MANAGERIAL ECONOMICS

COURSE: B.COM

FIRST YEAR

1
 Managerial Economics

Unit 1:

Meaning, nature and scope of Managerial Economics, Managerial

Economics and Micro-economics, Managerial Economics and Macro-
economics, Applications of Economics in Managerial decisions making.

Unit 2:

Proprietary Firms, Partnership Firms, Joint Stock Companies, Public Sector

Undertakings, Cooperative Societies, Non-profit Organizations, Business
Organizations in New Millennium, Organizational Goals, Profit
Maximization, Sales Maximization, Satisfying Theory, Enhancing value of
the firm and its goals.

Unit 3:

Determinants of Market Demand, Law of.-Demand, Elasticity of Demand,

Measurement and its use, Demand Forecasting, Techniques of Demand
Forecasting.

Unit 4:

Meaning of Production Function, Law of variable proportions, Law of

Supply and Elasticity of Supply, Costs and Cost Functions, Short Terms
Costs and their use in decision making, Determinants of costs, Break Even
Analysis, Cost Forecasting.

Unit 5:

Pricing decisions under different market forms like perfect competition,

monopoly, oligopoly, Pricing Methods, Pricing in Public Sector Undertakings
and Cooperative Societies.

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 Unit 6:
Private Vs Public Goods, Government investment, Overall resource
allocation, Steps in cost benefit analysis, Justification for the use of cost
benefit analysis.

Unit 7:

Need for Government intervention in the market, Price Controls , Support

Prices And Administered Prices , Prevention and control of monopoly,
Protection of Consumers' interest, Economic Liberalization Process of
disinvestments , Need And methods, Policy planning as a guide to overall
business development

Unit 8:

Concepts and various methods of its measurement, Inflation, types and

causes, Business Cycle, Profit concept and major theories of profits;
Dynamic Surplus theory, Risk & Uncertainty bearing theory and
Innovation theory.

Reference
1. S. Sankaran - Business Economics – Margam Publications
2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand &
Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

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BLOCK 1

UNIT 1: Economics An Overview

UNIT 2: Micro-Macro Economics

UNIT 3: Business Economics

UNIT 4: Managerial Economics in other Applications

BLOCK 2

UNIT 5: Forms of Business Organisations

BLOCK 3

UNIT 6: Demand

UNIT 7: Law of demand

UNIT 8: Elasticity of Demand

UNIT 9: Demand Forecasting

BLOCK 4

UNIT 10: Production Analysis

UNIT 11: Law of Production

UNIT 12: Cost Concepts

UNIT 13: Cost Output Relations

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BLOCK 5

UNIT 14: Basics of Market Structure

UNIT 15: Perfect Competition

UNIT 16: Monopoly and Monopolistic Competition

UNIT 17: Duopoly & Oligopoly

UNIT 18: Pricing Policy

UNIT 19: Capital Budgeting

BLOCK 6

UNIT 20: Cost- Benefit Analysis

BLOCK 7

UNIT 21: Government intervention in the market

BLOCK 8

UNIT 22: Business Cycle

UNIT 23: Inflation, Deflation & various Theories of Market

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BLOCK
1

UNIT 1
ECONOMICS – AN OVERVIEW
UNIT 2
MICRO & MACRO ECONOMICS
UNIT 3
BUSINESS ECONOMICS
UNIT 4
MANAGERIAL ECONOMICS IN OTHER
APPLICATIONS & ECONOMIST

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UNIT 1
ECONOMICS – AN OVERVIEW

STRUCTURE

1.1 Objectives

1.2 Introduction

1.3 Definition of Economics

1.4 Characteristics of Economics

1.5 Scope of Economics

1.6 Let Us Sum Up

1.7 Key Words

1.8 Some useful Books

1.9 Answer to Check Your Progress Exercise

1.1 OBJECTIVES

After having studied this unit, you should be able

 To Understand the fundamentals of Business Economics
 To Know whether Economics is a Science or an Art
 To Study the Basic Economic terminologies
 To know the Scope of Economics

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1.2 INTRODUCTION

Managerial Economics refers to the application of economic principles and methodologies to

the decision making process within a business firm or organization. The growth of the field
indicates that much of the economic theory to fit the real world conditions, can be put to use by
business managers in making decisions that most likely to lead to the realization of the goals or
objectives of the firm. Managerial economics is the application of the economic theory and
methodology to the decision-making problems faced by a firm. Over the years, economics has
developed large number of concepts and analytical tools and techniques that enable the manager
to efficiently allocate the resources of the firm and subsequently, help the manager to understand
the economic environment on resource allocation within the firm. The focus of managerial
economics evolves round identifying and solving the decision making problems which a
manager faces in a given business environment. It lies on the borderline of Management and
Economics. It is primarily an applied branch of knowledge.

There are a good number of related problems between managerial economics and economics.
Primarily, there are common interests in problems of scarcity and resource allocation. The
managers of the firms must make judgments about the disposition of their resources at their
disposal, to attain maximum profit and to attain their goals. Secondly, both the disciplines are
interested in the working of the price system. Economists have viewed the problems at a broad
level, taking a dispassionate view of the growth and decline of industries and the consequent
changes in profits and incomes. Business managers have a more committed interest in the
working of the market mechanism pertaining to their business interests. They benefit from the
broader perspectives of the economists. Both Economics and Managerial Economics have a
common methodology to solve their problems. Business managers seek to develop analytical
techniques to achieve their objectives. This is similar to that of the Economist who analyses the
problems in a scientific manner. The methodologies of both the disciplines are similar.

1.3 DEFINTIONS OF MANAGERIAL ECONOMICS

Managerial Economics is a science which deals with the application of economic theory in
managerial practice. It is the study of allocation of resources available to a firm among its
activities. To be very precise, Managerial Economics is 'Economics applied in decision-
making'. It fills the gap between economic theory and managerial practice.

Milton H. Spencer and Louis Siegelman define managerial economics as"the integration of
economic theory with business practice for the purpose of facilitating decision-making and
forward planning by management."

Decision-making and forward planning are the two important functions of executives in a
business organization. Decision-making is the process of selecting a particular course of action
from among a number of alternatives. Forward planning means establishing plans for the
future. Forward planning goes hand-in-hand with decision-making.

James Bates and J.R. Parkinson have defined managerial economics as follows: "It is the study
of the behaviour of firms in theory and practice. It is to some extent a study of the way in
which firms behave in response to changes in techniques, markets, economic structures,
organizations, habits, and tastes, and how they themselves bring about change."

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Managerial Economics makes use of the analytical tools of economic theory in solving
business problems. According to Baumol, "a managerial economist can become a far more
helpful member of management group by virtue of his studies of economic analysis."

Managerial Economics is pragmatic and realistic in nature. It is applied to solve problems

faced by the business firm. These problems are related to choice and allocation of resources
which are economic in character. It should be remembered that decision making in business is
influenced not only by economic factors, but also by many other factors such as

(a) human,
(b) behavioural,
(c) technological; and
(d) environmental.

Several definitions of Economics have been given. For the sake of convenience let us
Classify the various definitions into four groups:

1. Science of wealth
2. Science of material well-being
3. Science of choice making and
4. Science of dynamic growth and development

We shall examine each one of these briefly:

1. Science of wealth.

Some earlier economists defined Economics as follows:

“An inquiry into the nature and causes of the wealth of the nations.’’ by Adam Smith.
“Science which deals with wealth." by J.B. Say.

In the above definition wealth becomes the main focus of the study of Economics.

The definition of Economics, as science of wealth, had some merits. The important ones
are:

(i) It highlighted an important problem faced by each and every nation of the world,
namely creation of wealth.

(ii) Since the problems of poverty, unemployment etc. can be solved to a greater extent
when wealth is produced and is distributed equitably; it goes to the credit of Adam
Smith and his followers to have addressed to the problems of economic growth and
increase in the production of wealth.

The study of Economics as a 'Science of Wealth' has been criticized on several grounds. The
main criticisms leveled against this definition are;

(i) Adam Smith and other classical economists concentrated only on material wealth. They
totally ignored creation of immaterial wealth like services of doctors, chartered
accountants etc.

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 (ii) The advocates of Economics as 'science of wealth' concentrated too much on the
production of wealth and ignored social welfare. This makes their definition incomplete
and inadequate.

2. Science of material well-being.

Under this group of definitions the emphasis is on welfare as compared with wealth in the
earlier group. Two important definitions are as follows:

(i) "Economics is a study of mankind in the ordinary business of life. It examines that part
of individual and social action which is most closely connected with the attainment and
with the use of the material requisites of well-being. Thus, it is on the one side a study
of wealth and on the other and more important side a part of the study of the man.” -
Alfred Marshall
(ii) "The range of our inquiry becomes restricted to that part of social welfare that can be
brought directly or indirectly into relation with the measuring rod of money"- A.C.
Pigou.

In the first definition Economics has been indicated to be a study of mankind in the ordinary
business of life. By ordinary business we mean those activities which occupy considerable
part of human effort. The fulfillment of economic needs is a very important business which
every man ordinarily does. Professor Marshall has clearly pointed that Economics is the study
of wealth but more important is the study of man. Thus, man gets precedence over wealth.
There is also emphasis on material requisites of well-being. Obviously, the material things
like food, clothing and shelter, are very important economic objectives.

The second definition by Pigou emphasizes social welfare but only that part of it which can
be related with the measuring rod of money. Money is general measure of purchasing power
by the use of which the science of Economics can be rendered more precise.

Marshall's and Pigou's definitions of Economics are wider and more comprehensive as they
take into account the aspect of social welfare. But their definitions have their share of
criticism.

Their definitions are criticized on the following grounds.

(i) Economics is concerned with not only material things but also with immaterial things
like services of singers, teachers, actors etc. Marshall and Pigou chose to ignore them.

(ii) Robbins criticized the welfare definition on the ground that it is very difficult to state
which things would lead to welfare and which will not? He is of the view that we would
study in Economics all those goods and services which carry a price whether they
promote welfare or not.

3. Science of choice making.

Robbins gave a more scientific definition of Economics. His definition is as follows:

"Economics is the science which studies human behavior as a relationship between ends

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and scarce means which have alternative uses.”

The definition deals with the following four aspects:

(i) Economics is a science:

Economics studies economic human behaviour scientifically. It studies how humans try to
optimise (maximize or minimize) certain objective under given constraints. For example,
it studies how consumers, with given income and prices of the commodities, try to
maximize their satisfaction.

(ii) Unlimited ends:

Ends refer to wants. Human wants are unlimited. When one want is satisfied, other wants
crop up. If man's wants were limited, then there would be no economic problem.

(iii) Scarce means:

Means refer to resources. Since resources (natural productive resources, man-made
capital goods, consumer goods, money and time etc.) are limited economic problem
arises. If the resources were unlimited, people would be able to satisfy all their wants and
there would be no problem.

(iv) Alternative uses:

Not only resources are scarce, they have alternative uses. For example, coal can be used
as a fuel for the production of industrial goods, it can be used for running trains, it can
also be used for domestic cooking purposes and for so many purposes. Similarly,
financial resources can be used for many purposes. The man or society has, therefore, to
choose the uses for which resources would be used. If there was only a single use of the
resource then the economic problem would not arise.

It follows from the definition of Robbins that Economics is a science of choice. An important
thing about Robbin's definition is that it does not distinguish between material and non-
material, between welfare and non-welfare. Anything which satisfies the wants of the people
would be studied in Economics. Even if a good is harmful to a person it would be studied in
Economics if it satisfies his wants.

No doubt, Robbins has made Economics a scientific study and his definition has become
popular among some economists. But his definition has also been criticised on several
grounds.

Important ones are:

1. Robbins has made Economics quite impersonal and colourless. By making it a
complete positive science and excluding normative aspects he has narrowed down its
scope.
2. Robbins' definition is totally silent about certain macro-economic aspects such as
determination of national income and employment.
3. His definition does not cover the theory of economic growth and development.
4. While Robbins takes resources as given and talks about their allocation, it is totally
5. silent about the measures to be taken to raise these resources i.e. national income
and wealth.

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 4. Science of dynamic growth and development.
Although the fundamental economic problem of scarcity in relation to needs is undisputed
it would not be proper to think that economic resources - physical, human, financial are
fixed and cannot be increased by human ingenuity, exploration, exploitation and
development.

A modern and somewhat modified definition is as follows:

1. "Economics is the study of how men and society choose, with or without the use of
money, to employ scarce productive resources which could have alternative uses, to
produce various commodities over time and distribute them for consumption now and in
the future amongst various people and groups of society". Paul A. Samuelson

The above definition is very comprehensive because it does not restrict to material well-being
or money measure as a limiting factor. But it considers economic growth over time.

1.4 CHARACTERISTICES OF MANAGERIAL ECONOMICS

1. Managerial Economics is micro economic in character. The unit of study is a firm and its
problems are studied in it.

1. Managerial Economics is normative in character. It is prescriptive rather than descriptive.

It tells the businessmen how best to achieve the objectives of the firms under given
circumstances.

2. Managerial Economics mostly uses the theory of the firm and profit theories which
belong to the realm of Micro Economics.

3. Besides Micro Economic concepts, Macro Economic concepts like, business cycles.
National income accounting, Tax policy of the Government, price control measures. Anti-
monopoly measures, foreign trade etc., are highly used in Managerial Economics to
understand the external forces affecting the business.

4. Managerial Economics bridges the gap between the purely abstract analytical problems and the
pragmatic policies that management must face. It offers powerful tools and approaches for
managerial policy making.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss the characteristics of Managerial Economics
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………

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1.5 SCOPE OF MANAGERIAL ECONOMICS

Since this is a newly formed discipline, no uniform pattern is adopted, and different authors treat
the subject in different ways. However, the following topics have been regarded as the scope of
the subject, managerial economics CI Whether Managerial Economics is normative or
Positive economics.

I. Whether Managerial Economics is Normative or Positive economics

II. Area of study
III. Profits —The Central Concept in Managerial Economics
IV. Optimisation
V. Relationship of Managerial Economics with other Disciplines.
Let us discuss the scope of the subject, as stated above, in greater detail.
I. Managerial Economics —is it positive or normative?
Economics is divided into two categories, namely,
(i) Positive Economics, and
(ii) Normative Economics. Positive economics is descriptive in character telling things 'as
they are', while normative economics deals-with things as they 'Ought to be', or
'should be'. This is prescriptive in character.
Prof. Lionel Robinson advocated positivism telling that economics should be neutral between
'ends' and it cannot pronounce on the validity of ultimate judgments of value. Managerial
Economics lays emphasis on prescribing choice and action and it is a normative economics.
Managerial Economics draws from descriptive economics and tries to pass judgments of
value in the context of the firm. Managerial Economics is mainly a normative economics.
II. Area of Study
Broadly, Managerial Economics deals with the following topics :
(a) Demand Analysis and Forecasting
(b) Cost and-Production analysis
(c) Pricing Decisions, Policies and Practices
(d) Profit Management
(e) Capital Management
(f) Linear Programming and Theory of Games J

(a) Demand Analysis and Forecasting:

Accurate estimation of demand by analysing the forces acting on demand of the product
produced by the firm forms the vital issue in taking effective decision at the firm level.
Demand analysis attempts at finding out the forces determining the sales. This has two
main managerial purposes:

(i) Forecasting Sales, and

(ii) Manipulating demand.

The demand analysis covers the topics like Demand Determinants; Demand Distinctions;
and Demand Forecasting.

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(b) Cost and Production Analysis:
In decision-making, cost estimates are very essential. Production planning, profit
planning, etc., depend upon sound pricing practices and accurate cost analysis.
Production analysis deals with physical terms of the product, while cost analysis deals
with monetary terms. Cost analysis is concerned with cost concepts, cost-output relations,
economies of scale, production function and cost control.

(c) Pricing Decisions, Policies and Practices:

Pricing forms the core of Managerial Economics. The success or failure of a firm mainly
depends on accurate price decisions to effectively compete in the market. The important
aspects of the study under this are Price Determination under different market conditions,
Pricing Methods and Policies, Product-line Pricing and Price-Forecasting.

(d) Profit Management:

All business enterprises are profit-making institutions. The success or failure of a firm is
measured only in terms of profit it has made and the percentage of dividend it has
declared. Hence profit management, profit policies and techniques, profit-planning like
break-even analysis are studied under this category.

(e) Capital Management:

Capital management is the most troublesome and also ticklish problem for the
management of a business involving high-level decisions. Capital management deals with
Planning and control of Capital expenditure, cost of Capital, rate of return and selection of
Project, etc.

(f) Linear Programming and Theory of Games:

Linear Programming and Theory of Games have come to be regarded as part of
Managerial Economics recently, as there is a trend towards integration of Managerial
Economics and Operations Research.
III. Profits: The Central Concept in Managerial Economics

Generally, profits are the primary measure of the success of any business. It is the acid test of
the economic strength of the firm. Economic theory makes a fundamental assumption that
maximising profit is the basic aim of every firm. This assumption is by and large true,
though in modern society this may not always hold good; Modern firms pursue multiple
objectives such as welfare, obligations to the society and consumers, etc. However, profit
maximisation receives top priority, if not the sole objective. Consequently, It maximisation
continues to be the objective of the firm and the study of firm in Managerial Economics has
centered round the concept of profit.

The maximisation of profits is the main objective of any firm and the survival of the firm
depends on the profits it earns. Profit is the main indicator of firm's success. It is the index of
business efficiency. Further, the concept of profit maximization is very much useful in
selecting the alternatives in making a decision at the firm level.

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IV. Optimisation
Another important concept used in Managerial Economics is 'Optimisation'. This aims at
optimising a given objective. The aim of linear programming is to aid the process of
optimisation and choice. It offers numerical solutions to problem of making optimum
choices. This point of optimisation emerges when there are constraints. In recent years,
operations researchers have discovered the term 'sub-optimisation'. The greatest merit of this
concept is its flexibility. Optimisation is basic to Managerial Economics in decision-making.

V. Relationship of Managerial Economics with other Disciplines

(Managerial economics is closely related to other subjects, like Microeconomic Theory,
Macroeconomic Theory, Mathematics, Statistics, Accounting, Decision-making and
Operations Research) Hague has described Managerial Economics "as using the logic of
Economics, Mathematics and statistics to provide effective ways of thinking about business
decision problems."

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss the scope of Managerial Economics.

……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………

1.6 LET US SUM UP

We have studied the different definitions of economics given by noted economists of

different time period. Also we discussed the nature of economics and concluded that
economics is both a science and art.

1.7 KEYWORDS
Economic theory Decision-making
Economist Technological
Environmental Behavioural
Human Wealth
Dynamic growth Immaterial
Scarce

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1.8 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta.
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

1.9 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 1.4
Check Your Progress – 2
1. See Section 1.5

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UNIT- 2
MICRO & MACRO ECONOMICS

STRUCTURE

2.1 Objectives

2.2 Introduction

2.3 Nature of Economic Laws

2.4 Methods of Economic Analysis

2.4.1 Deduction

2.4.2 Induction

2.5 Micro-Economic Analysis

2.6 Macro-Economic Analysis

2.7 Let Us Sum Up

2.8 Keywords

2.9 Some Useful Books

2.10 Answer to Check Your Progress Exercise

2.1 OBJECTIVES

After having studied this unit, you should be able

 To Understand the nature of Economic Laws
 To Know the methods of Economic Laws
 To Study the Micro and Macro approach

2.2 INTRODUCTION

Economic analysis is concerned with how an economy works, the formulation of economic
laws, the methods of economic enquiry and the different approaches to economics. Economic
laws, unlike the exact laws of physical sciences, are more exact than laws of other social

17
sciences. The two methods of economic enquiry namely deduction and induction play a vital
part in economic reasoning. The two branches of economic analysis, viz.
1) Micro-economics and
2) Macro-economics are two different approaches, the one analysing small individual
units of the economy microscopically, whereas the other looks at the economy as a
whole and its large aggregates respectively. Each has its advocates, but now every
economics student recognizes the importance and complementarity of both.

2.3 NATURE OF ECONOMIC LAWS

Every science, natural or social, has its laws. These laws are generalizations built upon the
bases of facts, reasoning and scientific verification. In economic science also, there are many
such laws. But, by their nature, economic laws are different from those of physical sciences
like Physics and Chemistry. First of all, economic laws are hypothetical; they are valid with
the qualifying phrase “ceteris paribus’ which means “other things being equal”. This
condition qualifies all economic laws. In actual life, other things seldom remain equal. But
this does not deter the validity of economic laws. All social sciences are under the necessity
to make certain assumptions. To quote Alfred Marshall, “Economic laws or statements of
economic tendencies are those social laws which relate to branches of conduct in which the
strength of the motives chiefly concerned can be measured by a money price”. The
implication of this definition is that given certain conditions, certain results are likely to
occur. There is an element of uncertainty about them. For instance, the Law of Demand states
that, if price rises, the demand for the commodity will contract. This is true and the law is
quite valid, only when counteracting forces do not operate. Hence we say that economic laws
are merely statements of tendencies. The hypothetical nature of economic laws in contrast to
laws of natural sciences is due to the following reasons:

1. Economic laws are concerned with human behavior which is subject to emotions,
impulses and feelings.
2. Time factor also makes for the hypothetical nature of economic laws.

With the passage of time, conditions change, and so also economic laws. However, economic
laws are more exact than other social laws, because economic science makes use of the
“measuring rod of money”. To Marshall, the laws of economics are to be compared with the
laws of tides rather than with the simple and exact law of gravitation. Economic laws, like
tides, lack predictability and exactness.

Lionel Robbins, however, did not subscribe to this narrow view and broadened the scope of
economic laws. Whether any objective or conduct of man is concerned with money or not is
immaterial; still, it will fall within the ambit of economic laws, if it is involving the problem
of choice, i.e., allocation of limited means among competing ends. In the view of Lionel
Robbins, economic laws are statements of tendencies which govern human behavior relating
to the use of scarce means for the achievement of unlimited wants.

Economic laws are not permanent, general and everlasting because they are framed in a
particular social and institutional set-up. When the set-up itself changes, no longer the
established law will remain relevant. Economic laws will undergo change with the evolution
of economic life of man and transformation in the institutional set-up. Thus, economic laws
applying to hunting and pastoral stages did not make sense in the agricultural and industrial
stages.

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Economic laws framed in the context of capitalistic institutional set-up may not apply to the
socialist countries. Laws of economics, valid for developed economies, may fail to apply to
less developed countries because different conditions and factors obtain in these countries.
Economic laws are not statutory commands or moral laws or even customary laws. They are
merely in the indicative mood and not in the imperative mood.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Explain the nature of Managerial Economics.

……………………………………………………………………………………………
……………………………………………………………………………………………

2.4 METHODS OF ECONOMIC ANALYSIS

As in the case of every other science, so in the field of economic analysis, there are two
important methods useful for investigation and formulation of its principles, laws,
generalizations or theorems. They are
1. The deductive method and
2. The inductive method.

The issue of whether deductive method is preferable to inductive method or vice versa was a
raging controversy in the 19th century. The English classical economists like David Ricardo,
T.R.Malthus, John Stuart Mill and Nassau Senior were solid advocates of deductive
methodology.

2.4.1. Deduction

The deductive method is also called the abstract, analytical or a priori method. In this method,
we start from a few indispensable facts and after making certain assumptions, through logical
reasoning, certain conclusions are reached. It consists of three important stages, namely
(i) observation,
(ii) logical reasoning, and
(iii) inference and testing by means of further observations.
Deductive reasoning provides us with hypothesis which are tested and verified with relevance
to facts and figures and then we draw valid economic laws.
In economics we start with simple premises and step by step work up to more complex and
refined hypothesis. In this method, we descend from the general to the particular.

The following merits are found in the deductive method:

1. It is simple and logical.
2. It does away with the need for experimentation.
3. It leads to accuracy in generalisation due to logical reasoning.

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However, there are certain defects:

1. If assumptions made are wrong, generalizations made on the basis of wrong

assumptions will also be invalidated.
2. 2. There is too much abstraction and economists through their intellectual
exercise give rise to only "intellectual toys" without any reality.
3. Generalizations of deduction based on wrong premises may become dangerous and
disastrous results will follow when governments frame policies on such premises.

2.4.2 Induction Method

The inductive method is also known as the empirical method. It derives economic
generalizations based on experience and observations. In this, data are collected with
reference to certain economic phenomena and finally generalizations are derived from the
collected data and observations. Here we mount from the particular to the general. From
observations we build up through reasoning founded on experience, to formulate
generalizations based on observed data. The historical school of Germany represented by
Carl Knies, Hildebrand, Prof. Roscher and Von Thunen were strong and staunch supporters
of the inductive method. It should, however, be emphasized that the division of opinion
between the two schools of thought was neither complete nor clear-cut. In the inductive
method, economic scientists proceed from a particular angle to scientific problems to bridge
the gap between theory and practice. Induction is done by either experimentation or the
statistical approach and these are the two forms of induction. Experimentation has larger
scope in the physical sciences and the statistical approach in social sciences like economics.
The famous Malthusian Theory of Population and Engel’s Law of Consumption are based on
the statistical approach.

The merits of the inductive method are as follows:

1. It leads to precise, measurable conclusions.

2. It is highly practical and realistic.
3. It is helpful in verifying the conclusions of the deductive method.
4. It emphasises relativity of economic laws which are valid only under certain
conditions and circumstances.

The following are the drawbacks of the inductive method:

1. There is an underlying risk of drawing false and hurried conclusions from

inadequate data and facts.
2. The collection of data and facts in itself is no easy work.
3. Divorced from deduction which uses logical analysis, it would only produce a mass of
unrelated and unconnected facts and figures. Induction alone would not deliver the
goods unless it is supplemented by using deductive reasoning.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

20
 1. Discuss the methods of Managerial Economics.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………

2.5 MICRO-ECONOMIC ANALYSIS

The subject matter of economics consists of two parts, namely Micro economics and Macro
economics. Ragnar Frisch. Who is among the first Nobel laureates in Economics coined these
terms. Which are now universally used. "Micro" is derived from the Greek word “Micros"
meaning small and "Macro" from "Makros" meaning large.

In Micro–Economics we study the economic behaviour of an individual, firm or industry in

the national economy. It is thus a study of a particular unit rather than all the
units combined. We mainly study the following in Micro-Economics:

(i) Product pricing;

(ii) Consumer behaviour
(iii) Factor pricing;
(iv) Economic conditions of a section of the people;
(v) Study of firms; and
(vi) Location of a industry.

According to K.E. Boulding, "Micro economics is the study of particular firms, Particular
households, individual prices, wages, incomes, individual industries, particular
commodities". Thus, it deals with the analysis of small individual units of the economy such
as individual consumers, firms and small groups of individual units such as various industries
and markets; it is a microscopic study of the economy. Herein it should be emphasized that it
does not study the economy in its totality. It looks at the economy through a microscope, to
analyse how the millions of units in the economy (analogous to cells in any organism) play
their part in the functioning of the entire economic organisation. To quote Prof.Mc.Connel,
"Micro Economics is concerned with specific economic units and a detailed consideration of
the behavior of these individual units. In Micro Economics, we examine the trees, not the
forest. Micro Economics is useful in achieving a worm's-eye view of some very specific
component of our economic system’’
Check Your Progress – 3
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss the Micro – Economics Analysis.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………

21
2.6 MACROECONOMIC ANALYSIS

Macroeconomics is the study of aggregates; hence called Aggregative Economics. It is the

analysis of the entire economic system, the overall conditions of an economy like total
investment and total production. In the words of K.E.Boulding, "Macroeconomics deals not
with individual quantities as such but with aggregates of these quantities; not with individual
incomes, but with the national income; not with individual prices but with the price levels;
not with individual outputs but with the national output." It analyses the entire economy and
its large aggregates like total national income and output, aggregate consumption, saving and
investment and total employment.

In Macro-Economics, we study the economic behaviour of the large aggregates such as the
overall conditions of the economy such as total production, total consumption, total saving
and total investment in it. It is the study of overall economic phenomena as a whole rather
than its individual parts. It includes:

(i) National income and output;

(ii) General Price level;
(iii) Balance of trade and payments;
(iv) External value of money;
(v) Saving and investment; and
(vi) Employment and economic growth.

Thus, when we study why we continue to have balance of payments deficits, or why the value
of rupee vis-a-vis dollar is falling or why saving rates are high or low in a particular country
we are studying Macro-Economics.

In the view of Prof. Mc. Connel, “The level of Macroeconomics is concerned either with the
economy as a whole or with the basic sub-divisions or aggregates such as governments,
households and businesses which make up the economy In short, macroeconomics examines
the forest, not the trees. It gives us a bird's-eye view of the Economy.” It deals with the great
averages and aggregates of the system rather than with particular units composing it.
Check Your Progress – 4
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss the Macro – Economic Analysis.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
2.7 LETS SUM UP

In this lesson we discussed in detail the nature and methods of economic analysis. We also
studied Micro and Macro economic analysis.

22
2.8 KEYWORDS

Micro-economics Macro-Economics
Transformation Agricultural
Industrial Developed
Imperative Indicative
Deductive Inductive
Observation Logical Reasoning

2.9 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson
2.10 ANSWER TO CHECK YOUR PROGRESS EXERCISE
Check Your Progress – 1
1. See section 2.3
Check Your Progress – 2
1. See Section 2.4
Check Your Progress – 3
1. See Section 2.5
Check Your Progress – 4
1. See Section 2.6

23
UNIT 3
BUSINESS ECONOMICS

STRUCTURE

3.1 Objectives

3.2 Introduction

3.3 Definition of Business Economics

3.4 Characteristics of Business Economics

3.5 Objective of Business Economics

3.6 Scope of Managerial or Business Economics

3.7 Fundamental concepts of Applied Managerial Economics

3.8 Let Us Sum Up

3.9 Key words

3.10 Some Useful Books

3.11 Answer to Check Your Progress Exercise

3.1 OBJECTIVES

After having studied this lesson, you should be able to understand

To Know t h e definition and characteristics o f Business
Economics
To understand the goal of Business Economics

To widely appreciate the scope of Business Economics

3.2 INTRODUCTION

Managerial Economics consists of that part of economic theory which helps the business
manager to take rational decisions. Economic theories help to analyse the practical problems
faced by a business firm. Managerial Economics integrates economic theory with business

24
practice. It is a special branch of economics that bridges the gap between abstract theory and
business practice. It deals with the use of economic concepts and principles for decision
making in a business unit it is over wise called Business economics or Economics of the Firm.
The terms Managerial Economics and Business Economics are used interchangeably. The
term Managerial Economics is more in use now-a- days. Managerial Economics is economics
applied in business decision-making. Hence it is also called Applied Economics.

3.3 DEFINITION OF BUSINESS ECONOMICS

1. In simple words, business economics is the discipline which helps a business manager
in decision making for acheiving the desired results. In other words, it deals with the
application of economic theory to business management.

2. According to Spencer and Siegelman, Business economics is "the integration of

economic theory with business practise for the purpose of facilitating decision-making
and forward planning by management".

3. According to Mc Nair and Meriam, "Business economics deals with the use of
economic modes of thought to analyse business situation".

From the above said definitions, we can safely say that business economics makes in depth
study of the following objectives:
 Explanation of nature and form of economic analysis
 Identification of the business areas where economic analysis can be applied
 Spell out the relationship between Managerial Economics and other disciplines
outline the methodology of managerial economics.

3.4 CHARACTERISTICS OF BUSINESS ECONOMICS

The following characteristics of business economics will indicate its nature:

1. Micro economics:
Managerial economics is micro economic in character. This is so because it studies the
problems of an individual business unit. It does not study the problems of the entire economy.

2. Normative science:
Managerial economics is a normative science. It is concerned with what management should
do under particular circumstances. It determines the goals of the enterprise. Then it develops
the ways to achieve these goals.

3. Pragmatic:
Managerial economics is pragmatic. It concentrates on making economic theory more
application oriented. It tries to solve the managerial problems in their day-today functioning.

4. Prescriptive:
Managerial economics is prescriptive rather than descriptive. It prescribes solutions to
various business problems.

25
5. Uses macro economics:
Marco economics is also useful to business economics. Macro-economics provides an
intelligent understanding of the environment in which the business operates. Managerial
economics takes the help of macro-economics to understand the external conditions such as
business cycle, national income, economic policies of Government etc.

6. Uses theory of firm:

Managerial economics largely uses the body of economic concepts and principles towards
solving the business problems. Managerial economics is a special branch of economics to
bridge the gap between economic theory and managerial practice.

7. Management oriented:
The main aim of managerial economics is to help the management in taking correct decisions
and preparing plans and policies for future. Managerial economics analyses the problems and
give solutions just as doctor tries to give relief to the patient.

8. Multi disciplinary:
Managerial economics makes use of most modern tools of mathematics, statistics and
operation research. In decision making and planning principles such accounting, finance,
marketing, production and personnel etc.

9. Art and science:

Managerial economics is both a science and an art. As a science, it establishes relationship
between cause and effect by collecting, classifying and analyzing the facts on the basis of
certain principles. It points out to the objectives and also shows the way to attain the said
objectives.
Check Your Progress – 3
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Explain the Characteristics of Business Economics.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
……………..

3.5 OJECTIVES OF BUSINESS ECONOMICS

Managerial economics provides such tools necessary for business decisions. Managerial
economics answers the five fundamental problems of decision making. These problems are:

(a) What should be the product mix?

(b) Which is the least cost production technique and input mix?
(c) What should be the level of output and price of the product?
(d) How to take investment decisions?

26
 (e) How much should be the selling cost. In order to solve the problems of decision-
making, data are to be collected and analysed in the light of business objectives.
Business economics supplies such data to the business economist.

As pointed out by Joel Dean "The purpose of managerial economics is to show how
economic analysis can be used in formulating business policies"

The basic objective of managerial economics is to analyse economic problems of business and
suggest solutions and help the managers in decision-making. The objectives of business
economics are outlined as below:

 To integrate economic theory with business practice.

 To apply economic concepts: and principles to solve business problems.
 To employ the most modern instruments and tools to solve business problems.
 To allocate the scarce resources in the optimal manner.
 To make overall development of a firm.
 To help achieve other objectives of a firm like attaining industry leadership,
expansion of the market share etc.
 To minimise risk and uncertainty
 To help in demand and sales forecasting.
 To help in operation of firm by helping in planning, organising, controlling etc.
 To help in formulating business policies.
 To help in profit maximisation.

Business economics is useful because:

 It provides tools and techniques for managerial decisions,
 It gives answers to the basic problems of business management,
 It supplies data for analysis and forecasting,
 It provides tools for demand forecasting and profit planning,
 It guides the managerial economist.

Thus, Business economics offers a number of benefits to business managers. It is

also useful to individuals, society and government.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Explain the Objectives of Business Economics.

……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………

27
3.6 SCOPE OF MANAGERIAL OR BUSINESS ECONOMICS

Managerial economics is a developing science which generates the countless problems to

determine its scope in a clear-cut way. From the following fields, we can examine the scope
of business economics.

1. Demand analysis and forecasting:

The foremost aspect regarding scope is demand analysis and forecasting. A business firm is
an economic unit which transforms productive resources into saleable goods. Since all output
is meant to be sold, accurate estimates of demand help a firm in minimising its costs of
production and storage. A firm must decide its total output before preparing its production
schedule and deciding on the resources to be employed. Demand forecasts serves as a guide
to the management for maintaining its market share in competition with its rivals, thereby
securing its profit.

2. Cost and production analysis:

A firm's profitability depends much on its costs of production. A wise manager would
prepare cost estimates of a range of output, identify the factors causing variations in costs and
choose the cost-minimising output level, taking also into consideration the degree of
uncertainty in production and cost calculations. Production processes are under the charge of
engineers but the business manager works to carry out the production function analysis in
order to avoid wastages of materials and time. Sound pricing policies depend much on cost
control. The main topics discussed under cost and production analysis are: Cost concepts,
cost-output relationships, Economies and Diseconomies of scale and cost control.

3. Pricing decisions, policies and practices:

Another task before a business manager is the pricing of a product. Since a firm's income and
profit depend mainly on the price decision, the pricing policies and all such decisions are to
be taken after careful analysis of the nature of the market in which the firm operates. The
important topics covered in this field of study are: Market Structure Analysis, Pricing
Practices and Price Forecasting.

4. Profit management:

Each and every business firms are tended for earning profit, it is profit which provides the
chief measure of success of a firm in the long period. Economists tells us that profits are the
reward for uncertainity bearing and risk taking. A successful business manager is one who
can form more or less correct estimates of costs and revenues at different levels of output.
The more successful a manager is in reducing uncertainity, the higher are the profits earned
by him. It is therefore, profit-planning and profit measurement constitute the most
challenging area of business economics.

5. Capital management:

Still another most challenging problem for a modern business manager is of planning
capital investment. Investments are made in the plant and machinery and buildings which
are very high. Therefore, capital management requires top- level decisions. It means capital

28
management i.e., planning and control of capital expenditure. It deals with Cost of capital,
Rate of Return and Selection of projects.

6. Inventory management:

A firm should always keep an ideal quantity of stock. If the stock is too much, the capital is
unnecessarily locked up in inventories at the same time if the level of inventory is low,
production will be interrupted due to non-availability of materials. Hence, a firm always
prefers to have an optimum quantity of stock. Therefore, managerial economics will use
some methods such as ABC analysis, inventory models with a view to minimising the
inventory cost.

7. Linear programming and theory of games:

Linear programming and theory of games have came to be regarded as part of managerial
economics recently.

8. Environmental issues:

There are certain issues of macroeconomics which also form a part of managerial economics.
These issues relate to general business, social and political environment in which a business
enterprise operates.

9. Business cycles:

Business cycles affect business decisions. They refer to regular fluctuations in economic
activities in the country. The different phases of business cycle are depression, recovery,
prosperity, boom and recession. Thus, managerial economics comprises both micro and
macro-economic theories. The subject matter of managerial economics consists of all those
economic concepts, theories and tools of analysis which can be used to analyse the business
environment and to find out solution to practical business problems.

Check Your Progress – 3

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss the Scope of Managerial Economics or Business Economics.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………

3.7 FUNDAMENTAL CONCEPTS OF APPLIED MANAGERIAL ECONOMICS

Decision making is the core of Managerial Economics. Some fundamental concepts and
techniques help the management to take correct decisions. The following are the six
fundamental concepts used in Managerial Economics:

29
1. Principle of opportunity cost:

Every scarce goods or activity has an opportunity cost. Opportunity cost of anything is the cost
of the next best alternative which is given up. It refers to the cost of foregoing or giving up an
opportunity. It is the earnings that would be realised if the available resources were put to
some other use. It implies the income or benefit foregone because a certain course of action
has been taken. Thus opportunity costs are measured by the sacrifices made in the decision. If
there is no sacrifice involved by a decision there will be no opportunity cost. It is also called
alternative cost or transfer cost.

The opportunity cost of using a machine to produce one product is the income forgone which
would have been earned from the production of other products. If the machine has only one
use, it has no opportunity cost. Similarly, the opportunity costs of funds invested in one's own
business is the amount of interest earned if the amount had been used in other projects. If an
old building is proposed to be used for a business, likely rent of the building is the opportunity
cost. These are called opportunity costs because they represent the opportunities which are
foregone.

Devenport, an American Economist explains the concept of opportunity cost with reference to
an example. Suppose a girl had two kinds of fruits- one pear and one peach, and if a bad boy is
after her to seize the fruits, then the best way for the girl is to drop one fruit and run with the
other, so that, she can at least save one fruit, at the cost of the other.
When the girl so drops by the way - side one fruit and runs with the other, then the opportunity
cost of the fruit she saves is the foregone alternative of the fruit she lost. This
is the opportunity cost theory.

The concept of opportunity cost plays an important role in managerial decisions. This concept
helps in selecting the best possible alternative from among various alternatives available to
solve a particular problem. This concept helps in the best allocation of available resources.

2. Principle of incremental cost and revenue:

Two important incremental concepts used in Managerial Economics are fundamental concepts
of Managerial Economics are incremental cost and incremental revenue. Incremental cost is a
change in total cost resulting from a decision. Incremental revenue means the change in total
revenue resulting from a decision. A decision is profitable only if

 It increases revenue more than costs,

 It decreases some costs more than it increases others,
 It increases some revenue more than it decreases others, and
 It reduces costs more than revenue.

Incremental principle can be used in the theories of consumption, production, pricing and
distribution. Incremental concept is closely related to marginal cost and marginal revenue in
the theory of pricing.

30
3. Principle of Time Perspective.

Another principle is the principle of time perspective which is useful in decision-making in

output, prices, advertising and expansion of business. Economists distinguish between the
short run and the long run in discussing the determination of price in a given market form
because in the long run a firm must cover its full cost. On the contrary, in the short-run it can
afford to ignore some of its (fixed) costs. Modern economists have started making use of an
"intermediate run" between the short run and the long run in order to explain pricing and
output behaviour under what is called oligopoly. The principle of time perspective can be
stated as under: A decision should take into account both the short run and the long run
effects on revenues and costs and maintain a right balance between the long run and the short
run perspectives.

4. Equi-marginal principle:

This is one of the widely used concepts in managerial economics. This principle is also known
the principle of maximum satisfaction. According to this principle, an input should be
allocated in such a manner that the value added by the last unit of input is same in all uses. In
this way, this principle provides a base for maximum exploitation of all the inputs of a firm so
as to maximise the profitability. The equi-marginal principle can be applied in different areas
of management. It is used in budgeting. The objective is to allocate resources where hey are
most productive. It can be used for eliminating waste in useless activities. It can be applied in
any discussion of budgeting. The management can accept investments with high rates of return
so as to ensure optimum allocation of capital resources. The equi-marginal principle can also
be applied in multiple product pricing. A multi product firm will reach equilibrium when the
marginal revenue obtained from a product is equal to that of another product or products. The
equi-marginal principle may also be applied in allocating research expenditures.

5. Optimisation:

This is another important concept used managerial economics. Managerial economics often
aims at optimising a given objective. The objective may be maximisation of profit or
minimisation of time or minimisation of cost. The important techniques for optimisation
include marginal analysis, calculus, linear programming etc.

3.8 LET US SUM UP

This Lesson discusses in detail business economics, its characteristics, objectives and scope.
Fundamental concepts of economics that help the management to take correct decisions are
also dealt with.

3.9 KEYWORDS

Integration Micro economics

Normative science Pragmatic:
Prescriptive Multi disciplinary
Art and science Demand analysis
Forecasting Production analysis

31
Pricing decisions Profit management
Capital management Inventory management
Environmental issues Linear programming

3.10 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

3.11 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 3.4
Check Your Progress – 2
1. See Section 3.5
Check Your Progress – 3
1. See Section 3.6

32
UNIT 4
MANAGERIAL ECONOMICS IN OTHER
APPLICATIONS & ECONOMIST

STRUCTURE

4.1 Objectives

4.2 Introduction

4.3 Managerial Economics and Statistics

4.4 Managerial Economics and Mathematics

4.5 Managerial Economics and Operations Research

4.6 Managerial Economics and Accounting

4.7 Role of Managerial Economist

4.8 Responsibilities of a Business Economist

4.9 Let Us Sum Up

4.10 Keywords

4.11 Some Useful Books

4.12 Answer to Check Your Progress Exercise

4.1 OBJECTIVES

After having studied this lesson, you should be able

 To know the relationship of Managerial Economics with
various other fields of study.
 To acquire Knowledge on the Role of a Business Economist
 To familiarize the Responsibilities that a Business Economist should
possess

33
4.2 INTRODUCTION

To broadly appreciate the nature and scope of managerial economics it is necessary to

examine its relationship with other sciences. At this juncture it is apt to specially mention the
relationship of managerial economics with the important fields of study such as statistics,
mathematics, operations research, and accounting.

A managerial economist plays a vital role in modern business. He helps the management of a
firm in decision making and forward planning by using his skills and techniques. In advanced
countries like U.S.A., U.K. and Canada, almost all big firms employ anagerial economists. In
leading business firms are employing business economists. Tatas, industan Lever and
Reliance have managerial economists on their staff. The role of a managerial economist is
that of a business analyst and of an advisor. It is a part and parcel of modern business
activities. Accordingly, his responsibilities are also heavy. Let us explain his role any
responsibilities in detail.

4.3 MANAGERIAL ECONOMICS AND STATISTICS

Statistics provides several tools to Managerial Economics; Statistical techniques are used in
collecting, marshalling and analysing business data that makes possible an empirical testing
of the economic generalisations before they are applied for decision making. Economic
generalisations cannot be fully accepted until they are verified and found Valid against the
real data. The theory of probability and forecasting techniques help the manager in decision-
making process. When the manager is to meet with the reality of uncertainty in decision
making the theory of probability provides the logic for dealing with such uncertainty

4.4 MANAGERIAL ECONOMICS AND MATHEMATICS

Mathematics is especially of to the manager when several economic relationships are to logic
in the analysis of economic events provides clarity of the concepts and also helps to establish
a quantitative relationship. Managers deal primarily with concepts that are quantitative in
nature eg., demand, price, cost, capital, wages, inventories etc. Mathematics is the manager's
most useful logical tool.

4.5 MANAGERIAL ECONOMICS AND OPERATION RESEARCH

Operation research and managerial economics are related to a certain extent. Operation
research is the application of mathematical and statistical techniques in solving business
problems. It deals with construction of mathematical models that helps the decision making
process. Operation research is helpful in business firms in studying the inter-relationship and
relative efficiencies of various business aspects like sales, production etc. Linear
programming, techniques of inventory control, game theory etc. are used in managerial
economics. These are used to find out the optimum combination of various factors to achieve
the objects of maximisation of profit, minimizations of cost and time etc

34
4.6 MANAGERIAL ECONOMICS AND ACCOUNTING

Accounting is closely related with managerial economics. Accounting is the main source of
data regarding the operation and functioning of the firm. Accounting data and
statements represent the language of the business. A business manager needs market
information, production information and accounting information for decision-making. The
profit and loss statement reflects the operational efficiency of the firm. The balance sheet tells
the financial position of the firm. The accounting information provides a basis for the
manager in decision making and forward planning. In short, accounting provides right
information to take right decisions

4.7 ROLE OF MANAGERIAL ECONOMIST

1. Study of the business environment.

Every firm has to take into consideration such external factors as the growth of national
income, volume of trade and the general price trends, for its policy decision. A firm works
within a business environment. The basic element of business environment for a firm are the
trend of growth of national economy and world economy and phase of the business cycle in
which the economy is moving. At what rate and where is population getting concentrated?
Where are the demand prospects for established and new products? Where are the
prospective markets? These questions lead the economists into purposeful studies of the
economic environment. The international economic outlook is a very important
environmental factor for exporting firms. The nature and degree of competition within the
industry in which a firm is placed are also a part of the business environment. The kind of
economic policies pursued by the government constitute a powerful element of the business
environment of a firm. What are the priorities of the new five year plain? In which sectors of
the economy have the outlays been bran increased? What are the budgetary trends? What
about changes in expenditure, tax rates tariffs and import restrictions? For all purposes the
economists place a significant role.

2. Business Plan and Forecasting.

The business economists can help the management in the formation of their business plan by
forecasting and economic environment. The management can easily decide the timing and
locating of their specific action. The managerial economists has to interpret the national
economic trends and industrial outlook for their relevance to the firm in which he is working.
He advises top management by means of short, business like practical notes. In a partially
controlled economy like India, the business economists translates the government's intentions
in business jargon and also transmits the reaction of the industry to propose changes in
government policy.

3. Study of business operations.

The business economist can also help the management in decision making relating to the
internal operations of a firm, i.e., in deciding about price, rate of operations, investment and
growth of the firm for offering this advice ; the economist has specific analytical and
forecasting techniques which yield meaningful conclusions. What will be the reasonable sales
and profit budget for the next year? What are the suitable production schedules and inventory

35
policies? What changes in wage and price policies are imperative now? What would be the
sources of finance? Thus, he is trained to answer such questions posted by the top
management.

4 Economic intelligence.

The business economist also provides general intelligence services by supplying the
management with economic information of general interest so that they can talk intelligently
in conferences and seminars. They are also supplied the facts and figures for preparing the
annual reports of the firm. Those facts and figures are collected by the business economist as
he understands the literature available on business activities

5 Specific functions.

Business economists are now performing specific functions as consultants also. Their specific
functions are demand forecasting, industrial market research, pricing problems of industry,
production programmes, investment analysis and forecasts. They also offer advice on trade
and public relations, primary commodities and foreign to capital projects in agriculture,
industry, transport and tourism and also of the export environment.

6. Participation in Public Debates.

The business economists participate in public debates organised by different agencies. Both
governments and society seek their advice. Their practical experience in business and
industry gives value to their observation. In nut shell a business economist can play a multi-
faceted role. He is not only an analyst of current trends and policies for his employers but
also a bridge between the businessmen in the specific industry and the Govt.
Check Your Progress – 1
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss the Role of Managerial Economist.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
……………..

4.8 RESPONSIBILITIES OF A BUSINESS ECONOMIST

A business economist is well familiar with his responsibilities. He must keep in the mind the
main objective of making a reasonable profit on the invested capital in his firm. Firms are not
always after profit-maximization, but to continue in business, every firm has to operate for
profit. Therefore, a business economist has the main responsibility of helping the
management to make more profits than before. All his other responsibilities flow from this
basic obligation. The responsibilities of a business economists are summarised below :

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1. Making successful Forecasts.
Managements have to take decisions concerning the future and it is uncertain. This
uncertainity cannot be eliminated altogether but it can be reduced through scientific forecasts
of the economic environment to his employers. This is required for business planning. If a
business economist can make successful forecasts about business trends, the management
will hold him in great esteem. A wise managerial economist will revise his forecasts from
time to time keeping in view new developments in his business. As soon as he finds a change
in his forecasts, he has to alert the management about it. He assists the management in
making the needed adjustments. This will help him to strengthen his position as a member of
the managerial team.

2. Maintaining Relationships.
The managerial economists must establish and maintain contacts with data sources for his
analysis and forecasts. He makes contacts with individual who are specialists in the different
fields. He must join professional associations and subscribe to the journals giving him fresh
and latest information. In other words, his business biggest quality is his ability to obtain
information quickly by establishing contacts with the sources of such information.

3. Earning full Status on the Managerial team.

A business economist has to participate in decision-making and forward- planning. For this
he must be able to earn full status on the business team. He must be prepared to take up
assignments on special project also. He should be able to express himself clearly so that his
advice is understood and accepted. Finally, he must be in tune with the industry's thinking,
and not lose the national perspective in giving advice to the management. Thus, we can
conclude from our discussion that managerial economists can earn an important place in the
managerial team only if the understands and undertakes his responsibilities.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss the Responsibilities of a Business Economist.

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4.9 LET US SUM UP

Business Economics helps the manager of an organization to take rationale decision by

implementing its concepts, principles and methods. It helps to achieve the organizational
objective in an efficient manner. It is interconnected with other fields of
study.

The Role and Responsibilities of a managerial economist are dealt with in detail in this lesson

37
4.10 KEYWORDS

Statistics Mathematics
Quantitative Operation research
Linear programming Game theory
Accounting Business environment
Business plan Forecasting.
Business operations Intelligence.
Forecasts. Managerial team

4.11 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

4.12 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 4.7
Check Your Progress – 2
1. See Section 4.8

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BLOCK
2
UNIT 5
FORMS OF BUSINESS ORGANISATION

39
UNIT - 5:
FORMS OF BUSINESS ORGANISATION

STRUCTURE

5.1 Objectives
5.2 Introduction
5.3 Sole Proprietorship
5.4 Joint Hindu Family Business
5.5 Partnership
5.6 Cooperative Organization
5.7 Joint Stock Company
5.8 Choice of Form of Business Enterprises
5.9 Factors to Be Considered For Starting A Business
5.10 Scope for Setting up Small Business
5.11 Public Sector
5.12 Private Sector and Public Sector
5.13 Forms of Organising Public Sector Enterprises
5.14 Business Organisation in New Millennium
5.15 Profit maximization as business objective
5.16 Controversy over profit maximization objective (Theory Vs Practice)
5.17 Alternative objectives of business firms
5.18 Baumol’s hypothesis of sales revenue
5.19 Let Us Sum Up
5.20 Keywords
5.21 Some Useful Books
5.22 Answer to Check Your Progress Exercise

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5.1 OBJECTIVES

After read this lesson you must be able to understand;

 Sole Proprietorship
 Joint Hindu Family business
 Partnership
 Cooperative Societies
 Joint Stock Company
 Non-Profit Organisation
 Business Organisations in new Millennium
 Profit maximization as business objective
 Controversy over profit maximization objective (Theory Vs Practice)
 Alternative objectives of business firms
 Baumol’s hypothesis of sales revenue

5.2 INTRODUCTION

There are different forms of business organization ranging from small scale one man
business to large scale limited companies. Following are the important forms of organization
in the private sector. Sole proprietorship
 Joint Hindu Family business
 Partnership
 Cooperative Societies
 Joint Stock Company

5.3 SOLE PROPRIETORSHIP

A business owned and controlled by a single individual is known as sole proprietorship
organization. The owner of such business is known as sole proprietor. He contributes all the
capital. He is responsible for all the management decisions. The proprietor need not share the
profits of the business with anyone. At the same time, if the business makes any loss, the
proprietor has to bear the entire loss.

Features of Sole Proprietorship

1. Individual Ownership:
A sole proprietorship business is owned and controlled by a single individual who is known
as the sole proprietor.

2. Risk bearing:
The sole trader is the single owner who is entitled to take out the whole profits of the
business. There is no sharing of profit or sharing of risk. Similarly the proprietor is solely
responsible for making all decisions.

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 3. Unlimited Liability:
There is no restriction as to the amount upto which the owner is to bear the losses of the
business. If the assets of the business are not sufficient to pay off the liabilities, the owner has
paid them off from his private wealth.

4. Freedom of operation:
The sole proprietor is free to run his business according to his wish. He need not approval
from others in running the business. Government restrictions are very limited in case of sole
proprietorship business.

5. Control:
The proprietor has personal control over all the matters related to the business. Even if he
appoints a manager the proprietor will continue to hold control over the business.

Merits of Sole Proprietorship

1. Ease of Formation
A sole proprietorship organization is easy to form. There is hardly any legal formality in
setting up this type of organization. It is not governed by any specific law. A sole proprietor
should only comply with the general laws and regulations regarding commercial activities.

2. Flexibility of operation
In a sole proprietorship business, all decisions are made by a single person. There are no
delays in decision making process. The business can respond quickly to changes in business
environment.

3. Sole Beneficiary of profits

The profit earned in sole proprietorship business is not shared with anyone. There is direct
relation between effort and reward. This motivates the proprietor to work hard.

4. Suitability for small scale operations

The sole proprietorship form is generally adopted for small scale businesses where personal
attention to details is required. When capital availability is limited sole proprietorship form is
the most appropriate form of organizations.

Limitations of Sole Proprietorship

1. Unlimited Liability
The sole proprietorship business has the basic disadvantage of unlimited liability. When the
business funds are not sufficient to pay off the business liabilities the proprietor has to
arrange money from his personal savings to meet the needs of the business.

2. Limited Capital
The sole proprietor has limited scope for raising capital. He mainly depends his own savings
for investment. This reduces the scope of expansion of business.

3. Limited managerial skill

Managerial skills are essential for successful running and expansion of business. The lack of
managerial ability is a serious hindrance for the growth of a sole proprietorship business.

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 4. Lack of continuity
The business is dependent on a single individual. If he becomes incapable of running the
business it is most likely that the business will be closed down.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the sole proprietorship.
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5.4 JOINT HINDU FAMILY BUSINESS

The Joint Hindu Family business refers to a business owned by the members of a Joint Hindu
Family. This form of organization is governed by the provisions of the Hindu Law and the
Law of Succession. A joint family business is owned by all the male members of a Hindu
family. The oldest member of the family has right to manage the business. He is known as
Karta.

Features of Joint Family Business

1. Membership by birth:
Membership of a joint Hindu family business is by birth of male child. It is not created by an
agreement between persons.

2. Management by Karta:
The management of business is carried out by the oldest member of the family who is known
as Karta. He may associate other members of the family to assist him in the management of
business.

3. Liability:
Only the Karta of a Joint family business has unlimited liability. All other members of the
family have limited liability. The liability of members of a Joint Family is limited up to the
value of their share in the family business.

4. No maximum limit of membership:

There is no maximum limit of members of a Joint Family business. However the membership
is restricted to three successive generations.

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5. Minor members:
A male child in a joint family automatically becomes member by birth. Thus the membership
of a joint family business is not restricted on the basis of age.

6. Limited Capital:
The availability of capital in a Joint Family business is restricted to the financial status of the
family. A joint family business cannot expand beyond a certain limit because of capital
restrictions.

7. Unaffected by the death of members:

HUF business continues even after the death of a coparcener including the Karta. However
the business will come to an end if all the members of the Joint family decide to wind up
business.

Merits Joint Family Business

1. Economic security and status of members:

The joint family business provides a sense of economic security to its members. It also
provides a sense of belonging as they work together for the progress of business. A reputed
business is a prestige symbol to the family..

2. Continuity of business:
A joint family business is not affected by personal misfortunes of members. The business
will come to an end only by a joint decision by members of the family to discontinue the
business.

3. Family pride:
The members are likely to work with dedication and loyalty because the business belongs to
the entire family. The business is not only an economic unit, but also a matter of family
prestige.

Limitation Joint Family Business:

1. Unlimited Liability of Karta

The Karta is personally liable for all the business obligations. If the properties of the business
are not enough to settle the business liabilities the Kata has to settle them from his personal
savings.

2. Limited capital
The availability of capital in a Joint Family business is restricted to the financial status of the
family. A joint family business cannot expand beyond a certain limit because of capital
restrictions.

3. Karta too powerful

The Karta of a Joint Family has almost unquestionable rights in taking business decisions.
An incompetent Karta may ruin the business.

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Check Your Progress – 2
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about the Joint Hindu Family Business.

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5.5 PARTNERSHIP

Partnership
`Partnership is a form of business owned and managed by a group of people. They pool their
managerial skill and finance set up and run the business. The Indian Partnership Act governs
"rules or organization and running of the business in India. It is defined as, “the relation
between two or more persons who have agreed to share profits of a business carried on by all
or any one them acting for all.”

Features of Partnership
1. Agreement:
A partnership business is formed on the basis of an agreement between persons who have
consented to act as partners of a business. This agreement may be oral or written.

2. Business:
A partnership may undertake any lawful business activity, which may consist of trade,
profession, or industry. In the absence of a lawful business, mere agreement to work together
does not become a partnership.

3. Sharing of profits:
The partners of a firm are entitled to share the profits or losses of the business. The profit
sharing ration will be generally mentioned in the partnership agreement. In the absence of
such a profit sharing condition in the partnership agreement the partners are entitled to share
profits or losses equally.

4. Number of members:
There must be at least two members to start a partnership business. The partnership law
stipulates the maximum number of members allowed for a business. In case the business is
engaged in ordinary business the maximum number allowed is 20 and for banking business
the maximum number is 10.

5. Agency relationship:
Each partner is an agent of the firm. He has capacity to bind the firm by any commitment
accepted by him. Similarly he is bound by the actions of other partners.

