demand

Individual and Market Demand

The quantity of a product, which an individual is willing to buy at aparticular price during a specific time period, given his money

income, his taste, and prices of other commodities (particularlysubstitutes and complements), is called 'individual's demand for a

product'. The total quantity, which all comsumers are willing to buyat a given price per time unit, given their money income, taste, andprices of other commodities is known as 'market demand for the

good'. In other words, the market demand for a good is the sum ofthe individual demands of all the c6-nsumers of a product, over atime period at given prices.

Demand for Firm's Product and Industry's Products

The quantity of a firm's yield, that can be disposed of at a given price

over a period refers to the demand for firm's product. The aggregatedemand for the product of all firms of an industry is known as themarket-demand or demand for industry's product. This distinction

between the two kinds of demand is not of much use in a highlycompetitive market since it merely signifies the distinction between a

sum and its parts. However, where market structure is oligopolistic, adistinction between the demand for firm's product and industry'sproduct is useful from managerial point of view. The product of each

firm is so differentiated from the products of the rival firms thatconsumers treat each product different from the other. This givesfirms an opportunity to plan the price of a product, advertise it in

order to capture a larger market share thereby to enhance profits. Forinstance, market of cars, radios, TV sets, refrigerators, scooters,

toilet soaps and toothpaste, all belong to this category of markets.

In case of monopoly and perfect competition, the distinctionbetween demand for a firm's product and industry's product is not of

much use from managerial point of view. In case of monopoly,



industry is one-firmindustiy andthe demand for firm's product is thesame as that of the industry. In case of perfect competition, productsof all firms .of the industry are homogeneous and price for each firm

is determined by industry. Firms have little opportunity to plan theprices permissible under local conditions and advertisement by afirm becomes effective for the whole industry. Therefore, conceptual

distinction between demand for film's product and industry'sproduct is not much use in business decisions making.

Autonomous and Derived Demand

An Autonomous demand for a product is one that arisesindependently of the demand for any other good whereas a derived

demand is one, which is derived from demand of some other good. Tolook more closely at the distinction between the two kinds of demand,consider the demand for commodities, which arise directly from the

biological or physical needs of the human beings, such as demand forfood, clothes and shelter. The demand for these goods is autonomousdemand. Autotnomous demand also arises as a' result of

demonstration effect, rise in income, and increase in population andadvertisement of new produCts. On the other hand, the demand for a

good that arises because of the demand for some other good is calledderived demand. For instance, demand for land, fertiliser andagricultural tools and implements are derived demand, since the

demand of goods, depends on the demand of food. Similarly, demandfor steel, bricks, cement etc., is a derived demand because it is

derived from the demand for houses and other kind of buildings. [ngeneral, the demand for, producer goods or industrial inputs is aderived one. Besides, demand for complementary goods (which

complement the use of other goods) or for supplementary goods(which supplement or provide additional utility from the use of othergoods) is a derived demand. For instance petrol is a complementary

goods for automobiles and a chair is a complement to a table.Consider some examples of supplement goods. Butter is supplement



to bread, mattress is supplement to cot and sugar is supplement totea. Therefore, demand for petrol, chair, and sugar would beconsidered as derived demand. The conceptual distinction between

autonomous demand and derived demand would be useful accordingto the point of view of a bllsinessman to the extent the former canserve as an indicator of the latter.

Demand for Durable and Non-durable Goods

Demand is often classified under demand for durable and non-durable

goods. Durable goods are those goods whose total utility is notexhausted in single or short-run use. Such goods can be usedcontinuously over a period of time. Durable goods may be consumer

goods as well as producer goods. Durable consumer goods includeclothes, shoes, house furniture, refrigerators, scooters, and cars. Thedurable producer goods include mainly the items under fixed assets,

such as building, plant and machinery, office furniture and fixture. Thedurable goods, both consumer and producer goods, may be further

classified as semi-durable goods such as, clothes and furniture anddurable goods such as residential and factory buildings and cars. Onthe other harid, non-durable goods are those goods, which can be

used only once such as food items and their total utility is exhaustedin a single use. This category of goods can also be grouped undernon-durable consumer and producer goods. All food items such as

drinks, soap, cooking fuel, gas, kerosene, coal and cosmetics fall inthe former category whereas, goods such as raw materials', fuel and

power, finishing materials and packing items come in the lattercategory.

The demand for non-durable goods depends largely on their

current prices, consumers' income and fashion whereas the expectedprice, income and change in technology influence the demand for thedurable good. The demand for durable goods changes over a relatively

longer period. There is another point of distinction between demandsfor durable and non-durable goods. Durable goods create demand for



replacement or substitution of the goods whereas non-durable goodsdo not. Also the demand for non-durable goods increases ordecreases with a fixed or constant rate whereas the demand for

durable goods increases or decreases exponentially, i.e., it maydepend· upon some factors such as obsolescence of machinery, etg.For example, let us suppose that the annual demand for cigarettes in a

city is 10 million packets and it increases at the rate of half-a-millionpackets per annum on account of increase in population when other

factors remain constant. Thus, the total demand for cigarettes in thenext year will be 10.5 million packets and 11 million packets in thenext to next year and so on. This is a linear increase in the demand for

a non-durable good like cigarette. Now consider the demand for adurable good, e.g., automobiles. Let us suppose: (i1 the existingnumber of automobiles in a city, in a year is 10,000, (ii) the annual

replacement demand equals 10 per cent of the total demand, and (iii)the annual autonomous increase ·in demand is 1000 automobiles. As

such, the total annual clemand for automobiles in four subsequentyears is calculated and presented in Table 2.1.

Table 2.1: Annual Demand for Automobiles

Beginning Total no. of Replacement Annual Total Annualof the year automobiles demand autonomous demand increase

;(Stock) demand in

, demand1st year 10,000 - - 10,000

_

-2nd year 10,000 1000 1000 12,000 2000-3id year 12,000 1200 1000 14,200 2200

4th year 14,200 1420 1000 16,620 2420

Stock + Replacement + Autonomous demand = TotalDemand

It may be seen from the Table 2.1 that the total demand forautomobiles is increasing at an increasing rate due to acceleration

in the replacement demand. Another factor, which might acceleratethe demand for automobiles and such durable goods, is the rate ofobsolescence of this category of goods.

Short-term and Long-term Demand



Short-term demand refers to the demand for goods that aredemanoed over a short period. In this category fall mostly the fashionconsumer goods, goods of seasonal use and inferior substitutes

during the scarcity period of superior goods. For instance, the demandfor fashion wears is short-term demand though the demand for thegeneric goods such as trousers, shoes and ties continues to remain a

long¬term demand. Similarly, demand for umbrella, raincoats,gumboots, cold drinks and ice creams is of seasonal nature; 'The

demand for such goods lasts till the season lasts. Some goods of thiscategory are demanded for a very short period, i.e., 1-2 week, forexample, new greeting cards, candles and crackers on occasion of

diwali.

Although some goods are used only seasonally but are durable inpature, e.g., electric fans, woollen garments, etc. The demand for such

goods is of also durable in nature but it is subject to seasonalfluctuations. Sometimes, demand for certain gools suddenly increasesbecause of scarcity of their superior substitutes. For examp1e, when

supply of cooking gas suddenly decreases, demand for kerosene,cooking coal and charcoal increases. In such cases, additional demand

is of shGrt¬term nature. The long-term demand, on the hand, refersto the demand, which exists over a long-period. The change inlong-term demand is visible only after a long period. Most generic

goods have long-term demand. For example, demand for consumerand producer goods, durable and non-durable goods, is long-termdemand, though their different varieties or brands may have only

short-term demand. Short-term demand depends, by and large, onthe price of commodities, price of their substitutes, current disposable

income of the consumer, their ability to adjust their consumptionpattern and their susceptibility to advertisement of a new product. Thelong-term demand depends on the long-term income trends,

availability of better substitutes, sales promotion, and consumer creditfacility. The short-term and lcmg-term concepts of demand are usefulin designing new products for established producers, choice of



products for the new entrepreneurs, in pricing policy and indetermining advertisement expenditure.

DETERMIN!\NTS OF MARKET DEMAND

The knowledge of the determinants of market demand for a productand the nature of relationship between the demand and itsdeterminants proves very helpful in analysing and estimating demand

for the product. It may be noted at the very outset that a host offactors determines the demand for a product. In general, following

factors determine market demand for a good:

Price of the good- .

Price of the related goods-substitutes, complements and

supplements

Level of consumers' income

Consumers' taste and preference

Advertisement of the product

Consumers' expectations about future price and supply

position

Demonstration effect and 'bend-wagon effect’

Consumer-credit facility

Population of the country

Distribution pattern of national income.

These factors also include factors such as off-season discountsand gifts on purchase of a good, level of taxation and general socialand political environment of the country. However, all these factors

are not equally important. Besides, some of them are not quantifiable.For example, consumer's preferences, utility, demonstration effect

and expectations, are difficult to measure. However, both quantifiableand non-quantifiable determinants of demand for a product will bediscussed.

1. Price of the Product

The price of a product is one of the most important determinants of



demand in the long run and the only determinant in the short run.The price and quantity demanded are inversely related to each other.The law of demand states that the quantity demanded of a good or a

product, which its consumers would like to buy per unit of time,increases when its price falls, and decreases when its price increases,provided the other factors remain' same. The assumption 'other

factors remaining same' implies that income of the consumers, pricesof the substitutes and complementary goods, consumer's taste and

preference and number of consumers remain unchanged. Theprice-demand relationship assumes a much greater significance in theoligopolistic market in which outcome of price war between a firm and

its rivals determines the level of success of the firm. The firms have tobe fully aware of price elasticity of demand for their own products andthat of rival firm's goods.

2. Price of the Related Goods or Products

The demand for a good is also affected by the change in the price of

its related goods. The related goods may be the substitutes orcomplementary goods.

Substitutes

Two goods are said to. be substitutes of each other if a change in priceof one good affects the deinand for the other in the same direction.

For instance goods X and Y are considered as substitutes for eachother if a rise in the price of X increase demand for Y, and vice versa.Tea and coffee, hamburgers and hot-dog, alcohol and drugs are some

examples of substitutes in case of consumer goods by definition, therelation between demand for a product and price of its substitute is ofpositive nature. When, price of the substitute of a product (tea) falls (or

increase), the demand for the product falls (or increases). Therelationship of this nature is shown in Figure 2.1 and 2.2.



Complementary Goods

A good is said to be a complement for another when it complementsthe use of the other or when the two goods are used together in sucha way that their demand changes (increases or decreases)

simultaneously. For example, petrol is a complement to car andscooter, butter and jam to bread, milk and sugar to tea and 1 coffee,mattress to cot, etc. Two goods are termed as complementary to each

other -i if an increase in the price of one causes a decrease in demandfor the other. By definition, there is an inverse relation between the

demand for a good and the price of its complement. For instance, anincrease in the price of petrol causes a decrease in the demand for carand other petrol-run vehicles and vice versa while other thing's

remaining constant. The nature of relationship between the demand



for a product and the price of its complement is given in Figure 2.2.

3. Consume's Income

Income is the basic determinant of market demand since it

determines the purchasing power of a consumer. Therefore, peoplewith higher current disposable income spend a larger amount ongoods and services than those with lower income. Income-demand

relationship is of more varied nature than that between demandand its other determinants. While other determinants of demand,e.g., product's own price and the price ohts substitutes, are more

significant in the short-run, income as a determinant of demand isequally important in both short run and long run. Before

proceeding further to discuss income-demand relationships, it willbe useful to note that consumer goods of different nature havedifferent kinds of relationship with consumers having different

levels of income. Hence, the managers need to be fully aware of thekinds of goods they are dealing with and their relationship with theincome of consumers, particularly about the assessment of both

existing and prospective demand for a product.

For the purpose of income-demand analysis, goods and serv:icesmaybe grouped under four broad categories, which ate: (a) essential

consumer goods, (b) inferior goods, (c) normal goods, and (d) prestigeor luxury goods. To understand all these terms, it is essential to

understand the relationship between income and different kinds ofgoods.Esscntial Consumcr Goods (ECG): The goods and services of this

category are called 'basic needs' and are consumed by allpersons of a society such as food-grains, salt, vegetable oils,

matches, cooking fuel, a minimum clothing and housing.Quantity demanded for these goods increases with increase inconsumer's income but only up to certain limit, even though the

total expenditure may increase in accordance with the quality ofgoods consumed, other factors remaining the same. Therelationship between goods of this category and consumer's



income is shown by the curve ECG in Figure 2.3. As the curveshows, consumer's demand for essential goods increases onlyuntil his income rises to OY2. It tends to saturate beyond this

level of income.Inferior goods: Inferior goods are those goods whose demanddecreases with the increase in consumer's income. For example

millet is inferior to wheat and rice; bidi (indigenous cigarette) isinferior to cigarette, coarse, textiles are inferior to refined ones,

kerosene is inferior to cooking gas and travelling by bus isinferior to travelling by taxi. The relation between income anddemand for an inferior good is shown by the curve IG in Figure

2.3 under the assumption that other determinants of demandremain the same demand for such goods rises only up to acertain level of income, i.e., OY1 and declines as income

increases beyond this level.



Normal goods: Normal goods are those goods whose demandincreases with increaseiri the consumer income. For example,

clothings, household furniture and automobiles. The relationbetween income and demand for normal goods is shown by thecurve NG in Figure 2.3. As the curve shows, demand for such

goods increases with the increases in consumer income but atdifferent rates at different levels of income. Demand for normal

goods increases rapidly with the increase in the consumer'sincome but slows down with further increase in income. Itshould be noted froms Figure 2.3 that up to certain level of

income (YI) the relation between ¬income and demand for alltype of goods is similar. The difference is of only degree. Therelation becomes distinctly different beyond YI level of income.

Therefore, it is important to view the income-demand relationsin the light of the nature of product and the level fconsumer's

income.

Prestige and luxury goods: Prestige goods are those goods,which are consu!TIed mostly by rich section of the society, e.g.,

precious stones, antiques, rare paintings, luxury cars and suchother items of show-bff. Whereas luxury goods include jewellery,

costly brands of cosmetics, TV sets, refrigerators, electricalgadgets and cars. Demand for such goods arises beyond a certainlevel of consumer's income, i.e., consumption enters the area of

luxury goods. Producers of such goods, while assessing thedemand for their goods, should consider the income changes inthe richer section of the society and not only the per capita

income. The relation between income and demand for suchgoods is shown by the curve LG in Figure 2.3.

4. Consumer's taste and preference

Consumer's taste and preference play an important role in



detennihing demand for a product. Taste and preference depend,generally, on the changing. life-style, social customs, religious valuesattached to a good, habi of the people, the general levels of living of

the society and age and sex of the consumers. Change in thesefactors changes consumer's taste and preferences. As a result,consumers reduce or give up the consumption of some goods and

add new ones to their consumption pattern. For example, followingthe change in fashion, people switch their consumption pattern from

cheaper, old-fashioned goods to costlier ‘mod’ goods, as long asprice differentials are proportionate with their preferences.Consumers are prepared to pay higher prices for 'mod goods' even if

their virtual utility is the same as that of old-fashioned goods. Themanufacturers of goods and services that are subject to frequentchange in fashion and style, can take advantage of this situation in

two ways: (i) they can make quick profits by designing new models oftheir goods and popularising them through advertisement, and (ii)

they can plan production in abetter way and can even avoidover-productiorlifthey keep an eye on the changing fashions.

5. Advertisel11ent ExpenditureAdvertisement costs are incurred with the objective of increasing thedemand for the goods. This is done in the following ways:

By informing the potential consumers about the availability of thegoods.

By showing its superiority to the rival goods.

By influencing consumers' choice against the rival goods, and

By setting fashions and changing tastes.

The impact of such effects shifts the demand curve upward to theright.

In other words, when other factors' remain same, the expenditureon advertisement increases the volume of sales to the same extent.The relation between advertisement outlay and sales is shown in

Figure 2.4.



AssumptionsTherelatiqnship between demand and advertisement cost as shown in

Figure 2.4 is based on the following assumptions:

Consumers are fairly sensitive and responsive to various modesof advertisement.

The rival firms do not react to the advertisements made by afirm.

The level of demand has not already reached the saturation

point. Advertisement beyond this point will make only marginalimpact on demand.

Per unit cost of advertisement added to the price does not makethe price prohibitive for consumers, as compared particularly to

the price of substitutes.

Others determinants of demand, e.g., income and tastes, etc.,are not operating in the reverse direction.

In the absence of these conditions, the advertisement effect onsales may be unpredictable.

6. Consumers’ ExpectationsConsumers’ expectations regarding the future prices, income and



supply position of goods play an important role in determining thedemand for goods and services in the short run. If consumers expect arise in the price of a storable good, they would buy more of it at its

current price with a view to avoiding the possibility of price rise future.On the contrary, if consumers expect a fall in the price of certaingoods, they postpone their purchase with a view to take advantage of

lower prices in future, mainly in case of non-essential goods. Thisbehaviour of consumers reduces the current demand for the goods

whose prices are expected to decrease in future. Similarly, an expectedincrease in income increases the demand for a product. For example,announcement of ‘dearness allowance’, bonus and revision of pay

scale induces increase in current purchases. Besides, if scarcity ofcertain goods is expected by the consumers on account of reportedfall in future production, strikes on a large scale and diversion of civil

supplies towards the military use causes the current demand for suchgoods to increase more if their prices show an upward trend.

Consumer demand more for future consumption and profiteersdemand more to make money out of expected scarcity.

7. Demonstration EffectWhen new goods or new models of existing ones appear in themarket, rich people buy them first. For instance, when a new model of

car appears in the market, rich people would mostly be the first buyer,Colour TV sets and VCRs were first seen in the houses of the rich

families some people buy new goods or new models of goodsbecause they have genuine need for them. Some others do sobecause they want to exhibit their affluence. But once new goods

come in fashion, many households buy them not because they have agenuine need for them but because their neighbors have bought thesame goods. The purchase made by the latter category of the buyers

are made out of such feelings' as jealousy, competition, equality inthe peer group, social inferiority and the desire to raise their social

status. Purchases made on account of these factors are the result of



what economists call 'demonstration effect' or the'Band-wagon-effect.' These effects have a positive effect on demand.On the contrary, when goods become the thing of common use, some

people, mostly rich, decrease or give up the consumption of suchgoods. This is known as 'Snob Effect'. It has a negative effect'on thedemand

for the related goods.

8. Consumer-Gredit Facility

Availability of credit to the cansumers fram the sellers, banks,relatians and friends encourages the conSumers to buy more thanwhat they would buy in the aosence of credit availability. Therefore,

the consumers who can borrow more can consume more than thosewho cannot borrow. Credit facility affects mostly the demand"fordurable goods, particularly those, which require bulk payment at the

time of purchase. The car-loan facility may be one reason why Delhihas more cars than Calcutta, Chennai and Mumbai. Therefore, the

managers who are assessing the prospective demand for their goodsshould take into account the availability of credit to the consumers.

9. Population of the CountryThe Jotal domestic demand for a good of mass consumption dependsalso on the size' of the population. Therefore, larger the population

larger will be the demand for a product, when price, per capitaincome, taste and preference are given. With an increase or decrease

in the size of population, employment percentage remaining thesame, demand for the product will either increase or decrease.

10. Distribution of National Income

The level of national income is the basic determinant of the marketdemand for a good. Therefore, pig her the national income higher willbe the demand for all normal goods and services. Apart from this, the

distribution pattern of the national income is also an importantdeterminant for demand of a good. If national income is evenly



distributed, market demand for normal goods will be the largest. Ifnational income is unevenly distributed, i.e., if majority of populationbelongs to the lower income groups, market demand for essential

goods, including inferior ones, will be the largest whereas thedemand for other kinds of goods will be relatively less.

REVIEW QUESTIONS1.Give short note on 'Demand Analysis'.

2. What are the determinants of market demand for a good? How do

the changes in the following factors affect the demand for agood?

A.PriceB. IncomeC. Price of the substitute

D.AdvertisementE. Population.

Also describe the nature of relationship between demand for a

good and these factors (consider one factor at a time assumingother factors to remain constant).

3. Explain different types of determinants of demand.



LESSON - 3

COST CONCEPTS

Business decisions are generally taken on the basis of money values of

the inputs and outputs. The cost production expressed in monetaryterms is an important factor in almost all business decisions, speciallythose pertaining to (a) locating the weak points in production

management; (b), minimising the cost; (c) finding out the optjmumlevel of output; and (d) estimating or projecting the cost of businessoperations. Besides, the term 'cost' has different meanings under

different settings and is subject to varying interpretations. It istherefore essential that only relevant concept of costs is used in the

business decisions.

CONCEPT OF COST

The concepts of cost, which are relevant to business operations anddecisions, can be grouped, on the basis of their purpose, under two

overlapping categories such as concepts used for accounting purposesand concepts used in economic analysis of business activities.

SOME ACCOUNTING CONCEPTS OF COST

Opportunity Cost and Actual Cost

Opportunity cost is the loss incurred due to the unavoidable situationssuch as scarcity of resources. If resources were unlimited, there would

be no need to forego any income yielding opportunity and, therefore,there would be no opportunity cost. Resources are scarce but have

alternative uses with different returns, Resource owners who aim atmaximising of income put their scarce resources to their mostproductive use and forego the income expected from the second best

use of the resources. Thus, the opportunity cost may be defined as theexpected returns from the second best use of the resources foregone



due to the scarcity of resources. The opportunity cost is also called thealternative cost.

For example, suppose that a person hps a sum of Rs. lOO,OOO for

which he has only two alternative uses. He can buy either a printingmachine or, alternatively, a lathe machine. From printing machine, heexpects an annual income of Rs. 20,000 and from the lathe, Rs.

15,000. If he is a profit maximising investor, he would invest histnoney in printing machine and forego the expected income from the

lathe. The opportunity cost of his income from printing machine is,·the expected income from the lathe machine, i.e., Rs. l5,000. Theopportunity cost arises because of the foregone opportunities. Thus,

the opportunity cost of using resources in the'Printing business is thebest opportunity ahdthe expected return from the lathe machine isthe second best alternative. In assessing the alternative cost, both

explicit and implicit costs are taken into account.Associated with the concept of opportunity cost is the concept of

economic rent or economic profit. In our example, economic rent ofthe printing machine is the excess of its earning over the incomeexpected from the lathe machine (i.e., Rs. 20,000 - Rs. 15,000 = Rs.

5,000). The implication of this concept for a businessman is thatinvesting in printing machine is preferable as long as its economicrent is greater than zero. Also, if firms have knowledge of the

economic rent of the various alternative uses of their resources, it willbe helpful for them to choose the best Investment A venue. In

contrast to opportunity cost, actual costs are those which are actuallyincurred by the firm in the payment for labour, material, plant,building, machinery, equipments, travelling and transport,

advertisement, etc. The total money expenditures, recorded in the'books of accounts are, the actual costs, Therefore, the actual costcomes under the accounting concept.

Business Costs and Full Costs

Business.costs include all the expenses, which are incurred to carry



out a business. The concept of business costs is similar to the actualor the real costs. Business costs include all the payments and'contractual obligations made by the firm together with the book cost

of depreciation on plant and equipment. These cost concepts areused for calculating business profits and losses, for filing returns forincome tax and for other legal purposes. The concept of full costs,

include business costs, opportunity cost and. normal profit. As statedearlier the oppor¬tunity cost includes the expected earning from the

second best use of the resources, or the market rate of interest on thetotal money capital and the value of entrepreneur's own services,which are not charged for'in the current business. Normal profit is a

necessary minimum earning in addition to the opportunity cost, whicha firm must get to remain in its present occupation.

Explicit and Implicit or Imputed Costs

Explicit costs are those, which fall under actual or business costsentered in the books of accounts. For example, the payments for

wages and salaries, materials, licence fee, insurance premium anddepreciation charges etc. These costs involve cash payment and, are

recorded in normal accounting practices. In contrast with these costs,there are other costs, which neither take the form of cash outlays, nordo they appear in the accounting system. Such costs are known as

implicit or imputed costs. Implicit costs may be defined as the earningexpected froin the¬second best alternative use of resources. Forexample, suppose an entrepreneur does not utilise his services in his

own business and works as a manager in ·some other firm on a salarybasis. If he starts his own business, he foregoes his salary as a

manager. This loss of salary is the opportunity cost of income from hisbusiness. This is an implicit cost of his business. The cost is implicit,because the entrepreneur suffers the loss, but does not charge it as

the explicit cost of his own business. Implicit costs are not taken intoaccount while calculating the loss or gains of the business, but theyform an important consideration in whether or not a factor would



remain in its present occupation. The explicit and implicit coststogether make the economic cost.

Out-of-Pocket and Book Costs

The items of expenditure, which involve cash payments or cashtransfers recurring and non-recurring are known as out-of-pocketcosts. All the explicit costs such as wage, rent, interest and transport

expenditure. On the contrary, there are actual business costs, whichdo not involve cash payments, but a provision is made for them in thebooks of account. Thes costs are taken into account while finalising

the profit and loss accounts. Such expenses are known as book costs.In a way, these are payments that the firm needs to pay itself such as

depreciation allowances and unpaid interest on the businessman'sown fund.

Fixed and Variable Costs

Fixed costs are those, which are fixed in volume for a given output.Fixed cost does not vary with variation in the output between zero and

any certain level of output. The costs that do not vary for a certainlevel of output are known as fixed cost. The fixed costs include cost ofmanagerial and administrative staff, depreciation of machinery,

building and other fixed assets and maintenance of land, etc.

Variable costs are those, which vary with the variation in the totaloutput. They are a function of output. Variable costs inclue cost of raw

materials, running cost on fixed capital, such as fuel, repairs, routinemaintenance expenditure, direct labour charges associated with thelevel of output and the costs of all other inputs that vary with the

output.

Total, Average and Marginal Costs

Total cost represents the value of the total resource requirement forthe production of goods and services. It refers to the total outlays ofmoney expenditure, both explicit and implicit, on the resources used

to produce a given level of output. It includes both fixed and variable



costs. The total cost for a given output is given by the cost function.The Average Cost (AC) of a firm is of statistical nature and is not

the actual cost. It is obtained by dividing the total cost (TC) by the

total output (Q), i.e.,

AC =TC

= average costQ

Marginal cost is the addition to the total cost on account of

producing an additional unit of the product. Or marginal cost is thecost of marginal unit produced. Given the cost function, it may be

defined as

These cost concepts are discussed in further detail in thefollowing section. Total, average and marginal cost concepts are usedin economic analysis of firm's producti on activities.

Short-run and Long-run Costs

Short-run and long-run cost concepts are related to variable and fixedcosts, respectively, and often appear in economic analysi.s

interchangeably. Short-run costs are those costs, which change withthe variation in output, the size of the firm remaining the same. In

other words, short-run costs are the same as variable costs. Long-runcosts, on the other hand, are the costs, which are incurred on thefixed assets like plant, building, machinery, etc. Such costs have

long-run implication in the sense that these are not used up in thesingle batch of production.

Long-run costs are, by implication, same as fixed costs. In the

long-run, however, even the fixed costs become variable costs as thesize of the firm or scale of production increases. Broadly speaking, theshort-run costs are those associated with variables in the utilisation of

fixed plant or other facilities whereas long-run costs are associated

AC=aTC

aQ



with the changes in the size and type of plant.

Incremental Costs and Sunk Costs

Conceptually, increment natal costs are closely related to the concept

of marginal sot. Whereas marginal cost refers to the cost of themacgmalunit of output, incremental cost refers to the total additionalcost associated with the marginal batch of output. The concept of

incremental cost is based on a specific and factual principle. In the realworld, it is not practicable for lack of perfect divisibility of inputs to

employ factors for each unit of output separately. Besides, in the longrun, firms expand their production; hire more men, materials,machinery, and equipments. The expenditures of this nature are the

incremental costs, anq not the marginal cost. Incremental· costs alsoarise owing to the change in product lines, addition or introduction ofa new product, replacement of worn out plan and machinery,

replacement of old technique of production with a new one, etc.

The sunk costs are those, which cannot be altered, increased or

decreased, by varying the rate of output. For example, once it isdecided to make incremental investment expenditure and the fundsare allocated and spent, all the preceding costs are considered to be

the sunk· costs since they accord to the prior commitment andcannot be revised or reversed when there is change in marketconditions orchange in business decisions.

Historical and Replacement Costs

Historical cost refers to the cost of an asset acquired· in the past

whereas replacement cost refers to the outlay, which has to be madefor replacing an old asset. These concepts own their sigtlificance tounstable nature of price behaviour. Stable prices over a period of time,

other things given, keep historical and replacement costs on par witheach other. Instability in asset prices, however, makes the two costs

differ from each other.Historical cost of assets is used for accounting purposes, in the

assessment of net worth of the firm.



Private and Social Costs

We have so far discussed the cost concepts that are related to theworking of the firm and those which are used in the cost-benefit

analysis of the business decision process. There are, however,certain other costs, which arise due to functioning of the firm but donot normally appear in business decisions. Such costs are neither

explicitly borne by the firms. The costs of this category are borneby-the society. Thus, the total cost generated by a firm's workingmay be divided into two categories:

• Those paid out or provided for by the firms,• Those not paid or borne by the firm.

The costs that are not borne by the firm include use of resoucesfreely available and the disutility created in the process of production.The costs of the former category are known as private costs and of the

latter category are known as external or social costs. A few examplesof social cost are: Mathura Oil Refinery discharging its wastage in theYamuna River causes water pollution. Mills and factories located in city

cause air pollution by emitting smoke. Similarly, plying cars, buses,trucks, etc., cause both air and noise pollution; Such pollutions cause

tremendous health hazards, which involve health cost to the society asit whole Thes'e costs are termed external costs from the firm's point ofview and social cost from the society's point of view. The relevance of

the social costs lies in understandipg the overall impact of firm'sworking on the society as a whole and in working out the social cost of

private gains. A further distinction between private cost and social costtherefore, requires discussion.

Private costs are those, which are actually incurred or provided

by an individual or a firm on the purchase of goods and services fromthe market. For a firm, all the actual costs both explicit and implicitare private costs. Private costs are the internalised cost that is

incorporated in the firm's total cost of production.

Social costs, on thehand refer to the total cost for the societyon account of production ofa commodity. Social cost can be the



private cost or the external cost. It includes the cost of resources forwhich the firm is not compelled to pay a price such as rivers and lakes,the public, utility services like roadways and drainage system, the cost

in the form of disutility created in through air, water and noisepollution. This category is generally assumed to be equal to totalprivate and public expenditures. The private and public expenditures,

however, serve only as an indicator of public disutility. They do notgive exact measure of the public disutility or the social costs.

COST-OUTPUT RELATIONS

The previous section discussed the variou cost concepts, which help inthe business decisions. The following section contains the discussion

of the behaviour of costs in relation to the change in output. This is, infact, the theory of production cost.

Cost-output relations play an importai)t role in business

decisions relating to cost minirnisalioil"Of'profiHnaximisation andoptimisation of output. Cost-output relations are specified through acost function expressed as

T(C) = f(Q) (1)

where,TC = total cost

Q = quantity produced

Cost functions depend on production function andmarket-supply function of inputs. Production function specifies the

technical relationship between the input, and the output. Productionfunction of a firm combined with the supply function of inputs or

prices of inputs determines the cost function of the firm. Precisely,cost function is a function derived from the production function andthe market supply function. 'Depending on whether short or long-run

is considered for the production, there are two kinds of cost functions:such as short-run cost-function and long-run cost function.Cost-output relations in relation to the changing level of output will be

discussed here u.nder both kinds of cost-functions.



Short-run Cost Output Relations

The basic analytical cost concepts used in the analysis of costbehaviour are total average and marginal costs. The totalcost (TC) is

defined as the actual cost that must be incurred to produce a givenquantity of output. The short-run TC is composed of two majorelements: total fixed cost (TFC) and total variable cost (TVC). That is,

in the short-run,TC = TFC + TVC (2)

As mentioned earlier, TFC (i.e" the ·cost·of plant, building,

equipment, etc.) remains fixed in the short-run, where as TVC varieswith the variation in the output.

For a given quantity of output (Q), the average total cost, (AC),

average fixed cost (AFC) and, average var!able cost (AVC) can 'bedefined as follows:

AC =TC

=TFC + TVC

Q Q

AFC =TFC

Q

AVC =TVC

Q

and AC = AFC +AVC (3)

Marginal cost (MC) is defined as the change in the total cost divided bythe change in the total output, i.e.,

MC =∆TC

oraTC

∆Q aQ

(4)

Since ∆TC = ∆TFC + ∆TVC and, in the short-run, ∆TFC = 0,



therefore, ∆TC=∆TVCFurthermore, under marginality concept, where ∆Q = 1,MC = ∆

TVC.

Cost Function and Cost-output Relations

The concepts AC, AFC and AVC give only a static relationship between

cost and output in the sense that they are related to a given output.These cost concepts do not tell us anything about cost behaviour, i.e.,how AC, A VC and AFC behave when output changes. This can be

understood better with a cost function of empirical nature.Suppose the cost function (I) is specified as

TC = a + bQ - CQ2 + dQ3 (5)

(where a = TFC and b, c and d are variable-cost parameters)

And also the cost function is empirically estimated asTC = 10 + 6Q - 0.9Q2 + 0.05Q3 (6)

and TVC = 6Q - 0.9Q2 + 0.05Q3 (7)

The TC and TVC, based on equations (6) and (7), respectively, have

been calculated for Q = I to 16 and is presented in Table 3.1. The TFC,TVC and TC have been graphically presented in Figure 3.1. As thefigure shows, TFC remains fixed for the whole range of output, and

hghce, takes the form of a horizontal line, i.e., TFC. The TVCcurveshows that the total variable cost first increases ata'i decreasing rateand then at an increasing rate with the increase it the total output. The

rate of increase can be obtained from the slope of TVC curve. Thepattemof change in the TVC stems directly from the law of increasing

and diminishing returns to the variable inputs. As output increases,larger quantities of variable inputs are required to produce the samequantity of output due to diminishing returns. This causes a

subsequent increase in the variable cost for producing the sameoutput. The following Table 3.1 shows the cost output relationship.

Table 3.1: Cost Output Relations

Q FC TVC TC AFC AVC AC MC



(I) (2) (3) (4) (5) (6) (7) (8)0 10 0.0 10.00 - - - -I 10 5.15 15.15 10.00 5.15 15.15 5.152 10 8.80 18.80 5:00 4.40 9.40 3.653 10 11.25 21.25 3.33 3.75 7.08 2.454 10 12.80 22.80 2.50 3.20 5.70 1.555 10 13.75 23.75 2.00 2.75 4.75 0.956 10 14.40 24.40 1.67 2.40 4.07 0.657 10 15.05 25.05 1.43 2.15 3.58 0.658 10 16.00 26.00 1.25 2.00 3.25 0.959 10 17.55 27.55 1.11 1.95 3.06 1.5510 10 20.00 30.00 1.00 2.00 3.00 2.4511 10 23.65 33.65 0.90 2.15 3.05 3.6512 10 28,80 38.80 0.83 2.40 3.23 5.1513 10 35.75 45.75 0.77 2.75 3.52 6.9514 10 44.80 54.80 0.71 3.20 3.91 9.0515 10 56.25 66.25 0.67 3.75 4.42 11.4516 10 70.40 80.40 0.62 4.40 5.02 14.15

From equations (6) and (7), we may derive the behaviouralequations for AFC, AVC and AC. Let us first consider AFC.

Average Fixed Cost (AFC)

As already mentioned, the costs that remain fixed for a certain level ofoutput make the total fixed cost in the short-run. The fixed cost is

represented by the constant term 'a' in equation (6). We know that

AFC =

TFC (8)

Q

Substituting 10 for TFC in equation (8), we get

AFC =10 (9)

Q

Equation (9) expresses the behaviour of AFC in relation tochange in Q. The behaviour of AFC for Q from 1 to 16 is given in

Table 3.1 (col. 5) and is presented graphically by the AFC curve in theFigure 3.1. The AFC curve is a rectangular hyperbola.



Average Variable Cost (AVC)

As defined above,

AVC =TVC

Q

Given the TVC function in equation 7, we may express AVC asfollows:

AVC =6Q-0.9Q2+0.05Q3

= 6- 0.9Q+0.05Q3

(10)Q

Having derived the A VC function (equation 10), we may easily

obtain the behaviour of A VC in response to change in Q. Thebehaviour of A VC for Q from I to 16 is given in Table 3.1 (co 1. 6),and is graphically presented in Figure 3.2 by the A VC curve.

Critical Value of A VC

From equation (10), we may compute the critical value or Q in respectof A Vc. The critical value of Q (in respect of A VC) is that value of Q



at which A VCis minimum. The Ave will be minimum when itsdecreasing rate of change is equal to zero. This can be accomplishedby differentiating equation (10) and setting it equal to zero. Thus,

critical value of Q can be obtained as

Q=aAVC

= 0.9+0.10Q=0

(11)aQ

Q= 9

Thus, the critical value of Q=9. This can be verified from Table

3.1Average Cost (AC)

The average cost in defined as

AC =TC

Q

Substituting equation (6) for TC in above equation, we get

AC =10+6Q-09Q2+0.05Q3

(12a)

Q

=

10

+ 6-0.9Q+0.05Q2Q

The equation (l2a) gives the behaviour of AC in response tochange in Q. The behaviour of AC for Q from I to 16 is given in Table

3.1 and graphically presented in Figure 3.2 by the AC-curve. Note thatAC-curve is U-shaped.

From equation (12a), we may easily obtain the critical value of Q inrespect of AC. Here, the critical valuepf Q in respect of AC is one atwhich AC is minimum. This can be obtained by differentiating equation



(l2a) and setting it equal to zero. This, critical vallie of Q in respect ofAC is given by

aAC=

10- 0.9 + 0.1Q = 0(12b)

aQ Q2

This equation takes the form of a quadratic equation as-10 – 0.9Q2 + 0.1Q3= 0

or, Q3 – 9Q2= 100 = 0

By solving equation (12b), we getQ = 10

Thus, the critical value of output in respect of AC is 10. That is,AC reaches its minimum at Q = 10. This can be verified from Table.3.1 shows short-run cost curves.

Marginal Cost (MC)The concept of marginal cost (MC) is particularly useful in economicanalysis. MC is technically the first derivative of TC function. That is,

aTC



MC = aQ

Given the TC function as in equation (6), the MC function can beobtained as

aTC= 6-1.8Q+0.15Q2 (13)aQ

Equation (13) represents the behaviour of MC. The behaviour ofMC for Q from 1 to 16 computed as MC = TCn - TCn- i is given in

Table 3.1 (col. 8) and graphically presented by MC-curve in Figure3'.2. The critical 'value of Q in respect of MC is 6 or 7. It can be seen

from Table 3.1.

One method of solving quadratic equation is to factorise it andfind the solution.

Thus, Q3 – 9Q2 – 100 = 0

(Q – 10) (Q2 + Q + 10) = 0

For this to hold, one of the terms must be equal to zero,

Suppose (Q2 + Q + 10) = 0

Then, Q – 10 = 0 and Q = 10.

COST CURVES AND THE LAWS OF DIMINISHING RETURNS

We now return to the laws of variable proportions and explain it

through the .cost curves. Figures 3.1 and 3.2 clearly bring out theshort-term laws of production, i.e., the laws of diminishing returns.Let us recall the law: it states that when more and more units of a

variable input are applied to those inputs which are held constant, thereturns from the marginal units of the variable input may initially

increase but will eventually decrease. The same law can also beinterpreted in term's of decreasing and increasing costs. The law canthen be stated as, if more and more units of a variable inputs are

applied to the given amount of a fixed input, the' marginal costinitially decreases, but eventually increases. Both interpretations of the



law yield the same information: one in terms of marginal productivityof the variable input, and the other, in terms of the marginal cost. Theformer is expressed through production function and the latter

through a cost function.Figure 3.2 represents the short-run laws of returns in terms of

cost of production. As the figure shows, in the initial stage of

production, both AFC and AVC are declining because of internaleconomies. Since AC = AFC + AVC, AC is also declining, this shows

the operation of the law of increasing returns. But beyond a certainlevel of output (i.e., 9 units in out example), while AFC continues tofall, AVC starts increasing because of a faster increase in the TVC.

Consequently, the rate of fall in AC decreases. The AC reaches itsminimum when output increases to 10 units. Beyond this level ofoutput, AC starts increasing which shows that the law of diminishing

returns comes in operation. The MC, curve represents the pattern ofchange in both the TVC and TC curves due to change in output. A

downward trend in the MC shows increasing marginal productivity ofthe variable input mainly due to internal economy resulting fromincrease in production. Similarly, an upward trend in the MC shows

increase in TVC, on the one hand, and decreasing marginalproductivity of the variable input, on the other.

SOME IMPORTANT COST RELATIONSHIPS

Some important relationships between costs used in analysing theshort-run cost behaviour may now be summed up as follows:

As long as AFC and AVC fall, AC also falls because AC = AFC

+AVC.

When AFC falls but A VC increases, change in AC depends onthe rate of change in AFC and AVC then any of the following

happens:

ifthereisdecrease in AFC and increase in A VC, AC falls,

if the decrease on AFC is equal to increase in Ave, AC remains



constant, and

if the d~crease in AFC is less than increase in A VC, ACincreases.

The relationship between AC and MC is of varied nature. It may

be described as follows:

When MC falls, AC follows, over a certain range of initial

output. When MCis failing, the rate of fall in MC is greater thanthat of AC This is because in case of MC the decreasing

marginal cost is attributed, : to a single marginal unit while; incase of AC, the decreasing marginal cost is distributed overallthe entire output. Therefore, AC decreases at a lower rate than

MC.

Similarly, when MC increase, AC also increases but at a lowerrate fbr the reason given in'the above point. There is however

a range of output over which this relationship does not exist.For example, compare the behaviour of MC and AC over the

range of output frbm 6 units to 10 units (see Figure 3.2). Overthis range of ~utput, MC begins to increase while ACcontinues to decrease. The reason for this can be seen in

Table. 3.1. When MC starts increasing, it increases at arelatively lower rate, which is sufficient only to reduce the rateof decrease in AC, i.e., not sufficient to push the AC up. That

is why AC continues to fall over some range of output even, ifMC falls.

MC iJ1tetsects AC at its minimum point. This is simply amathematical relationship between MC and AC curves whenboth of them are obtained from the same TC function. In

simple words, when AC is at its minimum, then it is neitherincreasing nor decreasing it is constant. When AC is constant,AC = MC.

Optimum Output in Short-run

An optimum level of output is the one, which can be produced at a



minimum or least average cost, given the required technology isavailable. Here, the least't¬cost' combination of inputs can beunderstood with the help of isoquants and isocosts. The least-cost

combination of inputs also indicates the optimum level of output atgiven investment and factor prices. The AC and MC cost Curves canalso be used to find the optimum level of output, given the size of the

plant in the short-run. The point of intersection between AC and MCcurves deterinines the minimum level of AC. At this level of output AC

= MC. Production beloW or beyond thislevelwill be in optimal. Ifproduction is less than 10 units (Figure 3.2) it will leave some scopefor reducing AC by producing more, because MC < AC. Similarly, if

production is greater than 10 units, reducing output can reduce AC.Thus, the cost curves can be useful in finding the optimum level ofoutput. It may be noted here that optimum level of output is not

necessarily the maximum profit output. Profits cannot be knownunless the revenue curves of firms are known.

Long-run Cost-output Relations

By definition, in the long-run, all the inputs become variable. Thevariability of inputs is based on the assumption that, in the long run,

supply of all the inputs, including those held constant in the short-run,becomes elastic. The firms are, therefore, in a position to expand thescale of their production by hiring a larger quantity of all the inputs.

The long-run cost-output relations, therefore, imply the relationshipbetween the changing scale of the firm and the total output;conversely in the short-run this relationship is essentially one between

the total output and, the variable cost (labour). To understand thelong-run cost¬output relations (lnd to derive long-run cost curves it

will be helpful to imagine that a long run is composed of a series ofshort-run production decisions. As a' corollary of this, long-run costcurves are composed of a series of short-run cost curves. We may now

derive the long-run cost curves and study their' relationship withoutput.



Long-run Total Cost Curve (LTC)

In order to draw the long-run total cost curve, let us begin with ashort-run situation. Suppose that a firm having only one-plant has its

short-mn total cost curve as given-by STCl in panel (a) of Figure 3.3.In this example if the firm decides to add two more plants to its sizeover time, one after the other then in accordance two more short-run

total cost curves are added to STCl in the manner shown by STC2 andSTC3 in Figure 3.3 (a):. The LTC can now be drawn through the

minimum points of STCl, STC2 and STC3 as shown by the LTC curvecorresponding to each STC.

Long-run Average Cost Curve (LAC)

Combining the short-run average cost curves (SACs) derives thelong-run average cost curve (LAC). Note that there is one SACassociated with each STC. Given the STC1 STC2, and STC3 curves in

panel (a) of Figure 3.3, there are three corresponding SAC curves asgiven by SAC1 SAC2 arid SAC3 curves in panel (b) of Figure 3.3. Thus,

the firm has a series of SAC curves, each having a bottom pointshowing the minimum SAC. For instance, C1Q1 is the minimum ACwhen the firm has only one plant. The AC decreases to C2Q2 when the

second plant is added and then rises to C3Q3after the inclusion of thethird plant. The LAC carl be drawn through the bottom of SAC1 SAC2and SAC3 as shown in Figure·3.3 (b) The LAC curve is also known as

‘Envelope Curve' or 'Planning Curve' as it serves as a guide to theentrepreneur in his planning to expand production.



The SAC curves can be derived from the data given in the STCschedule, from STC function or straightaway from the LTC-curve.Similarly, LAC can be derived from LTC-schedule, LTC function or

from LTC-curve. The relationship between LTC and output, andbetween LAC and output can now be easily derived. It is obvious. from

the LTC that the long-run cost-output relationship is similar to theshort-run cost-output relationship. With the subsequent increase inthe output, LTC first increases at a decreasing rate, and then at an

increasing rate. As a result, LAC initially decreases until the optimumutilisation of the second plant and then it begins to increase. Fromthese relations are drawn the 'laws of returns to scale'. When the scale

of the firm expands, unit cost of production initially decreases, but itultimately increases as shown in Figure 3.3 (b).



Long-run Marginal Cost Curve

The long-run marginal, cost curve (LMC) is derived from the short-runmarginal cost curves (SMCs). The derivation of LMC is illustrated in

Figure 3.4 in which SAC3'and LAC arethe same as'in Figure 3.3(b). Toderive the LMC3, consider the points of tangency between SAC3 and theLAC, i.e., points A, Band C. In the long-run production planning, these

points determine the output levels at the different levels of production.For example, if we draw perpendiculars from points A, Band C to theX-axis, the corresponding output levels will be OQ1 OQ2 and OQ3 The

perpendicular AQ1 intersects the SMC1 at point M. It means that atoutput BQ2, LMC, is MQ1. If output increases to OQ2, LMC rises to BQ2.

Similarly, CQ3 measures the LMC at output OQ3. A curve drawn throughpoints M3B and N, as shown by the LMC, represents the behaviour ofthe marginal cost in the long run. This curve is known as the long-run

marginal cost curve, LMC. It shows the trends in the marginal cost inresponse to the change in the scale of production.

Some important inferences may be drawn from Figure 3.4. The

LMC must be equal to SMC for the output at which the correspondingSAC is tangent to the LAC. At the point of tangency, LAC = SAC. For

all other levels of output (considering each SAC separately), SAC >LAC. Similarly, for all levels of outout corresponding to LAC = SAC,the LMC = SMC. For all other levels output, i:he LMC is either greater

or less than the SMC. Another important point to notice is that theLMC intersects LAC when the latter is at its minimum, i.e., point B.There, is one and only one short-run plant size whose minimum SAC

coincides with the minimum LAC. This point is B where, SAC2 = SMC2= LAC = LMC.

Optimum Plant Size and Long-run Cost Curves

The short-run cost curves are helpful in showing how a firm can

decide on the optimum utilisation of the plant-which is the fixedfactor; or how it can determine the least-cost output level. Long-run



cost curves, on the other hand, can be used to show how themanagement can decide on the optimum size of the firm. An Optimumsize of a firm is the one, which ensures the most efficient utilisation of

resources. Given the state: of technology overtime, there is technicallya unique size of the firm and lever of output associated with the leastcost Concept. This uriique size of the firm can be obtained with the

help of LAC and LMCIn Figur 3.4 the optimum size consists of twoplants, which produce OQ2 units of a produd, at minimum long-run

average cost (LAC) of BQ2.

The downtrend in the LAC ihdicates that until output reaches thelevel of OQ2, the firm is of non-optimal size. Similarly, expansion of

the firm beyond production capacity OQ2 causes a rise in SMC as wellas LAC. It follows that given the technology, a firm trying to mini miseits average cost over time must choose a plant which gives minimum

LAC where SAC = SMC = LAC = LMC. This size of plant assures mostefficient utilisation of the resource. Any change in output level, i.e.,

increase or decrease, will make the firm enter the area of in optimality.

ECONOMIES AND DISECONOMIES OF SCALE

Scale of enterprise or size of plant means the amount of investment inrelatively fixed factors of production (plant and fixed equipment).

Costs of production are generally lower in larger plants than in the



smaller ones. This is so because there are a number of economies oflarge-scale production.