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6. Liability:
The partners have unlimited liability. They are individually and collectively liable for all the
amounts due to the creditors of the partnership business.

7. Ownership and control:

Normally, every partner has a right to take part in the management of the business. The rights
or ownership and control are jointly held by the partners.

8. Non transferability of share:

A partner is not allowed to transfer his investment in a partnership business to any other
person without the consent of all the partners.

9. Registration:
Registration is not compulsory to run a partnership business. However the partners are
allowed to register their firm with the Registrar of Firms. There are several advantages of
registration of a firm.

10. Duration:
Generally partnership agreements remain valid till the retirement or death of a partner.
Insolvency of a partner, insanity or any such personal incapacity can also cause dissolution of
partnership agreement. The business can continue after reconstitution of the firm according
to the provisions of the partnership agreement.

Types of Partnership
According to the nature of agreement among partners, there can be three types of
partnerships as follows:

i. Partnership at will:
This is a partnership that can exist as long the partners wants to remain in partnership
business. It can be brought to an end whenever any partner gives notice of his intension to
wind up the partnership.

ii. Particular partnership:

A particular partnership is formed for undertaking a particular venture, such as construction
of a bridge, building etc. The partnership comes to an end automatically with the completion
of the venture.

iii. Partnership for a fixed duration:

Such a partnership is for a fixed period. This partnership comes to an end by expiry of the
fixed period for which the partnership agreement was made.

Types of Partners
i. Active Partners:
Partners who take active part in the conducting of business are called active partners. These
partners carry on business on behalf of all partners of the firm.

ii. Dormant or Sleeping Partners:

Sleeping partners do not take active part in the conducting of business. Such partners only
contribute capital and depend on active partners to run the business. However they share
profits or losses of the business.

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iii. Nominal Partners:
Nominal partners do not have any actual investment in the firm. They only allow the firm to
use their name as a partner. They generally get a share of profit for lending their name to the
firm. They are liable to creditors like other partners.

iv. Partner by Holding Out:

These are individuals who falsely project themselves as partners. They do not have any
investment in the business. They may even be unknown to the partners of the firm. These
people are liable to parities who grant credit to the firm trusting that they are actual partners.

5.4.4 Minor Admitted into the Benefits of Partnership:

A minor is a person who has not attained the age of 18 years. A minor cannot enter into any
valid agreements. Therefore a minor cannot become partner of a firm. However a minor can
be admitted to the benefits of a partnership business. In other words, the partners of a firm
can decide to grant a profit share to a minor. A minor partner does not have unlimited
liability in a firm. He can decide to become regular partner on attaining the age of majority.

Merits of Partnership

1. Easy to Form:
Formation of partnership is relatively easy. There are no lengthy procedures to follow for
formation of a partnership business. Government control is limited in a partnership business.

2. Pooling of Skills:
Partners can provide skills and knowledge in different areas of business. Sharing of
managerial responsibility will provide more efficiency in management

3. Larger Financial resources:

A partnership firm can have larger capital compared to a sole proprietorship business. The
partners contribute their capital share which generate larger funds for the business.

4. Sharing or risks:
The risk of running a business is shared by two or more partners. The provides them better
confidence in dealing with business problems. The partners can undertake riskier projects
that are more profitable.

Limitations of Partnership

1. Unlimited liability:
Generally all partners have unlimited liability. Partners are individually and collectively
liable for the debts of the firm. In special cases the partners can make the liability of some of
them limited.

2. Uncertainty of existence:
The continuous existence of a of a partnership business is uncertain. There are many reasons
such as retirement, death, insolvency, and insanity that can cause the dissolution of a
partnership business. Moreover a partner can demand the dissolution of the firm and thereby
bring it to an end.

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3. Non-transferability of ownership:
A partner cannot transfer his ownership easily. He can do so only with the consent of other
partners.

4. Scope for conflicts:

Partnerships are jointly owned and managed by all the partners. Sometimes partners fail to
agree on certain issues which may cause conflicts in the business

Partnership Deed

Partnership Deed is the agreement in writing between partners. It is the basis of a partnership
business. Written agreement between partners will reduce disputes between partners.
Partnership deed normally contains the following clauses:
i) Name of the firm
ii) Name and addresses of partners
iii) Nature of business
iv) Place of business
v) Capital contributed by each partner
vi) Profit sharing ratio
vii) Duties, power and obligations of partners
viii) Preparation of accounts and auditing
ix) Whether interest is payable on capital and rate applicable
x) Whether interest is payable on drawings and rate applicable
xi) Whether interest is payable on loans provided by partner and rate applicable
xii) Whether salary is payable to partners
xiii) Method of solving disputes
xiv) Provisions regarding dissolution of firm

Registration of the Firm

Registration of a partnership firm is not compulsory. But an unregistered firm suffers from
certain disadvantages. Therefore it is a common practice to register the partnership firm with
registrar of firms.

Consequences of non registration

An unregistered firm suffers from the following disadvantages:

i) A partner of an unregistered firm cannot file a suit against the firm or any other
partner for enforcing his rights arising from the partnership business.
ii) An unregistered firm cannot file a suit against any third party.
iii) Such a firm also cannot file a file a suit against any partner.
Check Your Progress – 3
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

48
 1. Discuss about the Partnership firms.
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5.6 COOPERATIVE ORGANIZATION

A cooperative organization is a voluntary association of persons for mutual benefit through

self help and collective effort. The main principle behind cooperative organization is mutual
support for individual benefit. Cooperative societies are registered under Cooperative
societies Act. A minimum number of ten people are required to register a cooperative
society. The capital of a cooperative society is collected from its members by selling shares.
It can also obtain additional resources from the state or central governments by way of loans.

Types of cooperative societies

Cooperative societies may be classified on the basis of activities performed by them.

Following are the main types:
i) Consumers’ Cooperative societies
ii) Producers’ Cooperative societies
iii) Cooperative marketing societies
iv) Cooperative credit societies
v) Cooperative farming societies
vi) Cooperative housing societies

i. Consumers Cooperative Societies:

Consumers’ cooperative societies are established to reduce the presence of middlemen in the
retail market. These societies are formed by the consumers to ensure a steady supply of goods
and services of high quality at reasonable prices. The society directly deals with producers or
wholesalers. Profit is not the main aim of these societies. However, if they earn any profit it
will be distributed to the members as profit share on the basis of capital contribution or bonus
on the basis of purchases made by them.

ii. Producers’ cooperative societies:

Producers’ cooperative societies are formed by producers to cooperate in arranging facilities
for running their business smoothly. These societies usually arrange raw materials, tools and
equipment and other common facilities. This will help the producers to concentrate on
production. The society purchases the products from the members and markets them. Profit
share will be distributed to members on the basis of products supplied by them. Handloom
weavers’ cooperative society, silk manufacturers’ society etc are examples of producer’s
cooperative society.

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iii. Cooperative marketing societies:

Cooperative marketing societies are associations of small producers who find it difficult sell
their products individually. The main purpose of such societies is to ensure a smooth and
favourable market for the products of its members. The output is pooled together and sold at
the best price. Sale proceeds are distributed in proportion to the contribution of members to
the pool. Marketing cooperatives eliminate middlemen and ensure honest trading practices in
weighing, measuring, and accounting.

iv. Cooperative credit societies:

Such societies are formed to provide financial assistance to members by way of loans. The
funds of these societies consist of share capital contributed by members and deposits from
members and outsiders. The funds are used in giving loans to needy members on easy terms.
Thus the members are protected from money lenders who charge high rates of interest.
Another important function of credit societies is to develop the habit of saving and investing
among their members.

v. Cooperative farming societies:

Cooperative farming societies are formed by small farmers to pool their resources for
cultivating their land collectively. Their main objective is to take advantage of the economies
of large scale farming by combining the resources and efforts. These societies are especially
significant in countries like India where agriculture suffers from excessive sub-division and
fragmentation of land. Cooperative societies help provide irrigation facilities, modern
agricultural tools and implements and better seeds and fertilizers to small farmers.

vi. Cooperative housing societies:

These societies are formed to provide residential accommodation to the members. They
undertake purchase and development of land and construction of buildings. Some societies
provide housing loans to members at low rates of interest. Cooperative housing societies also
provide common facilities such as security service, maintenance of gardens and play area.

Characteristics of Cooperative Organization

i. Voluntary association:
Membership of a cooperative society is voluntary. A person joins a cooperative society at his
will. Similarly he is free to leave the society anytime by giving notice to that effect.

ii. Equal voting rights:

All members of a cooperative society have equal voting rights irrespective of the number of
shares held by the member. A cooperative society is managed purely on democratic basis.
‘One man one vote’ is the principle followed in a cooperative society.

iii. Separate legal entity:

A cooperative society is registered under the Cooperative Societies Act. Registration of
society provides it a separate identity apart from the members. The society has its own
existence. It can buy and sell land and properties in its own name, employ people and act as
an artificial person. Individual members have less influence on the society. Death, insolvency
or insanity of members will not result in the dissolution of a cooperative society.

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 iv. Service motive:
The main objective of a cooperative society is to render service to its members. Earning
profit is the most important aim of all other forms of organizations. But profit is only
secondary in a cooperative society.

v. Distribution of surplus:
Profits earned by a cooperative society is used for distributing bonus to members and on
basis of business done with them and to distribute dividend on the basis of share held by
them.

Merits of Cooperative Organization

i. Easy to form
Formation of a cooperative society is easy. There are limited formalities to be completed. A
society can be formed by associating ten persons.

ii. Open membership

Membership in a cooperative society is open to all individuals having a common interest. A
person can become a member of cooperative society at any time likes and can leave the
society at his will.

iii. Democratic management

A cooperative society is managed according to democratic principles. All members have
equal rights and have equal opportunity to get elected to the Board of Directors.

iv. Limited liability

The liability of members of a cooperative society is limited to the extent share capital held by
them. They do not have to bear personal liability for the debts of the society.

v. Stability
A cooperative society has a separate legal existence. It has an identity apart from the
members. Personal misfortunes of members have only little influence on the society. It will
continue to exist irrespective of problems faced by the members.

vi. Economical operations

A cooperative society operates on relatively larger scale. It has advantages in purchasing
selling etc. It can eliminate middlemen and reduce cost of operations due to voluntary
services rendered by its members.

vii. Government patronage

Government gives priority treatment to cooperative societies. Supporting cooperative
societies by granting soft loan, providing legal safeguards etc will promote social welfare
which is one of the major concerns of the government.

viii. Other benefits

Certain non economic benefits are also derived by the activities of a cooperative society.
Credit cooperatives, for example, promote the habit of saving and investment and producers’
cooperatives encourage joint activity among members

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Limitations of Cooperative Organizations:

i. Limited capital
Availability of capital in a cooperative society is limited. It depends mainly on financial
ability of the members. Shares of the cooperative societies are not widely distributed as in the
case of companies.

ii. Inefficient management

Management of cooperative societies is generally inefficient. Societies are managed by the
representatives of members who are less educated or less experienced in running an
organization. Societies cannot afford to appoint qualified professional managers.

iii. Absence of motivation

A cooperative society is formed to promote group interest. There is no direct link between
effort and reward. In most cases members hesitate to put their best effort in running the
society.

iv. Difference and factionalism among members

Once the initial enthusiasm about the cooperative society is exhausted, differences and group
conflicts are arise among members. It becomes very difficult to get full cooperation of
members in running the society. Selfish motives of members begin to dominate the service
motive is sometimes forgotten.

v. Rigid rules and regulations

Excessive government control sometimes affects the smooth running of cooperative
societies. Government regulations restrict the freedom of operation of the society. It affects
the efficiency of management.

5.7 JOINT STOCK COMPANY

The company form of organization is considered to be the most suitable form for organizing
business on large scale. It does not suffer the limitations of capital or managerial ability. The
shareholders of a company enjoy safety of limited liability. Companies are ideal form to set
up large scale profitable ventures.

Features of a Company

i. Compulsory registration:
Registration is compulsory for every joint stock company. The basic documents of the
company should be filed with ‘Registrar of Companies along with the application for
registration. The company is formed under the provisions of Indian Companies Act, 1956.

ii. Distinct legal entity:

A company is regarded as legal entity apart from its members. A company can conduct
business in its own name enter into contracts, buy, sell or hold proper.

iii. Artificial person:

This feature of a joint stock company is closely related to its separate legal entity. A
company is a legal person. The business is conducted in the name of the company. Its
functions are performed by directors who are elected representatives of shareholders.

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iv. Perpetual succession:
A company has continuous existence independent of its members. Death of member will
result in automatic transfer of his shares to his legal representative. It does not affect the
existence of the company. The life of the company can come to an end only through the
prescribed procedure of winding up.

v. Common seal:
Common seal of the company serves as the equivalent of the signature of a company.
Common seal will be affixed on all important documents of the company.

vi. Limited liability:

Liability of members of a joint stock company is limited. It is limited to the extent of face
value of shares held by a member. If the share fully paid up the member need not pay
anything thing further to settle the debts of the company. The members cannot be held
personally liable for the debts of the company.

vii. Transferability of shares:

The capital of a company is divided into shares for convenient buying and selling in the stock
market. Normally the shares of a company are freely transferable. However transferability of
shares of private limited company is restricted.

Merits of a Company
i. Collection of huge financial resources:
The biggest advantage of a joint stock company is the opportunity to collect large amounts of
capital by way of selling shares. Shares of small value can be purchased even by people with
small savings. Companies can undertake large ventures as capital is easily available.

ii. Limited liability:

Limited liability of members in a joint stock company attracts large number of people to
make an investment. In case of collapse of business it will not affect other private savings of
members.

iii. Free transferability of shares:

A company permits its members to transfer their shares. No restrictions can be placed on
transfer of shares in a public company. The financial results of the company will be
published every year which makes it easier for the investors to judge the performance of the
business.

iv. Durability and stability:

A company form of organization enjoys continuous existence and stability. The investment
in shares of a company cannot be withdrawn by the investor. However he can sell the shares
in the stock exchange, which does not affect the funds of the company. As a result the
company can undertake projects of long duration which attracts more profits.

v. Growth and expansion:

Joint stock company form provides the most ideal business setting for future growth and
expansion. The company structure permits collection of capital from the public whenever the
need arises for expansion of business. Reputed companies can raise any amount of capital for
a feasible project.

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vi. Efficient management:
Companies can afford to attract the best managerial talents to run their business. Large scale
businesses cannot be managed by crude rule of thumb. Professional managers require
attractive compensation packages which small scale businesses cannot afford. Companies
can afford to attract and retain best managers which result in professionalism in every aspect
of business.

vii. Public confidence:

A company enjoys greater trust and confidence of the public. Companies are required by law
to publish their financial results. Almost every business activities are watched the
government authorities, investors, and general public. Transparency in business builds up
public confidence.
viii. Social benefits:
Company form of organization provides the following social benefits:

a. Democratization of management
A joint stock company is organized on democratic lines. The Board of Directors which is the
highest decision making body in the business mainly consist of representatives of
shareholders. In rare cases additional directors are appointed to represent government or
major creditors. Democratic management enables even small investors to become part of the
decisions of a large company.

b. Dispersal of ownership
Shares of a company are usually sold out all over the country. Thus the ownership as well as
the benefits of the business are distributed to a wide area.

c. Assumption of social responsibilities

Joint stock companies are famous for their social service. There are several reputed
educational institutions including schools, colleges and management institutions established
by companies. Several reputed hospitals and research institutions run by companies. They
also actively promote charitable causes. They also support relief efforts in the event of
natural calamities.

Limitations of Company Organization

Joint stock company form is considered the most ideal form of organization for most
businesses. However it is not free from limitations. Following are the important limitations of
company form of organization:

i. Lengthy and expensive legal procedures:

Formation of a joint stock company is a lengthy process. There are several documents to be
prepared and filed with authorities. Approvals have to be obtained from various authorities,
before actually commencing the business. These procedures are time consuming and
expensive. Complicated registration formalities often discourage businessmen.

ii. Excessive government regulations:

The government is keen to place safeguards wherever large scale finance from the general
public is involved. Since joint stock companies collect large amounts from the public by
ways of shares, debentures, or public deposits, it becomes the responsibility of the
government to have a closer look at the affairs of the business. The well intended government
regulations often become an inconvenience to honest companies.

54
iii. Lack of incentive:
There is no direct ownership control over the business. Shareholders are the real owners of a
business. It is not practical for all the shareholders to participate in the decision making
process. The Board of Directors represents the shareholders as the ministers represent the
citizens. Below the directors there is often a big team of paid managers who implement the
policies of directors in the business. Shareholders’ interest is protected in a company to the
extent it protects the interest of Directors and mangers of the company.

iv. Delay in decision making:

A large scale organization has a set of administrative procedure for every activity. The
administration procedures in decision making process often delays decisions. In many cases,
by the time the management comes out with a solution, the problem would have complicated
beyond a curable stage.

v. Conflict of interest:
Since a joint stock company involves a large number of people with diverse interest there
ought to be some sort of conflict of interest. Managerial objectives sometimes conflict each
other, even while the managers are seeking the common benefit of the business. The business
will run successfully when there is a right balance attained between the diverse interests of
various groups.

vi. Oligarchic management:

Oligarchy is the kind of administration by a small group. Company has a democratic setup of
administration. But perfect democracy is only in theory. In almost every company there is a
powerful group of people who get elected to the Board of Directors every time and they
control the business. Such individuals are usually keen to safeguard their personal interest
rather than the interest of the company. In other words the interest of the company is
important as far as it serves the personal interests of the directors.

vii. Speculation:
Speculation in shares and securities of the company is another problem. Very few of the
millions of transactions taking place in the stock market every day are genuine investment or
disinvestment. They are mostly speculative transactions. Speculative transactions are aimed
at making money by playing the game of buying and selling of shares according to the
market trends. Speculative transactions are win/lose transactions. One man makes profit out
of another man’s loss. Genuine transactions are win/win transactions. One person wants
genuine investment and another one wants money.

viii. Growth of monopolistic tendencies:

Joint stock companies are generally large business houses. They have the scope for unlimited
growth. Large corporations have inherent tendency to build up monopoly. Society benefits
from healthy competition between businesses. Concentration of economic power and
monopoly harms the process of social welfare.

ix. Influence government decisions:

Large corporations generally become powerful enough to control government decisions.
Government policies are often framed to favour the interest of the businesses rather than the
interest of the people. They even corrupt the government officials by paying bribes or
granting favours.

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Types of Companies
Companies are broadly classified into private companies and public companies.

i) Private Company
Private companies are registered as such under Companies Act. They enjoy most of the
privileges of a limited company. Private companies are generally smaller and owned by a
small group of individuals known to each other. A private company differs from the public in
respect of number of members, right to invite public to invest in the company, right to sell
shares in the stock exchange etc. Following are he important features. Following are the
important characteristics of private companies

1. Membership
A private company can be registered with a minimum number of two members. The
maximum number of members allowed for a private company is fifty, excluding present and
past employees of the company.

2. Transfer of shares
A private company places restrictions on the transfer of shares. A private company is not
allowed to list the shares in stock exchange.

3. Invitation to public to subscribe the shares

A private company is not allowed to invite the public to subscribe to its shares. Capital of a
private company is raised either by the promoters or their friends and relatives.

4. No public deposits
A private company cannot invite or accept public deposits. However a private company is
allowed to obtain negotiated loans from individuals or financial institutions because such
loans are not considered public deposits.

ii) Public Company

According to Section 3 of the Indian Companies Act, 1956, “a public company is one which
is not private”. Most of the joint stock companies are public companies. The term ‘pubic’
does not mean government ownership. It simply indicates that there is larger involvement of
general public, because the company is allowed to invite the public to invest in shares,
debentures or deposits of the company. Following are the important features:

1. Membership
Minimum membership in a public company is seven. There is no maximum limit of
membership in a public company.

2. Invitation to public for investment

A public limited company is allowed to invite the public to invest in shares, debentures or
public deposits of the company.

3. Transferability of shares
The company cannot place any restrictions on the transfer of shares in a public company.
They are freely transferable. Public shares of a public company are listed in major stock
exchanges for easy buying and selling.

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Distinction between Private and Public Company

Points of Private Companies Public Companies

difference
Minimum
Minimum number of members in Minimum number of members in
number of
private company is two public company is seven
members
Maximum number of members in
Maximum
private company is 50, excluding No maximum limit of membership
number of
members who are employees of in public companies
members
the company
Number of Minimum number of directors is Minimum number of directors is
directors two. three
Public invitation by way of
Not allowed to issue public
Issue of shares prospectus and public issue of
invitation for investing in the
to public shares, debentures, and deposits
company
allowed.
Private company restricts the
A public company cannot put any
Transferability transfer of shares. The shares
restriction on the transfer of shares.
of shares cannot be listed in stock
They are freely transferable
exchanges
Minimum The minimum paid up capital for The minimum paid up capital of a
Capital a private company is Rs.100,000. public company is Rs.500,000
Directorships held in private
Restriction on companies are excluded while
A person cannot hold directorship
holding counting the maximum number
in more than 15 public companies
directorship of directorships a person can
hold.

Privileges of Private Company

A private company is a hybrid product that incorporates many of the features of a partnership
business under the umbrella of Companies Act. (Many of the privileges discussed below are
just meaningless exercise of words taken from your NCERT text book. Read, write the
exam., then forget it)

1. Number of members
A private company can be formed with just two members. But at least seven members are
required to form a public company

2. Number of Directors
A private company needs to have only two directors whereas the public company must have
minimum three directors. (What a great privilege)

3. Index of Members
The Companies Act requires every company having more than 50 members to keep an index
of members in addition to register of members. A private company generally consists of less
than 50 members it need not keep an index of members.

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4. Loan to Directors
A private company is allowed to give loan to directors without obtaining prior approval from
the central government as mandatory in case of public company.

5. Legal Formalities
Private companies are exempt from several legal formalities that are essential in case of
public companies. A private company needs not issue prospectus, obtain certificate of
commencement of business, collect minimum subscription etc.

Deemed Public Company

Section 43 A of Indian Companies Act stated certain conditions under which a private
company would be considered a public company. The amendment of 2000 cancelled these
provisions. So the concept of “deemed public company” is part of history now.

5.8 CHOICE OF FORM OF BUSINESS ENTERPRISES

Form of business is an important factor contributing to the success of a business. Therefore it
is a crucial decision to be taken before starting the business. The choices available range
from the small scale, one man controlled sole proprietorship to large scale public corporation.
Each one has its own merits and demerits. The suitable form of business is selected on the
basis of following factors:

1. Nature of business
The nature of business activity is the first factor that decides the form of business. If the type
of business activity requires personal attention of the owner, sole proprietorship is the option.
A sole proprietorship form is ideal for starting a tailoring unit or beauty parlor, whereas
company from is ideal for starting an automobile manufacturing unit. Professional firms such
as auditors, or lawyers, architects etc. are organized as partnership business. HUFs are family
businesses.

ii. Capital Requirement

Capital requirement of the proposed business is another important consideration in deciding
the form of business. Sole proprietorship business is ideal when the business is very small
which can be financed by the proprietor himself of by way of loans he can raise. Partnership
business has little more finance because of the presence of more owners. When the project
requires huge investment, company form is the most suitable. Joint stock companies can raise
large amount of capital by issuing shares. More over it can easily raise additional funds by
way of debentures and public deposits.

iii. Degree of Control Desired

If a businessman requires absolute control over the business, sole proprietorship is the only
option. A partnership business is controlled jointly by the partners. Cooperative societies and
joint stock companies are controlled by the representatives of share holders. When a
businesses requires large capital the promoter must be willing to share control of business
with other investors.

iv. Degree of Risk Involved

Owners of sole proprietorship and partnership businesses are personally liable, without
limits, for the debts of the business. Therefore these forms of business are suitable only when
the risk is limited. Limited company form is the ideal option to setup businesses in high risk
areas.

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v. Freedom from Government Regulations

Government is concerned when large amount of funds are raised from the public in the name
of investment. All activities of companies are rule bound. The company has to maintain all
financial and non financial records according to government guidelines. It has the file reports
of its activities in prescribed format.

Government interest in sole trading and partnership business are limited. There is no
government control as long the business activity is legal and the owners pay the taxes on
time. If the businessman wants to be free from any government control sole proprietorship or
partnership are the options available.

vi. Duration of Business Venture

When the proposed business is planned to run for a limited period and then to dissolve, only
partnership or sole proprietorship form are more convenient. Joint stock companies require
more time to set up because of several legal formalities to be completed for registration.
Similarly liquidation of a company also has to follow lot of procedures. Partnerships are
formed for a limited period or for the completion of a particular project, and at the end of the
period or the completion of the project the partnership firm is automatically dissolved
without much hassle.

5.9 FACTORS TO BE CONSIDERED FOR STARTING A BUSINESS

Starting a business involves many crucial decisions. Correct decisions taken at the initial
stage is important for the survival and stability of the business. Following are some of the
important factors to consider at for starting a business:

1. Market Analysis
Market analysis will indicate if there is enough demand for supporting a business. There
should be potential for growth and expansion of the business.

2. Development and Production Analysis

Analysis of various stages and processes involved is important. The production planning is
essential to organize machines, materials and skills at the right places. By working out the
details of production process the management can allocate sufficient resources for each stage
of production.

3. Financial Analysis
Financial analysis involves the estimation of funds requirement and the source of funds. A
person intending to start a business must have a fairly accurate idea of the funds required for
the project. Either he should have the funds or the position to mobilize it. Cost of finance is
also an important factor. Sufficient finance when the need arises is an important factor for the
business success.

4. Location of Business
Location of business is a decision to be taken on the basis of several factors. Ideal location
will greatly help the progress of business. Similarly unsuitable location can become the
greatest handicap of a business. To set up a business in a city the investor has to spend a lot
of money initially because of high cost of land or high rent. But it pays back itself because of

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higher demand or lesser transport cost. Similarly if a business is using bulky raw materials, it
would be better to set up the business near the source of raw materials to reduce the cost of
transportation. In addition to cost of transportation or rent there are several other factors such
as availability of power, labour supply etc. before making a final decision to locate a
business.

5. Personal Characteristics
A businessman needs to be different form a common man in his approach towards problems
and opportunities. This difference in attitude decides his success or failure. Businessman has
inherent ability in finding opportunities in many of the problems. Success in business is said
to be the reward for risk taking. If a person is too cautious in every step of his life better that
he does not attempt business.

6. Government Policy
Attitude of government is very important for the success of business. Before deciding on
starting a business it is essential to study the legal and social environment. Without
government support and the safety of legal system, no business can flourish. Liberal import
policies, clear tax structure, transparent labour laws and favourable social climate will attract
more and more investments in a place.

5.10 SCOPE FOR SETTING UP SMALL BUSINESS

Despite the growth of large scale industry, there is a special place for survival and growth of
small scale businesses. The following factors contribute to the existence of small scale
business.

1. Limited Resources
Resource availability is the first factor determining the size of a business. Small scale
business, as the name suggests, does only limited business. There are a large number of
business activities that can be successfully operated with limited capital. Small scale
businesses operate in those specialized areas. Formalities in setting up such business are very
limited.

2. Flexibility
Small businesses are generally owner-operated. The owner can make decisions according to
circumstances. This is not possible in a large scale business where decisions have to be taken
and implemented through established channels. Thus small business can introduce new
products, services, withdraw products all without much administrative formalities.

3. Personal Touch
Small businesses generally cater to the need of small number of known customers. Owner
himself directly controls most of the work. There is greater degree of personal touch in
dealing with the customers. This personal touch is the secret of the success of many of the
small scale businesses.

4. Limited Demand
There and products or markets that are not sufficient to sustain large business. Small scale
businesses operate in such areas efficiently, because the limited demand is sufficient for the
limited quantity of goods and services they produce.

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5. Supplying the Needs of Large Corporations
Many large corporations depend of small businesses to supply their needs. Many of the
products that come with big labels are in fact manufactured by small scale businesses on sub-
contract basis. There are several components in products that are better manufactured by
small scale businesses. For example, car manufacturers depend on small suppliers for the
supply of seats, rubber parts etc. according to their specifications and quality requirements.

6. Individual Temperament
Some individuals are too much independent by nature. In spite of their sincere efforts they
cannot adjust with the discipline requirements of a large organization. Small self managed
business ventures are suitable for such people.

7. Inherent Disadvantage of Large Business

Large scale business suffers from several inherit problems such as potential for too much
concentration of economic power, inefficiency in management and lack of personal touch in
dealing with customers or employees.

5.11 PUBLIC SECTOR

Public sector business played an important role in the development of our country. The
concept of welfare state and the ideologies of socialism were the driving force behind setting
up of state enterprises. In recent years the government is shifting form involving in business.
Private sector is gradually gaining recognition in most of the business sectors. In recent years
global enterprises are gaining popularity. Some of the Indian companies have already gained
global recognition.

5.12 PRIVATE SECTOR AND PUBLIC SECTOR

In India, public sector enterprises have been increasing in number since independence.
During the initial years of independence, public sector had been considered the key to
economic liberation of the nation after decades of foreign occupation. Such high hopes have
faded when tested against the prevailing realities in the country. Intellectuals in the country
realized right from the 60s that our public sector experiment was a big flop. But it was a
convenient tool to nurture the dreams of the poor and the pockets of the corrupt. Thus we
contributed several great ideas to the world as to why we should continue to feed the public
sector from the tax payers’ money. Some of those wonderful ideas are discussed below:

Rationale of Public Sector

i) Defense requirements
Investment in public sector was essential to make sure continuous supply of goods and
services for the defense forces of our country. Strategic supply cannot be left to the private
sector. American army depends almost entirely on private sector for their defense supply. We
cannot make such mistakes.

ii) Basic and heavy industries

Basic and heavy industries require huge capital. Private sector cannot make such huge
investments. Private sector is less interested in such enterprises because these industries
generate return very slowly.

61
[Tata started steel factory in 1907, which is running very well. It was during British time, so
we could not stop them.]

iii) Public utilities

Public utility services such as water supply, electricity, gas and public transportation do not
generate high profits. Public sector enterprises are essential to provide these services.

iv) Preventing concentration of economic power and monopolies

Concentration of economic power in the hands of a few is an undesirable situation. Creation
of monopolies is another bad effect in the economy. Government took over some of the
private sector companies to prevent concentration of economic power and creation of
monopolies.

v) Infrastructure
Private sector is not interested in infrastructure development industries. Infrastructure such as
transport, power, roads, and communication networks are essential for the development of
other industries. Private sector is less committed to such social causes. They are interested
only in business activities that can generate quick profit on their investment. It becomes the
duty of the government to invest in these industries to ensure improvement in standard of
living.

vii) Development of backward regions

When a private businessman selects a place for setting up a business, his first consideration is
the success of the business. Noble ideas like development of the country and welfare of the
people are not the guiding principle for the private sector investor. Government is the only
investor who can afford to start a business purely for development of backward regions.

viii) Financing of economic development and full employment

Employment generation is another aim of public sector business. In fact many of the public
sector industries are doing only employment generation.

ix) Socialist pattern of society

Socialism was the dream of 20th century. Socialistic ideologies basically require all the
means of production owned by the government. They were really great dreams, state owned
businesses giving the highest salaries to workers, supplying the best products to customers
and charging lowest price for goods and services, and finally as icing on the cake the whole
profit going to the government treasury to enrich the country. It took almost half a century
for India to wake up from this dream and by that time the rest of the world had gone far
ahead.

5.13 FORMS OF ORGANISING PUBLIC SECTOR ENTERPRISES

Public sector enterprises are organized in three different forms:

a. Departmental undertakings
b. Public corporations
c. Government companies
a. Departmental Undertaking
This is the oldest form of state enterprise. A departmental undertaking is formed as a
government department. In India, railways, post and telegraphs, ordinance factories etc. are
organized as government departments.

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b. Public Corporations
Public corporations are also known as statutory corporations. Public corporations are
autonomous corporations. They are created by an Act passed by Parliament or State
Legislature. This Act defines all the legal, administrative and business framework of the
public corporation. Some of the major public corporations in India are the following: The
Life Insurance Corporation of India, Air India, Indian Airlines, Food Corporation of India,
Oil and Natural Gas Commission and Central Warehousing Corporation.

c. Government Company
Government Company is a joint stock company registered under Indian Companies Act in
which the Central or State Governments hold not less than 51% of the shares. The
government company is subject to the rules and regulation of the Companies Act like any
other company in the private sector. However the Government has the authority to exempt a
government company from the any of the provisions of the Companies Act through
notification in the official gazette.

5.14 BUSINESS ORGANISATION IN NEW MILLENNIUM

Global enterprises are large business houses with multinational operations. They have
production centres in many countries. They also have global market for their products. Its
head quarters are located in one country which is considered its home country. They make
strategic alliances with local companies in the countries in which they set up operation.

Features OF MNC

i. Giant size
Multi National Companies are very large business ventures. They have large number of
production distribution centres in many parts of the world. Their turnover exceeds the Gross
National Product of several developing countries.

ii. Centralized control

Multinational companies are controlled by the central office in their home country. The main
office makes major policy decisions. All the subsidiaries and branches follow uniform policy
in every country they operate. Minor adjustments are made according to local conditions in
each country.

iii. International operations

A multinational corporation has facilities all over the world for production, marketing and
administration. It owns and controls assets in many countries. I also influence global markets.

iv. Oligopolistic power

Oligopoly is a system in which the majority is controlled by a limited minority. Multinational
corporations acquire lot of power globally and they virtually eliminate competition by taking
over the competitors. Some of the competing businesses are pushed out of business due to
more efficient business strategies followed by MNCs.

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v. Sophisticated technology
Multinationals have access to better technology. They use capital intensive methods of
production and they get first hand information about the global trend in product designs and
the changes in customer preferences. Their production techniques are more efficient and the
product quality is world class.

vi. Professional management

Being large scale business venture operating in a fiercely competitive global market, a
multinational business cannot afford to poor management. Problems in a global business are
different in a multinational business because of diverse social cultural and legal environment
in which it operates. It has to handle huge funds and large investment.

vii. International market

Products of a multinational company are not directed at a single country alone. They locate
production centers in country where raw materials and labour are easily available and sell
them in countries where there is demand.

Role of Multinationals

The activities of multinational corporations can have positive and negative effect on the
economy of a country. On the positive side multinationals are considered a channel for
bringing new technology, capital and employment generation. As a negative force
multinationals are blamed for causing the collapse of many local businesses in the host
countries. They try to influence the economic decisions of host countries.

Following are the benefits to host countries from multinationals:

i. Employment generation
Multinationals are big employers. The generate employment opportunities in host countries.
They also set new standards of employment in host counties. Salaries and service conditions
offered by Multinational companies are far better that that offered by domestic employers.
Better employment offers by MNCs compel domestic employers to improve their standards
of salaries and service conditions.

ii. Foreign capital

Multinationals bring in large amount of capital. They make heavy investment in building up
production facilities and markets. Capital investment by MNCs leads to increase in income
levels through generating direct and indirect employment opportunities. They offer best
career option to young professionals by giving them a chance to work in an international
atmosphere and to train abroad. MNCs profoundly influence standards of employment in host
countries.

iii. Advanced technology

Technology transfer is perhaps the most important contribution of Multi National
Corporations. Global enterprises bring advanced technology to developing countries.
Advance countries have latest technology in production and management. MNCs bring the
benefits of research and development to developing nations. Quality of goods and services in
the market has improved because of better international brands in the market.

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iv. Growth of domestic firms
MNCs are supported by many domestic companies in supplying components and services for
their production activities. Several ancillary units come up around a large multi national
company.
These domestic industries learn from the expertise of international corporations.

v. Improve inflow of foreign currency

In addition to technology, global enterprises bring in capital from outside. Global enterprises
invest large capital in their production facilities. Capital transfer by global enterprises
improves the foreign exchange reserves of host countries.

vi. Standard of living

Standard of living is influenced in many ways. MNCs provide direct employment to large
number of people. In addition it provides indirect employment opportunity to lot of people.

vii. Managerial revolution

The management of Multinational companies is highly professional. They operate in a
competitive environment. Their techniques are world class. They also train management
professionals of host countries.

viii. World economy

Multinationals encourage the integration of national economies into the system of world
economy. There is greater economic and cultural exchange because of the influence of
international businesses.

ix. Healthy competition

Multinational changes the rules of game in the market. Many domestic monopolies which
survived on the strength of lack of competition are now compelled to improve the quality of
their products to survive in the market. Many Indian companies who were supplying low
quality products to Indians have now achieved standards of international quality such as ISO
9000, 90001 and 9002. Competition from Multinationals has become wake up call for many
companies in India.

Criticisms of Multinationals

Multinationals are criticized on several grounds. They provide several benefits to host
countries. At the same time there are problems also.

i. Disregard of national priorities

MNCs are not concerned about the national priorities of host countries. They are interested
matters that serve their business interests. The national priorities such as development of
backward areas or improvement of long term growth or infrastructure development do not
find place in the list of objectives of Multinational companies. They are interested in the
business that they already own and they are interested to promote that business.

ii. Obsolete technology

Many multinational companies are blamed for bringing in outdated technology to developing
countries. Outdated models and outdated technology are marketed in developing countries.
Many new products are not released in the market as long as they can continue to market the
old ones.

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iii. Excessive remittance
Multinational companies are highly profitable. Their profits are generally transferred to their
home countries or other places where they have business interest. Regular remittance of profit
strains the delicate foreign exchange position of developing countries.

iv. Creation of monopoly

Multinationals are big and strong. Their clever strategies push many small businesses into
extinction. They sometimes take over smaller competing businesses to create absolute
monopoly.

v. Restrictive clauses
Multinational companies add several restrictive clauses in the collaboration agreements with
local companies. They usually include restrictions on passing the technology to other
companies, right to fix prices, right to export the goods produced under collaboration
agreement. These clauses keep the associate companies in host countries under tight control
of the multinational company.

vi. Threat to national sovereignty

MNCs meddle with the local politics to build up their support structure in the administration.
They interfere in political process of host countries. Their money power enables them to buy
corrupt politicians who make rules and regulations to suit the business interest of
multinationals. With enormous funds at their disposal and international influence they are
able to put pressure on small countries to make favourable decisions.

vii. Alien culture

Multinationals represent a culture different from that of the host countries. They try to
influence the social and cultural habits of people to create demand for their products.
Multinational companies continuously try to alter the consumption habits of people in their
target markets. For example, cornflakes manufactures have been trying to change the
breakfast menu of Indians for long time. Fortunately, most Indians still refuse to give up their
old favourites.

viii. Depletion of natural resources

Ruthless extraction of national resources causes fast depletion of non-renewable resources. It
also causes permanent damage to environment.

5.15 PROFIT MAXIMIZATION AS BUSINESS OBJECTIVE

Maximization has been the most important assumption on which economists have built price and
production theories. This hypothesis has, however, been strongly questioned and alternative
hypothesis suggested. This issue will be discussed in the forthcoming sections. Let us first
look into the importance of the profit maximization hypothesis and theoretical conditions of
profit maximization.

The conventional economic theory assumes profit maximization as the only objective of
business firms. Profit maximization as the objective of business firms has a long history in
economic literature. It forms the basis of conventional price theory. Profit maximization is
regarded as the most reasonable and analytically the most 'productive' business objective. The
strength of this assumption lies in the fact that this assumption 'has never been
unambiguously disproved'.

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Besides, profit maximization assumption has a greater predictive power. It helps in predicting
the behaviour of business firms in the real world and also the behaviour of price and output
under different market conditions. No alternative hypothesis explains and predicates the
behaviour of firms better than the profit maximization assumption.

Check Your Progress – 4

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the Profit Maximization Business Objectives.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
……………..

5.16 CONTERVERSARY OVER MAXIMIZATION OBJECTIVE ( THEORY VS

PRACTICE

As discussed above, traditional theory assumes profit maximization as the sole objective of a
business firm. In practice, however, firms have been found to be pursuing objectives other
than profit maximization. It is argued, in the first place, that the reason for the firms,
especially the large corporations, pursuing goals other than profit maximization is the
dichotomy between the ownership and management. The separation of management from the
ownership gives managers an opportunity and also discretion to set goals for the firms they
manage other than profit maximization. Large firms pursue such goals as sales maximization,
maximization of managerial utility function, maximisation of firm's growth rate, making a target
profit, retaining market share, building up the net worth of the firm, etc.

Secondly, traditional theory assumes full and perfect knowledge about current market
conditions and the future developments in the business environment of the firm. The firm is
thus supposed to be fully aware of its demand and cost functions in both short and long runs.
Briefly speaking, a complete certainty about the market conditions is assumed. On the
contrary, it is widely recognized that the firms do not possess the perfect knowledge of their
costs, revenue, and their environment. They operate in the world of uncertainty. Most price and
output decisions are based on probabilities.

Finally, the marginality principle of equalizing MC and MR has been found to be absent in
the decision-making process of the firms. Empirical studies of the pricing behaviour of the
firms have shown that the marginal rule of pricing does not stand the test of empirical
verification. Hall and Hitch" have found, jn their study of pricing practices of UK 38 firms,
that the firms do not pursue the objective of profit maximization and that they do not use the
marginal principle of equalizing MR and MC in their price and output decisions. Most firms aim
at long-run p*to fit maximization. In the short-run, they set the price of their product on the
basis of average cost principle, so as to cover AC = AVC + AFC and a normal margin xjf

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profit (usually 10 per cent). In a similar study, Gordon 2 has found that there is^ marked
deviation in the real business conditions from the assumptions of the traditional theory and
that pricing practices were notably different from the marginal theory of pricing. He has
concluded that the real business world is much more complex than the one postulated by the
theorists. Because of the extreme complexity of the real business world and ever-changing
conditions, the past experience of the business firms is of little use in forecasting demand,
price and costs. The firms are not aware of their MR and MC. The average-cost-principle of
pricing is widely used by the firms. Findings of many other studies of the pricing practices
lend support to, the view that there is little link between pricing theory and pricing practices.

The Defense of Profit Maximization

The arguments against the profit-maximization assumption, however, should not mean that
pricing theory has no relevance to the actual pricing policy of the business firms. A section of
economists has strongly defended the profit maximization objective and 'marginal principle' of
pricing and output decisions. The empirical and theoretical support put forward by them in
defense of the marginal rule of pricing may be summed as follows.

In two empirical studies of 110 'excellently managed companies', J.S. Earley13 has concluded
that the firms do apply the marginal rules in their pricing and output decisions. Fritz Maclup14
has argued in abstract theoretical terms that empirical studies by Hall and Hitch, and Lester
do not provide conclusive evidence against the marginal rule and these studies have their own
weaknesses. He further argues that there has been a misunderstanding regarding the purpose
of traditional theory of value. The traditional theory seeks to explain market mechanism,
resource allocation through price mechanism and has a predictive value, rather than deal with
specific pricing practices of certain firms. The relevance of marginal rules in actual pricing
system of firms could not be established because of lack of communication between the
businessmen and the researchers as they use different terminology like MR, MC and
elasticities. Besides, businessmen even if they do understand economic concepts, would not
admit that they are making abnormal profits on the basis of marginal rules of pricing. They
would instead talk of a 'fair profit'. Also, Maclup is of the opinion that the practices of setting
price equal to average variable cost plus a profit margin is not incompatible with the
marginal rule of pricing and that the assumptions of traditional theory are plausible. This
point has been discussed further in chapter 14.

While the controversy on profit maximization objective remains unresolved, the conventional
theorists, the marginalists, continue to defined the profit maximization objective and its
marginal rules.

Arguments in Defense of Profit Maximization Hypothesis

The conventional economic theorists defend the profit maximization hypothesis also on the
following grounds.

1. Profit is indispensable for firm's survival.

The survival of all 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 competition
.Nevertheless, what is a reasonable profit? May be a matter of opinion. But, making a profit
is a necessary condition for the survival of the firm. Once the firms are able to make profit,
they try to make it as large as possible, i.e., they tend to maximize it.

68
2. Achieving other objectives depends on firm's ability to make profit.
Many other objectives of business firms have been cited in economic literature, e.g.,
maximization of managerial utility function, maximization of long-run growth, maximization
of sales revenue, satisfying all the concerned parties, increasing and retaining market share,
etc. The achievement of such alternative objectives depends wholly or partly on the primary
objective of making profit.

3. Evidence against profit maximization objective not conclusive.

Profit maximization is a time-honoured objective of business firms. Although this objective
has been questioned by many researchers, the evidence against it is not conclusive or
unambiguous.

4. Profit maximization objective has a greater predicting power.

Compared to other business objectives, profit maximization assumption has been found to be
a much more powerful premise in predicting certain aspects of firms' behaviour. As Friedman
has argued, the validity of the profit-maximization objective cannot be judged by a priori logic
or by asking business executives, as some economists have done. The ultimate test of its
validity is its ability to predict the business behaviour and the business trends.

5. Profit is a more reliable measure of firm's efficiency.

Thought not perfect, profit is the most efficient and reliable measure of the efficiency of a firm.
It is also the source of internal finance. Profit as a source of internal finance assumes a greater
significance when financial market is highly volatile. The recent trend shows a growing
dependence on the internal finance in the industrially advanced countries, In fact, in
developed countries, internal sources of finance contribute more than three-fourths of total
finance. Finally, whatever one may say about firms' motivations, if one judges their
motivations by their acts, profit maximization appears to be a more valid business objective'5.

5.17 ALTERNATIVE OBJECTIVES OF BUSINESS FIRMS

While postulating the objectives of business firms, the conventional theory of firm does not
distinguish between owners' and managers' interests. The recent theories of firm called
'managerial' and 'behavioural' theories of firm, however, assume owners and managers to be
separate entities in large corporations with different goals and motivation. Berle and Means
were the first to point out the dichotomy between the ownership and the management and its
role in managerial behaviour and in setting the goal(s) for the firm that they manage. Later on
Galbraith17 wrote extensively on this issue which is known as Berle-Means-Galbraith (B-M-
G) hypothesis.

The B-M-G hypothesis states (i) that owner controlled firms have, higher profit rates than
manager controlled firms; and (ii) that managers have no incentive for profit maximization.
The managers of large corporations, instead of maximizing profits, set goals for themselves
that can keep the owners quiet so that managers can take care of their own interest in the
corporation. In this section, we will discuss very briefly some important alternative objectives
of business firms, especially of large business corporations.

69
5.18 BAUMOL’S HYPOTHESIS OF SALES REVENUE MAXIMISATION

Baumol18 has postulated maximization of sales revenue as an alternative to profit-maximization

objective. The reason behind this objective is the dichotomy between ownership and
management in large business corporations. This dichotomy gives managers an opportunity to
set their goals other than profit maximization goal which most owner-businessmen pursue.
Given the opportunity, managers choose to maximize their own utility function. According to
Baumol, the most plausible factor in managers' utility functions is maximization of the sales
revenue.

The factors which explain the pursuance of this goal by the managers are following.
First, salary and other earnings of managers are more closely related to sales revenue than to
profits.
Second, banks and financial corporations look at sales revenue while financing the
corporation.
Third, trend in sale revenue is a readily available indicator of the performance of the firm. It
helps also in handling the personnel problem.
Fourth, increasing sales revenue enhances the prestige of managers while profits go to the
owners.
Fifth, managers find profit maximization a difficult objective to fulfill consistently over time
and at the same level. Profits may fluctuate with changing conditions.
Finally, growing sales strengthen competitive spirit of the firm in the market and vice versa.
So far as empirical validity of sales revenue maximization objective is concerned, factual
evidences are inconclusive. Most empirical works are, in fact, based on inadequate data
simply because requisite data is mostly not available. Even theoretically, if total cost function
intersects the total revenue function (TR) function before it reaches its climax, Baumol's
theory collapses.

Besides, it is also argued that, in the long run, sales maximization and profit maximization
objective converge into one. For, in the long run, sales maximization tends to yield only
normal levels of profit which turns out to be the maximum under competitive conditions.
Thus, profit maximization is not incompatible with sales maximization.

Check Your Progress – 5

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about the Baumol’s Hypothesis of Sales Revenue Maximization

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……..

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5.19 LET US SUM UP

In this lesson we discussed in detail the various forms of business and we also studied
multinational companies. Multinationals play positive and negative roles. It is for the host
country to introduce judicious safeguards to protect their national interest. In India, we were
sitting on a gold mine for decades without knowing how to dig it out. We have started
welcoming multinationals and results are everywhere. Now we complain that they make soft
drinks and low technology products. They do make soft drinks and they make decent cars
also. It is for our consumers to choose how they want to spend their money, not the
government to decide what we eat, drink or how to go to work.

5.20 KEYWORDS
Profit maximization Millennium
Joint Stock Company Cooperative Societies
Partnership Joint Hindu Family business
Sole Proprietorship sales revenue
Liability Formation
managerial skill continuity

5.21 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

71
5.22 ANSWER TO CHECK YOUR PROGRESS EXERCISE
Check Your Progress – 1
1. See section 5.3
Check Your Progress – 2
1. See Section 5.4
Check Your Progress – 3
1. See section 5.5
Check Your Progress – 4
1. See Section 5.15
Check Your Progress – 5
1. See section 5.18

72
BLOCK
3
UNIT 6
DEMAND
UNIT 7
LAW OF DEMAND
UNIT 8
ELASTICITY OF DEMAND

UNIT 9
DEMAND FORECASTING

73
UNIT– 6
DEMAND

STRUCTURE

6.1 Objectives

6.2 Introduction

6.3 Meaning of Demand

6.4 Determinants of Demand

6.5 Let us Sum Up

6.6 Keywords

6.7 Some Useful Books

6.8 Answer to Check Your Progress Exercise

6.1 OBJECTIVES

After having studied this unit, you should be able

To understand the concept of demand
To identify the determinants of the demand for a commodity

6.2 INTRODUCTION

This lesson examines demand and its determinants. Demand is the force that drives all
business without a demand for its goods or services, a firm is doomed to failure

6.3 MEANING OF DEMAND

In economic science, the term "demand" refers to the desire, backed by the necessary ability
to pay. The demand for a good at a given price is the quantity of it that can be bought per unit
of time at the price. There are three important things about the demand: 1. It is the quantity
desired at a given price.
2. It is the demand at a price during a given time.
3. It is the quantity demanded per unit of time

74
6.4 DETERMINANTAS OF DEMAND

The factors that determine the size and amount of demand are manifold. The term "function"
is employed to show such "determined" and "determinant" relationship. For instance, we say
that the quantity of a good demanded is a function of its price i.e.,

Q = f(p)
Where Q represents quantity demanded
f means function, and p represents price of the good.

There are many important determinants of the demand for a commodity:

1. Price of the goods:

The first and foremost determinant of the demand for good is price. Usually, higher the price
of goods, lesser will be the quantity demanded of them.

2. Income of the buyer:

The size of income of the buyers also influences the demand for a commodity. Mostly it is
true that "larger the income, more will be the quantity demanded".

3. Prices of Related Goods:

The prices of related goods also affect the demand for a good. In some cases, the demand for
a good will go up as the price of related good rises. The goods so inter-related arc known as
substitutes, e.g. radio and gramophone. In some other cases, demand for a good will comes
down as the price of related good rises. The goods so inter-related are complements, e.g. car
and petrol, pen and ink, cart and horse, etc.

4. Tastes of the buyer:

This is a subjective factor. A commodity may not be purchased by the consumer even though
it is very cheap and useful, if the commodity is not up to his taste or liking. Contrarily, a good
may be purchased by the buyer, even though it is very costly, if it is very much liked by him.

5. Seasons prevailing at the time of purchase:

In winter, the demand for woolen clothes will rise; in summer, the demand for cool drinks
rises substantially; in the rainy season, the demand for umbrellas goes up.

6. Fashion:
When a new film becomes a success, the type of garments worn by the hero or the heroine or
both becomes an article of fashion and the demand goes up for such garments.

7. Advertisement and Sales promotion:

Advertisement in newspapers and magazines, on outdoor hoardings on buses and trains and
in radio and television broadcasts, etc. have a substantial effect on the demand for the good
and thereby improves sales. The need to have clarity in demand analysis makes us adopt a
'ceteris paribus' assumption, i.e. all other things remain the same except one. This enables us
to consider the relation between demand and each of the variable factors considered in
isolation.

75
 Check Your Progress – 1
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Determinants of Demand.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
……………..

6.5 LET US SUM UP

We have studied that the term demand refers to the quantities of goods that consumers are
willing and able to purchase at various prices during a given period of time. Also we
identified the various vital determinants of the demand for a commodity.

6.6 KEYWORDS

Demand Quantity
Price Unit
Determined Goods
Income Buyer
Related Seasons
Prevailing Fashion
Advertisement Sales promotion

6.7 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari

76
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

6.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1
1. See section 6.4

77
UNIT 7
LAW OF DEMAND
STRUCTURE

7.1 Objectives
7.2 Introduction
7.3 Law of Demand
7.4 Demand Schedule
7.5 Demand Curve
7.6 Market Demand
7.7 Shifts in Demand Curve
7.8 Why the demand curve slopes downward?
7.8 Exceptions to the law of demand
7.10 Types of Demand
7.11 Extension and Contraction of demand
7.12 Shift in demand
7.13 Other types of demand
7.14 Indifference Curve analysis and Consumer’s equilibrium
7.15 Let Us Sum Up
7.16 Keywords
7.17 Questions for Discussions
7.18 Suggested Readings

7.1 OBJECTIVES

After having studied this lesson, you should be able

 To understand the relation of price to sales
 To know about the reasons for the Law of Demand
 To sort out certain cases where the Law of demand does not hold good
 To Know the various types of demand
 To explain consumer’s demand through indifference curve analysis

78
7.2 INTRODUCTION

For a long period of time economists are much interested to study the relationship of price
and sales. An in depth knowledge of such relationship is necessary for the management.

7.3 LAW OF DEMAND

Among the many causal factors affecting demand, price is the most significant and the price-
quantity relationship called as the Law of Demand is stated as follows:
"The greater the amount to be sold, the smaller must be the price at which it is offered in
order that it may find purchasers, or in other words, the amount demanded increases with a
fall in price and diminishes with a rise in price" (Alfred Marshall). In simple words other
things being equal, quantity demanded will be more at a lower price than at higher price. The
law assumes that income, taste, fashion, prices of related goods, etc. remain the same in a
given period. The law indicates the inverse relation between the price of a commodity and its
quantity demanded in the market. However, it should be remembered that the law is only an
indicative and not a quantitative statement. This means that it is not necessary that such
variation in demand be proportionate to the change in price.

7.4 DEMAND SCHEDULE

It is a list of alternative hypothetical prices and the quantities demanded of a good

corresponding to these prices. It refers to the series of quantities an individual is ready to
buy at different prices. An imaginary demand schedule of an individual for apples is given
below:
Table 1. Demand of a consumer for apples

Price of Apples Per unit (in Rupees) Quantity demand of apples (in dozens)
5 1
4 2
3 3
2 4

Assuming the individual to be rational in his purchasing behaviour, the above schedule
illustrates the law of demand. At Rs.5/- per apple, the consumer demands 1 dozen of apples;
at Rs.4/- per unit 2 dozens, at Rs.3/- per unit 3 dozens and at Rs.2/- per unit 4 dozens. Thus
the inverse relationship between price and demand is shown in the demand schedule.

7.5 DEMAND CURVE

When the data presented in the demand schedule can be plotted on a graph with quantities
demanded on the horizontal or X- axis and hypothetical prices on the vertical or Y- axis, and
a smooth curve is hypothetical prices on the vertical or Y- axis, and a smooth curve is drawn
Joining all the points so plotted, it gives a demand curve. Thus, the demand schedule is
translated into a diagram known as the demand curve.

79
The demand curve slopes downwards from left to right, showing the inverse relationship
between price and quantity as in Figure 1.

7.6 MARKET DEMAND

The market demand reflects the total quantity purchased by all consumers at alternative
hypothetical prices. It is the sum-total of all individual demands. It is derived by adding the
quantities demanded by each consumer for the product in the market at a particular price. The
table presenting the series of quantities demanded of all consumers for a product in the
market at alternative hypothetical prices is known as the Market Demand Schedule. If the
data are represented on a two dimensional graph, the resulting curve will be the Market
Demand Curve. From the point of view of the seller of the product, the market demand curve
shows the various quantities that he can sell at different prices. Since the demand curve of an
individual is downward sloping, the lateral addition of such curves to get market demand
curve will also result in downward sloping curve.

7.7 SHIFTS IN DEMAND CURVE

The price-quantity relationship represented by the law of demand is important but it is more
important for the manager of the firm to know about the shifts in the demand function (or
curve). For many products, change in price has little effect in the quantity demanded in
relevant price ranges. Many other determinants like incomes, tastes, fashion, and business
activity have larger effect on demand for such product. Thus, changes or shifts in demand
curve rather than movement along the demand curve is of greater significance to the decision-
maker in the firm.

Let us clearly know the difference between movement along one and the same
demand curve and shift in demand curve due to changes

80
in demand. When price of a good alone varies, ceteris paribus, the quantity demanded of the
good changes. These changes due to price variations alone are called as extension or
contraction of demand represented by movement along the same demand curve. Such
movement along the same demand curve is shown in Figure 2(a).

Price declines from OP1 to OP2 and demand goes up from OM1 to OM2. Here the demand
for the good is said to have extended or expanded. This is represented by movement from
point A to point B along the demand curve. On the contrary, if price rises from OP2 to OP1
demand falls from OM2 to OM1. Here the demand for the good is said to have contracted.
This is represented by movement from point B to point A along the demand curve D1D1.

Shifts in demand curve take place on account of determinants other than price such as
changes in income, fashion, tastes, etc. The ceteris paribus assumption is relaxed; other
factors than price influence demand and the impact of these factors on demand is described as
changes in demand or shifts in demand, showing increase or decrease in demand. This kind
of change is shown in Figure 2(b). The quantity demanded at OP1 is OM1. If, as a result of
increase in income, more of the product is demanded, say OM2 at the same price OP1. Note
that OM2 is due to the new demand curve D2D2. This is a case of shift in demand. Due to
fall in income, less of the good may be demanded at the same price and this will be a case of
decrease in demand. Thus increase or decrease in demand with shifts in demand curves
upward or downward are different from extension or contraction of demand.

Causes of changes in demand may be due to:

1. Changes in the consumer's income.

2. Changes in the tastes of the consumer.
3. Changes in the prices of related goods (substitutes and complements).
4. Changes in exogenous factors like fashion, social structure, etc.

81
7.8 WHY THE DEMAND CURVE SLOPES DOWNWARD?

Truly, the demand curve slopes left downward to right, throughout its length although the
slope may be much steeper in some parts. It means, demand increases with the fall in price
and contracts with an increase in price. There are several reasons responsible for the inverse
price demand relationship which has been explained as under:

1. Law of Diminishing Marginal Utility:

The law of demand is based on the law of diminishing marginal utility which states that as
the consumer purchases more and more units of a commodity, the utility derived from each
successive unit goes on decreasing. It means as the price of the commodity falls, consumer
purchases more of the commodity so that his marginal utility from the commodity falls to be
equal to the reduced price and vice-versa.

2. Substitution Effect:

Substitution effect also leads the demand curve to slope from left downward to right. As the
price of a commodity falls, prices of its substitute goods remain the same, the consumer will
buy more of that commodity. For instance, tea and coffee are the substitute goods. If the price
of tea goes down, the consumers may substitute tea for coffee, although price of coffee
remains the same. Therefore, with a fall in price, the demand will increase due to favourable
substitution effect. On the other hand with the rise in price, the demand falls due to
unfavourable substitution effect. This is nothing but the application of Law of Demand.

3. Income Effect:

Another reason for the downward slope of demand curve is the income effect. As the price of
the commodity falls, the real income of the consumer goes up. Real income is that income
which is measured in terms of goods and services. For example, a consumer has Rs.20, he
wants to buy oranges whose price is Rs.20 per dozen. It means 45 the consumer can buy one
dozen of oranges with his fixed income. Now, suppose, the price of the oranges falls to Rs.15
per dozen which leads to an increase in his real income by Rs.5. In this case, either the
consumer will buy more quantity of oranges than before or he will buy some other
commodity with his increased income.

4. New Consumers:

When the price of commodity falls, many other consumers who were not consuming that
commodity previously will start consuming the commodity. As a result, total market demand
goes up. For example, if the price of radio set falls, even the poor man can buy the radio set.
Consequently, the total demand for radios goes up.

5. Several Uses:
Some commodities can be put to several uses which lead to downward slope of the demand
curve. When the price of such commodities goes up they will be used for important purposes,
so their demand will be limited. On the other hand, when the price falls, the commodity in
question will extend its demand. For instance, when the price of coal increases, it will be used
for important purposes but as the price falls its demand will increase and it will be used for
many other uses.

82
6. Psychological Effects:

When the price of a commodity falls, people favour to buy more which is natural and
psychological. Therefore, the demand increases with the fall in prices. For example, when the
price of silk falls, it is purchased for all the members of the family.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Why the Demand Curve slopes downward?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

7.9 EXCEPTIONS TO THE LAW OF DEMAND

The Law of Demand will not hold good in certain peculiar cases in which more will be
demanded at a higher price and less at a lower price. In these cases the demand curves will be
exceptionally different, differing from the usual downward sloping shape of the demand
curve. The exceptions are as follows:

(i) Conspicuous goods:

Some consumers measure the utility of a commodity by its price i.e., if the commodity is
expensive they think that it has got more utility. As such, they buy less of this commodity at
low price and more of it at high price. Diamonds are often given as example of this case.
Higher the price of diamonds, higher is the prestige value attached to them and hence higher
is the demand for them.

ii) Giffen goods:

Sir Robert Giffen, an economist, was surprised to find out that as the price of bread increased,
the British workers purchased more bread and not less of it. This was something against the
law of demand. Why did this happen? The reason given for this is that when the price of
bread went up, it caused such a large decline in the purchasing power of the poor people that
they were forced to cut down the consumption of meat and other more expensive foods. Since
bread even when its price was higher than before was still the cheapest food article, people
consumed more of it and not less when its price went up. Such goods which exhibit direct
price-demand relationship are called 'Giffen goods'. Generally those goods which are
considered inferior by the consumers and which occupy a substantial place in consumer's
budget are called 'Giffen goods'. Examples of such goods are coarse grains like bajra, low
quality of rice and wheat etc.

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(iii) Future expectations about prices:

It has been observed that when the prices are rising, households expecting that the prices in
the future will be still higher tend to buy larger quantities of the commodities. For example,
when there is wide-spread drought, people expect that prices of food grains would rise in
future. They demand greater quantities of food grains as their price rise. But it is to be noted
that here it is not the law of demand which is invalidated but there is a change in one of the
factors which was held constant while deriving the law of demand, namely change in the
price expectations of the people.

(iv) The law has been derived assuming consumers to be rational and knowledgeable about
market-conditions. However, at times consumers tend to be irrational and make impulsive
purchases without any cool calculations about price and usefulness of the product and in such
contexts the law of demand fails.

(v) Similarly, in practice, a household may demand larger quantity of a commodity even
at a higher price because it may be ignorant of the ruling price of the commodity. Under
such circumstances, the law will not remain valid.

The law of demand will also fail if there is any significant change in other factors on which
demand of a commodity depends. If there is a change in income of the household, or in prices
of the related commodities or in tastes and fashion etc. the inverse demand and price relation
may not hold good.

7.10 TYPES OF DEMAND

There are three types of demand. They are

1. Price Demand
2. Income Demand and
3. Cross Demand which are explained below:

1. Price Demand

It refers to the various quantities of the good which consumers will purchase at a given time
and at certain hypothetical prices assuming that other conditions remain the same. We are
generally concerned with price demand only. In the explanation of the law of demand given
above, we dealt in detail with price demand only.

84
II. Income demand:
Income demand refers to the various quantities of a commodity that a
consumer would buy at a given time at various levels of income. Generally, when the income
increases, demand increases and vice versa.

III. Cross Demand:

When the demand of one commodity is related with the price of other commodity is called
cross demand. The commodity may be substitute or complementary. 48 Substitute goods are
those goods which can be used in case of each other. For example, tea and coffee, Coca-cola
and Pepsi. In such case demand and price are positively related. This means if the price of
one increased then the demand for other also increases and vise versa. Complementary goods
are those goods which are jointly used to satisfy a want. In other words, complementary
goods are those which are incomplete without each other.

These are things that go together, often used simultaneously. For example, pen and ink.

Tennis rackets and tennis balls, cameras and film, etc. In such goods the price and demand
are negatively related. This means when the price of one commodity increases
the demand for the other falls.

Check Your Progress – 3

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

85
 1. Discuss about the various types of Demand.
……………………………………………………………………………………………
……………………………………………………………………………………………

7.11 EXTENTSION AND CONTRACTION OF DEMAND

Extension and Contraction of Demand

The change in demand due to change in price only (when other factors remain constant) is
called extension and contraction of demand. Increase in demand due to fall in price is called
extension of demand. Decrease in demand due to rise in price is called contraction of
demand. Extension and Contraction of demand results in movement on the same demand
curve. It is shown in the following diagram.

When price is OP, the quantity demanded is OQ. Suppose the price falls from OP2 to 0P2
demand will be increased to OQ2. This is a downward movement along the demand curve DD
from a to c. This indicates extension of demand. When the price rises to OP1, the demand will
be decreased to OQ2 this is an upward movement along the demand curve from a to b. This
indicates contraction of demand

7.12 SHIFTS IN DEMAND

We have seen that the demand depends not only on price but also on other factors like
income, population, taste and preference of consumers etc. The change in demand due to
change in any of the factors other than the price is'called shift in demand. Change in any one
of the factors shifts the entire demand curve. A change in demand will shift the demand curve
either upwards or downwards. An upward shift in demand curve is called increase in demand.
Downward shift in demand curve is called decrease in demand. Shift in demand is shown in
the following diagram.

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In the given figure DD is the original demand curve. When the demand increases, (e.g., due
to increase in income) the curve will shift upwards to D2D2 without any increase in price. It
is constant at OP. Similarly when the demand decreases, (e.g., due to decrease in income) the
curve will shift downwards to D1D1. The price remains constant.
Thus extension of demand is different from increase in demand. Likewise, contraction of
demand doesn't mean decrease in demand.

7.13 OTHER TYPES OF DEMAND

It should be noted that exclusion and contraction of demand is called "change in quantity
demanded" and shift in demand is called "change in demand".

Joint demand:
When several commodities are demanded for a joint purpose or to satisfy a particular want. It
is a case of a joint demand. Milk , sugar and tea dust are jointly demanded to make tea.
Similarly, we may demand paper, pen and ink for writing. Demand for such commodities in
bunch is known as joint demand. Demand for land, labour, capital and organisation for
producing commodity is also a case of joint demand.

Composite demand:

The demand for a commodity which can be put to several uses is a composite demand. In this
case a single product is wanted for a number of uses. For example, electricity is used for
lighting, heating, for running the engine, for the fans etc. Similarly coal is used in industries,
for cooking etc.

Direct and Derived demand:

The demand for a commodity which is for direct consumption, i.e.. Demand for ultimate
object, is called direct demand, e.g food, cloth, etc. Direct demand is called autonomous
demand. Here the demand is not linked with the purchase of some main products. When the
commodity is demanded as a result of the demand for another commodity or service, it is
known as the derived demand or induced demand. For example, demand for cement is
derived from the demand for building construction; demand for tires is derived from the
demand for cars or scooters, etc.

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Importance of the Law of Demand

The law of demand plays a crucial role in decision-making and forward planning of a
business unit. The production planning in a firm mainly rests on accurate demand analysis.
The law of demand has theoretical as well as practical advantages. These are as
follows:

1. Price determination:
With the help of law of demand a monopolist fixes the price of his product. He is able to
decide the most profitable quantity of output for him.

2. Useful to government:
The finance minister takes the help of this law to know the effects of his tax reforms and
policies. Only those commodities which have relatively inelastic demand should be taxed.

3. Useful to farmers:
From the law of demand, the farmer knows how far a good or bad crop will affect the
economic condition of the fanner. If there is a good crop and demand for it remains the same,
price will definitely go down. The farmer will not have much benefit from a good crop, but
the rest of the society will be benefited.

4. In the field of planning:

The demand schedule has great importance in planning for individual commodities and
industries. In such cases it is necessary to know whether a given change in the price of the
commodity will have the desired effect on the demand for commodity within the country or
abroad. This is known from a study of the nature of demand schedule for the commodity.

7.14 INDIFFERENCE CURVE ANALYSIS AND CONSUMER’S EQUILIBRIUM

In the last section we discussed marginal utility analysis of demand. A very popular
alternative and more realistic method of explaining consumer's demand is the Indifference
Curve Analysis. This approach to consumer behaviour is based on consumer preferences. It
believes that human satisfaction being a psychological phenomenon cannot be measured
quantitatively in monetary terms as was attempted in Marshall's utility analysis. In this
approach it is felt that it is much easier and scientifically more sound to order preferences
than to measure them in terms of money.

The consumer preference approach, is, therefore an ordinal concept based on ordering of
preferences compared with Marshall's approach of cardinality.

Assumptions Underlying Indifference Curve Approach

1. The consumer is rational and possesses full information about all the relevant
aspects of economic environment in which he lives.
2. The consumer is capable of ranking all conceivable combinations of goods
according to the satisfaction they yield. Thus if he is given various combinations
say A, B, C, D, E he can rank them as first preference, second preference and so
on.
3. If a consumer happens to prefer A to B, he can not tell quantitatively how much
he prefers A to B.
4. If the consumer prefers combination A to B, and B to C, then he must prefer

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 combination A to C. In other words, he has consistent consumption pattern behaviour.
5. If combination A has more commodities than combination B, then A must be
preferred to B.

What are Indifference Curves?

Ordinal analysis of demand (here we will discuss the one given by Hicks and Allen) is based
on indifference curves. An indifference curve is a curve which represents all those
combinations of goods which give same satisfaction to the consumer. Since all the
combinations on an indifference curve give equal satisfaction to the consumer, the consumer
is indifferent among them. In other words, since all the combinations provide same level of
satisfaction the consumer prefers them equally and does not mind which combination he gets.
To understand indifference curves let us consider the example of a consumer who has one
unit of food and 12 units of clothing. Now we ask the consumer how many units of clothing
he is prepared to give up to get an additional unit of food, so that his level of satisfaction does
not change. Suppose the consumer says that he is ready to give up 6 units of clothing to get
an additional unit of food. We will have then two combinations of food and clothing giving
equal satisfaction to consumer: Combination A has 1 unit of food and 12 units of clothing,
combination B has 2 units of food and 6 units of clothing.

Similarly, by asking the consumer further how much of clothing he will be prepared to forgot
for successive increments in his stock of food so that his level of satisfaction remains
unaltered, we get various combinations as given below:

Combination Food Cloth MRS

A 1 12
B 2 6 6
C 3 4 2
D 4 3 1

Now if we draw the above schedule we will get the following figure.
In Figure 8, an indifference curve IC is drawn by plotting the various combinations of the
indifference schedule. The quantity of food is measured on the X axis and the quantity of
clothing on the Y axis. As in indifference schedule, combinations lying on an
indifference curve will give the consumer same level of satisfaction.

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Indifference Map:

A set of indifference curves is called indifference map.

An indifference map depicts complete picture of consumer's tastes and preferences. In Figure
9, an indifference map of a consumer is shown which consists of three indifference curves.
We have taken good X on X-axis and good Y on Y-axis. It should be noted that while the
consumer is indifferent among the combinations lying on the same indifference curve, he
certainly prefers the combinations on the higher indifference curve to the combinations lying
on a lower indifference curve because a higher indifference curve signifies a higher level of
.satisfaction. Thus while all combinations of IC, give same satisfaction, all combinations
lying on IC2 give greater satisfaction than those lying on IC1.

Check Your Progress – 3

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Indifference Curve analysis and consumer’s equilibirium.
……………………………………………………………………………………………
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7.15 LET US SUM UP

In this lesson we introduced a concept which establishes the relationship between Price and
Sales called as ‘Law of demand’. We also discussed in detail the reasons for Law of demand
and pointed out some exceptional cases where Law of demand does not hold good.

We also identified various types of demand and a detailed discussion has been made on
indifference curve analysis method to know about the consumers demand for a commodity.
At the end of this lesson we studied about the ways by which consumer reaches equilibrium
position.
___________________________________________________________________________
7.16 KEYWORDS

Demand curve Market demand

Marginal utility Substitution effect
Income effect New consumer
Several uses. Psychological effects
Conspicuous goods Giffen goods
Future expectations Price demand

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7.17 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peter

7.18 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1
1. See section 7.7
Check Your Progress – 2
1. See Section 7.10
Check Your Progress – 3
1. See section 7.14

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UNIT 8
ELASTICITY OF DEMAND

STRUCTURE

8.1 Objectives
8.2 Introduction
8.3 Elasticity of Demand
8.4 Definition of Price Elasticity of Demand
8.5 Factors determining Price Elasticity of Demand
8.6 Income Elasticity of Demand
8.7 Cross Elasticity of Demand
8.8 Importance of Elasticity of Demand
8.9 Let us sum up
8.10 Keywords
8.11 Some Useful Books
8.12 Answer to Check Your Progress Exercise

8. 1 OBJECTIVES

After having studied this lesson you should be able

1. To Understand the concept of Elasticity
2. To Know the different kinds of Elasticity of demand
3. To acquire knowledge on the importance of elasticity of demand

8.2 INTRODUCTION

In this lesson a detailed discussion regarding elasticities as a measure of the responsiveness of

one item to changes in another item is made. Elasticity is a common concept that economists,
Business people and others rely upon for the measurement between two variables say for
example the ratio of percentage change in quantity demanded to percentage change in some
other factor like Price or Income.

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8.3 ELASTICITY OF DEMAND

The concept of price-elasticity of demand was first of all introduced in economics by Dr.
Marshall. In simple words, price elasticity of demand is the ratio of percentage change in
quantity demanded to the percentage change in price. In other words, price elasticity of
demand is a measure of the relative change in quantity purchased of a good in response to a
relative change in its price. It is, thus a rate at which the demand changes to the given change
in prices. So, it means the rate or the degree of response in demand to the change in price.
Thus, the co-efficient of price-elasticity of demand can be expressed as under:

E4 =

8.4 DEFINITION OF PRICE ELASTICITY OF DEMAND

The concept of price elasticity of demand has been defined by different economists as
under :
According to Alfred Marshall: "Elasticity of demand may be defined as the percentage
change in quantity demanded to the percentage change in price."
According to A.K. Cairncross : "The elasticity of demand for a commodity is the rate at
which quantity bought changes as the price changes."
According to J.M. Keynes : "The elasticity of demand is a measure of the relative change in
quantity to a relative change in price."
According to Kenneth Boulding : "Elasticity of demand measures the responsiveness of
demand to changes in price."

8.5 DEGREES OF PRICE ELASTICITY

Different commodities have different price elasticities. Some commodities have more elastic
demand while others have relative elastic demand. Basically, the price elasticity of demand
ranges from zero to infinity. It can be equal to zero, less than one, greater than one and equal
to unity. According to Dr. Marshall : "The elasticity or responsiveness of demand in a
market is great or small according as the amount demanded increases much or little for a
given fall in price and diminishes much or little for a given rise in price." However, some
particular values of elasticity of demand have been explained as under ;

Perfectly Elastic Demand.

Perfectly elastic demand is said to h happen when a little change in price leads to an infinite
change in quantity demanded. A small rise in price on the part of the seller reduces the
demand to zero. In such a case the shape of the demand curve will be horizontal straight line
as shown in figure 13

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The figure 13 shows that at the ruling price OP, the demand is infinite. A slight rise in price
will contract the demand to zero. A slight fall in price will attract more consumers but the
elasticiy of demand will remain infinite. But in real world, the cases of perfectly elastic
demand are exceedingly rare and are not of any practical interest.

2. Perfectly inelastic Demand

Perfectly inelastic demand is opposite to perfectly elastic demand. Under the perfectly
inelastic demand, irrespective of any rise or fall in price of a commodity, the quantity
demanded remains the same. The elasticity of demand in this case will be equal to zero. In
diagram 14, DD shows the perfectly inelastic demand. At price OP, the quantity demanded is
OQ. Now, the price falls to OP, from OP1, demand remains the same. Similarly, if the price
rises to OP2 the demand still remains the same. But just as we do not see the example of
perfectly elastic demand in the real world, in the same fashion it is diffcult to come across the
cases of perfectly inelastic demand because even the demand for bare essentials of life does
show some degree of responsiveness to change in price.

3. Unitary Elastic Demand.

The demand is said to be unitary elastic when a given proportionate change in the price level
brings about an equal proportionate change in quantity demanded, The numerical value of
unitary elastic demand is exactly one i.e.,
ed = 1. Marshall calls it unit elastic.

In figure 15, DD demand curve represents unitary elastic demand. This demand curve is
called rectangular hyperbola. When price is OP, the quantity demanded is OQ1. Now price
falls to OP1, the quantity demanded increases to OQ1. The shaded area in the fig. equal in

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terms of price and quantity demanded denotes that in all cases price elasticity of demand is
equal to one.

4. Relatively Elastic Demand.

Relatively elastic demand refers to a situation in which a small change in price leads to a big
change in quantity demanded. In such a case elasticity of demand is said to be more than one.
This has been shown in figure 16. In fig.16, DD is the demand curve which indicates that
when price is OP the quantity demanded is OQ1, Now the price falls from OP to OP1, the
quantity demanded increases from OQ1 to OQ2 i.e. quantity demanded changes more than the
change in price.

5. Relatively Inelastic Demand.

Under the relatively inelastic demand a given percentage change in price produces a
relatively less percentage change in quantity demanded. In such a case elasticity of demand is
said to be less than one as shown in figure 17. All the five degrees of elasticity of demand
have been shown in figure 18. On OX axis, quantity demanded and on OY axis price is given.
It shows:

1. AB — Perfectly Inelastic Demand

2. CD — Perfectly Elastic Demand
3. EQ — Less Than Unitary Elastic Demand
4. EF — Greater Than Unitary Elastic Demand
5. MN — Unitary Elastic Demand.

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Check Your Progress – 1
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss the Factors determining Price Elasticity of Demand.

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8.6 FACTORS DETERMINING PRICE ELASTICITY OF DEMAND

The factors that determine elasticity of demand are numberless. But the most important
among them are the nature, uses and prices of related goods and the level of income. They are
stated below:

I. Nature of the commodity:

Generally, all commodities can be dividend into three categories i.e.

(i) Necessaries of Life.

For necessaries of life the demand is inelastic because people buy the required amount of
goods whatever their price. For example, necessaries such as rice, salt, cloth are purchased
whether they are dear or cheap.

(ii) Conventional Necessaries.

The demand for conventional necessaries is less elastic or inelastic. People are accustomed to
the use of goods like intoxicants which they purchase at any price. For example, drunkards
consider opium and wine almost as a necessity as food and water. Therefore, they buy the
same amount even when their prices are higher and highest.

(iii) Luxury Commodities.

The demand for luxury is usually elastic as people buy more of them at a lower price and less
at a higher price. For example, the demand of luxuries like silk, perfumes and ornaments
increases at a lower price and diminishes at a higher price. Here, we must keep in mind that
luxury is a relative term, which varies from person to person, place to place and from time to
time. For example, what is a luxury to a poor man is a necessity to the rich. The luxury of the
past may become a necessity of today. Similarly a commodity which is a necessity to one
class may be a luxury to another. Hence, the elasticity of demand in such cases should have
to be carefully expressed.

2. Substitutes.

Demand is elastic for those goods which have substitutes and inelastic for those goods which
have no substitutes. The availability of substitutes, thus, determines the elasticity of demand.
For instance, tea and coffee are substitutes. The change in the price of tea affects the demand
for coffee. Hence, the demand for coffee and tea is elastic.

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3. Number of Uses.

Elasticity of demand for any commodity depends on its number of uses. Demand is elastic; if
a commodity has more uses and inelastic if it has only one use. As coal has multiple uses, if
its price falls it will be demanded more for cooking, heating, industrial purposes etc. But if its
price rises, minimum will be demanded for every purpose.

4. Postponement.

Demand is more elastic for goods the use of which can be postponed. For example, if the
price of silk rises, its consumption can be postponed. The demand for silk is, therefore,
elastic. Demand is inelastic for those goods the use of which is urgent and, therefore, cannot
be postponed. The use of medicines cannot be put off. Hence, the demand for medicines is
inelastic.

5. Raw Materials and Finished Goods.

The demand for raw materials is inelastic but the demand for finished goods is elastic. For
instance, raw cotton has inelastic demand but cloth has elastic demand. In the same way,
petrol has inelastic demand but car itself has only elastic demand.

6. Price Level.

The demand is elastic for moderate prices but inelastic for lower and higher prices. The rich
and the poor do not bother about the prices of the goods that they buy. For example, rich buy
Benaras silk and diamonds etc. at any price. But the poor buy coarse rice, cloth etc. whatever
their prices are.

7. Income Level.

The demand is inelastic for higher and lower income groups and elastic for middle income
groups. The rich people with their higher income do not bother about the price. They may
continue to buy the same amount whatever the price. The poor people with lower incomes
buy always only the minimum requirements and, therefore, they are induced neither to buy
more at a lower price nor less at a higher price. The middle income group is sensitive to the
change in price. Thus, they buy more at a lower price and less at higher price.

8. Habits.

If consumers are habituated of some commodities, the demand for such commodities will be
usually inelastic. It is because that the consumer will use them even their prices go up. For
example, a smoker does not smoke less when the price of cigarette goes up.

9. Nature of Expenditure.

The elasticity of demand for a commodity also depends as to how much part of the income is
spent on that particular commodity. The demand for such commodities where a small part of
income is spent is generally highly inelastic i.e. newspaper, boot-polish etc. On the other
hand, the demand of such commodities where a significant part of income is spent, elasticity
of demand is very elastic..

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10. Distribution of Income.

If the income is uniformly distributed in the society, a small change in price will affect the
demand of the whole society and the demand will be elastic. In case of unequal distribution
of income and wealth, a change in price will hardly influence the poor section of the society
and the demand will be relatively inelastic.

11. Influence of Diminishing Marginal Utility.

We know that utility falls when we consume more and more units but not in a uniform way.
In case utility falls rapidly, it means that the consumer has no other near substitutes. As a
result, demand is inelastic. Conversely, if the utility falls slowly, demand for such commodity
would be elastic and raises much for a fall in price.

8.7 INCOME ELASTICITY OF DEMAND

According to Stonier and Hague: "Income elasticity of demand shows the way in which a
consumer's purchase of any good changes as a result of change in his income."
It shows the responsiveness of a consumer's purchase of a particular commodity to a change
in his income. Income elasticity of demand means the ratio of percentage change in the
quantity demanded to the percentage change in income. In brief income elasticity.

Degrees of Income Elasticity of Demand

Positive income elasticity of Demand :

Positive income elasticity of demand is said to occur when with the increase in the income of
the consumer, his demand for goods and services also increases and vice-versa. Income
elasticity of demand is positive in case of normal goods. In fig. 22, quantity of commodity T
has been measured on X-axis and income of the consumer on Y-axis. DD is the positive
income elasticity of demand curve. It slopes upward from left to right indicating that increase
in income is accompanied by increase in demand of goods and services and vice-versa.

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 

1.Income Elasticity is Unity.

The change in demand is proportionate to the change in income. For example

Income Elasticity = 1 when

2. Income Elasticity Greater than One.

When the change in demand is more than proportionate change in income, income elasticity
of demand is greater than one or unity.
For example,

Income Elasticity >1 when = 1.5

3. Income Elasticity Less than One.

If change in demand is less than proportionate

change in income, income elasticity of demand is less than one or unity. For example.

Income Elasticity <1 when = 0.5

(ii) Negative Income Elasticity of Demand:

Negative income elasticity of demand is said to occur when increase in the income of the
consumers is accompanied by fall in demand of goods and services and vice-versa. It is the
case of giffen goods. In fig. 23 when income of the consumer is 01, demand for goods and
services is OX. Now as the income I1 increases to I1 quantity demanded falls o to OX1.
Again as the income increases to I2, quantity demanded falls to OX2. DD is the negative
income elasticity of demand curve.

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 
(iii) Zero Income Elasticity of Demand:

Zero income elasticity of demand is said to exist when increase or decrease in income has no
impact on the demand of goods and services.
In fig. 24 initially when income is OI, quantity demanded is OD. Now, income increases to
OI2 demand Remains constant i.e. OD. Even when income reduces to 01 , quantity demanded
remains OD Generally, as income increases demand for goods increases. But in some cases,
demand may not change to change in income or demand may diminish for an increase in
income. The former case represents zero income elasticity. Income elasticity is zero if a
change in income fails to produce any change in demand. Income elasticity is negative, if an
increase in income leads to a reduction of demand. This happens only in the case of inferior
goods. But in all other cases it is positive.


In short income elasticity is greater than one for luxuries but less than one for necessaries.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about Cross Elasticity of Demand.

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8.8 CROSS ELASTICITY OF DEMAND

It is the ratio of proportionate change in the quantity demanded of Y to a given proportionate

change in the price of the related commodity X. It is a measure of relative change in the
quantity demanded of a commodity due to a change in the price of its substitute complement.
It can be expressed as

Cross elasticity is zero, if a change in the price of one commodity will not affect the quantity
demanded of the other. In the case of goods which are not related to each other, cross
elasticity of demand is zero.
Check Your Progress – 3
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss the importance of Elasticity of Demand.

……………………………………………………………………………………………
………………

8.9 IMPORTANCE OF ELASTICITY OF DEMAND

The concept of elasticity of demand is of great importance in practical life. Its main points are
given as under:

1. Useful for Business:

It enables the business in general and the monopolists in particular to fix the price. Studying
the nature of demand the monopolist fixes higher prices for those goods which have inelastic
demand and lower prices for goods which have elastic demand. In this way, this helps him to
maximise his profit.

2. Fixation of Prices:
It is very useful to fix the price of jointly supplied goods. In the case of joint products like
paddy and straw, the cost of production of each is not known. The price of each is then fixed
by its elastic and inelastic demand.

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3. Helpful to Finance Minister:
It helps the Finance Minister to levy tax on goods. After levying taxes more and more on
goods which have inelastic demand, the Government collects more revenue from the people
without causing them inconvenience. Moreover, it is also useful for the planning.

4. Fixation of Wages:
It guides the producers to fix wages for labourers. They fix high or low wages according to
the elastic or inelastic demand for the labour.

5. In the Sphere of International Trade:

It is of greater significance in the sphere of international trade. It helps to calculate the terms
of trade and the consequent gain from foreign trade. If the demand for home product is
inelastic, the terms of trade will be profitable to the home country.

6. Paradox of Poverty.
It explains the paradox of poverty in the midst of plenty. A bumper crop instead of bringing
prosperity may result in disaster, if the demand for it is inelastic. This is specially so, if the
products are perishable and not storable.

7. Significant for Government Economic Policies.

The knowledge of elasticity of demand is very important for the government in such matters
as controlling of business cycles, removing inflationary and deflationary gaps in the
economy. Similarly, for price stabilization and the purchase and sale of stocks, information
about elasticity of demand is most useful.

8. Determination of Price of Public Utilities.

This concept is significant in the determination of the prices of public utility services.
Economic welfare of the society largely depends upon the cheap availability

8.10 LET US SUM UP

In this lesson we studied the concept of elasticity which is the slope relationship of two
variables expressed in percentage terms. We discussed about price elasticity, income
elasticity and cross elasticity of demand. While concluding this lesson we also looked into the
general importance of elasticity of demand

8.11 KEYWORDS

Elastic demand. Inelastic demand

Unitary Commodity

Luxury commodities Conventional

Substitutes Postponement

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8.12 SUGGESTED READINGS
1. S. Sankaran - Business Economics – Margam Publications
2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

8.13 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1
1. See section 8.5
Check Your Progress – 2
1. See Section 8.7
Check Your Progress – 3
1. See section 8.8

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UNIT 9
DEMAND FORECASTING

STRUCTURE

9.1 Objectives

9.2 Introduction

9.3 Meaning of demand forecasting

9.4 Objectives of demand forecasting

9.5 Factors affecting demand forecasting

9.6 Methods of demand forecasting for established products

9.7 Methods of demand forecasting for new products

9.8 Let us sum up

9.9 Keywords

9.10 Questions for Discussions

9.11 Suggested Readings

9.1 OBJECTIVES

After having studied this lesson you should be able

 To familiarize the meaning and objectives of demand forecasting
 To identify the factors that affects the demand forecasting
 To know about the various methods of demand forecasting

9.2 INTRODUTION

Today business enterprises are working under the conditions of uncertainties. Uncertainties
can be minimized through planning and forecasting. The success of a business firm depends
upon its ability to forecast future events.

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9.3 MEANING OF DEMAND FORECASTING

Future is uncertain. There is great deal of uncertainty with regard to demand. Since the
demand is uncertain, production, cost, revenue, profit etc. are also uncertain. Through
forecasting it is possible to minimise the uncertainties. Forecasting simply refers to
estimating or anticipating future events. It is an attempt to foresee the future by examining the
past. Thus demand forecasting means estimating or anticipating future demand on the basis of
past data.

9.4 OBJECTIVES OF DEMAND FORECASTING

A. Short Term Objectives

1. To help in preparing suitable sales and production policies.

2. To help in ensuring a regular supply of raw materials.
3. To reduce the cost of purchase and avoid unnecessary purchase.
4. To ensure best utilization of machines.
5. To make arrangements for skilled and unskilled workers so that suitable labour
6. force may be maintained.
7. To help in the determination of a suitable price policy.
8. To determine financial requirements.
9. To determine separate sales targets for all the sales territories.
10. To eliminate the problem of under or over production.

B. Long term Objectives

1. To plan long term production.

2. To plan plant capacity.
3. To estimate the requirements of workers for long period and make arrangements.
4. To determine an appropriate dividend policy.
5. To help the proper capital budgeting.
6. To plan long term financial requirements.
7. To forecast the future problems of material supplies and energy crisis.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the objectives of demand forecasting.
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9.5 FACTORS AFFECTING DEMAND FORECASTING

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

1. Prevailing business conditions:

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

2. Conditions within the industry:

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

3. Conditions within the firm:

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

4. Factors affecting export trade:

If a firm is engaged in export trade also it should consider the factors affecting the export
trade. These factors include import and export control, terms and conditions of export, exim
policy, export conditions, export finance etc.

5. Market behaviour :
While preparing demand forecast, it is required to consider the market behavior which brings
about changes in demand.

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

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

8. Competitive conditions:
The competitive conditions within the industry may change. Competitors may enter into
market or go out of market. A demand forecast prepared without considering the activities of
competitors may not be correct.

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Process of Demand Forecasting/ Steps in Demand Forecasting
Demand forecasting involves the following steps:
1. Determine the purpose for which forecasts are used.
2. Subdivide the demand forecasting programme into small I parts on the basis of
2. product or sales territories or markets.
3. Determine the factors affecting the sale of each product and their relative
4. importance.
5. Select the forecasting methods.
6. Study the activities of competitors.
7. Prepare preliminary sales estimates after, collecting necessary data.
8. Analyse advertisement policies, sales promotion plans, personal sales arrangements
etc. and ascertain how far these programmes have been successful in promoting the
sales.
9. Evaluate the demand forecasts monthly, quarterly, half yearly or yearly an necessary
adjustments should be done.
10. Prepare the final demand forecast on the basis of preliminary forecasts and the results
of evaluation.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Factors affecting demand forecasting.
……………………………………………………………………………………………
……………………………………………………………………………………………
…………………………
9.6 METHODS OF DEMAND FORECASTING (FOR ESTABLISHED PRODUCTS)

There are several methods to predict the future demand. All methods can be
broadly classified into two.
(A) Survey methods,
(B) Statistical methods

(A) Survey methods

Under this method surveys are conducted to collect information about the future purchase
plans of potential consumers. Survey methods help in obtaining information about the
desires, likes and dislikes of consumers through collecting the opinion of experts or by
interviewing the consumers. Survey methods are used for short term forecasting.
Important survey methods are
(a) consumers interview method,
(b) collective opinion or
sales force opinion method
(c) experts opinion method,
(d) consumers clinic and
(e) end use method.

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(a) Consumers' interview method (Consumers survey):
Under this method, consumers are interviewed directly and asked the quantity they would
like to buy. After collecting the data, the total demand for the product is calculated. This is
done by adding up all individual demands. Under the consumer interview method, either all
consumers or selected few are interviewed. When all the consumers are interviewed, the
method is known as complete enumeration method. When only a selected group of
consumers are interviewed, it is known as sample survey method

Advantages
1. It is a simple method because it is not based on past record.
2. It suitable for industrial products.
3. The results are likely to be more accurate.
4. This method can be used for forecasting the demand of a new product.

Disadvantages
1. It is expensive and time consuming.
2. Consumers may not give their secrets or buying plans.
3. This method is not suitable for long term forecasting.
4. It is not suitable when the number of consumer is large.

(b) Collective opinion method:

Under this method the salesmen estimate the expected sales in their respective territories on
the basis of previous experience. Then demand is estimated after combining the individual
forecasts (sales estimates) of the salesmen.
This method is also known as sales force opinion method.

Advantages
This method is simple.
1. It is based on the first hand knowledge of Salesmen.
2. This method is particularly useful for estimating demand of new products.
3. It utilises the specialised knowledge of salesmen who are in close touch with the
prevailing market conditions.

Disadvantages
1. The forecasts may not be reliable if the salespeople are not trained.
2. It is not suitable for long period estimation.
3. It is not flexible.
4. Salesmen may give lower estimates that make possible easy achievement of sales
quotas fixed for each salesman.

(c) Experts' opinion method:

This method was originally developed at Rand Corporation in 1950 by Olaf Helmer, Dalkey
and Gordon. Under this method, demand is estimated on the basis of opinions of experts and
distributors other than salesmen and ordinary consumers. This method is also known as
Delphi method. Delphi is the ancient Greek temple where people come and prey for
information about their future.

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Advantages
1. Forecast can be made quickly and economically
2. This is a reliable method because estimates are made on the basis of knowledge
and experience of sales experts.
3. The firm need not spare its time on preparing estimates of demand.
4. This method is suitable for new products.

Disadvantages
1. This method is expensive.
2. This method sometimes lacks reliability

(d) Consumer clinics:

In this method some selected buyers are given certain amounts of money and asked to buy the
products. Then the prices are changed and the consumers are asked to make fresh purchases
with the given money. In this way the consumers" responses to price changes are observed.
Thus the behaviour of the consumers is studied. On this basis demand is estimated. This
method is an improvement over consumer’s interview method.

Merits
1. It provides an opportunity to study the behaviour of consumers directly.
2. It provides reliable and realistic picture about future demand.
3. It gives useful information to aid in the decision making process.

Demerits
1. It is a time consuming method.
2. Selecting the participants is very difficult.
3. It is expensive.
4. Consumers may take it as a game. They may not reveal their preferences.

(e) End use method:

This method is based on the fact that a product generally has different uses. In the end use
method, first a list of end users (final consumers, individual industries, exporters etc.) is
prepared. Then the future demand for the product is found either directly from the end users
or indirectly by estimating their future growth. Then the demand of all end users of the
product is added to get the total demand for the product.

Statistical Methods
Statistical methods use the past data as a guide for knowing the level of future demand.
Statistical methods are generally used for long run forecasting. These methods are used for
established products. Statistical methods include:

(i) Trend projection method,

(ii) Regression and Correlation,
(iii)Extrapolation method,
(iv) Simultaneous equation method, and
(v) Barometric method.

109
(i) Trend projection method:
Future sales are based on the past sales, because future is the grand-child of the past and child
of the present. Under the trend projection method demand is estimated on the basis of
analysis of past data. This method makes use of time series (data over a period of time). We
try to ascertain the trend in the time series.
The trend in the time series can be estimated by using any one of the following four methods:

(i) Least-square method,

(ii) Free-hand method,
(iii)Moving average method and
(iv) semi-average method.

(ii) Regression and Correlation:

These methods combine economic theory and statistical technique of estimation. Under these
methods the relationship between the sales (dependent variable) and other variables
(independent variables such as price of related goods, income, advertisement etc.) is
ascertained. Such relationship established on the basis of past data may be used to analyse the
future trend. The regression and correlation analysis is also called the econometric model
building.

(iii) Extrapolation:
Under this statistical method, the future demand can be extrapolated by applying Binomial
expansion method. This method is used on the assumption that the rate of charge in demand
in the past has been uniform.

(iv) Simultaneous equation method:

This involves the development of a complete econometric model which can explain the
behaviour of all the variables which the company can control. This method is not very
popular.

(v) Barometric technique:

This is an improvement over the trend projection method. According to this technique the
events of the present can be used to predict the directions of change m the future. Here certain
economic and statistical indicators from the selected time series are used to predict variables.
Personal income, non-agricultural placements, gross national income, prices of industrial
materials, wholesale commodity prices, industrial production, bank deposits etc. are some of
the most commonly used indicators.

Advantages of Statistical Methods

1. The method of estimation is scientific
2. Estimation is based on the theoretical relationship between sales (dependent variable)
and price, advertising, income etc. (independent variables)
3. These are less expensive.
4. Results are relatively more reliable.

Disadvantages of Statistical Methods

1. These methods involve complicated calculations.
2. These do not rely much on personal skill and experience.
3. These methods require considerable technical skill and experience in order to be
4. effective.

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9.7 METHODS OF DEMAND FORECASTING FOR NEW PRODUCTS

Demand forecasting of new product is more difficult than forecasting for existing product.
The reason is that the product is not available. Hence, no historical data are available. In these
conditions the forecasting is to be done by taking into consideration the inclination and
wishes of the customers to purchase. For this a research is to be conducted. But there is one
problem that it is difficult for a customer to say anything without seeing and using the
product before. Thus it is very difficult to forecast the 90 demand for new products. Any way
Prof. Joel Dean has suggested the following methods for forecasting demand of new
products:

1. Evolutionary approach:
This method is based on the assumption that the new product is the improvement and
evolution of the old product. The demand is forecasted on the basis of the demand of the old
product. For example, the demand for black and white TV should be taken in to consideration
while forecasting the demand for colour TV sets because the latter is an improvement of the
former.

2. Substitute approach:
Here the new product is treated as a substitute of an existing product, e.g. polythene bags for
cloth bags. Thus the demand for a new product is analysed as a substitute for some existing
goods or service.

3. Growth curve approach:

Under this method the growth rate of demand of a new product is estimated on the basis of
the growth rate of demand of an existing product. Suppose Pears soap is in use and a new
cosmetic is to be introduced in the market. In this case the average sale of Pears soap will
give an idea as to how the new cosmetic will be accepted by the consumers.

4.Opinion poll approach:

Under this method the demand for a new product is estimated on the basis of information
collected from the direct interviews (survey) with consumers.

5. Sales Experience approach:

Under this method, the new product is offered for sale in a sample market, i.e. by direct mail
or through multiple shop or departmental shop. From this the total demand is estimated for
the whole market.

6. Vicarious approach:
This method consists of surveying consumers' reactions through the specialised dealers who
are in touch with consumers. The dealers are able to know as to how the customers will
accept the new product. On the basis of their reports demand can be estimated.

The above methods are not mutually exclusive. It is de desirable to use a combination of two
or more methods in order to get better results. In this lesson we have studied the meaning of
demand forecasting and identified the short and long term objectives of demand forecasting.

111
Check Your Progress – 3
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about the methods of demand forecasting for new products.

……………………………………………………………………………………………
……………………………………………………………………………………………
……………
9.8 LET US SUM UP

In this lesson we have studied the meaning of demand forecasting and identified the short and
long term objectives of demand forecasting. As a last part of this lesson we have looked into
the forecasting techniques used by firms to predict the level of demand
for their established and new products.

9.9 KEYWRODS

Least-square method Free-hand method

Moving average method Semi-average method.
Prevailing Industry
Firm Export trade

9.11 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications
2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

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9.12 ANSWER TO CHECK YOUR PROGRESS EXERCISE
Check Your Progress – 1
1. See section 9.4
Check Your Progress – 2
1. See Section 9.5
Check Your Progress –3
1. See section 9.7

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BLOCK
4
UNIT 10
PRODUCTION ANALYSIS
UNIT 11
LAWS OF PRODUCTION

UNIT 12
COST CONCEPTS
UNIT 13
COST – OUTPUT RELATIONS

114
UNIT 10
PRODUCTION ANALYSIS

STRUCTURE

10.1 Objectives

10.2 Introduction

10.3 Meaning of Production

10.4 Factors of Production

10.5 Characteristics of Production

10.6 Basic concepts in Production theory

10.7 Production Function

10.8 Cobb-Douglas Production Function

10.9 Let us sum up

10.10 Keywords

10.11 Some Useful Books

10.12 Answer to Check Your Progress Exercise

10.1 OBJECTIVES

After having studied this lesson, you should be able

To understand the meaning of Production
To Know the factors and characteristics of Production
To familiarize the basic concepts in production theory
To understand the production function

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10.2 INTRODUCTION

Production is an important economic activity. It directly or indirectly satisfies the wants and
needs of the people. Satisfaction of human wants is the objective of production. In this lesson
a general discussion of the concept of production and its functions are carried
out.

10.3 MEANING OF PRODUCTION

Production is the conversion of input into output. The factors of production and all other
things which the producer buys to carry out production are called input. The goods and
services produced are known as output. Thus production is the activity that creates or adds
utility and value. In the words of Fraser, "If consuming means extracting utility from matter,
producing means creating utility into matter". According to Edwood Buffa,“Production is a
process by which goods and services are created"

10.4 FACTORS OF PRODUCTION

As already stated, production is a process of transformation of factors of production (input)

into goods and services (output). The factors of production may be defined as resources
which help the firms to produce goods or services. In other words, the resources required to
produce a given product are called factors of production. Production is done by combining
the various factors of production. Land, labour, capital and organisation (or entrepreneurship)
are the factors of production (according to Marshall).

We can use the word CELL to help us remember the four factors of production: C. capital;
Entrepreneurship; L land: and L labour.
Check Your Progress – 1
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the factors of production.
……………………………………………………………………………………………
……………………………………………………………………………………………
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……………..
10.5 CHARACTERISTICS OF PRODUCTION

1. The ownership of the factors of production is vested in the households.

2. There is a basic distinction between factors of production and factor services.
It is these factor services, which are combined in the process of production.

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 3. The different units of a factor of production are not homogeneous. For example,
different plots of land have different level of fertility. Similarly labourers differ in
efficiency.

4. Factors of production are complementary. This means their co-operation or

combination is necessary for production.
5. There is some degree of substitutability between factors of production. For example,
labour can be substituted for capital to a certain extent.

10.6 BASIC CONCEPT IN PRODUCTION THEORY

The firm is an organisation that combines and organises labour, capital and land or raw
materials for the purpose of producing goods and services for sale. The aim of the firm is to
maximise total profits or achieve some other related aim, such as maximizing sales or growth.
The basic production decision facing the firm is how much of the commodity or services to
produce and how much labour, capital and other resources or inputs to use to produce that
output most efficiently. To answer these questions, the firm requires engineering or
technological data on production possibilities (the so called production function) as well as
economic data on input and output prices. Production refers to the transformation of inputs or
resources into outputs of goods and services. For example: IBM hires workers to use
machinery, parts and raw materials in factories to produce personal computers. The output of
a firm can either be a final commodity (such as personal computer) or an intermediate
product such as semiconductors (which are used in the production of computers and other
goods). The output can also be a service rather than a good. Examples of services are
education, medicine, banking, communication, transportation and many others. To be noted
is, that production refers to all of the activities involved in the production of goods and
services, from borrowing to set up or expand production facilities, to hiring workers,
purchasing raw materials, running quality control, cost accounting and so on, rather than
referring merely to the physical transformation of inputs into outputs of goods and services.
Inputs are the resources used in the production of goods and services. As a convenient way to
organise the discussion, inputs are classified into labour. (Including entrepreneurial talent),
capital and land or natural resources. Each of these broad categories however includes a great
variety of the basic input. For example, labour includes bus drivers, assembly line workers,
accountants, lawyers, doctors scientists and many others. Inputs are also classified as fixed or
variable. Fixed inputs are those that can not be readily changed during the time period under
consideration, except at very great expense. Examples of fixed inputs are the firm's plant and
specialized equipment. On the other land, variable inputs are those that can be varied easily
and on the very short notice. Examples of variable inputs are most raw materials and
unskilled labour.

The time period during which at least one input is fixed is called the short run, while the time
period when all inputs are variable is called the long run. The length of the long run depends
on the industry. For some, such as the setting up or expansion of a dry cleaning business, the
long run may be only few months or weeks. For others, much as the construction of new
electricity, generating plant, it may be many years. In the short run, a firm can increase output
only by using more of the variable inputs together with the fixed inputs. In the long run, the
same increase in output could very likely be obtained more efficiently by also expanding the
firm's production facilities. Thus we say that the firm operates in the short run and plans
increases or reductions in its scale of operation in the long run. In the long run, technology

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usually improves, so that more output can be obtained from a given quantity of inputs or the
same output from less input.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the basic concept in production theory
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………

10.7 PRODUCTION FUNCTION

Production is the process by which inputs are transformed in to outputs. Thus there is relation
between input and output. The functional relationship between input and output is known as
production function. The production function states the maximum quantity of output which
can be produced from any selected combination of inputs. In other words, it states the
minimum quantities of input that are necessary to produce a given quantity of output.

The production function is largely determined by the level of technology. The production
function varies with the changes in technology. Whenever technology improves, a new
production function comes into existence. Therefore, in the modern times the output depends
not only on traditional factors of production but also on the level of technology.

The production function can be expressed in an equation in which the output is the dependent
variable and inputs are the independent variables. The equation is expressed as follows:
Q= f (L, K, T……………n)
Where, Q = output
L = labour
K = capital
T = level of technology
n = other inputs employed in production.

There are two types of production function - short run production function and long run
production function. In the short run production function the quantity of only one input varies
while all other inputs remain constant. In the long run production function all inputs are
variable.

Assumptions of Production Function

The production function is based on the following assumptions.

1. The level of technology remains constant.

2. The firm uses its inputs at maximum level of efficiency.
3. It relates to a particular unit of time.

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 4. A change in any of the variable factors produces a corresponding change in the
output.
5. The inputs are divisible into most viable units.

Managerial Use of Production Function

The production function is of great help to a manager or business economist. The managerial
uses of production function are outlined as below:

1. It helps to determine least cost factor combination:

The production function is a guide to the entrepreneur to determine the least cost factor
combination. Profit can be maximized only by minimizing the cost of production. In order to
minimize the cost of production, inputs are to be substituted. The production function helps in
substituting the inputs.

2. It helps to determine optimum level of output:

The production function helps to determine the optimum level of output from a given
quantity of input. In other words, it helps to arrive at the producer's equilibrium.

3. It enables to plan the production:

The production function helps the entrepreneur (or management) to plan the production.

4. It helps in decision-making:
Production function is very useful to the management to take decisions regarding cost and
output. It also helps in cost control and cost reduction. In short, production function helps
both in the short run and long run decision-making process.
Check Your Progress – 3
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the production functions.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
……………..

10.8 COBB – DOUGLAS PRODUCTION FUNCTION

Paul H. Douglas and C.W Cobb of the U.S.A have studied the production of the American
manufacturing industries and they formulated a statistical production function.
It is popularly known as Cobb-Douglas Production Function. It is stated as follows.
Q = KLaC,,a) where,
Q = output
L = quantity of labour
C = quantity of capital
K and a = positive constants

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An important point in Cobb Douglas production function is that it indicates constant returns
to scale. This means that if each input factor is increased by one percent, output will exactly
increase by one percent. In other words, there will be no economies or diseconomies of scale.

Although the Cobb Douglas production function is nonlinear, it can be transformed into a
linear function by converting all variables into logarithms. That is why this function is known
as a log linear function.

In 1937, David Duerentt suggested that it will be better to present Cobb-Douglas production
function in the form of following equation :
Q = j aC KL
In the above equation, 'a' and 'j' stand for elasticity of production of labour and capital
respectively.

Importance of Cobb-Douglas Production Function

Cobb-Douglas production function is most commonly used function in the field of

economics. It graduates data on output and input well. Many economists used it
independently. Hence, there are a number of varieties of the Cobb-Douglas form which yield
variable elasticity’s of production and substitution. It is useful in international or inter-
industry comparisons.

Cobb-Dougla's research has been a test of the marginal productivity theory of wages (or
theory of distribution) as well as descriptions of production technology.

Check Your Progress – 4

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about Cobb-Douglas Production function.

……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
……………..
10.9 LET US SUM UP

A detailed study is made about the concept of production in this lesson. The initial portion of
this lesson explains us the meaning, factors and characteristics of production.
We discussed the production function and its managerial uses. An illustration is made on the
Cobb-Douglas production function as the last part of this lesson

120
10.10 KEYWORDS

Economic activity Satisfaction

Input Output
Producer Services
Transformation Homogeneous
Complementary Substitutability

10.11 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

10.12 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 10.5
Check Your Progress – 2
1. See Section 10.6
Check Your Progress – 3
1. See section 10.7
Check Your Progress – 4
1. See Section 10.8

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UNIT– 11
LAWS OF PRODUCTION

STRUCTURE

11.1 Objectives

11.2 Introduction

11.3 Law of Diminishing Returns

11.4 Why does the Law of Variable Proportion Operate?

11.5 Importance of Law of Variable proportion

11.6 Law of Returns to Scale

11.7 Production function with two variable inputs

11.8 Let us sum up

11.9 Keywords.

11.10 Some Useful Books

11. 11 Answer to Check Your Progress Exercise

11.1 OBJECTIVES

After having studied this lesson, you should be able

122
  To understand the Laws of Production
 To Know Why the Law of Variable Proportion Operate
 To understand Law of Returns to Scale
11.2 INTRODUCTION

Production function shows the relationship between input and output. The law of production
shows the relationship between additional input and additional output. The
laws of production consists of

(1) Law of Diminishing Returns (to analyse production in the short period), and
(2) Laws of Returns to Scale (to analyse production in the long period).

11.3 LAW OF DIMINISHING RETURNS

The law of variable proportion is the modern approach to the 'Law of Diminishing Returns
(or The Laws of Returns). This law was first explained by Sir. Edward West (French
economist). Adam Smith, Ricardo and Malthus (Classical economists) associated this law
with agriculture. This law was the foundation of Recardian Theory of Rent and Malthusian
theory of population. The law of variable proportion shows the production function with one
input factor variable while keeping the other input factors constant.

The law of variable proportion states that, if one factor is used more and more (variable),
keeping the other factors constant, the total output will increase at an increasing rate in the
beginning and then at a diminishing rate and eventually decreases absolutely.

According to K. E. Boulding, "As we increase the quantity of any one input which is
combined with a fixed quantity of the other inputs, the marginal physical productivity of the
variable input must eventually decline".

In this law we study the effect of variations in factor proportion on output. When one factor
varies, the others fixed, the proportion between the fixed factor and the variable factor will
vary, (e.g., land and capital will be fixed in the short run, while labour will be variable).That
is why the law is called the law of variable proportion.

The law of variable proportion is also known as the law of proportionality, the law of
diminishing returns, law of non-proportional outputs etc.

The following table illustrates the operations of Law of Variable Proportion.

Table - 2
No. of workers Total Average Marginal Remarks
(variable Input Product (TP) Product (AP) Product (MP)
factor)
1 10 10 10
2 24 12 14
3 39 13 15 I Stage

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 4 56 14 17
5 70 14 14
6 78 13 8
7 84 12 6 II Stage
8 84 10.5 0
9 81 9 -3 III Stage

In the above table we can see that both the average and marginal products increase at first and
then decline. Average product is the product for one unit of labour. It is calculated by
dividing the total product by the number of workers. Marginal product is the additional
product resulting from additional labour. The total product increases at an increasing rate till
the employment of the 4th worker. Beyond the 4th worker, the marginal product is
diminishing. The marginal product declines faster than the average product. When 7 workers
are employed, the total product is maximum. For 8 workers marginal product is zero and the
marginal product of 9 workers is negative. Thus when
more and more units labour are combined with other fixed factors, the total product increases
first at an increasing rate, then at a diminishing rate and finally it becomes negative.

The above idea can be more clearly illustrated with the help of a diagram (Fig.5).

Fig. 5
When one input is variable and others are held constant, the relations between the input and
the output are divided into three stages. The law of variable proportion may be explained
under the following three stages as shown in the graph:

Stage 1: Total product increases at an increasing rate and this continues till the end of this
stage. Average product also increases and reaches its highest point at the end of this stage.
Marginal product increases at an increasing rate. Thus TP, AP and MP - all are increasing.
Hence this stage is known as stage of increasing return.

Stage II:
Total product continues to increase at a diminishing rate until it reaches its maximum point at
the end of this stage. Both AP and MP diminish, but are positive. At the end of the second
stage, MP becomes zero. MP is zero when the TP is at the maximum. AP shows a steady

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decline throughout this stage. As both AP and MP decline, this stage is known as stage of
diminishing return.

Stage III:
In this stage the TP declines. AP shows a steady decline, but never becomes zero. MP
becomes negative. It goes below the X axis. Hence the 3rd stage is known as
stage of negative return. According to classical economists there were three laws of returns:
(i) Law of increasing returns,
(ii) Law of constant returns, and
(iii) Law of diminishing returns. But the modern economists do not accept this. According to
them there are not three laws of production but there is only one law of production i.e. law of
variable proportion. It has three stages. It is necessary to understand the following terms:

Total Product or Total Physical Product (TPP):

This is the quantity of output a firm obtains in total from a given quantity of input.

Average Product or Average Physical Product (APP):

This is the total physical product (TPP) divided by the quantity of input.

Marginal Product or Marginal Physical Product (MPP):

It is the increase in total output that results from a one unit increase in the input, keeping all
other inputs constant.

Assumptions of the Law

The law of variable proportion is valid when the following conditions are fulfilled:
1. The technology remains constant. If there is an improvement in the technology,
due to inventions, the average and marginal product will increase instead of
decreasing.
2. Only one input factor is variable and other factor are kept constant.
3. All the units of the variable factors are identical. They are of the same size and quality.
4. A particular product can be produced under varying proportions of the input
combinations.
5. The law operates in the short run.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about the Law of Diminishing Returns.

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 ……………………………………………………………………………………………
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11.4 WHY DOES THE LAW OF VARIABLE PROPORTION OPERATE?

The law of variable proportion operates on account of the following reasons:

1. Imperfect substitutes:
There is a limit to the extent to which one factor can be substituted for another. In other
words, two factors are not perfect substitutes. For example, in the construction of building,
capital cannot substitute labour fully. 127

2. Scarcity of the factors of production:

Output can be increased only by increasing the variable factors. In the short run certain input
factors like land and capital are scarce. This leads to diminishing marginal productivity of the
variable factors.

3. Economies and diseconomies of scale:

The internal and external economies of large scale production are available as production is
expanded. Therefore average cost goes on diminishing. But this continues only up to a certain
stage. When the production is expanded beyond a level the diseconomies will start entering
into production. Hence the output will come down (or cost will go up).

4. Specialisation :
The stage of diminishing returns comes into operation when the limit to maximum degree of
specialisation reaches. This stage emerges when the fixed factor becomes more and more
scarce in relation to the variable factor thereby giving less and less support to the latter. As a
result of this, the efficiency and productivity of the variable factor diminish.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Why Does the law of Variable proportion operate?
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11.5 IMPORTANCE OF LAW OF VARIABLE PROPORTION

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The law of variable proportion is one of the most fundamental laws of Economics.
The law of variable proportion is applicable not only to agriculture but also to other
constructive industries like mining, fishing etc. It is applied to secondary or tertiary sectors
too. This law helps the management in the process of decision making. The law is a law of
life and can be applicable anywhere and everywhere. The applications of this law are as
follows:

Basis of Malthusian theory of population:

Malthus based his theory of population on the law of variable proportion.

1. Basis of the Ricardian theory of rent: Ricardo's theory of rent is based on

this law.
2. Basis of the marginal productivity theory of distribution:
The marginal productivity theory of distribution is also based on this law.
3. Optimum production:
This law can be used to estimate the optimum proportion of the factors for the producer.
4. Price determination:
This law is also important in the price determination.
5. Explanation of disguised unemployment:
Less developed countries like India have good deal of disguised unemployment. Many
farm workers are in fact surplus. This is called disguised unemployment. The law helps us
in explaining the presence of disguised unemployment. In short, the law of variable
proportion is a universal law.

11.6 LAW OF RETURNS TO SCALE

The law of variable proportion analyses the behaviour of output when one input factor is
variable and the other factors are held constant. Thus it is a short run analysis. But in the long
run all factors are variable. When all factors are changed in same proportion, the behaviour of
output is analysed with laws of returns to scale. Thus law of returns to scale is a long run
analysis. In the long period, output can be increased by varying all the input Factors this law
is concerned, not with the proportions between the factors of production, but with the scale of
production. The scale of production of the firm is determined by those input factors which
cannot be changed in the short period. The term return to scale means the changes in output
as all factors change in the same proportion. The law of returns to scale seeks to analyse the
effects of scale on the level of output. If the firm increases the units of both factors labour and
capital, its scale of production increases. The return to scale may be increasing, constant or
diminishing. We shall now examine these three kinds of returns to scale.

Increasing Returns to Scale

When inputs are increased in a given proportion and output increases in a greater proportion,
the returns to scale are said to be increasing. In other words, proportionate increase in all
factors of production results in a more than proportionate increase in output It is a case of
increasing returns to scale. For example, if the inputs are increased by 40% and output
increased by 50%, return to scale are increasing (= >1). It is the first
stage of production.

If the industry is enjoying increasing returns, then its marginal product increases. As the
output expands, marginal costs come down. The price of the product also comes down.

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Constant Return to Scale
When inputs are increased in a given proportion and output increases in the same proportion,
constant return to scale is said to prevail. For example, if inputs are increased by 40% and
output also increases by 40%, the return to scale are said to be constant ( = 1). This may be
called homogeneous production function of the first degree.