Economies of Scale

Marshall classified the economies of large-scale production into twotypes:

1. ExternalEconomies

2. Internal EconomiesExternal Economies are those, which are available to all the firms

in an industry, for example, the construction of a railway line in acertain region, which would reduce transport cost for all the firms, thediscovery of a new machine, which can be purchased by all the firms,

the emergence of repair industries, rise of industries utilisingby-products, and the establishment of special technical schools fortraining skilled labour and research institutes, etc. These economies

arise from the expansion in the size of an industry involving anincrease in the number and size of the firms engaged in it.

Internal Ecnomies are the economies, which are available to aparticular firm and give it an advantage over other firms engaged inthe industry. Internal economies arise from the expansion of the size

of a particular firm. From the managerial point of view, internaleconomies are more important as they can be affected by managerialdecisions of an individual firm to change its size or scale.

Types of Internal Economies

There are various types of internal economies such as labour,

technical, managerial, marketing and so on. We will discuss the typesof internal economies in detail in the following section:

Labour Economies: If an firm decides to expand its scale of

output, it will be possible for it to reduce the labour costs perunit by practising division of labour. Economies of division of

labour arise due to increase in the skill of workers, and thesaving of time involved in changing from one operation to the



other. Again, in many cases, a large firm may find it economicalto have a number of operations performed mechanically ratherthan manuaily. These economies will be of great use in firms

where the product is complex and the manufacturing processescan be sub-divided.

Technical Economies: These are economies derived from the

use of sub¬size machines and such scientific processes likethose which can be carried out in large production units. A small

establishment cannot afford to use such machines andprocesses, because their use would bring a saving only whenthey are used intensively. On the other hand, their use will be

quite uneconomical if they were to lie idle over a considerablepart of the time. For example, a large electroplating plant costsa great deal to keep it in operation. Therefore, the cost per unit

will be low only if the output is large. Similarly, a machine thatfacilitates the pressing out a side of a motorcar will take a week

or more to be put ready for operation to produce a particulardesign. The greater the output of cars of this particular designsthe lower the cost per unit of getting the machine ready for

operation. Similarly, if a dye is made to produce a particularmodel of cars, the cost of dye per unit of cars will depend upon

the output of the cars. Very often large firms may find iteconomical to produce or manufacture parts and componentsfor their products rather than buy them from outside sources.

For example, Hind Cycles, unlike small mariufacturers, producedparts and components themselves. Moreover, large firms mayfind it profitable to utilise their by-products and waste products.

For example, Tata use the smoke from their furnaces tomanufacture coal tar, naphthalene, etc. A small firm's output of

smoke would not be large enough to justifY setting up the .equipment necessary to do so.

Managerial Economies: When the size of the fern increases, the

efficiency of the management usually increases because there



can be greater specialisationin managerial staff. In a large firm,experts can be appointed to look after the various sections ordivisions of the business, such as purchasing, sales, production,

financing, personnel, etc. But a small firm cannot providefull-time employm·entto these experts naturally, the variousaspects of the business have to be looked after by few people

only who may not necessarily be experts. Moreover, a large firmcan afford to set up data processing and mechanised accounting,

etc., whereas small firms cannot afford to do so.

Marketing Economies: A large firm can secure economies in itspurchasing and sales. It can purchase its requirements in bulk

and thereby get better terms. It usually receives prompt deliveries,careful attention and special facilities from its suppliers. This issometimes due to the fact that a large buyer can exert more

pressure·, at times compulsive in nature, for specially favouredtreatment. It can also get concessions from transport agencies.

Moreover, it can appoint expert buyers and expert salesmen.Finally, a large firm can spread its advertising cost over biggeroutput because advertising costs do not rise in proportion to a

rise in sales.

Economies of Vertical integration: A large firm may decide tohave vertical integration by combining a number of stages of

production. This¬integration has the advantage that the flow ofgoods through various stages in production processes is more

readily controlled. Steady supplies of raw materials, on the onehand, and steady outlets for these raw materials, on the other,make production planning more certain and less subject to erratic

and unpredictable changes. Vertical integration may also facilitatecost control, as most of the costs become controllable costs forthe enterprise. Transport' costs may also be reduced by planning

transportation in such a way that cross hauling is reduced to theminimum.

Financial Economies: A large firm can offer better security and is,



therefore, in a position to secure better and easier credit facilitiesboth from its suppliers and its bankers. Due to a better image, itenjoys easier access to the capital market.

Economies of Risk-spreading: The larger the size of the business,

the greater is the scope for spreading of risks throughdiversification. Diversi¬fication is possible.on two lines as follows:

o Diversification of Output: If there are many products, theloss in the sale of one product may be covered by the

profits from others. By diversification, the firm avoidswhat may be called putting all eggs in the same basket.For example, Vickers Ltd., make aircrafts, ships,

armaments, food-processing plant, rubber, plastics,paints, instruments arid a wide range of other products.Many of the larger firms have taken to diversification. ITC

diversified to include marine products and hotel businessin its operations.

o Diversification of Markets: The larger producer isglenerally in a position to sell his goods in many differentand even far-off places. By depending upon one market,

he runs the risk of heavy loss if sales in that marketdecline for one reason or the other.

Sargant Floren'ce and Economies of Scale

Sargant Florence has attributed the economies of scale the threeprinciples, which are in operation in a large-sized business, namely,the principle of bulk transactions, the principle of massed reserves,

and the principle of multiples.

Principle of Bulk Transactions: This principle implies that thecost of dealing with a large batch is often no greater than the cost

of dealing with a small batch, for example,' the cost of placing anorder, large or small; availability of discounts on bulk orders, orannual purchase contracts; economies in the use or'large

containers such as tanks or trucks of special design, for a



container holding, say, twice as much as the other one, does notcost double the amount.

• Principle of Massed Reserves: A large firm has a number of

departments or sections and its overall demand for services, say,transport services, is likely to be fairly large. But it is unlikely thatall departments will make heavy demands of the particular service

at the saine time. Thus the firm can afford to have its owntransport fleet and fully utilise it and thereby ultimately reduce its

costs. The larger the firm, the greater are the advantages.

Principle of Multiples: This principle was first raised by Babbagein 1832 and has also been referred to as 'Balancing of Processes'.

The principle can be better explained through an example.Suppose a manufacturing, operation involves three processes,first in which a machine (:an make 30 units a week; second in

which an automatic machine can make 1,000 units per week; anda third in which a semi-automatic machine can make 400 units

per week. Unles~ the output of the plant is some commonmultiple of 30,1,000 anti 400, one or more of the processes willhave unutilised capacity. Their LCM is 6,000 and, therefore, to

best utilise all the machines the plant size must be of at least6,000 units or any of its multiples.

Economies of Scale and Empirical Evidence

According to the surveys conducted by the Pre-investment SurveyGroup (FAG) and later on by the NCAER, it has been pf()Ved that inpaper industry, profitability decreases with lower scaly of operations

and bigger plants beneht from economies of scale. The report of thePre-investment Survey Group (FAG) reveals that the manufacturing

cost of writing and printing paper would fall from Rs. 1,489 in a100-tonne per day plant to Rs. 1,238 in a 200-tonne per day plantand further to Rs. 1,104 in a 300-tonne per day plant. The following

Table 3.2 further shows the capital cost of raw materials andoperating cost per tonne of paper according to the size of the unit, as



estimated by the NCAER.

Table 3.2: Paper Industry: Investment and Other

Costs of Paper Mills according to Size

Size Tonnes Fixed Cost of raw Operatingper day) investment cost ma terials per cost per tonne

'. per tonne tonne of paper of paper100 • 4,473

4,473

324 1,307200 4,070 263 1,116250 3,945 258 1,056

Another study of cement industry by the Economic and ScientificResearch undation-shows that the per unit of capacity capital

investment of a 3,000 tonne per' day (TPD) capacity cement plantislower than the plants of 50 TPD size. Thus a single cement plant

producing 3,200 TPD requires 46 per cent less capital investment than8 plants of 400 TPD productions would. As regards cost of production,a 800 TPD plant has a 15 per cent cost advantage over a 400 TPD

plant. The difference between the cost of production of a tonne ofcement by a 3,000 TPD plant and of a50 TPD plant is as high as Rs.100 per tonne. In fact, there has been a perceptible increase in the

size of cement plants in India. For example, the 600 tonnes per daycapacity cement plants during the early 1960s gave way with their size

going up to 1,200 tonnes per day. The latest preference is for 3,200tonnes per day capacity plants. A significant policy implication ofeconomics of scale is that in order to earn a reasonable return and at

the same time ensure a fair deal to the consumers, the industry shouldgo in for larger plants and expand the existing plants to .the optimumlevel.

The 6/10 Rule

A useful rule that seeks to measure economies of scale is the 6/1 0rule. According to this rule, if we want to double the volume of acontainer, the material needed to make it will have to be increased by

6/10, i.e., 60 per cent. A proofofthe'6/l0 rule is easy and can be given



here with its advantage. Let us begin with the volume of a containerand the material required to make it. Suppose the container is of theshape of a Gube with its side. The volume of the container then is:

Vo = ao x ao x ao = ao3

Now, to find out the area of material needed, we know that thecontainer will have six equal square faces, each of area an 2 so, the

area of total material needed IS:Mo = 6 x ao2 = 6ao2

Suppose now, that the container's dimension increases from an to

all the volume of the container will then increase to al3 and the areaof t~e material needed will increase to 6a12.

Thus, for two containers of dimensions an and al the ratio of the

areas of material needed will be:

M1

=

6a1/2

=

a1/2

M0 6a0/2 a0

The corresponding ratio of the volumes will be:

V1

=

a1/3

=

a1/3

V0 a0/3 a0

From the above, it follows that:

M1

=

a1/2

=

a1/3.2/3=

V 1 2/3

M0 a0/2 a0 V0

Now, if we double the volume, i.e., if

V1 = 2V0 orV1

=2V0

Then,

M1 V1 2/3



M0 = V0 = (20) 2/3 = 1.59

M1 = 1.59 M0

In other words, doubling the volume requires 59 per cent

increase in material. This is rouJded off as 60 per cent, which is thesame as 6/1O. It may be added that, if in place of a cubical container,we had taken the example of a spherical or a rectangular or a

cylindricai or for that matter a conical container, we would have aijivedat the same relationship, viz.,

M1

=V12/3

M0 V0

The 6/10 rule is of great practical significance. Its significance can

well be realised if we visualise, for example, blast furnaces as boxescontaining the ingredients needed to produce iron, or tankers as largeboxes containing oil.

Minimum Economic Capacity (MEC) SchemeSmall size firms do not enjoy economies of scale. As such, in

pursuance of government's policy to encourage minimum efficientcapacity in industrial und~i1akings, the Government of India hasintroduced' MEC Scheme to petrochemical industries, for example,

Naphtha / Gas Cracker (3 to 4 lakhs tonnes), Bopp Film (56,000tonnes), Polyster Film (5,000 tonnes), Polyster Filament Yam (25,000tonnes), Acrylic Fibre (20,000 tonnes), MEG (One lakh tonnes), PTA

(2lakh tonnes), etc.

World SdaleWith re·cent trends towards globalisation of industries in India, theconcept of "World Scale" has emerged. The term 'World Scale' refers to

that scale or size of the enterprise, which is large enough to enable thefirm to reap various large-scale economies so as to competesuccessfully on the world basis with global rivals. Thus Reliance

Industries Limited has recently announced to build a world scalepolyester facility at Hnzira and a cracker project with capacity



expanding from earlier 40,000 tonnes·to the world scale of 7,50,000tonnes per annum.

Diseconomies of ScaleEconomies of increasing size do not continue indefinitely. After acertain point, any further expansion of the size leads to diseconomies

of scale. For example, after the division of labour has reached its mostefficient point, further increase in the number of workers will lead to a

duplication of workers. There will be too many workers per machinefor really efficient production. Moreover, the problem of co-ordinationof different processes may become difficult. There may be divergence

of views concerning policy problems among specialists inmanagementand reconciliation may be difficult to arrive. Decision-making process

becomes slow resulting in missed opportunities. There may be toomuch of formality, too many individuals between the managers and

workers, and supervision may' become difficult. The managementproblems thus get out of hand with consequent adverse effects onmanagerial efficiency.

The limit of scale economics is also often explained in terms ofthe possible loss of control and consequent inefficiency. With thegrowth in the size of the firm, the control by those at the top

becomes weaker. Adding one more hierarchical level removes thesuperior further away from the subordinates. Again, as the firmexpands, the incidence of wrong judgements increases and errors in

judgement become costly.

Last be not the least, is the limitation where the larger the plant,the larger is the attendant risks of loss from technological changes as

technologies are changing fast in modern times.

Diseconomies of Scale and Empirical Evidence

Large petro-chemical plants achieve economies in both full usage andin utilisation of a wider range ofby-products, which would otherwise,



be wasted. But above 5,00,000 tonnes, diseconomies of scale sets inbecause of the following occurrences:

The plant becomes so large that on-site fabrication of some

parts is required which is much more expensive;

Starting up costs are much higher, more capital is tied up anddelays in commissioning can be extremely expensive; and

The technical limit to compressor size has been reached.

There is, however, no substantial evidence of diseconomies oflarge-scale production. In the final analysis, however, a significant

test of efficiency is survival. If small firms tend to disappear and largeones survive, as in the automobile industry, we must conclude thatsmall firms are relatively inefficient. If small firms survive and large

ones tend to disappear as in the textile industry, then large firms arerelatively inefficient. In reality, we find that in most industries, firms

of very different sizes tend to survive. Hence, it can be concluded thatusually there is no significant advantage or disadvantage to size overa very wide range of outputs. It may mean, of course, that the

businessman in his planning decisions determines that beyond acertain size, plants do have higher costs and, therefore, does notbuild them.

Somewhat surprisingly, some Indian entrepreneurs have beenperceptive enough to attempt to derive the advantages of both largeand small-scale enterprises. In the late sixties, the Jay Engineering Co.

Ltd. evolved a strategy of blending large units with small enterprisesto obtain the best of both worlds. It manufactures its Usha fans in

three different plants (Calcutta, Hyderabad and Agra), with each plant'manu facturing the same or a similar range of products. Each unit isautonomous and is free to take operational decisions except in highly

strategic areas. Within each unit, the work-force is kept small to carryout vital operations such as forgoing, blanking, notching and finalassembly. The rest of the work is sub-contracted to neighbouring

small-scale units, which over a period or time have become almost



integral parts of each plant. Loans for the purchase of machinery arealso advanced and technical know-how and sometimes-eve training isprovided to these ancillary units.

Payments are made promptly. The whole system operates likefamilies within a larger family. Managers in the US, who are alwaysquick in innovating, have also begun adopting this blended system

during the past few years. General Motors encourages the creation ofacluster of independent enterprises in an area, with adequate autonomy

granted to the company's area chief to encourage their growth anddevelopm.ent. Consequently, though a giant in the automobileindustry, General Motors enjoys a large number of the privileges that

acerue to small units and also reaps the special benefits accruing tolarge business firms.

Economies of Scope

This concept is of recent development and is different from theconcept of economies of scale. Here, the cost efficiency in production

process is brought out by variety rather than volume, that is, the costadvantages follow from variety of output, for example, productdiversification within the given scale of plant as against increase in

volume of production or scale 6f output. A firm can add new andnewer products if the size of plant and type of technology make itpossible. Here, the firm will enjoy scope-economies instead of scale

economies.

COST CONTROL AND COST REDUCTION

Cost Control

The long-run prosperity of a firm depends upon its ability to eamsustaid profits. Profit depends upon the difference between the sellingprice and the cost of production. Very often, the selling price is not

within the control of a firm but many costs are under its control. Thefirm should therefore aim at doing whatever is done at the minimum

cost. In fact, cost control is ail essential element for the successfuloperation of a business, Cost control by management means a search



for better and more economical ways of completing each operation. Ineffect, cost control would mean a reduction in the percentage of costsand, in turn, an increase in the percentage of profits. Naturally, cost

control is and will continue to be of perpetual concern to the industry.

Cost control has two aspects' such as a reduction in specificexpenses and a more efficient use of every rupee spent. For example,

if sales can be increased with the same amount of expenditure, say,on advertising and saTesmen, the cost as a percentage of sales is cutdown. In practice, cost control will ultimately be achieved by looking

into both these aspects and it is impossible to assess the contribution,which each has made to the overall savings. Potential savings in

individual businesses will, however, vary between wide extremesdepending upon the levels of efficiency already achieved before costcontrols are introduced.

It is useful to bear in mind the following rules covering cost controlactivities:

It is easier to keep costs down than it is to bring costs down.

The amount of effort put into cost control tends to increasewhen business is bad and decrease when business is good.

There is more profit in cost control when business is. good than

when I business is bad. Therefore, one should not be slack whenconditions are good.

Cost control helps a firm to improve its profitability andcompetitiveness. Profits may be drastically reduced despite a large andincreasing sales volume in the absence of cost control. A big sales

volume does not necessarily mean a big profit. On the other hand, itmay create a false sense of prosperity while in reality; increasing costs

are eating up profits. Profit is in danger-when good merchant¬disingand cost control do not go hand in hand. Cost control may also help afirm in reducing its costs and thus reduce its prices. A reduction in

prices of a firm would lead to an increase in its competitiveness. Theaspect is of particular relevance to Indian conditions because of highcosts, India is being priced out of the world markets.



Tools of Cost ControlFollowing ar.e the tools that are used for the cost control:

Standard Costs and Budgets: The technique of standard, costing

has been developed to establish standards of performance forproducing gvuus and services. These standards serve "as a goal for theattainment and as basis of comparison with actual costs in checking

performance. The analysis of variance between actual and standardcosts will: (i) help fix the responsibility for non-standard performanceand (ii) focus attention on areas in which cost improvement should be

sought by pinpointing the source of loss and inefficiency. Theprinciple here is that or controlling by exception. Instead of

attempting to follow a mass of cost data, the attention of thoseresponsible for cost control is concentrated on significant variancesfrom the standard. If effective action is to be taken, the cause and

responsibility of a variance, as well as its amount, must be established.

The prime objective of standard costs is to generate greater costconsciousness and help in cost control by directing attention to

specific areas where action is needed. To those who are immediatelyconcerned, variances wou1d indicate whether any action is required

on their part. It must be noted that

Costs are controlled at the points where they are incurred and atthe time of occurrence of events, and

At the same time they may be uncontrolled at some points.

It is, therefore, necessary to understand the difference betweencontrollable and uncontrollable costs. The variances may also be

controllable and uncontrollable. For example, if the material costvariance is due to rise in prices, it is not within the control of the

production manager. But if the variance is due to greater usage,control action is certainly possible on his part. The highermanagement can also deCide whether or not they should intervene in

the matter. Sometimes, variances may be so significant that acomplete reapRraisal of the standard costs themselves may be needed.



For example, if the variances are always favourable, it may pointto the fact that the standards have not been properly fixed. Standardcosting can also provide the means for actual and standard cost

comparison by type of expense, by departments or cost centres. Yieldsand spoilage can be compared with the standard allowance for loss.Labour operations and overheads also can be checked for efficiency.

Flexible budgets constitute yet another effective technique of costcontrol, especially control of factory overheads. Flexible budgets, also

known as variable budgets; provide a basis for determining costs thatare anticipated at various levels of activity. It provides a flexiblestandard for comparing the costs of an actual volume of activity with

the cost that should be or should have been. The variances can thenbe analysed and necessary action can be taken in the matter. Table 3.3gives a specimen flexible budget.

Table 3.3: Finishing Department, Modern Manufacturing Co.

Standard hours of direct labour35,000 40,000 45,000

Labour cost hour at Rs. 3 per Rs. 1,05,000 Rs. 1,20,000 Rs. 1,35,000Other variable costs 17500 20.000 22,500Semi-variable costs 9,250 10,000 10,250Fixed costs 50,000 50,000 50,000Total Rs.l,81,75Q Rs. 2,00,000 Rs.2,17,750

The scientific establishment of standards of performance through

standard costs and budgets has not only provided better cost controlbut has led to cost reduction in a number of companies. This hasbeen the case especiilIIy in companies where standards were tied to

wage-incentive plans and improyement in control is part of a generalprogramme of better management. The above table shows threebudgets, one each for 35,000, 40,000 and '45,000 standard hours of

work. In practice, one may come across 50 or more cost items in the



budget and not just four as shown in the table.

Ratio AnalysisRatIo is a statistical yardstick that provides a measure of the

relationship betweeri two figures. This relationship may be expressedas a rate (costs per rupee of sales), as a per cent (cost of sales as apercentage of sales), or as a quotient (sales as a certain number of

time the inventory). Ratios are commonly used in the analysis ofoperations because the use of absolute figures might be misleading.

Ratios provide standards of comparison for appraising theperformance of a business firm. They can be used for cost controlpurposes in two ways:

A businessman may compare his firm's ratios for the period

under scrutiny with similar ratios of the previous periods. Such acomparison would help him identify areas that need his

attention.

• The businessman can compare his ratios with the standard ratiosin his jndustry. Standard ratios are averages of the results

achieved by thousands, of firms in the same line of business.

If these comparisons reveal any significant differences,

thtYmanagement call analyse the reasons for these differences andcan take appropriate action to remove' the causeS responsible forincrease in costs. Some of the most commonly used ratios for cost

corrtparisons are given below:• Not profits/sales.

Gross profits/sales.

Net profits/total assets.

Sales/totaLassets.

• Production costs/costs of sales.

Selling Costs/costs of sales.

Admiriistration costs/costs of sales.

Sahes/iriventory or inventory turnover.

Material costs/prod1, Jction costs.



Labour costs/production costs.

Overhead/prqduction costs.

Value Analysis: Value analysis is an approach to cost saving that

deals with product design. Here, before making or buying anyequipment or materials, a study is made of the purpose to which thesethings serve. Would other lower-cost designs work as well? Could

another less costly item fill the need? Will less expensive material, dothe job? Can scrap be reduced by changing the design or the type of

raw materiaJ? Are the seller's costs as low as they ought to be?Suppliers of alternative materIals can provide the ample data to makethe appropriate choice. Of course, absorbing and reviewing the data

will need some time. Thus the objective of value analysis is theidentification of such costs in a product that do not in any manner

contribute to its specifications or functional value. Hence, valueanalysis is the process of reducing the cost of the prescribed functionwithout sacrificing the required standard of performance. The

emphasis is, first, on identificatiqn of the required function and,secondly, on determination of the best way to perform it at a lowercost. This novel method of cost reduction is not yet seriously exploited,

in our country. Value analysis is a supplementary device in addition tothe con~entional cost reduction methods.

Value analysis is closely related to value engineering, though

they are not identical. Value analysis refers to the work thatpurchasing department does in-this direction whereas valueengineering usually refers to what engineers are doing in this area.

The purchasing department raises questions and consults theengineering department and even the vendor company's department.

Value analysis thus requires wholehearted co-operation of not only thefirm's expertise in design, purchase, production and costing but alsothat of the vendor and other company expertise, if necessary. Some

examples of savings through value analysis are given below:

Discarding tailored products where standard components can

do.



Dispensing with facilities not specified or not required by the

customer, for example, doing away with headphone in a radioset.

Use ofnewly-deyeloped, better and cheaper materials in place of

traditional materials.

Taking the specific case of TV industry, there are various

components of cost, which can be questioned. The various items areas under:

Whether to have vertical holding chassis or the chassis should

be tied down horizontally. In case, chassis is held vertically,additional expenditure in terms of holding clamps is required.

Whether to have plastic cabinet or wooden cabinet.

Whether to have two speakers or one speaker.

Whether to have sliding switches or stationary switches.

Whether to have PVC back cover or wooden back cover.

Whether to have costly knobs or cheaper knobs.

Whether to have moulded mask or extruded plask.

Whether to have Electronic Tuner or Turret Tuner.

Whether to have digital operating unit or noble operating unit.

Cost control is applicable only to such costs, which can bealtered by the management on their own initiative. It may be noted in

this context that, by and large, non-controllable costs exceed far morethan controllable ones thereby restricting the scope of profit

impfoyement through cost, control. Of course, attempts may be madeto convert an uncontrollable cost into a controllable one. Verticalcombinations to secure control over sources of supply provide an

example. So also instead of buying a component, a firm may decide tomake the conversion possible.

AREAS OF COST CONTROLFolloviing are the areas where the cost can be controlled:

1. Materials



There area number of ways that help in reducing the cost ofmatenals.Ifbuying is done properly, a firm avails itself of quantity discounts.While buying from a particular source, in addition to the cost of

materials, consideration should be given to freight charges. In somecases, lower prices of materials may be offset by higher freiight to thefirm's godown. Whiie buying, one may attempt to buy from the

cheapbt source by inviting bids. At times, it may be possible to havemore economical substitutes for raw materials that the firm is using.

Many a times, improvell1ent in product design may lead to reductionin material usage. It is desirable to concentrate attention on the areaswhere saving potential is the highest.

Another area, which needs examination in this respect, iswhether to make or buy components from outside source. Very oftenfirm may find it advantageous to manufacture certain parts and

components in one's own factory rather than buying them. Yet inmany cases there are specific advantages in purchasing spares andcomponents from outside because suppliers may deliver goods at low

cost with high quality. For example, Ford and Chrysler of the US AutoIndustry purchase their components from outside source. But General

Motors could not do so because the firm has its own departments forhandling the process of production. This type of firm is referred asvertically integrated firm where it owns the various aspects of making

seIling and delivering a product Hind Cycles, which has now beentaken over by the Government, manufactures all its components. Butmanu¬facturers of Hero and Avon Cycles purchased most of their

components from outside source and successfully competed with HindCycles.

Continuous Research and Development (R & D) may also lead to

a reduction in raw material costs. For example, Asian Paints made highsavings in costs of raw materials by its phenomenal success on

Research and Development front, by manufacturing synthetic resinsfor captive consumption. Total materials consumed as a ratio of valueof production fell from 67.66 per cent in 1973 to 60-67 per cent in



1977. General Motors have reduced the weight of their cars to makethem more fuel-efficient. Better utilisation of materials' may also savethe cost of materials by avoiding wastes in storing, handling and

processing. Some of the factors, responsible for excessive wastage ofmaterials are: lack of laid down requirements for raw materials, badprocess planning, rejects due to faulty materials or poor workmanship,

lack of proper tools, jigs and fixtures, poor quality of materials, loosepacking, careless and negligent handling and careless storage.

Exploration of the possibilities of the use of standardised parts

and components and the utilisation of waste and by-products, mayalso lead to a significant reduction in the cost of materials.

Inventory control is yet another area for reducing materials

cost. Thro inventory control, it is possible to maintain theinvestment in inventories at lowest amount consistent with the

production and the sales requirements of firm. The cost of carryinginventories ranges from 15 to 20 per cent per annum account ofinterest on capital, insurance, storage and handling charges, spilla

breakage, physical deterioration, pilferage and obsolescence. Again50 per cent the gross working capital may be locked up ininventories.

Some important ways of reducing inventories are:

Improved production planning.

Having dependable sources of supplies, which can ensure

prompt deliver of materials at short notice.

Elimination of slow-moving stocks and dropping of obsolete

items.

Improved flow of part and materials leading to increased machine

utilisation and shorter manufacturing cycles.

Packaging constitutes a significant proportion of raw materials(9 to 24 per cent) and of the total manufacturing expenses (7 to 22

per cent). Firm should mal attempts to reduce the packaging costs tothe minimum. For example, instead discarding containers that the



materials come in it may be used for shipping tl goods and thus, thepackaging cost can be saved. The manufacturing firms such; cars andmotor bikes may request its customers to return the containers in

whic are goods were sent so that they could be used in future. This isbecause packin of such goods as well as the materials used forpacking is very expensive.

2. LabourReduction in wages for reducing labour costs is out of question. Onthe other hand, wages might have to be increased to provide

incentives to workers. Yet there is good scope for reduction in thewage cost per unit. A reduction in labour costs is possible by proper

selection and training, improvement in productivity and by automation,where possible. A study by cn (Confederation of Indian Industry)showed that Hero Cycles improved their productivity per employee by

6.4 per cent. 'Purolators' were able to increase their productivity by100 per cent. Work· study might result in a lot of savings by reducingovertime and idle time and providing better workloads. Labour

productivity might increase if frequent change of tools is avoided.Improvement in working conditions may reduce absenteeism and thus

reduce costs per unit. Scrutiny of overtime may reveal substantialscope for savings.

All efforts must be made to redllce wastage of human effort.

Wastage of human effort may be due to lack of co-ordination amongvarious departments by having more workers thannecessary, ·under-utilisation of existing manpower, shortage of

materials, improper scheduling, absenteeism, poor methods and poormorale. For example, Metal Box adopted a Voluntary Severance

Scheme in 1975¬76 to reduce their work force by 950 workers afterthey faced a huge operating loss ofRs. 2.4 crores. General Motorseliminated 14,000 white-collar jobs through attrition to reduce cost.

Japan's big 5 steel producers announced substantial retrenchmentprogrammes and workers co-operated with the management.Attempts must be made to secure co-operation of employees in cost



reduction by inviting suggestions from them. These suggestionsshould be carefully examined and implemented if found satisfactory.Hindustan Lever has a suggestion box scheme and employees who

come out with good suggestions receive awards. These suggestionsmay either lead to savings or improve safety and work convenJence.The basic idea is to motivate workers and make them perceive working

in the firm as a participative endeavour.

3. Overheads

Factory overheads may be reduced by proper selection of equipment,effective utilisation of space and .equipment, proper maintenance ofequipment and reduction in power cost, lighting cost, etc. For

example, fluorescent lighting can reduce lighting cost. Faulty designsmay lead to excessive use of materials or multiplicity of components,waste of steam, electricity, gas, lubricants, etc. A British team invited

by the Government of India to report on standards of fuel efficiency inIndian industry found that fuel wastages might be as high as an

average of 25 per cent. Keeping them in check even in the face ofincreasing sales may reduce overhead costs per unit. For example,Metal Box maintained their fixed costs in 1976-77 even when there

was an increase in sales of over 18 per cent.Taking advantage of truck or wagonloads may reduce

transportation cost. Careful planning of movements may also save

transportation cost. Another point to be examined is whether it wouldbe economical to use one's own transport or hire a transport. For

reasons of economy, many transport companies hire trucks rather thanowning them. This is because purchase and maintemince of trucks canbe more expensive. By chartering vehicles the problems of

maintenance is left to the owner who in turn Cuts cost for the firm.Thus by keeping a smaller work force on rolls and by introducing acontract rate linked to a safe delivery schedule it is possible to ensure

speedy point-to-point delivery of goods. Many firms now prefer to useprivate taxis rather than have their own staff cars.

Reduction of wastes in general can also reduce manufacturing



costs considerably. Of course, a certain amount of waste and spoilageis unavoidable because employees do make mistakes, machines do getout of order and sometimes raw materials are faulty. However,

attempts can be made to reduce these mistakes and faulty handling tothe minimum. The normal figure for the waste and spoilage dependsupon the complexity of the product, the age of the manufacturing

plant, and the skill and experience of the workers. Once normalwastage is found out, production reports must be watched carefully to

find out whether the wastages are excessive. Wastes can be reducedconsiderably by educating operators in the causes and cures of thewastes. Bad debt losses can be reduced considerably by selecting

customers carefully, and keeping an eye on the receivables.Concentrating on areas and media can reduce advertising costs, whichgive the best results.

Selling costs can be controlled by improving the supervision andtraining of salesmen, rearrangement of sales territories, replanting

salesmen's routes and calls and redirecting of the sales efforts, toachieve a more economic product mix. It may be possible to saveselling costs by the use of warehouses, making bulk shipments to the

warehouses and giving faster deliveries to the customers.Centralisation, reduction, clerical and accounting work may also lead tocost savings. A look at the telephone bills and the communication cost

in general may also reveal areas for substantial savings. For example atelegram may be sent in place of a trunk call.

(a) Cost Reduction

The Institute of Cost and Works Accounts of London has defined costreduction as "the achievement of real and permanent reductions in the

unit costs of goods manufactured or services rendered withoutimpairing their suitability for the use intended". Thus, cost reduction isconfined to savings in the cost of manufacture, administration,

distribution and selling by eliminating wasteful and unnecessaryelements from the product design and from the techniques andpractices carried out in coilOection with cost reduction?



(b) Cost Contro/and Cost Reduction

According to the Institute of Cost and Works Accounts, London, "costcontrol, as generally practised, lacks the dynamic approach to many

factors affecting costs, which determine the need of cost reduction."For example, under cost control, the tendency is to accept standardsonce they are fixed and leave them unchallenged over a period. In cost

reduction, on the other hand, standards must be constantlychallenged for improvement. And there is no phase of business, which

is exempted from the cost reduction. Products, processes, proceduresand personnel are subjected to continuous scrutiny to see where andhow they can be reduced in cost.

To achieve success in cost reduction, the management must beconvinced of the need for cost reduction. The formulation of a detailedand co-ordinated plan of cost reduction demands a systematic

approach to the problem. The first step would be the institution of aCost Reduction Committee consisting of all the departmental heads tolocate the areas of potential savings and to determine the priorities.

The Committee should review progress and assign responsibilities toappropriate personnel. Every business operation should be approached

in the belief that it is a potential source of economy and may benefitfrom a completely new appraisal. Often, it may be possible to dispenseentirely with routines, which, by tradition, have come to be regarded

as a permanent feature of concern. Cost reduction is just as muchconcerned with the stoppage of unnecessary activity as with the

curtailing of expenditure. It is imperative that the cost ofadministering any scheme of cost reduction must be kept withinreasonable limits. What is reasonable must be determined in all cases

from the relationship between the expenditure and the savings, whichresult from it.

Essentials for the Success of a Cost Reduction Programme

Following are the some of the points that firms should take care in



order to achieve success in the cost reduction programme:

Every individual within the firm should recognise· hisresponsibility. The co-operation of every individual requires a careful

dissemination of the objectives and interest of the employees in theachievement of the firm's goals.

Employee resistance to change should be minimised by

disseminating complete information about the proposedchanges and convincing the emplcyees that the changes areconcerned with the problems faced by the firm and that they

would ultimately benefit.

Efforts should be concentrated in the areas where the savings are

likely to be the maximum.

Cost reduction efforts should be continuously maintained.

There should be periodic meetings with the employees to review

the progress made towards cost reduction.

(c) Factors Hampering Cost Control in India

The cost of raw material and other intermediate products is generallyhigh. In many cases: the cost of raw materials is substantially higherthan their international prices, which makes it difficult for the Indian

firms to compete in foreign markets. The sharp rise in oil prices inrecent years also gave a severe push to the cost of raw materials withpetrochemical base. Shortages of raw materials are a usual

phenomenon. With a view to insuring against these shortages,manufacturers keep larger inventories, which result in increase in their

costs. This occurs especially in case of imported raw materials. Wagesare always being linked to cost of living. There are wage boards foralmost every industry and management has little control on wage rates.

Overheads are also higher in India due to the following reasons:

The size of the plant is very often uneconomic due to the

Government's desire to prevent concentration of economic power.



However, there is now a marked change in the policy. In 1986,the Government announced that 65 industries would be startedwith minimum economic capacity so as to 'make India's products

competitive. This process got a boost after the new IndustrialPolicy was announced in July 1991.

There is under-utilisation of capacities due to lack of raw

materials and power shortage. However a manufacturer canexceed his capacity by improving the techniques of production

process. Even after making improvements, a manufacturer lacksthe way to completely minimise the possibilities of increase inthe overheads.

Machinery and equipment obtained under tied credits usually

cost 30 to 40 per cent more than what it wouid cost if purchasedin the open market.

There are delays in the issue of licences and by the time licencesare issued, cost of equipment goes up. The number of industries

subject to licensing has now been drastically reduced.

Increase in administered prices for many items crucial to theindustrial production by the Government from time to time also

pushes up costs.

Finally, there is what lis called by businessmen as 'unseenoverheads' in the nature of demands for illegitl gratification by

various Government officials at different administrative levels.

There are indirect taxes, which also tend to raise the overallcosts of production in India. Excise duties and saies taxes also

heighten the impact of indirect taxes on the cost of production. Indiais perhaps the only country where basic raw materials carry heavy

excise duties. According to an estimate by Mr. S. Moolgaokar,Chairman, TELCO, as much as Rs. 25 crores of working capital islocked up in inventories and work-in-progress with TELCO and its

suppliers solely due to the present tax structure.

Until recent times the Indian industrialists operated in a sheltered



domestic market. They were protected against foreign competition byimport controls and against domestic competition due to industriallicensing. So long as this sellers' market prevailed competition among

sellers was absent and there was no ¬compelling reason for theindustrialists to pay any attention to cost reduction. Costconsciousness was thus by and large absent in India. The price fixation

for products under price control ensured that the rise in costs wasfully reflected in the prices. This made it possible for the industrialists

to pass on any increase in costs to the consumers. However, now withthe advent of recession tendencies, and liberalisation in licensingpolicies, the Indian industrialist is compelled to pay greater attention

to cost reduction and cost control.

APPENDIX - I

Calculation of Variances

The difference between the standard cost and the comparable actual,

cost for the same element and for the same period is known as costvariance. The total of the variances consequently represents thedifference between the actual profits and the standard profits, i.e., the

profits that ought to have been made. The variances are said to befavourable or credit Variances when the actual performance exceeds

the standard performance or the actual costs are lower than thestandard costs. On the other hand, the variances are unfavourableordebit variances when the actual, performance falls short of the

standard performance or the actual costs exceed the standard costs.



All variances must state the direction of the variance as well as theamoUnt. Calculation of cost variances is an important feature ofstandard costing. The formulae for calculating the various variances

are given below:

Material Cost Variance(Actual Quantity x Actual Price) - (Standard Quanity x Standard

Price)or, (AQ x AP) - (SQ x SP)Material Price Variance

(Actual Price - Standard Price) x Actual Quantityor, (AP - SP) x AQ

Material Usage or Quantity Variance(Actual Quantity - Standard Quantity) x Standard Price

or, (AQ - SQ) x SP

Material usage variance can be further sub-divided into (i) Mixvariance and (ii) Yield variance. When the process uses severaldifferent materials that are supposed to be combined in a standard

proportion, mix variance shows the effeclofvariations from thestandard proportion. The formula for calculating the mix variance is:

(Actual Quantity - Standard Proportion) x Standard Price

Yield variance shows the loss due to the actual loss being more orless than the standard loss. The formula for calculating the yield

variance is:(Actual Loss - Standard Loss) x Average Standard Input Price

Labour CostVariance

(Actual Hours x Actual Rate)-(Standard Hours x Standard Rate)or, (AH x AR) - (SH x SR)

Labour Rate (Price) Variance

(Actual Rate - Standard Rate) x Actual Number of Hoursor, (AR- SR) x AH



Overhead Efficiency Variance

The object is to test the efficiency achieved from the actualproduction. The variance is thus, analogous in nature to the labour

efficiency variance. The formula for calculation of the variance is:(Actual Hours - Standard Hours for Actual Production)x Standard Overhead Rate

or, (AH - SH) x SOlt

Cost control ultimately depends on action, which is based onvariances. However, these actions can be taken only by people who

have the appropriate authority. It is, therefore, futile to presentvariances to a person if those variances are related to matters, whichfall outside his guthority. Such variances are called uncontrollable

whereas those relating to matters within his authority ilre termed ascontrollable variance.

APPENDIX II

Cost Control Drive in Coal India Limited (Cll)

CIL closed in 1984-85 with a provisionally estimated profit of Rs. 20pro res after fully discharging its depreciation and loan repaymentobligations. The company had to initiate a series of stringent measures

to achieve the profit figure, the thrust being on controlling costs. Fourspecific areas chosen include: salary and wages, administrationexpenditure, stores and realisation of dues. In 1983-84, the incidence

of salary and wages being what it was, the cost of manpower, pertonne of coal worked out to Rs. 97.04. In 1984-85, the rise was

contained at 88 paisa and the cost of manpower per tonne came to Rs.97.92.This was despite the fact that there was a rise of 51 points inthe consumer price index. And then factors would have justifledan



increase of Rs. 6.44 in the cost of manpower per tonne of coal but itwas contained at 88 paisa.

The CIL Chairman pointed out that a major effort was made to

ensure gainful redeployment of manpower through persuasion andmotivation and at times even by force:' Empowered teams of seniorexecutives were sent to interview people and persuade them to accept

jobs that would suit them. Local redeployment was insisted uponalthough in some places non-availability of residential accommodation

caused a problem. Secondly, increase of manpower was controlled verystrictly. Instructions were issued to subsidiary companies that no newappointment was to be made without Director of Finance and the

Chairman approving it. Thirdly, a drastic reduction was made inovertime allowance and for achieving this objective even threat ofsacking had to be administered.

In the sphere of administration expenditure, the thrust was oncutting down the expenses on account of travelling allowance.However, cost control measures were most effective in the sphere of

stores management. The system of 'fortress checks', introduced in1984-85 resulted in straight saving of Rs. 30 crores. CIL's profit in

1984-85 would have been about Rs. 80 crores, ,if only there was anappropriate system of pricing.

PRICE DISCOUNTS AND DIFFERENTIALS

Distributors' Discounts

Distributors' discounts are the price reductions that systematically

make the net price vary according to buyers' position in the chain ofdistribution. They are called so because these discounts are given tovarious distributors in the trade channel, for example, wholesale

factors, dealers and retailers. For the same reason, they are also calledas trade channel discounts. As these discoUnts create differential

prices for different customers on the basis of marketing functionsperformed by them for example, whether they are wholesalers or



retailers, they are also called as functional discounts. However, it mustbe pointed out that the special discounts may also be given to personsother than distributors and not, associated with distribution function.

For example, special discounts may be given to manufacturers whoincorporate the product in their own product. Tyres and tubes sold; tocycle manufactUrers for use in their bicycles, is a typical example.

Special prices may be charged to members of the same industry; forexample, one company may exchange petroleum with another

company at a special price. Again, special prices may be quoted toCentral and State Governments and to the Universities; for example,Remington typewriters, Godrej safes, etc., are sold at low prices to

these places.

Forms of Distributors Discounts

Distributors' discounts take different forms determined mainly by theconsent of all the business firms in an industry. Nevertheless, at times

firms may have to decide about the form in which discount is to beoffered. There are mainly three forms:

Different net prices for different distributor levels. Net prices

are rarely used for quoting differential prices to distributors.Manufacturers give them to certaii1iliithorised dealers. The

simplicity of this method enables some savings in invoicing andaccounting.

A uniform list price modified by a structure of discounts, each

rate applicable to a different level of distributor, List prices withdiscounts are more common. This method makes it easy to dealwith diverse trade channels. It also facilitates cyclical 'and

seasonal adjustments in prices by merely varying the discounts.This may also help in keeping actual prices a secret, not only

among distributors but also from competitors· and customerssecret, not only among distributors but also from competitorsand customers.

A single discount combined with different supplementary



discounts to different levels of distributors. For example, 5 percent to regional distributors.Thus, the chief advantage of the prices with discounts is greater

flexibility. Further, this method helps the manufacturers to exercisegreater control over the realised' margin of different categories ofdistributors. But real control is achieved only when such discounts are

coupled with resale price maintenance. A supplementary discountgives the manufacturers, a picture of the entire trade channel structure.

These discounts may be intended to reflect distributors cost at'different stages and competition between different kinds ofdistributors. The supplementary discounts are very descriptive in

nature while their accounting is expensive. Distributors' discountsdiffer widely in industries. They also differ among the various businessfirms within industry.

How to Determine Distributors' Discounts

The economic function of distributors' discounts is to induce differentcategories of distributors to perform their respective marketing

functions. As such, to build up a discount structure on soundeconomic lines, it is essential to know the services to be performed bythe distributors, distributors' operating costs, discount structure of

competitors, effects of discounts on distributor population, cost ofselling to different channels and opportunities for market

segmentation.

Services to be performed by the distributors at different levels:The main objective of the manufacturer is to get the distributor

function performed most econoiIlically and effectively. For thispurpose, he may decide upon the various types of services to be

performed by the various types of distributors. The larger is thenumber of services' to be performed by the distributor concerned,the larger is the discount allowed to him, and. vice versa. For

example, a sewing machine manufacturer might de£idethat thedealer will only display the various models of the machinemanufactured by the firm and settle the terms of sale. The



delivery and servicing of the machines may be given to onedistributor in the city. Naturally, in such a cast the discount givento the dealer will be lower than in the case where he has to stock

the commodity and provide after-sales services as well.

Distributors’ operating costs: Trade discounts should naturallycover the operllting costs and the normal profits of the

distributors. In case of high margins, distributers would beinduced to make extra selling efforts. If margins do not cover

costs, the distributors concerned would not be interested inpushing up the sale of the product. Sometimes distributorsbelonging to the same category by name may be performing

widely diflcl'ing functions, Their operating cost is, therefore,determined by the funel ions they perform, For example, if adistributor is required to warehouse and ship the goods as and

when required by the actual users, he would require greaterdiscounts than a distributor who receives the consignments in

truckloads and merely reships them to the different actual userswithout having to warehouse' them. Even when distributors arepcrforming identical services, operating costs'may differ among

individual distrihutors depending upon variations in theiroperating efficiency. In such cases, the manufacturer has to

determine as to whose costs will he try to cover through tradediscounts. There are two possible alternatives: (I) the costs or themost efficient two-thirds of the dealers plus normal profits, or (2)

an estimate of his own cost of performing the distributionfunction. This is very oncn used when the manufacturer is alreadyengaged in some sort or distribution runction.

Competitor’s discount structure: The discounts granted bycompetitors arc usel'lII guides in framing the structure of

discounts. Their relevance becomes still greater when it isrealised that distributors' discounts are given in order to scek thedealers' sales assist~nce in a, competitive market. In quite a good

number of trades, discount rates are fixed by custom and



manufacturers have no option but to fall in line. In manyindustries, the actual discounts' granted by rival sellers vary. Insuch a case, the manufacturer has to decide whether he should be

guided by the higher or the lower discounts. In case the productof the manufacturer is' at some disadvantage in consumeracceptance, he may decide to allow 'larger margins than those of

his competitors. The success of the policy, however, woulddepend upon the following conditions: (a) whether this high

margin of discount merely, compensates for the low turnover andwhether the distributor gets any real economic in~entive? (b)Whether the discount margin will be adequate to induce the

distributor to push the product? (c) How much influence does thedistributor have in pushing a particular brand over that of thecompetitor? (d) Whether the dealer has scope for profitable

market segmentation and personal price discrimination? And (e)Whether competitor are likely to meet the wider discount margi

varying their own? Thus, in general, the success of a particular disscheme requires that the consumers are considerably indifferentto bl have great confidence in the distributor and the

manufacturers' IT share is so small that large competitors will notfeel compelled to cI their own wider margins. A related question is:should a lower p~i, offered to dealers who handle a certain brand

exclusively? Naturall exclusive dealer in general will get a higherdiscount in addition to price advantage arising from quantity

discounts.

Effect of discounts on distributors' population: Very often, Idiscounts may be allowed to encourage the entry of new

distribute push up the sales of a new product line. Similarly,smaller discounts In allowed when the number of distributors hasto be restricted.

Costs of selling to different channels: There is asaving inoverheat selling to retailers as compared to consumers and· to

wholesalel compared to retailers and the regular system of



discounts has somethil do with this saving in overheads.

Opportunities for market segmentation: Trade channeldiscounts C2 used to achieve profitable market segmentation. In

some industries market is divided into several fairly distinctsub-markets, each havin own peculiar competitive and demandcharacteristics. For example, il tyre market, the following

sub-markets may be distinguished:o Original equipment market characterised by skill and bargai

strength ofthe buyers and by big cyclicaJ fluctuations indemand.

o Individual consumer replacement. Market characterise by

unskilled buying, brand preferences, and cyclical stability.o Commercial operators' replacement market characterisedby I buyers who are price-wise and quality-wise, for

example, munic transport undertakings.o Government sale in market characterised by large orders,

foil bids and publication of successful bidders' price.o Export market characterised by international competition.

Each one of these sub-markets .has different elasticity of,

demand. There! The need to charge different prices in each marketsegment arises from difference in the elasticities of demand in thesesubmarkets. The disc (structure can be so devised as to produce the

relevant differential prices suitable for each market segment. Forexample, in the case of original equipment market, price has little

influence on the total number of tyres purchased because the price ofthe tyrespaid by automobile manufacturers would form very smallpercentage of the wholesale price of the car, say, less than 5 per cent.

As such, no feasible reduction in tyre prices would affect cat pricesenough to increase perceptibly the demand for cars and hence of tyres.Very often, while pricing a product which is to be used as a

component of the finished product of another manufacturer, e.g.,pricing of spark plugs or tyres, their manufacturers may be influenced

by such considerations as earning prestige through associating the



component with the finished product, getting replacement business ifthe product is used as a component with some well-known product,etc. Hence, while selling the component product to the manufacturer

of finished product; lower prices and for that purpose higherdiscounts may be allowed. In case of individual consumer replacementmarket, i.e., where buyers are consumers demanding the product for

replacement. The level of price affects the timing of the demandwithin fairly regroups limits set by the age of the product, say tyre.

Here because of brand preferences, buyers' responsiveness to pricedifferences is lower than in other markets where buyers' knowledge isgreater.