In case of constant returns to scale the average output remains constant. Constant returns to
scale operate when the economies of the large scale production balance with the
diseconomies.

Decreasing Returns to Sale

Decreasing returns to scale is otherwise known as the law of diminishing returns. This is an
important law of production. If the firm continues to expand beyond the stage of constant
returns, the stage of diminishing returns to scale will start operate. A proportionate increase in
all inputs results in less than proportionate increase in output, the returns to scale is said to be
decreasing. For example, if inputs are increased by 40%, but output increases by only 30%, (
= < 1), it is a case of decreasing return to scale. Decreasing return to scale implies increasing
costs to scale.

Check Your Progress – 3

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about the Law of Returns to Scale.

…………………………………………………………………………………………………
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11.7 PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

So far we have assumed that the firm is increasing output either by using more of one input
(in laws of return) or more of all inputs (in laws of returns to scale). Let us now consider the
case when the firm is expanding production by using more of two inputs (varying) that are
substitutes for each other. A production function with two variable inputs can be represented
by isoquants. Isoquant is a combination of two terms, namely, iso and quant. Iso means equal.
Quant means quantity. Thus isoquant means equal quantity or equal product. Isoquants are
the curves which represent the different combination of inputs producing a particular quantity
of output. Any point on the isoquant represents or yields the same level of output. Thus
isoquant shows all possible combinations of the two inputs (say labour and capital) capable of
producing equal or a given level of output. Isoquants are also known as iso product curves or
equal product curves or production indifferent curves.
An isoquant may be explained with the following example:

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Equal Product Combinations

Table 3

Combination Units of Labour Units of Capital Total Output

A 20 1 1000
B 15 2 1000
C 11 3 1000
D 8 4 1000
E 6 5 1000

In the above schedule, there are five possible combinations. All the five combinations yield
the same level of output i.e. 1000 units. 20 units of labour and 1 unit of capital produce 1000
units. 15 units of labour and 2 units of capital also produce 1000 units and so on. All
combination are equally likely because all of them produce the same level of output i.e. 1000
units. Now if plot these combination of labour and capital, we shall get a curve. This curve is
known as an isoquant. In the below diagram units of capital are measured on horizontal axis
and units of labour on vertical axis. The five combinations are known as A, B, C, D and E.
After joining these points, we get the is product curve IQ. Here we assume that the level of
technology remains constant. We also assume that the input can be substituted for each other.
If quantity of labour is reduced, the quantity of capital must be increased to produce the same
output. Thus an isoquant shows various combinations of the two inputs in the existing state of
technology which produce the same level of output.

Diminishing Marginal rate of Technical Substitution

As already stated, an important assumption in the isoquant diagram is that the inputs can be
substituted for each other. If a unit of labour is reduced, the units of capital must be increased
in order to produce the same output. Here we want to know the rate at which one factor is
substituted for the other. The term marginal rate of technical substitution refers to the rate at
which one factor of production is substituted in place of the other factor, the quantity of
output remaining the same. It is the rate at which one input must be substituted for another, in

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order to keep the same level of output. Thus the marginal rate of technical substitution of
capital for labour may be defined the units of labour which can be replaced by one unit of
capital; keeping the same level of output. In other words, it is the ratio of small decrease in
the amount of labour and a small increase in the amount of capital so as to keep the same
level of output. The ratio of is called the marginal rate of technical substituttion of capital
for labour. L refers to changes in the units of labour and K refers to change in the units of
capital. In Fig.6 on the 1Q for 1000 units the MRTSKL over AB segment is = =
Over the segment BC is = and so on. In short, the marginal rate of technical

substitution of measures the slope of the isoquant at a particular point. For example, the

slope of the isoquant at point A is where as at B = it is Thus the slope of an isoquant at

a point represents marginal rate of technical substitution. It is also important to note that the
marginal rate of technical substitution is the ratio of marginal productivity of labour to
marginal productivity of capital.

As more and more units of capital are substituted to labour, each additional unit of capital
contributes less and less output, while when labour is reduced each last unit of labour
contributes more and more to output, because inefficient units of capital are coming to
production while inefficient units of labour are going out of production. Marginal
productivity of capital will decrease and marginal productivity of labour will increase. Thus
when we move from left to right on an isoquant (substituting more capital in place of labour)

diminish.

As more capital is used, marginal productivity of capital will get diminished. At the same
time as the unit of labour is reduced, the marginal productivity of labour will increase. Hence
the marginal rate of technical substitute of capital for labour diminishes so as to maintain the
same quantity. It is shown as follows:
MRTSKL= =

Isoquant Map or Equal Product Map

An isoquant map consists of a number of isoquants. An isoquant map gives a set of equal
product curves which show different production levels. Each isoquant in the map indicates
different levels of output. A higher isoquant represents a higher level of output. The distance
of an isoquant from the origin shows the relative levels of output. The farther the isoquant
from the origin the greater will be the level of output along it. But it should be noted that the
distance between two equal product curves does not measure the absolute difference in the
volume of output. Isoquant map is shown in the following diagram.

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Properties or Features of Isoquant

The following are the important properties of isoquants:

1. Isoquant is downward sloping to the right. This means that if more of one factor is
used less of the other is needed for producing the same output.
2. A higher isoquant represents larger output.
3. No isoquants intersect or touch each other. If so it will mean that there will be a
common point on the two curves. This further means that same amount of labour and
capital can produce the two levels of output which is meaningless. The isoquant as
shown in Fig.8 will never exist.

4. Isoquants need not be parallel to each other. It so happens because the rate of
substitution in different isoquant schedules need not necessarily be equal. Usually
they are found different and therefore, isoquants may not be parallel.

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 Fig. 9
5. Isoquant is convex to the origin. This implies that the slope of the is quant diminishes
from left to right along the curve. This is because of the operation of the principle of
diminishing marginal rate of technical substitution.

6. No isoquant can touch either axis. If an isoquant touches X axis then it would mean
that without using any labour the firm can produce output with the help of capital
alone. But this is wrong because the firm can produce nothing with OK units of
capital alone. If an isoquant touches Y axis, it would mean that without using any
capital the firm can produce output with the help of labour alone. This is impossible.

7. Isoquants have negative slope. This is so because when the quantity of one factor
(labour) is increased the quantity of other factor (capital) must be reduced, so that
total output remains the same. If the marginal productivity of the factor becomes zero
the isoquant will bend back and it will have positive slope as shown below.

The portions AC and BD of the isoquant have positive slope.

If the inputs are perfect substitutes, each isoquant will be a straight line (case a).
If the inputs cannot be substituted at all, the isoquants will be right angles (case b). Typical
isoquants lie between the extreme cases of straight lines and right angles
(case c).
Along a curved isoquant, the ability to substitute one input for another varies.

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Optimum Input Combination (Least cost combination or Producer's Equilibrium)

The iso-quant shows different combinations of two factors producing the same level of
output. However, the producer will not accept all combinations. He wants to maximise his
profit. It is possible only by maximising the output at minimum cost. Therefore, he will select
the optimum input combination which involves the least cost. Optimum input combination or
least cost combination is that combination which produces maximum output at the minimum
cost. In other words, the optimum or least cost combination is that combination where the
average cost of production is the minimum. This is the producer's equilibrium. This can be
found out by combining the firm's production function and cost function. The production
function is represented by iso-quant and cost function is represented by iso-cost curve.
The principle of least cost combination is based on the following assumptions:

1. Capital and labour are the two factors involved in production.

2. All the units of both the factors are homogeneous.
3. The prices of the input factors are given.
4. The total money outlay is also given.
5. There is perfect competition in the factor market.

In order to analyse producer's equilibrium the firm should combine its iso-quant (already
discussed) and iso-cost line.

Iso-cost Curve

In order to select the optimum quantity of two inputs, the firm has to consider their quantities
and their prices. Factors of production are available at a price. Therefore their prices and
amount of money which the firm wants to spend has to be taken into consideration. Iso-cost
line represents these two things. An iso-cost line indicates the different combination of the
two factors which the firm can buy at given prices with a given amount of money. It shows
all the combinations of labour and capital that the firm can purchase with a given outlay and
at given prices.

Thus iso-cost shows the prices of the two factors and the total amount of money to spend.
To make it more clear, let us take an example. Suppose a firm deci to spend Rs.5000 on 2
factors - capital and labour. If the weekly wage of a worker is Rs.50, the firm can employ 100
workers. Similarly if one unit of capital costs Rs.20, the firm buy 250 units of capital. Thus
the firm can spend the whole amount of Rs.5000 either on labour (100 workers) or on capital
(250 units) or partly on labour and partly on capital. The isocost line is shown in the Fig. 12

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The iso-cost line L, K, indicates on outlay of Rs.5000. With Rs.5000 the firm can buy either
OL, units of labour or OK., units of capital or any combination of labour and capital between
the extremes L( K.,. Similarly the iso-cost line L2 K... shows an outlay of Rs.6000 which
means that either 120 workers may be employed or 300 units of capital may be bought or
some units of both capital and labour. Thus iso-cost line shows all those combinations of
capital and labour which the firm can use with the given amount of money. An iso-cost curve
represents the same cost for all the different combination of input. Iso-cost line is always a
straight line (because the firm has no control over market prices of factors).
The slope of the iso-cost line is determined by the firm's outlay and the price of two factors. It
represents the ratio of the price of capital to the price of labour

=.

If the price of any one of the factors changes, there would be a corresponding change in the
slope of the isocost line. If the firm wants to spend more amounts there will be a parallel
upward shift in the isocost line. If it wants to spend less, there will be a parallel
downward shift in the isocost line.

Selection of the Optimum or Least Cost Combination

The optimum or least cost combination (producer's equilibrium) can be found out with the
help of isoquants and isocost lines. A firm’s equilibrium will be attained at a point where the
isoquant touches the isocost line. This may be explained with the help of the following
diagram.

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Equal product curves (IQ1,IQ2, and IQ3 ), represent output of 1000 units, 1250 units and 1500
units respectively. AB is the isocost line representing the outlay of Rs. 5000. At point E the
isocost line AB is tangent to isoquant IQ2, representing 1250 units. The Isocost curve and
Isoquant curve are equal at this point. Therefore combination of L1, labour K1, capital is the
least cost combination to produce the output of 1250 units. F and G are not least cost
combination because they lie on the lower isoquant curve indicating lesser output of 1000
units. Cost will be minimum at point E because it is at this point the Isocost line AB is
tangent to Isoquant IQ2. The firm is in equilibrium at point E. At E the average cost is Rs. 4
(5000/1250). At an output of 1000 units the average cost would be Rs. 5 (5000/1000). He
cannot produce an output of 1500 units because he has only Rs. 5000 with him to spend. The
combination at point E is thus the least cost combination. This combination will give
maximum output at minimum cost.

At the point E the slope of isoquant is equal to the slope of isocost line. The ratio between the
prices of capital and labour and the MRTS are equal.

MRTSKL= =.

Capital is substituted for labour.

Slope of isocost line=

This is the point of optimum input combination

MRTSKL = slope of isocost line = .

The equality between the MRTS between price of capital and labour to the price
ratio gives maximum output at minimum cost.

11.8 LET US SUM UP

In this lesson we studied the concept o laws of production. We identified the constituents of
laws of production. We studied in detail the law of diminishing returns or
otherwise called as law of variable proportion. We also discussed in detail the law of
returns to scale.

11.9 KEYWORDS

Production Agriculture
Population Proportion
Marginal Physical
Diseconomies Scarcity

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11.10 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

11.11 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1
1. See section 11.3
Check Your Progress – 2
1. See Section 11.4
Check Your Progress – 3
1. See section 11.6

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UNIT– 12
COST CONCEPTS

STRUCTURE

12.1 Objectives

12.2 Introduction

12.3 Various Cost Concepts

12.4 Let us sum up

12.5 Keywords

12.6 Some Useful Books

12.7 Answer to Check Your Progress Exercise

12.1 OBJECTIVES

After having studied this lesson, you should be able

To familiarize the cost concept used in managerial decision making process.
To understand about the various costs

12.2 INTRODUCTION

The word 'cost' has different meanings in different situations. The accounting cost concept or
the historical cost concept is not useful as such for business decision-making. The accounting
records end up with the balance sheet and income statements which are meant for legal,
financial and tax needs of the enterprise. The financial recordings reveal what has been
happening. It is a historical recording which is not of very much help to the managerial
economist in his business decision-making. The actual cost is not the relevant cost concept
for business decision-making because it only reveals what has been happening. The decision-
making concepts of cost aim at projecting what will happen in the alternative courses of
action. Business decisions involve plans for the future and require choices among different
plans. These decisions necessitate profitability calculations for which a comparison of future
revenues and future expenses of each alternative plan is needed.

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12.3 VARIOUS COST CONCEPTS

A managerial economist must have a proper understanding of the different cost concepts
which are essential for clear business thinking. The several alternative bases of classifying
cost and the relevance of each for different kinds of problems are to be studied. The various
relevant concepts of costs used in business decisions are given below.

Total, Average and Marginal Costs

Total cost is the total cash payment made for the input needed for production. It may be
explicit or implicit is the sum total of the fixed and variable costs.
Average cost is the cost per unit of output. It is obtained by dividing the total cost (TC)
by the total quantity produced (Q)
Average Cost =
Marginal cost is the additional cost incurred to produce an additional unit of output. Or it is
the cost of the marginal unit produced.

Example
A company produces 1000 typewriters per annum. Total fixed cost is Rs. 1,00,000
per annum. Direct material cost per typewriter is Rs. 200 and direct labour cost Rs. 100.
Variable cost per typewriter = direct material + direct labour = 200 + 100 = Rs. 300

Total variable cost (1000x300) = Rs.300000

Fixed Cost = Rs. 100000
Total cost = Rs.400000
TC = Rs. 400000
Average Cost = = = Rs. 400

If output is increased by one typewriter, the cost will appear as follows:

Total variable cost (1001x300) = 300300
Fixed cost = 100000
Total = 400300
Here the additional cost incurred to produce the 1001th typewriter is Rs.300
(400300 - 400000). Therefore, the marginal cost per typewriter is Rs.300.

Fixed and Variable Costs

This classification is made on the basis of the degree to which they vary with the changes in
volume. Fixed cost is that cost which remains constant up to a certain level of output. It is not
affected by the changes in the volume of production. Then fixed cost per unit aries with
output rate. When the production increases, fixed cost per unit decreases. Fixed cost includes
salary paid to administrative staff, depreciation of fixed assets, rent of factory etc. These costs
are fixed in the sense that they do not change in short-run. Variable cost varies directly with
the variation in output. An increase in total output results in an increase in total variable costs
and decrease in total output results in a proportionate decline in the total variable costs. The
variable cost per unit will be constant. Variable costs include the costs of all inputs that vary
with output like raw materials, running costs of fixed assets such as fuel, ordinary repairs,

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routine maintenance expenditure, direct labour charges etc. The distinction of cost is
important in forecasting the effect of short-run changes in volume upon costs and profits.

Short-Run and Long-Run Costs

This cost distinction is based on the time element. Short-Run is a period during which the
physical capacity of the firm remains fixed. Any increase in output during this period is
possible only by using the existing physical capacity more intensively. Long- Run is a period
during which it is possible to change the firm's physical capacity. All the inputs become
variable in the long-term. Short-Run cost is that which varies with output when the physical I
capacity remains constant. Long-Run costs are those which vary with output when all the
inputs are variable. Short-Run costs are otherwise called variable costs. A firm wishing to
change output quickly can do it only by increasing the variable factors. Short- Run cost
concept helps the manager to take decision when a firm has to decide whether or not to
produce more or less with a given plant. Long-Run cost analysis.

Opportunity Costs and Outlay Costs

This distinction is made on the basis of the nature of the sacrifice made. Outlay costs are
those expenses which are actually incurred by the firm. These are the actual payments made
for labour, material, plant, building, machinery, traveling, transporting etc. These are the
expense items that appear in the books of accounts. Outlay cost is an accounting cost concept.
It is also called absolute cost or actual cost. Whenever the inputs are to be bought for cash the
outlay concept is to be applied.

A businessman chooses and investment proposal from different investment opportunities.

Before taking the decision he has to compare all the opportunities and choose the best. When
he chooses the best he sacrifices the possibility of making profit from other investment
opportunities. The cost of his choice is the return that he could have earned from other
investment opportunities he has given up or sacrificed. A businessman decides to use his own
money to buy a machine for the business. The cost of that money is the probable return on the
money from the next most acceptable alternative investment. If he invested the money at 12
percent interest, the opportunity cost of investing in his own business would be the 12 percent
interest he has forgone.

The outlay concept is applied when the inputs are to be bought from the market. When a firm
decides to make the inputs rather than buying it from the market the opportunity cost concept
is to be applied. For example, in a cloth mill, instead’ of buying the yarn from the market
they spin it themselves. The cost of this yam is really the price at which the yarn could be
sold if it were not used by them for weaving cloth.

The opportunity cost concept is made use of for long-run decisions. For example, the cost of
higher education of a student should not only be the tuition fees and book costs but it also
includes the earnings foregone by not working. This concept is very important in capital
expenditure budgeting. The cost of acquiring a petrol pump in Trivandrum City by spending
Rs. 6 lakhs is not usually the interest for that borrowed money but it is the profit that would
have been made if that Rs. 6 lakhs had been invested in an offset printing press, which is the
next best investment opportunity. Opportunity cost concept is useful for taking short-rum
decisions also. In boom periods the scarce lathe capacity used for making a product involves
the opportunity cost of not using it to make some other product that can also produce profit.

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Opportunity cost is the cost concept to use when the supply of inputs is strictly limited.
Estimates of cost of capital are essentially founded on an opportunity cost concept of
investment return. Investment decision involves opportunity costs measurable in terms of
sacrificed income from alternative investments. The opportunity cost of any action is
therefore measured by the value of the most favorable alternative course which has to be
foregone if that action is taken.

Opportunity cost arises only when there is an alternative. If there is no alternative,

opportunity cost is the estimated earnings of the next best use. Thus it represents only the
sacrificed alternative.

Hence it does not appear in financial accounts. But this concept is of very great use in
managerial decision-making.

Out-of-pocket and Book Costs

Out-of-pocket costs are those costs that involve current cash payment. Wages, rent, interest
etc., are examples of this. The out-of-pocket costs are also called explicit costs. Book costs do
not require current cash expenditure. Unpaid salary of the owner manager, depreciation, and
unpaid interest cost of owner's own fund are examples of book costs. Book costs may be
called implicit costs. But the book costs are taken into account in determining the legal
dividend payable during a period. Both book costs and out-of-pocket costs are considered for
all decisions. Book cost is the cost of self owned factors of production. The book cost can be
converted into out-of-pocket cost. If a self owned machinery is sold out and the service of the
same is hired, the hiring charges form the out-of-pocket cost The distinction is very helpful in
taking liquidity decisions.

Incremental and Sunk costs

Incremental cost is the additional cost due to a change in the level or nature of business
activity. The change may be caused by adding a new product, adding new machinery,
replacing machinery by a better one etc. Incremental or differential cost is not marginal cost.
Marginal cost is the cost of an added (marginal) unit of output. Sunk costs are those which
are not altered by any change. They are the costs incurred in the past. This cost is the result of
past decision, and cannot be changed by future decisions. Once an asset has been bought or
an investment made, the funds locked up represent sunk costs. As these costs do not alter
when any change in activity is made they are sunk and are irrelevant to a decision being taken
now. Investments in fixed assets are examples of sunk costs. As soon as fixed assets have
been installed, their cost is sunk.

The amount of cost cannot be changed. Incremental cost helps management to evaluate the
alternatives. Incremental cost will be different in the case of different alternatives. Sunk cost,
on the other hand, will remain the same irrespective of the alternative selected. Cost estimates
of an incremental nature only influence business decisions.

Explicit and Implicit or Imputed costs

Explicit costs are those expenses that involve cash payments. These are the actual or business
costs that appear in the books of accounts. Explicit cost is the payment made by the employer
for those factors of production hired by him from outside. These costs include wages and

140
salaries paid payments for raw materials, interest on borrowed capital funds, rent on hired
land, taxes paid to the government etc. Implicit costs are the costs of the factor units that are
owned by the employer himself. It does not involve dash payment and hence does not appear
in the books of accounts. These costs did not actually incur but would have incurred in the
absence of employment of self-owned factors of production. The two normal implicit costs
are depreciation and return on capital contributed by shareholders. In small scale business
unit the entrepreneur himself acts as the manager of the business. If he were employed in
another firm he would be given salary. The salary he has thus forgone is the opportunity cost
of his services utilized in his own firm. This is an implicit cost of his business. Thus implicit
wages, implicit rent and implicit interest are the highest interest, rent and wages which self-
owned capital, building and labour respectively can earn from their next best use. Implicit
costs are not considered for finding out the loss or gains of the business, but help a lot in
business decisions.

Replacement and Historical costs

These are the two methods of valuing assets for balance sheet purpose and to find out the cost
figures from which profit can be arrived at; Historical cost is the original cost of an asset.
Historical cost valuation shows the cost of an asset as the original price paid for the asset
acquired in the past. Historical valuation is the basis for financial accounts. Replacement cost
is the price that would have to be paid currently to replace the same asset. For example, the
price of a machine at the time of purchase was Rs. 17,000 and the present price of the
machine is Rs. 20,000. The original price Rs. 17,000 is the historical cost while Rs. 20,000 is
the replacement cost. During periods of substantial change in the price level, historical
valuation gives a poor projection of the future cost intended for managerial decision.
Replacement cost is a relevant cost concept when financial statements have to be adjusted for
inflation.

Controllable and Non-controllable costs

Controllable costs are the ones which can be regulated by the executive who is in charge of it.
The concept of controllability of cost varies with levels of management. If a cost is
uncontrollable at one level of management it may be controllable at some other level.
Similarly the controllability of certain costs may be shared by two or more executives. For
example, material cost, the price of which comes under the responsibility of the purchase
executive whereas its usage comes under the responsibility of the production executive.
Direct expenses like material, labour etc. are controllable costs. Some costs are not directly
identifiable with a process or product. They are apportioned to various processes or products
in some proportion. This cost varies with the variation in the basis of allocation and is
independent of the actions of the executive of that department. These apportioned costs are
called uncontrollable costs.

Business and Full costs

A firm's business cost is the total money expenses recorded in the books of accounts. This
includes the depreciation provided on plant and equipment. It is similar to the actual or real
cost. Full cost of a firm includes not only the business costs but also opportunity costs of the
firm and normal profits. The firm's opportunity cost includes interest on self-owned capital,
the salary forgone by the entrepreneur if he were, working in his firm. Normal profit is the
minimum returns which induces the entrepreneur to produce the same product.

141
Economic and Accounting Cost
Accounting costs are recorded with the intention of preparing the balance sheet and profit and
loss statements which are intended for the legal, financial and tax purposes of the company.
The accounting concept is a historical concept. It records what has happened. The past cost
data revealed by the books of accounts does not help very much in decision-making.
Decision-making needs future costs. Economic concept considers future costs and future
revenues which help future planning and choice. When the accountant describes what has
happened, the economist aims at projecting what will happen. Accounting data ignores
implicit. or imputed cost. The economist considers decision-making costs. For this, different
cost classifications relevant to different kinds of problems are considered. The cost
distinctions such as opportunity and outlay cost, short run and long-run cost and replacement
and historical cost are made from the economic viewpoint.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the various cost concepts.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
……………………..
12.4 LET US SUM UP

In this lesson initially we studied the meaning of cost, and a detailed discussion has been
made into various concepts of costs such as total cost, average cost, marginal cost, fixed cost,
variable cost; short run and long run cost, opportunity cost, out lay cost, book costs, such
cost, incremental cost, explicit and implicit cost historical cost replacement cost, controllable
abnormal controllable cost, business and full cost, economic cost, and according cost.

12.5 KEYWORDS

Average cost Marginal costs

Fixed and variable costs Short-run and long-run costs
Opportunity costs and outlay costs Cost distinction
Book costs Incremental and sunk costs
Explicit Implicit

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12.6 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

12.7 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 12.3

143
UNIT– 13
COST – OUTPUT RELATIONS

STRUCTURE

13.1 Objectives

13.2 Introduction

13. 3 Short run Cost - Output Relations

13.4 Long run Cost - Output Relations

13.5 Let us sum up

13.6 Keywords

13.7 Questions for Discussions

13.8 Suggested Readings

13.1 OBJECTIVES

After having studied this lesson, you should be able

 To understand the concept of cost-output relations
 To know the important role of cost-output relationship in determining the optimum
level of production.
 To know and analyse the movement of costs both in short run and long run

13.2 INTRODUCTION

The cost-output relationship plays an important role in determining the optimum level of
production. Knowledge of the cost-output relation helps the manager in costcontrol, profit
prediction, pricing, promotion etc. The relation between cost and output is technically
described as the cost function.
TC = (Q)
Where
TC = Total cost
Q = Quantity produced

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F = function

The production function combined with the prices of inputs determines the cost function of
the firm. Considering the period the cost function can be classified as
(a) short-run cost function and
(b) long run-cost function.

In economic theory, the short-run is defined as that period during which the physical capacity
of the firm is fixed, and during which output can be increased only by using the existing
capacity more intensively. The long-run is a period during which it is possible to increase the
firm's capacity or to reduce it in size, if trade is very bad.

13.3 SHORT RUN COST – OUTPUT RELATIONS

The cost concepts made use of in the cost behavior are total cost, average cost and marginal
cost. Total cost if the actual money spent to produce a particular quantity of output. It is the
summation of fixed and variable costs.

TC = TFC + TVC

Upto a certain level of production total fixed cost, i.e. the cost of plant, building, equipment
etc. remains fixed. But the total variable costs i.e., the cost of labour, raw materials etc. vary
with the variation in output

AC =

Or it is the total of average fixed cost (TFC / Q) and average variable cost
(TVC/Q)

Marginal cost is the addition to the total cost due to the production of an additional unit of
product. Or it is the cost of the marginal unit produced. It can be arrived at by dividing the
change in total cost by the change in total output.

MC =

In the short-run there will not be any change in total fixed cost. Hence change in total cost
implies change in total variable cost only.

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Table 1 represents the cost-output relation. The table is prepared on the basis of the Law of
Diminishing Marginal Returns. The fixed cost Rs.60 may include rent of factory building,
interest on capital, salaries of permanently employed staff, insurance etc. These fixed costs
are independent of output, whose amount cannot be altered in the shortrun. But the average
fixed cost, i.e. the fixed cost per unit, falls continuously as the out put increase. The greater
the out put, lower the fixed cost per unit. The total variable cost (TVC) increases but not at
the same rate. If more and more units are produced with a given physical capacity AVC will
fall initially. AVC declines upto 3rd unit, it is constant upto 4th unit and then rises. This is
because the efficiency first increases and then decreases. The variable factors seem to
produce somewhat more efficiently near a firm's optimum capacity output level than at very
low levels of output. But once the optimum capacity is reached, any further increase in output
will increase AVC.

The average total cost (AC) declines first and then rises. The rise in AC is felt only after the
AVC starts rising. In the table AVC starts rising from the 5th unit onwards whereas the AC
starts rising from the 6th unit only. AFC continues to fall with increase in output. But AVC
initially declines and then rises. Thus there will be a stage where the AVC may have started
rising, yet AC is still declining because the rise in AVC is less than the drop in AFC, the net

146
effect being a decline in AC. Thus the table A shows an increasing returns or diminishing
cost in the first instance and eventually diminishing returns or increasing cost.

The short-run cost-output relationship can be shown graphically also. Fig.1 shows the
relationship between output and total fixed cost, total variable cost and total cost. TFC curve
is a horizontal straight line representing Rs.60, whatever be the output TVC curve slopes
upward starting from zero, first gradually but later at a fast rate. TC = TFC+TVC. As TFC
remains constant, increase in TC means increase in TVC only. As TFC remains constant the
gap between TVC and TC will always be the same. Hence TC curve has the same pattern of
behaviour as TVC curve.

Fig.2 shows the law of production more clearly. AFC curve continues to fall as output rises
from lower levels to higher levels. This is because the total fixed cost is spread over more and
more units as output increases. TVC increases with the increase in production since more raw
materials, labour, power etc. would be required for increasing output. But AVC curve (i.e.
variable cost per unit) first falls and then rises. This is due to the operation of the law of
variable proportions.

The behaviour of AC curve depends upon the behaviour of AVC curve and AFC curve. In the
initial stage of production both AFC and AVC are declining. Hence AC also declines. AFC
continues to fall with an increase in output while AVC first declines and then rises. So long
as AFC and AVC decline AC will also decline. But after a certain point AVC starts rising. If
the rise in AVC is less than the decline in AFC, AC will still continue to decline. When the
rise in AVC is more than the drop in AFC, AC begins to rise. In the table we can see that
when the production is increased to 5 units AVC increases but AC still declines. Here the
increase in AVC is less than the decline in AFC, the net effect being a decline in AC. AC
curve, thus declines first and then rises. At first AC is high due to large fixed cost. As output
increases the total fixed cost is shared by more and more units and hence AC falls. After a
certain point, owing to the operation of the law of diminishing marginal returns, the variable
cost and, therefore, AC starts increasing. The lower end of AC curve thus turns up. and gives
it a U-shape. That is why AC curves are U-shaped. The least-cost combination of inputs is
indicated by the lowest point in Ac curve i.e. where where the total average cost is the
minimum. It is the short-run stage of optimum output. It may not be the maximum output
level. It is the point where the per unit cost of production will be at its lowest.

A downward trend in MC curve shows increasing marginal productivity (i.e. decreasing

marginal cost) of the variable input. Similarly, an upward trend in MC curve shows the rate
of increase in TVC, on the one hand and the decreasing marginal productivity (i.e. increasing
marginal cost) of the variable input on the other. MC curve intersects both AVC and AC
curves at their lowest points.

The relationship between AVC, ATC and AFC can be summed up as follows:
1. If both AFC and AVC fall, AC will also fall because AC=AFC+AVC
2. When AFC falls and AVC rises

147
 (a) AC will fall where the drop in AFC is more than the rise in AVC
(b) AC remains constant if the drop in AFC=rise in AVC
(c) AC will rise where the drop in AFC is less than the rise in AVC.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about the short run cost-output relations.

…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………..

13.4 LONG RUN COST – OUTPUT RELATIONS

Long-run is a period long enough to make all inputs variable. In the long-run a firm can
increase or decrease its output according to its demand, by having more or less of all the
factors of production. The firms are able to expand the scale of their operation in the long-run
by purchasing larger quantities of all the inputs. Thus in the long-run all factors become
variable. The long-run cost-output relations therefore imply the relationship between total
costs and total output. As the change in production in the longrunis possible by changing the
scale of production, the long-run cost-output relationships influenced by the law of returns to
scale. In the long-run a firm has a number of alternatives in regard to the scale of operations.
For each scale of production or plant size, the firm has a separate short-run average cost
curve. Hence the long-run average cost curve is composed of a series of short-run average
cost curves.

A short-run average cost (SAC) curve applies to only one plant whereas the longrun average
cost (LAC) curve takes into consideration many plants. At any one time the firm has only one
size of plant. That plant remains fixed during that period. Any increase in production in that
period is possible only with that plant capacity. That plant has a corresponding average cost
(SAC) curve. But in a long period the firm can move from one plant size to another. Each
plant has its corresponding SAC curve.

148
 The long-run cost-output relationship is shown graphically by the LAC curve. To
draw an LAC curve we have to start with a number of SAC curves. In the fig. 5.3 we have
assumed that there are only three sizes of plants-small, medium and large, S ACj refers to the
average cost curve for the small plant, S AC, for the medium size plant and SAC3 for the
large size plant. If the firm wants to produce OP units or less, it will choose the small plant.
For an output beyond OQ the firm will opt for medium size plant. Even if an increased
production is possible with small plant production beyond OQ will increase cost of
production per unit. For an output OR the firm will choose the large plant. Thus in the long-
run the firm has a series of SAC curves. The LAC curve drawn will be tangential to the three
SAC curves i.e. the LAC curve touches each SAC curve at one point. The LAC curve is also
known as Envelope Curve as it envelopes all the SAC curves. No point on any of the LAC
curve can ever be below the LAC curve. It is also known as Planning Curve as it serves as a
guide to the entrepreneur.

In his planning the size of plant for future expansion. The plant which yields the
lowest average cost of production will be selected. LAC can, therefore, be defined as the
lowest possible average cost of producing any output, when the management has adequate I
time to make all desirable changes and adjustments. In the long-run the demand curve of the
firm depends on the law of returns to scale. The law of returns to scale states that if a firm
increases the quantity of all inputs simultaneously and proportionately, the total output
initially increases more than proportionately but eventually increases less than
proportionately. It implies that when production increases, per unit cost first’ decreases but
ultimately increases. This means LAC curve falls initially and rises subsequently. Like SAC
curve LAC curve also is Unshaped, but it will be always flatter then SAC curves. The U-
shape implies lower and lower average cost in the beginning until the optimum scale of the
firm is reached and successively higher average cost thereafter. The increasing return is
experienced on account of the economies of scale or advantages of large-scale production
Increase in scale makes possible increased division and specialization of labour and more
efficient use of machines. After a certain point increase in production makes management
more difficult and less efficient resulting in less than proportionate increase in output.

Long-run Marginal Cost Curve

149
The long-run marginal cost curve represents the cost of an additional unit of output when all
the inputs vary. The long-run marginal cost curve (LMC) is derived from the short-run
marginal cost (SMC) curves. LMC curve intersects LAC curve at its minimum point C. There
is only one plant size whose minimum SAC coincides with the minimum

LAC and LMC.

SAC2 = SMC2 = LAC = LMC

The point C indicates also the optimum scale of production of the firm in the long-run or
optimum output. Optimum output level is the level of production at which the cost of
production per unit, i.e. AC, is the lowest. The optimum level is not the maximum profit
level. The optimum point is where AC=MC. Here C is the optimum point.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the long run cost-output relations.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……..
13.5 LET US SUM UP

It is clear from this lesson that the Cost-Output relationship concept would help the manager
in cost control, pricing, profit prediction, promotion etc. We also discussed about the
movement of cost in short run and long run.

13.6 KEYWORDS

Shot run cost Long run cost

Output relations Optimum level
Profit prediction Pricing
Promotion Short-run cost function
Long run-cost function Marginal cost
Diminishing marginal returns Permanently employed staff
Insurance Optimum capacity
Marginal productivity

150
13.7 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

13.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1
1. See section 13.3
Check Your Progress – 2
1. See Section 13.4

151
BLOCK
5

UNIT 14
BASICS OF MARKET STRUCTURE

UNIT 15
PERFECT COMPETITION

UNIT 16
MONOPOLY AND MONOPOLISTIC COMPETITION

UNIT 17
DUOPOLY AND OLIGOPOLY

UNIT 18
PRICING POLICY

152
UNIT-14
BASICS OF MARKET STRUCTURE

STRUCTURE

14.1 Objectives

14.2 Introduction

14.3 Classification of Market

14.4 Let us sum up

14.5 Key Words

14.6 Some Useful Books

14.7 Answer to Check Your Progress Exercise

14.1 OBJECTIVES

After having studied this lesson you should be able

 To define the term Market
 To identify the basic components of a market
 To classify the different types of market

14.2 INTRODUCTION

In ordinary language, the term market refers to a public place in which goods and services are
bought and sold. In economics, it has a different meaning. Different economists have tried to
define market in different ways. Cornet defines market as, "not any particular market place in
which things are bought and sold, but the whole of any region in which buyers and sellers are
in such free intercourse with each other that the prices of the same goods tend to equality
easily and quickly". To Ely, "Market means the general field within which the force
determining the price of particular product operate". According to Benham," Market is any
area over which buyers and sellers are in close touch with one another, either directly or

153
through dealers, that the price obtainable in one part of the market affects the prices paid in
other parts". Stonier and Hague explain the term market as "any organisation whereby buyers
and sellers of a good are kept in close touch with each other". There is no need for a market
to be in a single building. The only essential for a market is that all buyers and sellers should
be in constant touch with each other, either because they are in the same building or because
they are able to talk to each other by telephone at a moment's notice.

1. There should be buyers of the product. If a country consists of people who are very
poor, there can hardly be market for luxuries like cars, VCR etc.
2. A commodity should be offered for sale in the market. Otherwise there is no question
of buying the commodity. Therefore, existence of sellers is a necessity for any
market.
3. Buyers and sellers should have close contact with each other.
4. There should be a price for the commodity. The exchange of commodities between
buyers and sellers occurs at a particular price which is mutually agreeable to both the
buyers and sellers.

14.3 CLASSIFICATION OF MARKET

Market may be classified into different types:

On the basis of area

Markets may be classified on the basis of area into local, national and international markets.
If the buyers and sellers are located in a particular locality, it is called as a local market, e.g.
fruits, vegetables etc. These goods are perishable; they cannot be stored for a long time; they
cannot be taken to distant places. When a commodity is demanded and supplied all over the
country, national market is said to exist.

When a commodity commands international market or buyers and sellers all over the world,
it is called international market. Whether a market will be local, national or international in
character will depend upon the following factors:

a. nature of commodity;
b. taste and preference of the people;
c. availability of storage;
d. method of business;
e. political stability at home and abroad;
f. portability of the commodity.

On the basis of time

Time element has been used by Marshall for classifying the market. On the basis of time,
market has been classified into very short period, short period, long period and very long
period. Very short period market refers to the market in which commodities that are fixed in
supply or are perishable are transacted. Since supply is fixed, only the changes in demand
influence the price. The short period markets are those where supply can be increased but
only to a limited extent. Long period market refers to a market where adequate time is
available for changing the supply by changing the fixed factors of production. The supply of
commodities may be increased by installing a new plant or machinery and the output can be
changed accordingly. Very long period or secular period is one in which changes take place
in factors like population, supply of capital and raw material etc.

154
On the basis of nature of transactions
Markets are classified on the basis of nature of transactions into two broad categories viz.,
Spot market and future market. When goods are physically transacted on the spot, the market
is called as spot market. In case the transactions involve the agreements of future exchange of
goods, such markets are known as future markets.

On the basis of volume of business

Based on the volume of business, markets are broadly classified into wholesale and retail
markets. In the wholesale markets, goods are transacted in large quantities. Wholesale
markets are in fact, a link between the producer and the retailer while the retailer is a link
between the wholesaler and the consumer.

On the basis of status of sellers

During the process of marketing, a commodity passes through a chain of sellers and
middlemen. Markets can be classified into primary, secondary and terminal markets.

On the basis of time

Time element has been used by Marshall for classifying the market. On the basis of time,
market has been classified into very short period, short period, long period and very long
period. Very short period market refers to the market in which commodities that are fixed in
supply or are perishable are transacted. Since supply is fixed, only the changes in demand
influence the price. The short period markets are those where supply can be increased but
only to a limited extent. Long period market refers to a market where adequate time is
available for changing the supply by changing the fixed factors of production. The supply of
commodities may be increased by installing a new plant or machinery and the output can be
changed accordingly. Very long period or secular period is one in which changes take place
in factors like population, supply of capital and raw material etc.

On the basis of nature of transactions

Markets are classified on the basis of nature of transactions into two broad categories viz.,
Spot market and future market. When goods are physically transacted on the spot, the market
is called as spot market. In case the transactions involve the agreements of future exchange of
goods, such markets are known as future markets.

On the basis of volume of business

Based on the volume of business, markets are broadly classified into wholesale and retail
markets. In the wholesale markets, goods are transacted in large quantities. Wholesale
markets are in fact, a link between the producer and the retailer while the retailer is a link
between the wholesaler and the consumer.

On the basis of status of sellers

During the process of marketing, a commodity passes through a chain of sellers and
middlemen. Markets can be classified into primary, secondary and terminal markets.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

155
 1. Discuss about the classification of market.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
……………..

14.4 LET US SUM UP

In this lesson we have learned various definitions of the term market. We also listed
the basic components of the market and we classified different types of market.

14.5 KEY WORDS

Term market Buyers

Commodity Method of business
Political stability Wholesale
Spot market The retailer
Chain of sellers Terminal markets

14.6 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson
14.7 ANSWER TO CHECK YOUR PROGRESS EXERCISE
Check Your Progress – 1
1. See section 14.3

156
UNIT– 15
PERFECT COMPETITION

STRUCTURE

15.1 Objectives

15.2 Introduction

15.3 Perfect Competition

15.4 Short-run Equilibrium of the firm

15.5 Short-run Equilibrium of the industry

15.6 Long-run Equilibrium of the firm

15.7 Long-run Equilibrium of the industry

15.8 Price determination under Perfect competition

15.9 Let us sum up

15.10 Key Words

15.11 Some Useful Books

15.12 Answer to Check Your Progress Exercise

15.1 OBJECTIVES

After having studied this lesson you should be able

To understand the Perfect Competition market structure
To analyze the Price and Output decision under perfect competition

15.2 INTRODUCTION

The term market structure refers to the degree of competition prevailing in that particular
market. For price analysis it is vital for business management to gain knowledge of the nature
and process of competition in the prevailing business society. Hence a thorough study on the
different types of market structure is essential for the determination of price. In this lesson we
will confine our discussion to perfect competition

157
15.3 PERFECT COMPETITION

Perfect competition in economic theory has a meaning diametrically opposite to the everyday
use of the term. In practice, businessmen use the word competition as synonymous to rivalry.
In theory, perfect competition implies no rivalry among firms. Perfect competition, therefore,
can be defined as a market structure characterized by a complete absence of rivalry among
the individual firms.

FEATURES

1. Large number of buyers and sellers

There must be a large number of firms in the industry. Each individual firm supplies only a
small part of the total quantity offered in the market. As a result, no individual firm can
influence the price. Similarly, the buyers are also numerous. Hence, no individual buyer has
any influence on the market price. The price of the product is determined by the collective
forces of industry demand and industry supply. The firm is only a 'price taker'. Each firm has
to adjust its output or sale according to the prevailing market price.

2. Homogeneity of products

In a perfectly competitive industry, the product of any one firm is identical to the products of
all other firms. The technical characteristics of the product as well as the services associated
with its sale and delivery are identical.

The demand curve of the individual firm is also its average revenue and its marginal revenue
curve. The assumptions of large numbers of sellers and product homogeneity imply that the
individual firm in pure competition is a price taker. Its demand curve is infinitely elastic
indicating that the firm can sell any amount of output at the prevailing market price.

3. Free entry exit

There is no barrier to entry or exit from the industry. Entry or exit may take time but firms
have freedom of movement in and out of the industry. If the industry earns abnormal profits,
new firms will enter the industry and compete away the excess profits. Similarly, if the firms
in the industry are incurring losses some of them will leave the industry which will reduce the
supply of the industry and will thus raise the price and wipe away the losses.

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4. Absence of government regulation
There is no government intervention in the form of tariffs, subsidies, relationship of
production or demand. If these assumptions are fulfilled, it is called pure competition which
requires the fulfillment of some more condition.

5. Perfect mobility of factors of production

The factors of production are free to move from one firm to another throughout the economy.
It is also assumed that workers can move between different jobs. Raw materials and other
factors are not monopolized and labour is not unionised. In short, there is perfect competition
in the factor market.

6. Perfect knowledge

It is assumed that all sellers and buyers have complete knowledge of the conditions of the
market. This knowledge refers not only to the prevailing conditions in the current period but
in all future periods as well. Information is free and costless. Under these conditions
uncertainty about future developments in the market is ruled out.

7. Absence of transport costs

In a perfectly competitive market, it is assumed that there are no transport costs.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the perfect competition.
………………………………………………………………………………………………
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……..

15.4 SHORT-RUN EQILIBRIUM OF THE FIRM

The firm is in equilibrium at the point of intersection of the marginal cost and marginal
revenue curves. The first condition for the equilibrium of the firm is that marginal cost should
be equal to marginal revenue. The second condition for equilibrium requires that marginal
cost curve should cut the marginal revenue curve from below.

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The firm is in equilibrium only at 'e' because only at 'e' both the conditions are satisfied. At 'e
' the firm is not in equilibrium as the second condition is not fulfilled. The fact that the firm is
in equilibrium in the short run does not mean that it makes excess profits. Whether the firm
makes excess profits or losses depends on the level of average total cost at the short run
equilibrium. In figure 3. (A), the SATC is below the price at equilibrium; the firm earns
excess profits. In figure 3. (B), the SATC is above the price; the firm makes a loss. In the
short run a firm generally keeps on producing even when it is incurring losses. This is so
because by producing and earning some revenue, the firm is able to cover a part of its fixed
costs. So long as the firm covers up its variable cost plus at least a part of annual fixed cost, it
is advisable for the firm to continue production. It is only when it is unable to cover any
portion of its fixed cost, it should stop producing. Such a situation is known as shut down
point. The shut down point of the firm is denoted by W. If price falls below P the firm does
not cover its variable costs and is better off if it closes down.

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15.5 SHORT- RUNS EQILIBRIUM OF THE INDUSTRY

Given the market demand and market supply, the industry is in equilibrium at the price at
which the quantity demanded is equal to the quantity supplied.

The industry is in equilibrium at price P at which the quantity demanded and supplied is OQ.
However this will be a short-run equilibrium as some firms are earning abnormal profits and
some incur losses as shown in figures 5. (B) and 5. (C) respectively. In the long run, firms
that make losses will close down. Those firms which make excess profits will expand and
also attract new firms into the industry. Entry, exit and readjustment will lead to long run
equilibrium in which firms will be earning normal profits and there will be no entry or exit
from the industry.

15.6 LONG-RUN EQILIBRIUM OF THE FIRM

In the long run firms are in equilibrium when they have adjusted their plant so as to produce
at the minimum point of their long run AC curve, which is tangent to the demand curve. In
the long run the firms will be earning just normal profits, which are included in the LAC. The
long run equilibrium position of the firm is shown in figure 6.

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At the price of OP, the firm is making excess profits. Therefore, it will have an incentive to
build new capacity and hence it will move along its LAC. At the same time, attracted by
excess profits new firms will be entering the industry. As the quantity supplied increases, the
price will fall to Pi at which the firm and the industry are in longrun equilibrium. The
condition for the long-run equilibrium of the firm is that the marginal cost tie equal to the
price and to the long run-average cost.

LMC = LAC = P

The firm adjusts its plant size so as to produce that level of output I which the LAC is the
minimum. At equilibrium the short run marginal is equal to the long run marginal cost and
the short run average cost is equal to the long run average cost. Thus, in equilibrium in the
long

SMC = LMC = LAC = SAC = P = MR

This implies that at the minimum point of the LAC the plant worked at its optimal capacity,
so that the minimal of the LAC and SAC coincide.

15.7 LONG- RUN EQILIBRIUM OF THE INDUSTRY

The industry is in long run equilibrium when price is reach which all firms are in equilibrium
producing at the minimum point oft LAC curve and making just normal profits. Under these
conditions there is no further entry or exit of firms in the industry. The long run equilibrium
is shown in the figure. 7.

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At the market price P the firms produce at their minimum cost, earning just normal profits.
The firm is in equilibrium because at the level of output x

LMC = SMC = P = MR

This equality ensures that the firm maximises its profit. At the price P the industry is in
equilibrium because profits are normal and all costs are covered so that there is no incentive
for entry or exit.

15.8 PRICE DETERMINATIONUNDER PERFECT COMPETITION- ROLE OF

TIME

Price of a commodity in an industry is determined at that point where industry demand is

equal to industry supply. Marshall laid emphasis on the role of time element in the
determination of price. He distinguished three periods in which equilibrium between demand
and supply was brought about viz., very short period or market period; short run
equilibrium and long run equilibrium.

Market period

Price is determined by the equilibrium between demand and supply in market period. In the
market period, the supply of commodity is fixed. The firms can sell only what they have
already produced. This market period may be an hour, a day or few days or even few weeks
depending upon the nature of the product. So far as the supply curve in a market period is
concerned, two cases are prominent-one is that of perishable goods and the other is that of
non perishable durable goods.

For perishable goods like fish, vegetables etc. the supply is given and cannot be kept for the
next period; therefore, the whole of it must be sold away on the same day whatever be the
price. The supply curve will be a vertical straight line.

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QS is the supply curve. OQ is the quantity of fish available. DD is the market demand curve.
The equilibrium price OP is determined at which quantity demanded is equal to the available
supply i.e. at the point where DD intersects the vertical supply curve QS. If demand increases
from DD to D1D1 supply remaining the same price will increase from OP to OP1. On the
contrary, if there is a decrease in demand from DD to D2D2 the price will fall and the
quantity sold will remain the same.

If the commodity is a durable good, its supply can be adjusted to demand. If the demand for
commodity declines the firms will start building inventories, while on the other hand, if
demand goes up the firms will increase their supplies out of the existing stocks. The firm can
keep on supplying out of its existing stocks only upto the availability of stocks. If demand
increases beyond that level, the firm cannot supply any additional quantity of the good. Thus
the supply curve for the durable goods is upward sloping upto a distance and then becomes
vertical. A firm selling a durable good has a reserve price below which it will not like to sell.
The reserve price, is influenced by the cost of production.

SRFS is the supply curve of the durable goods. OM1 is the total amount of stock available.
Upto OP1 the quantity supplied varies will I price. At OS price, nothing is sold. It is the
reserve price. At OP1 price, the whole stock is offered for sale. DD is the demand curve. Price
ul determined at OP at which quantity demanded is equal to the quantity supplied. At this
price OM quantity is sold. If demand increases form DD to D1 D1 the price will increase to
OP1 and the whole stock will be sold. If the demand decreases from DD to D2D2 the price
will fall to OP2 and the amount sold will fall to OM2.

Short run equilibrium

In the short period the firm can vary its supply by changing the variable factors. Moreover,
the number of firms in the industry cannot increase or decrease in the short run. Thus the
supply of the industry can be changed only within the limits set by the plant capacity of the
existing firms. The short period price is determined by the interaction of short period supply
and demand curves. The determination of the short run price is shown in figure 10.

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DD is the demand curve facing the industry. MPS is the market period supply, curve and SRS
is the short run supply curve of the industry. If there is an increase in demand form DD to
D1D1 the market price will increase from OP to OP1. The supply of the commodity will be
increased by intensive utilisation of fixed factors and increasing the amount of variable
factors. So in the short run price will fall to OP3 at which new demand curve D1D1 intersects
the short run supply curve SRS. Thus OP3 is the short run price and quantity supplied has
increased from OM to OM1.

Long-run equilibrium

In the long run, supply is adjusted to meet the new demand conditions. If there is an
increase in demand, the firms in the long run will expand output by increasing the fixed
factors of production. They may enlarge their old plants or build new plants. Moreover, in the
long run new firms can also enter the industry and thus add to the supplies of the product.
The determination of price in the long run is shown in figure 11.

LRS is the long run supply curve; MPS is the market period supply curve and SRS is the
short run supply curve. DD is the market demand curve and OP is the market price. If there is
an increase in demand from DD to D1D1 the market price will increase from OP to OP1. In
the short run, however, the firms will increase output. Price in the short run will fall to OP2 at
which D1D1 intersects the short run supply curve SRS. In the long run new firms will enter
the industry. As a result output will increase and price will fall to OP3. Thus OP3 is the long
run price.

15.9 LET US SUM UP

In this lesson we discussed the features of perfect competition. An extensive study is made on
the price determination during short-run and long-run of the firm and industry in the perfect
competition scenario.

15.10 KEY WORDS

Short-run equilibrium Long-run equilibrium

Price determination Perfect competition
Buyers and sellers Homogeneity
Government regulation Perfect mobility
Perfect knowledge Absence of transport costs

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15.11 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

15.12 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 15.3
Check Your Progress – 2
1. See Section 15.8

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UNIT -16
MONOPOLY AND MONOPOLISTIC COMPETITION

STRUTURE
16.1 Objectives
16.2 Introduction
16.3 Monopoly Competition
16.4 Price-Output determination under monopoly
16.5 Price discrimination
16.6 Price-Output determination under discriminating monopoly
16.7 Equilibrium under price discrimination in the case of dumping
16.8 Monopoly Equilibrium Vs Competitive Equilibrium
16.9 Concentration of Economic Power
16.10 Monopolistic Competition
16.11 Price-Output determination under monopolistic competition
16.12 Product Differentiation
16.13 Let us sum up
16.14 Key words
16.15 Some Useful Books
16.16 Answer to Check Your Progress Exercise

16.1 OBJECTIVES

After having studied this lesson you should be able

 To understand the features of Monopoly and Monopolistic competition

 To analyse the price-output determination under Monopoly and Monopolistic
competition
 To know about Concentration of Economic Power
 To explain the concept of Product differentiation

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16.2 INTRODUCTION

The behaviour of a firm under two different market structures, namely monopoly and
monopolistic competition is analysed in detail. While analysing the market structure it is
essential to assume that the firms are guided by profit maximization.

16.3 MONOPOLY COMPETITION

Monopoly is that market form in which a single producer controls the entire supply of a
single commodity which has no close substitutes. There must be only one seller or producer.
The commodity produced by the producer must have no close substitutes. Monopoly can
exist only when there are strong barriers to entry. The barriers which prevent the entry may
be economic, institutional or artificial in nature.

Features

1. There is a single producer or seller of the product.

2. There are no close substitutes for the product. If there is a substitute, then the
monopoly power is lost.
3. No freedom to enter as there exists strong barriers to entry.
4. The monopolist may use his monopolistic power in any manner to get maximum
revenue. He may also adopt price discrimination.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss the term Monopoly Competition
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16.4 PRICE-OUTPUT DETERMINATION UNDER MONOPOLY

The aim of the monopolist is to maximise profits. Therefore, he will produce that level of
output and charge a price which gives him the maximum profits. He will be in equilibrium at
that price and output at which his profits are maximum. In order words, he will be in
equilibrium position at that level of output at which marginal revenue equals marginal cost.
The monopolist, to be in equilibrium should satisfy two conditions

1. Marginal cost should be equal to marginal revenue and

2. The marginal cost curve should cut marginal revenue curve from below.

The short run equilibrium of the monopolist is shown in figure 12.

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AR is the average revenue curve, MR is the marginal revenue curve, AC is the average cost
curve and MC is the marginal cost curve. Upto OQ level of output marginal revenue is
greater than marginal cost but beyond OQ the marginal revenue is less than marginal cost.
Therefore, the monopolist will be in equilibrium where MC = MR. Thus a monopolist is in
equilibrium at OQ level of output and at OP price. He earns abnormal profit equal to PRST.
But it is not always possible for a monopolist to earn super- normal profits. If the demand and
cost situations are not favourable, the monopolist may realise short run losses.

Though the monopolist is a price maker, due to weak demand and high costs, he suffers a loss
equal to PABC.

Long run equilibrium

In the long run the firm has the time to adjust his plant size or to use the existing plant so as
to maximise profits. The long run equilibrium of the monopolist is shown in
figure 14.

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The monopolist is in equilibrium at OL output where LMC cuts MR curve. He will charge
OP price and earn an abnormal profit equal to TPQH. In order to show the difference
between the short run equilibrium and long run equilibrium under monopoly, both can be
shown in a single figure.

The monopolist is in the s h o r t r u n equilibrium at E producing OS level of output. In the

long run he can change the plant and will be in equilibrium at F where MR curve cuts LMC
curve. The monopolist has increased his output from OS to OL and price has fallen from OP
to OJ. Profits have also increased in the long run from TPQR to GHKJ.

16.5 PRICE DISCRIMINATION OR DISCRIMINATING MONOPOLY

Price discrimination refers to the practice of selling the same product at different prices to
different buyers. Mrs. Robinson defines it as "charging different price for the same product or
same price for differentiated product". Prof. Stigler defines price discrimination as "the scale
of technically similar products at prices which are not proportional to Marginal costs".

Price discrimination may be divided into three types-personal, local and according to use.
Price discrimination is personal when a seller charges different prices for different persons.
For example, hair cut for children and adult. Price discrimination is local when the seller
charges different prices for people of different localities. For instance, a seller may charge
one price at domestic market and another price in international market. Discrimination is
according to use when the same commodity is put to different uses. For example, electricity
is usually sold at a cheaper rate for industrial uses than for domestic purposes.

Degrees of price discrimination

Prof. A.C. Pigou has distinguished between three degrees of price discrimination.

1. Price discrimination of the first degree.

2. Price discrimination -of the second degree.
3. Price discrimination of the third degree.

Price discrimination of the first degree

It is also known as perfect price discrimination. Price discrimination of the first degree is said
to occur when the monopolist is able to sell each separate unit of the output at a different
price. In other words, it involves maximum possible exploitation of each buyer. Price
discrimination of the first degree is depicted in figure. 16.

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At price Rs. 10 the buyer will purchase one unit cf the good; at price Rs. 9 the buyer would
purchase 2 units of the good; at price of Rs. 8 he would purchase 3 units of the good; at price
of Rs. 7 he would take 4 units of the good and so on. Under simple monopoly, if the seller
fixes the price at Rs. 7 the buyer buys 4 units then he would pay Rs. 28 as the price for 4
units. By doing so, he gets a consumer surplus of Rs. 6. This is so because; the buyer is
willing to pay Rs. 10 for the first unit, Rs. 9 for the second, Rs.8 for the third and Rs. 7 for the
fourth. In all he is willing to pay Rs. 34. He actually pays only Rs. 28. But under price
discrimination of the first degree the monopolist charges Rs. 34. As a result the buyer has no
consumer’s surplus.

Price discrimination of the second degree

In price discrimination of the second degree buyers are divided into different groups and from
each group a different price is charged which is the lowest demand price of that group. This is
shown in figure. 17.

Market is divided into four groups. DD is the market demand curve. In the first group X units
of output will be sold at a price of OP1. All the buyers in this group pay OP1 price and the
group gets DK1 P1 as consumer’s surplus. Similarly for other groups, consumers pay OP2,
OP3, OP4 and get the consumer's surplus equal to DK2 P2, DK3 P3 and DK4 P4
respectively.

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Price discrimination of the third degree

It occurs when the seller divides his buyers into two or more than two submarkets or groups
and charges a different price in each sub-market. The price charged in the sub-market need
not be the lowest demand price of that sub-market..

Possibility of price discrimination

Price discrimination is possible in the following cases:

The nature of the commodity should be such as to enable the monopolist to charge different
prices. This is possible only when there is no possibility of transference of the commodity
from one market to the other. For example, doctors charge different fees for the rich and for
the poor for same service.

1. When the markets are separated by long distance or tariff, then price discrimination is
possible. If the transportation cost is higher than the price difference between the two
markets, one monopolist can charge different prices. For example, a commodity may be
sold at Rs. 10 in Delhi and Rs. 20 in Madras. If the transportation cost between Delhi and
Madras is greater than Rs. 10 it is not profitable for the consumers to transport the
commodity from Delhi to Madras on their own. Similarly when domestic market is
protected by tariff, the monopolist can sell the product at a lower price in the foreign
market and at a higher price in the domestic market.

2. In certain cases, the firms have a legal sanction for price discrimination. For example,
electricity board charges a lower price for industrial purposes and a higher price for
domestic purposes. Similarly, transportation companies charge different fares for
different classes of passengers.