Another pricing problem relating to individual consumerreplacement market arises because the manufacturer has to decidewhether to allow high discounts as to permit dealers to

make-individual concessions to customers. Here, a dealer can chargefull price from some customers who are averse to shopping and

bargaining but quite substantially lower prices to more careful and·bargaining type of customers. Thus, allowing high discounts to dealersprovides them sufficient leeway to charge higher or lower prices from

their own customers according to their demand elasticity. It isnormally appropriate to allow the dealer large discounts and therebyconsiderable latitude where the unit cost of the article is high, where

service concessions and trade-ins are provided to the customers byway of veiled price concessions and where the customer is not tied

strictly to the dealer by continuity of service or by customer relations.A related pricing problem of the manufacturer is to decide

whether different distributor margins should be fixed for high-quality

high-price commodities, on the one hand, and low-quality low-priceproducts, on the other. The manufacturer has to consider whether he'is to concentrate more on high quality or on low quality products in

view of their respective profitability. Market segmentation achievedthrough differential distributors' discounts enables building big plants'

to reap economies of size. Manufacturers have sometimes built bigger



plants and to work them to full capacity, they have taken up privatelabel business (manufacturing _ goods to order with private andexclusive brarids), allowing greater discounts till their own brand

becomes sufficiently popular and its demand increases sufficiently towork the big plant fully. If so, they can discontinue the private labelbusiness.

Distributors' demand elasticity higher than that of consumers:

Distributors' demand for the competing brand of differentmanufacturers is more elastic than the corresponding demand of final

consumers. The distributor is generally more capable of judging priceand quality than ultimate consumers who have insufficient knowledge

of the competing brands, and apprehend that a low price may besynonymous with inferior quality. The consumer finds it difficult tochoose between different competing brands, and he often allows

himself to be guided by the retailers. It may be safely asserted thateven the smallest difference in price may cause a dealer to switchover from one brand to another whereas an even greater price change

might not cause any reaction on the ultimate consumers. It is,therefore, of decisive importance to the manufacturers that they

secure the goodwill of the distributors. In. fact, the distributors'potential selling power is great and the manufacturers should try togain their promotional support.

However, in the case of a few highly advertised branded products,which occupy a firm's position in the minds of the consumers,

distributors have to be content with very small margins. For example,the retailer's margin in a 5-kilo Dalda tin comes to 1.5 per cent only.It would be better for a manufacturer to adopt a standard discount

policy. With latitude in discount policy, there is much danger ofconfusion, inequity, loss of goodwill and loss of sales. It may also benoted that distributor discounts do not matter much in industrial

goods.

Quantity Discounts



Quantity discounts are price reductions related to the quantitiespurchased. Quantity discounts may take several forms and may berelated to the size of the order being measured in terms of physical

units of a particular commodity. This is practicable where thecommodities are homogeneous or identical in nature, or where theymay be measured in terms of truckloads. However, this method is not

possible in case of heterogeneous commodities, which are hard to addin terms of physical units, or truckloads. Drug industry and textile

industry offers examples of this type. Here, quantity discounts arebased upon the rupee value of the quantity ordered. Rupee becomes acommon denominator of value.

Quantity discounts based on physical units become importantwhere the cost of packing is a significant factor and orders of less thanstandard quantities, say, less than a case of 6 pressure cookers, may

involve higher packing charges per cooker. Since the space remainsunutilised, the quantity discounts may be employed to induce full-case

purchasing. In some cases, sellers may clearly mention that packingcharges will be the same whether you purchase a full case or less thana full case. Here also, the buyer may like to go for a full case and in

essence avail himself of the quantity discounts. Discounts based onphysical units are less likely to be distorted by changes in prices.

In some cases, to prompt large orders, it may he specified that

orders up to a certain size will not be entitled to any discount. Butbeyond this size, the customer would be entitled to a discount for his

extra purchases over and above the minimum size. The discount ratesmay vary with successive slabs of quantities ordered. Alternatively,discount may be allowed on the entire purchases provided they exceed

a certain minimum. In some cases, quantity discounts mflY be basedon the cumulative purchases made during the particular period,usually at year or a. season, e.g., Diwali discounts may be given on the

basis of cumulative purchases made during the Diwali season spreadover September to Novembe'r. This is different from quantity



discounts based upon individual lots ordered at a time. ThesediscountS ensure customer loyalty and discourage purchasing fromseveral competitors simultaneously, but the limitation of cumulative

discounts is that, they do not tackle the problem of high cost ofservicing small orders, because, buyers get no incentive to order forbigger lots and to avoid hand-to-mouth purchasing. Buyers may be

inclined to place larger orders towards the end of the discount periodto qualify for higher discounts. This may disrupt the production

schedule of the manufacture .The following genital conclusions can be reached:

• Individual order size is a' better basis than cumulative purchases

made during a particular period.

Discounts based on the quantity of individual commoditiesordered have advantages over those based on the total size of

mixed commodities ordered.

Physical units are preferable to rupee value as a measure oforder size on which to base quantity discounts.

Objectives of Quantity Discounts

One important objective of quuntity discountS' is to reduce thenumber of small orders and thereby avoid the high cost of servicing

them. Quantity discounts can facilitate economic size orders in threeways:

A given set of customers is encouraged tbbuy the same quantity

batiste bigger lots.

The customers may be 'induced to give the seller a larger: ihare of

their total requirements by giving preference over, competitors.

Small size purchasers may be discouraged and bigger sizecustomers may' be attracted.

Quantity discount system enables the dealer to reap economiesof buying in lager lots. These economies may enable the dealer tocharge lowler prices from the customers thereby benefiting the



customers. Finally, lower prices to customers may increase thedemand for the commodities, which in turn may enable the dealer topurchase larger quantities, reaping still greater discounts, and the

manufacturer to reap economies of large-scale production, Theadvantages to the manufacturer, dealer and customer are as suchcircular. In fact, in many cases discounts become a matter of trade

custom.

A noted disadvantage of quantity discounts is that dealers mayoften find it cheaper to purchase from wholesalers availing

themselves of these quantity , discounts than from the manufacturerdirectly. This is because the wholesalers may pass on some of their

discounts to the dealers. This may ultimately affect the image of themanufacturer in the minds of the dealers. Again, if the seller becomesdependent upon a few buyers, they may be able to dictate, his

policies ap.d practices. But if his product is sufficiently differentiatedor his service' is unique, he may find it possible and worthwhile topursue an independent discount policy. Quantity discounts are most

useful in the marketing of materials and Applies but are rarely usedfor marketing equipment and components.

Quantity discounts have attracted the attention of the Monopoliesand Restrictive Trade Practices Commission. The Commissionconceded the claim of Reckitt and Coleman of India Ltd., that it was

entitled to gateway under Section, 38(1) (h) of tlie Act in respect ofdiscounts given on larger orders. It was held that the Company’s pricestructure did not directly or indirectly restricts competition to any

material degree. However, some time later, the Commission extnictedan assutance from the five manufacturers of grinding wheels that

they would give up the practice of discounts based on the quantity.Their practice of pricing on ‘slab’ Basis' was alleged to give advantageto buyers of larger quantities compared to Players of smaller

quantities.

Cash Discounts



Cash discounts are price reductions based on promptness of payment.An example of discount can be "2 per yent off if paid in ten days, fullinvoice price in 30 days." In practice, the size of cash discount may

vary widely. Cash discount is a convenient device to identify andovercome bad credit risks. In certain trades where credit risk is high,cash discount would be high. If a buyer decides to purchase goods on

credit, this reflects his weak bargaining position, and he has to pay ahigher price by forgoing the cash discount. There is another way to

look at cash dis.counts. Though cash discounts encourage promptpayment, yet allowing of cash discount also involves certain costs.

These costs have to be compared with the cost of carrying the

account, viz., locking up of working capital, expense of operating acredit and collection department- and risk of bad debts andalternative ways of attaining prompt settlements. By prompt

collections, manufacturers reduce their working capital requirementsand thus save their interest costs. However, allowing discounts may

involve paying 36.5 per cent in order to save 15 per cent. Thus it isthe reduction in collection expenses and in risks rather than savingson interest, which should be the guiding consideration for cash·

discounts. The main point of distinction between cash discounts andquantity discounts is that the former are price reductions based onpromptness ·of payment whereas the latter are price reductions

depending on the quantities purchased (physical units or rupee valueof the quantity purchased). As such, cash discounts induce prompt

payments or collections whereas quantity discounts induce buying inlarge quantities.

Time Differentials

Charging different prices on the basis of time is another kind of price

discrimination. Here the objective of the seller is to take advantage of

the fact that buyer' demand elasticity varies over time. Two broad

types of time differentials may be distinguished:

Clock-time differentials,



Calendar-time differentials.

Clock-time Differentials: When different prices are charged forthe sMne service or commodity at different times within a 24 hours

period, the price differentials are known as clock-time differentials.The common examples of these are the differences between the dayand night rates on trunk calls, differences between morning and

regular shows in cinema houses, and different tates charged' forelectricity sold to industrial users during peak load hours (day time)

and off¬peak load hours. In the case of telephone services, day timingis the period of more inelastic demand and the night time is the moreelastic demand period. Two conditions, which make the clock-time

differentials profitable are as follows:

Buyers must have a definite and strong preference for purchasingat certain timings over others giving rise to significant differences

in demand elasticity.

The product or service must be non-storable either wholly or inparts, i.e., the buyer must consume the entire product at one time

when and for which he pays. In case the product is storable, it willbe purchased at lower rates to be used later when needed making

price differential a losing proposition.

Calendar-time Differentials: Here price differences are basedon a period longer than 24 hours; for example, seasonal pricevariations in the case of winter clothing's, or betel accommodation at

hill and tourist stations. Here, the objective is also to exploit the timepreferences of the buyers.

Geographical Price Differentials

Geographical price differentials refer to price differentials based onbuyers location. The objective here again is to minimise the

differences in transport costs due to the varying distances betweenthe locations of the plants and the customers. There are various typesof geographical price differential, which are explained below:

FOB factory pricing: It implies that the buyer pays all the freight



and is responsible for the risks occurring during transport exceptthose that are assumed by the carrier. The advantages of FOB factorypricing are as follows:

It assures u uniform net price on nIl shipments regardless of

where they go.

No risk is assumed by the seller.

The seller is not responsible for delay in carriage.

Postage stamp pricing: Postage stamp pric1rg means charging

the same delivered price for all destinations irrespective of buyers'location. The quoted price naturally includes the estimated averagetransportation costs. In effect, these prices become discriminatory,

that the short distance buyers have to pay more for transportationthan the actual costs involved while long distance buyers have to payless than the actual costs of transporting goods. Postage stamp

pricing is most Hnmonly employed for goods of popular brands andhaving nation wide distribution. The basic idea is to maintain a

uniform retail price at all places. This common retail price can also beadvertised throughout the country. Bata footwears provide the bestexample of postage stamp pricing other examples are Usha sewing

machines and fans, radios, pressure cookers, typewriters, drugs andmedicines, newspapers and magazines, etc.,

Postage stamp pricing is most suitable in case of products where

transportation costs are significant. It can also be used with advantageby manufacturers to avoid the disadvantage of location being far away

from the main customers who if charged on the basis of actual costsmight have to pay much more and hence refrain from purchasing. Thisadvantage is particularly striking in the case of products involving high

transportation costs. This pricing gives a manufacturer access to allmarkets regardless of his location. Market access is particularlyimportant when products of the rivals are substantially the same.

Zone pricing: Under zone pricing, the seller divides the countryinto zones and regions and charges the same delivered price within



each zone, but different prices between different zones. For example,Parle Company has divided the country into 9 zones, the intra-regionalprice differentials ranging between 5 and 15 per cent approximately.

Generally speaking, zone pricing is preferred where the transportationcost on goods is too high to permit their sale throughout the countryat uniform price. The more significant the transportation costs, the

greater the number of zones and smaller their size. Conversely, forproduct involving lower transportation costs, zones are generally few

but big in size. In India, zone pricing has been widely used invanaspatiand sugar industries.Basing point pricing a basing point price consists of a factory price

plus transportation charges calculated with reference to a particularbasing point. Under this system, the delivered price may be computedby using either single basing point or multiple basing points. In the

single basing point system, all sellers (irrespective of the locations)quote delivered prices, which arc the sum of the basing point price

and cost of transport from the basing point to the particular point ofdelivery. Thus, the delivered prices quoted by all sellers for a givenpoint of delivey are uniform regardless of the point from which

delivery is made. In the multiple point pricing system, two or moreproducing centres are selected as basing points, and the seller thenquotes a delivered price equal to the factory price plus transportation

costs from the basing point nearest to the buyer. Rasing-point pricinghas been widely used in the USA, especially in the steel industry where

at first the single basing-point system known as Pitts burgh plus wasemployed. It was followed by mulliple basing point pricing whenPittsburgh plus was declared illegal.

Consumer Category Price Differentials

Price discrimination is frequently practised according to consumer

categories in the case of public utilities, for examples, electricity,transportation, etc. Electricity firms quote different rates for

residential consumers and industrial consumers. The rates may also



differ for domestic power, light and fan. Railways also chargedifferently from children to adults. They also charge differently -ondifferent classes of goods and different classes of passengers.

Personal Price Discrimination

Price concessions are commonly made to individuals at times forpersonal considerations. For instance, special prices may be given to

companies own employees, shareholders or personal acquaintances.These special prices may take several forms such as additionalservices free of cost, leniency in fixation of prices for used goods in

exchange of new ones and extending credit, interest-free credit.

REVIEW QUESTIONS1. Explain with illustration the distinction between the following:

A.Fixed cost and variable costsB. Acquisition cost and opportunity cost.

2. What is opportunity cost? Give some examples. How are thesecosts relevant for managerial decisions?

3. When MC changes, AC changes (a) at the sane rate, (b) as ahigher rate, or (c) at a lower rate? Illustrate your answer with

the help of diagrams.

4. Explain the relationship between marginal cost, average cost,

and total cost.5. Distinguish between the following:

A. Marginal cost rind incremental cost; B.

Business cost and full cost;C. Actual cost and imputed cost;D. Private cost and social cost of private business.

6. Discuss the various economies or scale. Also discuss SargentFlorence's principles in this regard.

7. "Economics of scale may be either external or internal; they maybe technical, managerial, financial or risk-bearing." Elucidate.

8. Discuss the various economies of scale. Do they result in

monopolies?



9. What are the advantages and limitations of large-scaleproduction?

10.State the importance of cost control in profit planning and

discuss the various areas of cost control.11.Distinguish between cost control and cost reduction. What arethe essentials for the succcss of a cost reduction programmc?



LESSON – 4

PRODUCTION FUNCTION

The term "production function" refers to the relationship between

inputs used and outputs produced by a firm. The terms "factors ofproduction" and "resources" are used interchangeably with the term

"inputs". The relationship is purely physical or technological incharacter and therefore it ignores the prices of inputs and outputs.The study of the production function is aimed at achieving the

maximum output. This can be done with a given set of resources orinputs, and with a given state of technology. The production functioncan be expressed in the form of a schedule. Table 4.1 shows two

inputs viz; labour [X], i.e., number of workers, and capital [Y], i;e., sizeof machine in terms of horsepower, and one output (Q), i.e., the

number of tonnes of iron produced with the various combinations ofinputs.

Table 4.1: Production Function

Capital (Y) - Size of machines (in horse power)250 1,000 1,500 2,000

Labour (X) 1 2 20 32 26(Number of 2 4 48 58 88workers) 3 8 88 110 100

4 12 110 120 1105 32 120 124 1206 58 124 126 1247 88 126 128 1288 100 126 130 1309 110 126 130 13210 104 124 130 134

The production function can also be stated in a form of an eqation:

Q = f (X1, X2, etc.),Where Q = A function ofthedesired output as a result of utili sing

the quantity of two or more inputsXl = units of labour,X2 = units of machinery.



Some factors of production are assumed to be fixed (i.e., notvarying with changes in output); and hence are not included in theequation. The production function is estimated by the method of least

squares.In economic theory, we are concerned with three types of

production functions, viz.,

Production function with one variable input.

Production function with two variable inputs.

Production function with all variable inputs.

PROPUCTION FUNCTION WITH ONE VARIABLE INPUT

In economics, the production function with one variable input isexplained with the help of'Law of Variable Proportions', which is as

follows:

Law of Variable Proportions

The law of variable proportion is one of the fundamental laws of

economics. It is also known as the 'Law of Diminishing MarginalReturns' or the 'Law of Diminishing Marginal Productivity.' This Law ofvariable proportion shows the input-outPut relationship or production

function with one variable factor, i.e., a factor, which can be changed,while other factors of production are kept constant. This is explainedwith the help of the following example:

Suppose a farmer has 20 acres of land to cultivate. The land hassome fixed investment, Le., capital in the form of a tube well,

farmhouse and farm maehinery. The amount of land and capital issupposed to be fixed factors of production. However, the farmer canvary the number of workers employed on its land. Labour is thus the

variable factor of production. The change in the number of workerswill change the output.

The point worth noting here is that the law does not state that

each and every increase in the amount of the variable factor that isemployed in the production process will yield diminishing marginal



returns. It is, however, possible that preliminary increases in theamount of a variable factor may yield increasing marginal returns.While increasing the amount of the variable factor, a point will " be

reached though, where the; marginal increases in total output or themarginal retums will begin declining.

Assumptions for Law of Variable ProportionsThe law of variable proportions functions is based on following

assumptions:

Constant technology: The technology is assumed to be

constant because technological changes will result into rise ofmarginal and average product.

Snort-run: The law operates in the short-run because it is here

that some factors are fixed and others are variable. In thelong-run, all factors are variable.

Homogeneous input: The variable input employed is

homogeneous or identical in amount and quality.

Use of varying amount of variable factor: It is possible to use

various amounts of a variable factor on the fixed factors ofproduction.

Three Stages of Production

A graphic description of the production function is shown in followingfigure 4.1. The total, marginal and average product curves in Figure4.1, demonstrates the law of variable proportions. The figure also

shows three stages of production associated with law of variableproportions. The total product curve is divided info three segments

popularly known as three stages of production, which are as follows:



Stage I

The figure 4.1 shows stage 1 as the segment from the origin topointX2. Here, total product (TP) rises at an increasing rate. At thispoint, the marginal product (MP) of X equals its average product (AP).

X2 is, also the point at which the average product is maximised. In thisstage, the production function is characterised first by increasing

marginal returns from the origin to point X1and then by diminishingmarginal returns, from X1to X2. It should not be assumed that in stage1, only increasing marginal returns take place. Because increasing

returns may occur until a certain point, and thereafter diminishingreturns may take place. Stage I should not therefore be identified withincreasing marginal returns only. Here, both AP and MP increase. In

this stage, a firm can move towards optimum combination of factorsof production and increasing returns, by adding more and more

variable units to fixed factors.

Stage II

The stage II is depicted by the figure in the range from X2 to X3. In

othcr words, stage II begins where the average product of the variablefactor is maximised. It continues till the point at which total product ismaximised and marginal product is zero. Here, TP rises at diminishing

rate. This stage is thus, called the stage of diminishing returns, where



a firm decides its level of production.

Stage IIIFinally, we have stage III, which is depicted by the area beyond X3where the total product curve starts decreasing. Here, too muchvariable input is being used as related to the available fixed inputs andthus variable inputs' are overutilized. The efficiency of both variable

inputs and fixed inputs decline through out this stage. In this range,the marginal product of the variable factor is negative. It starts fromthe point where MP is nil and TP is maximum and covers the whole

range of negative marginal productivity. The following Table 4.2shows the various stages.

Table 4.2: Stages of Production

Total Physical Product Marginal Physical Average PhysicalProduct Product

Stage IIncreasing at an Increases, reaches its Increases and reachesincreasing rate maxiIhum and then its maximum

declines till MR = APStage IIIncreases at diminishing Is diminishing and Starts diminishingrate till it reaches becomes equal to

zeromaximumStage IIIStarts declining Becomes negative Continues to decline

From this stage-wise description of the production function we

can reach two conclusions, which are as follows:

Stage II is Rational

Only stage II is rational and denotes the relevant range-within which arationai firm should operate. In Stage I, it is profitable for the fiim to

keep on increasing the use of labour and in Stage, III, MP is negativeand hence it is inadvisable to use additional labour. The firm, therefore,has a strong incentive to expand through Stage I into Stage II.



Stages I and /II are Irrational

Stages I and III are described as irrational stages. They are called sobecause management, if it is to maxi mise profits will neverintentionally apply the variable to the fixed factors in any combination,

which will yield a total product falling in either of these two stages.

PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

To understand a production function with two variable inputs, it isnecessary to explain what is an ' Isoquant'.

Isoquants

An isoquant is also known as an 'iso-product curve', 'equal productcurve' or a 'production indifferent curve'. These curves show thevarious combinations of two variable inputs resulting in the same level

of output. Table 4.3 shows how different pairs of labour and capitalresult in the same output.

Table 4.3: Different Pairs of Labour and Capital

Labour Capital Output(Units) (Units) (Units)I 5 10

2 3 10

3 2 10

4 1 10

5 0 10

It is evident that output is the same either when 4 units oflabour with 1 unit of capital or 5 units of labour with 0 units of capital

are employed. This relationship, when shown graphically results in anisoquant. Thus, by graphing a production function with two variable

inputs, one can derive the isoquant that helps in tracing all the



combinations of the two factors of production that yield the sameoutput. Thus, an isoquant can be defined as "the curve passingthrough the plotted points representing all the combinations of the

two factors of production, which will produce the given output." Figure4.2 depicts a typical isoquant digram in which by an upwardmovement to the right, one can obtain higher levels of outputs, using

larger quantities of output. For each level of output, there will bedifferent isoquant. When the whole array of isoquants is represented

on a graph, it is called 'isoquant map'.

Substitutability of Inputs

An important assumption regarding the isoquant diagram is that the

inputs can be substituted for each other. For example a particularcombination of X and Y results in output quantity of 600 units. By

moving along the isoquant 600, one finds other quantities of theinputs resulting in the same output. Let us suppose that X representslabour and Y represents machinery. If the quantity of the labour (X) is

reduced, the quantity of machinery (Y) must be increased in order toproduce the same output. The following Figure 4.2 shows a typicalisoquant.



Marginal Rate of Technical Substitution (MRTS)

The slope of the isoquant has a technical name; Marginal Rate ofTechnical Substitution (MRTS) or sometimes, the marginal rate of

substitution in prodtltioti.) Thus, in terms of inputs of capitalservices K and Labour L.

MRTS = aK/dL

MRTS is similar to MRS, I.e., Marginal Rate of Substitution, (whichis slope, of an indifference curve).

Types of Isoquants

Isoquants assume different shapes depending upon the degree ofsubstitutability of inputs under consideration. Based on this thetypes of isoquants can be enlisted as follows:

Linear Isoquants: In the case of linearisoquants, there is perfect

substitutability of inputs. For example, a given output say 100units can be produced by using only capital or only labour or by

a number of combinations of labour and capital, say 1 unit oflabour and 5 units of capital, or 2 units of labour and 3 units of

capital, and so on. Likewise, a giyen power plant that isequipped to burn either oil or gas, for producing variousamounts of electric power can do so by burning either gas or oil,

or varying amounts of each. Gas and oil are perfect substituteshere. Hence, the isoquants are straight lines. The followingFigure 4.3 shows the isoquant for oil and gas.



Right Angle Isoquant: When there is complete

non-substitutability between the inputs (or strictcomplimentarily) then the isoquant curves take the form of right

angle isoquants. For example, exactly two wheels and one frameare required to produce a bicycle and in no way can wheels besubstituted for frames or vice-versa. Likewise, two wheels and

one chassis (The rectangular, steel frame, supported on springsand attached to the axles, that holds thepody and motor of an

automotive vehicle) are required for acooter. This is also knownas 'Leontief Isoquant' or Input-output isoquant. The followingFigure 4.4 shows the isoquant for chasis and wheels.

Convex Isoquant: This form of isoquants assumessubstitutability of inputs but the substitutability is not perfect.

For example, in Figure. 4.5 a shirt can be made with relativelysmall amount of labour (L1) and a large amount of cloth (C1). Thesame shirt can be as well made with less cloth (C2), if more,

labour (L2) is used because the tailor will have to cut the clothmore carefully and reduce wastage. Finally, the shirt can be

made with still less cloth (C3) but the tailor must take extremepains" so that JabourinpiJt requirement increases to C3. So, whilea relatively small addition of labour from L1 to L2 allows the

input of cloth to be reduced from C1 to C2, a very large increasein labour from L2 to L3 is needed to obtain a small reduction in



cloth from C2 to C3. Thus the substitutability of labour for clothdiminishes from L1 to L2 to L3. The following Figure 4.5 showsisoquant for cloth and labour.

Main Properties of Isoquants

All the above-mentioned isoquants are featured with some commonproperties, which are as follows:

An isoquant is downward sloping to the right, i.e., negatively

inclined. This implies that for the same level of output, thequantity of one variable will have to be reduced in order toincrease the quantity of other variable.

A higher isoquant represents larger output. Jhat is, with the

same quantity, of one input and larger quantity of the other

input, larger output will be produced.

No two isoquants intersect or touch each other. If twoisoqua~tsinter.seCt or touch each other, this would mean that

there will be a common point the Two curves; and this wouldimply that the 'same amount of two inputs could produce twodifferent levels of output (i.e., 400 and 500 units), which is

absurd.

Isoquant is convex to the origin. This means that its slopedeclines from left to right along the curve. In other words,

when we go on increasing the quantity of one input say labourby reducing that quantity of other input say capital, we see that



less units of capital are sacrificed for the additional units oflabour.

PRODUCTION FUNCTIONS WITH ALL VARIABLE INPUTS

A closely related question in production .economics is how a

proportionate increase in all the input factors will affect totalproduction. This is the question of returns to scale, which brings tomind three possible situations:

If the proportional increase in all inputs is equal to the

proportional increase in output, returns to scale are constant.For instance, if a simultaneous doubling of all inputs results in a

doubling of production then returns to scale are constant. Thefollowing figure 4.6 shows a constant rate to scale.

If the proportional increase in output is larger than that of theinputs, then we have increasing returns to scale. The following

Figure 4.7 shows increasing returns to scale.



If output increases less than proprotionally with input increase,

we have decreasing returns to scale. The following Figure 4.8shows decreasing returns to scale.

The most typical situation is for a productin function to havefirst increasing then decreasing returns to scale is shown in Figure 4.9.



The increasing returns to scale attribute to specialisation. As

output increases, specialised labour can be used and efficient,large-scale machinery can be employed in the production process.However beyond some scale of operations further gains from

specialisation are limited, and co-ordination problems may begin toincrease costs substantially. When co-ordination price is more thanoffset additional benefits of specialisation, decreasing returns to scale

begin.

Returns to Scale and Returns to an Input

Two important features of production functions are returns to scaleand returns to input, which are explained as follows:

Returns to scale: These describe the impact on the output when

the same proportion increases each input rate. If output increases by alarger percentage than the increase in each input then there areincreasing returns to scale. Conversely, if output increases by a

smaller percentage, there are diminishing returns to scale and if itincreases by the same proportions there are constant returns to scale.

Returns to input: These describe the impact on the outputwhen only one input is varied, holding all others constant. Thesereturns may be increasing,' diminishing, or constant.

Optimal Input Combinations



From the overall discussion so far itisobvious that productionfunction, has a pure 'physical or technological' character. However, itdoes not tell which input combinations are optimal. For that purpose,

one has to take into account the input prices. The following Figure4.10 shows the iscost curves.

Isocost CurvesIn this connection, one has to consider yet another but importantdiagram consisting of isocost curves. Here also, the axes represent

quantities of the inputs X and Y. Suppose that the prices of the inputsare given, and there are no quantity discounts for the firm to get larger

quantities at lower prices. The next step will be to plot the variousquantities of X and Y which may be obtained from the given monetaryoutlays. Figure 4.10 shows the resulting isocost curyes, which are

straight lines under the assumption made here. One isocost showingthe quantities of X and Y that can be purchased for Rs. 1,000 andanother isocost curve showing the quantities of X and Y which can be

purchased for an expenditure of Rs. 2,000 and so on.Now we can easily superimpose the isocost diagram on the

isoquant diagram (as the axes in both the cases represent the samevariables). With the help of Figure 4.11, it can be ascertained that themaximum output for a given outlay, is say Rs. 2,000. The isoquant



tangent represents this maximum output, which is possible with thisoutlay, to the isocost curve. The optimum combination of inputs isrepresented by point E, the point of tangency. At this point, the

marginal rate6f substitution (MRS, sometimes known as the rate oftechnical substitution), between the inputs is equal to the ratiobetween the prices of the inputs.

Likewise, in order to mini mise the cost for a given output, onemay again refer to the isoquant and isocost curves in Figure 4.11. In

this case one moves along the isoquant representing the desiredoutput. It should be clear that the minimum cost for this input isrepresented by isocost line tangent to the isoquant.

Firm's Expansion Path

A firm's expansion path is defined by the cost-minimising

combination of several inputs for each output level. Thus the linerepresenting least cost combination for different levels of output is

called firm's expansion path or the scale line shown by line ABC inFigure 4.12.



MEASUREMENT OF PRODUCTION FUNCTION

Several types of mathematical functions are commonly used formeasuring production function but in applied research, four types are

used extensively. These are linear functions, power functions,quadratic functions and cubic functions.

(1) Linear Function

A linear production function is expressed as follows:Total product: Y = a + bX, where Y = output and X = input. From

this function, equation for average product will beY/X=a/X+b

The equation for the marginal product will

be Y/X = b

(2) Power FunctionA power function expresses output, Y, as a function of input X in the

form:Y = aXb

Some important distinctive properties of such power functions are:

The exponents are the elasticities of production. Thus, in theabove function, the exponent 'b' represents the elasticity of

production.

The equation is linear in the logarithms, that is, it can be written



as: log Y = log a + b log X

When the power function is expressed in logarithmic form as above,the coefficient represents the elasticity of production.

If one input is increased while all others are held constant,

marginal product will decline.

(3) Quadratic ProductionFunction

The production function may be quadratic and is expressed as follows:Y = a + bX = cX2

Where the dependent variable, Y, represents total output and the

independent variable, X, denotes input. The small letters areparameters and their probable values are determined by a statistical

analysis ofthe data.The distinctive properties of the quadratic production function are

as follows:

The minus sign in the last term denotes diminishing marginal

returns.

The equation allows for decreasing marginal product but not for

both inerellsing and decreasing marginal products.

The elasticity of production is not constant at all points along

the curve as in a power function, but declineswiih inputmagnitude.

The equaItion never allows fotan increasing marginal product

When X = 0, Y = a, this means that there is some output evenwhen no variable input is applied.

The quadratic equation has only one bend as compared with a

linear equation, which has no bends.

(4) Cubic Production Function

The cubic production [unction is expressed as follows:Y = a -I- bX -I- cX2 – dX3

Some important distinctivc properties of a cubic production

function arc as follows:



It allows for both increasing and decreasing marginal productivity.

The elasticity of production varies at each point along the curve.

Marginal productivity decreases at an increasing rate in the later

stages.

PRODUCTION FUNCTION AND EMPIRICAL STUDIES

The measurement of production function dates back to a centurywhen certain r pioneer studies were made in the field of agriculture.

And though economic concepts and statistical techniques have nowadvanced a lot, its major work is still in agriculture.

Cobb-Douglas Function

A very popular production function, which deserves special mention, is

the Cobb¬I Douglas function. It relates output in Americanmanufacturing industries from 1899 to 1922 to labour and capitalinputs, taking the form.

P = bLaC1 - aWhere,P = Total output

L=Index of employment of labour in manufacturing

C = Index of fixed capital in manufacturing.

The exponents ‘a’ and ‘1 – a’ are the elasticity of productionthat is, ‘a’ and ‘1- a’ measure the percentage rexsponse of output to

percentage changes in labour and capital respectively. The functionestimated for the USA by Cobb and Douglas is:

P = 1.01L.75C25

R2 = .94.09

This production function shows that a 1 per cent change inlabour input, with the capital remaining constant, is associated with a

0.75 per cent change in output. Similarly, a 1 per cent change incapital, with the labour remaining constant, is associated with a 0.25per cent change in output. The coefficient of determination (R2) means

that 94 per cent of the variations on the dependent variable (P) were



accounted for, by the variations in the independent variables (L and C).

An inportant point to note is that the Cobb-Douglas functionindicates constant returns to scale. That is, if factors of production are

each increased by 1 per cent, the output will increase by 1 per cent. Inother words, one can assume constant avberage and marginalproduction costs for the US industries during the period. The following

Figure 4.13 shows the graph of Cobb-Douglas production.

Criticism

The production function ordianrily discussed in economics is a

rigorously developed micro-economic concept. However,Douglas and his colleagues, estimated production function for

nation’s economies for manufacturing sectors and even forindustries. Thus they “transferred” strictly micro- economic

concept to a macro-econornic setting, without sufficientlyjustifying their act on logical economic grounds. Therefore, theresult of their studies, in the form of equations which they

derived, may be incorrect, and hence the interpretations basedon their equations are uncertain.

The production function of economic theory assumes that the

quantities of inputs used are those that are actually used inproduction. Therefore no variable input is ever redundant. In theDouglas studies however, only labour was measured by the

quantity actually used in production, while capital was measured



by the capital investment, i.e., the quantity available forproduction. Therefore, with the possible' exception of the yearsin which full employment and prosperity prevailed and industry

made reasonably fuil use of the available inputs, the measure ofcapital employed was not theoretically correct one. If annualcapital input always remained as a constant proportion of total

capital investment, then only the elasticity would be the same. Inspite of this criticism, the Cobb-Douglas type of production

function has been found useful for interpreting economic results,since the elasticity of production; is given directly by theexponents when the data are in original form, or by the

regression coefficients when the data are in logarithmic form.

MANAGERIAL USE OF PRODUCTION FUNCTIONS

Though production functions may seem to be highly abstract and

unrealistic, in fact, they are both logical and useful. If the price of afactor of production declines whereas that of another goes up, theformer is likely to substitute the latter. The usefulness of the

production function can be explained with the help of an example,dairy economists are interested in minimising the cost of feeding cows

in milk production. Taking a cow as a single firm, and grain androughage as inputs, the question arises: What proportion of grain androughage would be economical in feeding the cow? In the past, there

has been some tendency to prescribe a fixed ratio, but economicanalysis suggests that the optimal ratio depends on the inptlt prices.

For instance, if we draw isoquantsrelating various quantities of grainand roughage, to various levels of milk output and then superimposeisocost curves on the isoquant diagram, the optimum point of largest

output for a given outlay or of minimum outlay for a givenoutput-would depend on the prices of the factors of production, and itwould change as these prices change. The dairy farmer can use such

analysis for increasing the return from his expenditure on feeds.

Certain economists have focused especially on the application of



their findings. For instance, Earl Heady and his associates havedeveloped a mechaniclIl device known as Pork Postulator, whichfacilitates the farmer to determine the most profitable ration for

feeding pigs under different price conditions.

Production functions thus are not just theoretical and futiledevices. They can also be used as aids in decision-making because

they can give guidance in two directions regarding:

Obtainfng the maximum output from a given set of inputs

Obtaining a given output from the minimum aggregation of

inputs

Of course, in more complex problems, with larger numbers of

inputs and outputs, the mathematics of optimisation becomescomplicated. But recently, the development of linear programming hasmade it possible to handle these complex problems. The use of

complex production functions in managerial decisiull making is goingto be further facilitated with the development of electrollic computers.

DERIVING INPUT COMBINATIONS FROM

PRODUCTION FUNCTIONGiven a production function for a certain output, one can derive all thecombinations of the factors of production that will yield the same

output. This can be illustrated as follows:

IIIustrationSuppose the production function is:

0= 0.196 H 0.880 N 1.815Where,

0= output oftransformers in terms of kilovolt-ampere (kVA)

produced

H = average hours worked per dayN = number of men.

Now, to derive the input combinations for an output level of1,200 kVA, we will have to set the above equation equal to 1,200:



1,200 = 0.196 H 0.880 N 1.815

Then, substituting any value of H (or N) in the equation, we canobtain the associated value of N (or H). We compute below the number

of hours required (H) for an output of 1,200 kVA, if 38 men areemployed.

1,200 = 0.196 H 0.880 N 1.815

log 1,200 = log 0.196 + 0.880 log H + 1.815 log N= log 1,200 = log 0.196+ 0.880 log H + 1.815 log 38

In the same way, we can derive the value of H, if N is 40, 42, 44

and so on, if the desired output level is 1,200 KVA. We can also derivevarious combinations ofH and N for other levels, say, 1,300 KVA or

1,400 KVA.

PRICE AND OUTPUT DECISION UNDER

VARIOUS MARKET SITUATIONSTo understand the concept of market and its various conditions, it is

necessary to study the thcory orthe firm. This is discussed as follows:

The Theory of the FirmThe basic, assumptions of the theory of the linn are as follows:

The objective of a firm is to maximise net revenue in the face of

given prices and technologically determined production function.

A price incrcase far a product raises its supply, whereas prices

increase for a factor reduccs its demand.

The theory or lhe firm deals with the role of business firms in

the resource allocation process. It uses aggregation as a tacticand attempts to specify total market supply and demand curves.

The firm operates with perfect knowledge of all relevant variable

involved in making a decision and it acts rationally while doingso.

Originally the theory assumed that the firm is operating within a

perfectly competitive market. But it has now been extended tocover other market situutions.



The theory has been criticised in the context that profitmaximisation is not the only objective of a firm. It has been suggestedthat long-run survival is the primary motive of an entrepreneur.

Though the importance of profit has not been denied, manyeconomists have argued that profit maximisation should be replacedwith a gonl of makll1g satisfactory profits. However, there is a general

agreement that the theory or the firm explains at a general level, theway in which resources are alloclIted by the price system, when profit

is the main criterion used by the firms.

From the viewpoint of price analysis, it is very important forbusiness management to gain a proper understanding of the nature

and process of competition in the modem industrial society. Themanagement should undcrstllnd the rationale of the free enterprisesystem within which its own business decisions have to be made and

the purpose and limitations of that system. Next it musl hnve fullknowledge of the markets and market situations in which its ownbusiness operates. It should be aware of the policies appropriate to

those market situations. The management should also have anunderstanding of the competitive process and the way variables

involved in the process such as price; product innovnt ion andpromotional activity may be manipulated in enlarging the firm'smarket share. The firms having monopoly power should be familiar

with the nature and llie purpose of the law relating to monopoly andrestrictive practices. The management must also be alert and shouldbe able to recognise when market conditions change. Experienced

executiv.es cannot gain the intimate knowledge of the ways or llicircompetitors. Consequently it is necessary to obtain, an understanding

of the nature of competition, which can provide an insight into theprobable behaviour pnlll'llls of the competitors. To study how pricesare determined the types of market situations need to be studied are

as follows:

Perfect competition.



Imperfect competition

o Monopoly and monopsony

o Monopolistic competition

o Oligopoly and oligopsony.

PURE AND PERFECT COMPETITION

Perfect competition is a market situation where large number ofbuyers and scllns operate freely and commodity sells at a uniform

price. In such a situation no seller or buyer has any influence on themarket price. In this market, a firm is the price taker and industry isthe price maker.

Main FeaturesThe main features of perfect competition are as follows:

There are a large number of buyers and sellers. Each seller

must be small and the quantity supplied by any ne seller mustbe so insignificant that no increase or decrease in his output

can appreciably affect the total supply and the market price. Soalso, each buyer must be small and the quantity bought by anyof the buyers should be so insignificant that no increase or

decrease in his purchases can· appreciably affect the totaldemand and the price. As a result, each seller will accept themarket price as it is. So also each buyer will regard the price as

determined by forces beyond his control.

Each competitor offers a homogenous product, i.e. the

products are similar to ach other in terms of quality, size,design and colour. Thus one product could be substituted forthe other if the price is lower. Again, the commodity dealt in

must be supplied in quantity.

There is no obstacle with regard to entry or exit of the firms.

When these aforesaid three conditions arc fulfilled there is amarket condition that can be defined as a pure competitivemarket.



The market iil which the commodity is bought and sold is well

organised and trading is continuous. Therefore, buyers andsellers are well informed about the price of the commodities.

There are many competitors (whether buyers or sellers), each

acting independently. There must be no restraint upon the

independence of any seller or buyer, either by custom, contract,collusion, and fear of reprisals by the competitors, or by theimposition of government control.

The market price is flexible over a period of time. In other

words, it rises or falls constantly in response to the changingconditions of supply and demand.

All the firms have equal access to production technologies andtechniques.

There are no patents, proprietary designs or special skills that

allow an individual firm to do the job better than itscompetitors.

Firms also have equal access to all their inputs, which areavailable on similar terms.

Thus, perfect competition in an extreme case and is rarely to befound. Actual competition always departs from the ideal of perfectionPerfect competition is a mere concept, a standard by which to measure

the varying degrees of imperfect competition.Sometimes, a distinction is made between perfect competition

and pure I competition. But the line of distinction drawn between thetwo is very fine. That is why many economists have preferred to usethe two terms synonymously. Hence, from managerial viewpoint, there

does not seem to be any difference between the two. The underlyingpresumption in a free competition (close to perfect cmpetition) is thatit social interest interest unless the contrary can be proved.

Competition safeguards the consumer against exploitation byproviding the buyer with alternatives, and makes it unnecessary for the

state to intervene by regulating process and production in order toprotect him.



Determination of PriceThe forces of demand and supply determine prices under perfect

competition. The equilibrium price is obtained at the intersection ofdemand and supply curves as shown in following Figure 4.14. Theequilibrium price will change only with changes in forces of demand

and supply.

Price and Quantity VariabilityResponses to a cnange in demand or to a change in supply may be

primarily in price or quantity. If the demand is highly elastic,consumers will respond readily to price changes by dropping out ofthe market when prices are lowered'a little. As a result, most of the

adjustments to changes in supply (an increase leading to a reductionin price and a decrease leading to an increase.in price) would be those

in quantity purchased, if the demand is highly elastic. If the demand isinelastic, the adjustments will take place primarily in price. Similarly, ifsellers respond readily by greatly increasing their offerings on slight

increases in price or by heavy withdrawals in slight price drops, theadjustments to changes in demand willbe largely in quantityexchanged. If sellers are quite responsive to, price in their offerihgs (if

supply is very inelastic), the adjustments to changes in demand, willtake place largely through shifts in price. In view of the above

explanation, 'we may state thefollowing rules:



If demand rises then price goes up and vice versa. For example,

in Figure. 4.15, the demand curve shifts. upwards, to the rightfrom DD to D’D’ whereas the supply curve remains the same. As

a result, the price goes up from OP to OP1. Thus, the salesincrease from OQ to OQ1. If supply rises then the price decreasesand vice versa. For example, in Figure. 4.16, the supply curve

shifts downward to the right from SS to S’S’ while the demandcurve remains unchanged. The result is that price falls from OP

to OP1. Dul the sales increase from OQ to OQ1. The followingFigures 4.15 and 4.16 shows shift in demand curve and shift insupply curve due to increase in price, respectively.

Given a shin in the demand curve the following can occur:

Price will rise less or falllcss if the supply curve is elastic (flat)

Price will rise more or fall more if the supply curve is inelastic

(steep)

If the rise in price is more than the rise in sales will be less

If the rise in price is less than the rise in sales will be moreFor example, in Figure 4.17, the demand eurve shifts from DD to D’

D’.



The supply curve S"S" is steep. Another supply curve S'S' israther flat. Both the supply curves cut the original demand curve atpoint E giving the equilibrium prices as OP. The flat supply curve S'S'

cuts the new demand curve D'D' at E2 giving the equilibrium price asOP2, which is less than OP1 and more than OP.

In the same way the following will occur when there is a shift in

the supply curve

o The price will rise less or fall less if demand curve is

elastic

o The price will rise more or fall more if demand curve is

inelastic.

For example, in Figure 4.18, SS is the original supply curve, S'S'is the new supply curve, D'D' is the steep demand curve (indicating

relatively inelastic demand) and D”D” is the flat curve intersecting thesupply curve at point E. After the shift in the supply curve, however,the S'S' cuts the D'D' curve at point E' giving OP' as the equilibrium

price. But the SS curve cuts the D"D" curve at point E giving theequilibrium price as OP which is higher than OP'.

If both demand and supply increase, sales are bound to increase

but the price mayor may not increase. In this case there case canbe two possibilities

o Price will rise if the amount, which will bedemandedattheold price exceeds the supply, which will be



made at that old price as shown in Figure 4.19.

o But the price will fall if the amount, which will be suppliedat the old price, is more than the amount demanded

currently at that price as shown in Figure 4.20. In otherwords, if at the old price, new demand exceeds the newsupply, the price will rise but if the new demand is less

than the new supply, the price will fall.

An increase in demand with a simultaneous decrease in supplywill raise price and increase sales if the new demand price for the oldequilibrium amount is higher than its new supply price. Similarly, the

price will rise and sales will dimfnish if the new supply price for theold amount is higher than itsnew demand

GOVERNMENT INTERVENTION IN PRICE FIXING

Quite often the government interferes with the normal process of price

determination by fixing prices either above the equilibrium level orbelow it. In order to make these attempts by the government aboutartificial price fixation successful, government intervention is required

with the forces of supply or demand or both, through elaborateadministrative regulations.

Difficulties in Price Fixing

The government has to face several difficulties while fixing prices dueto certain reasons. There can be elaborated as follows:



Attempts to fix prices above an equilibrium level are illustrated

by minimum wage legislation and price support policies. Whenthe Government undertakes the activity of fixing a minimum

price say, Rs. 375 per quintal for wheat much above theequilibrium price say, Rs. 300 per quintal, consumers restricttheir consumption of 'wheat' (postpone their purchases at all

levels). Conversely, farmers are encouraged to increase theirproduction under the incentive of higher' prices. This results in

disequilibrium between the demand and supply. As such, thereare only two ways to maintain prices at a high level:

o The government can buy large quantities to absorb the

difference between the quantity supplied and quantitydemanded.

o The government can ask the farmers to limit their output.

The government also tries to set maximum prices below the

equilibrium level. This is illustrated by the price control on sugar,

on steel and a number of othcr commodities. Let us assume thatthe equilibrium price of sugar is Rs. 10.00 per kilo but price hasbeen controlled at Rs. 7.00. The suppliers would hold back their

supplies and this would leave a large body of unsatisficdconsumers. The problem would arise as to who should get asharclof the limited supply of sugar. There would be long

queues for the available supply. In short, lots of difficultieswould arise. The government would have t.o adopt both-or

either of the following measures:o Introduction of rationingo Payment of subsidey to sugar producers to neutralise the

effects of low prices and to encourage them to producemore.

In this way, the Government would substitute ration cards for

the rationing mechanism of a free-market system and it wouldsubstitute subsidies for the price incentive of a free market the

following Figure 4.21 and 4.22 shows the demand for wheat and sugar,



respectively.

Effect of Time Upon Supply

Economists find it important to discuss the way in which supplychanges in the course of time. The reason why such a study is

necessary lies in the technical conditions of production, i.e., it alwaystakes time to make those adjustmcl'lts ill the size and organisation of

a factory, which are necessary for greater production. For the purposeof analysis in this connection, it is usual to follow the method ofanalysis used by Marshall. Marshall suggested three periods of time

namely market period, short period and long period. Marshallconsidered the market period as being only a single day or few days.The fundamental feature of the market period is that it is supposed to

be so short that supplies of the commodity in question will be limitedto the existing stocks or at the most to the supplies in sight.

Graphically, the supply curve will be vertical, i.e., the supply remainsfixed irrespective of the price.

The 'market period' supply curve is not applicable in all cases. lt is

particularly important in the case of perishable goods, which aredifficult or impossible to store, and in case of demand, which issubject to short-run fluctuations.

Marshall defined short period as "a period long enough for thesupplies of a commodity to be altered by increase or decrease incurrent output but not long enough for the fixed equipment to be

changed to produce a larger or a smaller output." In other words; the



short-run cost curve remains the same. Here, the supply curve wouldbe a slopmg lme, moving upward Irom left to right thereby indicatingthat as price goes up, supply increases.

In the long period, as defined by Marshall, there is time to buildadditional plants or clear more land for crops; or alternatively, oldmachines and factories can be closed down. A firm producing at

overtime rates or by using standby equipment will usually plan toincrease output by buying new plants and machinery. It will do sowhen provided that it thinks the increased demand will be maintained.

The long-period supply curve will, therefore, tend to have a flatterslope than the short¬run supply curve indicating thereby that given a

price increase, the supply tends lo be larger than in the short-runperiod.

EQUILIBRIUM AND TIME

The following discussion now concentrates on how price would bedetermined in different time periods, given a change in demand.

In the market period, an upward shift in the demand curve

would result in an immediate rise in price, as there will be noincrease in supply.

This will be followed by greater production during the short

period and a fall in the price as firms increase their output. Later,as more capital equipment is installed the output would increase

still further and prices would again drop. Conversely, adownward shift in the demand curve would not immediately

affect the quantity supplies but the price would drop sharply,followed by some recovery as the firms reduce output in theshort period.

In the long period, firms would see more profitable uses for their

plants and would decide not to replace capital output as it wearsout. This would reduce equipment still further and permit some



recovery in price.

Illustration

To take an example, in Figure 4.23 DD shows the demand for fishwhereas SS, S'S', and S"S" represent the market-period, short-period

and long-period supply curves respectively. Suppose the demand forfish in the market shifts to D'D'.

Now, supply of fish cannot be increased immediately and hencemarket or momentary equilibrium is established at price OP”.

In the short run, however, fish supply can be increased by amore intensive use of the existing equipment, viz., boats and nets and

by working for longer hours. As a result, the price drops to OP". In thelong run, supply can be fully adjusted to meet the demand conditions.

New fishermen would be attracted (entry of new firms), new boats;nets and other equipment would be produced and employed in service.As a result, supply would increase further and the long-run

equilibrium would take place at a still lower price OP".

The Firm in Pure Competition

In pure competition, the firm has to accept the given market price.At this given price, it can sell all the products, which it desires but atany higherprice, it cannot sell anything. If the market price is below its



cost, it has to either take the loss or withdraw from the market. As aresult, any single firm in a purely competitive situation has to adjustits production and sales policies to the given market price. However,

the market prices arc determined through the mutual consent of allthe individual competitive buyers and sellers together. But anyindividual firm has no control over the price. Since a purely

competitive seller has no control over the price at which he sells, hisaverage marginal revenue schedule is infinitely elastic. In perfect

competition, marginal revenue is equal to the average re.xenue,because every unit is sold at the same market price, irrespective of the'quantity sold. Graphically, a horizontal line at the market price

represents it. As expansion of sales does not require any reduction inthe price at all; the greater the quantity sold, the larger is the revenue.Under ordinary circumstances, the owner· of a linn will not question

whether to produce or not to produce. Rather he will have to decidewhether it will be bettcr to producc, say, 10,000 units or 11,000 units.

In order to answer this question, hc will compare thc incremental costand tIll' incremental revenue resulting (i'om thc altcrnative courses ofaction. To express in technical terms, the maximum profit (or the

minimum loss) position can be attained by in.creasing output so longas the marginal revenue continues to exceed the marginal cost. Whenmarginal cost is above the marginal revenue, an increase in output

would reduce profits and it would be better to decrease the output. Ifthe amount of marginal rcvenuc is greater than the marginal cost, it

would be beneficial to increase the output. Thus, profit is maximised,or the loss is minimised, by increasing the output just up to the pointa.t which marginal cost equals marginal revenue.

Output Decisions and Consumer Interests

An entrepreneur will expand his output so long as the addition to hiscost is less than the worth of the incrcase in output price to the

consumers. In this respect, the entreprencur acts consistently with theinterests of the consumers though his purpose is merely to maximise



his own profits.

This rcquires continuing the hiring of additional workers andbuying additional raw materials so long as the wage paid for the

labour and the price paid for the matcrials is less than the amount thatevery unit of output will add to his revenues. In this rcspect, theentrepreneur acts in harmony with the interests of the sellers of labour

and raw materials though his purpose is to maximise his own profits.A consistcney with the consumer preferences is also maintained in

bidding for the additional units of input for his firm. Without being inthe least a philanthropist, the purely competitive entrepreneur seekingto maximise profits provides a very cffective service in helping the

allocation of resources in consistence with consumer preferences andwith the interests"of resource owners.

The Firm and Shutdown Point

The amount that a particular firm offers for scale in the short-run atdifferent prices for its product depends upon the cost conditions ofthe firm. In case there is any price that is lower than the lowest

variable cost per unit, the firm will have to be shut down. It would notbe useful to operate even in the short run at a price lower than this,

sincc variablc costs are not covered. It is not held, however, that in theshort run, the average total costs play no role in the output decisionsof the prbfit-.seeking entrepreneur. This is because the fixed costs,

which are a component of the average total costs, would remainunaffected by the decision to shut down.

The Decision to Operate at Loss or Shut down

The above discussion shows that in the short run any firm may decideto operate at a loss but try to minimise it. However, the question maywell arise: Why should a firm operate at all when it is suffering losses,

and why should it not.shut down? The explanation to the abovequestion lies in the fixed costs, which a firm has to incur any way. In

the short-run, certain costs, for example, rent, interest, etc., are fixed.They continue to exist whether the firm operates or not. Even if the



firm shuts down, it cannot avoid these costs in the short-run. If, forexample, these fixed costs are Rs. 1,000 per month, the firm will losethis amount every· month even if it decides to cease operations.

Under these circumstances, it will be clearly beneficial to the firm tocontinue operating if it can cover its variable costs and still havesomething left to contribute towards its irreducible Rs. 1,000 every

month. Thus, supposing till' price is Rs. 40, output is 70 units and theaverage variable cost is Rs. 35, the firm's receipts would be Rs. 800.Total variable cost will be Rs. 2,450 and the finll would be left with Rs.

350 to meet part of its fixed costs. The net .loss to be suffered wouldbe RS.650 only. If the firm were to close down, its loss would have

been Rs. 1,000; hence it would decide to operate even at a lossbecause by so doing, its losses would be less than they would havebeen in the case of firm's shutdown.

If, however, the price comes down to Rs. 35 only and theaverage variabe cost is Rs. 35, the sales receipts would just cover totalvariable cost, leaving nothing towards covering the finn's fixed costs.

Hence, the firm would be indifferent and perhaps decide to shut down.If price is below the average variable cost (Rs. 35), the firm would fail

to recover even its variable costs and would certainly shut down. Toconclude, therefore, the shutdown point is whcre AVC=AR.

Consequences of Pure Competition

The consequences of pure competition can be enlisted as follows:

If the market price is below the cost of production of a particularproduccr, he can do nothing but to take a loss (in the short run).

If tbe price remains below his cost of production for asufficiently long period, he has no alternative but to go out ofbusiness.

A firm can increase its profits by selling more units.

Products subject to a competitive market situation, face agreater degree of price instability than is the case with



differentiated products.

No useful purpose is served by advertising. When products soldby individual sellers are identical, advertising by anyone seller

would have a negligible effect on the demand for his product.

Equilibrium of Industry

The short-term and long-term adjustment processes can be clearly

identified by understanding the concept of equilibrium of an industry.These are explained as follow.

Meaning of Industry

The term industries are sometimes used in a broad sense so as toinclude all the producers of a similar type of commodity such asvanaspati industry or cigarette industry. It is sometimes used in a

narrow sense to include only the producers of commodities, which areidentical from the point of view of purchasers such as wheat or more

precisely still a particular grade of wheat. In a purely competitiveindustry, however, the commodity is uniform and there is no productdifferentiation, even in the slightest way. As such, under perfect

competition, an industry may be said to consist of all firms producinga uniform commodity. It may be further added that a firm, whichproduces more than one product, may be said to participate in more

than one industry. Strictly speaking, different brands of cigarettes maybe regarded as different commodities because there are set consumer

preferences for one brand over another. Yet, these consumerpreferences are so slight that for many purposes all the standardbrands may be regarded as one commodity and the industry as a

whole, for example, the cigarette industry. Of course, the industry issaid to be characterised by product differentiation as different brandshave different characteristics to attract consumers.

Adjustment Process Towards Long-run Equilibrium in Industry

An industry is said to be in equilibrium when there is no tendency onthe part of the firms within the industry to leave it or on the part of the



firms outside; to enter the industry. Long-run adjustments in anindustry take place through the entry or withdrawal of firms. These areadjustments that take place over a time period I.ong enough to permit

such a shifting of firms and of relatively fixed productive agents usedby the firms. An industry is said to be in equilibrium when there is noadvantage to any productive agent in moving into or out of the

industry, or when there is no incentive for entrepreneurs to inaugurateor withdraw firrtls from the industry.

Firms will move into or drop out of the .inqustry until expectationsof profits and losses have been roughly eliminated or until it is nolonger possible for anyone to better his position by moving into or out

of the industry in question. Under pure competition, this equilibriumwill be reached when price is almost equal to the lowest cost on thetypical firm's total unit cost curve. Under competition, the price cannot

stay higher for long; and withdrawal of firms will keep it from stayinglower for a long period.

Survival of the Fittest

At any given time, there may be firms of varying sizes and efficiency inan industry, possibly some making profits and others incurring losses.Ellt so long as industry is open for anyone to enter freely, an excess of

price over the attainable average total costs will encourage the entry ofnew firms. As such new firms move in, they compete with existing

firms and the most inefficient firms are eliminated. In the long-run,therefore, only those firms will remain in the industry, which have thelowest average total costs, as low as those, which would be incurred

by new enterprises in optimal scale adjustments. If a long-runequilibrium position is linally attained, there might still be many

differences between firms but the lowest average total costs of allfirms would be the same. For instance, some entrcpr.eneurs may bemore efficient than others, some firms may be located near markets

and may be paying higher rents whereas others are more distant andmay be paying lower rents. Again, some firms may be small with closepersonal supervision and hence with greater efficiency whereas others



may be large and with mass production methods, In view of thesedifferences, the firms may not be having identical or similar costcurves. Still, each firm must produce at an average cost as low as that

of its competitors. In other words, though there may be differencesbetween firms, these may be balanced by balancing advantages anddisadvantages giving rise to uniformity of minimum average total

costs.

To illustrate, two manufacturers of cotton textiles may bedifferently located; one may qave the advantage of nearness to buyers

but the disadvantage of higher rent. The other may be located awayfrom the buyers and as such may have the advantage of lower rent but

the disadvantage of higher transport costs. Here the advantages anddisadvantages may balance so that the two firms have the same lowestaverage costs. Another example is that of one firm having a more

efficient manager than the other. Here the efficient firm may have theadvantage of higher productivity but disadvantage of higher salarypayments as' compared to the less efficient firm. On balance, the two

firms may have the same lowest average costs.

In an industry adjustments towards long-run equilibrium do not

necessarily I take place smoothly. In fact, too many firms may enter· aprofitable industry. Thus, by the time they are turning out finishedproducts, market price may drop below costs. As a result, firms may

start withdrawing from the industry so much so that too many firmswithdraw with opposite effects. This is most likely to occur whereinitial investments are relatively small or where given fixed equipment

can be' utilised in other industries. This is because these conditionsfacilitate quick entry as well as withdrawal. Agriculture provides an

example of this type where the same fixed assets can be utilisedalternatively as, for example, either for producing wheat or cotton, juteor rice.

Restrictions on Firm's Entry and Withdrawal



Free entry'of new firms is usually restricted through

Financial or technical barriers to entry into costlyand complex techno¬logical processes;

Government intervention and legal restrictions; and

Collusion among producers on prices, market shares, tendering,

etc.

Until 1991, the Indian economy was regulated by numerous

Government decisions on wages, price, size and scope of production,industrial relations, foreign exchange, etc. Due to these Government

regulations, hardly any industry was free to decide on its scale andmethods of production, wage policies retrenchment, equipment etc.Again, the Indian industrialist operated in a completely sheltered

market. He was protected against external (foreign) competition byimport and exchange controls. The requirement of a licence beforestarting a large-scale unit further protected him from internal (Indian)

competition. Thus, entry and withdrawal of firms was highly restrictedin Indian conditions. However, now the entrepreneurs are free to

decide about the industry they want to establish and its size except ina limited number of industries, which are still subject to Governmentregulation.

VARIANTS OF PERFECT COMPETITION

1. Effective or Workable Competition

Competition among the sellers, even though it may not be perfect, canbe regarded as effective if it offers real alternatives to consumers thatare sufficient to compel sellers to vary quality, service and price

substantially with a view to attract buyers.The prerequisites of effective competition are as follows:

Ready substitution of one product for another.

General availability of essential information about a1ternati (itssignificance lies in that buyers cannot influence the behaviour of



the sellers unless alternatives are known)

Presence of several sellers, each of them possessing the capacityto survive and grow

Preservation of conditions which keep alive the basis or potential

competition from others

Substantial independence of action that is each selIn must be

able and willing constantly to reconsider his policy and to modifyit in the light or changing conditions of demand and supply.

Effective competition cannot be expected in fields where sellers

are so few ill number, capital requirements so large, and the pressureof fixed charges so strong that price warfare, or its threat of will lead

almost inevitably to collusive (deceitful) understanding among themembers of the trade of. the industry concerned. In brief, competitionis said to be effective whenever it operates over time to provide

alternatives to buyers and to afford them substantial protectionagainst exploitation. The concept of effective competition, thoughless definite, is more realistic and relevant than that of perfect

competition.

2. Potential Competition

Potential competition may restrain producers from overcharging those

to whom they sell or from underpaying those from whom they buy.The essential precondition for potential competition is the

preservation of freedom to enter or to leave the market. The exclusiveownership of scarce resource, the heavy investment required for entryinto many fields, the fixed character of much of the existing

equipment, high costs of transportation, restrictive tariffs, exclusivefranchises, and patent rights constantly operate to destroy the hasis ofpotential' competition. Science, invention and the development of

technology constantly operate to keep this potentiality alive. Potentialcompetition, insofar as its basis continues, may compensate in part

for the shortcomings of the, lack of perfect competition.



Key Lessons of Perfect Competition of Managers

The key lessons of perfect competition or competitiveness formanagers in highly competitive market environment are as under:

It is important to enter a growing market as far ahead of the

competitors as possiblc. Smart managers should take advantagewell before the competitors enter the market when supply is low

and price is high. This requires entrepreneurial skill to take a risk.

A firm, which is earning an economic profit (distinguished fromnorm.al profit), cannot afford to be complacent or unprepared for

increasing cOlllpditioll hccausc cconomic profit will eventuallyattract new entrants encouraging mare production and enhancingsupply, drive prices down down and reduce economic profits.

Here, it is impossible for a firm in a pcrkclly compclitive marketto compete based on product differentiation. Therefore, the only

way that it can earn or maintain profit in the face of added supplyand lower prices is to keep its costs as low as possible. Thelesson that one can learn from understanding the perfectly

competitive model is that a firm is to be amongst the lowest costproducer to ensure its survival.

PRICE AND OUTPUT DECISIONS UNDER MONOPOLY

Monopolistic market situation allows an individual seller or groups ofsellers, which arc acting as a unit, to exercise direct control over price.Similarly, any such control on the part of buyers is called a

monopsonistic market situation. The monopo.listic and monopsonisticmarket situations may be distinguished according to the nature and

extent of the deviation from the perfect competition. A usefulclassification Can be: (i) monopoly and monopsony; (ii) monopolisticcompetition; and (iii) oligopoly and oligopsony. However, in this

chapter, the discussion is confineclto monopoly only.

Main Features of MonopolyThe essential features of monopoly are as follows:



Single seller: There is only one producer or firm of a commodity

in the market. This is because there remains no distinctionbetween an industry and a firm in a monopolistic market. Here,

the firm itself becomes the industry and thus has full controlover supply of the commodity. The monopolist may be anindividual, a firm or a group of firms or even Government itself.

There are many buyers of the commodities produced by amonopolist, against a single seller.

No close substitutes of the commodity: The commodity sold

by the monopolist has no close substitutes. This implies that thecross-elasticity of demand between the monopofist'"s product

or commodity is very low. Though substitutes of products are·available but they are not close substitutes.

Difficult entry of a new firm: The monopolist controls the

market situation in such a way that it every new firm finds it tobe very difficult to enter the monopoly market and also to

compete with the monopolistic firm to produce either thehomogeneous or identical product. This makes the monopolist,the price maker himself.

Negatively sloped demand curve: The demand curve of amonopolist firm is negatively sloped, which means that a

monopolist can sell more products only at a lower price and notat a higher price.

Keeping in mind the features of a monopoly, it can be said that

the monopolist is in a position to set the price himself and also enjoysthe market power.

The strength of a monopolist lies in his power to raise his prices

without the fear to loose his customers. However, the extent to whichhe can raise depends on the elasticity of demand for his particular

product. This, in turn, depends on the extent to which substitutes forhis products are available. In most cases, there is an endless series ofclosely competing substitutes. Therefore, exclusive monopolies like

railways or telephones also consider the possible competition by



alternative services. In this case, any increase in the rates by railways,may lead to their substitution by motor transport and of telephonecalls by telegrams. In fact, it is very difficult to draw a line between

what is and what is not a monopoly. The truth is that there is acontinuous shift between competition and monopoly, just as there isbetween light and darkness, or between health and sickness.

Even in those industries, which appear to be monopolised at anytime, monopoly has a constant tendency to break down. First, therehave been shifts in consumer demand. Secondly, inventions may

develop numerous substitutes for the monopolist's product. Thirdly,the monopolist may suffer from lack of stimulus to efficiency provided

by competition. He may not devote attention to the improvement ofhis product. In addition, new competitors may arise to fill the gap.Finally, the Government may intervene.

Causes of Monopoly

The government may grant a licence to any particular person orpersons for operating public utilities such as gas company, an

electricity undertaking, etc. In public utility services, economiesof scale are so prominent that it seems almost unbelievable tohave several firms performing the same service again. In such a

case, the Government may reserve the right of foreign traderelated to any commodity for itself or may give the right to any

other person. In all these cases, the statutory grant of specialprivileges by the State creates the condition of monopoly.

The use of certain scarce raw materials, patent rights, special

methods of production or specialised skill, might also give aproducer monopoly power. For example, Hoechst, held amonopoly for some time in oral medicines for diabetes because

they were the first to find out the methods of reducing bloodsugar by an oral dose.

Monopoly also arises where the minimum efficient scale of

operations is very large. For example, it is so for making some



chemicals In fact, monopoly tends to arise in industriescharacterised by decreasing long-run costs.

Ignorance, laziness and injustice on the part of the buyers may

create monopoly in favour of a particular producer.

Revenue and Cost of MonopolistsThe revenue and costs of monopolistic firm can be understood with

the following explanations:

Average Revenue: By raising the prices slightly, a monopolist cansell less, but there will be some buyers of his product. He can

increase his sales only by reducing his price. In this situation, hisaverage revenue (demand curve) will slope downwards to theright. Such a change in AR curve shows that larger quantities can

be sold at lower prices whereas smaller quantities can be sold athigher prices.

Marginal Revenue and the Sale Value of the Incremental

Output: In the market situation of pure competition, bothmarginal revenue and the sale value of the incremental output

are identical. But this is not in the case of monopolly. Amonopolist needs to reduce his prices, to sell additional units ofhis commodities. This reduction in price will apply both to old as

well as· new customers. Lei us assume that a shirt manufacturerretails his shirts at Rs. 40 per unit. Total sales are 1,000 shirts.

To sell 1,100 shirts, he reduces his price to Rs. 38. The sale valueof the additional output will be Rs. 3,800 where as the marginalrevenue will be Rs. 1,800 only. Thus, under monopoly conditions

marginal revenue will always be less than the sale value of theadditional output. However, after a stage, the marginal revenuemay even become negative.

Adjustments under Monopoly

A firm under this market situation can choose to sell many units at a

lower price or fewer units at a higher price. For maximisation of profit



or minirnisation of loss, a monopolistic firm would minimise or reducethe use of inputs and outputs to the level at which the marginalrevenue equals the marginal cost. However, there is a significant

difference between a purely competitive firm and a monopoly. Thedifference lies in the fact that for a purely competitive firm, marginalrevenue equals the average revenue while in a monopolistic firm,

marginal revenue is less than the average revenue. Therefore, amonopolist in purely competitive firm can only produce up to the point

where average revenue equals the marginal cost. This can beunderstood with the help of the Figures 4.24 and 4.25 are givefl below:

With reference to these figures, under perfect competition,output would be OQP (Figure 4.24) as MR curve or the horizontal AR

curve, interesects the MC curve at point Ep. Butunder monopoly, MR =MC at a point Em corresponding to output OQm (Figure 4.24), whichis less than OQP. Under monopoly, the MR curve is not equal to AR

curve, but lies below it. Thus, the monopolist's output will be lower,and the use of productive services is also less than it that in the case

of pure comprtition, where adjustments are made to suit consumers'preferences. In other words, in ll1uximising the profits, themonopolist does not take into consideration the interests of the

consumers and the resource owners. It is the total profit that guidesthe monopolist in his price and output policy. The total profit is

calculated by multiplying the profit per unit by the number of units



sold. By using the process of trial uilci error with di fferent levels ofprice and output, a monopolist fixes a price-output combination thatyields him the highest total profit.

Disadvantages of Monopoly

Under monopolistic condition, a monopolist exercises themarket power by restricting supplies. By doing so, he is likely

to become richer than he' would have been if he had nomarket power. He also docs this even at the expense of those

who consume his products.

In a monopolistic situation, a consumer choice is restricted. Aconsumer depends on the monopolist’s decisions on the

mutters related to price, and the amount the direction ofresearch and development in the industry, the services offered,etc.

Under monopoly, there is a complete absence of competition,

which means that there will be no prcssure on the monopolistfirm to be economical and to keep its costs down. By keeping

its prices higher, a monopolist tends to wastc its cost orproduction. This is a biggest drawback of a monopolistic tinn.

By exercising the monopolistic power, a monopolist is likely to

misalloeate the resources from society's point of view. As themonopolist restricts output, his output becomes too small. He

employs too little of society's resources. As aresult, of this,too much of these resources are used into the production ofthe goods with low consumer preferences. Thus, resources are

mislilioclited or wasted.

A firm enjoying monopoly position in a strategic sector is a big

a risk for an economy. For example, any failure related to thepower engineering facilities of a firm, is a hindrance for aneconomy, In one BHEL, a firm is full of'risk, as any natural or

man made causes, which may lead to slow¬down or stoppageof production is a severe setback to the economy.



Long-run Considerations and Price Policies of a Monopolist

In deciding the current price policy, monopolists commonly take intoaccount' some long-run considerations, which may lead to a moremoderate price policy than would be followed by a firm taking into

account short-term factors only:

Price elasticity of demand: The ability to increase profits byrestricting supplies is the criterion of monopoly or market

power. In this respect, the more elastic the demalld for theproducts, the weaker is the position or Ihc monopolist. But therewill always be a price, above which the demand is so elastic that

it will not cost anything to the monopolist to incur the lossrelated to less sales by raising the prices higher. In the long-run,

consumer receptiveness to price may be much greater than inthe short run. Thererore, an intelligent monopolist mustconsider this factor before exercising monopolistic power. If a

monopolist's prices are held at high lewis, consumers may stoputilising that commodity. This will result in decreasedconsumption. On the other hand, if the prices remain lower over

extended periods, the consumers will get used to that product,more people will be interested in it and those already

consuming it may increase their consumption as well.

Potential competition from new tirms: If a firm is very wellestablished, exercise strong and exclusive control over essential

raw materials, possess indispensable patents, and licensingregulations, it may pursue extremely high price policies without

great concern for the competition that these prices may attract. If,on the other hand, its controls over firms are not so strong, itdepends primarily on unfair competition and uncclillin

manipulation, then the fear of potential competition may becomean important factor to modify the monopolist's policies.

State of public opinion: Public hostility to unfair practices and

exploitHI ion may appear in many forms like consumer boycotts,



both formal and informal, and legal restrictions and controls.Hostile public opinion is wry important to be ignored irrespectiveof the form in which it is. Many times it may temper the

behaviour of the monopolist seeking to maximise his profits.

If a monopolist is cautious, he needs not to work against publicinterest. This is because the monopolists, being big concerns can

enjoy the economies of large¬scale production. They are in a betterposition to maintain regular and satisfactory supplies. They can alsoavail the benefits of large-scale buying ar1d selling. In fact they can

operate a better level of efficiency. If they restrain themselves and donot exploit the consumers, they may not only build up a good image

in the market. By doing this, they are also likely to avoid potentialcompetition and Government interference.

Differenco between Monopoly and Pure Competition

The salient points of difference between monopoly and perfectcompetition are as follows:

Under perfect competition, there are a large number of sellers

or firms whercns in monopoly, there is a single seller or firm.

Under perfect competition, the individual seller has no controlover the market pries whereas under monopoly, the seller is in a

position to nlllnipulnte the output in order to control the prices.

Under perfect competition, the commodity produced by thefirms is homogeneous in nature whereas there is no close

substitute of the commodities produced by monopoly.

Under perfect competition, a firm is a price taker and not a price

maker whereas in monopoly a firm is a price maker.

Under perfect competition, there is free entry and exit of thefirms in the market whereas monopoly this is not so.

Under perfect competition, firms get only normal profits in the

long period whercas in monopoly, there is the possibility ofsuper-normal profits to take place.



Under perfect competition, there is no possibility of price

discrimination whereas in monopoly, price discrimination ispossible.

MONOPSONY

It is a market situation in which there is single buyer to buy the

commodities but there may be many sellers to sell the identical orhomogeneous commodity.

Features of Monopsony

The essential features of monopsony are as follows:

There is only onc buyer or the goods or services.

Rivalry from buyers, who offer the close substitutes of the

product, is so remote to make it insignificant.

As a result, the buyer is in a position to determine the price,

which he pays for the goods or commodities.

Actual causes closely approximating monopsony are rare. An,example, approximating monopsony is that of Indian Railways in

relation to the wagon industry. Monopsony may also arise whereresources are immobile. If for reason, workers are unable to move toother localities or other firms within same area, their existing

employer has, in effect, a inonopsony position over them.

Costs of Monopsonists

The monopsonist must choose between paying higher wages that willenable him to employ more workers or limiting his working force tothe analler number workers, who can be employed at lower wages.

This means that when additional worker is added to the labour force,an employer has to bear both, I wage of the new worker and also thetotal increase in the wages to be paid to t old employees at the new

rate. Thus, in monopsonistic market situation, margir expenditure ofeach input level exceeds average expenditure (Table I aild Figu 4.26).

Suppose a tailor employs six workers at Rs. 500 per month. To have I



additional worker, he must pay Rs. 550 per month to each worker. Ifhe employs the seventh worker, his total costs, thus, will increase byRs. 850. To represent the position graphically, two curves are needed,

one to show the average expenditur and the other to show themarginal expenditure. The marginal expenditure (ME) is consistentlyhigher than the average expenditure (AE) and the slope of thl marginal

expenditure cutve is steeper than that of the average expenditurecurve.

The following Table 4.4 shows the cost of a monopsonistic firmhiring workers.

Table 4.4: Cost of a monopsonistic firm hiring workers

---- -- -- ..•. _. _.- .. ~- .... - .-

- _ .. ~.Workers

AverangeExpenditureper Worker

(AE)(Rs.)

TotalExpenditure

(TE)(Rs.)

MarginalExpenditure

(ME)(Rs.)



678

910

11

500550600

650700

750

3,0003,8504,800

5,8507,000

8,250

-850950

1,0501, 150

1,250

Price Discrimination

Price discrimination, may be defined as the practice by a seller of

charging different prices to thL: samc buyer or to different buyers forthe same commodity or service without corresponding difference inthe cost. It is also known as differential pricing. Differences in rates

are somewhat related to the in costs. For example, it may cost less toserve one class of customers than another to sell in large quantitiesthan in smaller lots. !frates or prices are proportional to cost, some

buyers will pay more and others less, but this will not take place inprice discrimination. In such a situation, charging uniform price will

amount to discriminat ion. There arc three classes of pricediscrimination, which are as follows:

First-degree discrimination: The seller charges, the same buyer a

different price, for euch unit bought. For exumple, prices thatare determined by bargaining with individual customers orprices, which are quoted for tenders floated by government

authorities.

Second degree discrimination: The seller charges different pricesfor blocks of units, instead of, for individual units. For example,

different rates charged by an ekctrieity undertaking for light andfan, for domestic power and for industrial use.

Third degree discrimination: The seller segregates buyers

according to income, geographic location, individual tastes,kinds of uses for the product, etc. and charges different prices



to each group or market despite of charging equivalent costsfrom them. If the demand elasticities among different buyers areunequal, it will be profitable for the seller to put the buyer into

separate classes according to elasticity and thereby, to chargeeach class a different price. It is also referred as marketsegmentation and involves dividing the total market into

homogeneous sub-groups according to some economiccriterion, usually the demand elasticity.

Conditions for Price Discrimination

The conditions for price discrimination arc as follows:

Multiple demand elasticities: There must be difference in

demand elasticities among buyers due to differences in income,location, available alternatives, tastes, etc.

Market segmentation: The seller must be able to divide the total

market by separating the buyers into groups or sub-marketsaccording to elasticity.

Market sealing: The seller must be able to prevent any

significant resale of goods from the lower to the higher pricesub-market. Any resale by buyers among the sub-markets will,

beyond minimum critical levels, neutralisc the effect of differentprices.

Market Segmentation

Haynes, Mote and Paul have identified certain criteria according towhich market segmentation is practised. These criteria are givenbelow:

Segmentation by income and wealth: This can be understood byconsidering an example, in which the doctors separate patients

with high incomes from patients with low incomes. The fact thatdoctor's treatment is a direct personal service prevents its resale.

Segmentation by quantity of purchase: Traders often

distinguish between large and small purchasers, offering quantity



discounts to large purchasers. The big buyers because of theirbargaining power are able to extract special quantity discounts.However, if the quantity discounts are in proportion to the

marginal costs of selling to big and small buyers, they will not becounted in price discrimination.

Segmentation by social or professional status of the customer:

Special prices may be quoted to Central and State Governmentsor to Universities. Students are given concessions in cinema

tickets, railway fare and bus travel. Profes'sional journals usuallycarry lower student subscription rates. Faculty members orteachers are also sometimes offered books at special discounts.

Segmentation by geography: This can be understood by

considering an example. For example, business houses, which

are sold abroad at prices, lower than the domestic price.

Segmentation by time of purchase: Reduced rates are oftenquoted during festival seasons such as dussehra, diwali, etc.

off-season discounts are also popuinr in case of fans,refrigerators, etc.

Segmentation by preferences for brand names and other sales

promotion devices: Some firms sell the same type of productunder different branp names at, different prices. In this case,

ignorance on the part of consumer regarding similarity in thequality of products prevents a large-scale of customcrs to shiftfrom one brand to another. Market segmentation also ensures,

the manufactures, a certain degree of flexibility in pricing. Apartfrom this is also to be ensured that it should remain present in

every segment of market. For example, Hindustan Lever suppliesliril to satisfy the top-end of Ihe market, lifebuoy to the lowestend and lux to the middle¬end.

ObjectivesThe objectives of pricc discrimination are as follows:

To adjust the consumer's surplus in such a way that it accrues



to the producer and not to the consumer.

To dispose of occasional or irregula surpluses.

To develop a new market.

To make the maximum and proper use of the unutilised capacity.

To earn monopoly profits.

To enter into or retain report markets.

To destroy or to forestall competition or to make the

competition amenable to Ihc wishes of the seller adopting price

discrimination. It may be called predatory or discriminatorycompetition. The test of perdition of intent.

To raise the future sales. Quoting lower rates in the present

develop in future a taste for the similar commodities produceclby the same manufacturer. For example, Reader's Digest sellschildren's edition at lower rates. This develops the taste of

children towards the magazine and they are expected tocontinue purchasing it even when they become adults.

Single Monopoly Price Vs. Price Discrimination

To examine the policy of price discrimination, is more useful ratherthan to charge a single monopoly price. This can be done in following

ways:

First of all, a discriminating monopolist can increase his profitsby charging different prices to different buyers or groups of

buyers rather than to charge a single price to all the buyers.

Secondly, the policy of price discrimination is in the interests ofthe consumers as well. Bigger' output is made available to a

large number of customers. This is of special significance in thecase of public utility services. The larger the consumption of

these services, the greater is the economic welfare. Moreover,the consumers may be charged according to their ability to pay,which is quite fair and reasonable.

Finally, the policy of price discrimination enables better



utilisation of capacity, preventing waste of social resources. Thiscan be understood with the help of following Table 4.5.

Table 4.5: Costs, Prices and Sales of a Monopolist

Price Sales Total Cost(Rs.) (Rs.) (Rs.)9.00 100 1,4008.00 200 1,7507.00 300 2,0506.00 400 2,3005.00 500 2,5004.00 700 3,0003.00 1,000 3,4002.50 1,400 4,1002.00 2,000 5,0001.50 2,800 6,4001.00 3,600 8,000

The above Table gives the number of units, a monopolist can sell

at various prices and the total cost involved in producing them.Answer the following questions related to the table.

How much should the monopolist prodllce find what price

should be charge, if' he sells his entire output at a single price?How much profit will he earn?

How much should be produced if the monopolist fixes II

discriminatory price, dividing his customers into separategroups according to their ability to pay and charging maximum

prices from each group? How much will be the profit, which themonopolist will earn?

Will the monopolist be better off if he charges a single price or

discriminating prices and by how much?

Will it be in the interest of the consumers if the monopolistcharges discriminating prices? Explain.

Will the policy of price discrimination enable better utilisation ofcapacity' as compared to a single price?



How much maximum profit would the monopolist earn if he is

allowed price discrimination but cannot charge more than RS.2?Would it make any difference to capacity utilisation and

availability of supply the consumers?

Solution

If the monopolist sells the output at a single price, he will choose that

price, which will yield the largest profit, He will, therefore, produce400 units and charge Rs. 6. The maximum profit he will earn is Rs.

100. This will be clear from the following Table 4.6:

Table 4.6: Monopolist Selling at a Single Price

If the monopolist discriminates, dividing his customers into

groups according to their ability to pay and charging different pricesfrom each group, the results would be as given in the followingTable 4.7:

Table 4.7: Monopolist Selling at Discriminatory Prices

Price Sales Total Total Profit or(Rs.) (Uuits) Revenue Cost Loss

(Rs.) (Rs.) (Rs.)9.00 100 1,600 1,400 -5008.00 200 2,100 1,750 -1507.00 300 2,400 2,050 506.00 400 2,500 2,300 1005.00 500 2,SOO 2,500 04.00 700 3,000 3,000 -2003.00 1,000 3,500 3,400 -4002.50 1,400 4,000 4,100 -6002.00 2,000 4,200 5,000 -1.0001.50 2,800 3,600 6,400 -2,2001.00 3.600 8,000 -4,400

Price Sales Sales in Revenue Total Total Profit or(Rs.) (Units) each from each Revenue Cost Loss

Category

category (Rs.) (Rs.) (Rs.)(units) (Rs.)

1 2 3 4 5 6 79.00 100 100 900 900 1,400 -5008.00 200 100 800 1,600 1,750 -150



Here, the prices, sales and total costs are the same as they werein Table 4.5. But the monopolist divides his customers into separate

groups and charges different prices from each group. The basis ofdividing the customers is as follows:

When price is Rs. 9 per unit, 100 units are sold, when the price is

Rs. 8 per unit, 200 units are sold. This means that 100 units can besold for Rs. 9 per unit and another 100 for Rs. 9 per unit. Similarly, bycharging Rs. 7 per unit, the monopolist can sell another 100 units. In

this way, other categories have also been formed as shown in column3. Column 4 gives revenue from each category, which is calculated by

multiplying the figures of column 3 with the corresponding figures ofcolumn 1. Column 5 gives tot21 revenue obtained by selling goods tovarious categories of the customers. Column 6 gives total cost and

column 7 gives profit or loss.

In this situation, a. discriminating monopolist will also seek themaximum profit, which cen be obtained by creating a category of

customers and charging Rs. 9 from those on the top class and Rs. 2from those in the bottom of the category. With such a differential price

structure, the monopolist will sell 2,000 units and earn a maximumprofit of Rs. 2,400.

The monopolist will be better off by Rs. 2,300 by charging the

discriminating prices he will earn as much as Rs. 2,400 asagainst a maximum of Rs. 100 by charging the single price of Rs.

7.00 300 100 700 2,100 2,050 " 506.00 400 100 600 2,400 2,300 10005.00 500 200 500 2,500 2,500 -2004.00 700 300 800 2,800 3,000 -4003.00 1,000 400 900 3,000 3,400 -6002.50 1,400 600 1,000 3,500 4,100 -1,0002.00 2,000 800 1,200 4,000 5,000 -2,200

1.50 2,800 800 1,200 4,200 6,400 4,4001.00 3,600 800 3,600 .8,000



6.

The policy of discriminating prices is in the interest of thecustomers as well. Larger output of 2,000 units, is beneficial to

a larger number of customers. Moreover, each customer ischarged according to his ability to pay. Therefore, the policy isfair as well as reasonable.

The policy of price discrimination will enable better utilisation ofcapacity. Assuming the monopolist has a capacity to produce

3,600 units, he would operate at a level of 2,000 units which ismuch' closer to full capacity as against the level of 400 units,where the monopolist will operate if he chmges the single price

of Rs. 6.

If the maximum price that can be charged is Rs. 2, the monopolistwill earn a maximum profit of Rs. 200 by practising price

discrimination as shown in the following Table 4.8.

Table 4.8.: A Regulated Monopolist Discriminating in

Price but Charging not more than Rs. 3

Price Sales Sales in Revenue Total Total Profit or(Rs.) (Units) each from Revenue Cost Loss

Category each (Rs.) (Rs.) (Rs.)(units) category

(Rs.)1 2 3 4 5 6 7

3.00 1,000 1,000 3,000 3,000 3,400 -4002.50 1,400 400 1,000 4,100 4,100 -1002.00 2,000 600 1,200 5,200 5,000 2001.50 2,800 800 1,200 6,400 6,400 01.00 3,600 800 800 7,200 8,000 -800

But capacity utilisation and availability of supplies will remain

unaltered.



APPENDIX 1

Price Discrimination - Diagrammatic ExpositionA diagrammatic exposition of the theory of price discrimination isshown below. Figure 4.27 presents the diagram of price discriminate

adopted in traditional economic theory.

Let us suppose that the market for a product consists of twosegments, one with a more elastic demand curve than the other D1

shows the demand in the more elastic segment and D2 shows thedemand in the less elastic segment. MR. and MR2 represent thecorresponding marginal revenue curves. The total marginal, revenue

cllrve MRT adds together the quantities in both market segments ateach marginal revenue. Thus MRT = MR1+ MR2. On the cost side, the

diagram shows a marginal cost curve MC, which alone is relevant. Itmay be noted that only one I marginal cost curw exists because itmakes no difference from the cost point of view whethcr the products

sell in market segment 1 or market segment 2, since the product isthe same.

As usual, profit will be maximised where marginal revenue is

cquallo marginal cost. Such equality exists at point E in the diagram



where 'the total margimil revel1lie curve (MRT) intersects thell1argin::d cost curve (MC). A horizontal line drawn from this point ofintersection E, back to the Y-axis cuts the two marginal revenue

curves MR, and MR2 at points F and G respectively. These rointsdetermine the quantities to be sold in each market segment and theprices which shall prevail in each market segment. For this purpose

one should first draw a perpendicular line frolll point F on X-axis,showing OX, as the quantity in market segment 1. Agai by extending

this perpendicular line upward to meet the demand curve 0" one gets p.as the price for this market segment. Similarly, frol1l point drawingthe perpendicular to X-axis and thereafter extending it to the demand

c.urve D2, we get OX2 as·the quantity to be sold and P2 as the price tobe charged in market segment 2. The quantity sold in market segment1 (OXI) plus the quantity sold in market segment 2 (OX2) exhausts the

total quantity OQ (i.e., OX1 + OX2 = OQ). Further, the price PI is lowerthan the price P2 thus indicating that the price in the more elastic

market segment (DI) shall be less than the price in the less elasticmarket segment (D2). The two prices PI and P2 provide differentmargins of contribution to profit. It should also be noted that (he

solution equates the marginal revenue in each segment (i.e., X2G =X.F) besides equating the total marginal revenue to marginal cost atpoint F. If MR. was greater than MR2, the firm could increase profits by

transferring units of product from market segment 2 to-marketsegments I. This is an illustration of the equi-marginal principle. If

either MR1 or MR2 were greater than me, an expansion of outputwould be profitable. Optimisation thus requires that MR1 = MR2 = Me.



APPENDIX 2

Measures of Monopoly Power

Several economistS have given different measures of monopoly power.These are discussed below:

Lerner's measure: According to Lerner, the difference betweenprice dnd marginal cost, measures the gegree of monopoly power. Inother words, a seller's monopoly power depends upon his ability to

sell the commodity at a price above its marginal cost. A perfectlycompetitive seller enjoys no monopoly power and in his case:

Price = Marginal cost (or P - MC = 0).

But as monopoly po~er emerges, P - MC becomes greater thanzero and as the power increases, the gap between price and MCincreases. Thus, the degree or index of monopoly power can be

measured as being equal to:

P =MC

P

For instance, if price is Rs. 20 and marginal cost is Rs.12, the



degree of monopoly power is

20-12= 0.420

Lerner also relates the monopoly power to price-elasticity ofdemand. Accordingly, higher the price-elasticity of demand, smaller isthe degree of monopoly power. Also, the degree of monopoly power is

the reciprocal of the price-elasticity of demand. That is, if elasticity is2, the degree of monopoly is V*.

Bain's measure: Bain measures degree of monopoly power in terms

of supernormal profits. The supernormal profits are equal to (P -AC) Q, where P = Price, AC = average cost, and Q is output.

Rotbscbilds' measure: Rothschilos defines degree of monopolypower, in terms of the proportion of the slopes of the firms andindustry demand curves, i.e.,

degree of monopoly power

=

Slope of the firm’s demand curve

Slope of the industry’s demand curve

Triffin's measure: Trimn measures degree of monopoly power

in terms of price cross-elasticity of demand. Pricecross-elasticity of demand means the extent of substitution

between the products of two firms when one of them changesthe price of its product. If cross-elasticity of demand is zero,this implies that the firm has an absolute monopoly power.



REVIEW QUESTIONS

1. Define a production function. Explain and illustrate

isoquants and isocost curves.

2. Explain the nature mid managerial uses of productionfunction.

3. Discuss the equilibrium of the organisation with the

technique of' isoquants.

4. Distinguish between production function and costfunction. How would you develop the production function?

What are its uses?

5. What are the main features of pure competition? Howdoes an organisation adjust its policies to a purely

competitive situation?

6. What is the short-down point? Explain why a organisationsuffering losses still decides to operate and not shut

down.

7. Explain the following propositions:

A. If demand rises, price goes up.

B. If supply rises, price goes down.

C. If both demand and supply increase, sales is bound to



increase but price mayor may not.

8. Explain the possible effect of an increase in demand witha simultaneous decrease in supply on sales and price.

9. Explain the effects of government intervention in price

fixation. What steps are necessary to make thisintervention effective?

10. How does a company determiae the prices of its products?

Examine in this connection the validity of the theory thatlong-period price is equal to cost.

11. Explain very short period, short period and long period

situations in a market. Show price equilibrium under veryshort and iong periods.

12. What is meant by 'price discrimination'? What are its

objectives? Is price discrimination anti-social?

13. What does differential pricing mean? Discuss the varioustypes of geographical price differentials and explain how

they are determined.

14. Comment on the various types of discounts and theeffects of each on sales.

15. How does the equilibrium of the organisation underperfect competition differ from that of a monopolist? Is ittrue that in the long run II perfectly competitive

organisation earns no super-normal profits?16. Explain and illustrate the conditions for the establishment

of organisation's equilibrium under perfect competition.

17. Examine the weaknesses of the traditional theory ofpricing from the point of view of an individual

organisation.



LESSON - 5

PROFIT

MEANNING

Profit means different things to different people. The word ‘profit’ hasdifferent meanings to business, accountants, tax collectors workersand economists. In a general sense, profit is regarded as income of the

equity shareholders. Similarly wages getting accumulated of a labor,rent accruing to the owners of any land or building and interestgetting due to the investors of capital of a business, are a kind of

profit for labours, land owners and investors. To an account, profitmeans the excess of revenue over all paid out costs including both

manufacturing and overhead expenses. It is much similar to net profit.In accountancy, profit or business income means profit of a businessincluding its non allowance expenses. In economic, Profit is called

pure profit, which may be defined as a residual left after all contractualcosts have been met, including the transfer costs of managementinsurable risks, depreciation and payment to shareholders, sufficient

to maintain investment at its current level. Therefore pure profit canbe calculated with the help of following formula.

Pure Profit = Total Revenue - (explicit costs + implicit costs).Economic or pure profit also makes provision for insurable risks,depreciation and necessary minimum payments to shareholders to

prevent them from withdrawing their capital. Pure profit is consideredto be a short – term phenomenon. It does not exist in the long run,

especially under perfectly conditions. Because of this, they may eitherbe positive or negative for a single firm in a single year.

The concept of economic profit differs from that of accounting

profit Economic profit takes into account also the implicit or imputedcosts. The implicit cost is also called opportunity cost. If anentrepreneur uses his labor in his own business, he foregoes his

income or salary, which he might have earned by working as amanager in another firm. Similarly, by using assets like and building



and his own business, he foregoes the market rent, which might haveearned otherwise. All these foregone incomes such as interest, salaryand rent, are called opportunity costs or transfer costs. Accounting

profit does not consider the opportunity cost.

THEORIES OF PROFIT AND SOURCES OF PROFIT

There are various theories of profit, given by several economists,which are as follows:

Walker’s Theory of: Profit as Rent of AbilityThis theory is pounded by F.A. Walker. According to F.A. Walker, “Profit

is the rent of exceptional abilities that an entrepreneur may possessover others. Rent is the difference between the yields of the least andthe most efficient entrepreneurs. In formulating this theory, Walker

assumed a state of perfect completion in which all firms are presumedto possess equal managerial ability each firm receives only the wageswhich in Walker view forms no part of pure profit. Hen considered

wages of management as ordinary wages thus, under perfectlycompetitive conditions, there would be no pure profit and all firms

would earn only wages, which is known as normal profit.

Clark’s Dynamic Theory

This theory is propounded by J.B. Clark According to him, “profits arisein a dynamic economy and not in static economy.”A static economy and the firms under it, has the following features:

Absolute freedom of completion

Population and capital are stationary

Production process remains unchanged over time.

Homogeneous goods

Factors of production enjoy freedom of mobility but do not

move because their marginal product in very industry is thesame.



There is no uncertainly and risk. If there is any risk, It is

insurable

All firms make only normal profit

A dynamic economy is characterized by the following features:

Increase in population

Increase In capital

Improvement in production techniques.

Changes in the forms of business organization

The major function of entrepreneurs or managers in a dynamiceconomic is to take the advantage of all of the above features andpromote their business by expanding their sales and reducing their

costs of production.According to J.B. Clark, “Profit is an elusive sum, which

entrepreneurs grasp but cannot hold. It slips through their fingers andbestows itself on all members of the society”. This result in rise indemand for factors pf production and therefore rises in factor prices

and subsequent rise in the cost of production. On the other hand,because of rise in cost of production and the subsequent fall in sellingprice of the commodities, the profit disappears. Disappearing of profit

does not mean that profit arise in dynamic economy once only, but itmeans that the managers take the advantage of the changes taking

place in the economy and thereby making profits.

Howley’s Risk Theory of Profit

The risk theory pf profit is propounded by F.B. Hawley’s in 1893. Riskin business may arise due to obsolescence of a product, sudden fall inprices, non-availability of certain materials, introduction of a better

substitute by a competitor and risks due to fire, war, etc. Hawley’sconsidered risk taking as an inevitable element of production and

those who take risk are more likely to earn larger profits. According toHawley, Profit is simply the price paid by society assuming business



risks. In his opinion in excess of predetermined risk. They also look fora return in excess of the wags for bearing risk is that the assumptionof risk is irrelevant and gives to trouble and anxiety. According to

Hawley, Profit consists of two part, which are as follows:-

One Part represents compensation for actual or average losssupplementing the various classes of risk.

The other part represents a penalty to suffer the consequencesof being exposed to risk in the entrepreneurial activities.

Hawley believed that profits arise from factor ownership as longas ownership involves risk. According to Hawle’y an entrepreneur hasto assume risk to earn more and more profit. In case of absence of

risks, an entrepreneur would cease to be an entrepreneur and wouldnot receive any profit. In this theory, profits arise out of uninsured

risks. The amount of reward cannot be determined, until theuncertainly ends with the sale of entrepreneur products profit in hisopinion is a residue and therefore. Hawley theory is also called a

residential theory of Profit.

Knight’s Theory of Profit

This theory of profit is propounded by frank H. Knight who treatedprofit as a residual return because of uncertainly, and not because of

risk bearing. Knight made a distinction between risk and uncertainlyby dividing risk into two categories, calculable and non-calculablerisks. They are explained as below:-

Calculable risks are those, the prodigality of occurrence of which

van be calculated on the basis of available data. For examplerisk, due to fire theft accidents etc. are calculable and such risks

are insurable.

Incalculable risks are those the probability of occurrence of

which cannot be calculated. For Instance there may be a certainelements of cost, which may not be accurately calculable and thestrategies of the competitors may not be precisely assessable.



These risk are called includable risks. The risk element of suchincalculable costs is also insurable.It is in the area of uncertainly which makes decision-making a

crucial function for an entrepreneur. If his decisions prove to be right,the entrepreneur makes profit, Thus according to knight profit arisesfrom the decisions taken and implemented under the conditions of

uncertainly. The profits may arises as a result of decision related to thestate of market such as decision, which increase the degree of

monopoly, decisions regarding holding of stocks that give rise towindfall gains and the decisions taken to introduce new techniquesor innovations.

Schumpeter’s Innovation Theory of ProfitJoseph A. Schumpeter developed the innovation theory of Profit.

According to Joseph A. Schumpeter, factors like emergence of Interestand profits, recurrence of trade cycles only supplement the distinct

process of economic development to explain the phenomenon ofeconomic development and profit, Schumpeter starts from the state ofa stationary equilibrium, which is characterized by the equilibrium in

all the spheres. Under these conditions stationary equilibrium, thetotal receipts from the business are exactly equal to the cost. Thismeans that there will be no profit. The profit can be earned only by

introducing innovations in manufacturing technique and the methodsof supplying the goods innovations may include the following activities.

Introduction of a new commodity or a new quality of goods.

Introduction of a new method of production.

Introduction of a new market.

Finding the new sources of raw material

Organizing the industry in an innovative manner with the new

techniques.The factor prices tend to increase while the supply of factors

remains the same. As a result, cost of production increase. On the

other hand with other firms adopting innovations, supply of goods and



services increases resulting in a fall in their prices. Thus, on one hand,cost per unit of output goes up and on the other revenue per unitdecrease. Finally, a stage comes when there is no difference between

costs and receipts. As a result there are no profits at all. Here,economy has reached a state of equilibrium, but there is the possibilityof existence of profits. Such profits are in the nature of Quasi-rent

arising due to some special characteristics of productive services.Furthermore, where profits arise due to factors such as patents, trusts,

etc. they will be in the nature of monopoly revenue rather thanentrepreneurial profits.