3. Price discrimination is possible due to preferences or prejudices of the consumers.

Different prices are charged for different varieties although they differ only in label or
name. Upper class people may prefer to buy in fashionable quarters to buy in a congested,
ugly and cheaper locality.

4. Price discrimination may become possible due to ignorance and laziness of buyers. If a
seller is discriminating between two markets but the buyers are ignorant that the seller is
selling the product at a lower price in another market, price discrimination is possible.
Price discrimination is also possible if the buyers are aware that the seller is selling the
product at lower price in another market but due to laziness may not go for shopping, in
the cheaper market.

5. When a monopolist is able to meet different needs for his customers it is possible for him
to follow price discrimination. For example, railways charge different rates for carrying
coal, cotton, silk and fruit even though the service rendered is the same for
all.

6. A monopolist can easily charge discriminating prices when goods are being supplied to
special orders. In such a case, there is no question of comparing prices by the buyers. It is
obvious that price discrimination can be practised only under imperfect competition. It is
not at all possible when there is perfect competition. Under perfect competition, the seller
has to take the market price as given. Therefore, there is no scope for price

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 discrimination. The possibility of price discrimination under perfect competition exists
only if all sellers are combined together. But as soon as they combine, perfect competition
ceases to exist. Price discrimination can occur under conditions of imperfect or
monopolistic competition. Larger the market imperfection, greater is the possibility of
price discrimination. When there is monopoly, the market imperfection is maximum and
the possibility of price discrimination is also maximum. Since, in case of a monopoly
there are no other sellers selling the same product or its substitutes, the monopolist is in a
position to charge different prices from different parts of the market.

Conditions for profitable price discrimination

The monopolist may be able to charge discriminating prices but it need not necessarily be
profitable for him. It is only when the elasticity of demand in one market is different from
the elasticity of demand in the other market that the monopolist will find the policy of
price discrimination profitable. The monopolist will find it profitable to charge more in
the market where elasticity is low and low price where it is high. Mrs. Robinson says,
"The submarkets will be arranged in ascending order of their elasticities, the highest price
being charged in the least elastic market, and the lowest price in the most elastic market".

Same elasticity of demand in two markets

If the elasticity of demand is same in two markets, the marginal revenues in two markets
at every price of the product will also be the same and it will not be profitable for the
monopolist to discriminate between the two markets. This is illustrated in figure 18.

ARa and ARb are the iso-elastic demand curves of the markets A and B. At price OP
marginal revenue in the two markets is the same. If the monopolist transfers a given amount
from one market te another and thereby charge different prices, it would not be profitable for
the monopolist. Suppose, he reduces his sales in market A from OX to OQ1 and transfer it to
market B, where the sales go up from OQ2 to OX2. As a result of reduced sales in market A,
the monopolist loses Q1 X1 S1 L1 while he gains Q2 X2 L2 S2 in market B by increasing his
sales. Since the loss is greater than the gain, it is not profitable for the monopolist to
discriminate prices between the two markets having the same elasticity of demand.

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Elasticity of demand differs in two markets

If the monopolist wants to maximum profits, he must discriminate prices if the elasticities of
demand in the two markets at the given monopoly prices are different. This is shown in
Figure 19.

The monopolist reduces the output in market B and transfers it to market A. When he
increases his sales in market A from OX to OQi, he gains Xi Qj L\ S \ and when he reduces it
in market B his sales go down from OQ2 to OX2, he loses X2 Q2 L2 S2. Since the gain is
more than the loss it is profitable for the monopolist to follow price discrimination.

16.6 PRICE-OUTPUT DETERMINATION UNDER DISCRIMINATING

MONOPOLY

The graphical representation of price-output determination under conditions of discriminating

monopoly can be shown with the help of a figure. There are two markets A and B with
different price elasticities. The price elasticity in market B is lower than that in market A.

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The total marginal revenue arising from the two markets is arrived at by horizontal
summation of the marginal revenue curves for the two sub-markets. Da is the demand curve
and MRa is the marginal revenue curve in market A. Similarly, MRb is the marginal revenue
curve in market B corresponding to the demand curve D. AMR is the aggregate marginal
revenue curve, which has been derived by adding MRa and MR5 . MC is the marginal cost
curve of the monopolist. The discriminating monopolist will maximise his profits by
producing that level of output at which MC intersects AMR. Thus he will be producing OM
level of output. This total output will be distributed in such a way that marginal revenues in
two markets are equal and at the same time it should be equal to the marginal cost. Since
marginal cost is ME, the total output OM has to be distributed in such a way that the marginal
revenue in two markets should be equal to the marginal cost. Hence OM amount can be sold
in market A and OM2 in market B. Further, OM amount can be sold in market A at M1 P1
price and OM2 can be sold in market B at M2 P2 Price. Price is higher in market A where the
demand is less elastic than in market B where the demand is more elastic. Thus a profit
maximising monopolist charges different prices and supplies different quantities in the sub-
markets having different price elasticities.

16.7 EQUILIBRIUM UNDER PRICE DISCRIMINATION IN THE CASE OF

DUMPING

A special case of price discrimination is one in which a producer sells in two markets, one
under conditions of perfect competition and another under the conditions of monopoly. Such
a situation occurs when a producer sells his product in domestic market in which he is a
monopolist and also in the world market which is perfectly competitive. Equilibrium in such
a case is shown in figure 21. In the domestic market in which the producer has a monopoly
average revenue curve ARH slopes downwards. In the world market in which there is perfect
competition, the demand curve is perfectly elastic the average revenue curve ARW is
horizontal and MR curve coincides with it. MC is the marginal cost curve. Aggregate
marginal revenue curve is BFED which is the summation of MRH and MRW. MC intersects
the aggregate marginal revenue curve at E and the equilibrium level of output is OM. This
total output OM has to be distributed between domestic market and world market in such a
way that marginal revenue in each market is equal to each other and to the marginal cost.
Therefore, OR will be sold in the domestic market at the price of OP^ and RM will be sold in
the world market at price OPw. Total profit earned by the producer is CEFB. Price in the
world market is lower than the price in the home market. When a producer charges a lower
price in, the world market than in the home market, he is said to be dumping in the world
market.

16.8 MONOPOLY EQUILIBRIUM VS COMPETITIVE EQUILIBRIUM

The only similarity between the two is that a firm is in equilibrium at the level of output at
which marginal revenue is equal to marginal cost. But there are many differences:

1. Under perfect competition, the average revenue curve is horizontal straight line parallel to
the X axis. Therefore, MR is equal to AR at all levels of output and MR curve coincides
with AR curve. But under monopoly, AR is sloping downwards. Hence, MR is less than
AR at all levels of output and MR curve lies below the AR curve. In equilibrium the
marginal revenue will be smaller than the average revenue.

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2. Both under perfect competition and monopoly, the firm is in equilibrium where MC is
equal to MR. But in perfect competition, when MC is equal to MR, it is also equal to
price or AR. This is not so in case of monopoly. Under monopoly, MR is less than AR or
price; in equilibrium MC will be equal to MR but it will be less than price. Therefore, in
perfect competition, price is equal to MC and in monopoly price is higher than the
marginal cost.

3. Another significant difference between the two is that whereas a perfectly competitive
firm is in long-run equilibrium at the minimum point of the long-run average cost curve,
monopolistic firm is in equilibrium at the level of output where average cost is still
declining and has not yet reached its minimum point. Under perfect competition, it pays
the firm to expand production so long as the average cost is falling since AR and MR
remain constant. But it does not pay a monopolist firm to expand production to the
minimum of AC curve.

4. Another important difference between the two is that while under perfect competition
equilibrium is possible only when MC is rising at the point of equilibrium, but monopoly
equilibrium can be reached whether marginal cost is rising, remaining constant or falling
at the equilibrium output. This is so because the second order condition of equilibrium
namely MC curve should cut MR curve from below at the equilibrium point, can be
satisfied in monopoly in all the three cases, whereas in perfect competition the second
order condition is fulfilled only when MC curve is rising. Since in perfect competition the
MR curve is a horizontal straight line, MC curve can cut the MR curve from below only
when MC is rising. But under monopoly MR curve is sloping downward and therefore,
MC curve can cut the MR curve from below whether MC is rising, remaining constant or
falling. Th equilibrium of the monopolist in these three cases is shown in Figure 22. Fig.
illustrates the equilibrium of the monopolist when MC is rising at the equilibrium output.
Fig. B shows the monopoly equilibrium when MC is constant at and near the
equilibrium output. In Fig. C, monopolist is in equilibrium when MC is falling at and near
the point of equilibrium. In all these three cases, OP represents price, OM represents
output and RNQP represents profit.

5. Still another difference between the two is that while the perfectly competitive firm in the
long run, earns only normal profits, a monopolist can make supernormal profits even in
the long run. Under perfect competition, if firms in the short run are making supernormal
profits, the new firms will enter the industry to compete away the profits. But under

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monopoly, the firm continues to earn supernormal profits even in the long run since there
are strong barriers to the entry of new firms in monopoly. It does not mean that the
monopoly always guarantees supernormal profits. If the demand and cost conditions are
not favourable, the monopolist may suffer short run losses, as shown in the figure. 23.

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6. Another important difference between monopoly equilibrium and perfectly competitive
equilibrium is that under monopoly, price is higher and output smaller than under perfect
competition. Price-output level under perfect competition and monopoly is shown in
figure. 24.

DD and SS are demand and supply curves of the perfectly competitive industry.The two
curves intersect each other at P. Therefore, under perfect competition, price is MP and
output is OM. Under monopoly, SS will be the marginal cost curve, MR curve cuts MC
curve determining the monopoly price at M1 P1 and monopoly output at OM1. Thus
monopoly has resulted in a higher price and a lower output. Thus monopoly restricts
output to raise price.

Another significant difference between monopoly and perfect competition is that a

monopolist can charge discriminatory prices for his goods but a firm operating under
perfect competition cannot. Under perfect competition, the price is fixed by the market
and the producer cannot exercise any control over it. The question of charging different
prices from different set of customers does not arise. On the other hand, a monopolist
finds price discrimination both possible and profitable. For this purpose, he splits the
market for his goods into sub markets on the basis of elasticity of demand. Under perfect
competition the demand curve is perfectly elastic. But under monopoly the demand curve
is relatively inelastic. Therefore he can charge different prices in different parts of the
market.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

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 1. Discuss about Monopoly Equilibrium Vs Competitive Equilibrium.
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16.9 CONCENTRATION OF ECONOMIC POWER

Concentration of economic power manifests in the form of monopolistic and restrictive

practices. "Every practice whether it is by action or understanding or agreement, formal or
informal, to which persons enjoying monopoly power resort in exercise of the same to reap
the benefits of that power and every action, understanding and agreement tending to or
calculated to preserve, increase or consolidate such power should properly, be designated
monopolistic practice" (Monopolies Inquiry commission). The term restrictive practice
implies "Practices other than those pursued by monopolists which obstruct the free play of
competitive forces or impede the free flow of capital or resources into the stream of
production or of the finished goods in the stream of distribution at any point before they reach
the hands of the ultimate consumers". These two types of manifestation he come the tools for
economic concentration.

Types of concentration

There are two types of concentration viz., product-wise concentration and country-wise
concentration. When production and distribution of any particular commodity or service is in
a single concern or comparatively limited number of concerns or a fairly large number of
concerns controlled by a single family or a few families or business houses by reason of
ownership of capital or otherwise, it is product-wise concentration. When a large number of
concerns engaged in the production and distribution of different commodities are controlled
by one individual or group of persons or families, whether incorporated or not, by reasons of
financial or business interests, it is country-wise concentration. If the share of the three top
producers of a particular product is 75 percent or more, then concentration is high. Products
with high concentration are infant milk food, kerosene, stoves, dry batteries, tooth paste,
talcum powder etc. If the share of the three top producers is more than 60 percent but less
than 75 percent, concentration is regarded as medium. Medium concentration existed in the
production of biscuits, bicycles, cement, electric fans etc. Concentration is considered to be
low where the share is more than 50 percent but less than 60 percent e.g. Woollen fabrics,
pencils, knitting yarn etc. Where the share of the three top enterprises is less than 50 percent,
concentration is nil. e.g. Tea, coffee, coal, textiles, sanitary- wares etc. Country wise
concentration also known as inter-industry concentration refers to those concerns which are
subject to the ultimate and decisive decision-making power of the controlling interest in the
group. The groups do not confine to a single product but produce a number of diverse
commodities.

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Causes of concentration

An important cause for concentration of economic power is inter-company investment along

with interlocking of directorship. Managing agencies also fostered the process of
concentration of economic power by providing capital and managerial skill.

The major responsibility for the growth of concentration lies with the government. The
government promoted the growth of private industry through tax incentives and foreign
exchange allocations. The planned economy with a system of industrial licensing, control of
capital issues, regulation of imports, exchange control has led to further concentration.
Another important factor for growing concentration is the nature of the working of banks and
financial institutions. The bank deposits were used for financing large industries. Similarly 56
percent of the total financial assistance of public sector financial institutions had gone to the
large industrial houses.

Effects of concentration
Concentration of economic power has fostered economic growth. It promoted capital
formation. It also supplied managerial skill of high quality in abundance and as a result
production increased. Inspire of all these, concentration of economic power prevented the
entry of small and rival competitors, resulted in the deterioration of quality of products, and
paved the way for corrupt officials and politicians. It hindered the growth of managerial class.
It created imbalance in the distribution of national wealth and income. Concentration of
economic power has resulted in misdirection of investment. In those sectors where the rate of
return is low and slow, capital is scarce. In those areas where the return is high and quick,
investment flows in abundance.

Measurement of concentration
The technique of measuring the concentration of economic power is an underdeveloped art.
However, concentration may be measured by finding the aggregate share of the largest
producing corporations in the nation's facilities, markets, labour force or income. To Berle
and Means, "Concentration was an index of oligopoly in the economy and it showed the
extent to which a few executives had irresponsible control over a large proportion of nation's
productive plant-irresponsible in the sense of being beyond the control of market forces".
These executives enjoyed some non-market controls also. With such concentration, allocation
of resources is performed not by the price mechanism but by the policies of a relatively few
men who possess industrial power. Another way or measuring concentration of economic
power is by studying the proportion of net fixed assets held by the largest firms. We can also
measure economic power by a product-byproduct analysis of oligopoly in industry. The most
famous statistical device used for this purpose is the concentration ratio, which is the
percentage of total output of any commodity either in value or physical terms, made by its
four largest producers. The Federal Trade Commission (U.S.A) used new statistical concept
to study whether concentration is an inevitable consequence of modern technology or not.
The new concept measures the spread between company concentration (the proportion of
total output produced by the few biggest companies), and plant concentration (the proportion
produced by the few biggest plants). When the company shares too large a spread over plant,
the size of the bigger firms must be attributed to circumstances other than technological
economics of mass production. Yet another measure of concentration is Herfindahl index. For
example the total amount of loans sanctioned by a financial institution to different industrial
units has been taken into account to find out whether there is a tendency for the loans to flow
only to the larger units.

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Herfindahl index of 0.202 indicates that there is no concentration and there is an even
distribution of loans. Kindlcbcrger has given a measure of concentration of economic power
at the international level. If a group of nations were to form a cartel, as the Organisation of
Petroleum Exporting Countries did, they will extract maximum profits from its buyers. Their
ability to do is proportional to the elasticity of world demand for their exports. The elasticity
of demand depends on factors like elasticity of demand for cartel's product, elasticity of
competing supply and share of the world market. Symbolically it can be written as

Where 'dc' stands for elasticity of demand, ’d’ for world demand for the product, 'So' for
supply of the product and 'c' for share of the world market.

Control of concentration of economic power

Monopolies Inquiry Commission was appointed in April 1964 to examine the problem of
concentration and to suggest suitable measure to control the same. On the basis of the
recommendations of the Monopolies Inquiry commission, Monopolies and Restrictive Trade
Practices Act was passed in 1969. Under this Act, a permanent statutory commission known
as Monopolies and Restrictive Trade Practices Commission was set up to investigate and
control monopolies and restrictive trade practices. It has drawn a distinction between
monopolistic and restrictive trade practices. Monopolistic trade practices refer to the behavior
c" an individual firm or an oligopolistic group of not more than three firms which are able to
control the market by regulating prices or output or eliminating competition. Restrictive trade
practices refer to the action undertaken by a group of two or more firms to avoid competition
regardless of whether the market share of the member firms is or is not dominant. The
commission will perform two main functions investigation and control of monopolies and
restrictive trade practices. The Act also provides for the appointment of two officials, the
Director of Investigation and the Registrar of Restrictive Trade Practices to assist the

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commission in its work. On August 2, 1970, the government set up a three-man monopolies
commission to prevent concentration of economic power, for controlling monopolies and for
prohibiting monopolistic and restrictive trade practices by controlling the activities of
dominant undertakings. A dominant undertaking is one which either by itself or with
interconnected undertaking, controls not less than one-third of items of production, supply or
distribution of a commodity. The Act also defines a monopolistic undertaking as any
dominant undertaking which by itself or together with not more than two other independent
undertakings, supplies or distributes or otherwise controls not less than one-half of total
goods or services.

The first amendment to MRTP Act was introduced in November 1981 and the second
amendment in August 1982. The amendment revised the definition of a dominant
undertaking. In the revised definition the term production refers to the amount of goods
produced by a dominant undertaking for the domestic market i.e. production minus export of
that good.

MRTP Act was further amended in 1984 to include investment companies under its purview.
It also introduced a new concept of 'Group' to include enterprises under the same
management. The amendment also widened the scope of MRTP Act by redefining an
undertaking so as to include companies dealing in goods and services, stocks and shares and
investment companies. The Amendment Act has removed the concept of monopolistic
undertaking because monopolistic practices can exist even without monopolistic
undertakings.

The Industrial Policy (1991) states that "The interference of the government through the
MRTP Act in investment decisions of large companies has became deleterious in its effects
on Indian industrial growth. The pre-entry scrutiny of investment decision by so called
MRTP companies will no longer be required. Instead, emphasis will be on controlling and
regulating monopolistic, restrictive and unfair trade practices rather than making it necessary
for the monopoly houses to obtain prior approval of Central Government for expansion,
establishment of new undertakings, merger, amalgamation and takeover and appointment of
certain directors. The thrust of policy will-be more on controlling unfair or restrictive
business practices". The success of the government controlling concentration depends on the
extent to which it can generate competitive elements and control monopolistic tendencies.

16.10 MONOPOLISTIC COMPETITION

Perfect competition and monopoly are rarely found in the real world. Therefore, professor
Edward. H. Chamberlin of Harvard University brought about a synthesis of the two theories
and put forth, "Theory of Monopolistic Competition" in 1933. Monopolistic competition is
more realistic than either pure competition or monopoly. It is a blending of competition and
monopoly. "There is competition which is keen though not perfect, between many firms
making very similar products". Thus monopolistic competition refers to competition among a
large number of sellers producing close but not perfect substitutes.

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FEATURES

1. Large number of sellers

In monopolistic competition the number of sellers is large. No one controls a major portion of
the total output. Hence each firm has a very limited control over the price of the product.
Each firm decides its own price-output policy without considering the reactions of rival firms.
Thus there is no interdependence between firms and each seller pursues an independent
course of action.

2. Product differentiation

One of the most important features of monopolistic competition is product differentiation.

Product differentiation implies that products are different in some ways from each other.
They are heterogeneous rather than homogeneous. There is slight difference between one
product and others in the same category. Products are close substitutes but not perfect
substitutes. Product differentiation may be due to differences in the quality of the product.
Product may be differentiated in order to suit the tastes and preferences of the consumers.
The products are differentiated on the basis of materials used, workmanship, durability, size,
shape, design, colour, fragrance, packing etc. Products are differentiated in order to promote
sales by influencing the demand for the products. This can be achieved through propaganda
and advertisement. Advertisement brings a psychological reaction in the minds of the buyers
and thus influences the demand. In addition, location of the shop, its general appearance,
counter service, credit and other facilities increase sales. Patent rights and trade marks also
promote product differentiation. Kodak and Coca Cola are the examples of patent rights.
Trade marks like Hamam, Rexona, Lux etc. help the consumers to differentiate one product
over others.

3. Free entry and exit of firms

Another feature of monopolistic competition is the freedom of entry and exit of firms. Firms
under monopolistic competition are small in size and they are capable of producing close
substitutes. Hence they are free to enter or leave the industry in the long run. Product
differentiation increases entry of new firms in the group because each firm produces a
different product from the others.

4. Selling cost

It is an important feature of monopolistic competition. As there is keen competition among

the firms, they advertise their products in order to attract the customers and sell more. Thus
selling cost has a bearing on price determination under monopolistic competition.

5. Group equilibrium

Chamberlin introduced the concept of group in the place of industry. Industry refers to a
number of firms producing homogeneous products. But, firms under monopolistic
competition produce similar but not identical products. Therefore, chamberlin uses, the
concept of group to include firms producing goods which are close substitutes.

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6. Nature of demand curve

Under monopolistic competition, a single firm can control only a small portion of the total
output. Though there is product differentiation, as products are close substitutes, a reduction
in price leads to increase in sales and vice-versa. But it will have little effect on the price-
output conditions of other firms. Hence each will loose only few customers, due to an
increase in price. Similarly a reduction in price will increase sales. Therefore the demand
curve of a firm under monopolistic competition slopes downwards to the right. It is highly
elastic but not perfectly elastic. In other words, under monopolistic competition, the demand
curve faced by the firm is highly elastic. It means that it has some control over price due to
product differentiation and there are price differentials between the firms.

16.11 PRICE-OUTPUT DETERMINATION UNDER MONOPOLISTIC

COMPETITION

Since, under monopolistic competition, different firms produce different varieties of

products, prices will be determined on the basis of demand and cost conditions. The firms
aim at profit maximisation by making adjustments in price and output, product adjustment
and adjustment of selling costs. Equilibrium of a firm under monopolistic competition is
based upon the following assumptions:

1. The number of sellers is large and they act independently of each other.
2. The product is differentiated.
3. The firm has a demand curve which is elastic.
4. The supply of factor services is perfectly elastic.
5. The short run cost curves of each firm differ from each other.
6. No new firms enter the industry.

Individual Equilibrium and Price Variation

Based on these assumptions, each firm fixes such price and output which maximises its
profit. Product is held constant. The only variable is price. The equilibrium price and output
is determined at a point where the short run marginal cost equals marginal revenue. The
equilibrium of a firm under monopolistic competition is shown in figure 25. DD is the
demand curve of the firm. It is also the average revenue curve of the firm. MC is the marginal
cost of the firm. The firm will maximise profits by equating marginal cost with marginal
revenue. The firm maximises its profit by producing OM level of output and selling it at

Fig. 25

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a price of OP. The profit earned by the firm is PQRS. Thus in the short run, a firm under
monopolistic competition earns supernormal profits. In the short run, the firm may incur
losses also. This is shown in figure 26.

Fig. 26

The firm is in equilibrium by producing an output of OQ. It fixes the price at OP. As price is
less than cost, it incurs losses equal to pabc. Thus a firm in equilibrium under monopolistic
competition may be making supernormal profits or losses depending upon the position of the
demand curve and average cost curve.

Group Equilibrium and Price Variation

Group equilibrium refers to price-output determination in a number of firms whose products

are close substitutes. The product of each firm has special characteristics. The difference in
the quality of the products of the firms under monopolistic competition results in large
variation in elasticity and position of the demand curves of the various firms. Similarly the
shape and position of cost curves too differ. As a result there exist differences in prices,
output and profits of the various firms in the group. For the sake of simplicity in the analysis
of group equilibrium, Chamberlin ignores these differences by adopting infirmity assumption.
He assumes that the cost and demand curves of all the products in the group are uniform.
Chamberlin introduces another assumption known as 'symmetry assumption'. It means that
the number of firms under monopolistic competition is large and hence the action of an
individual firm regarding price and output will have a negligible effect upon his rivals. Based
on these assumptions, short run equilibrium of a firm under monopolistic competition can be
shown in Figure. 27.

Figure (A) represents short run equilibrium and figures (B) the long run equilibrium.
In the short run, the price is OP and average cost is only MR. Hence there is supernormal
profit equal to PQRS. But in the long run, as shown in figure 27 (B), the excess profit is

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competed away. MC = MR at OM level of output. LAR is tangent to LAC. Price is equal to
average cost and there is no extra profit. Only normal profit is earned.

16.12 PRODUCT DIFFERENTIATION

While analysing the equilibrium of a firm with regard to the variation of the product we
assume the price of product to be constant. The firm has to select among the various possible
qualities and attributes of the product. An important characteristic of product variation is that
it changes the cost curve and demand for the product. Therefore, the entrepreneur has to
choose the product whose cost and demand are such as to yield maximum profit. Yet another
feature of product variation is that product variation is qualitative and therefore, quantitative
measurement is not possible.

INDIVIDUAL EQUILIBRIUM AND PRODUCT VARIATION

The equilibrium of the firm under condition of product variation is shown in figure 28.

AA is the average cost curve of the product A and BB is the average cost curve of the product
B. The price of the product is OP. If OM quantity of the product A is demanded at the price
of OP, the total costs are OMRS. The entrepreneur earns an abnormal profit equal to PQRS.
If the Quantity demanded of the product B is ON, then the total costs are ONFG and the total
profits made by the entrepreneur are GFEP. Since the product B yields greater profits than A,
the entrepreneur will select the product B.

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Group Equilibrium and Product Variation
It is assumed that the demand is uniform and the possibility of product variation is also
uniform. The equilibrium adjustment of the product is shown in figure 29.

Fig. 29
CC1 is the average cost curve. If the quantity demanded is OM then the total cost is OMHG.
The firm earns supernormal profits equal to GHQP. This supernormal profits should be wiped
away to achieve group equilibrium. Attracted by the supernormal profits, new competitor
may enter the group. The quantity demanded will come down to OT. Price will cover only
cost of production. Besides, the adjustment in the number of firms, product improvement may
also take place. When all entrepreneurs improve their product, cost will increase as shown by
DD1 and become equal to the price at the point S.

Group equilibrium must satisfy the following conditions:

1. The average cost must be equal to price.

2. It is not possible for any one to increase his profits by making further
adjustment or improvement in his product.

Selling Cost and Price Determination

Selling cost is another important factor which influences pricing under monopolistic
competition. Selling costs are costs incurred on advertising, publicity, salesmanship, free
sampling, free service, door to door canvassing and so on. Selling costs are "the costs
necessary to persuade a buyer to buy one product rather than another or to buy from one
seller rather than another".

Under perfect competition, there is no need for advertising as the product is homogeneous.
Similarly, under monopoly also, selling costs are not needed as there are no rivals. But under
conditions of monopolistic competition, as the products are differentiated, selling costs are
essential to increase sales. Chamberlin defines selling cost,"as costs incurred in order to alter
the portion or shape of the demand curve for a product". Advertisement may be classified into
two types: informative and competitive.

Informative advertisement enables the buyers to know about existence and uses of the
product. It also helps to increase sales of all firms in the group. Competitive advertisement
refers to expenses incurred to increase the sales of the product of a particular firm as against
other products.

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Production cost versus selling cost
Selling Cost and Price Determination

Selling cost is another important factor which influences pricing under monopolistic
competition. Selling costs are costs incurred on advertising, publicity, salesmanship, free
sampling, free service, door to door canvassing and so on. Selling costs are "the costs
necessary to persuade a buyer to buy one product rather than another or to buy from one
seller rather than another".

Under perfect competition, there is no need for advertising as the product is homogeneous.
Similarly, under monopoly also, selling costs are not needed as there are no rivals. But under
conditions of monopolistic competition, as the products are differentiated, selling costs are
essential to increase sales. Chamberlin defines selling cost,"as costs incurred in order to alter
the portion or shape of the demand curve for a product". Advertisement may be classified into
two types: informative and competitive. Informative advertisement enables the buyers to
know about existence and uses of the product. It also helps to increase sales of all firms in the
group. Competitive advertisement refers to expenses incurred to increase the sales of the
product of a particular firm as against other products.

Production cost versus selling cost

D1 is the demand curve before advertisement expenditure is incurred. When advertisement

expenditures are undertaken, the demand curve shifts to D2 D3 D4 and D5.
At the price of OP, quantity demanded increases from Ql toQ2, Q2 to Q3 Q3 to Q4and
Q4 to Q5. After D4, diminishing returns occur.

The curve of selling cost is U-shaped, due to-the operation of the law of variable proportions.
The curve of selling cost first falls, reaches a minimum point and then starts rising as shown
in figure 31. SC is the curve of selling costs. The total cost of selling OA units of the product
is OAQS. At the minimum point of the selling cost curve i.e. at M, the selling cost is the
minimum. Beyond the point M, selling cost increases. For instance, the average selling cost
of OC is RC.

Individual Equilibrium and Selling Cost

Here it is assumed that the seller adjusts his selling cost keeping the price and product
constant. It is also assumed that one seller alone advertises, while all others do not. As a
result he attracts new buyers, sells more and makes profit. This is illustrated in figure 32.

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 Fig. 32

PC is the production cost curve. CC1 is the combined production and selling cost curve. MC
is the marginal cost curve. If the seller sells OQ level of output at OP price, he has no profit.
His cost of production is equal to price. Therefore, he advertises his product which increases
his cost. His combined production and selling costs are indicated by CC1. At OQ1 level of
output, his production cost is equal to OQ1 S1 R1. His selling cost is R1 S1 SR. He earns an
abnormal profit equal to PRST.

Group Equilibrium and Selling Cost

The abnormal profit earned by the firm makes all other firms in the group advertise. When all
firms advertise total cost of all will increase. Price will be equal to cost. There is no abnormal
profit. All firms earn only normal profit. This is shown in figure 33.

Fig. 33

PC is the production cost curve. TC is the total cost curve of the single firm. Due to
competition from others, the cost is equal to price. CC is the total cost curve of all the firms
in the group. As it is tangent to the price, there is no abnormal profit.

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Optimum Selling Costs

A producer undertakes advertisement only when it brings additional revenue. The producer
will increase his advertising expenditure as long as the marginal revenue is greater than
marginal cost. He will stop at the point at which marginal revenue is greater than marginal
cost. He will stop at the point at which marginal revenue is equal to marginal cost. Only at
that point, profit will be maximum. This is shown in figure 34. AR1 is the average revenue
curve before advertisement. AC is the average cost curve. OP is the price. The equilibrium
level of output is OQ. If advertisement is undertaken, average revenue curve will shift from
AR1 to AR2 The average cost curveAC1 includes the cost of advertisement. The equilibrium
price will be OP1 and the output OQ1 Profits will be larger. Since profits have increased the
firm will continue its advertisement

expenditure till the marginal revenue is equal to marginal cost. Profit maximisation is
achieved at OP2 price and OQ2 output. Beyond this point, advertisement expenditure will
lead to fall in profit. Therefore, a producer under monopolistic competition has to select that
cost and revenue curves where the profits are maximum.

Check Your Progress – 3

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Product Differentiation.
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16.13 LET US SUM UP

In the first part of this lesson we have studied about the market forces operating in monopoly
competition, the pricing and output decision in this market structure. We also discussed the
concept of price discrimination and its effect at various degrees. Concentration of economic
power is also widely studied in this part. The second part of this lesson deals with
monopolistic competition. We have studied its features, its price-output determination in an
extensive manner. The concept of product differentiation in monopolistic competition is also
discussed in the second part of this lesson.

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16.14 KEY WORDS

Monopoly competition Price-output determination

Price discrimination Price discrimination
Dumping Monopoly equilibrium
Competitive equilibrium Economic power
Monopolistic competition Product differentiation
Long run equilibrium Degrees of price discrimination
Elasticity of demand Dumping
Monopolistic firm Monopoly
Concentration Economic power

16.14 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson
16.14 ANSWER TO CHECK YOUR PROGRESS EXERCISE
Check Your Progress – 1
1. See section 16.3
Check Your Progress – 2
1. See Section 16.8
Check Your Progress – 3
1. See section 16.12

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UNIT 17
DUOPOLY AND OLIGOPOLY

STRUCTURE

17.1 Objectives

17.2 Introduction

17.3 Duopoly

17.4 Oligopoly

17.5 Types of Oligopoly

17.6 Models of Oligopoly

17.7 Let us sum up

17.8 Key words

17.9 Questions for discussion

17.10 Suggested readings

17.1 OBJECTIVES

After having studied this lesson you should be able

 To Understand the features of Duopoly and Oligopoly competition
 To know the various types of oligopoly
 To familiarize the various models of oligopoly behaviour

17.2 INTRODUCTION

The other forms of market situations, Duopoly and Oligopoly are dealt in this lesson. When
there are few sellers of homogeneous or differentiated product, it is the oligopoly market
structure. If there are only two sellers, it is a Duopoly market structure.

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17.3 DUOPOLY

When there are two monopolists who share the monopoly power then it is called duopoly. It
may be of two types-duopoly without product differentiation and duopoly with product
differentiation. Under duopoly without product differentiation, there are two monopolists
selling an identical commodity. There is no product differentiation. There is also a possibility
for collusion. They may agree on price or divide the market for goods. Suppose, if there is no
agreement between the two, a constant price war will emerge. In this case they will earn only
normal profits. If their costs are different, the one with lower costs will squeeze out the other
and a simple monopoly would result. The best course for the duopolists will be to fix the
monopoly price and share the market and profits. In the. short run, duopoly price may be
lower than the competitive price. In the long run, the price maybe somewhere between the
monopoly price and the competitive price. When there is product differentiation, each
producer will have his own customers. There is no danger of price war. There is no
agreement. Since products are differentiated the firm with better product will earn
supernormal profit

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about the term Duopoly.

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17.4 OLIGOPOLY

Oligopoly is a situation in which few large firms compete against each other and there is an
element of interdependence in the decision making of these firms. A policy change on the
part of one firm will have immediate effects on competitors, who react
with their counter policies.

Features
Following are the features of oligopoly which distinguish it from .other market structures

1. Small number of large sellers.

The number of sellers dealing in a homogeneous or differentiated product is small. The
policy of one seller will have a noticeable impact on market, mainly on price and output.

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2. Interdependence.
Unlike perfect competition and monopoly, the oligopolist is not independent to take
decisions. The oligopolist has to take into account the actions and reactions of his rivals while
deciding his price and output policies. As the products of the oligopolist are close substitutes,
the cross elasticity of demand is very high.

3. Price rigidity.
Any change in price by one oligopolist invites retaliation and counter- action from others, the
oligopolist normally sticks to one price. If an oligopolist reduces his price, his rivals will also
do so and therefore, it is not advantageous for the oligopolist to reduce the price. On the other
hand, if an oligopolist tries to raise the price, others will not do so. As a result they capture
the customers of this firm. Hence the oligopolist would never try to either reduce or raise the
price. This results in price rigidity.

4. Monopoly element.
As products are differentiated the firms enjoy some monopoly power. Further, when firms
collude with each other, they can work together to raise the price and earn some monopoly
income.

5. Advertising.
The only way open to the oligopolists to raise his sales is either by advertising or improving
the quality of the product. Advertisement expenditure is used as an effective tool to shift the
demand in favour of the product. Quality improvement will also shift the demand favorably.
Usually, both advertisements as well as variations in designs and quality are used
simultaneously to maintain and increase the market share of anoligopolist.

6. Group behaviour.
The firms under oligopoly recognise their interdependence and realise the importance of
mutual cooperation. Therefore, there is a tendency among them for collusion. Collusion as
well as competition prevails in the oligopolistic market leading to uncertainty and
indeterminateness.

7. Indeterminate demand curve.

It is not possible for an oligopolist to forecast the nature and position of the demand curve
with certainty. The firm cannot estimate the sales when it decides to reduce the price. Hence
the demand curve under oligopoly is indeterminate.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the term Oligopoly.
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17.5 TYPES OF OLIGOPOLY

Oligopoly may be classified in the following ways:

a. Perfect and imperfect oligopoly.

On the basis of the nature of product, oligopoly may be classified into perfect (pure) and
imperfect (differentiated) oligopoly. If the products are homogeneous, then oligopoly is
called as perfect or pure oligopoly. If the products are differentiated and are close substitutes,
then it is called as imperfect or differentiated oligopoly.

b. Open or closed oligopoly.

On the basis of possibility of entry of new firms, oligopoly may be classified into open or
closed oligopoly. When new firms are free to enter, it is open oligopoly. When few firms
dominate the market and new firms do not have a free entry into the industry, it is called
closed oligopoly.

c. Partial and full oligopoly.

Partial oligopoly refers to a situation where one firm acts as the leader and others follow it.
On the other hand, full oligopoly exists where no firm is dominating as the price leader.

d. Collusive and non- collusive oligopoly.

Instead of competition with each other, if the firms follow a common price policy, it is called
collusive oligopoly. If the collusion is in the form of an agreement, it is called open collusion.
If it is an understanding between the firms, then it is a secret collusion. On the other hand, if
there is no agreement or understanding between oligopoly firms, it is known as non-collusive
oligopoly.

e. Syndicated and organised oligopoly.

Syndicated oligopoly is one in which the firms sell their products through a centralised
syndicate. Organised oligopoly refers to the situation where the firms organise themselves
into a central association for fixing prices, output, quota etc.

17.6 MODELS OF OLIGOPOLY

1. Cournot's model of oligopoly:

Augustin Cournot, a French economist, published his theory of duopoly in 1838. Cournot
dealt with a case of duopoly. He has taken the case of two identical mineral springs operated
by two owners. His model is based on the following assumptions

1. The product is homogenous.

2. There is no cost of production. The average cost and marginal cost are zero.
3. Output of the rival is assumed to be constant.
4. The market demand for the product is linear. Cournot's solution

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DB is the market demand curve. OB is the total quantity of mineral water which can be
produced and supplied by the two producers. If both the producers produce the maximum
quantity of OB, the price will be zero. This is because cost of production is assumed to be
zero. Cournot assumes that one producer say X starts production first. He will produce OA
output and his profit will be OAPK. Suppose the second producer Y enters into the market.
He assumes that the first producer will continue to produce the same. So Y considers PB as
his demand curve. With this demand curve, he will produce AH amount of output. The total
output will now be OA + AH = OH and the price will fall to OF. The total profits for both the
producers will be OHQR. Out of this total profits, producers X will get OAGF and Y will
receive AHQG. Now that the profits of producers X are reduced from OAPK to OAGF by
producers Y producing AH output, producer X will reconsider the situation. But he will
assume that producer Y will continue to produce AH output. Therefore, he reduces his output
from OA to OT. Now the total output will be OT + AH = ON and the price will be OS and
the total profits of the two will be ONRS.

Out of the total profits, X will get OTLS and Y will get TNRL. Now the producer Y will
reappraise his situation. Believing that producer X will continue producing OT, the producer
Y will find his maximum profits by producing output equal to 1/2 TB. With this move of
producer Y, producer X will find his profits reduced. Therefore, X will reconsider his
position. This process of adjustment and readjustment by each producer will continue, until
the total output OM is produced and each is producing the same amount of output. In the final
position, producer X produces OC amount of output and producer Y produces CM amount of
output and OC = CM.
Cournot's duopoly solution can be extended to a situation with more than two sellers. If there
were three producers, the total output would be 3/4 of OB, each producing 1/4 OB. If there
are n producers, then under Cournot's solutions, the total output produced will be

of OB where OB is
The maximum possible output. The essential conclusion is that; as the number of sellers
increases from one to infinity the price is continually lowered from what it would be under
monopoly conditions to what it would be under purely competitive conditions, and that for
any number of sellers, it is perfectly determinate. The basic weakness of Cournot's duopoly
model is that the rivals assume the output of the other to be fixed, even though they observe
constant changes in output.

2. Bertrand's model

Joseph Bertrand, a French mathematician criticised Cournot's duopoly solution and put
forward a substitute model of oligopoly. In Bertrand's model, each producer assumes his
rival's price to be constant. The products produced and sold by the two producers are

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completely identical. The two producers have identical costs. Moreover, the productive
capacity of the producers is unlimited. Bertrand's model can be explained with an example.
There are two producers A and B. If A goes into business first, he will set the price at the
monopoly level, which is the most profitable for him. Suppose B also enters into the business
and starts producing the same product as produced by A. B assume that A will go on charging
the same pricei Therefore, he can undercut the price changed by A to capture the whole
market. He will set a price slightly lower than I A's price. A's sales fall to zero. Now A will
reconsider his price policy. He assumes that, B will continue to charge the same price. There
are two alternatives open to him. First, he may match the price cut made by B or he may
charge the same price as B charges. In this case, he will secure half the market. Secondly, he
may undercut B and set a slightly lower price than that of B. In this case A will seize the
entire market. Evidently the latter course looks more profitable and thus A undercuts B and
sets a price lower than B's price. Now producer B will react and think of changing his price,
He also has two alternatives: He may match A's price or undercut him. Since undercutting is
more profitable, B will set a price a little lower than A and seize the whole market. But again
A will be forced to undercut B. This price war will go on until price falls to the level of cost.
When price is equal to cost, neither of them will like to cut the price further or raise the price
and therefore, the equilibrium has been achieved. In Bcrtrand's model, equilibrium is
achieved when market price is equal to the average cost of production and the combined
equilibrium output of the two duopolies is equal to the competitive output.

3. Edgeworth model

F.Y. Edgeworth, a famous French economist, also attacked Cournot's duopoly solution. He
criticised 'Cournot's assumption that each duopolist believes that his rival will continue to
produce the same output irrespective of what he himself might produce. According to
Edgeworth each duopolist believes that his rival will continue to charge the same price. With
this assumption and taking the example of Cournot's "mineral wells", Edgeworth showed that
no determinate equilibrium would be reached in duopoly. Further, it is also assumed that the
products of the two duopolists are perfectly homogeneous. The cost conditions of the two
duopolists need not be exactly same but must be similar. Edgeworth's model is given in figure
36.

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AB is the demand curve for producer X and AB1 is the demand curve for producer Y. The
maximum possible quantity each producer can produce and supply is OQ by X and OQ1 by
Y. If each producer wants to sell his entire output, he will have to fix the price as OP1 On the
other hand, if the two rivals join together to maximise profit, they will fix the price at OP and
sell ON and ON1 output respectively. Each producer will get a maximum profit of ONCP and
ON1 C1P respectively.To start with, if the two producers charge the price OP then X and Y
will be selling ON and ON1 amounts of output respectively. Suppose producer X thinks of
revising his price policy. Producer X will believe that producer Y will keep his price
unchanged at OP. He realises that if he sets the price slightly lower than OP he can sell his
entire output and get maximum profit. So producer X will lower his price from OP to OR and
sells his entire output OQ and will earn profits equal to OQSR. This X would increase his
profit by lowering his price.

But when producer X reduces his price, producer Y will find his sales considerably reduced.
Profits will fall. As a result, producer Y will fix price at OR1 so that he can sell his entire
output. As a result of this, sales and profits of producer X will greatly decline. Producer X
will now react and will think that if he reduces his price a little below OR 1 he will be able to
sell his whole output by attracting customers of producer Y. Thus when producer X reduces
his price, his profits will increase for a moment. But producer Y will react and reduce his
price further to increase his profits. In this way, price cutting will continue until the price falls
to the level OP1 at which both producers sell their entire output. At OP1, producers X and Y
are selling OB and OB1 respectively and are making profits equal to OBTP1 and OB1T1P1
respectively. According to Edgeworth, equilibrium is not attained at OP1 price. Each will
have incentive to raise the price. If producer X raises the price to OP, he will earn ONCP
which are larger than profits at OP1 price. Producer Y will also raise his price to the level
slightly lower than OP. Producer X will now fix the price slightly lower than Y's level. In this
way, price will fluctuate between OP and OP1 gradually downwards but upwards in a jump.
Thus Edgeworth's duopoly solution is one of perpetual disequilibrium and price will be
constantly oscillating between the monopoly price and competitive price. No determinate and
unique equilibrium of duopoly is suggested by Edgeworth's duopoly model.

4. Chamberlin's Duopoly Model

Edward Chamberlin has modified Cournot's model by assuming that the rivals understand the
reality. His model is same as that of Cournot's. AB is the market demand for mineral water. If
producer X enters the market first, he will produce ON quantity at OP price and secure
maximum monopoly profit of ONCP. At this stage producer Y enters the market and
produces NQ amount and fixes OP' price and gets a profit of NQDE. Up to this point
Chamberlin's analysis is the same as Cournot's. From this point

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onwards, Chamberlin's analysis is different. Producer X immediately realises the mutual
interdependence of the two producers and he reduces his output from ON to OM. Producer Y
will produce the same amount NQ. Thus both produce the monopoly output of ON, fix the
monopoly price OP and share equally the monopoly profit. (OMLP for X and MNCL for Y).
Under this system there is stability but in Edgeworth's duopoly solution there is instability.
Besides Chamberlin's model is a realistic description of the actual duopoly market situation.

5. Sweezy's Model

P. Sweezy introduced the kinked demand curve to explain the determination of equilibrium
in' oligopolistic market. The demand curve facing an oligopolist has a kink at the prevailing
price. This is because each oligopolist believes that if he lowers the price below the
prevailing level increases his price above the prevailing level his competitors will not follow
his increase in price. Due to this behavioural pattern of the oligopolists, the upper segment of
the demand curve is relatively elastic and the lower portion is relatively inelastic.

If the oligopolist reduces its price below the prevailing price level MP, the competitors will
fear that their customers would go away from them. Therefore, they will also reduce the
price. Since all the competitors are reducing their price, the oligopolist will gain only very
little sales. Hence the demand curve which lies below the prevailing price is inelastic. If the
oligopolist raises his price above the prevailing price level his sales

Fig. 38

will be reduced. As a result of a rise in price, his customers will go to his competitors. Thus
an increase in price will lead to a large reduction in sales. This shows that the demand curve
which lies above the current price level is elastic. Since the oligopolist will not gain a larger
share of the market by reducing his price below the prevailing level and will loose a large
share of the market by increasing his price he will not change the price. For determining
profit maximising price-output, combination, marginal revenue curve has to be drawn. The
marginal revenue curve corresponding to the kinked demand

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curve has a gap or discontinuity between G and H. This gap in MR curve occurs due to he
kink in the demand curve and lies right below the kink. The length of the gap depends on the
relative elasticities of the two portions of the demand curve. The greater the difference in the
two elasticities the greater the length of the discontinuity. If the marginal cost curve of the
oligopolist passes through the discontinuous portion of the MR curve the oligopolist will be
maximising his profit at the prevailing price level OP. As he is maximising profits at the
prevailing price level he will have no incentive to change the price. Even if cost conditions
change the price will remain stable.

Fig. 40

When the marginal cost curve shifts upward from MC to MC1 , the price remains unchanged
as MC1 passes through the gap GH. Similarly, the price will remain stable even when the
demand conditions change. When the demand for the oligopolist increases from D to D1, the
given marginal cost curve MC cuts the new marginal revenue curve MR within the gap. This
means that the same price continues to prevail in the market. The major drawback of the
kinked demand curve is that it does not explain the determination of price. It explains only
price rigidity. Further it is not applicable to price leadership and cartels. Kinked demand
curve is also not applicable to oligopoly with product differentiation. Due to these
deficiencies, a general theory of pricing is impossible under oligopoly.

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 Check Your Progress – 3
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about the Models of Oligopoly.
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……………..

17.7 LET US SUM UP

In this lesson we have studied the character of duopoly market situation and also an extensive
discussion is made on oligopolistic competition. Types of oligopoly are also discussed.
Various models contributed by different economists are also illustrated in this lesson.

17.8 KEY WORDS

Duopoly Oligopoly
Homogeneous Market structure
Monopolists Duopolists
Small number of large sellers Interdependence.
Price rigidity. Monopoly element.
Advertising. Group behaviour.
Indeterminate demand curve. Closed oligopoly
Imperfect oligopoly Partial and full oligopoly
Collusive and non- collusive oligopoly Syndicated oligopoly
Cournot's model of oligopoly: Bertrand's model
Edgeworth model Sweezy's model

17.9 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases

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 5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

17.10 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 17.3
Check Your Progress – 2
1. See Section 17.4
Check Your Progress – 3
1. See section 17.6

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UNIT 18
PRICING POLICY

STRUCTURE

18.1 Objectives

18.2 Introduction

18.3 Importance of Pricing Policy

18.4 Pricing Objectives

18.5 Factors affecting pricing policy

18.6 Methods of Pricing

18.7 Pricing of New products

18.8 Kinds of Pricing

18.9 Let us sum up

18.10 Key words

18.11 Questions for discussion

18.1 OBJECTIVES

After having studied this lesson you should be able

 To Know in detail the concept of pricing
 To understand different methods and kinds of pricing
 To identify the factors affecting pricing policy
 To apply pricing decision at the time of introducing new products

18.2 INTRODUCTION

Pricing assumes a significant role in a competitive economy. Price is the main factor which
affects the sales o f a organisation. A good price policy is of great importance to the
producers, wholesalers, retailers and the consumers. Marketers try to achieve their long-run

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pricing objectives through both price policies and price strategies. If the prices are high, few
buyers purchase and if the prices are low, many buyers purchase. Thus market may be
reduced or increased. That is, the price increases in relation to the sales revenue. Thus pricing
is a critical situation. Therefore, a sound pricing policy must be adopted to have maximum
sales revenue.

In the early stages of men, prices were set by buyers and sellers negotiating with each other.
The seller may demand a higher price than expected and the buyer may offer a price less than
the expected one. Ultimately they arrive at an agreeable price through bargaining. Now in the
competitive economy, development of large business aims to have one price policy. In certain
cases, the buyer looks at the price as an indicator of product quality. If the price is higher, the
buyer believes the products to be of high quality.

In case the quality is not up to the mark he expects, he feels that the price is high. Hence, one
cannot say that the price is high or low, without considering the quality of the product to be
purchased. The price is greatly affected or influenced for future production and marketing.

Prices play an important role in the economy. The time within which the product is sold
varies. The goods, which are of a perishable nature and frequent changes of style, may not be
stocked for long time. In the case of durable goods, they can be stocked for longer time, in
the hope of getting favorable price rise. Holding the stock depends upon the financial
resources of farmer, middleman, wholesaler etc., and the perish ability of the goods.

Price

Price may be defined as the exchange of goods or services in terms of money. Without price
there is no marketing in the society. If money is not there, exchange of goods can be
undertaken, but without price; i.e., there is no exchange value of a product or service agreed
upon in a market transaction, is the key factor which affects the sales operations.

What you pay is the price for what you get.

Price is the exchange value of goods or services in terms of money. Price of a product or
service is what the seller feels it worth, in terms of money, to the buyer.

18.3 IMPORTANCE OF PRICING POLICY

A well formed price policy has special importance if price rise is a continuous process in
planned economy. It has not only the influenced the living standard of people but due to
increase in the expenditure of full planning, the prescribed aims and objectives of the
planning are shattered. As a result, there is obstruction of economic development.
But in underdeveloped countries, with economic development, price rise is quite natural. Till
the increase in monetary income of the public is more than price rise, there is no
comprehension. But when there is more price rise than investment and national income, there
is a need to protect from the defects of monetary fluctuations. It requires price regulation. In
short, in developing countries, the significance of price policy can be known from the
following facts:

1. To Maintain Appropriate Living Standard.

Price rise lets living standard of people fall and economic development of the country is
obstructed. To maintain the proper living standard, price control is essential.

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2. To Maintain Planning.
As price rises, the work of planning increases which results in obstruction in the prescribed
aims and objectives of the planning. To maintain the planning process in a fine manner,
prices should be controlled at all costs.

3. Protection from Monetary Fluctuations.

When price increase is more than investment and national income increases, monetary
fluctuation defects are created. To remove them appropriate price control is required.

4. Establishment of Balance in Demand and Supply.

In a developing economy, due to changing circumstances, balance of demand and supply
disrupts by which consumer, producer and investor have to take hardships. This shows that
there is need to balance the demand and supply in a proper way.

5. For Well Adjusted Distribution Management.

With the view point of consumers for quick supply of goods on less prices distribution
management should be well adjusted. For this, it is necessary to control the consumer price.

6. Multifaced Development of National Resources.

The major objective of economic planning is multifaced development of national resources.
Thus, price policy should be quite independent as price regulation can adjust this motto.

18.4 PRICING OBJECTIVES

Perform the marketing job efficiently, the management has to set goals first pricing is no
exception. Before determining the price itself, the management must decide the objectives of
pricing. These objectives are logically related to the company's overall goal or objectives The
main goals in pricing may be classified as follows.

1. Pricing for Target Return (on investment) (ROI):

Business needs capital, investment in the shape of various types of assets and working
capital. When a businessman invests capital in a business, he calculates the probable return
on his investment. A certain rate of return on investment is aimed. Then, the price is fixed
accordingly. The price-includes the predetermined average return. This is seller-oriented
policy. Many well-established firms adopt the objective of pricing in terms of "return on
investment." Firms want to secure a certain percentage of return on their investment or on
sales. The target of a firm is fixed in terms of investment For instance a company may set a
target at 10 or 15% return on investment. Further this target may be for a long term or short
term. Wholesalers and retailers may follow the short term, usually a year they charge certain
percentage over and above the price, they purchased, which is enough to meet operational
costs and a desired profit. This target chosen, can revised from time to time. This objective of
pricing is also known as pricing for profit. Certain firms adopt this method as a satisfactory
objective, in the sense they are satisfied with a certain rate of return.

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2. Market Share:

The target share of the market and the expected volume of sales are the most important
consideration in pricing the products. Some companies adopt the main pricing objective so as
to maintain or to improve the market share towards the product. A good market share is a
better indication of progress. For this, the firm may lower the price, in comparison to the rival
products with a view to capture the market. By reducing the price, customers are not
exploited rather benefited. The management can compare the present market share with the
past market share and can know well whether the market share is increasing or decreasing
When the market shares decreasing, low pricing policy can be adopted by large scale
manufacturers who produce goods needed daily by the consumers. So margin of profit comes
down because of low price, but the competitors are discouraged from entering the market. By
low pricing policy, no doubt, market share can be increased, besides attracting new users.

3. To Meet or Prevent Competition:

The pricing objective may be to meet or prevent competition. While fixing the price, the price
of similar products, produced by other firms, will have to be considered. Generally, producers
are not in a haste to fix a price at which the goods can be sold out one has to look to the
prices of rival products and the existing competition and chalk out proper price policy so as to
enable to face the market competition. At the time of introduction of products to the market, a
low price policy is likely to attract customers, and can establish a good market share. The low
price policy discourages the competitors.

4. Profit Maximisation:

Business of all kinds is run with an idea of earning profit at the maximum. Profit
maximisation can be enjoyed where monopolistic situation exists. The goal should be to
maximise profits on total output, rather than on every item- The scarcity conditions offer
chances for profit maximisation by high pricing policy. The profit maximisation will develop
an unhealthy image. When a short-run policy is adopted for maximising the profit, it will
exploit the customers. The customers have a feeling of monopoly and high price. But along
run policy to maximise the profit has no drawbacks. A short-run policy will attract
competitors, who produce similar goods at low cost. As a result, price control and
government regulations will be introduced.

5. Stabilize Price:

It is a long-time objective and aims at preventing frequent and violent fluctuations in price. It
also prevents price war amongst the competitors. When the price often changes, there arises
no confidence on the product. The prices are designed in such away that during the period of
depression, the prices are not allowed to fall below a certain level and in the boom period, the
prices are not allowed to rise beyond a certain level. The goal is to give and let live. Thus
firms forego maximum profits during periods of short supply of products.

6. Customer Ability to Pay:

The prices that are charged differ from person to person, according to his capacity to pay. For
instance, doctors charge fees for their services awarding to the capacity of the patient.

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7. Resource Mobilization:

This is a pricing objective, the products are priced it such a way that sufficient sources are
made available for the firms' expansion, developmental investment etc. Marketers are
interested in getting back the amount invested as speedily as possible. The management may
fix a higher price and this trend will invite competitors with low priced similar products.

8. Survival and growth:

An important objective of pricing is survival and achieving the expected rate of growth.
Profits are less important than survival. According to P. Drucker, avoidance of loss and
ensuring survival are more important than maximisation of profit.

9. Prestige and goodwill:

Pricing also aims at maintaining the prestige and enhancing the goodwill of the firm.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Pricing Objectives.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……..

18.5 FACTORS AFFECTING PRICING POLICY

Price policy is government by external factors and internal factors. External factors are-
elasticity of demand and supply competition goodwill of firm, trend of the market, and
management policy. Keeping in view above facts, certain general considerations which must
be kept in view while formulating a suitable price policy are listed below:

(A) Internal Factors

(1) Organizational Factors

Pricing decisions occur on two levels in the organisation. Over-all price strategy is dealt with
by top executives. They determine the basic ranges that the product falls into in terms of
market segments. The actual mechanics of pricing are dealt with at lower levels in the firm
and focus on individual product strategies. Usually, some combination of production and
marketing specialists are involved in choosing the price.

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(2) Marketing Mix

Marketing experts view price as only one of the many important elements of the marketing
mix. A shift in any one of the elements has an immediate effect on the other three-Production,
Promotion and Distribution. In some industries, a firm may use price reduction as a
marketing technique. Other firms may raise prices as a deliberate strategy to build a high-
prestige product line. In either case, the effort will not succeed unless the price change is
combined with a total marketing strategy that supports it. A firm that raises its prices may add
a more impressive-looking package and may begin a new advertising campaign.]

(3) Product Differentiation

The price of the product also depends upon the characteristics of the product. In order to
attract the customers, different characteristics are added to the product, such as quality, size,
colour, attractive package, alternative uses etc. Generally, customers pay more price for the
product which is of the new style, fashion, better package etc.

(4) Cost of the Product

Cost and price of a product are closely related. The most important factor is the cost of
production. In deciding to market a product, a firm may try to decide what prices are realistic,
considering current demand and competition in the market. The product ultimately goes to
the public and their capacity to pay will fix the cost; otherwise product would be flapped in
the market.

(5) Objectives of the Firm

A firm may have various objectives and pricing contributes its share in achieving such goals.
Firms may pursue a variety of value-oriented objectives, such as maximising sales revenue,
maximising market share, maximising customer volume, minimizing customer volume,
maintaining an image, maintaining stable price etc. Pricing policy should be established only
after proper considerations of the objectives of the firm.

(B) External Factors

3. External Factors
External factors are those factors which are beyond the control of an organisation.

The following external factors would effect the pricing decisions :

1. Demand:

The nature and condition of demand should be considered when fixing the price.
Composition of the market, the nature of buyers, their psychology, their purchasing power,
standard of living, taste, preferences and customs have large influence on the demand.
Therefore the management has to weigh these factors thoroughly. If the demand for a product
is inelastic, it is better to fix a higher price for it. On the other hand, if demand is elastic,
lower price may be fixed.

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2. Competition:

In modern marketing, a manufacturer cannot fix his own price without considering the
competition. A number of substitutes enter the market these days. Hence the influence of
substitutes has also to be considered when fixing a price. A firm must be vigilant about the
prices charged by competitors for the similar products. If prices are fixed higher than the
prices charged by competitors, the customers are likely to switch over to the products of
competitors. On the other hand, if the prices charged are much lower than the prices of the
rivals, the customers may become suspicious about the quality and hence lower price may not
lead to higher sales. To avoid competitive pricing, a firm may resort to product
differentiation. Sometimes a higher price may itself differentiate the product. In view of
these, the management must be very careful in determining the prices.