MONOPLOY PROFITMonopoly is a market situation in which there is a single seller of acommodity without a close substitute. Monopoly may arise due to

economies of scale, sole ownership of raw materials, legal sanction,protection, mergers and take–overs. A monopolist may earn pure

profit, which is also called monopoly profit in the case of a monopoly,and maintain it in the long run by using its monopoly powers.Monopoly powers are as follows:-

Powers to control supply and price.

Powers to prevent the entry of competitors by reducing the

prices.The Monopoly powers help a monopoly firm to make pure profit

or monopoly profit. In such cases, monopoly is the source of pure

profit.

PROBLEMS IN PROFIT MEASURMENT

Accounting profit is the difference between all explicit costs andeconomic profit or subtracting the difference of explicit and implicit

costs from revenue. Once profit is defined, it is easier for a firm tomeasure the profit for a given period. The problems regarding themeasurement of profits are as follows:



The choice between the two concepts of profits, to be given

preference while using.

The determination of the various costs to be included in the

implicit and explicit costs.The solutions to these problems are as follows:-

The use of a profit concept depends on the purpose of

measuring profit.

According concept of profit is used when the purpose is to

produce a profit figure for any of the following.o The shareholders, to inform them of progress of the firm

o Financiers and creditors, who would be interested in thefirm’s progress

o The Managers to assess their own performance

o For computation of tax-liability.To measure accounting profit for these purposes, necessary

revenue and cost data are, in general, obtained from the firm books of

account. It must, however, be noted that accounting profit maypresent an overstatement or understand of actual profit, if it is based

on illogical allocation of revnues and costs to a given accountingperiod.

On the other hand, if the objective is to measure true profit, the

concept of economic profit should be used. However true profitabilityof any investment or business has been completely done. But then thelife of a business firm is unending therefore , true profit can be

measured only in terms of maximum amount that can be distributedas dividends without harming the earning power of the firm. This

concept of business income is however, unattainable and therefore, isof little practical use. It helps in income measurement even frombusinessman point of view. From the above discussion, it is clear that,

for all practical purpose, profits have to be measured on the basis ofaccounting concept. But measuring even the accounting profit is notan easy task. The main problem is to decide as to what should be and

what should not be included in the cost one might feel that profit and



loss accounts and balance sheet of the firms provide all the necessarydata to measure accounting profit there are, however three specificitems of cost and revenue which cause problems, such as depreciation,

capital gains and losses and current vs. historical costs. Theseproblems are related to measurement and may arise because of thedifferences between economists and accountants view on these items.

The concept of current costs can be used understood from thefollowing description.

CURRENT vs. HISTORICAL COSTSMeaning of Historical Costs

The income statements are prepared in terms of Historical costs andnot in terms of current price. Historical costs is the purchase price ofany asset ands includes the following.

Money spent in the acquisition of the asset includingtransportation costs as well as the insurance cost.

Costs of installation such as wages paid for erection of

machinery and the amount spent on repairs at the time ofinstallation.

The reasons for using historical costs for calculatingdepreciation rather than current costs are as follows:-

Historical costs produce more accurate measurement of Income.

Historical costs are easily determined and more objective thanthe values based on the use of current value on asset.

Accountants also record historical costs and consider them to bemore relevant, The accountants approach ignores certain

important changes in earnings and looses of the firms, whichmay be any of the following:o The value of asset pretended in the books of accounts is

understand at the time of inflation and overstated at thetime of deflation.

o Depreciation is understated during deflation. The

historical cost recorded in the books of account does not



reflect these changes in values of assets and profits. Thisproblem becomes more critical in case of inventories andstock. The problem is how to evaluate the value of

inventory and the stocks.

Methods of Inventory Valuation

There are three popular methods of Inventory valuation, first in firstout (FIFO), last in fist out (LIFO) and weighted average cost (WAC)

Under FIFO method, material is taken out of stock for furtherprocessing in the order in which they are acquired. The stocks,therefore, appear in firms balance sheet at their actual cost price. This

method overstates profits at the time of rising prices.Under LIFO method, the stock purchased most recently become

the costs of the raw material in the current production under WAC

method, the weighted average of the costs of materials purchased atdifferent prices and different point of time is calculated to evaluate the

inventory.All these methods have their own disadvantages and do not

reflect the true profit of the business. So the problem of evaluating

inventories to yield a true profit remains unsolved.

Problems is Measuring Depreciation

Economists consider depreciation as capital consumption. For them,there are two distinct ways of charging depreciation either by

assuming the value of depreciation of equipment to its opportunitycost or to its replacement cost that will produce comparable earning.

Opportunity cost of equipment is the most profitable alternate

use of that is foregone by putting it to its present use. The problem isto measure the opportunity cost. One method of measuring theopportunity cost. One method of measuring the opportunity cost, as

suggested by Joel Dean, is to measure the fall in value during a year.By using this method cannot be applied when capital equipment has

no alternative use, like a hydropower project In such cases,



replacement cost is an appropriate measure of depreciation. Underthis method, the cost of the new asset and the residual value of theold asset are taken as the depreciation of the asset. But depreciation is

recorded only at the time of replacement of an asset. This method isused in public utility concerns like railway, electricity companies. Toaccountants, depreciation is an allocation of under expenditure over

time. Such allocation or charging depreciation is made underunrealistic assumptions such as stable prices and a given rate of

obsolescence. There are different methods of charging depreciation,which are of utmost importance. The use of different levels of profitreported by the accountants. It will be clearer after considering the

following example: Suppose a firm purchases a machine for Rs.10,000/- with an estimated life of 10 yrs. The firm can apply any ofthe following four methods of charging depreciation and the amount

of depreciation for the given example by using the different methodsis as follows:

Straight Balance Method

Annuity Method

Sum-of the years digit approaches

Under the straight – line method, the amount of depreciationremains the same throughout the life of the asset. Depreciation is

calculated according to a fixed percentage on the original cost. Theamount and rate of depreciation is calculated as under:

Amount of depreciation =Historical cost-residual value

Economic life of the asset

Rate of depreciation = Amount of depreciation x 100/HistoricalcostResidual value is the realizable value of an asset at the end of its

economic life. Keeping in view the above example, the amount ofdepreciation will be 10,000/10 = Rs. 1,000. It will be same for eachyear. The rate of depreciation will be

1000 x 100/10,000 = 10



Under the reducing balance method, depreciation is charged at aconstant rate or percent of annually written down values of themachine or any equipment. Assuming a depreciation rate of 20 per

cent, the amount of depreciation for different years will be calculatedas under :Amount of Depreciation = Historical value x rate of depreciation /100

But the amount of depreciation for the first year will be deducted

from the successive years. Therefore Rs. 2000 in the first year, Rs.1600 in the second year, Rs. 1280 in the third year, and so on.Under annuity method, rate of depreciation is fixed and is calculated

as under:-d = (C + Cr )/n, where n is the total number of years of capital, C isthe total capital and r is the interest rate. The amount of depreciation

in this method is calculated with the help of annuity table.Finally under sum-or-the year’s digits approach, the total years

of equipment life are aggregated. Depreciation is then charged at therate of the ratio of the last years digits to the total of the years. Withrespect to the given example, the aggregated years of the equipment’s

life’s will be 1+ 2 + 3 +... +10 = 55. Depreciation in the 1st year willbe 10,000 x 10/55 = Rs. 1818.18, in the 2nd year it will be 1,000 x9/55 = Rs. 1636.36 and in 3rd year it will be 10,000 x 8/55 = Rs.

1454.54, and so on. These four methods of depreciation results indifferent methods of depreciation and subsequently different levels of

profit.

TREATMENT OF CAPITAL GAINS AND LOSSES

Capital gains and losses arc regardea as windfalls. Fluctuation in thestock market prices is one of the most common sources of wind Ellis.According to Dean, capital losses are, greater than capital gains in a

progressive society. Many of the capital losses arc of insurable natureand the excess becomes the capital gain.

Profit is also affeckd by the way capital gains and losses are treated



in accounting. According to Dean, "a sound accounting policy to followconcerning windfalls is never to record them until they are turned intocash by a purchase or sale of assets, since it is never clear until then

exactly how large they are". But, in practice, some firms do not recordcapital gains until it is realised in money terms, but they do write offcapital losses from the current profit. The use of different policies

result in different profits. But an economist is not concerned with theaccounting practice or principle, which is followed in recording the

past events. An economist is concerned mainly with what happens infuture. According to an economist, the management should be awareof the approximate magnitude of such windfalls before they are

accepted by the accountants. This would be helpful in taking the rightdecision with respect of those assets, which are affected by the use ofpolicies given by the economists.

PROFIT MAXIMISATION AS BUSINESS OBJECTIVE

Profit maximisation is the most important assumption, which helpsthe economists to introduce the price and production theories. The

traditional economic theory assumes that the profit maximisation isthe only objective of business firms. According to this theory, profitsmust be earned by business to provide for its own survival, coverage

of risks, growth and expansion. It is a necessary motivating force andit is in terms of profits that the efficiency of a business is measured. It

forms the basis of conventional price theory. Profit maximisation isregarded as the most reasonable and analytically the most productivebusiness objective.

The profit maximisation assumption in this theory helps inpredicting the behaviour of business firms and also the behaviour ofprice and out pet under different market conditions. No alternative

hypothesis or assumption explains and predicts the behaviour of firmsbetter than the profit maximisation assumption. According to thistheory, total profit is the difference between total revenue and total

cost and is calculated as below:



TP = -TR – TC (1)where,

TR = total revenue

TC = total costThe total cost includes fixed cost and variable cost. The cost,

which remains same at different levels or output, is called fixed cost.

The sum of all t~ose costs, which vary directly with the level of output,is called variable cost. In context with the profit maximisation

objective, the total profit or the difference between total· cost andtotal profit is to be maximised. There are two conditions that must befulfilled for TR- TC to be maximum. These conditions are divided into

two categories, which are necessary or first order condition andsecondary or supplementary condition. These conditions are explainedas below:

The necessary or the first order condition states that marginalrevenue (MR) must be equal to marginal cost (MC). Marginal

revenue is the revenue obtained from the production and sale ofone additional unit of output. Marginal cost is the cost arisingdue to the production of one additional unit of output.

The secondary or the second order condition states that the firstorder condition must show the decreasing MR and rising MC. The

secondary condition is fulfilled only when both the MC is risingas well as the MR is decreasing. This condition is illustrated bypoint P2 in Figure 5.1.



Let us suppose that the total revenue and total cost functions are,respectively given as below:

TR = TC = f (Q)

where, Q = quantity produced and sold.Substituting total revenue and total cost functions In Equation

(I), profit function can be written as below:TP = f(Q)TR - f(Q)TC (2)

With the help of equation (2), The first order condition and the

secondary. Condition can be understood easily.

First-order Condition

The first-order condition of maximising a function is that the first

derivative of the profit function must be equal to zero. Bydifferentiating the total profit function and equating it to zero, the

following equation is obtained:

aTP=

aTR-

aTC=0(3)

aQ aQ aQ

This condition holds only when

aTR aTC



aQ = aQ

In Equation (3), the term aTR/aQ is the slope of the total

revenue curve, which is equal to the marginal revenue (MR). Similarly,the term aTC/aQ is the slope of the total cost curve, which is equalto the marginal cost (MC). Thus, the first-order condition for profit

maximisation can be stated as:MR=MC

The first-order condition is also called necessary condition, as it

is so important that its non-fulfilment results in non-occurrence ofthe secondary condition and thereby the profit maximisation

objective is not attained.

Second-order Condition

The second-order condition of profit maxirnisation requires that the

first order condition is satisfied under rising MC and decreasing MR.This condition is illustrated in Fig. I. The MC and MR curves are theusual marginal cost and marginal revenue curves, respectively. MC and

MR curves intersect at two points, PI and P2. Thus, the first ordercondition is satisfied at both the points but mathematically, the

second order condition requires that its second derivative of the profitfunction is negative. When second derivative of profit function isnegative, it shows that the total profit curve has bent downward after

reaching the highest point on the profit scale. The second derivative ofthe total profit function is given as:

a2TR=

a2TP=

a2TR-

a2TC<0

(4)aQ2 aQ2 aQ2 aQ2

But it requires:

a2TR a2TC



aQ2 - aQ2 < 0

a2TR<

a2TC< 0aQ2 aQ2

Since & TR/aQ2 is the slope of MR and & a2 TC/aQ2 is the slope of

MC, the second-order condition can also be written as:

Slope of MR < Slope of MC. It implies that MC curve mustintersect the MR curve. To conclude, profit is maximised where both

the first and second order conditions are satisfied.Example

It is known that:TR = P.Q

where, (5)

P = Price of a single quantity andQ = Total quantity.

Suppose price (P) function is given as

P = 100 – 2Q (6)Then TR = (100 – 2Q) Q

Or, TR = 100Q – 2Q2 (7)And also suppose that the total cost function as given as

TC = 10 + 0.5Q2 (8)

Applying the first order condition of profit maximisation andfinding the profit maximising output. It is known that profit ismaximum where:

MR – MCor,

aTR=

aTC

aQ aQ(9)

Putting the values of Equation (7) and (8) in (9)aTR aTC



MR = aQ < aQ = 100 – 4Qand

MC =aTC

=QaQ

Thus, profit is maximum whereMR = MC

100 – 4Q = Q5Q = 100Q = 20

The output 20 satisfies the second order condition also. Thesecond order condition requires that:

a2TR<

a2TC<0aQ2 aQ2

In order words, the second-order condition requires that

aMR-

aMC<0Q Q

Ora(100 – 40)

-

a(Q)

<0aQ aQ

- 4 – 1 <0

Thus, the second-order condition is also satisfied at output 20.

CONTROVERSY OVER PROFIT MAXIMISATION OBJECTIVE:THEORY vs. PRACTICE

According to the traditional theory, profit maximisation is the sole

objective of a business firm. In practice, however, firms have beenfound to be pursuing objectivies other than profit maximisation. For



the large business firms, pursuing goals other thon profitmaximisation is the distinction between the ownership andmanagement. The separntion of manllgement from the ownership

gives managers an opportunity to set goals for the firms other thanprotit maximisation. Large firms pursue goals such as salesmaximisalioll, mllximisulioll of lilllllagcrial utility function,

maximisation of firm's growth rate, making a target profit, retainingmarket share, building up the net worth of the firm, etc. Secondly,

traditionnl theory assumes perfect knowledge about current murketconditions and the future developments in the business environmentof the firm. Thus a business firm is fully aware of its demand and cost

functions in both short and long runs. The market conditions (Ireassumed to be certain. On the contrary, it is also recognised that thefirms do not possess the perfect knowledge of their costs, revenue,

and their environment. They operate in the world of uncertainty. Mostof the price and output decisions are based on probabilities.

Finally, the marginality principle in which MC and MR are same hasbeen found to be absent in the decision-making process of thebusiness firms. Hall and Hitch have found, in their study of pricing

practices in UK, that the firms do not pursue the objective of profitmaximisation and that they do not use the marginal principle ofequalising MR and MC in their price and output decisions. Most firms

aim at long-run profit maximisation. In the short-run, they set theprice of their product on the basis of average cost principle to cover

average cost and its components, average variable cost and averagefixed cost.

It also takes into account normal profit usually 10 per cent. Gordon,

a famous economist, has concluded that the real business world ismuch more complex than the one which is based on hypothesis andassumptions. The extreme complexity of the real business world and

ever-changing conditions makes it difficult for a business firm to useits past experience in order to forecast demand, price and costs. The

average-cost principle of Rricing is widely used by the firms and the



marginal costs and marginal revenu~ are ignored. On the basis ofmany such studies, it can be said that the pricing practices are relatedto pricing theories.

THE FAVOUR OF PROFIT MAXIMISATION

The arguments against the profit-maximisation assumption, however,should not mean that pricing theory is not related to the actual pricing

policy of the business firms. Many economists has strongly supportedthe profit maximisation objective and the marginal principle of pricingand output decisions. The empirical and theoretical policies support

the marginal rule of pricing in the following way:

In two empirical studies of 110 business firms, J.S.Earley has

concluded that the firms do apply the marginal rules in their pricingand output decisions. Fritz Maclup has argued that empirical studiesby Hall and Hitch, and Lester do not provide conclusive evidence

against the marginal rule and these studies have their ownweaknesses. He further argued that there has been a misundestandingregarding the purpose of traditional theory. The traditional theory

explains market mechanism, resource allocation through pricemechanism and has a predictive valu. The significance of marginal

rules in actual pricing system of firms could not be considcredbecausc of lack of communication between the busincssmcn and theresearchers as they use different terminology like MR, Me and

clasticitics. Also, Maclup is of the opinion that the practices of settingprice equal to the average variable cost plus a profit margin, is notinequitable with the marginal rule of pricing.

ARGUMENTS IN FAVOUR OF PROFIT MAXIMISATION HYPOTHESIS

The traditional theory supports the profit maximisation hypothesisalso on the following grounds:

Profit is essential for survival of a business: The survival ofall the profit¬oriented firms in the long run depends on their

ability to make a reasonable profit depending on the business



conditions and the level of competitior. Profit is the biggestincentive for work. It is the driving force behind the businessenterprise. It encourages a man to work to do the best of his

ability and capacity. Making a profit is a necessary condition forthe survival of the firm. Once the firms are able to make profit,they try to maximise it.

Achieving other objectives depends on the ability of a

business to make profit: Many other objectives of business are

maximisation of managerial utility function, maximisation oflong-run growth, maximisation of sales revenue. Theachievement of such alternative objectives depends wholly or

partly on the primary objective of making profit.

Profit maximisation objective has a greater predicting power:As comparcd to other business objectives, profit maximistion

assumption has been found 10 be good in predicting ccrtainaspects relatcd to a business. Friedman supports this by saying

that the profit maxilllisation is considered to be good only if itpredicts the business behaviour and the business trendscorrectly.

Profit is a more reliable measure of efficiency of a business:

Thought not perfect, profit is the most efficient and reliablemeasure of the efficiency of a firm. It is also the source of

internal finance. The recent trend shows a growing dependenceon the internal finance in the indlstrially advanced countries. Infact, in developed countries, internal sources of finance

contribute more than three-fourths or lotal linance. Keepingthis in mind, it can be said that profit maximisation is a more

valid business objective.

Alternative objectives of Business Firms

The traditional theory does not distinguish between owners and

managers' interests. The recent theories of firm, which arc also calledmanagerial and behavioural theories of firm, assume owners and



managers to be separate entities in large corporations with differentgoals and motivation. Berle and Means were the two economists, whopointed out the distinction between the ownership and the

management, which is also known as Berle-Means-Galbraith (BMG)hypothesis. The B-M-G hypothesis states the following:

The owners controlled business firms have higher profit rates than

manager controlled business firms, and

The managers have no in::entive for profit maximisation. Themanagers of large corporations, instead of maximising profits,

set goals for themselves that helps in controlling the owners also.In this section, some important alternative objectives of business

firms, especially of large business corporations are alsodiscussed.

Baumol's Hypothesis of Sales Revenue Maximisation

According to Baumol, "maximisation of sales revenue is an alternativeto profit¬maximisation objective". The reason behind this objective isto clearly distinct ownership and management in large business firms.

This distinction helps the managers to set their goals other than profitmaximisation goal. Under this situation, managers maxi mise theirown utility function. According to Baumol, the most reasonable factor

in managers' utility functions is maximisation of the sales revenue.The factors, which help in explaining these goals by the

managers, are following:Salary and other earnings of managers are more closely relatedto seals revenue than to profits.

Banks and financial corporations look at sales revenue while

financing the corporation.

Trend in sale revenue is a good indicator of the performance of

the business firm. It also helps in handling the personnelproblems.

Increasing sales revenue helps in enhancing the prestige of

managers while profits go to the owners.



Managers find profit maximisation a difficult objective to fulfil

consistently over tillle and at the same level. Profits mayfluctuate with changing conditions.

Growing sales strengthen competitive spirit of the business firm

in the nlilrkd and vice versa.

So far as cmpirical validity of sales revenue maximisation

objective is concerned, realistic evidences are unsatisfying. Mostempirical studies are, in fact, based on inadequate data because thenecessary data is mostly not available. If total cost lilllction intersects

the total revenue function (TR) function before it reaches its highestpoint, Baumol's theory fails. It is also argued that, in the long run,

sales maximisation and profit maximisation objective can be mergedinto one. In the long rnll, sales maximisation lends to yield onlynormal levels of profit, which turns out to be the maximum under

competitive conditions. Thus, profit maximisation is not inequitab!cwith sales maximisation objective.

MARRIS's HYPOTHESIS OF MAXIMISATION OF FIRM'S GHOWTH RATE

According to Robin Marris, managers maximise firm's growth ratesubject to managerial and financial constraints. Marris defines firms'

balanced growth rate (G) as follows:

G = Gd = Gc

where,

Jd = growth rate of dcmand for firms product.

Gc = growth rate of capital supply to the firm.

In simple words, a firm's growth rate is considered to bebalanced when demand for its product and supply of capital to the

firm increase at the same rate. The two growth rates according toMarris, are translated into two utility functions such as:

Manager’s ut i I ity function



Owner’s utility function

The manager’s utility function (Um) and owner's utility function(Uo) may be specified as follows:

Um = f (salary, powcr, job security, prestige, status) and

Un = f (output, capital, market-share, profit, public esteem).

Owner's utility function (Vo) implies growth of demand for firms'products and supply of capital. Therefore, maximisation of Uo mcans

maximisation of demand for a firm's products or growth of supply ofcapital.

According to Marris, by maximising these variables, managersmaximise both their utility function and that of the owner's. The,managers can do so because most of the variables such as salarics,

status, job security, power, etc., appearing in their own utility functionand those appearing in the utility function of the owners such as profit,capital market, share, etc. are positively and strongly correlated with

the size of the firm. These variables depend on the maximisation ofthe growth rate of the firms. The managers, therefore, seek to

maximise a steady growth rate. Marris's theory, though more accurateand sophisticated than Baumol's sales revenue maximisation, has itsown weaknesses. It fails to deal satisfactorily with the market

condition of oligopolistic interdependence. Another seriousshortcoming is that it ignores price determination, which is the mainconcern of profit maximisatioll hypothesis. In tbe opinion of many

economists, Marris's model too, does not seriously challenge the profitmaximisation hypothesis.

Williamson's Hypothesis of Maximisation of Managerial Utility

Function

Like Baulmol and Marris, Willamson argues that managers are verycareful in pursuing the objectives other than profit maximisation. The

managers seek to maxi mise their own utility function subject to aminimum level of profit. Managers' utility function (U) is expressed

below: V = f(S, M, ID)



where,S = additional expenditure on staffM = Managerial emoluments

ID = Discretionary investmentsAccording to Williamson's hypothesis, managers maximise their

utility function subject to a satisfactory profit. A minimum profit is

necessary to satisfy the shareholders and also to secure the job ofmanagers. The utility fU'1ctions which managers seek to maximise,

include both quantifiable variables like salary and slack earnings antinon-quantitative variable such as prestige power, status, job security,professional excellence, etc. The non-quantifiable variables are

expressed in order to make them work effectively in terms of ex; ensepreference defined as satisfaction derived out of certain types ofexpenditures. Like other alternative hypotheses, Williamson's theory

too suffers from certain weaknesses. His model fails to deal with theproblem of oligopolistic interdependcncc, Willinmsoli's theory is said

to hold only where rivalry between firms is not strong. In case there isslrong rivalry, profit maximisation is claimed to be a more appropriatehypothesis. Thus, Williamson’s managerial utility function too does not

offer a more satisfactory hypothesis than profit maximisation.

Cyert-March Hypothesis of Satisfying Behaviour

Cyert-March hypothesis is an extension of Simon's hypothesis offirms' satisfying behaviour. Simon had argued that the real business

world is full of uncertainly liS accurate and adequate data are notreadily available, If data are available, managers have little time andability to process them, Managers alsc work under a number of

constraints. Under such conditions it is not possible for the firms toact in terms of consistency assumed under profit maximisationhypothesis. Nor do the firms seek to maximise sales and growth.

Instead they seek to achieve a satisfactory profit or a satisfactorygrowth and so on. This behaviour of business firms is termed as

satisfaction behaviour.



Cyert and March added that, apart from dealing with uncertainty,managers need to satisfy a variety of groups of people such asmanagerial staff, labour, shareholders, customers, financiers, input

suppliers, accountants, lawyers, etc. All these groups have confiictinginterests in the business firms. The manager's responsibility is tosatisfy all of them. According to the Cyert-March, "firm's behaviour is

satisfying behaviour, which implies satisfying various interest groupsby sacrificing firm's interest or objectives." The basic assumption of

satisfying behaviour is that a firm is an association of different groupsrelated to various activities of the firms such as shareholders,managers, workers, input supplier, customers, bankers, tax authorities,

and so on. All these groups have some expectations from the firm,which are needed to be satisfied by the business firms. In order toclear up the conflicting interests and goals, managers fonn an

objective level of the firm by taking into consideration goals such asproduction, sales and market, inventory and profit.

These goals and objective level are set on the basis of themanagers past experience and their assessment of the future marketconditions. The objective level is also modified and revised on the

basis of achievements and changing business environment. But thebehaviouraI theory has been criticised on the following grounds:

Though the behavioural theory deals with the activities of the

business firms, it does not explain the firm's behaviour underdynamic conditions in the long run.

It cannot be used to predict the firm's activities in the future.

This theory does not deal with the equilibrium of the businessindustry.

This theory fails to deal with interdependecne or the linns and its

impact on linn's behaviour.

ROTHSCHILD's HYPOTHESIS OF LONG-RUN SURVIVAL AND MARKETSHARE GOALS

Rothschild suggested another alternative objective and alternative to



profit maximisation to a business firm. Accordingto Rothschild, theprimary goal of the firm is long-run survival. Some other economistshave suggested that attainment and 'retention of a market share

constantly, is an additional objective of the business firms. Themanagers, therefore, seek to secure their market share and long-runsurvival. The firms may seek to maxi mise their profit in the long run

though it is not certain.

Entry-prevention and Risk-avoidancel

Another alternative objective of firms as suggested by some

economists is to prevent the entry of new business firms into theindustry. The motive behind entry prevention may be any of thefollowing:

Profit maximisation in the long run.

Securing a constant market share.

Avoidance of risk caused by the unpredictable behaviour of

new firms.

The evidence related to the firms to maximise their profits in thelong run, is not certain. Some economists argue that if management is

kept separate from the ownership, the possibility of profitmaximisation is reduced. This means that only those firms with theobjective of profit maximisation can survive in the long run. A

business firm can achieve all other subsidiary goals easily bymaximising its profits. The motive of business firms behind

entry-prevention is also to secure a constant share in the market.Securing constant market share also favours the main objective ofbusiness firms of profit maximisation.

A Reasonable Profit Target

A business firm has variolls objectives to achieve. The survival of a

firmdepends on the profit it can make. So, whatever the goal of thefirm may be, it has to be a profitable firm. The other goals of a



business firm can be sales revenue maximisation, maximisation offirm's growth, maximisation of managers’ utility function, long-runsurvival, market share or entry-prevention. In technical sensc,

maximisation of profit, as a business objective, may not soundpractical , but profit has to be there in the objective function of thefirms for its survival. The firms may differ on the level of profit and

the extent to which it is to be achieved by various firms. Some firmsset standard profit as their objective, while some of them may set

target profit and some reasonable profit as their objective to beachieved. A reasonable profit, as a business objective, is the mostcommon objective. The policy question related to setting standard or

criteria for reasonable profits are as follows:

Why do modem corporations aim at a reasonable profit ratherthan attempting to maximise profit?

What are the criteria for a reasonable profit?

How should reasonable profits be determined?

Following are the suggestions as given by various economists toanswer the above policy questions:

1. Preventing entry of competitors: Under imperfect market

conditions, profit maximisation generally leads to a highpure profit, which attracts competitors, especially ill caseof a weak monopoly. Therefore, the firms adopt a pricing

and a profit policy that assures them a reasonable profit.At the same time, it also keeps the potential competitorsaway.

2. Maintaining a good public image: It is often necessaryfor large corporations to project and maintain a goodpublic image. This is because if public opinion turns

against it and government officials 'start questioning theprofit figures, firms may find it difficult to work smoothly.

So most firms set their prices lower than that to earn themaximum profit but higher enough to ensure areasonable profit.



3. Restraining trade union demands: High profits maketrade unions feel that they have a share in the high profitand therefore they demand for wage-hike. Wage-hike

may interrupt the firm’s objective of maximising profit.Any delay in profit is sometimes used as a weapon againsttrade union activities.

4. Maintaining customer goodwill: Customer's goodwillplays a significant role in maintaining and promotingdemand for the product of a firm. Customer's goodwill

depends on Jhe quality of the product and its fair price toa large extent. Firms aiming at bcllcr profit prospects in

the long run, give up their short-run profit maximisationobjective in favour of a reasonable profit.

5. Other factors: The other factors that interrupts the profit

maximisation objective include the following:

A. Managerial utility function, which is preferable for,profits maximisation to firms.

B. Friendly relations between executive levels within

the firm.

C. Maintaining internal control over management byrestricting firm's size and profit.

Standards of Reasonable Profits

Standards of reasonable profits are determined when a firm choosesto make only reasonable profits rather than to maximise its profit. The

questions that arise in this regard are as follows:

What form of profit standards should be used?

How should reasonable profits be determined?

These questions can be understood after going through thefollowing explanatory points.

FORMS OF PROFIT STANDARDSProfit standards is determined in terms of the following:



Aggregate money terms

Percentage of sales, and

Percentage return on investment.

All these standards are determined for each product separately.Among all the fonns of profit standards, the total net profit of the firm

is more common than other standards. But when the purpose is todiscourage the competitors, then the target rate of return oninvestment is the appropriate profit standard, provided the cost curves

of competitors' are similar. The profit standard in terms of ratio tosales is not an appropriate standard because this ratio varies widelyfrom linn to firm, evens irthey nil hove the snme return on capital

invested. These differences are following:

Vertieal integration of production process

Intensity of mechanisation

Capital structure

Turnover

SETTING THE PROFIT STANDARD

The following arc the important criteria that are considered whileselling the standards for a reasonable profit.

Capital-attracting standard: An important criterion of profit

standard is that it must be high enough to attract external capitalsuch as debt and equity. For example, if the firm's stocks are sold

in the market at 5 times their current earnings, it is necessary fora firm to earn a profit of 20 per cent of the total investment Butthere are certain problems associated with this criterion, which

are as follows:

Capital structure of the firms such as the proportions ofbonds, equity and preference shares, which affects the cost

of capital and thereby the rate of profit.

If the profit standard is based on current or long run averagecost of capital or not. The problem in this case arises as it



may also vary widely from company to company.

Plough-back' standard: This standard is appropriate in case

company depends on its own sources for financing its growth.

This standard involves the aggregate profit that provides for anadequate plough-back for financing a desired growth of thecompany without resorting to the capital market. This standard

of profit is used when liquidity is to be maintained by a firm anda debt is to be avoided as per the profit policy of the firm. Thisstandard is socially less acceptable than capital attracting

standard. From society's point of view, it is more desirable thatall carnings are distributed to stockholders and they should

decide the further investment pattern. This is based on a belicfthat an individual is the best judge of his resource use and themarket forces allocate funds more efficiently, On the other hand,

retained eamings, which are under the control or themanagemcnt are likely to be wasted on low-earning projects

within a business firm. But to choose the most suitable policyamong marketing and management the abilities of themanagement and outside investors are to be considered. This

helps in estimating the earnings prospects of a firm.

Normal earnings standard: Another important criterion forsetting standard of reasonable profit is the normal earnings of

firms of an industry over a period. This serves as a validcriterion of reasonable profit, provided it should take intoconsider the following points:

o Attracting external capital

o Discouraging growth of competition

o Keeping stockholders satisfied.

When average of normal earnings of a group of firms is used,

then only comparable firms are chosen. However, none of thesestandards of profits is perfect. A standard should, therefore be chosen



after giving due consideration to the existing marke conditions andpublic attitudes. Different standards arc used for different purposesbecause no single criterion satisfies all conditions of the customers.

PROFIT AS CONTROL MEASURE

An important aspect of profit is its use in measuring and controllingperfonnances of the individuals of the large business firms.

Researches have concluded that the business individuab of middle andhigh ranks often deviate from profit objective and try 10 maximise

their own utility functions. They give importance to job security,personal ambitions for promotion, larger perks, etc. But this oftenconflicts with firms' profit-making objective. The reasons for conflicts

as given by Keith Powlson are as follows:

More energy is spent in expanding sales volume and productlines than in raising profitability.

Subordinates spend too much time and money doing jobsperfectly regardless of its cost and usefulness.

Individuals depend more to the needs of job security in the

absence of any reward.

In order to control the conllicts and directing the individuals

towards the profit objective, the top management usesdecentralisation and control-by-profit techniques. Decentralisation isachieved by changing over from functional division of business

activities such as production branch, sales division, purchasedepartment, etc. to a system of commodity wise division. By doing so,

managerial responsibilities are fixed in terms of profit. Under thegeneral policy framework, managers enjoy self-sufficiency in theiroperations. They are allotted a certain amount to spend and a profit

target to be achieved by the particular division. Profit is then-themeasure of performance of each individual, not of the sales or quality.This kind of reorganisation of management helps in assessing

profit-performance of every individual. The two important problemsthat arise in the determination of profits are as follows:



Either the profit goals are set in terms of total net profit for the

divisions or they should be restricted to their share in the totalnet profit.

Determination of divisional profits when there is a vertical

integration. The most appropriate profit standard of divisionalperformance is calculated by deducting current expenses from

revenue of the firm.

Profit is essential for survival of a business. In the absence of

profits, the organisations will use up their own capital and close down.It also helps in replacing obsolete machinery and equipment and thusensures the continuity of a business.

ConclusionProfit maximisation is the most popular hypothesis in economicanalysis, but there are many other important objectives, which are not

to be avoided by any firm. Modem business firms pursue multipleobjectives. The economists consider a number of alternative objectives

of business firms. The main factor behind the multiplicity of theobjectives, especially in case of large business firms, is the separationof management from the- ownership. Moreover, profit maximisatjon

hypothesis is based on time. The empirical evidence against thishypothesis is not conclU3ive and unambiguous. The alternativehypotheses are also not so strong to repiace the profit maximisation

hypothesis. In addition to it, profit maximisation hypothesis has agreater explanatory and predictive power than any of the alternative

hypotheses. Therefore, profil maximisation hypothesis still fornls thebasis of firms' behaviour.

PROFIT PLANNING AND FORECASTING

A business is considered to be sound if it includes consistency in

earning profit while considering the various risks as well. A firm isfaced with a number of untertainties. 1bese uncertainties are in

-terms of nature of consumer needs, the diverse nature of



competition, the uncontrollable nature of most elements of cost andthe continuous technological developments. The uncertainty about thepattern and extent of consumer demand for a particular product

increases the degree of risk faced by the firm. The nature ofcompetition is related to either product, price or to bothsimultaneously. Prodoct competition is more important till 'the

product reaches the stage of maturity. Price competition begins a fierthe product is established and reaches the maurity stage. During the

growth stage, the risk of obsolescence of a product and shortening ofthe product life cycle is more. The degree of risk involved in productcompetition is greater than in price competition. When the prices rise

continuously, no firm can be certain of its internal cost structure. Thisis because it does not have any control over the prices of rawmaterials or the wages to be paid to the individuals. In course of time,

continuous technological improvements may make productioncompletely obsolete. If an improved process is available, a firm can

restrict its risk by neglecting its fixed investment. If it does not havean access to the improved processes, it may have to go out ofbusiness. Unless a firm is prepared to face the uncertainties, as a

result of risk element, its profits will be changed. To plan for profits, athorough understanding of the relationship of cost, price and volumeis ext~emely helpful to business individuals. The most important

method of determining the cost-volume¬profit relationship isbreak-even analysis, also known as cost-volume-profit (C-V-P)

analysis. Break-even analysis involves the study of revenues and costsof a firm in relation to its volume of sales. It also includes thedetermination of that volume at which the firm's costs and revenues

will be equal. The break-even point (BEP) may be defined as that levelof sales at which total revenue is equal to the total costs and the netincome is zero. This is known as no-profit no-loss point. The main

objective of the break-even analysis is not simply to find out the BEP,but to develop an understanding between the relationships of cost,

price and volume.



DETERMINATION OF THE BREAK-EVEN POINT

It may be determined either in terms of physical units or in moneyterms. This method is convenient for a firm producing single

prdducts only. The break-even volume is the number of units of theproduct, which must be sold to earn revenue. This revenue should beenough to cover all expenses, both fixed and variable. The selling

price of all units covers not only its variable cost but also leaves amargin called contribution )l1argin to contribute towards the fixed

costs. The break-even point is reached when sufficient number ofunits has been sold so that the total contribution margin of the unitssold is equal to the fixed costs. The formula for calculating the

break-even point is:

BEP =Fixed costs

contribution margin per unit

Where the contribution margin is: selling price Variable costs per unit.

Example 1: Suppose the fixed costs of a Factory are Rs. 10,000 peryenr, the variable costs are Rs. 2.00 per unit and the selling price is Rs.

4.00 per unit. The break~even point would be:

BEP =Rs. 10,000

= 5,000 units(4-2)

In other words, the company would not make any loss or profit at asales volume of 5,000 units as shown below:

Sales RS.20,000Cost of goods sold:Variable cost @Rs.2.00 Rs 10,000

Fixed costs Rs. 10,000 Rs.20,OOONet Profit Nil

Solution. Multi-product firms are not in a position to measure the

break-even point in terms of any common unit of product. It isconvenient for them to determine their break-even point in terms of



total rupee sales. The break-even point is the point where thecontribution margin is equal to the fixed costs. The contributionmargin is expressed as a ratio to sales. For example, if the sales is Rs.

200 and the variable costs of these sales is Rs. 140, the contributionmargin, ratio is (200 - 140)/200 or 0.3.

The formula for calculating the break-even point is:

BEP =Fixed costs

contribution margin ratio

Example 2:

Sales Rs. 10,000Variable costs Rs. 6,000Fixed costs RS. 3,000

With the help of given information, calculate net profit.

Solution. The contribution margin ratio is (10,000-6,000)/10,000= 0.4

BEP =Fixed costs

contribution margin ratio

3,000= Rs. 7 5000.4

Sales value Rs.7,500Less: Variable costs Rs.4,500(0.6 x 7,500)Fixed costs Rs.3,000Net profit Nil

Example 3: Sales were Rs. 15,000 producing a profit of Rs. 400 ina week. In the next week, sales amount to Rs. 19,000 producing aprofit of Rs. 1,200. Find out the BEP.

Solution.Increase in sales 19,000 - 15,000 = Rs. 4,000



Increase in profit 1,200 - 400 = Rs. 800

Increase in variable costs 4,000 - 800 = Rs. 3,200

Over sales of Rs. 4,000, variable costs are Rs. 3,200.

Hence VC per rupee of sale is 3,200 + 4,000 = 0.80.

Fixed costs will be as under:

Variable cost 15,000 x 0.80 12,000Profit 400VC + Profit 12,400Sales value 15,000Fixed cost 2,600

=S – V

=15,000 – 12,000

=3,000

= 0.2S 15,000 15,000

=2,600

= Rs. 13,0000.2

Break-even Point as a Percentage of Full Capacity

Full capacity can be defined as the maximum possible volume

attainable with the firm's existing fixed equipment, operating policiesand practices. Break-even point is usually expressed as a percentage

of full capacity. Considering the example I, the full capacity of the firmis 10,000 units; the break-even point at 5,000 units can be expressedas 50 per cent of full capacity.

Multi-product Manufacturer and Break-even Analysis

Most manufacturers produce more than one type of product. Thedeter¬mination of BEP in such cases is a little complicated and is

illustrated below:

Example 4: A manufacturer makes and sells tables, lamps and

Now, BEP =

FC

Contribution margin ratio



chairs. The cost accounting department and the sales department havesupplied the following data:

~Selling Price

VC

Per unit

% of rupee

Sales volumeProduct

Rs. Rs.Tables 40 30 20Lamps 50 40 30Chairs 70 50 50

Capacity of the firm is Rs. 1,50,000 of total sales value.Annual fixed cost - Rs. 20,000Calculate (1) BEP and (2) Profit if firm works at 50 per cent of

capacity.

Solution. The contribution towards fixed cost in each case is: .

Table Rs. 10Lamps Rs. 10

Chairs Rs. 20

Now, these contributions are to be converted into percentages ofselling prices, the formula to be applied is:

Contribution percentage =Selling price - VC

x 100Selling price

Thus, the contribution percentage for individual items is:

40 - 30 1Table ---x 100 = - xl 00 = 25 per cent

40 450 - 40 1

---x 100 = - xl 00 = 20 per cent50 5

70 - 50 2

---x 100 = -x 100 = 28.57 per cent70 7



Now, we multiply the contribution percentage of each of theproducts by the percentage of sales volume for that particularproduct and add the figures obtained. This gives the total

contribution per rupee of sales volume for tables, lamps and chairs.This is done as follows:

Contribution % of SalesTables 25.00 % X 20 % = 5.00 %Lamps 20.00 % X 30 % = 6.00 %Chairs 28.57 % X 50%= 14.28%·

25.28 % say 25 %

--

This 25 per cent is the total contribution per rupee of overall sales

given the present product sales mix. The calculations required in thequestion are as follows:

1. BEP: The BEP orthe firm is calculated as under:

BEP =Fixed costs

=20,000

Rs. 80,000Contribution marginper unit 25%

2. Profit: Calculation of profit or loss at various volumes can also

be made easily. If the firm produces at 80 per cent of capacity,the profit will be calculated as under:

Profit = Total revenue - Total costs

= 80% of (1,50,000) - Fixed costs - Variable costs= 1,20,000 - 20,000 - 75% of (1,20,000)

= 1,20,000 - 20,000 - 90,000= Rs. 10,000

Break-even Charts

Break-even analysis is very commonly presented by means of breakeven charts. Break-even charts are also known as profit-graphs. A



break-even chart prepared on the basis of example 1 above is given inFigure 5.2. In this figure, units of product are shown on the horizontalaxis OX while revenues and costs are shown on the vertical axis OY.

The fixed costs of Rs. 10,000 are shown by a straight line parallel tothe horizontal axis. Variable costs are then plotted over and above thefixed costs. The resultant line is the total cost line, combining both

variable and fixed costs. There is no variable cost line in the graph.The vertical distance between the fixed cost and th~ total cost lines

represents variable costs. The total cost at any point is the SU!TI of Rs.10,000 plus Rs. 2.00 per unit of variable cost multiplied by thenumber of units sold at that point. Total revenue at any point is the

unit price of Rs. 4.00 multiplied by the number of units sold. Thebreak-even point corresponds to the point of intersection of the totalrevenue and the total cost lines. A perpendicular from the BEP to the

horizontal axis shows the break-even point in units of the product.Dropping a perpendicular from BEP to the vertical axis shows the

break-even sales value in rupees. The firm would suffer a loss at anypoint below the BEP. Total costs are more than total revenue. Abovethe BEP, total revenue exceeds total costs and the firm makes profits.

Since profit or loss occurs between costs and revenue lines, the spacebetween them is known as the profit zone, which is to the right of theBEP, and the loss zone, which is to the len of the BEP. The following

Figure 5.2 shows Break-even Chart.



The break-even chart remains where the BEP is measured in

terms of sales value rather than in physical units. The only differenceis that the volume on the X-axis is measured in terms of sales value.

In that case, a perpendicular frqm the point BEP to either axis wouldshow the break-even rupee sales value. The same type of chart couldbe used to depict the BEP in relation to full capacity. In this case the

horizontal axis would represent the percentage of full capacity, insteadof physical units or the sale value.

Break-even Chart-A Variation

The break-even chart is a variation of the traditional break-even graph.This graph is prepared with the variable cost line instead of fixed costline, starting at the zero axis. On it is superimposed the total cost, the

line which includes the fixed cost and is, therefore, parallel to thevariable cost line. This graph is as much useful as the contribution to

fixed cost and profit. It is more deafly shown below in the Figure 5.3.



Profit-Volume Analysis

It is very similar to the break-even analysis and is based on therelationship of profits to sales volume. The profit-volume graph shows

the relationship ofa firm's profit to its volume. Total profit or loss ismeasured on the vertical axis above the X-axis and the loss below it.

The volume is measured on the X-axis, which is drawn at the point of'Zero-Profit'. Volume is usually expressed in tenns of percentage offull capacity. The maximum loss, which occurs at zero sales volume, is

equal to the fixed cost and is shown on the vertical axis below theX-axis. The maximum profit is earned when the firm works at fullcapacity. The point of maximum profit is shown on the vertical axis

above the X-axis. The two points of maximum loss and the maximumprofit are joined by a line, which is known as the profit line, also called

PN line. The profit line can also be established by detennining theprofit at any two points within the given range of volume and drawinga straight line through these points. The point, at which the profit line

intersects the X-axis, is the break-even point. The space between theX-axis and the profit line shows the profit zone, which is to the rightof BEP, and the loss zone, which is to the left of BEP. The usefulness of

the graph lise in the fact that it shows the profit or loss earned by thefirm by working at different levels of its full capacity. The following



Figure 5.4 shows the profit volume analysis.

Assumptions

1. All costs are either variable or fixed over the entire range of thevolume of production. But in practice, this assumption may not

hold well over the entire range of production.

2. All revenue is variable in nature. This assumption may Lot bevalid in all cases such as the case where lower prices are charged

to large customers.

3. The volume of sales and the volume of production are equal. Thetotal products, produced by the firm, are sold and here is no

change in the closing inventory. In practice, sales and productionvolumes may differ significantly. However, these assumptions

are not so unrealistic so as to weaken the validity of thebreak-even analysis.

4. In the case of multi-product firms, the product-mix shoulu be

stable. Fora multi-product firm, the BEP is determined bydividing total fixed costs by an average ratio of variable profit,also called contribution to'sales. If each product has the same

contribution ratio, the BEP is not affected by changes in theproduct-mix.

However, if different products have different contribution ratios,

shift in the product-mix may cause a shift in the break-even point. In



real life, the assumption of stable product-mix is somewhat unrealistic.

Managerial Uses of Break-even Analysis

To the management, the utility of break-even analysis lies in the fact

that it presents a picture of the profit struture of a business firm.Break-even analysis not only highlights the areas of economic strengthand weaknesses in the firm but also sharpens the focus on certaIn

leverages which cun be opernted upon to enhance its profitability.Through brenk-even analysis, it is possible for the management toexamine the profit structure of a business firm to the possible changes

in business conditions. For example, sales prospects, changes in Custstructure, etc. Through break-even analysis, it is possible to use

managerial actions to maintain and enhance profitability of the firm.The break-even analysis can be used for the following purposes:

Safety margin

Volume needed to attaintarget profit

Change in price Change in price

Expansion of capacity

Effect of alternative prices

Drop or add decision

Make or buy decision

Choosing promotion-mix

Equipment selection

Improving profit performance

Production planning

Safety Margin

The break-even chart helps the management to know the profitsgenerated at the various levels of sales. But while deciding the volume

at which the firm would operate, apart from the demand, themanagement should consider the safety margin associated with theproposed volume. The safety margin refers to the extent to which the

firm can afford a decline in sales before it starts occurring losses. The



formula to determine the safety margin is:

Safety Margin =(Sales – BEP) x 100

Sales

Example 5: Assume that our sales in Example 1 are 8,000 units.

Safety Margin =(8,000-5,000) x 100

= 37.5%8,000

Before incurring a loss, a business firm can afford to loose sales

up to 37.5 per cent of the present level. A decreasing safety marginindicates that the firm's resistance capacity to avoid losses hasbecome poorer. A margin of safety can also be negative. A negative

safety margin is the percentage increase in sales necessary to reachthe BEP in order to avoid losses. Thus, it reveals the minimum extent

of effort in terms of sales expected by the management. Suppose inthe same example sales are us low as 4,000 units. The safety marginwould be:

Safety Margin =(4,000-5,000) x 100

¬4,000

= 25%

In other words, the management must strive to increase sales atleast by 25 per cent to avoid losses.

Volume Needed to Attain Target Profit

Break-even analysis is also utilised for determining the volume ofsales, necessary to achieve a target profit. The formula for target sales

volume is:

Target Sales Volume =Fixed costs + Target profit

¬Contribution margin per unit

.

Example 6: Continuing with the same example, if the desired profit

is Rs. 6,000, the target sales volume would be calculated as follows:



10,000 + 6,000= 8000 units2

Change in Price

The management is also faced with a problem whether to reduce theprices or not. The management will have to consider a number of

points before taking a decision related to the change in the prices. Areduction in price results in a reduction in the contribution margin aswell. This means that the volume of sales will have to be increased to

maintain the previous level of profit. The higher the reduction in thecontribution margin, the higher will be the increase in sales needed tomaintain the previous level of profit. However, reduction in prices may

not always lead to an equal increase in the sales volume, which isaffected by the elasticity of demand. But the information about

elasticity of demand may not be easily available. Break¬even analysishelps the management to know the required sales volume to maintainthe previous level of profit. On the basis of this knowledge and

experience, it becomes much easier for -the management to judgewhether the required increase it sales will be feasible or not. Theformula to determine the new sales volume to maintain the same level

of profit, given a reduction in price, would be as under:

Qn =FC + P

¬SPn - VC

where Qn = New volume of salesFC = Fixed costP = Profit

SPn = New selling priceVC = Variable cost per unit (n denotes new)

Example 6(a): Continuing with the same example 6, if we proposea reduction of 10 per cent in price from Rs. 4.00 to Rs. 3.60, the newsales volume needed to maintain the previous profit ofRs. 6,000 will

be:10, 000 + 6,000 16, 000



3.60 – 2.00 = 1.60 = 10,000 units

This shows that there is an increase of 2,000 units or 25 per cent

in sales. The management can also easily decide whether this increasein sales volume is profitable for t~e business firm or not.

If a firm proposes the price increase, the question to be considered

is by how much the sales volume should decline before profitableeffect of the price increase gets eliminated.

Example 6(b): If the firm in example 6 considers an increase in

price by 12Y2per cent to Rs. 4.50, the new volume to maintain the oldprofit would be:

Q 2 =10, 000 + 6,000

=16, 000

= 6,400 units4.50 – 2.00 2.50

In other words, if the fall in sales, due to an increase in price, wereless than 1,600 units or 20 per cent, it would be profitable for the firmto increase the price. But if the decline were more than 1,600 units,

the proposed price increase would reduce the profit.

Change in CostsBreak-even analysis' helps to analyse the changes in variable

cost and fixed cost, which are explained as follows.Change in variable cost: An increase in variable costs leads to a

reduction in the contribution margin. In such a situation, a firmdetermines the total sales volume needed to maintain the prescntprofits withcut any increase in price. A firm also determines the price

lhut should be set to maintain the present level of profit without anychange in sales volume. The formulae to determine the new quantityor the new selling price, given a change in variable costs, are:

1. The new quantity will be:

Qn =FC +P

SP - VC n



2. The new selling price will be:SPn = SP + (VCn- VC)

Example 6(c): Continuing with the example 6, if variable cost

increases from Rs. 2 to Rs. 2.50 per unit.

Q 2 =10, 000 + 6,000

=15, 000

= 10,667 units4 – 2.50 1.50

SPn = 4 + (2.50 - 2) = Rs. 4.50

Change in fixed cost: An increase in fixed costs of a firm iscaused either by external circumstances such as an increase inproperty taxes or by a managerial decision such as an increase in

executive salaries. In both the cases, the affect is to raise thebreak-even point of the firm, while keeping the prices unchanged. The

same determination is undertaken by the firm regarding the salesvolume while keeping the profit level same as before. The formulae todetermine the new quantity or the new price, given a change in fixed

costs, would be:1.

Qn= Q +FCn – FC

SP - VC

2.

SPn = SP +FCn – FC

Q

Example 6 (d): Continuing with the same example 6, if fixedcost increases from Rs. 10,000 to Rs. 15,000.

Expansion of Capacity

The management may also be interested in knowing whether to

expand production capacity or not, through the installation equipment.Though even analysis, it wuuld be possible to examine the various



applkutions of this proposal or installation of the additionalequipment. The following example illustrates the points involved.

Example 7: A textile mill is considering a proposal to increase

its investment in fixed assets. If it decides to do so, fixed expenseswill go up by Rs. 5,00,000 per year without affecting the percentage ofvariable expenses. With the present plant, the maximum production is

estimated at an amount, which would enable the company to makeannual sales of Rs. 60,00,000. The increased production with the

additional plant would permit the company to make annual sales of Rs.80,00,000. The relevant cost, sales and profit data for 1997 are:

Sales Rs. 50,00,000Costs and expenses:Fixed Rs. 15,00,000Variable Rs. 32,00,000 Rs. 47,00,000Net profit Rs. 3,00,000

There are a number of points involved in the decision on

expansion of capacity. The information regarding the expansion ofcapacity is as follows:

Existing Plant Expanded PlantCapacity 0% 100 % 0% 100 %

Rs. (in Lakhs) Rs. (in Lakhs)Sales - 60 - 80Fixed costs 15 15 20 20Variable costs - 38.4 - 51.2Profit (Loss) (15) 6.6 (20) 8.8The expansion of capacity, to enable the firm so as to expand its

sales potential from Rs. 60,00,000 to Rs. 80,00,000, will increasethe maximum profit potential of the firm from Rs. 6,60,000 to Rs.

8,80,000. But there are certain risks involved. Answer the followingon the basis of above information:

1. How will the expansion of the firm's capacity will affect the

break-even point?

2. What would be the sales volume required to maintain the



present profit with the increased fixed costs?

Solution. It is evident that the break-even point of the firm wouldbe pushed up from Rs. 41, 66,667 to Rs. 55, 55,556. This means that

if the sales remain at the present level, the firm would operate at aloss.

The minimum sales volume needed to maintain the present profit

would be Rs. 63,88,889, i.e., an increase of about 28 per cent there isanother aspect. To earn the maximum profit possible at the present

sales capacity, i.e., Rs. 6,60,000 with the increase in fixed costs, theminimum sales volume needed would be Rs. 73,88,889, i.e., anincrease of 48 per cent. So the decision on the question of expanding

capacity hinges on the possibilities of expanding sales by the variouspercentages indicated above. The fact that the present sales volume is20 per cent less than the maximum possible sales volume of the

existing plant may be an indication that if may be difficult to expandsales. Another way of presenting the same infonnation is the

profit-volume chart. On the assumption that production efficiency andprices will remain unchanged, the profit-volume chart can help inpresenting the following:

The break-even points before and after expansion, and

At what capacity utilisation, the profit will be the same as at 100

percent capacity utilisation before expansion. The followingFigure 5.5. shows the profit volume chart.



In order to arrive at the data to plot on the figure, the sales, cost

and profit at either 100 per cent or nil capacity for both existing andexpanded plants should be calculated:

As can be seen from Figure 5.4, the break-even point for both the

plants lies above 70 per cent capacity utilisation. The capacityutilisation of the expanded plant, which gives the same profit as 100

per cent capacity utilisation of the existing plant, can be easily found.At 92 per cent of capacity utilisation, the expanded plant will give aprofit of Rs. 6,60,000.

Effect of Alternative PricesThe break-even chart can be modified to show the profit position atdifTerent price levels under assumed conditions of demand and costs.

Figure 5.5 shows the pr,ofit position at alternative prices for the firmin example 1. As can be seen from the figure, the break-even pointbecomes lower as the price increases. But it is not necessary that the

profit potential at higher prices may actually be achieved by the firm.A price of Rs. 4 per unit with a demand at 7,000 units will give a

higher profit than a price of Rs. 5 with a demand at 4,000 units. It isnot desirable for a firm to take every price into consideration. Theanalyst, while choosing a trial price, relies largely upon their

experience and judgement. Customary price is one such price. Thefollowing Figure 5.6 shows the effect of BEP in alternative prices.



Drop or Add DecisionAn economist takes the decisions regarding the following:

Addition of a new product keeping in consideration, its cslimated

revenue and cost.

Deletion of a product from the product-line keeping in

consideration, its consequent effects on revenue and cost.

Break-even analysis is also useful in taking decisions related toproduct planning. It can be understood with the help of following

example:

Example 8: The following are the present cost and output data of amanufacturer:

Product PrLe Variable costs % of(Rs.) Per unit sales

(Rs.)Book-cases 60 40 30Tables 100 60 20Beds 200 120 50

Total fixed costs per year: Rs. 75,000Sales last year: Rs. 2,50,000.

The manufacturer is considering whether to drop the line of taoles

and replace it with cabinets. If this drop-and-add decision is taken,



the cost and output data would be as follows:

Product Price Variable costs % of sales(Rs.) Per unit

(Rs.)Book-cases 60 40 50Tables 160 60 10Beds 200 120 40

Total fixed cost per year: Rs. 75,000Sales this year: Rs. 2,60,000.

On the basis of ubove informntion delermine if the change worthundertaking by the business firm?

Solution. On the basis of the information given in the question, the

profit on the present product line is computed as follows:

Rs. 60 - 40x 30% = 0.1060

Rs. 100 - 60x 20% = 0.08100

Rs. 200 - 120x 50% = 0.20/0.38200

Thus, the contribution ratio is 0.38, by adding 0.10, 0.08 and 0.20.

Total contribution = Rs. 2,50,000 x 0.38 = Rs. 95,000.

Profit = Rs. 95,000 - Rs. 75,000 = Rs. 20,000.Profit on the proposed product line would be as under:

Rs. 60 - 40x 50% = 0.1760

Rs. 160 - 60



160 x 10% = 0.06

Rs. 200 - 120x 40% = 0.16200

Thus, the contribution ratio is 0.39.

Total contribution = Rs. 2,60,000 x 0.39 = Rs. 1,01,400.Profit = Rs. 1, 01,400 - 75,000 - Rs. 26,400.

Hence the proposed change is worth undertaking.

Make or Buy Decision

Many business firms may opt to produce certain components or

ingredients, which are part of there finished products, or purchasingthem from outside suppliers. For instance, an automobilemanufacturer can make spark plugs or buy them. Break¬even analysis

can enable the manufacturer to decide whether to make or buy. Withthe help of following example, this can be easily understood:

Example 9: A manufacturer of sc.ooters buys certain

components at Rs. 8 each. In case he makes it himself, his fixed andvariable costs would be Rs. 10,000 and Rs. 3 per component

respectively. Should the manufacturer make or buy the component?

If the manufacturer needs more than 2,000 components per year,to make or produce the components is more profitable than to buy.

There are some special considerations, which helps in choosing thebest option, are as follows:

Solution. This can be detennined after calculating break-even

point of the manufacturer's firm, The break-even point is as follows:

BEP =Fixed costs

Purchse price – Variable Cost

=10,000

8 - 3



=10,000

= 2,0005

Quality: By manufacturing a certain part of the product itself,the firm is able to exercise control over quality. This may also

lead to reduction in assembly costs and increase in consumergoodwill. This helps in enhancing the future sales. The outside

suppliers may also possess a highly specialised knowledge,which may outshine the know-how of the firm. In this situationa firm, a firm may feel that it cannot match with the quality

assured by outsiders. Here, a firm is advisable to buy the highquality products from other firms so as to avoid the loss due topoor quality. This could also result in fewer sales.

Assurance of supply: By producing a product itself, a firm may

secure the advantage of co-ordinating the flow of parts more

effectively. Sometimes, the suppliers are unable to meet thedemand or make deliveries within the required time period. So,this is also an advantage for the firm to produce high quality

products and to give its best for the betterment of society.

Defence against monopoly: A firm can also manufacture partsto protect itself against a monopoly in supply. If a firm produces

some of it products itself, the other firms are less likely toovercharge or dictate thelT: in any respect. So producing a part

of the product is also beneficial for a firm.

Choosing Promotion-mixSellers often use several methods of sales promotion, such as

personal selling, advertising, etc. But the proportion of all thesemethods in the promotion mix varies from seller to seller. A retailshop may have to consider whether or not to employ a certain number,

say, five additional salesmen. Similarly, a manufacturer may have todecide if he should spend an additional sum of Rs. 20,000 on



advertising his product or not. Break-even analysis enables him totake appropriate decisions by showing how the additional fixed costsinfluence the break-even points. This can be explained with the help

of the following illustration:Example 10: A manufacturer sells his product at Rs. 5 each.

Variable costs are Rs. 2 per unit and the fixed costs amount to Rs.

60,000. Find the following:1. The break-even point.

2. The profit if the firm sells 30,000 units.3. The BEP if the firm spends Rs. 3,000 on advertising.

4. The sale of manufacturer to make a profit of Rs. 30,000 after

spending Rs. 3,000 for advertisement.

Solution: Tle calculations are as follows:

BEP =FC

SP - VC

=60,000

= 20,000 units5 - 2

Profit = Total revenue - Fixed cost - Variable cost= (5 x 30,000) - 60,000 - (2 x 30,000)

= 1,50,000 - 60,000 - 60,000= Rs.30,000

If the firm spends Rs. 3,000 on advertising, fixed costs would

rIse by Rs. 3,000, i.e., Rs. 63,000. Hence, BEP would be:

BEP =FC

SP - VC

=63,000

= 21,000 units5 - 2

The formula for finding out the volume of sales· necessary toachieve the age! Profit is:



Target sales volume =Fixed cost + Target profit

Contribution margin

=63,000 + 30,000

3

=93,000

= 31,000 units3

Equipment Selection

Break-even analysis can also be used to compare different wayso(doing jobs. For instance, use of simple machines, is usually best forsmall quantities. But when bigger quantities are to be produced, faster

but usually costlier machines are to be employed. Sometimes, a choiceis to be made in between three or more methods, depending upon the

most economical one. The following example explains how todetermine these ranges.

Example 11: A manufacturer has to choose from amongst three

machines for his factory. The conditions, which he wants to be fulfilledregarding the three machines, are as follows:

1. An automatic machine which will add Rs. 20,000 a year to his

fixed costs but the variable costs per unit will be only 40 p.

2. A semi-automatic machine which will add Rs. 8,000 a year to hisfixed costs but variable cost$ per unit will be Rs. 2 and

3. A hand-operated machine which will add only Rs. 2,000 a yearto his fixed costs but will cause variable costs per unit of Rs. 4.

Calculate the range of output over which automatic,

semi-automatic and hand-operated machines would be mosteconomical. How would you choose between hand-operated and

automatic machines, supposing the semi automatic machine does notexist?Solution. The cost formulae for the three machines would be,



Machine Cost formulaAutomatic Rs. 20,000 + 0.40 SSemi-automatic Rs. 8,000 + 2.00 SHand-operated Rs. 2,000 + 4.00 S

Now setting pairs of equations to each other, and solving them

to final the Value of S:1. Automatic vs. Semi- Nutomatie

Rs. 20,000 + 0. 40S = Rs. 8,000 + 2S

or, 1.60S = 12,000

or, S =12000 = 7,500 units1.60

2. Semi-automatic vs. Hand-operated:

Rs. 8,000 + 2.00S = Rs. 2,000 + 4S

or, 2S = 6,000

or, 8 = 3,000 units

Thus, up to 3,000 units, hand-operated machine is to be used.The semi¬automatic machine is to be used over the range of 3,000 -

7,500 units.

Beyond 7,500 units, automatic machine should be used. If, however,

the choice is to be made between hand-operated and automaticmachines, the former; is to be used up to 5,000 units and, thereafter,the latter would be more economical. This is calculated as under:

2,000 + 48 = Rs. 20,000 + 0.40or, 3.60S = 18,000or, 8 = 5,000 units.

IMPROVING PROFIT PERFORMANCE

There are four specific ways in which profit performance of a businesscan be improved, which are as follows:

Increasing the volume of sales: Considering the example I, the

present volume of sales is 8,000 units and the maximumproduction capacity 10,000 units. If the sales are increased to



the maximum production capacity, there will be an increase invariable expenses only. The profit will increase from, Rs.6,000to Rs. 10,000. It will be seen that though the increase in sales

volume has been only to the extent of 25 per cent, profit hasincreased by 67 per cent.

Increasing the seIling price: An increase in the price increases

the contribution margin and reduces the break-even point.Continuing with Example I, if the selling price is increased by

10 per cent, the profit will increase from Rs. 6,000 to Rs. 9,200showing an increase of more than ¬50 per cent.

Reducing the variable expenses per unit: If the variable

expenses are reduced by 10 per cent to Rs. 1.80, the profit willincrease from Rs. 6,000 to Rs. 7,600 at the present volume ofsales. This increase is more than 25 per cent, which is more

than the percentage reduction in variable expenses. Incost-volume-profit relationship, the higher proportionate

increase in profit than the change in selling price or the volumeof sales or the variable expenses is called the leverage effect. Attimes, it is not possible to increase the prices, but to increase

the volume of sales and to reduce the variable expenses ispossible.

Reducing the fixed cost: A reduction in fixed costs, without achange in variable expenses and the selling price, would lead to

an equal change in the profits. For example, if the fixedexpenses are reduced from Rs. 10,000 to Rs. 9,000 in theabove illustration, profit will increase from Rs. 6,000 to Rs.

7,000. As a change in the fixed costs does not change thecontribution margin per unit, there is no leverage effect.

Production planning

Break-even analysis can also help in production is planning so as to



give maximum contribution towards profit and fixed costs. This willbe clearly understood from-the following illustration:

Example 12: The management of Swadeshi Cotton Mills, Kanpur,

is interested in finding out the quantities of cloth X and Y forproduction in a week in order to maximiese profits. The total hoursrequired to produce 100 metres of each cloth are 20 and 25

respectively. The total hours available per week are 9,600. Themaximum possible sales of cloth X and Y for one week as estimated

are: X = 30,000 metres, Y for 40,000 metres.The following table shows, the variable costs and selling price permetre:

-Particulars Pcr mctrc

Cloth X Cloth YVariable cost Rs.2.00 RS.3.00

Selling price RS.2.60 RS.3.80

The total expenses for one week are estimatcd at Rs. 21,400. Findout the production plan, which the, company should follow. How

much profit shall be earned by following this production plan?

Solution. The contributions of Cloth X and Yare Re. 0.60 and Re. 0.80per metre respectively, which are calculated by subtracting variable

cost of each from selling price. Hence, priority should be gi~en to theproduction of cloth Y as it contributes more towards meeting the fixed

cost. The maximum of cloth Y that can be sold is 40,000 metres,which would require 10,000 hours. However, the total hours availableare 9,600. Hence, the maximum of cloth Y that can be produced is

38,400 metres (9,600 x 4). The production plan to be followed isgiven below:

_._--Cloth X NilCloth Y 38,400 metres

This plan shall provide profits as shown below:Total Revenue = Rs. 38,400 x 3.80 = Rs. 1,45,920



Total cost:

Variable cost = Rs. 38,400 x 3 = Rs. 1,15,200

Fixed cost 21,400 1,36,600

Net porfit Rs. 9,320

Policy Guidelines Originating from Break-even AnalysisThere are certain useful conclusions in terms of policy guidelines,

which may be drawn from break-even analysis as a result of the effectof changing conditions on a firm's operations, policies and actions. Ahigh BEP indicates the weakness regarding the profit position of the

firm. To reduce the BEI therefore, the selling price should be increased,variable and fixed costs should be reduced. If the variable costs per

unit asre large (Business 8 in Example 13), an increase in selling priceor a reduction in variable costs would be morc eLective. Whether it ismore desirable to raise prices or practicable to cut down variable costs,

depends upon competitive market conditions, the elasticity of demandfor firm's product and the efficiency of its operations. When thecOi.lribution margin rer unit is comparatively large (Business A in

Example 13), the firm is advised to lower the BEP by reducing the levelof fixed costs.

The higher the contribution margin, the higher is the survival ofbusiness or vice-versa. Business A with a higher contribution margin

can survive even if the prices drop to 50 paise per unit. Business Bwith a lower contribution margin will have to close down itsoperations if prices drop to 50 paise. In a period of boom, whcn both

the prices as well as sales rise, a firm with a higher percentage offixed costs to sales earns higher profits as compared to a business

with a higher percentage of variable expenses to sales. On the otherhand, in a period of depression, when both the prices as well as salesdecrease, the business with a higher percentage of fixed costs to

sales suffers greater losses than the business with a higher



percentage of variable expenses.

Example 13: The following example of two businesses, A and B,illustrates some of the points contained in the text above.

Business A Business BSelling price per unit Re. 1.00 Re.I.OO

Variable cost per unit Re.0.20 Re.0.60Fixed costs per year RS.5,000 Rs.2,500

With the help of above infonnation, find which of the businesses

among A and B is profitable for the business firm to suspendoperations? Give explanations to support your answer.

Solution. The break-even point of both the businesses is 6,250units or Rs. 6,250. If the sales are 10 pefcent above the BEP, businessA gains Rs. 500 while business B gains only Rs. 250. If the sales are

below the BEP, say 5,000 units, business A loses Rs. 1,000 andbusiness B loses only.

Rs. 500. If the market collapses and the prices also go down to

50 paise per unit and sales drop to, say, 3,000, business A suffers aloss of Rs. 4, 100 while business B suffers a loss of only Rs. 2.500

(the amount of fixed expenses only ns it would find it unprofitable tocontinue operntions). But one signifiennt point is that whilc businessA can continue to operate and contribute 30 paise per unit, sold

towards fixed expenses. Business B will find it profitable to suspendoperations.

Limitation of Break-even Analysis

There arc some important limitations of break-even analysis, whicharc to be kept in mind while using break-even analysis. Theselimitations are as follows:

When break-even analysis is based on accounting data, it maysuffer from various limitations of such data, such as

negligence towards imputed costs, arbitrary depreciationestimates and inappropriate allocation of overhead costs.



Break-even analysis, therefore, can be sound and useful onlyif the firm in question maintains a good accounting systemand uses proper managerial accounting techniques and

procedures. The figures must also be adequate and sound. Ifbreak-even analysis is based on past data, the same should beadjusted for changes in wages and price of raw materials.

Break-even analysis is static in character. It is based on theassumption of given relationship between costs and revenues.

On the one hand and input, on the other. Costs and revenuesmay change over time making the projection, based on pastdata wrong. Therefore, break-even analysis is more useful

only in situations relatively stable while it does not workeffectively in volatile, erratic and widely changing ones.

Costs in a particular period may not be caused entirely by the

output in that period. For example, maintenance expensesmay be the result of past output or a preparation for future

output. It may therefore, be difficult to relate them to aparticular period.

Selling costs are especially difficult to handle in break-even

analysis. This is because changes in selling costs are a causeand not a result of changes in output and sales.

A straight-line total revenue curve prcsumcs that any quantity

should be sold at onc price only. This implies a horizonwldemand curve and is true only under conditions of perfect

competition. The situation of perfect ~ competition is rare inreal world, which restricts the application of many total revenuecurves.

A basic assumption in break-even analysis is that the

cost-revenue-volume relationship is linear. This is realistic onlyover narrow ranges of output. For example, this type of analysis

is worthwhile in deciding if the selling price should be 50 or 60paise, volume should be attempted at 80 per cent of capacity



rather than 85 per cent, advertising expenditure should total Rs.1,00,000 or Rs. 1,15,000 or the product should be put in apackage costing 70 paise rather than 90 paise.

Break-even analysis is not an effective tool for long-range use

and its use should be restricted to the short run only. Thebreak-even analysis should better be limited to the budget

period of the firm, which is usually the· calendar year.

The area included in the break-even analysis should be limited iftoo many products, departments and plants are taken together

and graphed on a single break-even chart: it will be difficult forthe fim1 to distinguish between the good and bad performancesof the business firm.

Break-even analysis assumes that profits arc a function of

output ignoring the fact that they arc also caused by otherfactors such as technological change, improved management,

changes in the scale of the fixed factors of production and so on.

To conclude, it can be said that break-even analysis is a device,

simple, easy to understand and inexpensive and is there fore, usefulto management. Its usefulness varies from a firm to another firm andalso among industries. Industries suffering from frequent and

unpredictable changes in input prices, rapid technological changesand constant shifts in product mix will not benefit much frombreak-even analysis. Finally, break-even analysis should be viewed as

a guide to decision-making and not as a substitute for judgement,logical thinking.

PROFIT FORECASTING

Profit planning cannot be done without proper profit forecasting.Profit forecasting means projection of future earnings after

considering all the factors affecting the siz.e of business profits, suchas firm's pricing policies, costing policies, depreciation policy, and soon. A thorough study including a proper estimation of both economic

as well as non-economic variables may be necessary for a firm to



project its sales volume, costs and subsequently the profits in future.

According to joel Dean, a famous cconomist, there are threeapproaches to profit forecasting, which are as follows:

Spot Projection: Spot projection includes projecting the profit

and loss statement of a business firm for a specified futureperiod. Projecting of profit land loss statement means

forecasting each important element separately. Forecasts aremade about sales volume, prices and costs of producing the

expected sales. The prediction of profits of a firm is subject towide margins of error, from forecasting revenues to theinter-relation of the various components of the income

statement.

Brcak-even analysis: It helps in identifying functional relationsof both revenues and costs to output rate, kecping in

consideration the way in which output is related to the prolits. Italso helps in doing so by relating profits fo output directly by

th.e usual data used in break-even analysis.

Environmcntal analysis: It helps in relating the company'sprofits to key variabk, in the economic environment such as the

general business activity and the general price level. Thesevariables are not considered by a business firm.

All those factors that control profits move in regular and relatedpatterns such as the rate of output, prices, wages, material costs and

efficiency, which are all inter-related by their connections with thenational markets and also by their interactions in business activity.Theories of business cycles are based on the hypothesis, which is

shown by the national values of production, employment, wages andprices during any fluctuation in business activities. There is no clear

pattern in detailed analysis. These patterns helps in increasing thepossibility that the profits of a business firm, can be forecast directly



by finding a relation to key variables. The need is to find a directfunctional relation between profits of a business firm and activities atnational level that shows statistical signi ticance.

In practice, these three approaches need not be mutually exclusive.Theses approaches can also be used jointly for maximum information.In projecting the profit and lo.ss statement, the functional relations

can be used, arising out of the ratio of cost to output and to its otherdeterminants. In the same way, by measuring the impact of outsideeconomic forces upon the firms' profit helps in facilitating good spot

guesses. It can also enhance the accuracy of break-even analysis.

REVIEW QUESTIONS1. Distinguish between the following concepts or profit:

A. Accounting profit and economic profit.B. Normal profit and monopoly profit.C. Pure profit and opportunity cost.

2. Examine critically profit maximisation as the objective ofbusiness firms. What are the alternative objectives of businessfirms?

3. Explain the first and second order conditions of profitmaximisation.

4. Profit maximisation is theoretically the most sound but

practically unattainable objective of business firms. Do youragree with this statement? Give reasons for your answer.

5. Explain how profit is used as a control measure. 'What problemsare associated with the use of profit figures as a controlmeasure?



LESSON NO-6

NATIONAL INCOME

National income is the final outcome of total economic activities of a

nation. Economic activities generate two kinds of flow in a moderneconomy namely, product-flow and money-flow. Product-flow refers

to flow of goods and services from producers to final consumers.Money flow refers to flow of money in exchange of goods and services.In this exchange of goods and services, money income is generated in

the form of wages, rent, interest and profits, which is known as factorearning. Based on these two kinds of flows, national income is definedin terms of:

Product flow

Money flow

DEFINITION OF NATIONAL INCOME

National Income in Terms of Product FlowNational income is the sum of money value of goods and services

generated from total economic activities of a nation. Economicactivities result into production of goods and services and make netaddition to the national stock of capital. These together constitute the

national income of closed economy'. Closed economy refers to aneconomy, which has no economic transactions with the rest of theworld. I lowcvcr, in an opcn ecollomy, natiollul incomc ulso includes

the net results of its transactions with the rest of the world, i.e.,exports less imports.

Economic activities should be distinguished from thenon-economic activities from national income point of view. Broadlyspeaking, economic activities include all human activities, which

create goods and services that can be valued at market price.Economic activities include production by farmers (whether forhousehold consumption or for market), production by firms in



industrial sector, production of goods and scrvices by thc govcfl1mentcntcrpriscs, and services produced by business intermediaries(wholesaler and retailcr), banks and other financial organisations,

universities, colleges and hospitals. On the other hand, non¬economicactivities arc those activities, which produce goods and serviccs thatdo 110t have economic value. The non-economic activities include

spiritual, psychological, social and political services, hobbies, serviceto selr serviccs of housewives services of members of family to other

mcmbers and cxchangc of mutual services between neighbours.

National Income in Terms of Money FlowWhile economic activities generate flow of goods and services, on the

other hand, they also generate money-flow in the form of f~lctorpayments such as, wages, interest, rent, prolits and earnings ofself-employed. Thus, national insome can also be obtained by adding

the factor earnings after adjusting the sum for indirect taxes, andsubsidies. The national income thus obtained is known as nationalincome at factor cost.

The concept of national income is linked to the society as a whole.However, it differs fundamentally from the concept of private income.Conceptually, national income refers to the money value of the final

goods and services resulting from all economic activities of a country.However, this is 110t true for the private income in addition, there are

certain receipts of money or of goods and services that are notordinarily included in private incomes but are included in the nationalincomes and vice versa. National income includes items such as

employer's contribution to the social security and welfare funds for thebenefit of employees, profits of public enterprises and servIces ofowner occupied houses. However, it excludes the interest on

war-loans, social security benefits and pensions. Instead, these itemsare included in the private incomes. The national income is therefore,

not merely an aggregation of the private incomes. However, anestimate of national income can be obtain by summing up the privateincomes after making necessary adjustment for the items excluded



from the national income.

MEASURES OF NATIONAL INCOMEThe various measures of national income are as follows:

Gross National Product (GNP)

There are several measures of national income used in the analysis ofnational income. GNP is the most important and widely used measure

of national income. GNP is defined as the value of final goods andservices produced during a specific period, usually one ycar, plus thediflcrence between foreign receipts and" pnyment. The GNP so defined

is identical to the concept of 'Gross National Income (GNl)', Thus, GNP= GNI. The difference between the two is that while GNP is estimatedon the basis of product-flows, the GNI is estimated on the basis of

money flows.

Net National Product (NNP)

Net National Product (NNP) is the total market value of all final goods

and services produced by citizens of an economy during a givenperiod of time minus depreciation, i.e., Gross Nationnl Product lessdepreciation.

NNP = GNP - Depreciation

Depreciation is that part of total productive assets, which is usedto replace the capital worn out in the process of creating GNP. In

other words, while producing goods and services including capitalgoods, a part of total stock of capital is used up. This part of capital

that is used up is termed as depreciation. An estimated value ofdepreciation is deducted from the GNP to arrive at NNP.

The NNP, as defined above, gives the measure of net output

available for consumptionhy the society (including consumers,producers and the government), NNP is the real measure of thenational income. In other words, NNP is same as the national income

at factor cost. It should be noted that NNP is measured at marketprices including direct taxes. However, indirect taxes are not included



in the actual cost of production. Therefore, to obtain real nationalincome, indirect taxes are deducted from the NNP. Thus,National income = NNP - Indirect taxes

National income: Some accounting relationships

Relations at market price GNP = GNIo Gross Domestic Product (GDP) = GNP less net income

from abroado NNP = GNP less depreciation

o NDP (Net Domestic Product) == NNP less net income fromabroad

Relations at factor cost

o GNP at factor cost = GNP at market price less net indirecttaxes.

o NNP at factor cost = NNP at market price less net indirecttaxes

o NDP at factor cost = NNP at market price less net income

from ahroado NOP at factor cost = NDP at market price less net indirecttaxes

o NOP at factor cost = GOP at market price less depreciation

Methods of Measuring National IncomeFor mcasuring the national income, the national economy is viewed as

follows:

The national economy is considered as an aggregate of

producing units combining different sectors such as agriculture,mining, manufacturing and trade and commerce.

The whole national economy is viewed as a combination of

individuals and household owning different kinds of factors ofproduction, which they use themselves or sell-their factor

services to make their livelihood.

National economy is also viewed as a collection of consuming,saving and investing units (individuals, households and

government).



The above notions of a national economy helps to measurenational Income by following three different methods:

Net output method

Factor-income method

Expenditure method

These methods are followed in measuring national income in a

‘closed economy',

Net Output Method

This is also called as net product method or value-added method. This

method is used when whole national economy is considered as anaggregate of producing units. In its standard form, this method

consists of three stages:

1. Measurement of gross value of domestic output in the

various branches of production: For measuring the gross

value of domestic product, output is classified undervarious categories on the basis of the nature of activitiesfrom which they originate. The output classification varics

from country to country dey'ending on (i) the nature ofdomestic activities, (ii) their significance in aggregate

economic activities and (iii) availability ofrecjuisite data.For example, in USA, about seventy-one divisions andsub-divisions are used to classify the national output, in

Canada and Netherlands, classification ranges from adozen to a score and in Russia, only half-a-dozendivisions are used. According to the CSO publication, If

fleen sub-categories are currently used in India. After theoutput is classified under the various categories the value

of gross output is is computed in two alternative ways by:

A. Multiplying the output of each earegory of acctorby their respective market price and adding them

together.

B. Collecting data regarding the gross sales and



changes in inventories from the account of themanufacturing firms to compute the value of GDP.If there arc gaps in data then some estimates are

made to fill the gaps.

2. Estimation of cost of materials and services used

arid depreciation of physical assets: The next step in

estimating the net national income is to estimate (he costof production including depreciation. Estimating cost of

production is, however, a relatively more complicatedand difficult task because of non-availability of adequateand requisite data. Much morc difficult task is to

estimate depreciation since it involves both conceptualand statistical problems. For this reason, many countriesadopt faclor¬income method for estimating their

national income. However, countries adoptingnet-product method find some means to calculate the

deductible cost. The costs are estimated either inabsolute terms (where input data are adequatelyavailable) or as an overall ratio of input to the total

output. The general practice in estimatmg depreciation isto follow the usual business practice of depreciationaccounting. Traditionally, depreciation is calcul¬ated at

some percentage of capital, permissible under thetax-laws. In some estimates of national income, the

estimators have deviated from the traditional practiceand have instead estimated depreciation as some ratio ofthe currenL output of final goods. FoI1owing a suitable

method, deductible costs including depreciation areestimated for each sector. The cost estimates are thendeducted from the sectoral gross output to ohtain the

net sectoral products. The net sectoral products are thenadded together. The total thus obtained is taken to be·

the measure of net nationa I products or national income



by product method.

3. Deduction of these costs and depreciation from gross value toobtain the net value of domestic product: Net value of domestic

product is often called the value added or income product. Incomeproduct is equal to the sum of wages, salaries, supplementarylabour incomes, interest, profits, and net rent paid or accrued.

Factor-Income Method

This method is also known as income method and factor-share

method. factor¬income method is used when national economy isconsiderl:d as a combination of factor-owners and users. Under thismethod, the national income is calculated by adding up all the inconlcs

accruing to the basic factors of production used in producing thenational product. Factors of production are c1assi ficd as land, labour,capital and organisation. Accordingly,

National income = Rent + Wages + Interest + Profits

However, it is conceptually very difficult in a modern economy tomake a distinction between earnings from land and capital and

between the (;arnings from ordinary labour and organisational effortsincluding entrepreneurship. Therefore, for estimating national income

factors of production arc broadly grouped as labour lInd capital.Accordingly, national income is supposed to originate from twoprimary factors, viz., labour and capital. However, in some activities,

labour and capital are jointly supplied and it is difficult to separatelabour and capital from the total earnings of the supplier. Such

incomes are termed as mixed incomes. Thus, the total factor-incomesare grouped under three categories:

Labour incomes

Capital income

Mixed incomes.

Labour Income: Labour incomes included in the national incomehave five components:



Wages and salaries paid to the residents of the country including

bonus, commission and social security payments.

Supplementary labour incomes including employer's contribution

to social security and employee's welfare funds and directpension payments to retired employees.

Supplementary labour incomes in kind such as free health,

education, food, clothing and accommodation.

Compensations in kind in the form of domestic sr-rvants and

other free of¬cost services provided to the employees arcincluded in labour income.

Bonuses, pensions, service grants are not included in labour

income as they are regarded as 'transfer payments'. Certain othercategories of income such as incomes from incidental jobs,gratuities and tips are ignored because of non-availability of data.

Capital Incomes: According to Studenski, capital incomes includefollowing Incomes:

Dividends excluding inter-corporate dividends

Undistributed profits of corporation before-tax

Interests on bonds, mortgages and savings deposits (excluding

interests on bonds and on consumer credit)

Interest. earned by insurance companies and credited to the

insurance policy reserves

Net interest paid by commercial banks

Net rents from land and buildings including imputed net rents

on owner¬occupied dwellings

Royalties

Profits of government enterprises.

The data for the first two incomes is obtained from the firms'

accounts submitted for taxation purposes. There exist difference in



definition of profit for national accounting purposes and taxationpurposes. Therefore, it is necessary to make some adjm.ments in theincome-tax data for obtaining these incomes. The income-tax data

adjustments generally pertain to (i) Excessive allowance ofdepreciation made by tax authorities, (ii) Elimination of capital gainsand losses since these do not reflect the changes in current income,

and (iii) Elimination of under 0,' overvaluation of ir:ventories onbook-value,

Mixed Income: Mixed incomes include income from (a) fanning (b)sole proprietorship (not included ,Ilnder profit or capital income) (c)other professions such as legal and l.ledical practices, consultancy

services, trading and transporting. Mixed income also includesincomes of those who earn their living through various sources suchas wages, rent on own property and interest on own capital.

All the three kinds of incomes, viz., labour incomes, capitalincomes and Inixed incomes added together give the measure ofnational income by factor¬income method.

Expendit4re Method

The expenditure method, is also known as final product method. Thismethod is used when national economy is viewed as a collection of

spending units. It measures national income at the final expenditurestages. In other words, this method measures final expenditure on

'GDP at market prices' at the stage of disposal of GDP during anaccounting year. In estimating the total national expenditure, any ofthe following two methods are followed:

First method: Undcr this mcthod all the 111011';y cxpcnditurc III

IIlllrkc( prkc arc computed and added up to arrive at total

national expenditure. The items of expenditure which are takeninto account under the first method are (a) private consumptionexpenditure, (b) direct tax payments, (c) payment? to the

non-pro;it-making institutions and charitable organisations likeschools, hospitals and orphanage, and (d) private savings.



Second Method: Under this method the value of all the products

finally disposed of are computed and added up to arrive at thetotal national expenditure. Under the second method, the

following items are considered

Private consumer goods and services

Private investment goods

Public goods and services

Net investment from aboard.

This method is extensively used because the requisite da!J requiredby this method can be collected with greater ease and accuracy.

Treatment of Net Income from Abroad

Net Factor Income From Abroad (NFIA); We have so far discussed

the methods of measuring national income of a 'closed economy'.However, most modem economics are 'open economy'. These

open economics exchange goods and services with rest of theworld. In this exchange of goods and services, som\: nations

make net income through foreign trade through exports whilesome lose their income to the foreign nations through imports.These incomes are called as Net Factor Income from Abroa:d

(NFIA). The net earnings or losses in foreign trade affect thenational income. Therefore, in measuring national income the netresults of external transactions are adjusted to the total national

income arrived through any of the three methods. The totalincome from abroad is added and net losses to the foreigners are

deducted from the total national income. All the exports ofmerchandise and of services such as, shipping, insurance,banking, tourism and gifts are added to the national income. On

the contrary, all the imports of the corresponding items arededucted from the value of national output to arrive at theapproximate measure of national income.

Net Investment From Abroad: Net investment from abroad refers

to the di ITerllliee between investment a nation made abroad and



the in vcst· mcnt 111nde h~, thc rc~t or Ill(' world ill Ihnt 1If1liOIl.Thi'1'\\ ill\',\~tll"\I1I~ <I' \ mldeu (0 the l\lIt i01l1l1 i Ilcumeclllcullllcd II lieI' addillg or deduct illg N I: 1..\ from it.

Choice of Methods

As discussed above, there are standard methods of measuring thenational incOJ11I.: such as net output method, factor-income method

and expenditure method. 1\11 the I three methods would give thesame measure of national income, provided rcquisitc data for eachmethod arc adequately available. Therefore, any of the three methods

can be adopted to measure the national income. However, not all themethods arc suitable for all economies and purposes. Hence, the

problem of choice of method anses.

The two main considerations on the basis of which a particularmethod is chosen are:

The purpose of national income

analysis

Availability of necessary data.

If objective is to analyse the net output, then the net outputmethod would be more suitable. In case, objective is to analyse the

factor-income distribution then, suitable method would be incomemethod. If objective at hand is to find out the expenditure pattern ofthe national income then the expenditure method is more suitable.

However, availability of adequate and appropriate data is relativelymore important considerations in"selecting a method of estimating

national income.

However, the most common method is the net output methodbecause of the following reasons:

It requires classification of economic activities and output, which

is much easier to classifY than the income or expenditure.

The most common practice is to collect and organise the

national illcom!.; data by the division of economic activities.Therefore, easy availability of data on economic activities is the



main reason for the popularity of the .output method.

However, it should he borne in mind that no single method cangive an accurate measure of national income. This is because no

country's statistical system provides the total data requirements for aparticular method.

The usual practice is therefore, to combine two or more methods

to measure the national income. The combination of methods againdepends on the nature of required data and the sectoral breakdown ofthe available data.

Measurement of National Income in India

In India, a systematic measurement of national income was firstattempted in 1949. Earlier, some individuals and institutions made

many attempts. Dadabh'\i Narojoji made the earliest estimate ofIndia's national income in 1876 for the year 1867-68. Since then,mostly the economists and the government authurities made many

attempts to estimate India's national income.

These estimates differ in coverage, concepts and methodology and

they are not comparable. Besides, earlier estimates were made mostlyfor one year, only some estimates covered a period of 3-4 years. Itwas therefore, not possible to construct a consistent series of national

income and assess the pcrforniance of the economy over a period oftime. It was only in 1949 that National Income Committee (NIC) was

appointed with PC. Mahalanobis, as its Chairman and D.R. Gadgil andV.K.R.V. Rao as its members. The NIC not only highlighted thelimitations of the statistical system that existed at that time but also

suggested ways and means to improve data collectiol1' systems. Onthe recommendation of the Committee, the Directorate of NationalSample Survey was set up to collect additional data required for

estimating national income. Besides, the NIC estimated country'snational income for the period from 1948-49 to 1950-52. In its

estimates, NIC also provided the methodology for estimating nationalincome, which was followed until 1967.



After the NIC, the task of estimating national income was takenover by the Central Statistical Organisation (CSO). Until 1967, the CSOfollowed the methodology laid down by the NIC. Thereafter, the CSO

adopted a relatively improved methodology and procedure, which hadbecome possible due to increased availability of data. Theimprovements pertain mainly to the industrial classification of the

activities. The CSO publishes its estimates in its publication Estimatesof National Income.

Methodology

Currently, output and income methods are used by the CSO toestimate national income of our country. The output method is usedfor agriculture and manufacturing sectors, i.e., the commodity

producing sectors. Income method is used for the service sec(orsincluding trade, commerce, transport and governmeni' services. In its

conventional series of national income statistics from 1950-51 to1966-67, the fSO had categorised the income in 13 sectors. However,in the revised series, it had adopted the following 15 break-ups of the

national economy for estimating the national income.

(i) Agriculture (ii) Forestry and logging (iii) rishing. (iv) Mining andquarrying (v) Large-scale manufacturing (vi) Small-scale

manufacturing (vii) Construction (viii) Electricity, gas and water supply(ix) Transport and communication (x) Real estate and dwellings (xi)

Public Administration and Defence (xii) Other services and (xiii)External transactions. The national income is estimated at bothconstant ar.d current prices.

Growth and Composition of India's NaConallncome

The following Tables present the growth and change in composition ofIndia's national income, both at factor cost and current prices. Table.

6.1 presents the decennial trends in national income aggregates likeGDP, GNP, NDP, NNP, Net¬factor income from abroad, capitalconsumption and indirect tax and subsidies. Table 6.2 presents the



change in the composition of national income classified under fivebroad categories. Table 6.3 presents the decennial annual averagegrowth rate of GNP and GDP at constant prices. It can be seen from

Table 6.2 that the composition of India's national income has changedconsiderably over the past four decades. The share of ~griculture hasdeclined from 55.8% in GDP in 1950¬51 to 31.3% in 1994-95 and that

of industrial sector increased from 15.26 to 27.5 % during th; sameperiod.

Table 6.1: National Income Aggregates-1960-61 to1994-95 (Decennial) (At current prices) (Rs. Crores)

ANationalIncomeAggregates(AtF:actor C Jst)

1960-61 1970-71 1980-81 1990-91 1992-93

1GrossDomesticProdllct (GDP

15,254 39,708 1,22,427 4,27,600 6,27,600

2.Fixed CapitalConsumption

940 2,921 12,08751,884

71,569

3.NetDomesticProduct(NDP)= (1-2)

14,314 35,787 1,10,3404,20,775

5,56,344

4.Net FactorIncome fromAbroad

-72 -284 34506,833

-11409

Contd....

5.IndirectTaxesLessSubsideis

947 3,455 13,586 58,205 77,653

6.GrossNationalProduct(GNP)= (1 + 4)

15,182 39,424 122,772 4,65,8276,16,504



7.Net NationalProfit (NNP)= (6-2)

14,242 36,503 1,10,6854,13,943

5,44,935

8.GDP (atmarketprices)= (1+5)

16,201 43,163 1,36,0135,30,865

705,566

9.GNP (atMarketprice) = (8 +3)

16,129 42,879 1,36,3585,24,032

9,31,016

10.NDP (atMarketprice) = (8 –2)

15,261 40,292 1,23,9264,78,981

6,63,997

11.NNP (atmarketprice) = (9 –2)

15,189 39,958 1,24,2714,72,148

6,22,588

Source : CMIE, Basic Statistics Relating to Indian Economy, Aug 1994Table 13.3

Table 6.2: Change in Composition of National Income (GDP) (Atcurrent prices) (Rs. Crores)

Sectors Sectors 1960-

61

1970-

71

1980-

81

1990-

91

1994-95at

1980-81prices

1.Agricuitural andAllied sectors 45.8 45.2 38.1 31.8

31.3

2.Manufacturingand Mining, etc.

20.7 21.9 25.928.8

27.5

3.Transport,Trade andCommunication

12.1 13.2 16.719.6

19.0

4.Finance andReal Estate

11.9 10.0 8.88.3

11.1

5.Community andPersonalServices

9.4 9.7 10.5 11.6 11.1

6.CommoditySector (1 + 2) 66.5 67.1 64.0 60.5

58.8

7.Non-commoditySector (3 + 4 +5)

33.5 32.9 36.039.5

42.2



8.All Sectors 100.0 100.0 100.0

100.0100.0

Tavie 6.3: Annual Average Growth Rate of GNP and GDP (AT

Current Prices)(% share in GDP)

Period GNP (%) GDP (%)1950-51 to 1960-61 4.08 4.09

1960-61 to 1970-71 3.74 3.78

1970-71 to 1980-81 3.47 3.34

1980-81 to 1990-91 5.57 5.76

1990-91 to 1994,-95 3:95 4.08

1950-51 to 1994-95 4.04 4.07-- -----------

Inflation and Deflation

The term 'inflation' is used in many senses and it is difficult to give agenerally accepted, precise and scientific definition of the term.Popularly, inflation refers 1O a rise in price level. Kemmerer states,

"Inflation is too much money and deposit currency that is too muchcurrency in relation to the physical volume of business being done."This is what Coulburn also means when he defines inflation as, "Too

much money chasing too few goods". According to T.E. Gregory,inflation is "abnormal increase in the quantity of money".

The implication in these definitions is that prices rise due to anincrease in the volume of money as compared to the supply of goods.This is the quantity approach to the rise in the price level. However, it

should be noted that prices may rise due to other factors also such asrise in wages and profits. Besides, there can be an inflationarypressure on prices without actually rising of the prices.

Keynesian Definition

Kl:YlH:S rdales inl1ation to a price level that comes into existenceafter the stage of full employment. While, the quantity approach

emphasises the volume of money to be responsible for rise in theprice level. Keynes distinguishes between two types of rise in prices (a)



rise in prices accompanied by increase in production (h) rise in pricesnot accompanied by incrl:ase in production. If an economy is workingat a low level, with a large number of unemployed men and

unutilised resources then expansion of money or some other. factorsleading to an increase in demand will result not only in a rise in theprice level but also rise in the volume of goods and services in an

economy. This will continue until all unemployed men tindemployment arid capital and other resources are more fully utilised,

i.e., the stage of full employment. Beyond this stage, however, anyincrease in the volume of money or rise in demand will lead to a risein prices but lIO corresponding rise in production or employment.

Keynes states that the initial rise in prices up to the stage of fullemployment is a good thing far the country 'since there is an increasein. output and employment. Reflation or partial inflation is used to

designate such a rise in the price level. The rise in prices aller thestage of full employment is bad far the country since there is nocorresponding increase in production or employment. Inflation is

used to express such a rise in the price level. Therefore, inllationrefers

to a rise in the price level after full employment has been attained.(

According to Keynes, "inflation" can be applied to an

underdeveloped country like India where unemployment of men andresources exist side by side with inflationary rise in prices. This isdue to the existence of bottlenecks, such as limited amount of capital,

machinery, transport facilities and absence of technical know-how.As a result of these bottlenecks and shortages, a rise in the pricelevel may not lead to increase output beyond a certain stage, even

though the country may not have reached the stage of fullemployment. We can distinguish between three kinds of inflation on

the basis of their causes, viz., demand-pull, cost-push and sectoralinflation.



Demand-pull InflationThe most common cal;lse for inflation is the pressure of ever-risingdemand on a stagnant or less rapidly increasing supply of goods and

services. The expansion in aggregate demand may be due to rapidlyincreasing private investment or expanding government expenditurefor war or economic development. At a time whe.n demand is

expanding and exerting pressure on prices'cattempts are made toexpand production. However, this may not be possible either due to

non¬availability o(uqemployed resources or shortages of transport,power, capital and equipment. Expansion in aggregate demand, afterthe level of full employment, results into rf~e in the price level. In a

developing economy I ike India, resources are used for growth, forcreating fixed assets and production of consumer goods. Necessarily,large expenditure will create. large money income and large demand

but without a corresponding increase in supply of real output.

We should emphasise here the role played by deficit financing andincrease in money supply on the level of prices in a developing

COU1Hry. Ollen. the government of a developing country resorts todeficit spending Lo finance economic development i.e., borrowing

from the central bunk und cOllllllercial banks, which, in turn, leads toincrease in money supply in the country. This exerts a strong pressureon the level of prices. An increase in" foreign demand for the exports

of a country may also raise the price level in a country. Expansion inforeign demand aM consequent expansion in exports will raise incomeof the people. This will push up demand for goods and services within

a country. In case the additional money income is used to buy importsor is hoarded then it will not have inflationary effect in the country.