3. Distribution channels:

Distribution channels also sometimes affect the price. The consumer knows only the retail
price. But there is a middleman working in the channel of distribution. He charges his profit.
Thus when the articles reach the hands of consumers, the price becomes higher. It sometimes
happens that the consumers reject it.

4. General Economic conditions:

Price is affected by the general economic conditions such as inflation, deflation, trade cycle
etc. In the inflationary period the management is forced to fix higher price. In recession
period, the prices are reduced to maintain the level of turnover. In boom period, prices are
increased to cover the increasing cost of production and distribution.

5. Govt. Policy:

Pricing also depends on price control by the Govt, through enactment of legislation. While
fixing the price, a firm has to take into consideration the taxation and trade policies of govt.

6. Reactions of consumers:

An important factor affecting pricing decisions is the attitude of consumers. If a firm fixes the
price of its product unreasonably high, the consumers may boycott the product.

18.6 METHODS OF PRICING

There are four basic pricing policies. They are:

1. Cost-based pricing policies.

2. Demand - based pricing policies.
3. Competition - based pricing policies.
4. Value-based pricing policies.

Cost-based pricing policy

The policy of setting price essentially on the basis of the total cost per unit is known as cost-
oriented pricing policy. In about 68% of consumer goods companies and about 89% of

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industrial products manufacturing companies take their pricing decision based on cost of
production. The following are the four methods of pricing which fall under cost-oriented
pricing policy.

1. Cost plus Pricing:

The theory of full cost pricing has been developed by Hall and Mitch. According to them,
business firms under the conditions of oligopoly and monopolistic competitive markets do
not determine price and output with the help of the principle of MC = MR. They determine
price on the basis of full average cost of production AVC + AFC margin of normal profit.
This is the most common method used for pricing. Under the method, the price is fixed to
cover all costs and a predetermined percentage of profit. In other words, the price is
computed by adding a certain percentage to the cost of the product per unit. Under this
method, cost includes production cost (both variable and fixed) and administrative and selling
and distribution cost (both variable and fixed). This method is also known as margin pricing
or average cost pricing or full cost pricing or mark-up pricing. This method is very popular in
wholesale trade and retail trade.

Advantages of Cost plus Pricing

1. This method is appropriate when it is difficult to forecast the future demand.
2. This method guarantees recovery of cost. Hence it is the safest method.
3. It helps to set the price easily.
4. Both single product and multi product firms can apply this method for pricing.
5. It ensures stability in pricing.
6. If this method is adopted by all firms within the industry, the problem of price war
can be avoided.
7. It is economical for decision making.

Disadvantages Of Cost Plus Pricing

1. This method ignores the effect of demand.

2. It does not consider the forces of market and competition.
3. This method uses average costs, ignoring marginal or incremental costs.
4. This method gives too much importance for the precision of allocation of costs.

2. Target Pricing:

This is a variant of full cost pricing. Under this method, the cost is added with a
predetermined target rate of return on capital invested. In this case, the company estimates
future rates, future cost and calculates a targeted rate of return on investment after tax. This
method is also known as rate of return pricing.

Advantages of Target or Rate of Return Pricing

1. This method guarantees a certain rate of return on investment.

2. This method can be used for pricing new products.
3. Prevention is better than cure' principle is applied in this method.
4. This is a long term price policy.

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Disadvantages of Target Pricing

1. His method is not practical when there is a tough competition in a market.

2. This method ignores the demand of the product.
3. It is difficult to predetermine the cost of products.

3. Marginal Cost Pricing:

Under both full cost pricing and rate of return pricing, the prices are set on the basis of total
cost (variable cost + fixed cost). Under the marginal cost pricing, the price is determined on
the basis of marginal or variable cost. In this method, fixed costs are totally excluded.

Advantages of Marginal Cost pricing

1. This method is very useful in a competitive market.
2. This method helps in optimum allocation of resources. It is particularly useful when
the products have low demand.
3. This method is suitable to pricing over the life cycle of the product.
4. It is the most suitable .method of short run pricing.
5. The method is useful at the time of introducing a new product.

Disadvantages of Marginal cost pricing

(1) Firms may not be able to cover up costs and earn a fair return on capital employed.
(2) It requires a better understanding of marginal costing technique.
(3) When costs are decreasing this method is not suitable because it will result losses.
(4) This method is not suitable for long run.

4. Break even pricing:

This is a form of target return pricing. In fact, it is a refinement to cost-oriented pricing.
Under break even pricing, break even analysis is used for point. Even pricing, break even
analysis is used for pricing. The firm first determines the break even point. It is the point at
which the total sales are equal to total cost no profit no loss point at which the total sales are
equal to the average total cost of product. Thus, both variable cost and fixed cost are covered
under this methods but it does not include any profit.

Importance of break even pricing:

This method of pricing helps in understanding the relationship between revenue and cost of
the company in relation to its volume of sales. it helps in determining that volume at which
the company’s cost and revenue are equal. This method of pricing is very important in profit
planning. It shows the effects on profit of changing the amount invested in advertisement of
changing the sales compensation methods of adding a new product or of changing a
marketing in focusing channel this methods of pricing helps the marketer in a calculating
output or sales to earn a desired profit calculating margin of safety changes in price making
decisions, and changes in cost and priceet.

2. Demand - based Pricing Policy

Under this pricing policy, demand is the basic factor. Price is fixed simply adjusting it to the
market conditions. In short, the price is fixed according to the demand for a product. Where
the demand is heavy, a higher price is charged. When the demand is low, a low price is
charged. The following are the methods of pricing which fall under this policy

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(a) Differential pricing:
Under this method the same product is sold at different prices to different customers, in
different places and at different periods. For instance, a cinema house charges different rates
for different categories of seats. Telephone authorities charge less for trunk calls at night than
during day. This method is also called discriminatory pricing or price discrimination.

(b). Modified Break-even analysis:

This is a combination of cost based and demand based pricing techniques. This method
reveals price-quantity mix that maximizes total profit. In other words, under this method,
prices are fixed to achieve highest profit over the BEP in consideration of the amount
demanded at alternative prices.

3. Premium Pricing:
It is a phenomenon of the 1990s. It is based on the principle that the product or brand should
be positioned at the top of the market and must offer greater v a l u e in qualitative terms
than similar brands in other price segments. In short, it is called high pricing. The BPL, group
followed this when they invaded the refrigerator market with a Rs. 37,000 brand (a four -
door, 350 liter, frost - free refrigerator). The other companies which follow premium pricing
include Titan, Sony TV, Arial and Dove Conditioner.

4. Neutral Pricing:
It means offering extra value or benefits with the brand cost or price remaining competitive.
Cadbury is offering 30 percent more chocolate in its 5 Star bar at same price.

5. Competition-based Pricing Policy:

It is the policy of fixing the prices mainly on the basis of prices fixed by competitors. This
policy does not necessarily mean setting of same price. With a competition oriented pricing
policy, the firm may keep its price higher or lower than that of competitors. Actually this
policy implies that the firms 'pricing decisions is not based on cost or demand, prices are
changed or maintained in line with the competitor's prices. The following methods fall under
this policy.

6. Going rate pricing:

Under this method, prices are maintained at par with the average level of prices in the
industry. The firm adjusts its own prices to suit the general price structure in the industry. In
other words, it is the method of charging prices according to what competitors are charging.
This method is usually adopted by firms selling a homogeneous product in a highly
competitive market. Under this method a firm accepts the price prevailing in the industry to
avoid a price war. This method is also called acceptance pricing or market equated pricing or
parity pricing. LML Vespa was following this method for a number of years with market
leader Bajaj. This method is particularly useful where cost ascertainment is difficult. This
technique is adopted in the situation of price leadership.

Advantages of going rate pricing

1. It helps in avoiding cut-throat competition among the firm.
2. This method is found more suitable when costs are difficult to measure.
3. This method is less expensive because calculation of cost and demand is not
necessary.
4. It is suitable to avoid price war in oligopoly.
5. This can be used for pricing new products.

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Disadvantages of going rate pricing
1. This method is not suitable for long run pricing.
2. Cost of the product and other marketing factors are not considered at all under this
policy.

Customary pricing:
In case of some commodities the prices get fixed because they have prevailed over a long
period of time. For example, the price of a cup of tea or coffee is customarily fixed. In short,
these prices are fixed by custom. The price will change only when the cost changes
significantly. Before changing the customary prices, it is essential to study the prices of
competitors. Customer prices may be maintained even when products
are changed. For example, the new model of a radio may be parked at the same level as the
discontinued model. Thus, under this method, the existing price is maintained as long as
possible.

Sealed bid pricing:

In all business lines when the firms bid far jobs, competition based pricing is followed. Costs
and demand are not considered at all. The firm fixes its prices on how the competitors price
their products. It means that if the firm is to win a contract or job, it should quote less than the
competitors.

Value based Pricing

Under this policy the price is based on value to the customer. The following are the pricing
methods based on customer value.

Perceived - value pricing:

Another method is judging demand on the basis of value perceived by the consumers in the
product. Thus perceived value pricing is concerned with setting the price on the basis of value
perceived by he buyer of the product rather than the seller's cost. When a company develops a
news product. it anticipates a particular position for it in the market in respect of price,
quality and service, 'Then it estimates the quality it can sell at this price. The company then
judges whether at this level of production and sale, it will have a satisfactory return
investment. If it appears to be so, the company goes ahead with translating the perception into
practice, otherwise it drops the proposal. Jerome Rowitch, owner of the Sculpture Gardens
Restart in Venice. California invited a selected group of affluent residents to dine at his
restaurant and told them pay what they felt their meals were worth. Did it work?. The 100
plus diners who Rowitch up on the deal paid in average Rs.50, about 30% higher than the
prices he would have normally charged. A firm can try this pricing approach of Jerome
Rowitch.

Value for money pricing:

This is now seen as more than a pricing method. Under this method price is based on the
value which the consumers get from the product they buy. It is used as a complete marketing
strategy. Videocon did it when they launched their 63 cm flat screen Bazooka when BPL’s
HR and Onida's KY Series models are dominating the flat sit-in TV segment. Bazooka
perceived value was Rs. 25,000. But driven by value for money strategy, Videocon priced
Bazooka at Rs.21, 000 only.

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Check Your Progress – 2
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Methods of Pricing.
……………………………………………………………………………………………
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18.7 PRICING OF NEW PRODUCTS

The introduction of a new product will pose a challenging problem for any firm. In the case
of new products there is no past information for ascertaining trends and consumer reaction. If
the new product is with high distinctiveness among the existing products, then price should
be fixed on the basis of such factors as demand, market - target and the promotional strategy.
In the case of pioneer product, the estimation of its demand is very difficult. The estimate of
demand for such products should be made on the basis of the following factors:

1. Product acceptability:
The manufacturer should ascertain whether the new product will be accepted by the
consumers or whether the consumers are willing to buy the product. The willingness to buy
depends upon a factor like whether it would meet their requirements.

2. Range of prices:
It is very essential to assess the reactions of the consumers at different prices. For this, a
market research will have to be undertaken. The core question that arises is at what prices
different quantities of the product are demanded.

3. Expected volume of sales:

The next task is to determine the anticipated volume of sales at different prices. This depends
upon demand elasticity and cross elasticity.

4. Reaction to price:
The assessment of the reaction of the consumers to the price is a very tricky task. The
company which introduces a new product will have to monitor the activates of the rivals in
order to find out the marketing strategies that they are going to adopt. In short, the price of a
new product should be fixed after taking into account the potential demand, objectives,
degree of competition and strategy of competitors etc.

Methods or Strategies of Pricing of New Products.

In pricing a new product, generally two type are followed-

(a) Price Skimming

When a new product is introduced in the market, the firm fixes a price much higher than the
cost of production. The consumers are ready to pay a high price to enjoy the pleasure of being

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the first users of the product. The high price charged helps to skim the cream off the market
at a time when there is no competition this is possible because the newly introduced product
reached the hands of the consumers after a long waiting and by the time it comes to the
market a heavy demand for the same has accumulated. When fixing the price the producer
takes this advantage of the market. This market situation will not continue for long. In the
long run new firms will enter into the industry. In the long run the number of enthusiastic
buyers who are ready to buy at a high price will decrease. For example, when electronic
goods like TV, tape recorders, calculators, VCR etc, were introduced their prices were very
high. But gradually when more and more new producers imitated these products their price
came down. The firm makes a huge profit by price skimming. The price skimming policy is
followed as long as there is heavy demand without any competition from a rival. The
principle behind price skimming is to make hay while sun shines. In the long run the
possibility of making huge profit by price skimming disappears. The price, in fact, gets
normalized around the cost of production.

Under the following situations the price skimming policy can be easily followed.

(i) The new product is a novel item which can attract customers and is having no
competitors at present.
(ii) The product is meant for the higher income group whose demand is inelastic. The firm
can charge a high price which will help them to realise a good share of the heavy initial
investment in the form of research and development expense.
(iii) There are heavy initial promotion expenses and the firm wants to realise it from the
customers before other competitive firms-enter in. The firm, after squeezing the
enthusiastic buyers, goes on reducing the price step-by-step so that it can reach the
various sections of consumers who are willing to buy it at lower prices.

(b) Penetration Pricing

The price fixed is relatively a lower one. This pricing is resorted to when the new product
faces a strong competition from the existing substitute product. When the new firm enters an
existing market where there are a number of firms it has to penetrate the market and achieve
an acceptance for its product. In order o attain this it will charge only a very low price
initially, hoping to charge a normal price later when it is established in the market. For
example, a firm may, when it introduce a new bath soap in the market give a 100 gms Piece
free when consumers buy two 200 pieces at a time. Later when it picks up sales it takes out
the initial discount. In a foreign market a new country may have to penetrate through a highly
competitive price.
The penetration price may be sometimes below the cost of production. This can be justified in
the following cases.

a. The lead time in production is short.

b. Increased production will result in reduced cost of production.
c. The product is meant for mass consumption.
d. The product is one where brand loyalty counts.
e. The product cannot be protected by patent right.
f. The fear of competition.

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18.8 KINDS OF PRICING

By following the above principles, business firms nay opt various kinds of pricing
for products. A few, important of them are explained below.

1 Psychological Pricing:
Many consumers use the price as an indicator of quality. Costs and other factors are
important in pricing. Yet, psychology of the price is also considered certain people prefer
high priced products, considered to be of high quality. Costly items diamond, jewellery etc.,
reveal the status of the person who wears them. They demand highly priced items. For
example, highly priced television sets carrying prestige prices are in demand. Then in the
retail shops another pricing 'odd pricing' issued. The paces are set at odd amounts, such as Rs.
19.95 instead of Rs. 20; Rs. 299.90 instead of Rs. 300 Odd prices, by psychology brings more
sales. An article priced at Rs. 9.90 will have more sales than when it is priced Rs.10.

2. Customary Pricing:
Customers expect a particular price to be charged for certain products. The prices are fixed to
suit local conditions. The customers are familiar with the market condition. Manufacturers
cannot control the price. Such products are typically a standardized one. Certain business
people reduce the size of the product, if the cost of manufacturing increases, Sometimes, the
firm changes the price by adopting new package, size etc. For example confectionary items.

3. Skimming Pricing:
It involves a high introductory price in the initial stage to skim the cream of demand. The
products, when introduced in the market have a limited period free from other manufacturers.
During this period, it aims at profit Maximisation, according to the favorable market
condition. Generally, the price moves downwards are when competitors enter into the market
field.

4. Penetration Pricing:
A low price is designed in the initial stage with a view to capture market share. That is if the
pricing policy is to capture greater market share, then this is done only by adoption of low
prices in the initial stage. Because of the low price, sales value increases, competition falls
down.

5. Geographical Pricing:
The distance between the seller and the buyer is considered geographic pricing. In India, the
cost of transportation is an important pricing factor because of vide geographical distance
between the production centre and consuming centre. The majority producing centers are
located in Bombay, Delhi, Calcutta and Madras and at the same time consuming centers are
dispersed throughout India. There are three ways of charging transit.

(a) F.O.B. Pricing:

In FOB (original) pricing, the buyer will have to incur the cost of transit and in FOB
(destination) the price influences the cost of transit charges.

(b) Zone Pricing:

Under this, the company divides the market into zones and quotes uniform prices to all
buyers who buy within a zone. The prices are not uniform all over India. The price in one

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zone varies from that of another one. The prices are uniform within a zone. The price is
quoted by adding the transport cost.

(c) Base Point Pricing: Base point policy is characterized by partial absorption of transport
cost by the company. One or more cities are selected as points from which all shipping
charges are calculated

6. Administered Price:
Administered price is defined as the price resulting from managerial decision and not on the
basis of cost, competition, demand etc. But this price is set by the management after
considering all relevant factors. There are many similar products manifesting different firms
and m ore or less the price tends to be uniform. Usually the administered price remains
unaltered for a considerable period of time.

7. Dual Pricing:
Under this dual pricing system, a producer is required compulsorily to sell a part of his
production to the government or its authorized agency at a substantially low price. The rest of
the product may be sold in the open market at a price fixed by the producer.

8. Mark up Pricing:
This method is also known as cost plus pricing. This method is generally adopted by
wholesalers and retailers. When they set up the price initially, a certain percentage is added to
the cost before marking the price. For example, the cost of an item Rs.10and is sold at Rs.13
the Mark up is Rs. 3 or 30%.

9. Price Lining:
T his method of pricing is generally followed by the retailers than wholesalers this system
consists of selecting a limited number of prices at which the store will sell its merchandise.
Pricing decisions are made initially and remain constant for a long period. The firm should
decide the number of lines and the level of each price line. Many prices are not desired and
the prices should not be too close to each other or too far from each other. For example shoe
firm have several types of shoes, priced at Rs. 120, 140, 170 etc., a pair.

10. Negotiated Pricing:

It is also known as variable pricing. The price is not fixed. The price is fixed upon bargaining.
In certain cases, the product may be prepared on the basis of specification or design by the
buyer. In such cases, the price has to be negotiated and then fixed.

11.Competitive Bidding:
Big firms or the government calls for competitive bids when they went to purchase certain
products or specialized items. The probable expenditure is worked out then the after offer is
made quoting the price, which is also known as contract price. The lowest bidder gets the
work.

12.Monopoly Pricing:
Monopolistic conditions exist where a product is sold exclusively by one producer or a seller.
When a new product moves to the market, its price is monopoly price there no problem is no
competition or no substitute. Monopoly price will maximize the profits, as there is no pricing
problem.

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 Check Your Progress – 3
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about kinds of Pricing.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
……………..

18.9 LET US SUM UP

In this lesson the importance of pricing in the competitive economy is identified. We have
identified the factors that could affect the pricing policy in a broad manner. We have also
studied about the various methods of pricing and analysed its advantages and disadvantages.
We have discussed the strategies to be adopted while pricing new products. We have briefly
discussed the kinds of pricing which a business firm would adopt by keeping few principles
in mind.

18.10 KEY WORDS

Pricing policy Pricing objectives

Price strategies Bargaining
Durable goods Market transaction
Monetary income Living standard
Maintain planning. Monetary fluctuations
Demand and sup Distribution management
Target return Market share

18.11 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari

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 9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

18.12 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 18.4
Check Your Progress – 2
1. See Section 18.6
Check Your Progress – 3
1. See section 18.8

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BLOCK
6
UNIT 19
COST – BENEFIT ANALYSIS

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UNIT 19
COST – BENEFIT ANALYSIS

STRUCTURE

19.1 Objectives
19.2 Introduction
19.3 Private Goods And Public Goods Distinguished
19.3.1 Characteristics Of Private Sector Goods
19.3.2 Characteristics Of Public Goods
19.4 Project Planning Or Project Appraisal
19.5 What Is Cost-Benefit Analysis
19.5.1 Use Of Cost-Benefit Analysis
19.5.2 Constraints In Cash-Benefit Analysis
19.6 Issues Involved In Cost-Benefit Analysis Or Project Evolution
19.7 Analysis And Evaluation Of Benefits And Costs
19.7.1 Measuring Direct Benefits
19.7.2 Direct Costs
19.7.3 Secondary Or Indirect Benefits And Costs
19.8 Social Rate Of Discount
19.9 Criteria For Investment Evaluation For Public Sector Projects
19.10 Limitations And Benefits Of Cost-Benefit Analysis
19.11 Justification For Cost-Benefit Analysis
19.12 Let Us Sum Up
19.13 Key Words
19.14 Some Useful Books
19.15 Answer to Check Your Progress Exercise

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19.1 OBJECTIVES

After reading this lesson you must be able to understand the following topics briefly,
 Private Goods And Public Goods Distinguished
 Characteristics Of Private Sector Good
 Characteristics Of Public Good
 Project Planning Or Project Appraisal
 Cost-Benefit Analysis
 Analysis And Evaluation Of Benefits And Costs
 Social Rate Of Discount
 Limitations And Benefits Of Cost-Benefit Analysis
 Justification For Cost-Benefit Analysis

19.2 INTRODUCTION

In all previous chapters (from 3 to 18), attention was focussed on the problems of decision
making and resource allocation in the private sector, though the principles of microeconomic
theory discussed therein do apply to and can be made use of in taking managerial decisions on
the problems of the public sector and non-profit organisations. However, it is pertinent to note
that the public sector enterprises and non-profit organisations (see Chapter 2) generally prefer a
set of other normative goals rather than just concentrating on efficiency and profitability
criteria. Their other normative goals include:1
1. Achieving an equitable distribution of income;
2. Maintaining economic stability and full employment;
3. Controlling the country's balance of payments; and
4. Satisfying the demand of the primary contributors to not-for-profit organisations.
In developing countries, the emphasis is on the overall development of the economy. In our
country, till 1991, emphasis was on the establishment of a socialistic pattern of society. The
prime role was assigned to the development of heavy and strategic industries in our planned
economy till 1991, that too in the public sector. Still many of India's problems are unsolved,
such as regional imbalances and income disparities, social injustice, large population below
the poverty line, mass-scale illiteracy, slow rise in per capita income and low standard of living
for the majority of the people. The normative goals for these developing countries like ours will
be to deal with these problems.

Within the constraints of these normative goals, the objective of allocation of resources most
efficiently is very important in all organisations.2

Public sector corporations and non-profit organisations face a variety of problems, such as
provision of education, transport services, recreational facilities, national defence, health care
services for the poor, the aged, etc. These organisations also perform functions like managing
national resources, income maintenance, income transfers, equitable distribution of income,
research programmes, hospitals, police force protection, generation and distribution of power,
other infrastructural services, etc.

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19.3 PRIVATE GOODS AND PUBLIC GOODS DISTINGUISHED

In a purely competitive economy, market indicators like prices, supply and demand direct the
rational allocation of resources. However, nowhere does this type of economy exist, whether
countries are developed or developing. There are market distortions, market imperfections
and market failures. Market forces cannot be a useful guide for allocating resources, for
selecting public sector projects or projects for not-for-profit organisations. It is, therefore,
necessary to bring out distinguishing features of private and public goods.

19.3.1 CHARACTERISTICS OF PRIVATE SECTOR GOODS

1. Divisibility and excludability:

Private goods are divisible and excludable. Nearly all private consumers' goods are capable of
being divided into small units for consumption. For example, ball pens, clothes, tables,
chairs, shoes, etc.

Private consumption goods are excludable in the sense that non-buyers are excluded from
receiving the pleasures of consumption. For example, inheritance laws and property rights
exclude non-inheritors, non-owners of goods and property from the benefits of consumption
of inherited or owned private goods.

2. Externalities:
There are several economic transactions in production, distribution and consumption which
have side effects from which either benefits or harmful effects accrue to the people not
directly involved in such transactions. These side effects are called externalities. These
externalities from economic transactions, projects, etc. may be either beneficial or detrimental
to a third party not concerned in such activity. For example, a fertiliser factory may emit foul
smell into the atmosphere causing diseases or hardship to the people residing in the vicinity
or a cotton mill or a chemical factory may dump its effluents into the nearby river or sea,
which may have hazardous effects on the fishery, and fishermen may suffer because of
destruction of fish due to pollution. An example of beneficial externality is the advantage of
training by a firm, to other firms who receive trained workers. These externalities are so
called because these effects are external to the price mechanism of the market. These are
called 'spill-over effects' ox 'third party effects'. External benefits and costs are also known as
external economies and external diseconomies.

Externalities are defined as those effects of economic transactions due to which a third party
receives benefits or bears costs arising from these economic transactions in which such third
party is not a direct participant? When the producer builds a project, it may provide benefits
to others (third parties) for which the producer does not receive any payment. For example,
training scheme for the company workers. Benefit of such scheme not only goes to the
company workers, but also to other firms which may attract such workers for their purpose.
But the workers shifting to and getting higher wages in such other firms cannot be asked to
reimburse the cost of training, while leaving the original company that has trained them. In
the same way, a company may be responsible for inflicting cost on a third party due to its
project but the company is not required to compensate in a market oriented economy. We
have already cited the example of harmful effects of effluents released by a textile or
chemical factory into the rivers or seawaters, which cause damage to the fishery, and
fishermen have to bear the cost of getting less fish than before.

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Since in private decisions, externalities are not taken into account while planning for a
project, there is a misallocation of resources from the point of view of the whole society. The
society suffers at the macro level and the producers make profits at the micro level.

3. Monopoly power:

Since there never existed perfect competition in the real world, there has always been a
tendency among giant firms to eliminate small producers and maintain their monopolies. In
this age of technology development and large-scale production, this tendency is increasing.
This obviously results in higher prices and low level of consumption. In the private sector,
this is a common phenomenon.

4. Availability of information:

In a competitive market for private goods, there is access for consumers to compete, low cost
information which is available from the market, which enables them to pay right prices for
products they buy. If such information is not available, consumers pay higher prices and buy
inferior quality of goods.

19.3.2 CHARACTERISTICS OF PUBLIC GOODS

Public goods are those goods which can be consumed by more than one person at the same
time, and it is difficult to exclude potential consumers. Public goods are jointly consumed by
a group of people, e.g. defense, construction of a bridge, irrigation work, etc.

1. Indivisible and non-excludable:

Public goods are indivisible and non-excludable. These goods are available in bulk. Hence,
additional consumption does not add to the marginal cost and non-consumption partly does
not reduce the marginal cost of production. For example, under utilised or crowded trains,
under utilised or crowded public transport, radio and television programmes are other
examples of public goods. The cost of transmitting these programmes is the same whether
one person or a thousand persons view such programmes.

Public goods are non-excludable. Public goods and services like defence, street lighting,
health services, etc., are non-excludable; they are shared jointly by all whether anybody pays
a tax or not.

2. Externalities cannot be ignored:

While choosing public goods programmes, externalities cannot be ignored. Benefits and
costs to third parties and the whole society have to be taken into account while choosing a
public sector project or projects of not-for-profit organisations. A pertinent question to be
considered with regard to the production of public goods is whether social benefits exceed
social costs.

3. Market information not available:

Unlike the case of private goods, market information about the supply and demand conditions
for public goods or for activities of not-for-profit organisations is not available, since there is

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no competitive market or market mechanism for public goods, whereby public preferences can
be expressed. Decisions regarding choosing of production methods for public goods or for that
matter choosing of public goods to be produced cannot be based on market information as
there is no market indicator to provide such information. Consumers of public goods may not
reveal the prices they are prepared to pay for such goods as they may expect to get them free
and want others to pay for them.

4. Problem of goods with decreasing costs:

Next is the problem of goods with decreasing cost conditions, when the size of the plant is
enlarged to produce on a mass-scale, if such are essential goods or goods satisfying merit
wants. In the case of decreasing cost conditions of production when the plant is very large and
fixed costs occupy a large part of the total costs, significant economies of scale take place.
Under private monopoly, in such cases, the price of the good is fixed such that the marginal
revenue equals marginal cost. But the MR being much lower than the average revenue (i.e.
price) under monopoly, the price is fixed at a higher level than the marginal revenue. In the
case of public goods, however, this cannot be a criterion. Since fixed costs are incurred only
once and the goods are for the benefit of the whole community, the price has to be fixed
somewhere near the marginal costs.

Thus, public goods are characterised by indivisibility, non-excludability, non-monopoly,

favourable and unfavourable externalities, absence of market information and decreasing cost
of conditions in many cases.

It is for these reasons that the capital budgeting analysis discussed in Chapter 18, which is a
guiding factor for choosing projects in the private sector, cannot be applied to choose projects
in the public sector and in not-for-profit organisations, where objectives other than profitability
have prime importance. These are, to name a few, assistance to the poor, the aged and the sick,
anti-poverty drive in developing countries, employment to the educated and the uneducated in
urban and rural areas, redistribution of income, economic growth with stability, national
defence, and so on. Within the constraints of these objectives, efficiency criterion is Applied
to approve projects in the public sector and projects of not-for-profit organisations.

19.4 PROJECT PLANNING OR PROJECT APPRAISAL

In these days of planning, investment pattern is not only guided but carefully planned for the
whole economy. Investments in the public sector are directly decided by the government and
those in the private sector are controlled and directed by governmental agencies. Since the
national objectives and priorities are expressly laid down, particularly in developing countries,
projects selected should give better benefits than any available alternative projects, and these
selected projects should satisfy the national objectives to the maximum. Different alternative
projects have to be formulated and evaluated for comparing their contribution to the
objectives of the nation. The real worth of the projects to the entire economy has to be
appraised before any such project is chosen. The worth of the project has to be ascertained in
terms of national or social profitability which may differ from commercial profitability.
Individual firms would certainly base their choice on the basis of commercial profitability.
National benefits and costs may differ considerably from benefits and costs of the individual
firm. The techniques of project appraisal have been designed to evaluate projects both in the
public and private sectors in order to ascertain their benefits and costs to the whole economy,
keeping the national objectives and priorities in view. This technique is known as 'Cost-
benefit Analysis'.

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Project appraisal does not rest on a set of techniques that can be applied mechanically but is
an approach that must be interpreted analytically.5 Interpretation of projects become essential
because of the absence of perfect competition with no externalities. Markets in developing
countries are imperfect, distortions are commonly prevalent in foreign trade prices, factor
markets, the non-optimal income distribution and in use of non-optimal taxes and subsidies.
Some fiscal and monetary policies by themselves cannot correct these distortions. Choice of
investment projects through project appraisal is necessary to correct these distortions in
developing countries like ours.

In a perfectly competitive economy, there would be equality between the Marginal Social
Cost (MSC) and the Marginal Social Value (MSV) through market prices of goods and
factors. Then economic costs and benefits and the private commercial profitability will be
equal to social or national economic profitability. This is because the values of outputs and
inputs and market prices would reflect the correct values to be used for calculating the net
present value (NPV) of the project. However, as mentioned above, this is not so in developing
economies. There exists monopolies, glaring inequalities of incomes, externalities and price
distortions. Subsidies and taxes have to be used. Market prices are not honest prices; they do
not reflect the real value of inputs and outputs to the whole nation. Prices do not consider the
social benefits of merit wants. Therefore, they do not equate the MSC and MSV of different
commodities.
Check Your Progress – 1
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Project Planning or Project Appraisal.
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19.5 WHAT IS COST-BENEFIT ANALYSIS

In general, cost-benefit analysis is a method for assessing the desirability of a project, when it is
necessary to take both a long and wide view of the repercussion of a particular programme
expenditure or policy change.6 As in the case of capital budgeting in the private sector, cost-
benefit analysis is often used in cases where the economics of a project or a policy change is
likely to extend beyond one year in j time. However, unlike capital budgeting, cost-benefit
analysis seeks to measure all economic impacts of the project, that is, side effects as well as
direct effects.

Cost-benefit analysis (CBA) becomes relevant for the policy of the public sector and not-for-
profit organisations. CBA renders valuable help in macroeconomic decisions of allocation of
the aggregate investment budget among different projects I and the selection of projects to be
undertaken. The CBA measures social benefits and social costs as distinguished from private
benefits and private costs where choosing from alternate projects and policies in the public
sector and projects of nonprofit organisations is involved.

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CBA was first developed in France in 1844 by Jules Dupuit (On the Measurement of the
Utility of People's Works). CBA was used in America as a technique of project evaluation to
judge achievements of 'New Deal' programmes in the late thirties. United States' Flood
Control Act of 1936 was the landmark in the history of the United States. The technique of
CBA was widely used for developing countries by the agencies of the United Nations and the
World Bank during the early sixties. There are two major publications from UNIDO (United
Nations Industrial Development Organisation) in 19587 and OECD (Organisation for
Economic Cooperation and Development) in 1968.8 Much work has been done on this
technique later.

19.5.1 USE OF COST-BENEFIT ANALYSIS

CBA can be used for a number of purposes, depending on the nature of the project,
constraints of public policy, and the requirements of the information user or decision
maker.10

1. Accept/Reject decisions:
CBA can be used to determine whether a specific expenditure is economically justifiable. For
example, the recent (1996 Jan.) anti-polio vaccine programme in our country. The
expenditure is justified due to its several benefits, particularly to children and generally to
their parents in the long run, which have far exceeded the cost of the programme.
Benefits may be categorised in the cost avoided as mentioned below.
(a) Expenditure avoided on medical care of the child who may suffer from polio, which
includes fees of doctors and nurses, costs of medicines, equipment charges, hospital
charges, etc.
(b) Loss of earnings to the parents and to the child when he becomes an adult.
(c) Decreased or even 'nil' earnings to the child when he becomes employable.
(d) Mental and physical pains and strains associated with polio if the child is attacked
by the disease any time.

2. Expansion or reduction of public programmes:

The CBA helps in taking decisions about expansion or reduction in public programmes once
they are undertaken. For example, in our country, increase in antipoverty programme
expenditure or expenditure on creating employment in the rural sector may be justified on the
basis of cost-benefit analysis.

3. For general theory of resource allocation:

CBA technique serves as a guide for resource-allocation decisions both within and between
major government programme areas, such as health, education, defence and social welfare.
In short, maximisation of society's wealth is the primary objective function in cost-benefit
analysis."

19.5.2 CONSTRAINTS IN CASH-BENEFIT ANALYSIS

Objectives of the cost-benefit analysis may be limited by a number of constraints
that may exist while achieving them. These are:
1. Physical constraints such as limitation due to the extent of availability of technology,
production possibility due to input-output relations.

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 2. Legal constraints due to domestic and international laws about property rights.

3. Administrative constraints as individuals with the proper mix of technical and

administrative skills for carrying the public sector jobs are not available in sufficient
quantity.

4. Distributional constraints: Since gainers from a public policy or public sector

expenditure are seldom the same people who are losers, care has to be taken to ensure
that benefits-less-costs for a particular group reach a pre-specified level. It is necessary
to identify as to who are the gainers and who are the losers and whether the pre-
specified group has gained and the gain exceeds the loss to other groups.

5. Political constraints: Due to slowness and inefficiency of the political process, what is
considered an optimal public programme may not be feasible. It may happen that what
is best, is reduced to what is possible. Economic efficiency may be sacrificed for the
sake of political expediency,

6. Budget or financial constraints: In many cases, though socially beneficial, certain

programmes cannot be carried out to the level of optimising form of maximising
benefits because of budgetary constraints. Generally, all public programmes have some
absolute financial ceilings.

7. Social and religious constraints: Social constraints refer to social institutions,

traditions and social age old beliefs. Religious constraints refer to religious superstitions,
usages and beliefs. These constraints set a limit to the range of feasible public sector
projects or programmes of not-for-profit organisations. For example, people may not
allow or accept certain public programmes, however, they may be beneficial to them. If
these are against their religious beliefs and much of the expenditure would be wasted,
unless there is a simultaneous programme to educate them.

Stages of Project Analysis

G.M. Meier points out, project analysis can make maximum contribution to better allocation of
resources. Each stage of project preparation is crucial. The stages are:
1. Project identification.
2. Feasibility studies of technical possibility.
3. Feasibility studies of economic viability.
4. Fiscal calculation of Present Net Social Value.

19.6 ISSUES INVOLVED IN COST-BENEFIT ANALYSIS OR PROJECT

EVALUTION

The following issues are involved and have to be considered in social cost-benefit analysis:
1. Choice and formulation of constraints for deciding shadow prices or efficiency prices,
2. Specification of costs and benefits,
3. Valuation of costs and benefits,
4. Treatment of risk and uncertainty.
5. Choice of the rate of discount (interest) for discounting future costs and benefits, and
6. Choice of a decision rule for accepting or rejecting projects.

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Shadow prices:
Since market prices are not honest prices due to a number of reasons, such as market
imperfections in developing countries, emergence of monopolies, existence of glaring
inequalities of incomes, externalities and price distortions. Market prices, therefore, do not
reflect real value of inputs output to the whole nation. These prices do not consider the social
benefits of merit wants. Market prices which are used for calculating private commercial
profitability cannot be relied upon in social CBA.

It is for the above reasons, shadow or accounting prices reflecting scarcities are used for
project evaluation based on cost-benefit analysis. Imputed values that is the economic values
of costs and benefits are used in cost-benefit analysis. There is a great divergence between
Marginal Social Costs (MSC) and private costs and Marginal Social Value (MSV) and
private value and hence shadow or accounting prices are used after considering imputed or
economic value to costs and benefits resulting from public projects or from the activities of
not-for-profit organisations. Shadow prices involve efficiency prices which take full account
of scarcities, externalities and other impacts, such as consumers' surplus, welfare of future
generations and achievement of plan goals.

Why to calculate costs and benefits in terms of shadow or accounting or efficiency prices for
cost-benefit analysis? We have already noted above the main causes for this. Guidelines of
Project Evaluation published by UNIDO, United Nations, in 1972, point out that if a good
priced at £ 1 (or say Re. 1) gives the satisfaction worth £ 1 (or Re. 1) to the purchaser, does it
mean that its social value is also worth £ 1 or Re. 1? It may not be so for many reasons
outlined above, particularly when prices offered in the market are influenced by income
distribution and hence cannot be a good guide for social welfare in midst of inequality of
incomes.

Location:
The objective of redistribution of income from the point of view of social justice can be
achieved better by locating a public project in a poor region, using unskilled, poor labour,
than in a rich region using factors supplied by rich people. Thus, project choice has
distributional implications and it may be politically and socially more feasible to redistribute
income in this way by choosing projects located in backward regions rather through taxes or
other direct means.

Externalities to be considered:
Environmental dangers of a project, such as emission of smoke, foul air, destruction of
forests leading to ecological imbalances, are undesirable. Advantages of such projects in
providing training to local labour force may be laudable and desirable. These externalities
have to be taken into account while choosing a project. Externalities can arise in the process
of production, consumption and sales and distribution.

Consumers' surplus:
The extent of consumers' surplus is also important in choosing alternative projects on the
basis of social cost-benefit of a project. It is relevant to know the respective magnitude of the
consumers' surplus from alternative projects.

Welfare of future generations:

While calculating the present value (PV) of a project, individuals and firms in the private
sector consider their own life while estimating the private profitability. But in calculating PV

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from social point of view, planners and the governmental agencies have to take a larger view
and give greater importance to the welfare levels of future generations. Thus, the social rate
of discount to arrive at the PV of alternative projects may differ considerably from the
market rate discount, i.e. the current market rate of interest.

Maximum achievement of plan goals:

One of the most essential aspects in choosing projects whether in the public sector or private
sector from national point of view is that the evaluation of investment projects should be
carried out within the broad framework of objectives of planning. The projects chosen among
the feasible alternatives should be those that contribute most towards the achievement of
planned goals. Thus, there should be clear statement of the planning objectives before the
cost-benefit analysis is undertaken to evaluate various projects for choice.

Plan goals are generally many:

1. Raising the standard of living (present and future).
2. Improving the distribution of income.
3. Achieving economic independence.
4. Reducing unemployment, etc.
However, these goals are conflicting. Hence it is possible that one project may fulfil one goal
better and another project will achieve more in terms of another goal. The conflict can only
be resolved by allotting weights to divergent achievements.

We may take a few examples in this respect. The planners will have to choose the discount
rate after considering the expected growth rates of total consumption and of population.
While considering the goal of equality in distribution, the backward regions may be given
preferential treatment. For projects satisfying merit wants, such as education, self-reliance in
modern industrial technology, wider dissemination of modern science, employment of female
lab6ur in regions where there is no emancipation of women, additional weight age may be
given. These are meritorious expenditures.

As regards the goal of expansion of employment (in the present or the future), more
weightage may be given to additional/employment generation. The preferences should show
the amount of consumption which planners are ready to sacrifice for generating an additional
unit of employment. Similarly, a favourable balance of payments impact and/or earning of an
extra unit of foreign exchange from a project may be used to allot more weightage to such
project.

19.7 ANALYSIS AND EVALUATION OF BENEFITS AND COSTS

Just as in the traditional economic theory, private revenue of the project must equal or exceed the
private costs over the long period for a firm in the private sector, in respect of cost-benefit analysis,
the economist considers whether the whole society is better off by undertaking or not
undertaking a particular public project or by adopting one project to the exclusion of other
alternatives. Thus, the concept of social benefits in the place of private profits is considered in
the cost-benefit analysis, and instead of private costs, opportunity cost or social value
sacrificed elsewhere in choosing a specific public sector project or activity has to be
considered. For example, in constructing an irrigation project, the advantage to the whole
society is evaluated and its cost considered in terms of opportunity cost, say, by not devoting
the resources for some other alternative project in that or any other locality.

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According to McGuigan and Moyer (Managerial Economics, 1986), the following two
conditions are to be satisfied in choosing a public sector project or activity:
1. Consumers equate the value of the marginal unit of each commodity consumed to the
value of foregone alternatives, and
2. Producers operate so that each commodity is produced in a manner that sacrifices the
lowest value of foregone alternatives.

19.7.1 MEASURING DIRECT BENEFITS

Direct or primary benefits of a public sector project accrue from conditions associated with
the project as compared to the conditions without the project. For example, the primary
benefit of an irrigation project is the additional value in terms of crops produced in the
irrigated land minus the cost of production of the crops, viz., cost of seeds, fertilisers, labour,
etc., the direct benefit from adult education expenditure will be the benefits accruing to the
beneficiaries. There are, of course, serious conceptual problems while calculating direct
benefits from public sector activities, such as expenditure on health care, anti-poverty
programmes and other welfare activities.

19.7.2 DIRECT COSTS

Direct costs of public sector projects do not pose much problem. These can be measured in
terms of capital cost of the project, working costs in operating and maintaining the project
over its life and the cost of labour. However, while taking decisions in incurring money cost, it
is necessary to consider the opportunity cost of the project. For example, a vacant and idle
land may be used for the project, but its opportunity cost will have to be treated as zero
because it has no alternative use; it is immaterial that a sizeable compensation is paid to its
owner; it is just a distributional benefit to the owner for the use of land. Similarly, even
though wages are paid to unemployed labourers now employed on a public project, it is
necessary to consider the advantages of reducing unemployment. The social cost in such a
case will be much less than the market value of employing labour on such public sector
project.

19.7.3 SECONDARY OR INDIRECT BENEFITS AND COSTS

Government expenditures on public sector projects have invariably secondary or indirect

impacts. Secondary benefits and costs may be classified into:
1. Real or technological effects
2. Pecuniary effects.
Real secondary benefits are in the form of outlays avoided in other government projects or
activities. For example, expenditure on eye camps and free distribution of vitamin A tablets to
prevent or reduce occurrence of blindness among the people helps in avoiding expenditure on
the upkeep of the blind and on special training of these people, on finding jobs for them and
on their rehabilitation. Expenditure on dams and irrigation works avoids floods and
consequent expenditure on flood victims, etc. It is, therefore, necessary to count these
secondary or indirect benefits in the cost-benefit analysis.

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Similarly, it is necessary to count secondary costs resulting from undertaking a public sector
project. For example, while constructing a major dam like the Narmada dam in Gujarat state,
secondary cost in rehabilitating displaced families has to be counted in the cost-benefit
analysis.

Pecuniary benefits in the form of low cost inputs, increased volumes of business or changes in
the land values resulting from a public sector project should generally not be included in
counting benefits. Many of these benefits are distributional in nature.

Intangible: In case of certain intangible benefits, it is extremely difficult or even impossible to

calculate rupee value of such intangible benefits. For example, improvement in quality of life,
aesthetic contributions (or detriments) and favourable (or unfavourable) balance of payments
impacts. Such benefits or costs may be listed if these cannot be converted into rupee terms.

19.8 SOCIAL RATE OF DISCOUNT

Where the benefits and/or costs of a project continue beyond a year, it is necessary that they
may be discounted back for the purpose of counting their present value. We have discussed
the need for such discounting of costs and benefits over a period in Chapter 18 on Capital
Budgeting and Investment Decisions under the heading 'Discounted Cash Flow Technique'.
The choice of the appropriate discount rate to evaluate public sector investment is critical to
the conclusions of any cost-benefit analysis.14 There is a profound effect of the choice of a
discount rate on the type of projects to be accepted. According to McGuigan and Moyer
(Managerial Economics), a low rate of discount favours investments with long life, most of
which will be of the durable 'brick and mortar' variety, whereas a high rate favours those
whose benefits become available soon after the initial investment.

Boumol15 recommends the opportunity cost criterion for estimating the social rate of
discount. According to Boumol, resources invested in a particular manner in one sector could
be withdrawn from that sector and invested elsewhere to yield either a higher or lower rate of
discount. Boumel states, 'The correct discount rate for the evaluation of a government project
is the percentage rate of return that the resources utilized would otherwise provide in the
private sector.

For example, if resources can yield 15 per cent in the private sector, then they should earn
more than 15 per cent if they are to be transferred to the public sector. Funds transferred from
the corporate sector should yield higher rate of return than the funds transferred from
consumption. In the latter case, the rate of opportunity cost should be equal to what a risk-
free government bond or security yields. If the government security yields say 10 per cent,
then the rate of discount should not be less than this opportunity cost equal to what is paid on
risk-free government securities.

Boumal concludes,17 'The correct discount rate for a project will be a weighted average of the
opportunity cost rate for the various sectors from which the project would draw its resources,
and the weight for each sector in this average is the proportion of the total resources that
would come from that sector.'

The method of financing and the manner in which resources are acquired for the public sector
project can also affect the rate of discount to be used to find out the PV of public investment
costs and benefits.

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Check Your Progress –2
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Social Rate Discount.
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19.9 CRITERIA FOR INVESTMENT EVALUATION FOR PUBLIC SECTOR
PROJECTS

While selecting from alternative projects in the public sector, we have to apply certain
method for evaluating proposed public project expenditure. Here, we are faced with the
problems similar to those in the case of private investment expenditure, discussed under
'Capital Budgeting' in Chapter 18.

Thus, capital budgeting in the public sector projects involves three problems, viz.,
1. Quantum of money required.
2. Availability of funds. That is whether adequate funds are available or there is a
constraint on funds.
3. Allocation of funds or rationing of funds. If funds are unlimited or fund raising is easy, it
is simply the problem of ranking public sector projects according to their social benefits.
If, however, the funds are limited or scarce, such public projects are selected where the
limited funds are efficiently allocated thus that the net social benefits are maximised.
Since we have already discussed different methods of evaluating projects in Chapter 18, here
we restate some of these methods, in terms of social benefits and social costs.
These methods are:
1. Net present value (NPV) method.
2. Internal rate of return (IRR) method.
3. Benefit-cost ratio method.

1. Net present value method (NP V):

This is discussed in Chapter 18. Net present value of a public project can be found out by
deducting the net cash investment (social cost) from the present value (PV) of the gross
earnings (Social benefits) Over the life of the project. From various alternatives, that project is
acceptable where the NPV is positive and the highest among the alternatives, that is, where the
PV o" benefits is greater than the PV of costs.

2. Internal rate of return (IRR) Method:

Internal rate of return method referisii the rate of discount which equates the PV of social
benefits over the life of the project with the net cash (social cost) investment. In other words,
the social benefits are discounted at that rate of discount which reduced it to zero. If the
project or programme's internal rate of return is greater than or equal to the pre-detess-mined
social rate of discount (discussed earlier), it is acceptable investment. If not, it should be
rejected.

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3. Benefit-cost (B-C) ratio:

Benefit-cost ratio method for choosing a public project is the same as the profitability index
method as discussed in Chapter 18. Benefit-cost ratio is the ratio of the PV of social benefits,
discount at the predetermined social rate of discount to the PV of the costs, similarly
discounted. Thus,

ratio = The sum of discounted social benefits over the life of the project
Discounted social costs over the life of the project

If the benefit-cost ratio for a project is greater than or equal to one, it should be selected. If the
ratio is less than one, the public project should be rejected. Tie method indicates that the
social benefits are greater than or equal to the social costs when the said ratio is greater than or
equal to one. This method is equivalent to the NPV method discussed above.

19.10 LIMITATIONS AND BENEFITS OF COST-BENEFIT ANALYSIS

Cost-benefit analysis is, no doubt, essential while evaluating projects for national investment
of scarce resources for both developed and developing countries. The latter have, particularly,
to achieve a number of macrogoals for their rapid economic development. However, the
analysis presents a number of weaknesses am. difficulties. There are many problems of
enumeration and evaluation. There jaro also practical and conceptual problems. These are
summarized below.

1. Allotting weights:
Firstly, giving weights to a number of conflicting macrogoals poses a difficult problem. Since
there can be no rational criterion, weights are likely to be arbitrary, depending on the order or
priorities laid down by the planners.

2. Arbitrary calculation of costs and benefits:

In the absence of any tool for quantification, calculations of social costs and benefits become
arbitrary, and subjectivity plays its role, which may lead to wrong selections and decisions.
This happens particularly in the case of externalities. For example, social costs involve! in
terms of ecological imbalances, environmental pollution, congestion and crowding due to
construction and establishment of giant projects, destruction of peact, etc., cannot be
quantified and measured. Similarly, social benefits, such as emancipation of women,
promotion of education of children, cultural advance due to certain projects, development of
backward regions apart from distributional benefits, cannot be quantified and measured. As
pointed out by Dr. A.K. Sen, the approach should be to give some value to non-quantifiable in
line with general goals of planning without pretending to accuracy.18

3. Estimating shadow or accounting prices:

This is another difficulty. These have to be efficiency prices. Here also there has to be a lot of
guess work from the experts.

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4. Calculation of social rate of discount problematic:
There is still a lack of unanimity among economists as regards the appropriate social rate of
discount to be applied to find out the NPV of projects in the public sector. Though this is still
an issue of considerable concern, some yardsticks, though not accurate (it cannot be), has to
be applied.

5. Problems due to interrelationships:

In the case of many projects, there exist major interrelationships between the private and
public sectors or within the public sector itself. In such cases, decisions of one public authority
or agency have a profound impact on the performance of others. Either these relationships may
be complementary or conflicting. An example of the former is education programmes and
employment programmes. An example of a conflicting programmes is subsidy programmes
and anti-inflationary programmes. In such cases, it is necessary to determine appropriate
levels of programme activity, which requires a high degree of centralised decision making
and also a more sophisticated level of analysis.19

6. Hurdles in obtaining relevant data: This problem is not uncommon in developing

countries like India. Data regarding the extent of inequalities, the actual number of the
unemployed not reflected in the statistics of the employment exchange bureaus, consumption
standards, the number of people below the poverty line which cannot be correctly identified
regionwise—all this data is far from perfect and at times unreliable, magnified or
underestimated. Now such in correction in data is always to be assumed and discounted
reasonably while arriving at the final estimates.

Check Your Progress – 3

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about Limitations of Cost Benefit Analysis.

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19.10 JUSTIFICATION FOR COST-BENEFIT ANALYSIS

Despite the above-mentioned constraints and problems in calculating costs and benefits of
public sector expenditures, a significant advantage of cost-benefit analysis is that it forces
costs and benefits to be quantified as far as possible rather than to be estimated solely by
hunch and intuition or parochial, log rolling interests.20

The negative role of cost-benefit is worth noting. It at least helps the public authorities in
screening out programmes that are not justifiable on the basis of social costs and social
benefits and saves them from taking wrong decisions and choosing wrong projects.

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Lessons will have to be learnt and improvements made in giving weights; corrections will be
necessary to eliminate errors in determining shadow prices as the plan proceeds. I.M.D. Little
points out, 'Inadequate plans are first formulated using inadequate methods of project-
appraisal. This in turn should permit improvements in project analysis and appraisals and so
on. Macroeconomic planning can be gradually improved in the light of improvements in
microeconomic planning and vice-versa. By such iteration and reiteration, one gradually tries
to come nearer to optimum planning'.21

McGuigan and Moyer write, 'Once the strength and weaknesses of cost-benefit analysis are
recognized, this analysis may be applied in those areas where its potential utility is greatest.
It may be most effectively employed at lower levels of decision making where the range of
programmes being considered is reasonably narrow. When alternative projects are being
considered that have nearly the same purpose, and when the externalities and intangibles
associated with each alternative are roughly of the same magnitude, cost-benefit analysis can
be an extremely valuable tool for making resource allocation.'22

For example, cost-benefit analysis is more useful for choosing regions for locating a
particular public sector project or industry, but will be of limited use in deciding between
cutting of expenditure on defence and increasing of expenditure, say on hospitals. This
analysis could certainly have guided in indicating whether it is necessary to spend (Rs.
1,96,00,000) on buying of Contessa cars for ministers of Maharashtra state or for subsidising
Zunka-bhakhar programmes, which would have benefited lakhs of low income groups in
getting nutritious food at least once a day.

There is no doubt that cost-benefit analysis helps in making explicit economic considerations
connected with various public sector programmes, and it has an explicit advantage of
reducing the degree of subjectivity and, therefore, the level of arbitrariness involved in
resource-allocation decisions.

Check Your Progress – 4

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Justification of Cost-Benefit Analysis.
………………………………………………………………………………………………
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19.12 LET US SUM UP

In this lesson we have studied about Private Goods And Public Goods Distinguished,
Characteristics Of Private Sector Good, Characteristics Of Public Good, Project Planning Or
Project Appraisal, Cost-Benefit Analysis, Analysis And Evaluation Of Benefits And Costs,
Social Rate Of Discount, Limitations And Benefits Of Cost-Benefit Analysis, Justification
For Cost-Benefit Analysis, etc…

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19.13 KEY WORDS

Private Goods Public Goods

Project Planning Project Appraisal
Cost-Benefit Analysis Project Evolution
Measuring Direct Benefits Benefits And Costs
Direct Costs Indirect Benefits
Social Rate Of Discount Externalities
Monopoly power Decreasing costs
Distributional constraints Political constraints
Financial constraints Religious constraints
Shadow prices Consumers' surplus
Net present value method Internal rate of returns

19.14 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

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19.15 ANSWER TO CHECK YOUR PROGRESS EXERCISE
Check Your Progress – 1
1. See section 19.4
Check Your Progress – 2
1. See Section 19.8
Check Your Progress – 3
1. See section 19.10
Check Your Progress – 4
1. See Section 19.11

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BLOCK
7
UNIT 20
GOVERNMENT INTERVENTION IN MARKET

239
UNIT 20
GOVERNMENT INTERVENTION IN MARKET

STRUCTURE
20.1 Objectives
20.2 Introduction
20.3 Laissez faire policy
20.4 New economic policy
20.5 Significance of state intervention in managerial economics
20.6 Weakness or defects of free market mechanism
20.7 Government intervention in advanced countries
20.8 Government intervention in developing countries
20.9 Government intervention in india
20.9.1 1948 industrial policy resolution
20.9.2 industrial policy resolution of 1956
20.9.3 new industrial policy of 1991
20.10 Government measures for price stability
20.10.1 Support/procurement prices
20.10.2 Fixation of issue prices
20.10.3 Buffer stock operations
20.10.4 Administered prices
20.11 Norms or criteria for determining admistrative prices for public sector goods
20.12 Anti-inflationary policy in developing countries(with special reference to india)
20.12.1 Fiscal measures
20.12.2 Monetary measures
20.12.3 Supply management
20.13 Let us sum up
20.14 Key words
20.15 Some Useful Books
20.16 Answer to Check Your Progress Exercise

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20.1 OBJECTIVES

After reading this lesson you must be able to understand the following topics,

 Laissez faire policy

 New economic policy
 Significance of state intervention in managerial economics
 Weakness or defects of free market mechanism
 Government intervention in advanced countries
 Government intervention in developing count
 Government intervention in india
 Government measures for price stability
 Norms or criteria for determining admistrative prices for public sector good
 Anti-inflationary policy in developing countries

20.2 INTRODUCTION

Adam Smith, the father of economic science, advocated laissez faire and free trade policy for
efficient working of any economic system and for the rational allocation of resources of the
economy. In fact, laissez faire capitalism or free market economic policy came into vogue in
the middle of the 18th century. The influence of physiocrats ideology developed in France,
writings of Adam Smith and his contemporaries, writings of the French political thinkers in
France, the French Revolution of 1799, the American Declaration of Independence in 1776,
emergence of a capitalist class—these events led to the adoption of laissez faire and free trade
policies in various western countries—Britain, other West European countries and the United
States. Almost all restrictions on trade, commerce and production activities were removed,
making way for free market mechanism and individualism.

20.3 LAISSEZ FAIRE POLICY

Laissez faire capitalism had many achievements to its credit, such as tremendous increase in
productivity, production of wealth and in the standard of living of the people. Freedom of
enterprise and profit motive led to a higher level of efficiency and rise in per capita income.
Free enterprise mechanism afforded opportunities to individuals to find new commodities,
new processes and new inventions. A variety of innovations, and inventions, technological
progress, changes in consumers' preferences, rapid industrialisation, increasing urbanisation,
development of trans-port and communication, development of international trade—all these
were remarkable achievements of laissez faire policy. Managers of firms' had independence
of taking decisions in the allocation of firms' resources and in respect of forward planning.

However, despite its achievements, the laissez faire economic system created several
distortions in the national economies. Serious evils resulted. Monopolies emerged, which
created many evils like exploitation of labour and consumers, creation of excess capacities,
corruption, wastages, etc. Inequalities of income and wealth increased and two classes of

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'haves' and 'have nots' or rich capitalist class and poor working class emerged. There were
class struggles, economic instability and severe unrest among the masses. Events which took
place between the two World Wars—1914-18 (I) and 1939-45 (II)—greatly shook the roots
of laissez faire as the economic policy. Wars created chronic unemployment, inflation and
fluctuations in exchange rates in the capitalist countries. The Great Depression of the thirties
exposed the weaknesses of laissez faire policy. Depression caused unprecedented
unemployment, bankruptcies and unprecedented collapse in the prices of joint stock
companies. The government could no longer be a silent spectator to these various
happenings. The laissez faire policy was given up. The governments intervened to end the
economic crises, profoundly affecting all sectors of the national economic life.1

20.4 NEW ECONOMIC POLICY

Fortunately, it was for J.M. Keynes to evolve the General Theory of Employment, Interest
and Money, which advocated government intervention for recovering the national economies
from depression, since as Keynes proved that there cannot be automatic recovery of the
economy, wrongly thought of in the classical economic theory. President Roosevelt of the
United States initiated the 'New Deal' in 1933, to fight against depression and unemployment.
The catch phrase was Relief, Recovery and Reforms; policies to give immediate aid to the
unemployed, the destitute and the bankrupt; policies to enlarge the national income and
output and get back to full employment; and policies to initiate structural reforms in banking
and corporate finance, and much else—sufficiently deep to prevent a recurrence of ghastly
depression.2

The new economic policy was thus born in the industrially developed countries, making a
complete departure from laissez faire capitalism, though the main features of capitalism
remained, viz., private ownership of property, freedom of occupation and price-mechanism.
This was the beginning of government intervention in economic activities in the
industrialised capitalist countries. The new system came to be known as 'Welfare State
Capitalism'.

The Second World War further saw increasing state intervention to correct the problem of
inflation created by imbalances in the capitalist countries. Planning of some sort came to be
introduced in almost all the countries of the world. The French planning aimed at economic
rationalisation, full employment, high investment and rapid growth. It has been indicative
planning since then. Today, in India too, there is a shift from some sort of direct planning to
indicative planning since 1991. Many developing countries like India have adopted planning
for their rapid industrial development since the fifties

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

242
 1. Discuss about New Economic Policy.
………………………………………………………………………………………………
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……..

20.5 SIGNIFICANCE OF STATE INTERVENTION IN MANAGERIAL

ECONOMICS

While taking decisions, managers of firms are faced with a number of constraints. Some of
them are external pressures in the form of social or moral obligations. These are the social
responsibilities of the firm. Besides, there are codified legal restrictions and obligations.
These are government regulations which are meant ensure a smooth, efficient and
competitive working of the economy. Manager' resource allocation decisions are greatly
guided and influenced by such government regulations both in developed and developing
countries. Before we look into some aspects of such government interventions, we note down
a few points about the weaknesses of free market enterprise mechanism, necessitating
government intervention.

20.6 WEAKNESS OR DEFECTS OF FREE MARKET MECHNANISM

As we have noted in the beginning of this chapter, the free enterprise economy or what is
called laissez faire was supposed to be in the interest of the people. Any state intervention in
economic matters was looked upon as something evil or dangerous. It was held by the
classical economists that the invisible control in the form of demand and supply or free
market mechanism served the interests of the people in the best possible way.

However, it was observed that this invisible control left to itself, cannot serve the social
interest unless it is accompanied by the visible control exercised by the government. Due to
inequalities of income and wealth in the society, demand of the rich people became the
powerful force which influenced production. Demand of the low income groups and the poor
was completely neglected. Since producers produce for the profits, they serve the interests of
the rich people. Resources are diverted to produce luxury consumption needs of the rich.
Scarce goods are not equally distributed. Higher prices are charged and the poor are left
without such goods. Government intervention in the form of controls and regulations or
planning of some sort which exercises visible control over the market forces, therefore, be-
comes absolutely necessary. The following are the defects or weaknesses of the free market
economy or laissez faire capitalism.

1. Unequal distribution of income:

Under laissez faire capitalism, there is no automatic device to distribute the income equally.
Major slice of the national income goes to the property owning class and industry owners in
the form of interest, rent and profits. Less urgent, superfluous and luxury goods are produced
for the rich. The poor are unable to receive proper education, health services, good food,
decent houses and ordinary comforts. Underprivileged are denied equal opportunities. There
is inequality of both earned and unearned incomes.

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2. Human aspect ignored:
Means of production are owned by capitalists. They are after profits. Workers' rights are not
protected: they do not receive fair wages and are exploited since they are at the mercy of
capitalists. Under capitalism conditions of workers were very bad. Mercenary character of the
system has ignored human aspect. Human welfare is completely lost in laissez faire system.

3.Unemployment and misery:

Free enterprise has produced trade cycles, unemployment and misery. There is instability in
free enterprise. There is always a fear of insecurity to the working class. The sword of
Damocles would hang over the head of the poor labourer. There is poverty in the midst of
plenty.

4. Foreign trade badly handled:

The past experience prior to the government intervention shows that foreign trade is badly
handled by private producers.

5. No automatic full employment:

It is assumed that there is automatic full employment in the economy under free enterprise
price mechanism. There does not exist any involuntary unemployment, but this is proved
wrong during the Great Depression of the thirties. There was persistent unemployment during
the depression. In the USA, during the period of Great Depression of 1930s, capitalism was
in acute crisis. Unemployment as a percentage of total civilian labour force reached a peak of
25 per cent in 1933.

6. Misallocation of resources:
Under laissez faire economy, there was misalloca-tion of resources which were diverted to
the production of most profitable commodities demanded by the rich. Production of essential
goods suffered. While the few rich would celebrate Christmas everyday, the poor would be
groping in the dark under capitalism in West European capitalist societies.

7. Inherent contradictions:
There were inherent contradictions in old capitalism where there was no government
intervention. These are:

(a) Competition creates monopolies: Though competition under free enterprise economy is
meant to increase efficiency and reduce the cost of production in order to sell at lower prices
and capture the market to increase profitability of any enterprise. But as it is observed in the
USA, small enterprises are driven out of the market by an unrestricted cut-throat competition
and waging of advertising wars. This paves the way for the creation and formation of mo-
nopolies, which means higher prices, and exploitation of consumers and labourers. Thus, the
very competition which is a basic feature of capitalism, leads to the creation of monopolies.

(b) Paradox of profitability and unproductively: Secondly, free enterprise economy of

laisse'z faire capitalism contained a contradiction or a paradox of profitability and
unproductively. It is observed that under free market economy, what is profitable is not
necessarily productive. Since there is a tendency among producers under free market
mechanism to raise the value of the produce through the artificially created scarcity there is
no utility creation and t profitability is raised at the cost of productivity to the whole society.

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(c) Paradox of consumer's sovereignty: Under the laissez faire capitalism or free enterprise
market mechanism, the consumer is said to be the king. Production is directed according to
the invisible hand of demand coming from the consumer. However, the experience is
otherwise. The masses with poor purchasing power cannot buy whatever they desire to buy,
since production is directed by a few rich consumers. Secondly, the demand is greatly
influenced and moulded by large-scale advertising and consumers are misled into buying
unwanted, superfluous, redundant goods in the absence of any government control on
production. Thirdly, the very forces of competition lead to monopolistic, unfair trade
practices. Consumers are left to the mercy of monopolistic firms as regards the quality of the
good and its price. The consumer is no more the king under free market mechanism.

(d) Poverty in the midst of plenty:

Another paradox in with regard to overproduction. Wrong calculations and lure of profits
lead to overproduction and consequent unemployment. There are goods in the shop but the
unemployed poor have no money to buy these goods. There is, thus, poverty in the midst of
plenty.

Faults of decentralisation:
Completely free market economy is a decentralised economy and individualistic in nature,
there are conflicts between individual interests and social interests. There are some major
faults of decentralisation.

(a) Less dependable with regard to macroeconomic balances:

The free market economy under capitalism is effective in balancing demand and supply in
individual product markets, but is less dependable with regard to the macro-economic
balances.3 There are wide fluctuations in the overall level of economic activity and in the
general price level. There is much instability and imbalance in theJabour market at the macro
level. There is no device or mechanism under capitalism, whereby the aggregate demand and
the aggregate supply can be brought into equilibrium automatically. Government intervention
of some sort becomes necessary. In the market economy, decisions are taken by millions of
people and, hence there is lack of coordination, and undue expectations are generated which
lead to boom or slump, prosperity or depression, inflation or deflation and so on.

(b) Decentralisation and non-consideration of externalities—non-consideration of

social cost and benefits:
Decentralisation under laissez faire or free market economy has inherent fault of not
considering favourable or unfavourable externalities resulting from private investment
decisions. For example, a firm constructing a dam for private electric power generation, may
not take into account the favourable external effect of the power project, viz., advantage of
diminishing flood damage from the dam. It may not construct such a dam if it is individually
unprofitable. Similarly, a firm may construct a factory near a river. Now this may be
profitable for the individual firm, but it may cause danger to society in the form of pollution
of the river, noise pollution, etc. These are external diseconomies, which are not considered
while taking decisions in the private sector. Gregory Grossman rightly points out that a good

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deal of centralisation through government regulation, taxation or subsidies, nationalization or
outright prohibition is necessary to bring private and social costs and benefits closer together.
Some sort of planning and laying down of priorities are necessary.

(c) Decentralisation and socially disruptive, harmful or politically unacceptable results

of market mechanism:
Another shortcoming of decentralisation under laissez faire capitalism is that a decision in the
market through the working of the invisible hand (demand and supply forces) may tend to be
socially disruptive, harmful or politically unacceptable. Such undesirable effects include
exploitation of labourers, glaring inequality of incomes, overproduction and falling of
incomes, monopoly tendencies, exploitation of consumers, etc. It is to avoid these harmful
trends due to decentralisation that government intervention in the form of legislation to solve
labour disputes, support of farm incomes, support prices for agricultural goods, anti-monopoly
legislation, etc., becomes necessary, and things cannot be left to the market forces of demand
and supply.

Workers were paid not only a subsistence wage but their working conditions were miserable
during the nineteenth century capitalism. The Marxian theory against capitalism was based
on this misery, poverty and ruthless exploitation of the working class. It was for the
governments of various capitalist countries to legislate labour laws like Minimum Wages
Act, Factories Act to ameliorate the conditions of workers. Government regulations today
include ensuring of minimum incomes to individuals, provision of social security measures,
such as protection during unemployment, old age sickness, maternity benefits to women, etc.

8. Only the rich are beneficiaries of growth: Mere growth cannot be the objective of any
economic system today. Composition of output—what is produced and for whom—and
distribution of output are the necessary elements in decision making. However, these
questions are solved in favour of the elite or the affluent class under free market mechanism.
Trickle down theory which says that the benefits of high growth percolate down to the
masses has been proved wrong and unrealistic. Without some kind of government
intervention, without laying down of priorities and without proper direction for the use of
resources, in short, without some kind of planning, free market mechanism would by itself
not be able to promote human welfare.

9. Slow moving: Market economy is slow moving and does not quickly adjust to changing
conditions. A few people make exorbitant profits, whenever there arise scarcities of goods
and services, because resources do not move quickly to areas of scarcity from the areas of
abundance or where there is overproduction. State action is, therefore, necessary for speeding
up the mobility of resources.

10. Wasteful competition: The basic foundation of free market economy is healthy
competition. However, the competition never remains healthy. There is enormous wasteful
expenditure on advertising and sales promotion. Many a time, there is a cut throat advertising
war. Consumers have to pay higher prices.

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In short, free market mechanism or laissez faire capitalism which is supposed to work
through invisible hands of demand and supply forces does not work in the social interest.
State intervention had become necessary to ensure healthy competition, to eliminate
emergence of monopolies or control monopoly malpractices, to prohibit unfair trade
practices, to protect the interests of workers, to rationally allocate nation's scarce resources,
and so on.

20.7 GOVERNMENT INTERVENTION IN ADVANCED COUNTRIES

Though government intervention in economic activities of the private sector became more
and more overt during the Great Depression, i.e. during 1930s, a number of federal laws were
passed in the USA since 1890 as anti-trust legislation to curb monopolistic practices and
prevent formation of monopolies. The laws were meant for maintaining competition in US
industry. The ultimate aim of these antitrust laws has been to protect the people from
malpractices and inefficiencies of monopoly power, and to preserve a competitive economy.
The government of USA passed the first national anti-trust law, viz., the Sherman Act of
1890. Section I of the Act prohibits combinations and contracts of restrictive trade practices;
it prohibits 'every contract or conspiracy in restraint of trade': Section II prohibits
monopolising or attempting to form monopolies. A number of such Acts—were passed
thereafter to prevent unfair monopolistic trade practices. The Clayton Act of 1914 and the
Federal Trade Commission Act 1914 embodied the concept that the competition should be
fair as well as free.

Unreal price discrimination, contracts to exclude selling of competitors' goods, etc., are
prohibited under these Acts. Interlocking directors are also prohibited. The Robinson-Patman
Act of 1936 protects small purchasers against price discrimination that favour large buyers.
The Wheeler-Lea Act of 1938 prohibits unfair methods of competition and unfair and
deceptive acts in commerce. Since there were many loopholes in the Clayton Act, the Celler-
Kefauver Antimerger Act was passed in 1950, which prohibits any merger of companies, if it
tended to lessen competition substantially or create a monopoly. Such antitrust or
antimonopoly Acts have also been passed in other industrialised countries. Many Acts are
also passed for the welfare of workers, such as workers compensation Act, social security
legislations for sickness benefits, maternity benefits, etc.

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Government Intervention in Advanced Countries.
………………………………………………………………………………………………
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……..

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20.8 GOVERNMENT INTERVENTION IN DEVELOPING COUNTRIES

Characteristics of developing countries reveal that these countries have remained poor for
centuries, particularly since they were under alien rule. Their characteristics were;
1. Primary production, i.e. dependence on agriculture with hardly any developed industry
at the time of their independence.
2. Pressure of population, i.e. demographic factor—high birth rate and chronic rural
unemployment.
3. Underdeveloped, unutilised, underutilised or misutilised natural resources.
4. Economically backward population, i.e. low productivity.
5. Deficiency of capital, i.e. low capital accumulation and almost nil capital formation.
6. Dependence on foreign trade, i.e. exporters of raw materials and importers of costly
finished goods.
Per capita income of these countries even today is very low. It was US dollars 300 for India,
430 for Pakistan and 490 for China in 1993 (World Development Report, 1995). 40 per cent
of the people are still living below the poverty line in India. Besides the above characteristics,
these developing countries also suffer from crude and obsolete methods of production, lack of
development of infrastructural facilities like transport, communication and power systems,
illiteracy, social structure ridden by religious domination, castes and traditions, etc.

As a result, there are market imperfections, vicious circles of poverty and unfavourable foreign
trade. Market imperfections include factor immobility, rigid social structure, lack of knowledge about
market conditions and alternatives available, production rigidity and lack of specialisation. Vicious
circles show that poverty and backwardness is followed by poverty and backwardness due to defi-
ciency of capital which is due to low demand, low income and low savings. Unfavourable foreign
trade had created a small developed export sector exporting raw materials at low prices with
exploitation of peasants and importing finished goods at high prices, keeping the economy backward
and unstable. Foreign remittances aggravated the situation.

It is for these reasons, many developing countries adopted planning—some socialistic or

communistic type and some democratic type. Things could not be left to the invisible hand, viz.,
laissez faire capitalism. Government intervention in the form of planning became a sine-qua-non of
economic policy of these developing countries. India, which was highly undeveloped and poor on the
eve of independence, accepted democracy as a form of her government and decided to go for rapid
industrial development with the help of Five-Year Plans. Government's intervention in our economic
affairs is clearly reflected in India's industrial policy resolutions and industrial and economic policy
statement announced by the parliament from time to time.

Check Your Progress – 3

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Government Intervention in Developing Countries.
……………………………………………………………………………………………
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20.9 GOVERNMENT INTERVENTION IN INDIA

Indian economy. India adopted economic planning for this purpose and attempted to allocate
her resources through the Five-Year Plans. So far, seven Five-Year Plans have been
implemented. We have just finished the Eighth Five-Year Plan (1992-1997). The aim of
government intervention in industry and agriculture is to establish the socialistic pattern of
society in India.

In the case of agriculture, the Indian government introduced a number of land reforms, and
the state governments were directed to enact laws accordingly. This was meant to stop
exploitation of the actual tiller of land for ages. The tenants on the farm were greatly
indebted. There were a number of intermediaries between the state and the actual tiller of
land. Rents charged to the tiller were very high and exorbitant. The government of India
intervened in this sector by introducing a number of reforms through legislation by the state
laws. These were: Abolition of intermediaries like Zamindars, Talukdars, Jagirdars,
Inamdars, etc. (i.e. land to the tiller reform), tenancy reforms, viz., regulation of rent, security
of tenure for tenants and conferment of ownership on them; ceilings on landholdings and
redistribution of surplus land among the landless labourers; agrarian reorganisation including
consolidation of holdings and prevention of sub-division and fragmentation; and organisation
of cooperative farming. However, the capitalist elements in our agriculture could not be
ended despite the state control and state regulation. A class of big farmers emerged along
with the mass of poor and small farmers.

Government intervention in the industrial sphere after independence took the form of
declaration of Industrial Policy Resolution first in 1948 and then in 1956 by the Parliament
of India. The latter one was in vogue till July 1991. Following is the brief account of these
resolutions.

20.9.1 1948 INDUSTRIAL POLICY RESOLUTION

The policy resolution stated that the state must play a progressively dominant role in the
development of industry recognizing that the private sector has to continue to play an
important role in India's industrial development under the direction and control of the state.
Industries were divided into four categories as under:
1. Schedule 'A' included basic and strategic industries like atomic energy, arms and
ammunitions, ownership and management of railway transport. These industries were to
be the exclusive monopoly of the central government.

2. Schedule 'B' included heavy and key industries like iron and steel, aircraft manufacture,
ship building, telephone, telegraph, etc. In these industries, the private enterprise would
continue, but new undertakings were to be established by the state. The state reserved the
inherent right to acquire (nationalis any existing undertaking in this category.

3. Schedule 'C included certain industries declared as basic industries, which were to be
planned, controlled and regulated by the central government. These were: salt,
automobile, tractors, primemovers, heavy machinery, machine tools—heavy chemicals,
textiles, cement, etc. The central government could nationalise any of these industries.

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 4. Schedule 'D' included the remaining industrial field which was left open the private
sector enterprises, individuals and cooperatives.
Along with the above policy resolution, the government of India passed Industries
(Development and Regulation) Act, 1951. The Act introduced a system of registration for
industrial units and empowered the government to regulate establishment of new units and
expansion of existing ones through a system of licenses from the government, to look into the
affairs of the private sector and take over the management of any industrial unit. The Central
Advisory Committee, Licensing Committee and the Development Council were to advise the
government.

20.9.2 INDUSTRIAL POLICY RESOLUTION OF 1956

This resolution was in vogue till July 1991, when the new economic policy and industrial
policy was announced by the government of India.
The ruling Congress Party adopted at its Awadi Session in Nagpur held in 1954 the Socialistic
Pattern of Society as the country's fundamental and basic goal of Social and Economic Policy.
Besides, there were ambiguities in the 1948 resolution about the role of the state and the
private sector in the industrial development of India. There was a constant threat of
nationalisation. As a result, New Industrial Policy Resolution was adopted by our Parliament
in 1956.

The resolution of 1956 attempts to reflect the contents of the preamble to the constitution of
India which was adopted and enacted by the people of India on 26th day of November 1949.
The preamble states,
The Constitution of India is adopted and enacted to secure to all its citizens:
 Justice, social economic and political;
 Liberty of thought, expression, belief, faith and worship;
 Equality of status and opportunity; and to promote among them all;
 Fraternity assuring the dignity of the individual and the unity and integrity of
the nation.
Besides the preamble, the Directive Principles of State Policy given in part IV of our
Constitution lays down certain provisions which the state has to apply while intervening in
the economic affairs of the country.

'The state shall strive to promote the welfare of the people by securing and protecting as
effectively as it may a social order in which justice, social, economic, political, shall inform
all the institutions of national life.'

'The State shall, in particular, strive to minimise the inequalities in income....'

The State shall strive to secure
 An adequate means of livelihood to the citizens—men and women equally;
Distribute the ownership and control of the material resources of the community so as
best to subserve the common good;
 That the operation of the economic system does not result in the concentration of
wealth and means of production to the common detriment;
 That there is equal pay for equal work for both men and women;
 That the health and strength of workers, men and women, and the tender age of

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 children are not abused and that children are not forced by economic necessity to
enter vocations unsuited to their age or strength.

Further the Directive Principles state that the state shall endeavour to secure, by suitable
legislation or economic organisation or in any other way to all workers, agricultural,
industrial or otherwise, work, a living wage, conditions of work ensuring a decent standard of
life and full enjoyment of leisure and social and cultural opportunities and, in particular, the
state shall endeavour to promote cottage industries on an individual or cooperative basis in
rural areas.

It is further directed in this chapter of the Indian Constitution that the state shall take steps by
suitable legislation or in any other way, to secure the participation of workers in the
management of undertakings, establishment or other organisations engaged in any industry.
Companies Act of 1956 contained a number of provisions to remove the evils of the
managing agency system (MAS) under which private capital and enterprise was entering
Indian industries. Ultimately, MAS was abolished.

The 1956 resolution runs as under:

Industries were categorised into three types:
 Schedule 'A' included 17 industries to be the exclusive responsibility of the
state, viz., arms and ammunitions, atomic energy, heavy electricals, iron and
steel, heavy machinery, etc.

 Schedule 'B' included 12 industries to be progressively state-owned and where the state would
establish new industries. The private sector was expected to supplement the efforts of the
state. These industries were: other mining industries, aluminium and other non-ferrous metals
not included in Schedule 'A', machine tools, the chemical industry, antibiotics and other
essential drugs, fertilisers, etc.

Schedule 'C included the remaining industries, development of which was left to the private
initiative and the public sector. These had to fit into the framework of social and economic policy of
the state. For reasons of national importance, the state may enter these industries.

Joint consultations, progressive participation of labour in management, improvement in living and

working conditions of workers, and raising the standard of their efficiency, had been recognised as
part and parcel of the industrial policy.

Besides the Industries Act, 1951, a system of import licensing and other trade policy measures for
encouraging import-substitution-oriented industries and price and distribution controls in certain
industries at different points of time and in the regulation of import of foreign technology and foreign
capital were other features of India's industrial policy.

The industrial licensing policy led to a number of abuses and the emergence of giant monopolies.
Licences for new industrial units were cornered by large industrial houses through multiple
applications for the same products in order to force close licensable capacity. The implementation of
the industrial policy was haphazard. Licences were issued to new private units even for industries in
Schedule 'B', such as coal, fertilisers, machine tools, etc.

Dutt Committee (Industrial Licensing Policy Enquiry Committee) was set up in July 1967 to enquire

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into the working of the licensing system. The Committee exposed that there was a great concentration
of assets in 20 larger industrial houses. Foreign collaborations were allowed in non-essential luxury
consumer goods, such as refrigerators, cameras, record changers, toilet soaps, etc. .
The Monopoly Enquiry Commission appointed in 1964 revealed high concentration among
three top producers producing 75 per cent of total production of a product in respect of many
consumer goods, like infant milk food, petroleum, 'sewing machines, jeeps, razor blades,
scooters, toothpaste, typewriters, etc. There was both product-wise and country-wise
concentration in a few family of business groups. Following the recommendations of the
Hazari Committee and Dutt Committee, the government of India enacted the Monopolies and
Restrictive Trade Practices Ac 1969 (MRTP Act). Then was introduced Social Control of
Banks (1969).

Seventies and eighties during the seeds of liberalisation were sown and nurture in India.
Many industries were delicensed by the Policy Statements of 1973, 1975 1977, 1980 and
1985. These policies included delicensing of industries introducing of broad branding policy,
raising of MRTP limit to Rs. 100 crore. They was some external liberalisation like
machinery imports being included in op general license to a number of industries, relaxation
of licensing for foreign collaboration.

20.9.3 NEW INDUSTRIAL POLICY OF 1991

Due to the crisis of June 1991, under a great pressure from the IMF and the World Bank, the
government of India had to announce the New Industrial Policy (NIP) and New Economic
Policy (NEP) in July 1991, which was explained in Chapter 24. The following is a summary
of the new policy:
The NEP aims at securing the new goals of liberalisation, privatisation and globalization.

1.11 out of 17 industries reserved for the public sector dereserved and opened for the
private sector:
The 1956 industrial policy resolution had reserved 17 industries exclusively for the public
sector. As a step towards liberalisation, 11 industries from this list are dereserved and
removed from the list. These are now open for the private sector.

2.Radical changes in industrial licensing policy:

Industrial licensing policy was abused by the ministers and bureaucrats, who had thwarted the
growth of industry. Many radical changes are made.

• Concept of capacity licensing is abolished.

• Licensing is abolished for all industries except for 15 industries involved in hazardous
products and for safety reasons.
• Compulsory licensing will not apply to the small-scale sector with regard to the reserved
items.
3.Encouragement to foreign investment:
Automatic approvals will be granted for direct foreign equity investment up to 51 per cent of
the total capital invested in the case of 34 specified industries in Annex II of the statement.
The list is further enlarged.

4.Foreign technology agreements: Foreign technology agreements will now get automatic
permission within the prescribed limits for the above-mentioned industries.

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5.Public sector reforms (privatisation): The items in the reserved list for the public sector
is pruned to just 6. Even in these six industries, private investment may be allowed.
Secondly, now sick public sector enterprises will be referred to the BIFR (Board of Industrial
and Financial Reconstruction) for rehabilitation or closure.
Thirdly, part of the shareholding of the public sector enterprises has to be disinvested and
offered to mutual funds, financial institutions, general public and workers.
According to the new policy, the public sector will henceforth focus attention only on
strategic, high tech and essential infrastructure and not on the production of consumer goods
and services sector.

6. MRTP Act amended: The threshold limit prohibiting expansion beyond a certain level of
investment in assets (Rs. 100 crore) is totally removed. Secondly, there will be no bar to
mergers, amalgamations and take over in the private sector. Thirdly, emphasis will be on
controlling and regulating monopolistic, restrictive and unfair practices by the MRTP
Commission. Besides the above reforms, a number of relaxations have been made recently.
These are:
1. Full convertibility of rupee on trade account.
2. Liberalisation of trade policy. The list of open general license is enlarged to include
intermediate goods.
3. Import duties have been brought down substantially. The peak rate is reduced from 150
per cent to 50 per cent now in the budget of 1996-97.
4. The capital market is greatly liberalized and government control on capital issues is
withdrawn. The office of the Controller of Capital Issues is abolished.
5. The SEBI (Securities and Exchange Board of India) is converted into a statutorily
empowered Board to regulate the functioning of capital markets and stock exchanges.
6. Substantial liberalisation of FERA: The Foreign Exchange Regulation Act 1973
(FERA) is substantially relaxed and liberalized in January 1993.
7. 100 per cent foreign equity by non-resident Indians is allowed in high priority and other
industries; they can invest in export houses, trading houses, hotels and tourism related
industries.
8. A five-year tax holiday is allowed for new units in backward areas and union territories
and for power generation anywhere in India.
9. A safety net is created for retrenched workers due to new reforms in the form of National
Renewal Fund.

20.10 GOVERNMENT MEASURES FOR PRICE STABILITY

One of the important purposes for government intervention in the economic affairs of India is
the objective of price stability. Social justice is another objective. For this purpose, the
government of India has used fiscal and monetary measures. Besides, it has used supply
management policies which include price controls, support prices and administered prices.

Price controls: In order to ensure supplies of goods at reasonable prices, state governments
were asked to fix the wholesale and retail prices of foodgrains on the recommendations of the
Agricultural Prices Commission. Procurement prices are fixed for major crops by the
government.

Price controls were introduced during the sixties and early seventies, for essential goods like

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cement, paper, sugar, etc. However, these price controls paradoxically led to hoarding of
goods, black marketing and artificial shortages. This aggravated the situation, as for example,
controlling of cement prices led to shortages and black marketing of cement.
Following the recommendations of the Foodgrains Policy Committee of 1947 for progressive
decontrol, restrictions which were imposed during pre-independence period were relaxed in
respect of foodgrains. However, due to the food crisis of 1948, when food prices rose sharply
controls were reintroduced. Food situation had improved during 1953-54 and controls were
almost removed. Again food prices increased by the middle of 1955, and controls were
partially reintroduced. The government of India introduced state trading in foodgrains (rice
and wheat) in 1958. But this measure failed miserably.

Price controls are meant for protecting the vulnerable sections of the community. But at the
same time, care should be taken to ensure that price controls do not reduce incentives to
produce more. It is also necessary that price controls should be such that some consistent
relationship between agricultural prices, prices of manufacturers and prices of various services
is established.

Whenever there is acute scarcity, effective price controls prevent producers from raising the
prices of essential goods. Price controls are abused unless the government machinery is
strong and effective and free from bureaucratic corruption. In the absence of effective
administration of price controls, goods are hoarded, black-marketing thrives, corruption
increases and the purpose is defeated. Price controls, therefore, should be used as a medicine
and only for short periods. The long-term solution is to create incentives for producers to
produce more quantities so as to match the increasing demand as the economy develops.

In recent years, the government of India has adopted flexible price policy. Price controls have
been removed in respect of many commodities, such as cement, iron and steel, sugar, etc.
Price controls exist mainly in respect of bulk drugs and certain varieties of paper.

20.10.1 SUPPORT/PROCUREMENT PRICES

In the case of agriculture, monsoons play a very important role in deciding the production of
agricultural goods. If the monsoons fail, there are shortages in production and agricultural
prices rise enormously. If the monsoons are favourable, there is glut in the market and this
brings down the agricultural prices, many a time, even below the cost of production, and poor
farmers suffer. The government of India uses three types of policies.

Declaring support/procurement prices before the start of the sowing season: These
prices are fixed for main agricultural commodities like rice, wheat, maize, pulses, etc. In case,
the market prices of major crops fall considerably below the support prices, the government
of India guarantees to buy these commodities at the declared support prices. Thus, support
prices are an assurance to the farmer at the time of sowing that he would get a fixed price for
his product and need not worry about any fall in the market price below this support price.
The government also compulsorily procures part of the foodgrains at these prices. The
support/procurement prices are announced by the government of India on the
recommendations of the Commission for Agricultural Costs and Prices (formerly known as
the Agricultural Prices Commission which was set up in January 1965). While recommending
the support/procurement prices, the Commission is required to consider three requirements:
providing incentive to the producer for adopting improved technology, for maximising
production and for developing a pattern of production appropriate for national requirements;
ensuring rational utilisation of land and other resources, and keeping in view the likely effects

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of the price policy on the rest of the economy, particularly on the cost of living, level of wages,
industrial cost structure, terms of trade between agriculture and other sectors of the economy,
etc.
While recommending revision of minimum support/procurement prices, the Commission
considers, among other things, the changes in production costs of the product and the inter-
crop balance.

Shortcomings: The main shortcoming of the declaration of support/procurement prices is that

many a time it is politically motivated and higher support prices are fixed to please local
interests and strong agricultural lobbies. Secondly, any increase in support prices, particularly
wheat and rice and coarse grains, in turn, leads to increase in the market prices of these goods
and also the issue prices for public distribution system. Increase in the issue prices
consequent on increase in support prices affects the vulnerable sections of the community
who are already living below the poverty line.

20.10.2 FIXATION OF ISSUE PRICES

In order to protect the interest of the low income group, there is public distribution system
(PDS). Essential agricultural and other goods are sold at the government fixed prices through
fair price and ration shops. These fixed prices are known as issue prices. The PDS system
plays a significant role in ensuring smooth supply of the essential goods at fair prices,
particularly to the weaker sections of the society. Essential agricultural and industrial products
are procurred by the government at procurement prices which are lower than the market
prices. A part of total private production is thus procurred compulsorily and the remaining
supply is allowed to be sold by the private producer in the open market at market prices
which are decided by the forces of demand and supply.

Issue prices for selling essential products through the PDS are little higher than the
procurement prices or these may be subsidised by the government for the benefit of the poor
consumers.

In India, since support/procurement prices are increased from time to time, issue prices are
also increased and the very purpose of protecting the vulnerable sections of the community is
defeated. Increase in the support prices and procurement prices has an adverse impact on
market prices which are also increased and the entire price structure gets distorted.

Check Your Progress – 4

Note: 1. Give your answer in the space given below.

2. Check your answers with those given at the end of the unit.

1. Discuss about Fixation of Issue Prices.

…………………………………………………………………………………………………
…………………………………………………………………………………………………

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………………………………………………………………………………………………..

20.10.3 BUFFER STOCK OPERATIONS

Another way of controlling and stabilizing the price level of foodgrains and essential
agricultural products is by maintaining buffer stocks. Buffer stock operations serve a dual
purpose, viz., preventing the price fall during harvest of essential agricultural commodities.
And secondly, price moderation during years of shortfall in supply. Presently, the government
of India deals in buffer stock operations in respect of foodgrains.

For its effective implementation, it is necessary that buffer stock operations should be properly
planned out, protecting both the interest of the consumer and also providing an incentive price
to the producer. The operations to be successful must be timely and of such a magnitude that
a desired impact on prices is secured, since scarcities of foodgrains has an immediate adverse
impact on prices.

The main problem with buffer stock operations is the availability of adequate space of
warehouses for stocking the stocks of foodgrains. Besides, determining procurement and
issue prices is a difficult task. The problem is many a time solved in political terms rather
than in economic terms. Thirdly, for effective management and implementation of these
operations, skilled and trained administrative personnel are necessary.

20.10.4 ADMINISTERED PRICES

Administered prices are fixed or rigid prices generally fixed by the public authorities. These
prices remain at the same level for a period of weeks or months until they are deliberately
changed by the price fixing authorities.

In capitalist countries, government fixes the prices of certain essential commodities to protect
the interests of the masses. In developing countries, prices of essentially goods are fixed by
their governments mainly to help the poor people. These prices are fixed without reference to
demand and supply forces in the market. They are fixed according to certain other criteria as
discussed below.

Fixation of (minimum) floor prices and (maximum) ceiling prices: The government of a
country fixes minimum of floor prices (above the normal equilibrium level) for some
commodities, and maximum or ceiling prices (below the normal equilibrium level) for some
other commodities.
'Price Controls' is another name for 'administered prices'. We have already discussed the
necessity for price controls earlier in this chapter.

Objectives of administered prices or price controls

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1. Safeguarding or protecting the interest of the masses:
Prices of essential goods are fixed by the public authorities in order to ensure that these goods
are available to the masses, particularly to the weaker sections. This ensures social justice.
For example, sugar is made available at a lower price at rationing shops in India. So also
kerosene oil, matchboxes, rice, wheat, edible oil, etc.

2. Protecting interests of farmers:

Minimum support prices (higher than the normal equilibrium prices) are fixed for agricultural
commodities (such as rice, wheat, etc.) to ensure fair price to the farmer who need not sell
foodgrains at lower market prices when there is good harvest and glut in the market.

3. Ensuring fair wages to workers:

Minimum wages are fixed by the government to enable workers to earn fair wages in industry
and agriculture in order to prevent their exploitation at the hands of unscrupulous owners,
employers and landlords.

4. Avoiding undue competition:

When maximum rates of interest are fixed on company deposits, the goal is to prevent undue
competition among the companies receiving public deposits. Similarly, maximum interest rate
is fixed on saving bank deposits with commercial banks to prevent unhealthy competition
among these banks.

5. Discouraging superfluous consumption:

Certain goods are in short supply or they are required to be imported to meet the domestic
demand, which requires scarce foreign exchange. It is necessary to prevent superfluous
consumption of such goods and hence high administered prices are fixed. For example,
though international prices of gasoline were falling drastically in India, the administered price
of petrol was hiked by the government of India from time to time to restrict its consumption, so that
we could save our scarce foreign exchange.

6. Earning large revenues for the state:

A large revenue is earned by the government by raising administered prices of public sector goods to
fill up the gap between the revenue receipts and revenue expenditure in the annual budget. In India,
this has been done from time and again in respect of postal rates, steel prices, coal prices, and
telephone rentals and telephone call charges.

7. Ensuring beneficial and rational allocation of resources:

Certain inputs produced in the public sector are important in producing certain essential
goods in the private sector. For diverting resources for the production of such essential goods
in the private sector, the administered prices of inputs necessary for the private sector are
deliberately kept low. This ensures beneficial and rational diversion of resources.

8. Establishing the egalitarian society:

For social justice, weaker sections should receive essential foodgrains and other necessities
of life at lower rates. Hence, administered prices of goods distributed through the public
distribution system (PDS) in ration shops, fair price shops, consumers' cooperative, etc., are fixed at
concessional rates.

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20.11 NORMS OR CRITERIA FOR DETERMINING ADMISTRATIVE PRICES FOR
PUBLIC SECTOR GOOD

While determining the prices of the goods produced by the public sector enterprises, certain norms of
principles are applied by the governmental or departmental authorities as under:
1. Marginal cost pricing
2. Pricing on no profit-no loss basis
3. Discriminating pricing
4. Average cost pricing
5. Cost plus pricing (to earn some profits)
6. Import based pricing
7. Maximum profit principle
1. Marginal cost pricing:
According to this principle, the price of a public sector good equals its marginal cost of production.
This principle is justified theoretically for the optimum allocation of resources. However, there are a
number of practical difficulties, such as calculating accurate marginal cost, difficulties of
indivisibilities of goods, etc. In the case of excess capacity of the plant, that is, where the plant runs far
below the capacity, the marginal cost is very low; but it would be unadvisable to fix a low price
because of that reason.

2. No profit-no loss basis:

In the case of essential goods satisfying merit wants and public utilities satisfying social wants.
(Examples: public transport, supply of electricity, cooking gas (LPG), etc.), price is fixed on the basis
of 'No Profit-No Loss'. In case of such goods, a public enterprise is not expected to earn profits
because consumers must be able to satisfy their social and merit wants at low costs in any welfare
state.

3. Discriminating pricing:
It is considered to be one of the macro-goals of every developing country to protect the
interest of the poor, whose capacity to buy is very low. Hence, discriminating pricing
principle is followed. Essential goods like rice, wheat, kerosene are priced at low rates, to be
sold to the poor through ration shops, while the same goods are charged at high market prices
for the rich or non-poor consumers in the open market. This is called dual or discriminating
pricing. Fertilisers are sold at subsidised prices to the rural agriculturists. Electricity is sup-
plied at low rates to the rural agriculturists and at high rates to the urban commercial sector.
The commercial banks are called upon to lend to the priority sectors at lower rates of interest
and to other commercial sectors at a higher (market) rate of interest. Different rail fares are
charged for passengers traveling by the first class and those by the second class.

4. Average cost pricing principle:

In the case of certain public sector goods, average cost principle is followed whereby the
price charged equals the average cost of production. The enterprise becomes economically
viable as it can recover fall cost including the normal profits and so subsidy is necessary.
Though the method is simple for calculation and administration, the major disadvantage is
that since there is absence of competition due to the monopolistic nature of many of the public

258
sector enterprises, and since price covers the full cost, there is no check on inefficiency and
mismanagement. There is no incentive for managers and workers to reduce cost through
efficiency or to introduce economy in production.

5. Cost plus pricing:

Under this principle, the price equals the average variable cost plus some additional charge
(called contribution margin).4 This additional charge is calculated as a percentage of AVC
and includes average fixed cost and certain rate of profit on investment. Thus, the price
includes the full cost of production (AVC plus AFC) and some rate of predetermined profit. In
India, public enterprises like Hindustan Aeronautics, Hindustan Machine Tools, Mahanagar
Telephone Nigam Limited, follow this practice.

The main benefit of this pricing method is that it helps in accumulating surpluses for public
undertakings which can be used for further capital formation. However, as in the case of
average cost pricing, due to absence of competition (as many of these enterprises have
monopoly positions), there is no incentive or scope for making efforts on the part of the
management or workers to introduce efficiency and reduce costs. Managers take high salaries
for them and workers become inefficient.

6. Import based pricing:

Some public sector enterprises (PSEs) produce goods which have no domestic competition
but which enjoy monopoly power. For example, Bharat Heavy Electricals, Hindustan Photo
Films, Heavy Engineering at Bhopal, etc. Therefore, prices of goods produced by such
enterprises are fixed on the basis of the prices of similar imported goods. PSEs are thus made
to face competition from international producers. This method of fixing administered prices
increases efficiency of domestic PSEs. International producers in order to capture domestic
markets of foreign countries, always attempt to reduce prices by cutting down their costs
through maximum efficiency, innovations and technological changes, etc.

7. Maximum profits principle: It is expected from certain commercial PSEs producing

goods for commercial use that they must make maximum profits. Their prices should be able
to earn maximum profits for the PSEs.

Conclusion:
While fixing administrative prices for the goods of the PSEs, it is necessary to apply
efficiency criteria. For PSEs producing goods which satisfy social wants and merit wants, No
profit-no loss basis should be the criterion. For protecting the poor, subsidised pricing may be
followed, but care should be taken to ensure that this facility is not misused. In India,
subsidised prices for fertilisers have mainly benefited the rich farmers. Low priced essential
goods have found a way of disappearing from ration shops and getting entry into the open
market, thereby giving rise to black-marketing.

It is necessary that for bringing efficiency in the PSEs, it is necessary that they should be made
to face competition and their prices be fixed accordingly. It is necessary that they must make
maximum profits to provide surpluses for further capital formation. It is, however, regretted
that, in India, many PSEs are running inefficiently due to a number of reasons and are making
losses except a few. Their administrative prices have been increased from time to time without
any consideration for efficiency and quality.

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20.12 ANTI-INFLATIONARY POLICY IN DEVELOPING COUNTRIES(WITH
SPECIAL REFERENCE TO INDIA)

No government worth its while can ignore the damage done by the inflationary pressure on
its economy. A mild rise in the general price level of, say, 2 to 3 per cent, can be a tolerable
limit. But a continuous rise in the general price level at more than 3 per cent, inflation, is
injurious to the economic development of a country. In India, prices have risen by two digits
annually. In certain years inflation had taken an ugly shape. The government of any country
cannot be a passive onlooker. It is, therefore, necessary to take steps to curb inflation.
In India, three types of measures have been taken as anti-inflationary steps, viz.,
1. Fiscal measures,
2. Monetary measures, and
3. Supply management

20.12.1 FISCAL MEASURES

Fiscal measures refer to the budgetary policy of the government, viz., the policy of taxation
and public expenditure. This policy aims at reducing inflationary pressure in the economy.
Firstly, to encourage the production of goods and services, fiscal incentives in the form of tax
concessions, rebates, subsidies, etc., are given. However, this measure may not arrest inflation
since the non-developmental expenditure of the governments of developing countries, keeps
on rising simultaneously. And deficit financing crosses its limit as in India. This measure,
therefore, may not become effective.

Fiscal measures include reduction in income tax rate, adjustment in excise and customs
duties, introduction of'Modvat' or 'Vat' scheme of taxation, reduction in fiscal levy on man-
made fibre and yarn, excise concession to drug manufacturers. Such tax incentives are given
to encourage savings, investments and exports. Export subsidies and concession in export
duties are given to boost exports, so as to facilitate imports of essential raw materials and
capital goods to boost up production in domestic industries, and also essential consumer
goods. Fertiliser subsidies are given to reduce the cost of agricultural production. Similarly
'Modvat' (modified value added tax) or Vat (value added tax) schemes and excise duty
concessions are extended to encourage production of certain critical inputs and production of
essential goods.

In India, despite the above-mentioned fiscal measures, inflation could not be arrested in the
past, though recently, some such measures have yielded some limited fruits in arresting
inflation to around 4 1/2 to 5 per cent. However, the consumer price index is still showing
inflation of around 10 per cent.

It is, therefore, necessary that along with the fiscal measures of tax concessions, rebate,
subsidies, Modvat scheme, reduction in export duties, etc., the government should reduce its
non-developmental expenditure particularly on interest payments, defence and civil services.
Economists recommend that the fiscal deficit (borrowings plus budgetary deficit, that is
creation of new money) should be drastically reduced to around 4 per cent, from the present
5 to 6 per cent.

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20.12.2 MONETARY MEASURES
Monetary measures refer to the credit control measures by the central bank of the country. In
India, it is the Reserve Bank of India which is the central bank or the apex bank of the
country. Since it is the expansion of credit in the economy that is primarily responsible for
generating demand for goods and services which in turn leads to inflation, traditionally, credit
controls were used by the central banks of various countries to control the severity of
inflation.

In India, the Reserve Bank of India has used from time to time, the quantitative and
qualitative methods of credit control. In fact, price stability is one of the major objectives of
the monetary policy of any central bank and so is the case with the Reserve Bank of India.
The Reserve Bank has taken the following monetary measures to control the volume of credit
and promote price-stability.
1. Bank rate policy.
2. Open market operations.
3. Cash reserve ratio (CRR).
a. Net liquidity ratio (NLR) since abolished.
b. Statutory liquidity ratio (SLR).
4. RBI's discretionary and selective refinance to banks and the commercial sector, and
quantitative ceilings.
5. Selective credit controls (credit ceilings, minimum margin requirements for advances
against essential goods, minimum interest rates, ban on credit-against book debts and
clean credit).
6. Moral suasion, and
7. Credit Norms (Tandon and Chore Committee's recommendations).
The bank rate has been raised from time to time to curb the commercial banks' indulgence in giving
advances which would lead to excess expenditure in the economy.

The use of CRR and SLR has been made by raising them from time to time in order to restrict the
capacity of banks to create extra credit in the economy. However, it was observed that many
nationalized banks frustrated these efforts of the RBI by defaulting in maintaining the required CRR
and SLR declared by the RBI.

Open market operations have a very limited scope in India due to undeveloped and unorganised
money market and capital market.

Quantitative credit ceilings were imposed and discretionary refinance system was introduced to
divert the credit resources to desirable channels and prevent their use (or misuse) for hoarding and
production in non-priority sector.

The RBI also resorted to selective credit controls for influencing the cost and the direction of credit.
The selective controls have been extended to many essential commodities to strike against the
inflationary pressure being generated since the Second Five-Year Plan. The credit authorisation
scheme was introduced in 1965. However, the selective controls have limited impact on the economy
because of the flow of finance to the commercial sector from non-banking institutions and the
unorganised sector of the money market, which are not amenable to the credit policy of the Reserve

261
Bank of India.

The moral suasion has assumed prominence particularly with the social control of banks, introduced
in 1965 and nationalisation of banks in 1969. One of the stipulations was that 50 per cent of the total
advances to agriculture should go to the weaker sections. The RBI has been issuing directives to the
commercial banks to follow certain credit and deposit policies to arrest the pressure of inflation irr
India. Moral suasion or moral instructions to banks may be successful only when it is followed by
stringent action against defaulters in case they do not follow each instruction. However, in India, there
has been a lack of effective supervision over the banks.

The Tandon Committee study group (1974) and the Chopra Committee (1979) recommended that
medium and large borrowers' dependence on bank finance be reduced, and borrowers should furnish
quarterly returns on their need for funds. The banks were asked to follow these norms and were also
asked to fix separate limits for 'peak level' and 'non-peak level' requirements.

LIMITED SUCCESS

Regarding the impact of these measures in controlling and the inflationary pressure, it is sad to say
that the success had been very limited for several reasons. In fact, the RBI has failed in its objective of
anti-inflationary policy. This has been due to a number of constraints, viz.,

1. Banks have been raising additional resources of funds and many of these defaulted in
following the directives of the RBI due to lack of effective supervision and monetary
control, the RBI has since set up a separate department of supervision for this purpose.

2. Due to the unorganised and undeveloped money and capital markets, the link between
monetary policy instruments and financial variables is very weak. In April 1988, the RBI
has set up the Discount and Finance House of India (DFHI) to develop a secondary
market in two types of bills, viz., treasury bills and short-term commercial bills.

3. The RBI has no control over the credit demanded by the government of India for filling
up the annual budgetary deficit. The bank is under statutory obligation to lend to the
government of India without any limit. This leads to undue expansion of money, and
conflicts with the RBI's policy of contraction of money supply to contain inflation.
4. Open market operations are limited due to the public debt policy of the government,
which is followed independently by the government.

5. The adverse balance of payments situation adversely affects monetary policy operations
and the former is independently followed by the government of India.

6. The commercial sector, whenever credit policy is stringent, obtains its funds from the
unorganised sector consisting of indigenous bankers and moneylenders. The RBI has no
control over this source.

7. Many a time, there are delays in taking monetary policy decisions in restricting the
volume of credit while the damage is already done to the economy.

8. Long-term rates of interest till recently were rigid and hence it could not affect the cost
and availability of funds for long-term investments.

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9. Public sector investments and total consumption expenditure are not sensitive to interest
rate variation. Since agriculture receives much of its financial requirements from the
indigeneous sources, the monetary policy of the RBI has very little effect in affecting the
real variables.

10. The increasing "dimensions of unaccounted black money and its parallel economy have
been great constraints on the success of the RBI's monetary policy in arresting inflation.

11. The experience in India shows that whatever little is achieved to control inflation, it is
not due to the monetary policy of the RBI, but due to fiscal measures or higher output
growth in our economy.
Thus, looking at the above constraints, it is observed that monetary policy by itself cannot
control inflation in developing countries like India, unless strong and effective fiscal
measures (particularly keeping both the fiscal deficit and budgetary deficits under great
control) like reduction in non-developmental expenditure and avoidance of wasteful
expenditure, are undertaken and there is a favourable monsoon and proper national income
and wage policy.

Firstly, there must be a proper coordination and understanding between the government of
India and the Reserve Bank. Secondly, black money should be eliminated. Thirdly, there
should be strict supervision on both foreign and Indian banks. Fourthly, dependence of the
agricultural sector and the commercial sector on indigeneous sources of funds will have to be
reduced to achieve desirable impacts of the monetary policy. Fifthly, banking habits should be
encouraged among the rural people.

20.12.3 SUPPLY MANAGEMENT

Supply management policies to control inflation include price controls, the system of dual
pricing, public distribution system (PDS), imports of essential commodities during the
periods of shortages, procurement drive, buffer stock maintenance, extending fiscal
concessions to encourage production of essential goods, measures to increase agricultural
production and such other measures.

Price controls and dual pricing:

For protecting the people, particularly the poor, price controls and dual pricing are resorted to
as steps against inflationary hazards. We have already discussed these measures in our earlier
discussion in this chapter. However, price controls lead to shortages and black marketing of
goods as it happened in the case of cement and foodgrains and other essential commodities in
India during the seventies and eighties. Dual pricing has met with a limited success due to the
excess of demand over supply in the open market.

Public distribution system (PDS):

Public distribution system is meant to make available essential goods like edible oil, sugar,
cereals, pulses, kerosene, etc., to the weaker sections of the community at reasonable prices.
In fact, in India, this has been the main plank to hold the price line. Effective PDS ensures
supplies of essential consumer goods to people at reasonable rates. The government has
opened a large number of fair price shops (ration shops) to distribute foodgrains and other
essential commodities at lower prices than the inflated market prices. A full-fledged

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department of Civil Supplies and Cooperation was created during October 1974, to deal with
the inflationary forces and to ensure orderly production and distribution of essential goods.

Various schemes for consumer protection were introduced. Agencies like NAFED (National
Agricultural Cooperative Marketing Federation) and NCCF (National Consumer Cooperative
Federation) have been created as support organisations to make essential commodities available at
reasonable prices.

Shortcomings of PDS: The PDS in India is suffering from a number of shortcomings, such as the
supply of inferior quality goods sold at the ration shops. The PDS is used not as a permanent
measure for the poor, but only during the shortages of essential goods. Since the procurement
prices have been raised recently over the past three to four years, it has not only affected the
issue prices at the ration shops, but has added to the inflationary pressure in the economy.

Imports of essential goods:

Since the main reason for inflation in India is the shortages of essential goods like
foodgrains, sugar, edible oil, kerosene, etc., the government resorts to imports of such goods
from abroad. However, the experience (recent sugar scam) is that imports are resorted to only
after the traders, producers, wholesalers, retailers and merchants have made ample profits as
a result of price rise. It is necessary to make arrangements for timely imports of goods which
are in short supply in the domestic market.

Measures to augment production of agricultural and industrial goods:

Since inflation is mainly due to excess demand over the supply of goods and also due to
shortages due to bad monsoon and low agricultural and industrial production, it is but natural
for any government to provide incentives to agriculturists and manufacturers to stimulate
production. In India, the measures taken so far in this regard are: discretionary finance, loans
at concessional rates of interest to agriculturists, tax rebates and tax holidays to industrialists,
supply of raw materials at low prices, supply of seed through the high yielding varieties
(HYV) programmes, special food production programmes which include bonus for high
production and procurement programmes, increase in the plan allocation for major and
medium irrigation projects, etc. Since 1991, a new policy of liberalisation, privatisation and
globalisation is announced, abolishing the corrupt licensing system and capacity licensing,
allowing free foreign technology agreements and 51 per cent participation to foreign firms,
abolishing the threshold limit for expansion under the MRTP Act, and so on. Import duties
have been brought down to 50 per cent. Certain industries reserved for the public sector are
made open to the private sector. These steps will help in augmenting production, creating
competition and consequent increase in efficiency in the industrial sector which will bring
down the prices of goods and services. Expansion of industries under the new policy will
enable industries to get the advantage of external economies, which will help in cutting down
the cost of production, and raising the level of production. This will reduce the cost-push type
of inflation.

Action against hoarders, blackmarketeers and monopolistic unfair and restrictive trade
practices:
Though the MRTP Act has enabled the MRTP Commission to investigate and take action
against monopolistic, restrictive and unfair practices, the measure has not been very
successful in curbing such activities which are inflationary in character, sporadic raids and
sporadic action during the period of severe inflation are not very effective. A continuous,

264
constant vigilance and stringent action against hoarders, blackmarketeers and profit makers is
necessary. But this cannot be expected in the absence of political will and economic
discipline. Unfortunately, this is not possible in India where it is proved by evidence (Vohra
Committee Report) that there is a nexus between the political leaders, ministers, etc. and the
criminals, smugglers, hoarders and blackmarketeers. In India, inflation has become a non-
curable disease.

In India, non-developmental expenditure is rising with every Five-Year Plan and the annual
budget. Non-developmental expenditure of India increased from Rs. 43,973 crore in 1990-91
to Rs. 98,999 crore in 1993-94 and to a whopping sum of Rs. 1,23,651 crore in 1995-96
(Budget estimate) against the total expenditure of Rs. 76,212 crore, Rs. 1,41,853 crore and
Rs. 1,72,151 crore respectively. Fiscal deficit is soaring with every budget. The budgetary
deficit knows no bounds. Only during the Seventh Five-Year Plan, the total budgetary deficit
was a whopping Rs. 38,545 crore against the Plan5 target of Rs. 14,000 crore. The Seventh
Plan document has prescribed the following measures to curb inflation in India.
1. Avoidance of excess money creation by keeping the budget deficit down at
least to the level prescribed by the Plan document.

2. Buffer stocking and the public distribution of foodgrains to deal effectively with weather
induced fall in production.

3. Maintaining exchange reserves at such a level that an adequate margin is available for timely
imports of essential items, such as edible oil, fertilisers, etc., to meet the shortages in domestic
production.

4. Measures should be taken for improvement in productivity and cost production in various essential
sectors through better utilisation of existing capacity.

5. Support prices for agricultural crops should be rationally determined to stimulate foodgrains
production.

Check Your Progress – 5

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Supply Management.
……………………………………………………………………………………………
……………………………………………………………………………………………
……………………………………………………………………………………………
20.13 LET US SUM UP

In this lesson we have studied about Laissez faire policy, new economic policy, significance
of state intervention in managerial economics, weakness or defects of free market
mechanism, government intervention in advanced countries, government intervention in
developing countries, government intervention in India, government measures for price
stability, norms or criteria for determining admistrative prices for public sector good, anti-

265
inflationary policy in developing countries briefly.

20.14 KEY WORDS

Laissez faire policy New economic policy

Advanced countries Developing countries
1948 industrial policy resolution Industrial policy resolution of 1956
New industrial policy of 1991 Support/procurement prices
Fixation of issue prices Buffer stock operations
Administered prices Prices for public sector goods
Fiscal measures Anti-inflationary policy
Monetary measures Supply management

20.15 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

20.16 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 20.4
Check Your Progress – 2
1. See Section 20.7

266
Check Your Progress – 3
1. See section 20.8
Check Your Progress – 4
1. See Section 20.10.2
Check Your Progress – 5
1. See section 20.12.3

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BLOCK
8
UNIT 21
BUSINESS CYCLE

UNIT 22
INFLATION AND DEFLATION

268
UNIT 21
BUSINESS CYCLE

STRUCTURE

21.1 Objectives

21.2 Introduction

21.3 Definitions of business cycle

21.4 Characteristics of business cycle

21.5 Phases of business cycle

21.6 Let us sum up

21.7 Key words

21.8 Questions for discussion

21.9 Suggested readings

21.1 OBJECTIVES

After reading this lesion you must be able to understand the following topics
 Definitions of business cycle

 Characteristics of business cycle

 Phases of business cycle

21.2 INTRODUCTION

During the course of the last two centuries, many industrial economics of the world have
made tremendous progress and many backward agricultural countries have turned into the
biggest industrial nations of the world. This was due to their astounding capacity to increase
output and growth. However, the business and industrial activities of these economies could
not develop steadily and smoothly. An economy moving steadily along an even growth-path is
only an abstraction. The economic activity of a nation will have its periodic ups and downs
and they play an important part in determining the long-run trend which similarly plays an
important role in determining the nature, length and amplitude of the ups and downs. The study
of these ups and downs is called the study of Business Cycles or the Industrial Fluctuation.

269
So capitalistic economies, particularly, the course of economic activity seldom runs smooth.
Normally a period of prosperity is followed by a period of adversity or depression and vice
versa. Economists have devoted their attention in studying die causes, consequences and the
extent of such escalations in me economic activities of nations. The study of alternating
fluctuations in business activity is referred to in Economics as Business Cycle or Trade
Cycle.

21.3 DIFIITIONS OF BUSINESS CYCLE

A Business Cycle refers to oscillations in aggregate economic activity, particularly in

employment, output, income, etc., because of the inherent contraction and expansion of the
elements which energize the economic activities of die nation. The fluctuations are periodical,
differing in intensity and changing in its coverage. Many economists have defined the term
business cycle or trade cycle. We shall study some of the definitions.

Wesley Mitchell stated that "Business cycles are fluctuations in the economic activities of
organized communities. The adjective Business restricts the concept of fluctuations in
activities which was systematically conducted on a commercial basis. The noun Cycle bars out
fluctuations which do not recur with a measure of regularity."1

Prof. Lipsey states as follows: "The. irregular and often violent movements of the economy over
short periods of time have long occupied and attention of economists. These movements were once
commonly known as business cycles or trade cycles, the word cycle suggesting a regular oscillation
of good times and bad. At some times and places, these movements have been remarkably
regular."2

Keynes defined it as follows: "A Trade Cycle is composed of a period of good trade characterized by
rising prices and low unemployment percentage, alternating with a period of bad trade charaterized
by falling prices and high unemployment percentage."3 R.A. Gordon defined business cycle as
consisting of "recurring alternation of expansion and contraction in aggregate economic activity, the
alternating movements in each direction being self-reinforcing and prevailing virtually all parts of the
economy."

According to Hansen "The business cycle is peculiarly a manifestation of the industrial segment of the
economy from which prosperity or depression is redistributed to other groups in the highly
interrelated modern society." Tinbergen considers the occurence of business cycle as "the interplay
between erratic shocks and an economic system able to perform cyclical adjustment movements to
such shocks."

Ragnar Frisch explains it in an elaborate manner. "Impulses from outside operate upon the
economy, causing it to move in a wave-like manner, just as an external shock will set a pendulum
swinging. But it is die inner structure of the swinging system which determines the length of the wave
movement. The oscillations of the system may have a high degree of regularity even though the
impulses which set it going are quite irregular in their behaviour."