Thus, inflationary pressure is built by increasing aggregate demand inexcess of the available resources. The increase in aggregate demandcan be due to increase in government expenditure or increase in

private investment and private consumption or release of pent updemand of consumers immediately after a war or increase in exportsand so on. Deficit financing and increase in money supply further



aggregate the situation by boosting demand still further. In all thesecases, inflation is the result of demand-pull factors. It must beemphasised here that demand-pull inflation cannot be sustained

unless there is increase in money supply.

Cost-push Inflation

In certain circumstances, prices are pushed up by wage increases,

forced upon the economy by labour leaders under the threat of strike.Costs can also be raised by manufacturers through a system of fixinga higher margin of profit. The common man generally blames

profiteers, speculators, hoards and others for pushing up the costsand prices. Again, the government is responsible for raising the costs

by imposing new taxes and continuously raising the tax rates ofexisting commodity. Therefore, rising rates of commodity taxes, in asellers market, will enable the producers to raise the prices by the full

amount of taxes. Under conditions of rising prices, business andindustrial units find it easy to pass on the burden of higher wages tothe consumers by raising the prices. 1 II us, rise in wages; profit

margin and taxation are responsible for cost-push inflation.In periods when wages, prices and aggregate demand are all rising

and creating an inflationary situation, it is d-ifficult to find out activeand passive factor. In many cases, it is neither demand-pull inflationnor cOSt-push inflation, but it is a combination of both. However, it is

possible and often useful to separate the dominant factors. Ifaggregate de~and is responsible for the inflationary situation, it maypersist so long as excess demand persists and in the extreme case, it

may develop into hyperint1alion cwn thoug.h (osl-push fOt'\'l'S nl".'nhsl'llt. t)11 the other hand, cost-push inllation cannot pcrsist for long,

unless thcrc is increase ill aggrcg:llc <lClll:1I\(1. I r illf1ntillll iscOlllrolled lilnllip"l1llllli\('lilry IIIll! 1i""'111 Ill,'lli",h, aimcd atcontrolling aggregate dCllland then we have demand-pull inllation. Un

thc other hand, if wages and prices continue to rise even whcndemand ceases to grow, we have cost-push int1ation.



Sectoral Demand Shift Theory of InflationUnder dcmand-pull inflation, we have shown how expansion inaggregatc demand without a proportionate increase in the supply of

goods and services leads to an inflationary situation. However, it is notnecessary to have a general increase in demand to bring aboutinflationary pressure. Sometimes, the increase in demand may be

confined to some sector of the economy and this increase in demandand the consequent rise in the price in a particular sector may spread

to other sectors Suppose the demand for agricultural goods risesbecause of inadequate supplies of' these goods. There would be aconsequent rise in the price' of agricultural goods. Thus, the rise in

prices spreads to all other sectors in the economy, through rise in theprices of raw materials and wages. The rise in prices in the agriculturalsector may push up prices in the industrial sector. Therefore, the

inflationary rise in the price level is due to sectoral shifts in demand.

The "sectoral demand" emphasises the fact that prices are highlyflexible upwards but relatively rigid downwards, for example, there

may be rise in prices in the agricultural sector where there is scarcitywhereas price stability in the industrial sector where there .. is an

excess supply. However, in course of time, prices all over the economywill assume an upward trend. The "sectoral demand" is also useful toexplain the simultaneous existence of inflation and recession, i.e.,

inflation in some sectors and recession in certain other sectors.Industries coming under inflationary pressure will experiencepersistent rise in price but industries suffering from recession may not

experience a fall in the price level. Modern economists have coined theword "Stagflation" to refer to this situation in which stagnation in

some sectors of the economy is present while other sectors aresubject to a highly inflationary situation.

Other Classifications of Inflation

Open Inflation: Inflation is said to be open when prices rise

without any interruption. It may ultimately end into



hyper-inflation.

Suppressed inflation: Suppressed inflation refers to a situation inwhich price level is not allowed to rise with the use of price

controls and rationing, even though conditions exist for rise inthe price levcl. The price level may rise when the controlmeasures are lifted.

Suppressed inflation results in (a) postponement of present

demand to a future date (b) diversion of demand from one kind

of goods to another, i.e., from those goods which are subject toprice control. and rationing to those whose prices areuncontrolled and non-rationed. Suppressed inflation has many

dangers. First, it creates administrative problems of controls andrationing. Secondly, it leads to corruption of the price controladministration and risc of hlack IIlarkcls. Thirdly. it CHllses

1I1leCOIIOlllic diversion of productive resources from essentialgoods industries whose prices are· tixed or controllable to those .

industries whose products are less essential but prices areuncontrollable.

Creeping, Running and Galloping Inflation: In the initial stage of

rise in the price level, prices may be rising slowly and this isreferred as creeping inflation. In course of time, the rise in theprice level becomes more marked and alarming. This is referred

as running inflation. Ho.vcver, when the rise in the price level isstaggering and extremely rapid, it is often referred to asgalloping inflation or hyper-inflation, which a country should

avoid at all costs.

Consequences of Inflation on Production and Employment

Inflation affects both production and distribution of income in acountry. Inflationary rise in prices may not affect adversely theproduction of national income. When all aV2.ilabk men and materials

are employed then the stock of real wealth in the form of land and



building is not diminished and the total real income or output availablefor distribution between the different sections of people remains thesame. However, in course of time when inflation has gone beyond a

certain limit, it may lead to reduction in production and increase inunemployment due to the following reasons:

Firms may find it profitable to hoard rather than produce and

sell

Agriculturists may refuse to sell their surplus stocks in thehope of

getting higher prices

Production may be interrupted by bitter labour strikes.

Therefore, beyond a certain stage, surplus stocks accumulate,profits decline and invcstmcnt. prodllClillll and incomc rail and

lIncmpl()ymcnll\l·i~l's.

On Distribution of Income

It is true that in times of general rise in the price level, if all groups of

prices, such as agricultural prices, industrial prices, prices of minerals,wages, rent and profit rise in the same direction and by the sameextent, there will be no net effect on any section of people in the

community. For example, if the prices of goods and services, which aworker quys rises by 50 per cent and if the wage of the worker also

rises by 50 per cent then there is no change in the real income of theworker, i:e., his standard of living will remain constant. However, inpractice, all prices do not move in same direction and- by saine

percentage. Hence, some classes of reople in the community areaffected more favourably than others. This is explained as follows:

Producing Classes: All producers, traders and specu!.ators gainduring

inflation because of the emergence of windfall profits. The pricesof

goods rise at a far greater rate than costs of production whereas



wages,

interest rates and insurance premium are all mere or less fixed.Besides, the producers keep such assets, as commodities, real

estate, etc., whose prices rise much more than the general levelof prices. Thus, the producing and trading classes gainenormously during an inflationary period. However, farmers may

gain only if their output is maintained or increased.

Fixed Income Groups: Inflation is very severe on those who arcliving on past savings, fixed rents, pensions and other fixed

income groups called as the middle classes. Those persons whoare working in government and private concerns find their money

incomes more or less fixed while the prices of the goods andservices, which they buy are rising very rapidly. Those withabsolui~ly fixed incomes derived from interest and rent-known

as the renter class, realise that their money income is absolutelyworthless and their past savings have insignificant value in frontof high prices. In fact, the worst sufferers in inflation are the

middle classes who are considered as the backbone of any stablesociety.

Working Classe~: During inflation, the working classes also suffer,firstly because wages do not rise as much as the prices of thosecommodities and services, which the workers buy. Secondly,

there is also time lag between rise in th~.price level and wages.However, these days, many groups of workers are organised intrade unions and their wages rise simultaneously with rise, in the

cost of living. Therefore, it can be presumed that organisedworkers may not suffer· much during inflation. However, there

are many grOlIl)S of workers who arc not organised for example,the agricultural labourers, who find no way of pushing up theirwages in the face of rising prices and cost of living.

Inflation, lilus, brings shi fts in the distribution of incomc hctwccndi !Tcrellt sections of people. The producing classes such as



agriculturists, manufacturers and traders gain at the expense ofsalaried and working classes. The rich become richer and the poorbecomes poorer. Thus, there is a transfer of income from poor to rich

classes. Inflation, therefore, is unjust. Besides, those who are hard hitby inflation are the young, old, widows and-small savers, i.e., all thosewho are unable to protect themselves. But the most unfortunate thing

is that monetary arid fiscal authorities which are entrusted with thetask of maintaining price stability are often responsible for creating

inhltionary conditions, for example, a country at war resorts toprinting of currency notes as one of the methods of financing war.Similarly, the government of a developing economy may resort to

deficit financing as . one of the methods of financing developmentprojects; In these cases, inflationary finance, like taxation, brings inadditional revenue to the public authorities. However, taxation cannot

destroy an economy except in rare cases by eliminating whole groupsof people. Inflation, on the other hand, can destroy fixed income

group, pauperise the middle classes and destroy the very foundationsof an economy. No wonder inflation has been termed as "a species oftaxation, cruellest of all" and "open robbery". Inflation, particularly the

hyperinflation of the German type, will therefore endanger the veryfow(jations of the existing social and economic system. It will create asense of frustration distrust, injustice and discontent and may force

people to revolt against the government. It is, therefore, "economicallyunsound, politically dangerous and morally indefensible". Therefore, it

should be avoided and even if it occurs it should be controlled.

Control of Inflation

Inflation should be controlled in the beginning stage, otherwise it wiil

take the shape of hyper-inflation which will completely run thecountry. The different methods used to control inflation are known asanti-inflationary measures. These measures attempt mainly at

reducing aggregate demand for goods and services on the basicassumption that inflationary rise in prices is due to an excess of



demand over a given supply of goods and services. Anti-inflationarymeasures are of four types:

Monetary policy

Fiscal policy

Price controlnnd mtioning

Other methods

Monetary Policy

It is the policy of the central bank of the country, which is thesupreme monetary and banking authority in a country. The central

bank may use such methods as the bank rate, open marketoperations, the reserve ratio and selective controls in order tocontrol the credit creation operation of commercial banks and thus

restrict the amounts of bank deposits in the country. 'this is knownas tight money policy. .\ Monetary policy to control inflation is

based on the assumption that a rise in prices is due to a largerdemand for goods and services, which is the direct result ofexpansion of bank credit. To the extent this is true, the central

bank's policy wi}1 be successful.

Fiscal Policy

It is the policy of a government with regard to taxation, expenditure

and public borrowing. It has a very important influence on businessand economic activity. Taxes determine the size or the volume of

disposable income in the hands of the public. The proper tax policyto control inflation will avoid tax cuts, introduce new taxes and raisethe rates of existing taxes. The purpose being to reduce the volume

of purchasing power in the hands of the public and thus reducestheir demand. A precisely similar effect will be achieved if voluntary

or compulsory savings are increased. Savings will reduce currentdemand for goods and thus reduce the inflationary rise in prices.

As an anti-inflationary measure, government expenditure

should be reduced. This .indicates that demand for goods and



services will be further reduced. This policy of increasing publicrevenue through taxation and decreasing public expenditure isknown as surplus budgeting. However, there is one important

difficulty is this policy. It may be easy to increase revenue in times ofinflation when people have more money ineome !:Jut difficult toreduce public expenditure. During war as well as during a period of

development expenditure it is absolutely impossible to reduce theplanned expenditure. If the government has already taken up a

scheme or a group of schemes, it is ruinous to give them up in themiddle.; Therefore, public expenditure cannot be used as ananti-inflationary measure. Lastly, public debt, i.e., the debt of the

government may be managed in such a way that the supply ofmoney in the country may be controlled. The government shouldavoid paying back any of its previous loans during inflation so as to

prevent an increase in the circulation of moneY: Moreover, ifthegovernment manages to get a surplus budget it should be used to

cancel public debt held by the central bank. The result will beanti-inflationary since money taken from the public and commercialbanks is being cancelled out and is removed from circulation. But the

problem is how to get abudgct surplus, \vhich is extremely difficult,if not impossible.

Price Control and Rationing

This is the most important and effective method available during warparticularly oecause both monetary and fiscal policies are more or less

useless during this period. Price control implies the establishment tolegal upper limits beyond which prices of particular goods should notrisco The purpose of rationing, on the other hand, is to distribute the

goods in short supply in an equitable manner among all people,irrespective of their wealth and social status. Price control andrationing g.enerally go together. The chief objection behind use of this

method to fight inflation is that they restrict the freedom of theconsumers and thus limit their welfare. Besides, its success depends

on administrative efficiency, which in many underdeveloped countries



is very low.

Other Methods

Another important anti-inflationary device is to increase the

supply of goods through either increased production orimports. Production may be increased by shifting factors ofproduction from the production of less inflation sensitive

goods, which are in comparative abundance to the production-of those goods which are in short supply and which areinflation-sensitive~ Moreover, shortage of goods internally

may be relieved through imports of inflation sensitive goods,either on credit or in exchange for export of luxury goods and

other non-essentials.

A word may be added about the measures to controlcost-push inflation. It is suggested that wages, salaries and

profit margins should be controlled and fixed through asystem of income freeze. Business units may particularlywelcome wage freeze. However, wage freeze is not so easy or

just, unless trade unions agree to the proposal and there isalso freezing of prices. At the same time, the Government

should not raise the rates of commodity taxes. Thus, it isdifficult to control c'ost push inflation through controllingwages and other incomes. The best method is to bring a rapid

increase in production, which will automatically check pricesand wages also.

Inflation in an: Underdeveloped Economy

Basically, inflation is supposed to occur after reaching the stage of fullemployment, for till that stage is reached an increase in effective

demand and price level will,be fr)lowed by an increase in output,income and employment. It is after the stage of fuli employment when

all men are employed that a rise in the price level will not beaccompanied by an increase in production and employment.



Theoret.ically, therefore, it is not possible to imagine an inflationarysituation existing side by side with full employment. It is in thiscontext that the question of inflation in an under developed country

like India, which has both widespread unemployment andunderemployment is raised.

Bottleneck Inflation

It is interesting to observe that Keynes himself visualised thepossibility of an inflationary situation even before full employ·.lent was

reached. Such: a situation can arise even in advanced countries, ifthere are difficulties in perfect G\lasticity of supply of goods andservices. It is possible that full employment is not reached but even

then, there is no scope for increased production. The factorsresponsible for imperfect ela<;ticity of supply are law of diminishingreturns, absence of homogeneous factors and unemployed resources,

which cannot be used to increase production. All these factors arelumped together and are known as bottlenecks. As monetary demand

increases with the increase in money supply, supply of goods does notincrease in proportion, due to imperfect elasticity. The difficulties orhandicaps, which prevent supply from increasing in the face of rising

demand, are known as bottlenecks. The result is that the cost ofproduction is pushed up and price level is raised. Apart from these,other bottlenecks are as follows:

Market imperfections' in underdeveloped countries, such as

imperfect knowledge on the part of producers and consumers,mobility of factors, divisibility of factors and lack of specialisation.

All these are responsible f9r inefficient use of resources. There is,thus, imperfect elasticity of supply in an underdevelopeJ country.

Underdeveloped countries face shortage of technical labour,

capital, equipment and transport and power facilities. Therefore,these countries are unable to grow becauserofthese.bottlenecks.

Unemployment and underemployment are extensively present inan underdeveloped country. The existence of unemployment in



the advanced country helps increase' output, whenever there isincreased demand. However, this is not so in a country like Indiawith a large magnitude of disguised unemployment and open

unemployment. According to or.V.K.R.V. Rao, disguisedunemployment is not so resrollsive to an increase in effectivedemand.

Underdeveloped countries generally have II high mnrginulpropensity to consume. or.Rao believes that this factor prevents

an increase in the supply of goods and services. For instance, inthe field of agriculture, increased production may be _consumed at home ~nd, therefor;-:, less may be forthcoming to

the market.

A special feature of underdeveloped countries is that a largevolume of primary production is exported. Therefore, the supply

available for home consumption is reduced. The problem ofinflationary rise in prices i~ worsened whenever the income

earned from exports is spent on domestiC goods and not onimports.

Since World War II, many of the underdeveloped countries have

started resorting to extensive borrowing from the banks anddeficit fi.nrmcing with the idea of speed ing up economicdevelop!nent. For one thing, much of this expenditure is on social

and ccor:omic overheads, such as education, transport and powcrand on capital goods industries such as development of iron andsteel industry. This implies that there is an increase in the

production of consumption goods. Therefore, the volume ofpurchasing power with the general' public is increased, resulting

in increased demand for consumption goods.

All these factors explain the existence of inflationary pressure in allunderdeveloped country, even though the stage of full employment

has not been' reached. The existence of bottlenecks such as· shortageof technical know-how and scarcity of capital equipment hasworsened the various problems related to underdeveloped countries. It



is, therefore, correct to use th~ concept of inflation even inunderdeveloped countries, provided we remember the existence ofspecial bottlenecks.

Deflation

I I' prices an; abnormally high, it is indeed desirable to have a fall inprices. Such a fall in the price level is good for the community, as it

will not lead to a fall in the level of production or employment. Theprocess designed to reverse the inllationary trend in prices, without

creating unemployment, is generally known as disinflation. But ifprices fall from the level of full employment, then income andemployment will be adversely affected and this situation is termed as

deflation. The foll0wing Figure 6.1. shows if the price level continuesto rise even after the stage of full employment has been reached, it iscnlled intlntiol\. Decline in prkt' level as a result of anti-inl1ationary

measures is known as disinflation. If prices litll below 1'1111OlllploYlIlt'lll. lho ~illlr,li\l11 i~ ~\nlh'd 11011,,111111. Whllt'

11IC111lhlll IIIII,II\'~ excess demand over the avai lable supply.uel1l1tion implies dcticiency of dcmand to lift what is supplied. Whileinflation means rise in money incomes, deflation stands for fall in

money incomes.



Effects of DeflationThe following are the adverse effects of deflation:

On production: Deflation has an adverse effect on the level of

production, business activity and employment. During deflation,prices fall due contracting demand for goods and services. Fallin price results in losses' and sometimes forcing many firms to

go into liquidation. In the face of declining demand for goods,firms arc forced to close down either completely or leave part of

their plants idle. Thus, production of income is curtailed andunemployment is increased. 111is is a serious defect ofdeflation, as compared to inflation in which normally there may

not be an adverse effect on production and employment.

On distribution: Deflation adversely affects distribution of incometoo. In the first place, producers, merchants and speculators lose

badly during this period because price~ of their goods fall at afar greater rate than their costs, most of which tend to be fixedor sticky. Besides, most of these people are debtors who use

borrowed funds in their businesses. They have to repay theirdebts in money, which has now more value because of deflation.

For some debtors, who do not have adequate means to repaytheir loans had to go into liquidation.

Deflation implies fall in price level or rise in the value of money:

All those who have fixed incomes will be far better off becausetheir money income is fixed. In other words, the fixed incomegroups will enjoy a rise in their real income. Therefore, it is

assumed that salaried persons and wage C<llners wi II bcnefit bydenatioll. Ilowcvcr, this is not completely true since there is

increasing unemployment. Therefore, only those who aresuccessful in keeping their jobs will be able to gain from the risein the value of money. As a matter of fact, during deflation, there

is great suffering and mystery all round and millions of familiesare literally thrown onto the streets to make their living through



begging. The only group of people who may really gain is thatsmall minority, known as the renter class who get their income byway of fixed interest and rents.

Methods of Control

Anti-deflation measures are the opposite of those, which are used tocombat inflation. Monetary policy aimed at controlling deflation

consists of using the discount rate, open-market operations and otherweapons of control available to the central bank of a country to raisevolume of credit of commercial banks. This policy is known as cheap

money policy. This is based on an idea that with the increase in thevolume of credit, there will be an increase in investment, productionand employment. However, monetary policy is basically weak, for it

assumes that the volume of credit can be expanded by the centralbank. This may not be so, because even when commercial banks are

prepared to lend more to businesses to enable them to expand theirinvestment, the latter may not be willing to do so for fear of possiblefailure of their investments.

Fiscal policy to fight deflation is known as deficit financing, i.e.,expenditure in excess of tax revenues. On one hand governmentattempts to reduce the level of taxation to provide large amount of

purchasing power with the public. While, on the 'other hand, thegovernment increases its expenditure on public work programmes

such as irrigation, construction of roads and railways. By thisprogramme government will (:I) provide employment for those whomay be thrown out of employment in the private sector, (b) add tei

national wealth, and (c) counteract the deficiency of private demandfor goods and services. The budget deficit can be financed through

borrowing from the public of their idle cash balances or banks. Thebasic idea of fiscal policy is to expand demand for goods or tocounteract the decline in private demand. Therefore, fiscal policy is the

most important policy for economic stabilisation.

Other measures to control deflation include price support



programmes, i.e., to prevent prices from falling beyond certain levelsand lowering wage and other costs to bring adjustment between priceand cost of production. Price support programme has been

extensively used in the USA in recent years but it is very difficult tocarry it through. The government will have to fix the prices belowwhich the commodities will not be sold and undertake to buy the

surplus stocks" It is difficult for the government to secure thenecessary funds for such transactions as well as to devise ways and

means to dispose of the surplus stocks in other countries. Therefore,the best solution for deflation is to have a ready programme of publicworks to be implemented as and when unemployment makes its

appearance.

Compariso!between Inflation and Deflation

Inflation is rise in prices unaccompanied by increase in employment,while deflation is fall in prices accompanied by increasingunemployment. Inflation distorts the distribution of income between

different groups of people in' the country in such an unjust mannerthat the rich gain at the expense of the poor. Deflation, on the other

hand, reduces national income through contraction of production andincreas~ in unemployment.

Inflation is unjust and demoralising. Deflation, on the other hand,

inflicts on the people the harsh punishment of general unemployment.There exist factories and mills on one hand and workers ready to\';ork on the other hand, however, the whole team remaining idle, on

the other. Inflation at least implies that all factors are employed insome way or the other. There is one more reason why deflation is

worse than inflation. Inflation can be controlled except occasionally itgets out of control. However, deflation, if once started, injects somuch pessimism into businessmen and bankers that it is highly

difficult to control. However, there is nothing to choose between thetwo and the proper objective should be to aim at economicstabilisation at the level of full employment.



Inflationary and Deflationary Gaps

Keynes developed the concept of inflationary gap'. InfliJtionary gap

refers to, "excess of anticipated expenditures over the availahle outputal base pril'.c.~." Inflationary gap occurs when there is an excess ofdemand over available supplies. Let us take a simple and hypothetical

example to illustrate the eme~gence of inflationary gap.

During 'a period of war, the volume of money expenditure in acountry increases, because or" the government's expenditure on the

armed forces and armaments. Increased government expenditureresulting in increased income with the community will lead to

increased consumption expenditure and investment. The disposableincome of the community, which constitutes aggregate demand forgoods and services, is as follows:

(Rs. Crores)1. National income received during a given year: 20,0002. Taxes paid to the government: 5,000

3. Gross disposable income (I -2): 15,0004. Saving by the community at 10% oft',e income: 1,500

5. Net disposable income with the community: 13,500

The net disposable income with the people represents aggregatedemand for goods and services ofa community. As against the

aggregate demand, the aggregate supply comes from gross nationalproduct. However, not all output is available for the community. Thegovernment diverts some resources such as food grains, cloth, for war

purposes, then the total output available for civilian consumption isless than the gross national pro,duct (GNP). For instance,

(Rs. CIJres)1. National product (real income): 20,0002. Appropriated for war purposes: 8,000

3. Available for civilian consumption: 12,000

Now the net disposable income, which the community will like to



spend is Rs. 13,500 crores but the available output for civilianconsumption is only Rs. 12,000 crores. There is excess of demando'Ver available supply ~') tne extent of Rs. 1,500 crores, which is

referred to as the inflationary gap. The basic fact is that so long as theamount of disposable income with the people and the volume ofgoods and services available for them are the same, there will be price

stability; but whcn thL~ forillcr is Illore' thnllthe lillieI', nn i1t1llllinllllrylJ.lIp willllppc\;\r :ll\d IIIl' price level will rise; il~ 011 Ihe olher hUlld.

the volume of goods llnd services is InrgN 1111\11 lht' VI""I1I\' Ill'dhl'".'lld"ll 1111'111111', "dI1lllllilllllll,\' gllp \\'ill i'l'llI'lll,

Though Keynes assoeialed un inflationary gap with war, we cun

I\lso spcak of inflationary gap during periods of economicdevelopment Since 1951, India has undertaken economicdevelopment, financed partly through created money. As a result,

there has been enormous increase in money expenditure andmoney income but without a corresponding increase in the volume

of consumptioll goods (part of the increase in production has beenin capital goods). Besides, there is a ~' time interval or gap betweeninvestment and output of goods and services. Naturally, there is

excess demand resulting in inflationary pressure on the generalprice level. Inflationary gap can be illustrated by using theKeynesian concepts of aggregate demand and aggregate supply,

The following Figure 6.2 shows the' inflationary gap.



In Figure 6.2, the horizontal axis represents volunie of incomeand the vertical axis represents volume of total expenditure (C + I

+ G). The 450 vertical axis represents equilibrium line of Y = E andline C + I + G represents the total expenditure. At point E, theeconomy is in equilibrium because at E the supply of goods and

services or real income (OY) is equal to the demand for them at EY.Therefore, OY is' regarded as equilibrium income as well as full

employment income at current prices.Suppose, the Government increases its expenditure either for war ordevelop¬ment purposes, by an amount equal to EA. Then the new

aggregate demand is shifted upwards and beco~es C' +' l' + G'. C' of-l' -\- G' is parallel to C + r + G line by the amount MEA. The realoutput (or income)remains constant at OY but the mOlletary demand

for this output is not EY but Y A, there is, thus. an excess of demandand equal. to.EA. EA, therefore, represents inflationary gap, which is

responsible for pushing up the price level.

Wiping out Inflationary Gap

The inflationary gap can be wiped out in various ways. Essentially, it

starts with additional expenditure by the government, which in turncalls for additional expenditure by the community. Through economyin government expenditure, the excess of aggregate demand can be

reduced. However, this is not always possible in practice, asgovernment expenditure cannot be cut down during wartime or periodof economic devdopment. To remove this inflationary gap. various

mtlhods can be adopted, such as:

There cun be a rise ill voluntary saving by the community.

The government may use the tax system to mop up the surplus

purchasing power with people; this will reduce C + I by the sameamount as the increase in government expenditure.

The output of goods and services may be increased so as to

absorb the excess demand. In Figure 6.2, such an increase in real



income should be YY1• But, as mentioned already, there is noscope for such an increase in real income, as the economy isalready at full employment level.

Deflationary Gap

Deflationary gap is the opposite of inflationary gap. If the volumeof goods and services is larger than the aggregate demand for them, a

deflationary gap will arise. Deflationary gap arises when the C + I of-G line is pushed down to C' + I' + G'. The decline in demand may bebecause of reduction in government expenditure or decline in private

investment or fall in private consumption demand. This is shown inFigure 6.3. OY, = Volume of real income available for the community

As regards wiping out the deflationary gap, the government shouldincrease its expenditures or help to raise the expenditure of the

general public. The government can raise its own expenditure byinvesting in public works and financing them by borrowing from banks.

The expenditure of the community C + I can be raised by reducinglaxes and other incentives. If the C' + j' + G' is raised to the originallevel then the deflationary gap will disappear.

Stagflation

Inflationary gap occurs when aggregate demands exceeds the availablesupply and deflationary gap occurs when aggregate demand is less

than the available supply. These are two opposite situations. However,



we may show how deflationary forces follow inflation, which has notbeen controlled. For instance, when inflation goes unchecked forsometimes and priCes reach very high levels, aggregate demand

contracts and slumps follows. Consumption demand (C) declinesbecause of high price levels. The middle and lower income groupshave to curtail th<f" consumption of many of the goods. Increase in

private investment (I) does not take place because investors are afraidof future and there is decline in consumer demand at the height of

inflation. In fact, the decline in consumer demand and privateinvestment will reinforce each other and create a deflationary situation.Further, un excessive rise in the price 'level will affect exports

adversely and thus create a slu1np in the export industries as well. It is,thus, possible to visualise a situation in which inflationary anddeflationary pressures are present simultaneously. The existence of an

economic recession at the height of inflation has been called asstagflation (stagnation + inflation).

Trade Cycles '

Wesley C. Mitchell, a noted American authority 011 business cycles,wrote: "Business cycles are a species of fluctuations in the economic

activities of organised communities." The adjective ,'business' restrictsthe concept to fluctuations in the activities, which are systematicallyconducted on commercial basis. The noun 'cycles' bars out

fluctuations, which do not recur with a measure of regularity. Mitchellhas, thus, described all the important features of a business cycleadmirably. According to him, features of trade cycle are:

It occurs only in organised communities, which aremoney economies.

Refers to fluctuations or changes in business

conditions.

Implies regular and periodical changes in business and

economic activities.

According to Keynes, "A trade cycle is composed of periods of



good trade characterised by rising prices and low unemploymentpercentage, alternating with periods of bad trade characterised byfalling prices and high unemployment percentage. "

Characteristics of Trade Cycles

From the above definition, it should ,be clear that trade cy~les isrhythmic fluctuations of the economy, that is, periods of prosperity

followed by periods of depression. However, the waves of prosperityand depression need not always be of the same length and amplitude.Further, trade cycles varied tremendously in magnitude. Whde some

have smaller cyclical fluctuations in economic activity, others havegreat intensity of fluctuations. Expansion in some cycles reaches thefull employment level and stays there. However, in some cycles, the

peak is reached even before full employment. Sometimes, the cyclicalfluctuations may be prolonged for one reason or the other.

The American Economic Association emphasised the followingimportant characteristics of trade cycle:

Prices IInd production gencrnlly risc 01' 1111\ togctht.'r, Till'C:\l'l:ptl(\l\ i~ agricultllre, where during 1I dowllwlIrd phllsc or

business ey(k~, ",h,'1\ prices are falling. (he agricullurists maytend to produce more, so liS to onset the loss of lillling prices

11I1l1 thus 11I1I1IIlH11I tht' SilIlI\: 11"\'c1 <If income.

The total output and employment Jluctuate by a larger

percentage in durable and capital goods industries than innon-durable and consumption goods industries.

Large changes in total output, employment and the price levelare normally accompanied by large changes in currency, credit

and velocity of circulation of Illoney.

Prices of manufactures are comparatively rigid while prices ofagricultural goods are normally flexible.

Profits fluctuate by a much larger percentage than other types ofincome.



Industries are so inter-connected that fluctuations in one will

be passed on to others also, Thus, cyclical fluctuations affect allindustries.

Cyclical fluctuations tend to be international, in the sense that

prosperity and depression spread from one country to anotherthrough foreign trade,

Phases of a Trade Cycle

Every trade cycle is characterised by two main phases namely, theupward phase and the downward phase of'the trade cycle. These two

phases further have four or five different sub-phases, such asdepression, recovery, full employment, boom and recession. Inmonetary terminology, the same phases . correspond to depression,

deflation, full employment, disinflation and deflation.

The following Figure 6.4 shows· the different stages· of a trade

cycle. FE represents the full employment line-it may be taken as thedividing line. Above this line, there is business prosperity and boomand below this line, there is business depression. As a trade eycle is a

continuous phenomenon, it is essential to break it som~where. It iscustomary to start at the lowest point of the upward " phase, namely,the depression.



Depression: During depression, the level of economic activity is

extremely low. The price level is low, profit margins do not exist,firms incur losses and unemployment is high. Interests, wages and

profits are all low. While all sections in the economy suffer, somesuffer more than others do. For instance, the producers ofagricultural goods suffer badly because the prices of agricultural

goods fall the most during depression. This is due to inability of thefarmers to adjust their output according to the market demilnd,which is low. The worst hits are the working classes that suffer

heavily because of unemployment. The depression is thus, a periodof great suffering, low income and unemployment.

The phase of recovery: Depression gives place to recovery. There is

revival of business and economic activity. There is greater demandfor goods and services and consequently there is greater production.

Prices, wages, interests and profits all start rising. Employmentincreases and so docs the national income. There is increase in

investment, bank loans and advances, velocity of circulation ofmoney due to more brisk tnide. Through multiplier and accelerationeffects, the economy is proceeding upward steadily and rapidly. The

process of revival and recovery becomes cumulative. Increased



receipts result in increased expenditure causing further incrcasc inn:ceipts. which in turn, rcsult in further increased expendllure andso on. The wave of recovery on'ce initi"ted soon begins to feed upon

itself.

The phase of full employment: The cumulative process of recoverycontinues until the economy reaches full employment. Full

employment implies that all the available men arc employed. Theeconomy has reached the optimum level of economic activity.

During this phase, there is an all¬round economic stability referringto stability of output, wages, prices and income. Wages, interestsand profits are high, output is highest with the given technology

and employment is maximum. There may be small percentage ofunemployment, but it is not of an involuntary type but of voluntaryand frictional type. The period of full employment has become the

usual goal of most national economic policies.

The phase of boom or inflation: The phase of recovery frequentlyends not in a stable state of full employment o~ prosperity but

further leads to a boom or inflation. Beyond the stage of fullemployment, the rise in investment results in increas~d pressure for

the available men and materials and rise in wages and prices.During this period, there is hectic activity going on everywhere inthe economy such as new buildings come up, new factories are

commissioned and many new trades are started. In a matter ofweeks or months, full employment paves the way for overiiJlIemployment, i.e., a peculiar situation in which there are more jobs

than the available workers. Money wage rise, profits increase andinterest rates go up. The demand for bank credit increases and

there is all round optimism. At the same time, bottlen~.cks begin toappear in the economy. Factors of production, particularly' rawmaterials and labour becon~e scarce, commanding higher prices

and wages and thereby distort the cost calculations of theentrepreneurs. They now realise that they have overstepped themark and become overcautious. Their over-optimism paves way for



their pessimism. Generally, the failure ·01' a firm or bank burstsboom and lead to recession.

Recession: The entrepreneurs realise their mistakes and find that

many of tht: ventures started in the rosy anticipation of the boomare not profitable. The over oplimism of the boom gives way topessimism characterised by feelings of hesitation, doubt and fear.

Fresh enterprises are postponed for some remote future date andthose in hand are abandoned. Credit is suddenly curtailed sharply as

the banks are afraid of failure. Business l:xrnnsion stars. order~; :1re cancelled and workers are laid off. Liquidity preference suddenlyrises and people pref~r to hoard rather thail invest Building activity

slows down and unemployment appears in construction· industries.Unemployment spreads to other sectors also because the multipliereffect begins to work in the downward direction. Uncmployment

leads to fall in income, expenditure, prices, profits and industrialand trade activities. Panic prevai l~" in the stock market and the

prices of shares fall rapidly., Once business and economic activitystart declining, it becomes almost difficult to stop this decline andfinally ,ends in a hopeless depression.

We have described the various phases of a trade cycle, but weshould note, that all these phases rarely display smoothness andregularity. The movement at times may be irregular in such a manner

that one phase may not easily follow the other. Nor is the length ofeach phase by any means always defined. Thus it is quite likely that a

state of fairly stable business depression may lead to recovery or itmay decline to further recession, as was tlie case with England in1929. Similarly, a recovery may turn into a recession without

allo''/ing for either full employment or even boom, as witnessed inthe United States in J 937. Sometimes, the depression may beunstable and recover very rapid. So, alsc at times prosperity phase

may be fairly stable as was the case during the period between 1924and 1929.

Some of the important features of various phases 'of a trade cycle



should be 0 emphasised here. They are important when we have toevaluate the worth of different trade cycle theories.

The process of revival is generally very gradual but once it

picks up,

it becomes rapid.

The boom period of the trade' cycle is marked by high level ofbusiness activity.

The crash of the boom is always sudden and sharp.

The downward trend of the trade cycle is rather very' rapid.

The depression period is prolonged and is painful because of

widespread unemployment.

Trade Cycle Theories

The complex phenomenon of a trade cycle has received the gr,eatestattention from economist and there arc number of theories Oil trade

cyclc. The following theories on trade cycle are as follows:

Monctary llnd Non-monctary Thcorics: Trade cycle theories canhe classified into monetary lInd nOIHllOnctnry theories. The forll\el'

llll\phasbl's monetary factors as thc main cause for, while the Iallerelllphnsis 1l1l!1¬IlIllm'lllr)' Ihe!ll),:-I, :-Illl'lI ll:ll'lilllillll' l'lllltllllll'IIS.

psyl'll\\hlgy \II' hIlSIIll'~~llh'll and innovations as, thc main causefor the recurrence or econOllllC fluctuations.

Climatic Theory: The climatic theory is one of the oldest

theories oftradc cycle. The climatic theory, also known as the sunspot

theory because the spots that appear, on the face of the sunlargely influence climatic conditions. A bad climate causes thefailure of harvests, which in turn lead:i to depression in business

conditions because of a fall in the incomc of" farmers andconsequent fall in their demand for the products of industries, Agood climate, on the contrary, has quite the opposite effect on

trade and industry. The variations of climate are said to be so



regular that periods of good harvest are followed by periods ofbad Ones and consequently booms and slumps follow eachother just as the days and nights, This theory has been

discarded in modern times. While it is difficult to deny the factthat the prospects of agriculture affect the pwspects ofindustries, it is not easy to correlate such a complex

phenomenon of trade cycle exclusively with the climaticconditions. If the theory has to be correct, then it should accept

th"t trade cycles are less important in non-agricultural areas andwhen a nation becomes more completely industrialised, tradecycles would disappear or at least diminish in importance. This,

however, is not the case; in fact, it is advanced countries, whichseem to suffer most from the trade cycles.

Psychological Theory: Pigou attempted to explain the trade

cycle with reference to the feeling of optimism and pessimismamong businessmen and bankers. Businessmen have their

moods. Sometimes they feel depressed and at· other times, theyare jubilant and optimistic. Despair, hopelessness as well asoptimism are catching in nature. When 0ne businessman is

pessimistic, he passes it on to the others, similarly,. optimismspreads 'from OIlC to another. Thus. lIccording 10 the

psychological thcory. industrial l1uctuations are thc outCOIllCof" the waves or oplilllisl)/ among businessmen. Optimismresults in prosperity and - pessimism in recession and

depression. There is an element of truth in the psychologicaltheory in the sense that psychological waves of optimism andpessimism do play an imp()rtant role ill trade cycles. But

busincss con !1dcncc or abSCIll"C of it is often the result ratherthan the cause-ofbusiness conditions. Further, the theory does

/lot explain satisfactorily how depression starts or a recoverybegins.

Over-Investment Theory of Von Hayek and Others: Prof.Von

Hayek in his books "Monetary Theory and the Trade Cycle" and



"Prices and Production", has developed theory of business cyclesin terms of monetary over-investment and consequentover-production. According to him. there is a "natural" or

equilibrium rate of interest at which the demand for loanablefunds is equal to the supply of funds through voluntary saving.At the same time, there is also market rate of interest based on

demand for and supply of loanable funds in the market.According to Hayek's thesis as long as the market rate of interest

is same as the natural rate of interest. there will hc stahility illhusillcss cOlldiliolls alld allY dispilrity bctwcen the two will leadto busincss Iluctuations. For instance, a fall in the market rate of

interest below the natural rate wililcad to more investment and,therclore, an upward swing in business activity. On the otherhand, a rise in the market rate of interest over the natural rate of

interest will lead to a fall in investment and, therefore, adownward swing in business activity.

Now, the market rate of interest may fall below the natural rate of

interest because money supply increase in excess of demand for thesame. The banks lending to entrepreneurs; through whom it eventually

reaches the consumers bring about this increase in supply of money.The increased money supply is made available to the entrepreneurs bylowering the market rate of interest. There is a spurt of investment

activity. More capital intensive methods of production are adopted.The demand for capital goods naturally increases and accordingly theirprices go up. As a direct consequence of this rise in the prices of

capital goods there is a diversion of resources from the production ofconsumption goods to the production of capital goods resulting in the

reduction of the supply of consumer goods. But this situation cannotcontinue for long, for increase in the production of capital goods andhigher prices for them will result in larger income for the factor

owners who, in turn, can normally be expected to increase theirconsumption of goods. The demand for consumption goods will alsorise and their prices too will go up. There will now be a competition



between capital goods industries and consumption goods industriesfor scarce resources. Naturally, the prices ofJactor series will go up,raising the cost of production of capital goods industries. The profit

margins of capital goods industries will, therefore, becomeunattractivc. At the same time the banking system decides to reducethe rate of credit expansion by mising the market rate of interest

above the equilibrium rate, causing illvt'~;tment to (all abruptly. Thus,on the one hand, investment is unattractive because of lower yield,

and on the other, investment is made more expensive because ofhigher rate of interest. The business expansion and boom broughtabout by IbW market rate of interest and heavy investment activity

crashes when the banking system puts a stop to additiorlal lending tofirms by raising the rate of interest. Investment and production willdecline and depression will rise.

Hayek(basic thesis can now be summarised as follows. Alternatingstages of prosperity and depression are due to lengthening andshortening processes of production brought about by a change in the

money supply, which causes a change in the market rate of interestaway from the natural rate of interest. The lengthening of the process

of production is brought about by increase in moncy supply, whichcauses the market rate of interest to fall below the natural rate ofinterest. Shortening of the process of production is brought about by a

Lleel ine in the supply of bank money, which raises the market rate ofinterest above the natural rate of interest. Therefore, the failure of thebanking system to keep the supply of money constant is responsible

for business cycles. Therefore, to control cyclical fluctuations, Hayek'ssolution is simple, i.e., to keep constant supply of bank money,

making allowance for such increases or decreases in the velocity ofcirculation of money.

Weaknesses of Hayek's Approach

According to Von Hayek, a low rate of interest and large bank lendingto entrepreneurs result into expansion of investment and productionwhereas a high rate of interest puts a stop to this expansion and



brings about a depression. Hayek's theory is, therefore, referred to asmonetary over-investment theory of business cycles. The basicweakness of Hayek's approach is its emphasis on the rate of interest

and complete neglect of real factors such as technological changesand innovations inC'Juencing the volume of investment. Further,according to Hayek, the sole cause for change in the volume of

investment is the change in the market rate of interest relative to theequilibrium rate of interest. A lower market rate of interest in relation

to equilibrium rate of interest induces entrepreneurs to adopt more :capital-intensivep;1ethods of production, i.e., to change thecapital-output ratio. Hayek~;however, does not mention how

investment is related to consumer demand. Further more, theimportance given to the rate of interest by Hayek as the cause ofchange in the volume of investment is also questioned. Keynes has

shown that the rate of interest is not an important factor fordetermining the' volume of investment.

Finally, critics do not accept Hayek's rcmedy. to the problem of

business cyclcs. Hayck suggests that the volume of money supplyshould be kept neutral, so that business fluctuations may be

controlled. I r moncy supply is nol nClllml, investment will be eitherencouraged (expansion of money) or cliscouraged (contraction ofmoney supply) and as a result there will be business fluctuations. This

is based on the old quantity theory of money, which does notcommand general accepta'1ce .. Moreover, a change in the volume ofinvestment is not responsible for busines's fluctuations whereas

investment financed by involuntary savings or expansion of bankcredit is to be blamed for fluctuation.

Non-monetary Over-investment Theory

Some economists like Arthur Spiethofr and D.H. Robertson have alsosubscribed to the over-investment theory but in a modified form.

Their approach is based on the assumption that Say's law of markets,which oenies the possibility of over¬production, is valid in a barter



economy but not valid to a money economy in which transactions arenot direct but indirect through money.

Spiethoff believes that over-investment is a basic cause of business

slump but this is not due to low rate of interest or to expansion ofmoney supply, as Von Hayek has asserted. According to Spiethoff,over-investment and over-production in one sector may be passed on

to others. For instance, during a business depression there is excesscapacity of durable capital goods. There will be no investment in theseor other related industries. When business recovery starts, capital

goods industries start expanding, and with that other industries thatserve capital goods industries also expand. For example, expansion of

iron and steel industry will lead to expansion of coal, mining,manganese and transportation. When these industries expand, incomewill increase and consequently demand for consumption goqds will

also increase. The upswing continues till the investment in allindustries has reached the optimum point and in certain lines ofproduction, there is even over-investment. This leads to the crash of

boom conditions.

D.H. Robertson believes that over-investment in some industries isthe result of indivisibilities and this imbalance is worsened by the

banking system, which brings in more money. In his opinion, thecourse of economic progress is not generally smooth and as a malleI'

of (act, some degree of fluctuations may be necessary. The realproblem, however, is that the desirable fluctuations may createexcessive responses creating unstable conditions in the economy.

Robertson believes that part of this excessive response is due toexistence of indivisibility in certain investments. He cites the exampleof a railway company that faced the problem of congestion on a single

tmck, wanted to go 1'01' a double track. I'll,' introduction of,i secondtrack would create excess capacity but the additlull:l1 traffic Illa)' not

he slIrticiclll 10 f,dly IItiiisc lill' secolld traele Ilo",('ver. lilc rnilll':IYcompany has 110 allcllwlivL' hut 10 inll'tlducc Ihe Sl'l'(lIHI ll'lll.'k.II\\'l'Slllll'l\IS h"il\~ lumpy in many hcavy capital-intensive industries



result in exceSs capacity. Besides such investmcnts arctime-consuming because they have long gcst<ltiull periods, i.e., timegap between the decision to undertake the project and the time

project is commissioned. Two problems are created as a result of suchinvestment. Firstly, undertaking heavy investment in excessive ofcurrent demand would lead to blockage of capital and undertaking

smaller investment that would be insufficient to meet the currentdemand. Secondly, in a competitive system, many entrepreneurs may

go in for investments with long gestation periods' that rt:sult intoover-investment, over-production and glut of goods in the market.

While over-investment and over-production ale results of

indivisibilities. they are encouraged by monetary factors. For instance,the banking system may plJCC additional volume of money at thedisposal of entrepreneurs and thus increase the already existing state

of imbalance. Increase in money supply will cause prices to rise,thereby misleading their appraisal of prospective profits. This price

rise encourages entrepreneurs to further over-investment. Thus, D.H.Robertson successfully combines real and monetary factors to explainbusiness cycks. Over¬investment theory has definite merit in the

sense that the business boom is identified by too much investment ingeneral or particular industries. TIllS IS largely true. However, the realweakness of the theory is its failure to exp~ain revival from a business

depr~ssion.

Over-Saving or Under-Consumption Theory

This is one of the earliest theories of trade cycle and has been stated

in different forms at different times. Such "Yell-known names asMalthus, Marx and Hobson are associated with this theory. Accordingto this theory, in free capitalist society rich people have large incomes

but they are unable to spend all their incomes and hence they saveautomatically. These savings are usually invested in industry and

hence they increase the volume of goods produced. At the same time,the majority of people in the country have low incomes and



consequently have low propensity to consume. Thus, consumption isnot increasing correspondingly to production. As a result, the marketis flooded with goods and will be followed bY,depression unless prices

fall to a very low level in order to allow the goods to be carried oll themarket. The fundamental idea of the under-consumption theory isbased upon the conflict, which arises from the double effect, that

saving has on consumption and production. It is the decrease in thedemand lor and the increase in t.he supply of consumer goods as a

res'jlt of saving which seems to create under-consumption andover-production.

Like all other theories of trade cycles, this theory too is not free

from defects. It does not explain complete trade cycle. It is pointed outthat the theory concentrates too much on over-saving and its relatedevils and too little on the others. It considers savings automatically

linding their way into investments while in reality this is not so. Theavailability of savings does not guide entrepreneurs in t!lt.:ir

investment policies. Thus, a mere increase in savings is insufficient toexplain occurrence of a boom.

Hawtroy's Monetary Theory

Hawtrey regards trade cycle as a purely monetary phenomenon.According to him, non-monetary factors like wars, earthquakes,strikes and crop failures may cause partial and temporary depression

in particular sectors of an economy. However, these non-monetaryfactors cannot cause full and permanent depression involving generalunemployment of the factors of production in a trade cycle. On the

other hand, changes in the flow of money are the exclusive andsufficient cause of changes in trade cycle. In Hawtrey's opinion, the

basic cause of trade cycle is the expansion and contraction of moneyin a country. According to Hawtrey, changes in the volume of moneyare brought about by changes in the rate of interest. For instance, if

banks reduce their rate of interest, producers and traders will beinduced to borrow more from banks so as to expand their business.Borrowing from banks will lead to more bank money and rise in the



price level and business activity. On the other hand, if banks raisetheir rate of interest, producers and traders will reduce theirborrowing from banks. This will reduce the price level and business

activity. Thus, in Hawtrey's analysis, changes in interest rates lead tochanges in borrowing from banks and, therefore, changes in thesupply of money. Changes in the supply of money lead to changes in

'Jusiness activity.

Trade Cycle in Just Inflation and Deflationf-Iawtrey argues that the trade cycle is nothing but small-scale replica

of an outright money inflation and deflation. The upward phase of atrade cycle, such as revival, prosperity and boom is brought about by

an expansion of money and bank credit and also by increase incirculation of money supply. On the other hand, the downward swingof money supply is nothing but a monetary denatibn.

Expansion of bank loans is made possibk by fall in rute of interest,

which induces the merchants to' increase their stocks since banksgrants loan more liberally. Therefore, merchants begin to place more

orders and increase production by employing more resources. There isgreater demand for factors of production all round and consequentlyhigher income and employment leading to further increased demand

of goods. In course of time, a cumulative upward trend is set inmotion. As the volume of business expands and factors of production

arc rendered fully employed, prices rise further and further induceupward business expansion. resulting in inflationary conditions orboom conditions. However, the boom crashes when the ba'lking

authorities suspend their policy of credit expansion.

Why the Boom Crashes Suddenly?