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21.4 CHARACTERISTICS OF BUSINESS CYCLE

From the definitions given above, we can gather the features of business cycle. It occurs
periodically in a wave-like fashion with varying magnitude affecting not only the entire
economy of the country, but also making its impact on economies of other countries. Let us
discuss its features in detail:

(i) It occurs periodically:

The business cycles occur periodically in a regular fashion. This means the prosperity and
depression will be occurring alternatively. But there need not be uniformity 4n the extent and
magnitude. Though the general structure of different cycles may be the same, it may not be
perfectly rhythmical in character.

(ii) It is all embracing:

The business cycle implies that the prosperity or depressionary effect of the phase will be
affecting all industries in the entire economy and also affecting the economies of other
countries. It is international in character. The Great Depression of 1929 is an example of this.

(iii) It is wave-like:
The business cycle will have set pattern of movements which is analogous to waves. Rising
prices, production, employment and prosperity will become the features of upward
movement: Falling prices, unemployment will become the features of the downward
movement.

(iv) The process is cumulative and self-reinforcing:

The upward movement and downward movement are cumulative in their process. When once
the upward movement starts, it creates further movement in the same direction by feeding on
itself. This movement will persist till the forces accumulate to alter the direction and create
the downward movement. When downward movement starts, it persists in the same direction
leading to the worst depression and stagnation till it is retrieved to gain an upward movement

(v) The cycles will be similar but not identical:

Different cycles and waves in the business cycles will be similar in general features, but they
are not identical in all respects. "A typical cycle constructed by making, as it were, a
composite photograph of all the recorded cycles would not materially differ in form very
widely from any one of them. But this typical cycle is not an exact replica of any individual
cycle. The rhythm is rough and imperfect. All the recorded cycles are members of the same
family, about among them there are no twins."4

Besides these features, the American Economic Association stressed the following important
characteristics of business cycle.

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 1. Generally, prices and production fall or rise together. The exception is agriculture in
which, during the downward phase of the cycle, prices will be falling but production
will be increasing. The reason is, with falling prices of agricultural commodities, the
farmers would try to produce more to offset the loss of falling prices of their produce
and maintain the same level of income.

2. Fluctuations in output and employment will be greater in capital goods industries than
in consumption goods Industries.

3. Phenomenal changes in employment, output and price level will be normally

accompanied by changes in currency, credit and velocity of circulation of money in
the same direction.

4. Prices of agricultural goods will be flexible while the prices of manufactured goods
will be comparatively rigid as they will be kept stable by the manufacturers.

5. Profits fluctuate by a larger percentage than the other types of income.

6. Fluctuations will spread throughout, as industries are interconnected and the cyclical
fluctuations tend to be international in the sense that the prosperity or adversity will
affect the foreign countries through international trade.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about Characteristics of Business Cycle.

…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………..

21.5 PHASES OF BUSINESS CYCLE

Business Cycle is characterized by different phases called the
(i) Upward Phase and
(ii) Downward Phase. Each phase has got sub-phases. Though there is no uniformity of
terminology, the different phases of business cycles is referred to as
(a) Boom;
(b) Recession;
(c) Depression; and
(d) Recovery.

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I. Boom or Prosperity Phase
The full employment and the movement of the economy beyond full employment is
characterized as boom period. It starts with recovery and the expansion of business activities
takes place. During this period, there is hectic activity in the economy. In a matter of months,
full employment paves way for over-full employment. Money waves rise, profits increase and
interest rates go up. The demand for bank credit increases and there is all-round optimism.
This upswing or the prosperity phase of the cycle is described by Prof. Haberler as "a state of
affairs in which the real income consumed, real income produced, and level of employment
are high or rising, and there are no idle resources or unemployed workers, or very few of
either."5 The important features of the upswing are:
(a) Rising Prices
(b) Large volume of Production
(c) High level of Employment and Job opportunities
(d) Rising interest rates
(e) Bullish trends in stock exchange
(f) Expansion of credit and borrowing
(g) Rise in Wages, profits and income; and
(h) Overall business optimism.

II. Recession
The turning point from boom condition is called recession. Generally, the failure of a
company or a Bank, bursts the boom and brings a phase of recession. Businessmen begin to
realize that they have overstepped their mark and their over-optimism gives place to
pessimism. Investments are drastically reduced, production comes down and income and
profits decline. There is panic in the stock market and business activities show signs of
dullness. Liquidity preference of the people rises and money market becomes tight. "A
recession, once started tends to build upon itself such as forest fire, once underway, tends to
create its draft and gives an impetus to its destructive ability."6

III. Depression
Recession is only a turning point rather than a phase. When this deepens, it culminates into
depression. The features of depression are just the reverse of prosperity. During depression
the level of economic activity becomes extremely low. Prices fall, profit margins decrease,
firms incur losses and closure of business becomes a common feature and the ultimate result
is unemployment. -Interest and wages also fall. The agricultural class and wage earners
would be worst hit. There is all round pessimism. Banking institutions will be reluctant to
advance to businessmen. Depression is the worst phase of the business cycle.

IV. Recovery
After a period of depression, recovery sets in. This is the turning point from depression to
revival towards upswing. It begins with the revival of demand for capital goods. Autonomous
investments boost the activity. New blood, in the form of expansion of money and credit, is
injected in the money stream of the economy and the income of the people goes up. The
demand slowly picks up and in due course the activity is directed towards the upswing with

273
more production, profit, income, wages and employment. Recovery may be initiated by
innovation or investment or by government expenditure (autonomous investment).
The different phases of the business cycle are illustrated in the Figure 26.1

FIGURE 26.1
Phases of Business Cycle

Y peak

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Phases of Business Cycle.

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
……..
21.6 LET US SUM UP

In this lesson we have studied Definitions of business cycle, Characteristics of business cycle,
Phases of business cycle.

21.7 KEY WORDS

Capitalistic economies Boom

Large volume of production Depression
Recovery Boom or prosperity phase
Rising prices Recession

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21.8 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna
10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

21.9 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 21.3
Check Your Progress – 2
1. See Section 21.5

275
UNIT 22
INFLATION AND DEFLATION
STRUCTURE

22.1 Objectives
22.2 Introduction
22.3 Definition and meaning of inflation
22.4 Characteristics of inflation
22.5 Types of inflation
22.6 Other types of inflation
22.7 Effects of inflation
22.8 Anti- inflationary measures
22.9 Deflation
22.10 Effects of deflation
22.11 Control of deflation
22.12 Choice between inflation and deflation
22.13 Measures to be adopted by business firms to reduce the evil effects
of business cycle
22.14 Inflation and deflation with reference to India
22.15 Causes for inflationary pressures
22.16 Various theories of profit
22.17 Let us sum up
22.18 Key words
22.19 Some Useful Books
23.18 Answer to Check Your Progress Exercise

22.1 OBJECTIVES

276
After reading this lesson you must be able to know about
 Characteristics of inflation
 Types of inflation
 Other types of inflation
 Effects of inflation
 Anti- inflationary measures
 Deflation
 Effects of deflation
 Control of deflation
 Choice between inflation and deflation
 Measures to be adopted by business firms to reduce the evil effects of business cycle
 Inflation and deflation with reference to India
 Causes for inflationary pressures
 Various theories of profit

22.2 INTRODUCTION

Everyone is familiar with the term 'Inflation' as rising prices. This means the same thing as
fall in the value of money.

22.3 DEFINITION AND MEANING OF INFLATION

Inflation is a monetary ailment in an economy and it is defined by economists in so many

ways. When there is a persistant and appreciable rise in the general level or average of
prices, we have inflation. Crowther defines inflation as "a state in which the value of money
is falling, i.e., prices are rising."1 Pigou defines inflation as a condition "when money income
is expanding relatively to the output of work done by the productive agents for which it is
the payment."'' Coulbourn defines it as "too much money chasing too few goods." T.E.
Gregory calls inflation a state of abnormal increase in the quantity of purchasing power.
All these definitions indicate one basic phenomenon in the economy. Too much of money in
circulation compared to too little goods produced leading to extraordinary increase in prices.
This is what is called the quantity approach to the rise in price level. It should be noted here
that high prices should not be construed as inflation. It is only a persistent increase in prices
to an abnormal extent which should be termed inflation.
Keynes' Definition: While increase in volume of money is responsible for rise in the price
level, Keynes relates inflation and rise in prices as follows: (a) It comes into existence after
the stage of full employment, (b) Rise in prices may be accompanied by an increase in
production, (c) Rise in prices not accompanied by increase in production.

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If an economy is working at a low level with a-number of unemployed people and resources,
an expansion of money or other factors will not only increase the prices due to increase in
demand, but also increase the volume of goods and services produced in the system. This is
the case of rise in prices accompanied by increased production and employment. This
condition will continue till all the unemployed factors are fully utilized, i.e., a stage of full-
employment is reached. Beyond this stage, however, any expansion in the volume of money
will only lead to I rise in prices and not rise in production or employment.

Keynes opines that the stage of increasing prices with increasing output and employment is
desirable. Such a type of increasing prices is called Reflation or partial inflation which helps
the economy to move towards full employment condition. But increasing prices after full
employment is bad, as there will not be any increase in the production of goods or increase in
employment. Hence in the Keynesian sense, inflation :rejers to a rise in the price level after full
employment is reached.

But in an underdeveloped country, the term 'inflation' cannot be used in the Keynesian sense.
A country advancing towards full employment condition may show signs of inflation. This
does not mean that countries having inflationary conditions signify that they are moving
towards full employment. In a country like India, we can witness 'inflation' and
'unemployment' existing side by side. Abnormal rise in prices and persistent rise in prices are
in no way an indication of prosperity and mat the country is moving towards full employment.
On the other hand, the backlog of unemployment is mounting up year after year. Hence we see
a condition of stagnation with inflation. So, we should be able to distinguish between
inflation in the midst of prosperity and inflation in the midst of poverty. The former is
desirable.

The inflationary spiral in backward and developing economies is due to the existence of
bottlenecks, such as limited amount of capital and machinery, transport facilities and the lack
of technical know-how. As a result of these botdenecks and shortages, an increased volume of
money will lead to increased prices, but will not lead to increased output beyond a certain
stage, even though the country may not have reached the stage of full employment.

22.4 CHARACTERISTICS OF INFLATION

(1) The first characteristic feature of inflation is the persistent rise in prices. This conclusion
is based on observation of facts and it is by and large correct. Though there may be
recovery of prices here and there due to monetary and fiscal measures undertaken by the
government, it is an agreed fact that excessive rise in prices is the hall-mark of inflation.
(2) The second feature of inflation is an excessive supply of money in the economy. In times
of war or sudden preparations for war, the resources at the disposal of the government may
not be sufficient and the government may adopt war time measures to augment the
resources to meet the emergent situation. The government may resort to banks which
make advances on the basis of government bonds and securities. This results in an
expansion in the paper currency as well as bank credit in the economy.

(3) Another important characteristic feature of inflation is the vicious circle of inflationary spiral

278
 created by the velocity of circulation of money. Inflation will feed on itself to grow into an
inflationary spiral. Since the prices are rising and also expected to rise, the community will
have the least inclination to save money or hold cash assets as the value of money is
decreasing. There will be strong tendencies to spend more in commodities and services,
not only for the current period, but also for future. The tendency will be strong and persistent
in hoarding stock of goods, the prices of which are increasing. People will try to invest on
real estate and other tangible assets whose prices will increase with inflation. The people will
try to capitalize on the increasing prices and decreasing value of money. On the other hand,
businesses anticipating increased demand for goods will be expanding their investment
programmes. Thus spending on both accounts will be speeded up. The velocity of money
will be at a very high level. Increased prices and supply of money may not result in
increased goods either because the economy in production. These bottlenecks cause a further
hike in price due to high demand. Rising prices will lead to increased wages and costs which
will lead to further increase in prices. More of bank money will lead to more of spending.
Thus the vicious circle once started will continue to feed itself.

22.5 TYPES OF INFLATION

The term 'Inflation' is only a general term and there are different types in it. The distinction is
based on different considerations and categories which result in inflation. It is classified on the
basis of speed with which it occurs. Secondly, it is distinguished on the basis of the process
through which it is induced. Thirdly, it is distinguished on the basis of time. Fourthly, it is
classified on the extent of its coverage. Finally, it is divided into either open inflation or
suppressed inflation. We shall make a brief study of the different types of inflation.

1. On the Basis of Speed

On the basis of speed or the rapidity with which prices increase, inflation is divided into (a)
Creeping inflation

a. Walking inflation
b. Running inflation and
c. Galloping inflation or Hyper-inflation.

As the name itself suggests, creeping inflation is slow-moving and very mild. The rise in prices
will not be perceptible but spread over a long period. This type of inflation is in no way
dangerous to the economy. On the contrary, economists consider the creeping type as
favourable for economic development and also for preventing stagnation. The creeping type
of inflation has been attracting a good deal of attention in Germany and the U.S.A. Walking
inflation takes place when 'creeping' gets momentum. In this case, the rise in prices becomes
more marked and it is a danger signal for the running type of inflation under which rise in
prices will be very sharp and vigorous. In the case of galloping or hyper-inflation, the prices
not only rise sharply but they rise in fits and starts. There will be no limit to the height it will
reach. The galloping inflation is dangerous and also disastrous to the economy as it cannot be
controlled easily. Hence, it is also called 'Run Away' inflation. In the post-war inflation in
Germany and Austria, the quantity of money increased many million times over the pre-war
period and the prices increased to such fantastic heights that a 'bagful of currency' could
purchase only a 'handful of commodity'. This is a classic example of runaway inflation or
hyper-inflation.

279
Hyper-inflation is the highest degree of abnormality in the monetary system and under such
conditions, all assets having fixed income lose their real value. Fixed middle income groups
will be ruined as in the case of First World War Germany.

There is another school of thought which considers 'creeping inflation' as equally dangerous
as runaway inflation. According to them, creeping inflation is like a baby in the womb. The
creeping baby necessarily comes out walking, running, and finally jumping. So, a creeping
inflation, if not nipped in the bud, will result in running inflation and pose a threat to the
economy.
The four types of inflation are indicated in Figure26.2 . The figure indicates the slowness
with which the rise in price occurs in the first type, viz., 'creeping' and the fastness with
which rise in prices occurs in the fourth type, viz., 'galloping inflation'.

FIGURE 26.2
Different Types of Inflation

The figure indicates the rapidity with which the price increase takes place under different types
of inflation. In the case of creeping inflation, it takes more than nine years to register a 10 per
cent increase in price level. In case of walking inflation, a 50 per cent rise in price is
registered in a decade. But in the case of a running type, the price level increases 100 per cent in
less than five years and afterwards it shows a tendency to shoot up still more vertically. The
galloping type records more than a cent percent increase in price level in less than a year and
the nature of the curve indicates an abnormal increase in prices in less than two or three years.
II. On the Basis of Inducement
Inflation is classified on the basis of the process through which it is induced. Under this
category, we have
(a) Deficit-induced inflation;
(b) Wage-induced inflation; and
(c) Profit-induced inflation.

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(a) Deficit-induced inflation:
This is caused by the adoption of unbalanced budgetary policies. The government would
resort to deficit financing which means government spending in excess of its revenue
receipts. When the economy is not capable of sustaining the extra resources released by the
government, prices will rise and inflationary situation will occur. Persistent deficit-financing
policies will aggravate the situation and it may lead to an inflationary spiral.

(b) Wage-induced inflation:

This denotes a rise in prices due an increase in money wages. A small general increase in the
price le may induce the labour organizations to clamour for more wages or i change in the
monetary or fiscal policies of the government resulting ii increase of price level will make the
labourers demand more wages. When the increase is conceded through budgetary deficits, it
will lead to a furl increase in prices. The trade union organizations will again demand ma
wages. In the absence of linking productivity with increased wages, t increase will be only a
money-increase and this will lead to inflations conditions in the economy.

(c) Profit-induced inflation:

This occurs on account of increi in the profits of manufacturers. This is possible when there is
a genci increase in the price level or an increase in the price level of new capita goods. This
will enhance the profits of producers and the result will I profit inflation. The different
causes inducing inflation should not I considered in isolation. One cause will be the
contributory factor K another cause leading to an inflationary condition in the economy.
III. On the Basis of Time
Emergencies like war or preparation for war will create an inflation condition in the
economy. Sudden launching of war will strain economy, as all the factor resources have to be
pooled for war purposes. The government would resort to deficit-financing and there will be
massive expansion of money supply for producing materials and ammunitions for war,
besides food for defence personnel and also for the people. The sudden upsurge in economic
activity and rising prices will induce all producers big and small, to take up investment and
production. This will generate inflation, as all commodities will become scarce due to their
diversion to war purposes.
Besides war, the post-war period will also breed inflation due to rehabilitation and
development work undertaken by the government to set right the war-torn economy. Thus,
inflation can be classified as war-time inflation and post-war inflation and inflation due to
development activities.
IV. On the Basis of Extent of Coverage

On the basis of coverage, inflation may be classified as (i) Economy-wide and (ii) Sporadic.
The former signifies inflation of a very comprehensive nature covering the entire economy.
No section of the economy will be left untouched by the rising prices and the impact will be
felt by the nation as a whole. But sporadic inflation is only partial in character and sectional
in nature. It occurs only in specified sectors or sections of the economy due to abnormal but
temporary shortage of some specific goods. The defect may not be fundamental but only
superficial. The shortage of supply may be due to restricted physical condition.

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An example of this type of sporadic inflation would be an increase in prices of food products
as a result of crop failure in the season. Formation of monopolies which restricts output and
raises the prices can also be cited as an example of sporadic inflation.
Finally, inflation may be Open or Suppressed. Open inflation means the price rise will be
uninterrupted. The hyper-inflation, if it is allowed to have its own way will reach to dizzy
heights, as in the case of Germany, Russia, and Austria during the twenties. When such a
condition arises, the government will normally try do reduce the severity of inflation and
rising prices by many methods. By adopting various policies, the inflation will get suppressed
and the prices are prevented from rising. Among the measures to suppress inflationary effect
is the price control and rationing of commodities. Since there are physical controls, prices
may not rise. But this is only a suppression of the force. War time controls are examples of
suppressed inflation. Suppression may be (a) postponement of present demand; (b) Diversion
of demand from controlled commodities to non-controlled commodities, etc. But when the
controls arc removed, suppressed inflation bursts out into open inflation with added vigour
and vengeance.
The suppressed inflation has got its administrative problems and evils. Administrative
machinery will go beyond control due to plethora of officials for various purposes.
Inefficiency, corruption, black-marketing would prevail. This may ultimately demoralize the
national character.

Check Your Progress – 1

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Types of Inflation.
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22.6 OTHER TYPES OF INFLATION

There are two important forces which would create inflation in the economy. One force is
called the demand force and other is the cost force. Based on these two factors, economists
speak of Demand-pull inflation and Cost-push inflation.
1. Demand-Pull Inflation
This type of inflation occurs when there is an excess demand force acting in the economy
leading to rise in prices. It emerges when the aggregate demand exceeds the level of full
employment output. It is a situation where "too much money will be chasing too few goods."
Keynes calls this 'bottle-neck inflation'. Demand-pull inflation maybe caused by an increase,
in the quantity of money. As the quantity of money increases the rate of interest will fall and
as a result investment will increase. This will in turn increase the money income and the

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aggregate consumption expenditure will go up. Consumers and producers seek to buy more
than what could be produced. This type of demand-pull inflation can also occur without an
increase in money supply. This would occur when aggregate demand increases either because
of a rise in the marginal efficiency of capital or a rise in the propensity to consume.
Generally, demand-pull inflation occurs due to heavy government expenditure either for
financing war or financing development projects.

FIGURE 26.3
Graphic Representation of Demand-Pull Inflation
S

OUTPUT

The figure 26.3'' illustrates the demand-pull inflation. In the figure, curves Di, D2, D3, D4,
and D5, show aggregate demand function and curve S shows the given supply function. As
the demand function increases from D[ to D5, the price level increases from Pj to P5. In the
course of rising demand from Di to D3, the increase in price level is accompanied by
increase in aggregate output. This is because, full-employment has not been reached. At
point C, full employment is reached and therefore beyond C or above D3, rise takes place
only in the price level and not in production. This is known as true inflation. Any further
increase in demand will pull up the prices.

In the figure 263, A to C indicates rise in prices and also output due to increase in demand.
Point C indicates full employment level. Beyond C, i.e., D and E, increase in demand leads
to only increase in prices.

2. Cost-Push Inflation
For a long time the theory of inflation was established only in terms of demand-pull. But
recently another theory has been put forward. Accordingly, the inflation is started not by an
excess of general demand, but by increase in costs. This theory points out that prices rise on
account of a rise in the cost of raw materials and wages. That is, the prices of factors of
production increase resulting in the increase of cost of production. Labour being an important
element of cost, exercises tremendous influence on the cost of production and the consequent
increase in prices of finished goods. That is why 'cost-push' inflation can also be called 'wage
push' inflation. This may be due to the intrasigent attitude of labour unions who may demand
unreasonably higher wages with a plea that the increased cost of production may be passed
on to consumers in the form of higher prices. Under such a situation of threat by labour
unions, the producers would be driven to the necessity of , paying more for labour by

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increasing the prices. Of course, this will again become a vicious circle. The increased wages
will be only monetary increase and not real increase and hence the price level will again go
up and the labour unions will again clamour for more wages.

Cost-push inflation may also occur due to higher prices secured by business firms in
monopolistic or oligopolistic industries. In such-a case, it is called profit-push inflation. Just
as the existence of labour-unions is a pre-requisite to a generalized wage push inflation, the
existence of imperfectly competitive market is a pre-requisite of profit-push inflation. In
monopoly and oligopolistic markets, there will be administered prices and these prices will be
administered, normally, upwards to be higher than cost, in an effort to increase profits. But the
profit-push element is considered to be weak as the monopolists have to consider other
demand-pull factors. Further, in big corporations, those who make decisions to raise prices
may not be direct beneficiaries of increase in price. Hence, cost-push inflation is generally
attributed to wage-push, rather than profit-push.

OUTPUT

The figure26.4 indicates the full employment equilibrium at the point 'E' where the demand curve Di
and supply curve S\ intersect. At this point, the output is OQi and price OPj. When the aggregate
supply function shifts to S2, output declines to OQ2 and the price level increases to OP2. Similarly,
when the supply function further rises to S3, output declines to OQ3 and the price level rises to
OP3. The process will continue still further upward with shifts in the supply function.
3. Demand-shift inflation
We studied about the demand-pull inflation in which the demand force in excess of the
available supply of goods will create inflationary rise in prices. This type of inflation, as we
have seen, occurs due to upward rise in demand or due to increased supply of money.
But a rise in the price level may occur even without an increase in aggregate demand. This
may be due to structural shift in demand. The structure of demand will change so rapidly that
the resources cannot be shifted equally fast. Such type of structural shift in demand will take
place either after the war or due to any political upheavals. In the U.S.A., in the year after the
end of the Second World War, a phenomenal change was witnessed in the structure of
demand resulting in inflation, and this could be called a typical example of demand-shift
inflation. With the close of the war, there was a sudden reduction in government expenditure

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and increase in private consumption and private investment. In 1946, the real net national
product declined below 1945 level, although many national products continued to rise. Thus,
while the real output declined, the price level rose up. In this way there was a structural shift
in demand affecting the price level, without any increase in demand. In such structuralges,
wages and prices would rise in those sectors in which demand has increased. But wages and
prices would not decrease in the sector where the demand has decreased, as wages and prices
are inflexible in the downward direction. Hence, there will be inflation even though there
may not be any "rease in the aggregate demand.

22.7 EFFECTS OF INFLATION

Inflation has good as well as evil effects on the economy. In the initial stages, mild inflation
may create an all-round expansion of business activity and this proves beneficial to the
economy. "Inflation is welcome up to the stage of full employment" So opines Keynes.
Rising prices promote intensive business activity and a boom condition will be created. But
the trouble is that the rise in prices is not uniform throughout the economy and there may be
distortions due to inflation causing many imbalances. We shall study the effects of inflation
on different sections of the society.

(i) On Producers:
Inflation is a period of boom and prosperity for the producing classes. All businessmen,
traders, speculators gain during inflation because of (a) windfall profits and (b) appreciation
in the value of their stock. Normally, there is a time-lag between a rise in the prices of
commodities and rise in the cost of production. Prices of goods increase at a faster rate during
the period of inflation and the cost of production lags behind as wages, interest, insurance
premia, etc., are almost fixed. This gives enormous scope for windfall gain. Further, with the
fall in the value of money, businessmen, try to appreciate the value of their stock to the extent
of fall in the value of money or even perhaps more than -that. They would keep such assets as
real estate, commodities, etc., whose prices rise along with the general level of prices during
the inflationary period. Thus, inflation is a blessing in disguise to the business class at the
initial stages.

(ii) On Working Class :

Labouring classes suffer during inflation and price rise, as their wages do not rise* so easily
and proportionately with the increase in general price level and increased cost of living. It is
said that "Prices go up by lift, while wages go up by steps." In modern days, there are many
trade unions and associations which react quickly to the changes in the living cost of
labourers and they demand higher wages without losing time. Hence, labourers of the
organized group do not suffer much during the period of inflation. On the other hand, many
unorganized sections of workers like agricultural labourers and self-employed people find it
very difficult during inflation. The condition is equally distressing to workers who have little
bargaining power with their organizations.

(iii) On fixed income groups:

Perhaps, the worst hit class during inflation will be the group having fixed income. People
living on past savings, fixeif interest, on investments, pensioners, salaried class like teachers
and government servants find inflation and rising prices very agonising, as their fixed
purchasing power dwindle in the face of mounting cost of living. This class of people, called
the middle income group, which form the bulk of the society become the worst sufferers.

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(iv) On Distribution :
Inflation has bad effects on distribution too. Since the price rise and income rise may not be
uniform in all sectors and sections of the economy there will be distortions and imbalances
causing bottlenecks in distribution and fluctuations in production and effective distribution.
For instance, the price of industrial goods go up rapidly during inflation and prices of
agricultural produce are not so flexible. The returns for farmers dwindle and their economic
conditions worsen due to mounting cost of the consumer and industrial products which they
have to buy. This creates imbalance in the income of the different sectors. The resources get
diverted to the production of those commodities which rise up, as the entrepreneurs will be
lured by profits. The net result will be that while some classes of people enjoy the benefit of
inflation, some other sections of the society suffer.

(v) On Debtors and Creditors :

During the inflationary period the debtors (borrowers) gain much while creditors (lenders)
lose heavily. When prices rise, the real value of money falls and the debtors have to pay
money which has less purchasing power. This will be beneficial to the debtor while the
creditor will be getting back the amount whose value and purchasing power has dwindled.

(vi) On Government:
The government too will be affected by inflation. The public sector undertakings may have to
raise the expenditure level due to a fall in the value of money. Or, the alternative would be to
cut the size of their projects and programmes to meet with original budgeted expenditure. But
at the same time the government is also a beneficiary during the inflationary period. As the
government is the largest borrower, the burden of public debt is reduced during inflation, as
we have seen that debtors gain during this period.

(vii) Social Consequence:

If inflation is persistent and severe, it has a baneful influence on society. It makes the rich
richer and the poor poorer. There is an all-round frustration among the salaried and fixed
income groups. The producing and trading classes gain at the expense of salaried fixed
income groups. Thus there is transference of income from the poor to the rich. The old, the
sick, die pensioners, the widows and the small saver group cannot protect themselves against
rising prices. Further, because of enormous rise in prices and scarcity of essential
commodities, there is black-marketing, hoarding and profiteering. Inflation is 'confiscation
without compensation' and it is a 'legal robbery'. Unless effective steps are taken against
inflation, this becomes a social menace and a political problem.

22.8 ANTI- INFLATIONARY MEASURES

The methods of controlling inflation and mitigating its severity can be classified into three
broad categories. They are (i) Monetary measures (ii) Fiscal measures and (iii) Physical and
direct measures.

1. Monetary Measures:

Since too much money is the fundamental problem in the economy, the central banking
authorities use various weapons available in its armoury to combat inflation through reduction
of money supply and credit. The various methods available are: (a) Changing the bank rate; (b)
Open market operations; (c) Increasing the reserve ratio of commercial banks and (d) Placing
effective curbs on advances made by commercial banks. By these methods, the available

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money in the economy is reduced. A tight money condition is created. But if inflation is due to
expansion of currency to finance war or development, monetary measures will not be
successful.

If the inflationary pressures are generated by the inter-sectoral shifts of demand, the problem
can be tackled by the Central Bank through evolving a policy of selective credit controls. The
Central Bank can increase the commercial bank margin requirements in respect of the
extension on credit against the security of such commodities, the availability of which has
become deficient. The increase in margin requirements will reduce the availability of credit to
the business firms against the hypothecation of finished products, semi-finished products or
raw materials; discourage the speculative activity; and force the business firms to dishoard
the stocks of scarce finished products and the materials which will help in relieving the
inflationary pressures. The Central bank may also prohibit the extension of consumer credit or
the extension of credit to such sectors or industries which are under the increased pressures of
demand, as a result of the inter-sectoral shifts of demand.

2. Fiscal Methods
By adopting suitable measures in taxation, public expenditure and borrowing, the government
can effectively curb inflation. In order to reduce the disposable income with the people, the
tax rates could be enhanced on a selective basis and new taxes could be introduced by which
a sizeable portion of the purchasing power of the community could be reduced. The
government could adopt various measures to mop up the savings of the people and thereby
try to reduce current demand for goods. Reduction of public expenditure and surplus
budgeting would go a long way to reduce inflationary pressures in the economy.

3. Physical and Direct Measures

The two methods discussed above are only indirect methods. Under direct method, the
government resorts to actual control of supply of money and credit, in the country. Wage-
freeze and income-freeze are imposed. Wages, salaries and profit margins are controlled. Price-
control and rationing of essential commodities are resorted to, to reduce the evils of black-
marketing, hoarding and profiteering and also to ensure equitable distribution.
But the ultimate solution lies in increasing production to match the supply of money. By this,
price rise could be effectively checked.

22.9 DEFLATION

Deflation is the opposite of inflation. According to Paul Einzing, "Deflation is a state of

disequilibrium in which a contraction of purchasing power tends to cause or is the effect of, a
decline of the price level". The essential feature of deflation is falling prices, reduced money
supply and unemployment. Though falling prices are desirable at the time of inflation, such a
fall should not lead to the fall in the level of production and employment. The process of
reversing the inflationary trend without causing unemployment is called Disinflation. But if the
prices fall from the level of full employment, it is called Deflation. Similarly, when action is
taken up from depression to the full employment level, it is called reflation of controlled
inflation.

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The figure 26.5 indicates the different terms used in this context and their connotation.
In the figure, AA1 indicates the level of full employment. AB represents the Depressionary
Trend. BC indicates reflation or controlled inflation. CD shows the situation of inflation. DE
depicts the condition of Disinflation and EF represents the condition of Deflation.

NUMBER OF YEARS

Graphic Representation of Different Terms in Inflation and Deflation

FIGURE 26.5

Check Your Progress – 2

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Deflation.
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22.10 EFFECTS OF DEFLATION

We have already studied about the effects of inflation. The effects of deflation will be more or
less the opposite of effect of inflation. Inflation will affect the economic system in a very
unfavourable way. But, deflation is a much more menacing problem.

Effects on Production:
Deflation is caused by the deficiency in aggregate demand. As the price level decreases, costs
being relatively more stable, the losses are inflicted upon most of the producers. Their
expectations are adversely affected and pessimism overtakes the entire business world. The
productive activity, as a result, tumbles down and down and there is more and more of
unutilised and under-utilised productive capacity. Deflation, through falling prices, production
and general business activity, causes a drift of the system towards a state of depression.

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Effects on Employment:
The effects of deflation upon the level of employment are most devastating. Millions of
people will remain unemployed. Thousands of people will be parading in the streets of big
cities and towns in search of employment. To their disillusionment, they would only find 'No
Vacancy' sign boards at the door-steps of every office, firm and factory. There will be colossal
wastage of human resources of the country and the purchasing power of the community
continues to fall more and more.

Effects on Income Distribution:

The most beneficiaries of deflation are the; fixed income groups. A falling price level tends to
reallocate income and wealth in favour of the fixed income groups. The share of profit-
receivers in the aggregate income of the community declines progressively and the wage-
earning groups become relatively better off. But the effects of deflation upon the working class
can be favourable only if they keep their jobs secure. During the times when the factories and
firms are being closed down and the business houses collapse, more and more workers are
rendered jobless. Therefore, deflation may not have beneficial effects upon the working class,
in the long run. Certain sections of the community like consumers, creditors, investors, rent-
earners, small-savers, people with fixed interest-bearing securities and pensioners may
however be benefited by the rising value of money. But even these beneficial effects may be
illusive because of the depressing business conditions.

Effects on Debtors and Creditors:

During the deflationary period, the creditors (lenders) gain much, while debtors (borrowers)
lose heavily. When prices decrease during deflation, the real value of money increases and the
debtors have to pay money which has more purchasing power. This will be detrimental to the
debtor, while the creditor will be beneficial, as the value of money has increased and he can
now purchase more commodities and goods. In the same way, the Government will be a loser,
if it redeems the public debt during the period of deflation.

Political and Social Consequences:

As we have seen, deflation is a period of falling prices, low production, severe unemployment
and collapse of several business houses. As such, there will be general discontentment among
people. The unemployed people will become a menace in the society, causing moral
degradation, theft and pilfering, etc. This may also create problems of law and order. The social,
political and moral life may be threatened seriously. We know, how in U.S.A. during the
periods of great depression, the farmers had to burrLiheir corn for fuel purposes, as they did
not have enough income to buy fuel.

22.11 CONTROL OF DEFLATION

Since deflation is caused by the deficiency of aggregate demand due to poor purchasing power
of the people, the anti-deflationary policies should aim at increasing the level of employment.
As we had studied already, autonomous investments by the government is the first essential
requirement to combat the severity of deflation and reduction of unemployment.

Secondly, to stimulate private investment along with government investments, several

monetary measures should be undertaken by the government. These measures are liberal
extension of credit and low rates of interest. In addition, the fiscal measures like rationalized
business tax policies, provision of tax relief and payment of subsidies to raise, investment

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production and exports may be undertaken by the government. The most significant of all fiscal
measures is the increased government expenditure, financed by deficit budgeting, for the
provision of relief, social insurance payment, expenditure on the promotion of scientific and
industrial research, direct public participation in industrial investment and undertaking of the
public works programme. The public works programme can absorb unemployed workers and
raise their purchasing power in addition to raising the level of output. While undertaking the
public works, precaution must be taken that they do not off-set private investment. For this
purpose, the government should make investment in such projects or areas where the private
investment and enterprise are not forthcoming. The public works financed through public
borrowing or through deficit financing are more effective in counteracting the deflationary
situation than those financed through taxation.

Stagflation
We have studied about the business cycle in the economy; the upswing and the downswing. We
know how in the upswing there will be increasing prices, inflationary pressures, more
employment leading to near full-employment, more profit, more wages, etc. with all round
prosperity. We know how in the downswing there will be unemployment or lesser employment,
falling output, recession leading to depressionary condition with prevailing pessimism. In the
upswing there will be full utilisation of the resources of the economy, leading to full
employment and in the downswing there will be under-utilisation of productive capacity.

But in India, on several occasions, we had seen the combinations of ill-effects of both upswing
and downswing. There would be paradoxical situations wherein the economy would reel under
severe inflationary condition with abnormal rise in prices combined with low production and
unemployment leading to stagnation of the economy. This admixture of stagnation and inflation
has been termed as stagflation. India experienced a state of stagflation in 1973-74 and 1974-
75. With some improvement afterwards, the economy relapsed into stagflation again in 1978-
79 and 1979-80. The rate of industrial growth had dwindled down to near zero.

Such a state of stagflation was witnessed even by countries like Japan and USSR and also
countries of Western Europe. Those countries had to take comparing the purchasing power of
the rupee since the commencement of planning. As a matter of fact, the government has been
changing the base year every decade, from 1950-51 to 1960-61 and then to 1970-71 and finally
to 1981-82. The plea of the Government is that every time the new series has a larger coverage of
items of commodities with larger number of quotations. With such type of shifting the base year,
every decade, it is not possible to make valid and broad comparison of price movements, since
planning was introduced in 1950-51.
The success of the First Five-Year Plan in bringing down the price level was completely washed
out, due to the policy shift in the Second Five-Year Plan in which heavy dose of deficit
financing was undertaken. Consequently, there was steady rise in prices between 1955-56 and
1960-61 and the general level of prices rose by 20 per cent. During the Third Plan period, the
price position deteriorated very badly due to Chinese invasion of India towards the end of
1962, and Indo Pakistan conflict in 1965 and the consequent increase in defence expenditure.
Between 1961 and 1966, the rise in prices was abnormal; 40 per cent in foodstuffs; 45 per cent in
cereals and 70 per cent in pulses. The next two years were years of acute inflation when the
index number of wholesale prices shot up by 14 per cent and 11 per cent respectively. The
economy was on the brink of a galloping inflation. However, the bumper crop of 1967-68
saved the inflationary condition and the price rise still further was arrested. In 1968-69, the
prices fell marginally by one per cent.

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Price situation after the Fourth Plan was rather grim. Though the price rise was slow in the first
three years of the Fourth plan, the final years and the subsequent years exhibited enormous rise
in prices. The price level rose by 47 points due to large influx of refugees from Bangladesh,
and the heavy expenditure of the Government on refugees and also the widespread failure of
Kharif crops in 1972-73. Adding to this, the take over of wholesale trade in wheat in north India
resulted in total failure and it caused unprecedented rise in price level during 1973-74. The
situation was still further aggravated by a per cent rise in crude oil prices towards the end of
1973. The world-wide inflation of this period and the depreciation of the value of the rupee in
relation to many currencies of the world, pushed up the costs of imports leading to domestic
price-inflation of a very serious nature. The wholesale price index (WPI) of all commodities
stood at an all-time high of 331 in September 1974, with 1961-62 as 100.

The type of inflation during this period created a veritable crisis in the economy and the public
confidence was shaken on the ability of the government to manage the price situation.
However, the worsening situation was halted during the Emergency period (1975-77). The
steps towards expansionary monetary and fiscal policies. The predominance of cost-push
inflation resulted in the rise in unemployment. Further, the abandonment of fixed exchange
rates in 1973, increasing trade barriers and the restrictive monetary and fiscal policies created
much uncertainty and confusion.

"What is the remedy for situations like Stagflation? Definitely, Keynesian solutions cannot be
adopted, as it is essentially for depression economy. Keynes tools are intended to deal with the
problems of depression, stagnation and unemployment in the advanced countries. Resorting to
keynesian solution will accelerate the problem of inflation and also aggravate the problem of
unemployment in economies under stagflation. Hence, the problem of stagflation should be
tackled through a different strategy. There should be a proper blend of selective credit controls,
differential interest rates, differential taxation, easy availability of industrial inputs, and a
dynamic export policy can go a long way to overcome the malady of stagflation, afflicting the
economies from time to time.

Check Your Progress – 3

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

1. Discuss about Control of Deflation.

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22.12 CHOICE BETWEEN INFLATION AND DEFLATION

We had studied about the ill-effects of both inflation and deflation. Whether it is inflation or
deflation, it is a condition of disequilibrium in the economy. Both indicate misdistribution of
incomes and wealth increasing prices, inflationary pressures, more employment leading to
near full-employment, more profit, more wages, etc. with all round prosperity. We know how
in the downswing there will be unemployment or lesser employment, falling output, recession
leading to depressionary condition with prevailing pessimism. In the upswing there will be full
utilisation of the resources of the economy, leading to full employment and in the downswing
there will be under-utilisation of productive capacity.

But in India, on several occasions, we had seen the combinations of ill-effects of both upswing
and downswing. There would be paradoxical situations wherein the economy would reel under
severe inflationary condition with abnormal rise in prices combined with low production and
unemployment leading to stagnation of the economy. This admixture of stagnation and inflation
has been termed as stagflation. India experienced a state of stagflation in 1973-74 and 1974-
75. With some improvement afterwards, the economy relapsed into stagflation again in 1978-
79 and 1979-80. The rate of industrial growth had dwindled down to near zero.

Such a state of stagflation was witnessed even by countries like Japan and USSR and also
countries of Western Europe. Those countries had to take steps towards expansionary
monetary and fiscal policies. The predominance of cost-push inflation resulted in the rise in
unemployment. Further, the abandonment of fixed exchange rates in 1973, increasing trade
barriers and the restrictive monetary and fiscal policies created much uncertainty and
confusion.

"What is the remedy for situations like Stagflation? Definitely, Keynesian solutions cannot be
adopted, as it is essentially for depression economy. Keynes tools are intended to deal with the
problems of depression, stagnation and unemployment in the advanced countries. Resorting to
keynesian solution will accelerate the problem of inflation and also aggravate the problem of
unemployment in economies under stagflation. Hence, the problem of stagflation should be
tackled through a different strategy. There should be a proper blend of selective credit controls,
differential interest rates, differential taxation, easy availability of industrial inputs, and a
dynamic export policy can go a long way to overcome the malady of stagflation, afflicting the
economies from time to time.

22.13 MEASURES TO BE ADOPTED BY BUSINESS FIRMS TO REDUCE THE

EVIL EFFECTS OF BUSINESS CYCLE

To minimise the bad effects of business cycle, businessmen should adopt some policy measures
which fall into two general categories: They are (i) Preventive Measures; and (ii) Relief
measures.

Preventive measures are adopted during the period of expansion for the purpose of regulating
purchasing, safe-guarding assets and avoiding unwise credit expansion. Reief measures are
adopted during the period of contraction in order to stimulate sales and to stabilise
production.

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The several preventive measures are:
(1) Conserving assets during expansion and avoiding undue increase in plant and equipment
and also in declaring dividends.
(2) The plant should be managed in such a way as to avoid decrease in unit production; avoid
increase in unit overheads; and maintain satisfactory labour conditions.
(3) Avoiding excessive inventories of raw materials, materials in process, and finished products
(4) Avoiding purchase commitments in excess of financial resources;
(5) Avoiding excessive sales which result in cancellations; and
(6) Employing flexible credit standard which may be tightened during expansion and
relaxed during contraction.

The relief measures employed to mitigate the ill-effects of contraction are:

(1) Quick liquidation of inventories.
(2) Reduction of cost of manufacture, both direct and indirect (3) Improvement of quality to
enhance demand
(4) Adoption of selling methods based on accurate analysis of the new situation
(5) Development of plant and organisation for future business.
(6) Utilisation of profit gained in good times for payments to out-of work employees
(7) Launching new merchandise lines during slack periods
(8) Transferring of employees from one department to another during contraction.

Credit policy:
Apart from the above cited measures, credit standard should be stiffened during prosperity.
When orders are numerous, new orders from customers having poor records should be
accepted with great caution. During depression, credit may be extended with a fair degree of
freedom.

Advertising Expenditure:
The problems of business cycle have also a bearing on the firm's advertisement outlays over
the years. According to Milton Spencer, the following are some of the guidelines which may
help the management in formulating a cyclical advertising policy.

(1) Commodities with a high income elasticity of demand, i.e., durable goods and articles of
luxuries would require larger advertising expenditure to overcome consumer resistance
during period of low incomes.

(2) Firms should time their product improvement and new product development in
accordance with the need for effective advertising in depression periods.

(3) Firms should stabilise their advertising cycle with a view to securing two advantages.
This policy helps in maintaining consumer's brand preference in times of severe price
competition. In prosperity the firm would have strongly entrenched itself by advertising.

22.14 INFLATION AND DEFLATION WITH REFERENCE TO INDIA

We have already studied about the concepts of inflation and deflation in the economy, the
former being abnormal and persistent rise in prices with the deplorable fall in the value of
money, and the latter denotes fall in prices with rise in the value of money and very tight

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money condition in the economy. It is said, though an exaggerated one, that during the times
of inflation, a cart-load of money would fetch only a basket-load of vegetables; and in times of
deflation, the farmers will not have adequate money to buy fuel and they may have to burn
their corn produced for keeping their hearth burning.

After the First World War (1914-18) most of the countries of the world were scourged with
deflation and depression and the period from 1926 to 1934 was called the 'Great Depression'.
Almost all countries of the world, except U.S.S.R. were victims of this world-wide economic
calamity and India was no exception. Several countries of the world launched many monetary
and fiscal measures to combat the severity of depression; thanks to the Second World War
(1939-45) which revived the economies all over, due to war demand and employment. After
the second world war, the Indian economy was in shambles, due to scarcity of essential
commodities and also abnormal rise in prices. At this juncture, in 1947, India attained
independence and the primary task of the administrators was to combat the inflationary
pressure in the economy; black-money generated during the war period, besides the ravages of
partition of the country. Hence, the first five-year plan of India aimed at assuaging the
inflationary pressure in the economy, besides setting right the war-torn economy. Aided by
bumper crops, the first five-year plan largely succeeded in achieving the objectives of
combating inflation, and the price level did actually come down by 1955-56.

A proper study of the movements of prices in the economy in order to trace the course of
inflation and the value of money is essential through Wholesale Price Index (WPI) of all
commodities with 1950-51 as the base year. Though the Government of India started with such
a price .index, it gave up the series in the middle of the sixties and started a new series with 1960-
61 as the base year; presumably to prevent people from government took several fiscal and
monetary measures to check the rise in prices. The Compulsory Deposit Scheme (CDS) was
introduced to impound part of the income of the people. Credit squeeze was adopted by the
RBI, besides limitations were imposed on declaring dividends. At the same time, the use of
MIS A against smugglers, hoarders and biackmarketeers also had a favourable impact.
Consequently, there was a dramatic change in the price situation since September 1974. The
wholesale price index fell from 331 in September 1974 to 309 points in March 1975; and it still
further fell to 283 points in March 1976. (Base year 1961-62).

But, the trend in declining prices was only short-lived and there was again rise in prices since
March 1976. The rise in prices till March 1977 completely viped out the decline in prices of
the previous two years. Actually, in April 1977, the price level was the same as that in
September 1974. The propaganda that Emergency was a major factor for controlling the
prices was thus exploded.

The price level in 1977-79, i.e., during Janata rule was brought down considerably and the
Government was successful in holding the price line, besides maintaining the price stability.
The price level in March 1977 was 183 points; in January 1978 it was 184 points and in
January 1979, it stood at 185 points with 1970-71 = 100. Besides stability in prices, the buffer
stock of foodgrains had crossed 20 million tonnes and there was a record 131 million tonnes
6f foodgrains production. Industrial production had recorded a rise of 9.5 points in 1978 over
the previous year. The country had over Rs. 5,000 crores worth of foreign exchange reserves.
This type of price stability and reasonable growth was one of the achievements of the Janata
government during their short tenure. But, unfortunately, the inflationary budget introduced in
February 1979 by the then Finance Minister, Mr. Charan Singh with heavy does of indirect

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taxation and an overall deficit of Rs. 1,365 crores exerted inflationary pressures and the prices
started rising almost the day after the budget was presented. The wholesale prices which
stood at 185 shot up to 224 in January 1980 (1970-71 base).

The price movements during the first half of Eighties, i.e., during the Sixth Plan period were
moderate, but it was short-lived one. Again inflationary pressures started from the middle of
January 1983. During the first year of the Seventh Plan, there was a noticeable reduction of
inflationary process. However, with the shortfall in production, the inflationary rise in prices
reasserted itself.

The price situation during the Nineties is given in the Table 26.1

Table 26.1 Price movements since 1990 (1981-82 = 100)

Period Wholesale price Annual rate

Index of inflation
1990-91 180 12.1
1991-92 208 13.6
1992-93 229 7.0
1993-94 260 10.2
1994-95 285 10.4
1995-96 298 5.0
1998-99 310 5.2

The foregoing study of price level in India should not make us to conclude that Indian economy
is always prone to tremendous inflationary pressures and recession is a rare occurrence. It is not
so. Economic development since independence had witnessed not only tremendous
inflationary pressures, but also its vulnerability to Demand Recession. The 1966-67, 1974-76,
1982-83 and 1991-93 recessions are glaring examples in this point.

22.15 CAUSES FOR INFLATIONARY PRESSURES

There is no one theory to explain the inflationary rise in prices. It is the result of several
accumulated foices in the economy. The causes may be
(1) Demand-pull factors:
(2) Cost-push factors; and
(3) Other factors.

Under Demand-pull factors, the several causes are

(a) Increasing Government expenditure;

(b) Deficit financing and increase in money-supply;
(c) Role of Black money;
(d) uncontrolled growth of population, etc.

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Under cost-push factors, the causes are
(a) Fluctuations in output and supply;
(b) Taxation as a factor in rising cost;
(c) Administered prices; and
(d) Hike in oil prices and global inflation.

(i) Increasing Government expenditure:

Since the attainment of independence, the government expenditure is mounting up year after
year from a bare Rs. 740 crores (both Central and State Governments) in 1950-51 to Rs.
37,000 crores in 1980-81 and around Rs. 3,40,000 crores in 1995-96 and now heading towards
Rs. 4,00,000 crores. This includes both development and non-development expenditures. This
mounting expenditure of the government implies growing demand for goods and services. As
this exercises puts lot of money income in the hands of the public, without adequate production
of goods and services, it naturally stokes the fire of inflation.

(ii) Deficit Financing and increase in money supply:

The government has been adopting the technique of 'deficit financing' for economic
development since the First Five-year plan. Though this deficit financing was modest in the first
three plans, the magnitude rose fantastically from fourth plan onwards. The disturbing fact is
that these fiscal deficits are met through borrowing from RBI (monetised deficits) and partly
through borrowing from the market at growing rates of interest. Expenditures financed directly
through RBI, pushes up the money supply in the country, leading to demand-pull inflation.

(iii) Role of Black Money:

Everyone knows that black money in the hands of politicians, black-marketeers, income-tax
evaders and some of the higher officials in administration play a dominant role in running a
parallel economy in the country. Though there is no reliable estimate of black money, it is
presumed to be around Rs. 4,00,000 crores in 1996. This large unaccounted money is used in
several inflation-sensitive goods such as foodgrains, sugar, edible oils, real estate, etc. These
exert inflationary pressures in the economy.

(iv) Uncontrollable growth of populations:

Perhaps, this is the villain of the piece in demand-pull factors. The pressures of growing
population at the rate of 20 million every year is responsible for the persistent gap between
demand and supply in almost all consumer goods and services, exerting continuous pressure on
prices. The problem of increasing prices cannot be solved satisfactorily, unless the growth of
population is effectively checked.

(v) Fluctuations in output and supply:

The important cause in cost-push factors is the violent fluctuations in the production of
foodgrains in our country. India is primarily an agricultural country and the fortunes of the
economy rests on the production of the agricultural sector. For instance, the production of
foodgrains was 89 millions tonnes in 1964-65. In the next year the production declined by 20
per cent and it stood around 72 million tonnes. Again, after a record production of 108 million
tonnes in 1970-71, the production of foodgrains declined to 97 million tonnes in the next two
years, a fall of 11 million tonnes. But, in the next year, it fell to 100 million tonnes, a fall of 22
million tonnes in just one year. Thus, there were violent fluctuations in foodgrains output,
causing violent jerks in the general price level. Similarly, the production of manufactured

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goods also never remained smooth or static. Power breakdowns, labour unrest, strikes,
lockouts, transport bottlenecks, bandhs, etc., have contributed to the fluctuations in industrial
goods production leading to increased prices.

(vi) Taxation, as a factor in rising costs:

Generally, cost-push inflation is due to the increase in labour cost, profit margins and other
costs. In this context, the government and the public sector were responsible to a large extent,
for pushing up the price level in the country. In every budget, new taxes are imposed or the
existing taxes are enlarged, leading to increase in the cost of production of the commodities
and rise in prices. Whenever new taxes are imposed, the trading community will make use of
the opportunity to raise the prices more than proportionately than the levy of taxes.

(vii) Administered prices:

The public sector enterprises have been generally increasing the prices of their commodities and
services almost continuously. There has been always an upward revision of prices such as steel,
cement, coal, etc. Further, many of the commodities produced by the public sector constitute
raw materials for other industries, and as such, the actions of public sector enterprises in
increasing their administered prices leads to general increase of all commodities.

(viii) Hike in oil prices and global inflation:

Because of the sharp hike in the price of crude oil since September 1973, there was revision of
prices of oil and oil-based goods. In 1980 alone, there was 130 per cent increase in all fuel
prices by the OPEC. The gulf-surcharge which raised the prices of petroleum products to an
unprecedented level in one single jump is major cause for rising in prices during 1990-91.

Other Causes
Besides the causes discussed above, there are other causes for the inflationary pressures in the
Indian Economy. Generally, all governments fail in holding the price line due to their erratic
and unstable policy. In 1973, the Government nationalised the wholesale trade in wheat with a
threat to introduce similar measure in rice trade as well. This measure ended in a fiasco and
the net result was the rise in prices of wheat and the normal trade was upset. Secondly, the
government failed to procure adequate amount of foodgrains for the public distribution
system, nor was it able to import the necessary sector, the government has been following a
policy which is highly, vacillating, particularly in fixing procurement prices. In fixing up the
prices of essential commodities through the Public Distribution System also the governments
approach is highly erratic and also vacillating. The controls are not properly enforced giving
great scope for rampant black-marketing for the benefit of traders.

The principal causes of inflation in recent years, particularly in nineties are

(i) enormous fiscal deficits;

(ii) Excessive growth of money supply
(iii) automatic monetization of fiscal deficits;
(iv) supply-demand imbalances; and
(v) sharp increases in procurement prices of cereals and consequent rise in the
issue prices.

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 Check Your Progress – 4
Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.
1. Discuss about Causes for Inflationary Pressures.
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22.16 VARIOUS THEORIES OF PROFIT

Different theories have been developed over a period of time to explain the emergence of
Profit. Some of the theories are explained below. They are,
1.Risk Taking Theory
2.Uncertanity Bearing Theory of Profits
3.Innovation Theory
4.Dynamic Theory of Profits

1. Risk Taking Theory: Hawley:

American Economist, developed this theory. According to Hawley Profit is reward for risk
taking. Profit arises because considerable amount of risk is involved in business But this
theory has been criticized on several grounds. Hawley has not classified the types of risk.
Cawer has pointed out, profit is not the reward for risk taking. It is the reward for risk
avoiding. An entrepreneur is required to minimize his risk, if he cannot eliminate it totally. A
successful entrepreneur is he who earns good profits by eliminating the risk. On the other
hand a mediocre businessman is not able to reduce the risk in business and therefore is
subject to losses.

2. Uncertainty Bearing Theory of Profits:

Prof. F.H. Knight an American Economist developed this theory. He classified the risk under
two heads.

a. Certain risks like risk of fire, theft and accident can be covered through insurance and
the losses can be passed to an insurance company and they are less important. The
entrepreneur can take an insurance policy by paying the premium. These risks are called
insurable risks.

b. There are other risks in the markets, when the price of the raw material goes up then it
might affect the profit, as the cost of production will be up. The other one is the
substitute for the product so when a substitute enters in the market the sales will go down
and the stock will be higher in the stores. So it is very important that avoid these risk,
which can be done only by a continues market research and bring up new products. All
these factors are uncertain and losses arising out of these can be insured with any
insurance company.

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Uncertainty theory has been criticized on the ground that profit is the reward paid to an
entrepreneur for discharging several duties. Prof. Knight has overlooked other duties and has
glorified the uncertainty, the theory has no sound foundations either in logic or in practice. A
number of illiterate producers who have not studied the theory, are able to anticipate
precisely the profits or losses that would arise in future.

3. Innovation Theory: Joseph Schumpeter developed this theory. According to him, profit is
the reward paid to an entrepreneur for his innovative endeavors.

Schumpeter has made distinction between invention and innovation. A scientist may make an
invention, but an entrepreneur exploits this invention on a commercial basis. The basis on
which the invention is exploited depends upon the innovative nature of the entrepreneur. If he
is successful in exploiting the invention it is innovation.

Schumpeter theory has been criticized on several grounds. Profit is the reward for discharging
so many duties but Schumpeter has overlooked the other duties. Another point of criticism is
that Schumpeter has neglected the fact that profit is also the reward for risk and uncertainty
bearing. The most serious criticism of this theory is that a particular producer who exhibits an
innovative character may earn super normal profits in the short run. Super normal profit will
attract new firms, which will reduce the profit in the long run.

4. Dynamic Theory of Profit:

Renowned economist, J.B. Clark, developed the dynamic theory of profit. Prof. Clark points
out that the whole world is dynamic. Changes after the changes are taking place every day
and the economic consequences of these changes are of a far reaching character. Prof. Clark
has pointed out the following types of changes.

i. Changes in the quantity and quality of human needs

ii. Changes in the techniques of production
iii. Changes in the supply capital
iv. Changes in the Organization of business
v. Changes in population

These changes can occur at any time. Techniques of production may change and improved
machinery may be introduced. This may reduce the cost and increase the profit and output.
But to purchase the improved machinery, a larger amount of fixed capital is required. This
may necessitate the admission of a new partner or conversion of the partnership firm into a
joint stock company to raise capital on a large scale.

All these changes can occur suddenly, and an entrepreneur has to face them properly. A
producer who overcomes these hurdles is successful in earning higher profits. He must adjust
himself to the changing times. A producer who cannot address himself to the dynamic world
lags behind. In order to survive and grow every producer must change the methods to suit the
changing needs. According to Prof. Clark, Profit is the reward paid for dynamism.

Check Your Progress – 5

Note: 1. Give your answer in the space given below.
2. Check your answers with those given at the end of the unit.

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 1. Discuss about Various Theories of Profit.

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22.17 LET US SUM UP

In this lesson we have studied, Characteristics of inflation, types of inflation, other types of
inflation, effects of inflation, anti- inflationary measures, deflation, effects of deflation,
control of deflation, choice between inflation and deflation, measures to be adopted by
business firms to reduce the evil effects of business cycle, inflation and deflation with
reference to India, Causes for inflationary pressures, various theories of profit briefly.

22.18 KEY WORDS

Inflation Anti- inflationary measures

Deflation Inflationary pressures
Various theories of profit Inducement
Demand-pull inflation Cost-push inflation
Demand-shift inflation Monetary measures
Fiscal methods Physical and direct measures
Stagflation Preventive measures
Relief measures Credit policy

22.19 SOME USEFUL BOOKS

1. S. Sankaran - Business Economics – Margam Publications

2. Sen, K.K. “An Introduction to Economics”, Sultan Chand & Sons.
3. V.G Mankar - Business Economics.
4. Samuel Paul – Managerial Economics Concepts & Cases
5. R.L. Varshney & K.L. Maheswari – Managerial Economics – Sultan Chand & Sons
6. Managerial Economics , D.Salvatore
7. Managerial Economics , Mote, Paul and Gupta
8. Managerial Economics , Varshney and Maheshwari
9. A study of Managerial Economics , D.Gopalkrishna

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 10. Managerial Economics , D.C.Hauge
11. Managerial Economics , Reekie and Crooke
12. Managerial Economics , Gupta
13. Managerial Economics, 4th Ed., Craig Peterson

22.20 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress – 1

1. See section 22.5
Check Your Progress – 2
1. See Section 22.9
Check Your Progress – 3
1. See section 22.11
Check Your Progress – 4
1. See Section 22.15

Check Your Progress – 5

1. See section 22.16

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