The banks suspend credit and call on the borrowers to return theloans, ci'ther because banks have reached the maximum point beyond

which they cannot givc any more loans or they are afraid that thephase of business expansion has reached a saturation point and hence

a downward trend may set in the immediate future. Now the sudden



suspension of credit facilities by the banks comes as a shock toentrepreneurs and merchants. Until now entrepreneurs and merchantswere enjoying liberal policy of the banks and now, contrary to their

expectations, they receive sudden notices of immediate call-back ofloans to dispose of their stocks at any price in order to repay bankloans. This general desire of businessmen to dispose of their stocks

will definitely depress the market and bring down the prices. Withevery fall in prices, the desire to dispose of the stocks as quickly as

possible wi!! lead to confusion and collapse of the market. Marginaland average fimls may even go into liq-uidation, thus worsening theposition still further and making the banks extremely nervous. Banks

will proceed to further contraction and like the period of expansion, itwill become cumulative. Producers curtail output and consumers'income and outlays decrease and contraction spirals in a downward

direction, until it touches the lowest level possible.

How the revival takes place?

When the economy is working at the level of depression, the rate of

interest is low and the bank,....: have large cash reserves. On one hand,low interest rates make it profitable to 'borrow and invest. On theother hand, large cash reserves induce banks to lend. This starts the

phase of revival, which because of its cumulative character, leads toprosperity and boom conditions. This, according to Hawtrey, the

inherently unstable nature of the modem monetary and credit systemis the mother or economic fluctuations. This monetary explanation ofthe trade cycle has received powerful support from Milton Freidman,

who says, "In every deep depression, monetary factors playa criticairole~" According to Freidman, there is a direct relation between thevolume of money supply and the level or business activity in a country.

If the money supply increases at a rate faster than the economy's realoutput of goods and services, prices will decline and the economy is

bound to contract. Thus, there is direct relation between the level ofincome and economic activity, on the one side and the volume ofmoney supply on the other. If the 'economy has to be stable, monetary



expansi9n and contraction has to be avoided.

Weaknesses of the Monetary Expansion

The weakness of monetary expansion is as follows:

Finance is the soul of commerce and trade in modern times and

the banking system plays quite an important part in financingtrade activities. However, it is correct to say that banks cause

business crises.

Hawtrey's theory would have been all right in those days when

the gold standard was universal and when the volume of moneysupply was fixed to gold reserves. Currency and credit couldexpand only when gold reserves increases. These days, gold

standard does not exist clnd, therefore, Hawtrey's theory isreally weak.

Borrowing and investment will not depend upon the rate of

interest, as Hawtrey believes. A high rate of interest will not deterpeople· from borrowing for investment, and a low rate of interest

will always induce people to borrow and invest.

Expansion and contraction of money alone cannot explainprosperity and depression.

According to Hawtrey, expansion and boon'! are the result of

expansion of bank credit, but it is pointed out that the mereexpansion of bank credit by itself cannot initiate a boom.

Further, according to Hawtrey, a depression is marked bycontraction of bank loans and advances but actually, the

contraction of bank credit is the ·result of depression. .

Lowering of interest rate and willingness of banks to - give loansand advances cannot be a -sufficient reason to stimulate the

economy to revive. Businessmen will not borrow and investunless they are convinced that the economy will definitcly I"cvivc1I11d il will he prnntllbk to bOl'rnw Hnt! invest.

In recenl years, lhe technique \It' tinlllll:ing has been changing



illlLl practically all finns, both big and small, havc becn resortingto the policy or ploughing back of profits. The conclusion, whichfollows, is that the banking system can accentuate a boom or a

depression but it cannot originate one. In other words, expansionand contraction of bank credit can be a supplementary cause butnot the main cause of trade cycles.

Keynes' Theory of Trade Cycles

Keynes never worked out a pure theory of trade cycles, though hemade significant contributions to the trade cycle theory. Keynes states,

"The trade cycle can be described and ana lysed in terms of thefluctuations of the marginal efficiency of capital relatively to the rate of

interest." According to Keynes, the level of income and employment ina capitalist economy depends upon effective demand, comprising oftotal consumption and investment expenditure. Changes in total

expenditure will imply changes in effective demand and will lead tochanges fn income and employment in the country. Therefore, in theKeynesian system fluctuations in total expt(nditure are responsible for

fluctuations in business activity. Now, according to Keynes,consumption expenditure is relatively stable, and consequently it is

the fluctuations in the volume of investment that are responsible forchanges in the level of employment, income and output.

Investment depends up0l) two factors: (a) marginal efficiency of

capital, and (b) the rate of interest. Investment is carried on up to thepoint where the marginal efficiency of capital (the profitability ofcapital) is equal to the rate of interest (i.e., the cost of borrowing

capital). Keynes argues that the rate of interest will depend upon theliquidity preference of the people in the country and the quantity of

money available. In the short period, the rate of interest will be stableand hence it is not responsible for causing cyclical fluctuations intrade cycles. According to Keynes the fluctuations in the marginal

efficiency of capital are the fundamental cause of fluctuation in tradecycles.



The following Figure 6.5 shows how trade cycle depends upon themarginal efficiency of capital, which according to Keynes, is the villainof the piece. The substance of Keynes' theory is that an initial

investment outlay will generate multiplc amount of income andemployment under the int1uence of the multiplier and accelerationeffects. On the other hand, 'co;ntraction of investment will similarly

lead to multiple contractions of incom~and employment. But whether afresh investment will be Lindertaken will depend upon the marginal

efficiency of capital. We can explain these pOint$ a little moreelaborately.

How Recovery Starts?

Let us start at the bottom of a depression. At this point, the marginal

efficiency of capital will be high due to exhaustion of accumulatedstocks and necessity to replace capital goods. At the same time, therate of interest may be low because of large cash balances with

commercial banks or due to fall in the public liquidity preference. As aresult, the entrepreneurs may borrow fu~ds from banks and make

fresh investments. Under the impact of the multiplier an<iacceleration effects, the process of increased investment andemployment gets an upward trend. There is heavy economic activity

everywhere in the primary, secondary and tertiary sectors of the



economic system. This sudden shoot in investment activity gives riseto boom and as long as it lasts, the economic situution appears veryeasy and bright.

How the Boom Crashes?

The boom conditions thcmselves contain the very seeds;of their owndestruction. Very soon goods are accumulated beyond the

expectations of entrepreneurs and competition among them todispose their accumulated stocks bring crash in prices. While theprices of finished goods are declining, their costs of production

continuously rise because factors of production are bceoming scarceand hence are commanding hi,!~her prices. The· marginal efficiency of

capital is sandwiched between rising costs of production-on the oneside and falling prices of finished goods :In the other. The marginalefficiency of capital, therefore, collapses and brings about a crash in

the investment market.

Ineffectiveness of the Rate of InterestKeynes believes that the rate of interest could have prevented the

collapse of the marginal efficiency of the capital and revives theconfidence among the entrepreneurs, by exerting its pressure toreduce cost. Uut then, the rate of interest is very high, like all other

prices and wages. The rate of interest goes up due to a rise in theliquidity preference of the people. The marginal efficiency of capital

falls below the current rate of interest and thus, the decline ofinvestment is aggravated. Keynes believes that at this stage areduction in the rate of interest is neither easy nor adequate to

restore confidence and revive investment. In Keynes' theory of tradecycles, the margina~ efficiency of capital has great significance thanthe rate of interest. In fact, it disturbs the equilibrium of the economy

and thereby causes fluctuations in the economy. The other factor thatoccupies an equally important place in Keynes theory is the

"investment multiplier". However, for the active operation ofinvestment multiplier, the cycle needs to be milder in magnitude than



what it actually is.

Weaknesses of the Keynesian AnalysisKeynes' theory of the trade cycle has been regarded as quite

convincing since it explains cbm:ctly the cumulative processes, bothin the upswing as well as in the downswing. Besides, Keynes'advocacy of fiscal policy to bring about business stability has been

widely used. However, critics have found some weaknesses in theKeynesian analysis. First, according to Keynes, marginal efficiency ofcapital is the most important factor that guides the investment

decisions of the entreprencurs. However, this important factordepends on entrepreneurs' anticipation of future prospects that

further depend upon the psychology of investors. If'. such a .case,Keynes' theory of trade cycles approaches close to Pigou'spsychological theory. Secondly, in Keynes' theory, the rate of interest

plays a minor role. Keynes expresses the opinion that sizeable fall inthe rate of interest can do something to. revive the confidence amongthe entrepreneurs by exerting pressure on the cost of production.

However, Keynes himself has pointed out that this has beensufficiently proved to be correct that the rate of interest does not

have any influence on investment. Thirdly, his theory does not throwlight on the periodicity aspect of the trade cycle.

Finally, some critics like Hazlitt have pointed out that Keynes'

concept of the rate of interest does not tally with actual marketconditions. For instance, according to Keynes, in a period of recessionand depre~sion, the rate of ir:'erest ought to be high because of

strong liquidity preference but precisely during this period, the rate ofinterest is low. Likewise during boom conditions, the rate of interest

ought to be lower because of the weak liquidity preference among thepeople instead it is high.

Hicks' Theory of Trade CyclesIn his book "A Contribution to the Theory of the Trade Cycle," Hicks



has developed a theory mainly by combining the principles of the'multipiier and acceleration, which he has borrowed from Keynes andhas combined the concepts of autonomous and induced investment, a

distinction originally made by Roy Harrod. The multiplier is related tothe autonomous investment of the Government. The accelerationprinciple is based on induced investment.

The above Figure 6.6 shows the influence of the two types ofinvestment on the level of income and cyclical fluctuations. Thehorizontal axis represents the number of years and the vertical axis

represents the level of economic activity. Line AA' represents theprogress of autonomous investment over thc years and it slantsupward at a uniform rate to indicate that autonomous investment

grows over time at a constant rate. Line EE' represents the income (oroutput) corresponding to the aUlononious investment line AA·. EE' IS

at a higher level than AI\" because it rerresents the eomhinedinnllellce of mllitiplk'r flnd flccelerrllioll effects n.~ n resultor ,lulollOlllllUS illvestl:lellt (AA '), III fact, the distallce bC1WL'Cil A/\'

lIlld EE' will depend upon the combined inlluence of the multiplier andacceleration effects. Finally, line FF' represents the level of fullemployment.

The Process of Cyclical Fluctuation



Suppose the economy is at point P in the Figure 6,6 and at this .point,a certain invention is introduced. As a result, there is burst ofautonomous investment, which may be short-lived. But the induced

investment will push output and employment upward along the pathmarked PP1, away from the EE' line. Th,e upward trend touches fullemployment ceiling at PI and cannot ~ise further. At the most, the

expansion can "creep along" the' ceiling but only for a limited time.When the path has encountered the edling, it must bounce off from it

and begin to move in a downward direction.

According to Hicks, this downward swing is predictable. Theinitial burst of autonomous investment is short-lived and after a stagc,

it will fall to the usual level. But the induced investment, which was theresult of the initial autonomous investment and the initial increase inoutput, would continue and push ahead on path PP1• But the induced

investment is not sufficient to support a growth of output along thepath FF' but it is sufficient to support an output which expands alongthe equilibrium path EE', Output, therefore, will bounce back from FF'

towards EE'.

The downward swing is gradual along the path P2RRI and rapid alongP2RR2. At first, the downward swing may appear. to be gradual but,

in practice, it will be rapid. The reason is that once the decline inoutput is initiated, it gathers momentum and tends to proceed at a

fast rdte. Hicks give a monetary explanation to this phenomenon. Asthe downward movement starts, it becomes increasingly di fficult tosell goods and consequently the burden of fixed cost becomcs

oppressive. Therefore, firm after firm becomes bankrupt andliquidity preference records a sudden and abrupt rise and reactsmost adversely on credit situation. At [he same time the stringent

conditions in the credit market, forces business activity to fall to thelowest ebb and thereby aggravate the situation. Thus, Hicks' theory

of trade cycles makes use of multiplier and acceleration principles,which are combined, to the fluctuations of autonomous and induced



investment. It is induced investment, which is finally rcsponsibleJorthe upward push and downward swing of output and income ofprices and employment.

Schumpeter's Innovations Theory

Joseph Schumpeter has propounded a trade cycle theory in terms ofinnovations. An innovation can be regarding new product or new

method of production, such as new machinery, new method oforganisation of factors of production, opening of a new market forthe product and development of new source of raw materials. In

other words, an innovation is anything that is introduced by a firm oran industry to change the supply or demand conditions. An

innovation may be sufficient to cause changes in expectations ofentrepreneurs and their economic and business calculations. Thesechanges may cause the cost of production to change rapidly and

continuously and may shift the demand curve continuously in such amanner that the final stage . becomes indeterminate. Any innovation,thus, causes disequilibrium in the economic system, making it

necessary for the economic system to readjust itself at some newequilibrium position. Thus, Schumpeter explains the un-rhythmic

movements of an economy by reference to innovations.

The Effect of Innovations

Suppose we start with an economy, which is functioning at full

employment level. Suppose an innovation in the form of a newproduct has been introduced. The new industry will need to have newplant and equipment. Since the economy is already working at full

employment level, the new plant and equipment required by the newindustry can be acquired only by withdrawing labour and otherresources from old industries. As a result of higher cost of factor of

production, the old industries will experience both an increase intheir cost of production as well as j~crease in their output. The

promoters of the new product will have to attract all f(!ctors ofproduction by offering higher rewarqs and the necessary finance



may ,:i: 'me out of additional bank loans. Since the factors ofproduction, both in the new ;tl'd the old industries, are getting highermoney remuneration therefore, they will ',~( 'nand more goods and

services and consequently will push up prices, Thus,'ill '<'::IS<:Uucmanu [or anu the simultaneous decreased supply of the old goodswill ~ It:"h upward the prices of these goods. However, it is not

necessary that the in 'case in the demand alld costs of all industriesshould nec~ssarily be equal. The i l_: industries, whose demand for

products rises more rapidly than production ~ lHS, will reap abnormalprofits and consequently will expand, To the extent the l (1',1involved in such expansion is financed by hank credit therefore. the i

d1:qi"":1r\' I'I'I":'nll'l' "11 I'rk"'l <111.1 ,'\1';1.'1 i .. : Illt\gllilkd.

The Process of Rising Prices

When the new product introduced in the mark~, becomes

commercially successful and brings in profit for promoters, the rivalcompeting firms quickly introduce similar products and imitations.The production of many competing varieties of products sets in

motion expansion in many related industries. Therefore, resulting intoa period of cumulative prosperity.

The Process of Falling Prices

The deflationary effect follows when the novelty of the innovation islost with the production of so many competing varieties or brands ofthe S3me product. Abnormal profits are competed away. Some of the

firms may even incur losses and close down their businesses, thuslayoff labour and other agents of production. Therrfore, the demandfor goods is reduced. A similar deflationary effect is experienced whcn

the innovating firms return their bank loans out of their profits andthus reduce the volume of money supply in the economy. The "vicious

circle of deflation" is generated in this manner.

Criticism

First, Schumpeter's theory is based upon two assumptions regarding



full employments of rf'sources in the economic system and financingof innovation by means of bank loans. If an economy is working belowfull employment, the introduction of an innovation need not cause

diversion of factors of production from older industries and thuscause prices of goods to go up or their supply to iecline. Again,innovation is generally financed by the promoter themselves and

hence, resort to bank .finance does not arise at all. Secondly,innovation.s may be regarded as one cause for business fluctuations

but not the only cause, as there are many other causes also. As Hayekcorrectly points out, innovations alone cannot explain thephenomenon of trade cycles without a substantive monetary

explanation. We have described man;' theories of business cycles andthere are many morc. Therefore, none of the theories provides acomplete explanation of the causes of trade cycles. The reason for this

is that the trade cycle is not the result of anyone single factor but isdue to multiplicity of factors, of which sometimes one and sometimes

another becomes dominant.

Control of Trade Cycles

Thc trade cycle, which implies fluctuations in business activity, is not

beneficial to allY seetioll of a community. The period of expansion isaccompanied by large profits to producers and speculators but itbrings loss to lixcd income groups. The period of depression is one of

acute unemployment, poverty, suffering and misery to the poor and ofdistress to the busin(;ss dass(;s as a .result of exlensive hlltlk lIlIdfirms failures. Thus all sections of people in a country, especially the

working classes, are interested in preventing and avoid ing busihesscycles .. On/ of the 1110st important objectives of economic policy is

the elimination of cyclical fluctuations and attainment of stability atthe level of full employment. This has been, in fact, the main objectiveof both monetary and fiscal policies. We have already explained the

use of monetary policy and fiscal policy as wel'l as direct control, tocheck inflations and deflations.



There is no full proof method for solving the problem of tradecycles.

Karl Marx considered trade cycles as inevitable in a capitalist system

and the only rational method to solve the problem was to throw itoverboard and introduce a socialist economy. Like every business firmprepares its annual balance sheet of transactions with a view to know

its assets and liabilities, every nation carrying out economictransactions with foreign countries prepares its Balance of Payment

(BOP) Accounts periodically with a view to know stock of its assets andliabilities and its receipts from and payments to the rest of the world.

THE BALANCE OF PAYMENT

Definition

The balance of paYlllent is defined as a systematic record of alleconomic transactions between the residents of a country and

reside~ts of foreign countries during a certain period of time.Although the above definition of balance of payments is quiterevealing certain terms used in the definition may require some

clarification. The term's systematic record does not refer to anyparticular system. However, the system generally adopted is doubleentry book-keeping system. Economic transactions include all such

transactions that involve the transfer of title or ownership. While sometransactions involve physical transfer of goods, services, assets and

money along with the transfer of tille while other transactions do notinvolve transfer of title. For example, suppose that a subsidiarycompany of a foreign undertaking is operating in India and 'making

profit. This company may pay all its profits as dividend to theshareholders abroad, or it may, alterilatively reinvest its profit in Indiainstead of paying dividends to its parent company abroad. Both kinds

of transactions arc recorded in the balance of payments accounts. Thetrnnsl'l'I' 01' titk is important thlln lht: physi,l:l\llrl\nstl~r or

rCSlHlr\:cs. The term residcnts rcfcr to 'the nationals of thc rcportingcountry, Tourists. diplllllll\t~;, IIlililmy I'cr:lllllllcl, 11'llIlHlmry "lid



llligrnllll)' IVllrl\l\I',~ 111111 Iii,' "n,,"·I,,'n of foreign companiesoperating in the reporting clHllltr)' do not rail in till' category orresidents, Thc timc period for balance of payments is not speci fically

delincd. it can be of any period, The generally period is one financialyear of calendar.

Purpose

The balance of payment serves a very useful purpose as it yieldsnecessary information for the future policy formulation in regard todomestic monetary and fiscal pulicies and foreign trade policy.

Following are the important uses of balance of payments:

It provides useful data for the economic analysis of country'sweakness and strength as a partner in the international trade.

By comparing the statements contained in the balance ofpayments for several successive years, one can find out whetherinternational economic position of the country is improving or

deteriorating. In case it is deteriorating, necessary correctivemeasures can be taken.

It reveals the changes in the composition and magnitude of

foreign trade. The changes that curb ~conomic well-being of acountry are taken care by the government.

It also pwvides indications of future repercussions based on

countries past trade performances. I f balance of paymentsshows continuous and large deficits over time then it indicates

growing international indebtedness, which ultimately leads tofinancial bankruptcy. Similarly. a continuous large-scalc surplusin the balance of payments, particularly wht:n its magnitude

goes beyond the absorption capacity of the country indicatesimpending dangers of inflation.

Detailed balance of payments accounts also reveal weak and

strong points in the country's foreign trade rdationsund thereby



invite gove.-I1ll1cnt attention to the need for correctivemeasures against the weak spots.

Balance of Payments Accounts

The economic transactions between a country and the rest oCthe

world may be grouped under two broad categories:

1. Current transactions: Current transactions pertain to export andimport of goods and services that change the current level of

consumption in the country or bring a change in the currentlevel of national income.

2. Capital transactions: Capital transactions arc those transactions,

which increase or decrease counlry's Iota I stock of capital,instead of affecting the current level of consumption or national

income. In other words, current transactions arc flowtransactions. In accordance with the two kinds of transactions,balance of payments account is divided into two major accounts:

A. Current accountB. Capital accounts

Current Account

The items, which are entered in the current account of balance ofpayments, are listed in the Table. 6.4 -in the order of their importance.

The categories of items presented in the table were published by theIMf and are currently followed in India. In the 'credit' column valuesreceivable are entered and in 'debt' column values payable ar.e entered.

The net balance shows the excess of credit over the debit for eachitem, can be negative (-) or positive (+). The items listed in currentaccount can be further grouped into visible and invisible items.

Merchandise trade, i.e:, export and imports of goods, fall under thevisible items. Rest all other items in the current account-payment and

receipt for the services, such as banking, insurance and shipping aretermed as invisible. Sometimes another category, i.e., un-requiredtransfer, is created to give a separate treatment to the items like gifts,



donations, military aid, and technical assistance. These are differentfrom other invisible items since they involve unilateral transfers.

The net balance on the visible items, i.e., the excess of

merchandise exports (Xg) over the merchandise imports (Mg) is calledas balance of trade. If Xg < Mg it is unfavourable. The overall balanceon the Current Account is known as 'Balance on Current Account.' The

'Balance on the Current Account' either surplus or deficit is carriedover to the Capital Account.

. Table 6.4: Balance of Pa}'ments Current Account

Transactions Credit Debit Net BalanceI. Merchandise Export. Import -

2. Foreign travel Earnings Payments -

3. Transportation Earnings Payments -

4. Insurance Receipts Payments -(premium)

5. Investment Dividend Dividends -Income

6. Government Receipts Payments -Cr;:rchase andsales of goodsand services)

7. Miscellaneous* Receipts Payments -

Current Account - Payments Surplus (+)Balance Deficit (-)

* Includes motion picture royalties, telephones and telegraphservices, consultancy fees, etc.

Capital Account

As mentioned earlier, the items entered in the capital account ofbalance of payments are those items, which affect the existing stock of

capital of the country. The broad categories of capital account itemsare: (a) short-term capital movements; (b) long-term capitalmovements; and (c) changes in the gold and exchange reserves.

Short-term capital movements include (i) purchase of short¬term



securities such as treasury. bills, commercial bills and acceptance bills,etc.; (ii) speculative purchase of foreign currency; and (iii) cashbalances held by foreigners for suchfeasons as fear of war and political

instability. An item of short-term capital results often from the netbalances (positive or negative) in the Cljrrent Account. Long-termcapital movements include: (i) direct investment in shares, bonds, real

estate and physical assets such as plant, building and equipments, inwhich investors hold a controlling power; (ii) portfolio investments

including all other stocks and bonds such as government securities,securities of firms which do not entitle the holder with a controllingpower; and (iii) amortisation of capital, i.e., repurchase and resale of

securities carlier sold to or purchased from the foreigners. Directexport or import of capital goods fall under the category of directinvestment. It should be noted that export of capital is a debit item

whereas export of merchandise is a credit item. Export of goods resultin inflow of foreign currency, which is an addition to the circular flow

of money income, whereas export of capital results in outflow offoreign exchange which, amounts to withdrawal from the foreignexchange reserves. Geld and foreign exchange reserves make the third

major category of items in the capital account. Gofd and foreignexchange reserves are maintained to stabilise the exchange rate of thehome currency and to make payments to the creditors in case there

exists payment deficits on all other accounts.

Balance of Payments is always in BalancesThe balance of payments accounting is based on the double-entry

book-keeping system in which both sides of a transaction, i.e.,receipts and payments are recorded. For example, exports involve

outtlow of goods and inflow of foreign currency. Similarly, imports involve inflo\\ of goods and outflow of foreign currency. Both, inflowand outflow are recorded in this system. International borrowing and

lending give rise to credit to the lender and debit to the borrower.Both are recorded in the balance of paymcnts. However, donations,gifts, aids and assistance are unilateral transfers and do not involve



transfer of an equivalent value. In regard to these items, there is onlycredit and no debit since they are non¬refundable. Yet, the receivingcountry is debited to keep the record of non¬refundable amounts and

donator is credited for the record purposes. Such entries haveinformation value for non-economic purposes. Besides, thesetransactions reduce the deficit in the current account of the reporting

country. Since in this system of balance of payments accountinginternational transactions are entered on both debit and credit sides.

Balance of payments always balances from the accounting point ofview.

Disequilibrium in Balance of Payments

We have noted above that the balance-of payments is always inbalances from accounting point of view. Besides, in the accountingprocedure, a deficit in the current account is offset by a surplus in

capital account resulting from either borrowing from abroad orrunning down the gold and foreign exchange reserves.

Similarly, a surplus in the current account is 011set by 1I

mlltdling Jl'licit in capital account resulting from loans llnd gills todebtor country or by dcpklion (),' its gold and foreign exchange

reserves. In this sense also. lhe '11,lIallce (!I JlllYIJl!:lltS' 1IlwlI)'srcnlllills In hllllllll:C:. As :.udl. tbert' slllluid hc 1I11 qUC.Slll)11 1\1disequilibrium in the balance of payments. However, disequilibrium

in lhe balall!:l: of payments does arise because total receipts duringthe reference pl:riod need 1I0t be necessarily equal to the totalpayments. When total receipts do not m<lleh with total payment of

the accounting period, this is a position of disequilibrium in thebalance of payments. The final balance of payments position is

obtained in the manner described below.

For assessing the over-all balance of payments position, the totalreceipt and total payments arising out of transfer of goods and

services and long-run capital ' movements are taken into account. Allthe transactions are regrouped into autonomous and induced



transactions. Autonomous transactions take place on their own allaccount of people's desire to consumc morl: or to makc a larger profit.For example, export and imports of items in current account are

undcrtaken with a view to, make profit or consume more goods.Another autonomous item in the current account is gift or donations.They are voluntary and deliberate. In the capital account, export and

import of long-term capital are autonomous transactions. In addition,the short-term capital movements motivated by the desire

to invest abroad for higher return fall in the category of autonomous

transactions. Thus. all exports and imports of goods and services,long-term and short-term capital movements motivated by the desire

to earn higher returns abroad or to give

gi fts and donation are the autonomous transactions. Exports andimports take place irrespective of other trans~ctions included in thebalance of payments accounts. !-!ence, these are autonomous

transactions. If exports (Xg) equal imports (Mg) in value, there will beno other transaction. However, if Xg is less than Mg, it leads

to short-run capital movements, e.g., international borrowing or

lending. Such international borrowings or lending are not undertakenfor their own sake, but for making payment for the deficit in the

balance of trade. Hence, these are called induced transactions. Theyinvolve accommodating capital flows.

On the other hand, the short-term capital movemcnt's viz., gold

movemenls it and accommodating capital movements on accounts ofthc autonomous transactions are induced transactions. Thesetransactions lead to reduction in the <, gold and foreign exchange

reserves of the country.

In the assessment of balance of payments position only autonomous

transactions are taken into account. The total receipt and paymentsresulting from the autonomous transaction determine the deficit orsurplus in the balance of payments. I f total receipts and payments arc

unequal, the balance of payments is in disequilibrium. I I' the totalpayments exceed the lotal receipts, the balance or payment shows



deficit. On the contrary, if receipts from autonomous transactionsexceed the payments for autonomous transactions, the balance ofpayments is in surplus. Naturally, if both are equal, there is neither

deficit nor surplus, and the balance of payments is i~1 equilibrium.From the policy point of view, the depletion in the gold and foreignexchange reserves is generally taken as an indicator of balance of

payments running into deficit, which is a matter of concern for thegovernment. However, if reserves are plentiful and the government

has adopted a deliberate policy to run it down, then the deficit in thebalance of payments is not an in he?lthy sign for the economy. Besides,the disequilibrium of surplus nature except the one that might cause

inf1ation is not a serious matter as the disequilibrium of deficit nature.We will be therefore, concerned here mainly with the deficit kind ofdisequilibrium in the balance of payments.

Causes and Kinds of BOP DisequilibriumThe deficit kind of disequilibrium in the balance of payments arises

when a country's autonomous payments exceed its autonomousreceipts. The autonomous payments arise out of imports of goods andservices and export of capital. Similarly, autonomous receipts result

from the merchandise exports and import of capital. It may thereforebe said that disequilibrium of deficit nature arises when total importsexceed total exports. However, imports and exports do not determine

themselves. The volume and value of imports and exports aredetermined by a host of other factors. As regards the determinants of

imports, the total import of country depends upon three factor: (i)internal demand for foreign goods, which largely depends on the totalpurchasing power of the residents of the importing country, (ii) the

prices of imports and their domestic substitutes, and (iii) people'spreference for foreign goods. Similarly, the total export of a countrydepends on (i) foreign demand for its goods and services, (ii)

competitiveness of its price and quality, and (iii) exportable surplus.

Under static conditions, these factors remain constant. Therefore,

equilibrium in the balance of payments, once achieved, remains stable.



However, under dynamic conditions, factors that determine importsand exports keep changing, sometimes gradually but often violentlyand unexpectedly. The changes differ in their duration and intensity

from country to country and from time to time. The changes, whichoccur as a result of disturbances ,in the domestic economy and abroad,create conditions for dis-equilibrium in the balance of payment.

Causes of Disequilibrium and the Associated Nature of

Imbalances

Price Changes and Disequilibrium: The first and the major cause

of dis¬equilibrium in the balance of payment is the change inthe price level. Price changes may be inflationary or deflationary.

Deflation normally causes surplus in the balance of payment.The balance of payments surplus does no! cause a seriousconcern from the country's point of view. It may, however lead

to wasteful expenditure and mal-allocation of resources. On heC1ther hand, inflrtionary changes in prices causes deficits in the

balance of payments. The balance of payments deficit result inincreased indebtedness, depletion of gold reserves. loss ofemployment. and disfort:ons in the domestic economy and

causes other economic problems in the deficit countries.Therefore, we will discuss only the impact of inflationary pricechanges on the balance of payments position.

Inflation causes a change in the relative prices of imports andexports. While exchange rate remains same, inflation causesincrease in imports because domestic prices become relatively

higher than the impo;L prices. On the other hand, inflation leadsto decrease in exports because of decrease in foreign demanddue to increase in domestic prices. The increase in imports

depends also 011 price-elasticity of demand for imports in thehome market and decrease in the exports depends on the

price-elasticity of foreign demand for home-products. In caseprice-elasticity of imports and exports is not equal to zero,



imports are bound to exceed the exports. As a result, there willbe a deficit in the balance of payments. If inflationary conditionsperpetuate, it will produce long-run disequilibrium. If the size of

deficit is large and disequilibrium is inflexible, it is termed as afundamental disequjJibrium. The price changes or fluctuationsmay be local, confined to one or few countries or it may be

global as it happened in the ec:(/y 1930s. If price fluctuationstake the form of business cycle, most countries face depression

and inflation almost simultaneously. Since economic size of thenations differs, their imports are affected in varying degrees.Deficits and surpluses in the balance of payment vary from

moderate to large. The countries with higher marginalpropensity to import accumulate larger deficits duringinflationary phase of trade cycle and a moderate deficit or even

surplus, during depression. Such disequilibrium is known as;;'cyclical disequilibrium. This is however only a theoretical

possibility. Since little is known about the marginal propensitiesto import, any generalisation would be unwise.

Structural Changes and Dis-equilihriull1: Structural changes, in

an

economy arc caused by factors, such liS, (i) depletion orthecheap natural resources (ii) change in technology with which a

country is 110t in a position to keep pace, i.e., technology lagand, (iii) change ill consulllers' !lIsle IInd preference. Suchchanges incapacitate exporting countries and they lind it

difficult ,10 face competition in the intnnational market, duetoeither high cost of production or lack of foreign demand. To

quote the examples from P.T. ,Ellsworth the gradual exhaustionof better coal in Great Britain resulted' in increased cost of coalproduction despi!e improvement in technology. This factor

combined with labour problem converted Great Britain from anet coal-exporting nation to a net-importing one.

All such changes bring change in demand and supply conditions.



If size of foreign trade is fairly large, then the balance ofpayments is adversely affected. The ultimate result isdisequilibrium in the balance of paym~nts. It is called structural

disequilibrium. The structural disequilibrium may also originatefrom thc discovery of new resources, which may invite foreigncapital in a large measure. The large-scale capital inflow may

turn th~ balance of payments deficit into a surplus.

Other Factors: In addition to the fundamental factorsresponsible for disequilibrium in the balance of payments, there

are certain other factors, which may cause temporaldisequilibrium, Some of them are as follows:

Disturbances or crop failure particularly in the countries,

producing primary goods, for examplc, India.

Rapid growth in population leading to large-scale imports offood materials.

Ambitious developmen! projects requiring heavy imports of

technology, equipmenCs,machinery and technical know-how.

Demonstration-effect of advanced countries on the

consumption patternof less developed countries.

Balance of Payments Adjustments

The short-term and small deficits in the balance of payments are quitelikely to cmcrge in wide range of international transactions. Thesecleficits do not call for immediate corrective actions. More importantly,

irregular short-term changes in the domestic economic policies with aview toremove the short-term deficit in the balance of payments may

do morc harms than good to the economy. Since these changes causedislocations in the process of reallocation of resour'ces and short-Icrm lluctUlItiolls in the cconomy, Therefore, short-term del1dts of

snHllkr magnitude :lrc ,not II Ill:ltler or serious COlleCI'll I'or thepolicy-nlllkers. 11()\\'rn·l. const:lllt delicil or 1:l1'p.('1' 111:1p"llillllkh:,,~ n wide 1':1111<1' or I'ClII\(lInie nlld 11Itlili.'nl implil:alions, i\



constant delicil indicates country turning inlo an l'tl'I'I\III h(\I'I'\I\I ,'( ordepiction of' its lim:ign exchange lint! gold resnves. These countrieslos~ till'ir international liquidity and credibility. This situation often

leads to compromiSe with economic and political independence ofthese countries. India faced a similar situation in July 1990. Therefore,a country facing constant large deficits in ih balance of payments is

forced to adopt corrective measures, such as changes in its internaleconomic policies for wiping out the deficits, or at leasl to bring it l(l

•• manageable size. It is a widely accepted view that the conditionsfor an automatic corrcctive mcchanism visualised under gold standard,bascd on international price¬mechanism do not exist. Therefore, the

government has no option but to intervene . ~ with the marketconditions of demand and supply with the policy measures available (0them. It should be borne in mind that policy-mix in this regard may

vary from country to country and from time to time depending on theprevailing economic conditions.

Measures used to Correct Deficits in Balance of Payments

The various measures used to correct deficits in balance ofpayments are as follows:

Indirect measures to correct adverse BOP: Under free trade

system, the deficits in the balance of payments arise either dueto greater aggregate domestic demand for goods and services

than the total domestic supply of goods and services or domesticprices are significantly higher than the foreign prices. Thus, the

deficit may be removed either by increasing domestic productionat an internationally comparable cost of production or byreducing excess demand orby using the two methods

simultaneously. It may be very difficult to increase the output inthe short-run, specially when a country is close tofull-employment or when there ~re other limiting factors to its

industrial growth. Thcrcforl.:, thl.: only way to rcducl.: ddicil is Ito reduce the demand for foreign goods.



Income and Expenditure Policies: Here we discuss how reduction

in . income can lead to reduction in demand and how it helpsreducing the deficit in the balance of payments. The t'.vo policy

tools to change disposable income are monetary llnd fiscalpolicies. Monetary policy operates on the demand for and supplyof money while fiscal policy operates on the disppsable income

of the people. The working and efficacy on these policies asi,nstruments of solving balance of payment problem is

described below.

Monetary Policy

The instruments of mon~tary policy include discount 01" bank rate

policy, open market operations, statutory reserve ratios and selectivecredit controls. Of these, first two instruments are adopted in thecontext of balance of payment policy. This however should not mean

that other instruments are not relevant. The government is free tochoose any or all of these instruments amI adopt them simultttneously.

To solve the problem of deficit in the balance of payments, a 'tightmaney policy' or 'dear money.p6Iicy' is ,idoptl:d. Under 'dear money'policy, central Ilwlll:lar'y Clulil()ritics raise "[ilc discount rate.

Consequently, under nonna1 conditions, the demand 'for institutionalfunds for investment decreases. With the fall in investment andthrough its multiplier effect, income of the people decreases. lf

lnarginal propensity to consume is greater than zero, demand forgoods and services decreases. The decrease in demand also implies a

simultaneous decrease in imports while other things remain same.This is how 'a tight money policy' corrects deficit in balance ofpayments.

The effcacy of 'tig:,t money policy' is however doubtful underfollowing conditions: (i) when rates of returns are much higher thanthe increased bank rate due to inflationary conditions, (ii) when

investors have already affected their investment in anticipation ofincrease in the rate of interest. The tight money policy is then



combined with open market operation, i.e., sale of government bondsand securities. These two instruments together help to reduce demandfor capital and other goods. Therefore, if all goes well then the deficit

in the balance of payments is bound to decrease.

Fiscal Policy

Fiscal policy as a tool of income regulation includes vanatlon in

taxation and public expenditure. Taxation reduces householddisposable income. Direct taxes directly transfer the houseilOldincome to the public reserves while indirectlaxes serve the same

purpose through increased prices of the taxed commodities. Directtaxes reduce personal savings directly in a greater amount while

indirect taxe~ do it in a relatively smaller amount. Taxation reducesthe disposable income ofthe household and thereby the aggregatedemand including the demand for imports. Taxation also helps to

curtail investment by taxing capital at progressive rates.

The g~veinmeht can reduce income and demand also by adoptingthe policy of surplus budgding in which the government keeps its

expenditure less than its revenue. Ll'~:>tion reduces disposableincome of household and public expenditure increases household's

income and their purchasing power. However, multiplier effect ofpublic expenditure is greater by one than the multiolier effect oftaxation. Therefore, while adopting surplus-budget policy due

consideration should be given to this fact. To account for this fact, itis necessary that surplus is so largi.: that the total cumulative effectof taxati?n on disposable income exceeds the effect of public

expenditure. The reduction in income that will be necessary toachieve a certain given target of reducinG balance of payments deficit

depends on the rate foreign trade multiplier. .

Exchange Depreciation and Devaluation

Reducing 'excess demand through price measures involves changing

relative prices of imports and exports. Relati';e prices of imports andexports can be changed through exchange depreciation and



devaluation. Exchange depreciation refers to fall in the value of homecurrency in terms of foreign currency and devaluation refers to fall inthe value of home currency in terms of gold. However, ill terms of

purchasing power, parity between devaluation and depreciation turnsout to be the same and its impact on foreign demand is also the same.Therefore, we shall consider them as one in their role of correcting

adverse balance of payments.Devaluation and exchange depreciation change the relative prices

of imports and exports, i.e., import prices increase and export pricesdecrease, though not necessarily in the proportion of devaluation. Asa result of change in relative prices of exports and imports, the

demand for imports decreases in the country, which devalues itscurrency and foreign demand for its goods increases provided foreigndemand for imports is price elastic. Thus, if devaluation or exchange

depreciation is· effective, imports will decrease and exports willincrease. Country's payments for imports would decrease and export

earnings would increase. This ultimately decreases the deficits in thebalance of payments in due course of time. However, whetherexpected results of devaluation or exchange depreciation are

achieved or not depends on the following condition5.

The most important condition in this regard is the

Marshall-Lerner conditidh. The Marshall-Lerner condition statesthat devaluation will . improve the balance of payments only if thesum of elasticises of home demand for imports and foreign

demand for exports is greater than unity. If (he sum of elasticisesis less than unity, the balance of payments can be improvedthrough revaluation instead of devaluation.

Devaluation can be successful only if the alTectcd countries donol devalue their currency in retaliation.

Devaluation must not change the cost-price structure in favour of

imports.

Finally, the government ensures that inflation. which may be the

result of deyaluation, is kept undcr control, so that the effect of



devaluatibn is not counter-balanced by the effect of inflation.

Direct Measure: Exchange Control

The exchange control refers to a set of restrictions imposed on the

international transactions and payments, by the government or theexchange cotHrol authority. Exchange control may be partial, confinedto only few kinds of transactions or payments, or total covering all

kinds of international transactions depending on the requirement ofthe country.The main features of a full-fledged exchange control system are as

follows:

The government acquires, through the legislative measures, a

Complete domination over the foreign exchange transactions.

The government monopolises the purchase and sale offoreign

exchange.

Law el iminates the sale and purchase of foreign exchange by

theresid~nt individuals. Even holding foreign exchange withoutinforming the exchange control authority ;s declared illegal.

All payments to the foreigners and receipts from them are

routedthrough the exchange control authority or the authorised

agents.

Foreign exchange payments arc restricted, generally, to the

import

of essential goods and service such as food items, rawmaterials, other essential industrial inputs likepetroleum products.

A system of rationing is adopted in the foreign exchangeallocation

for essential imports.

To ensure the effectiveness of the exchange control system



and to

prevent the possible evasion, strict, stringent laws like FERA

and/COFEPOSA in India arc enactec.

The circuitous legal procedure of acquiring import amI export

licences is brought in force. In the process, the convertibilityof the

home-currency is sacri ficed.

Why Exchange Control?

The cxchange' control systcm as a mcasurc of' adjusting adversehalance 01 plIYlllcnl diffcrs I'IldiclIlly (hllil lhe Indirect elHTt'di\'l'

nll'IISlIrl'·S. Wllik till" 1"lkl works through the markct forccs, thefonncr works through a cOlllrol lIIechanism based on adhoc rules

and regulations. In contrast to the self-sustained and automaticfunctioning of the market system, the exchange control requires acumbersome bureaucratic system of checks and controls. Yet, many

countries facing balance of payment deficits opt for exchangecontrol for lack of options. In fact, automatic adjustment in the

balance of payments requires the existence 0 I' thc followingconditions.

International competitive strength of the deficit countries.

A fairly high elasticity of demand for imports.

Perfectly competitive international market mechanism.

Absence of government intervention with the demand and

supplyconditions. .

The existence of these conditions has always been doubted.Owing to differences in resource endowments technology, and thelevel of industrial growth, countries differ in their economic strength

and their industries lack the competitiveness. The protectionistpolicies adopted by various countries intervene with internationalmarket mechanism. Besides, automatic method of balance of

payments adjustment requires a strict discipline, economic strength



and political will to bear the destabilising shocks which theautomatic method is expected to bring to a country in the process ofadjustment. Since these conditions rarely exist, the efficacy of

internati'onal market mechUl1ism to bring automatic balance ofpayments adjustment is orten doubted.

For these reasons, exchange control remains the last resort for the

countries under severe str<lin of balancc or payments dclicits. Thee:-:ch:\llge contn)1 is qid to possess a superior effectiveness in

providing solutions to the deficit problem. Besides, it insulates aneconomy against thc impact of eeonOl'nir. nlleluOItioliS i'1' "~I foreigncountries. Another positive advantage or exchange control lies II' \lS

cfrcctivcness in dealing with the problem or capital movements. ThegovernlllCnl'S I monopoly over the roreign exchange can eflectivelystop or reduce the eapit:li t"i movements by simply refusing to release

foreign exchange for capital transrcr. Many countries, i.e., Germany,Denmark and Argentina, adopted exchange control during 1930s

because of this advantage. Although the exchange control is positivelya superior method of dealing with disequilibrium in th~ balance ofpayments, it docs not pro' -ide a perman<.:nt solution to the basic cau~es of

deficit problem.

Exchange control may no doubt provide solution to balance of paymentdeficits, but it also creates following problems:

When restrictions on exchange control becomes wide spread then large

number of currencies are rendered inconvertible. This restricts foreigntrade and the gains from foreign 1rade are either lost or reduced to a

minimum.

Even after the interest of an economy is secured, i.e., external deficit is

rCll1ov<.:d and insulation of e<.:onomy against external influence iscomplete; the exchange-control countries instead of giving up exchangecontrol feel lITe to gear their int<.:rnal policks, monetary and fiscal,

towards the promotion of economic growth, a<.:hieving full employmentand its maintenance. In doing so, they adopt easy monetary and



promotional fiscal policies. Consequently, income and prices tend to rise,and inflationary trend is set in the economy.

Price also tends to rise, since in an insulted economy, import-competing

industries are not under compulsion to check cost increases and toimprove efficiency. As a result, exports become relatively costlier andimports relatively cheaper and hence, exports tend to shrink and imports

tend to expand. These are the first outcome of overvaluation ofhome-currency. The balance of payments is no doubt maintained inequilibrium, but the init.ial advantage gradually disappears.

The countries confronted with the problems arising out of exchangecontrol ,II'C forced to find new outlets for their exports and new sources of

imports. The dTorts in this direction give rise to bilateral trade· agreementsbetween the countries having common interest. The basic feature of thebilateral trade ;Igreements is to accept each other's inconvertible currency for

exports and use the same Jor imports. Under the trade agreements, thecommodities and their quan~ilt'es or values should I also be specified.

Another outcome of exchange contr leading to bilateral trade agreement is theemergence of disorderly cross cxcl ,anl',1.: r[lte~, i.e., the multiplicity ofinconsistent exchange rates. In other words, i .. IlIhl(;rii~)1<; currencies have

different exchange ratep betweeI: them. -

''l(in'illeonvertible currency has different exchange relation with thecountries .. ~ p,\ty to the bilateral trade agreement therefore, exchange rates

are not consis fent with each other. The multiplicity of inconsistent exchangerates occom;;;s inevitable when countries having trade surplus and deficits fixup official r;llt's frnlll timc to time dq1l'ndin!-,- nn their requirelllents ,ll1d

1ll,Iintain it through arbitrary rules. Exchange rates beconie multiple alsobecause 'exchange arbitrage', i.e., the simultaneous purchase and saleof exchange in di fferent markets, becomes impossible.

Under the multiple exchange rate system, there may be a dualexchange rate policy. In dual exchange rate policy, there is an official

rate for permissible private transactions and official transactions and amarket rate for all other kinds of transactions. However, the multipleexchange rate system has its own shortcomings .. The system adds



complexity and uncertainty to international transactions. Besides, itrequires efficient and honest administrative machinery in the absenceof which it often leads to inefficient use of resources. It is, therefore,

desirable for the deficit countries to first evaluate the consequence:>,efficacy and pract'::ability of exchanre control and then decide on thecourse of action. It has been suggested that exchange control, if

adopted, should be moderate and as temporary measure until thebasic solution to the problems of balance of payments deficit is

obtaired. The exchange control problem does not provide permanentsolution to the balance-of-payments deficit and therefore, it shouldbe adopted only with proper understanding.

REVIEW QUESTIONSI. What is the relevance of national income statistics in businessdecisions?

2. What kinds of business decisions are influenced by the changein national income?

3. Describe the various methods of measuring national income.

How is a method chosen for measurfng national income?4. Distinguish between net-product method and factor-incomemethod.

Which of these methods is followed in India?

5. What is value-added? Explain the value-added method of

estimating national income.

6. Define inflation. Explain its effect on (a) total output, and (b)distribution of income between, different economic classes.

7. What are the causes of price inflation? Is it inevitable in thecourse of economic developm.ent?

8. What is an inflationary gap? Explain methods used to close this

gap.

9. Distinguish clearly between demand-pull, cost-push andsectoral infl~ltion.

10."Inflation is unjust and in~quitable and deflation is



inexpedient." Discuss this statement fully.11.What is meant by a trade cycle? Describe carefully the di fTcrcntphuses of a trade cycle.

12: Distinguish trade cycles from other economic fluctuations.What, in your opinion; is the most adequate explanation of atrade cycle?

13.Describe the various phases of the trade cycle. What coursescan the Government ~dopt to control a boom?

14."T,he business cycle is purely a monetary phenomenon." ~iscuss.

15.Discuss the view that innovations alone cannot explain thephenomenon of trade cycles without a substantial monetary

explanation.16.Define balance of payments. If balances of payments alwaysbalance, how is the deficit or surplus in balance of payments

known?17.What are the causes of different kinds of disequilibrium in thebalance of payments? Suggest measure to correct an adverse

balance of payments.18.What is the purpose of exchange control? Examine the efficacy

of exchange control as a measure to correct adverse balance ofpayments.

19.What is meant by devaluation? What are the conditions for its

effectiveness as a corrective measure of un favourable balanceof payments?

20.What is the difference hetween balance of trade and balance of

payment?



QUESTION PAPERPaper 1.3: MANAGIRIAL ECONOMICS

Time: 3 Hours Max. MaSECTION~A

(5 x 8 = 40)

Answer any Five questions

Note: All questions carry equal marks

1. What is Managerial Ecor.omics? How does it differ fromtraditional ece

2.Give short note on "Demand Analysis".3.Explain the relationship between marginal cost, average cost, and

tot4.What are the main features of pure competition? How does anorganisatil

its policies to a purely competitive situation?5.Distinguish between the Pure Profit and opportunity Cost.

6.What is meant by Price discrimination? What are its objectives?7.What is the difference between balance of trade and balanceofpaymCi

8.What is value-added? Explain the value-added method ofestimating Income.



SECTION -B

(4 x 15 = 60)

Answer any Four questions

9.Discuss some of the important economic concepts and

techniques busines~. management.10.What are the advantages and limitations of large-scale

production', II. Distinguish between 'Production function' andCost filllc{ion', I iow \' dcvclop tllC production fUllction? Whlltun:its uscs'!.

12.Explain the first and second order conditions of profitmaximization

13.Explain the effects of government interve.ntion in price fixation.

WI necessary to make this intervention effective?14."The Business Cycle is purely a monetary, phenomenon." Discuss.

15.Define Inflation. Explain its effect on(a) Total output(b) Distribution of income between, different economic classes.

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Managerial economics book

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