Prof. Pradeep Datar
M.A. (Economics)

Published by

Symbiosis Center for Distance Learning,

© Symbiosis Center for Distance Learning (SCDL)
No part of this book may be reproduced or copied or transmitted in any form without prior permission of the publisher.

April 2004

PREFACE Dear Reader, This book on Managerial Economics is written to present a simple text to the students who have limited exposure to Economics and are pursuing a programme in management studies.The book is also designed to provide standard reading materials especially for the students of M. B. A., M. M. M., C.A., Diploma and Degree Courses in Business Management. This book will satisfy the needs of the students who are pursuing a Distance Learning Programme in management studies. The book, I hope, would also help refresh the practicing managers. The book mainly lays emphasis on the applied part of the principles of Economics. The text of the book relies on standard works on the subject. I am deeply indebted to my teachers as well as colleagues, for inspiring me to write this book. To cap it all, my special thanks to the Director and the respected staff of Symbiosis Center for Distance Learning (SCDL) for their kind cooperation. Prof. Pradeep Datar Pune. April, 2004

ABOUT THE AUTHOR The author of this book is a Lecturer in the Department of Economics at S.P. College, Pune since 1980. He has written a few books on Economics both in English and Marathi. He has also been associated as a visiting faculty at various management institutes in and around Pune. As a member of the visiting faculty, he has been teaching a variety of subjects related to Economics, such as Managerial Economics at Master in Marketing Management Course., D. B. M.; Degree in Hotel Management and Catering Technology; Economics of Labour at M.P.M., Indian Economic Environment at M.M.M. level etc. All these courses are affiliated to Pune University. Furthermore, he has also worked as a visiting faculty at SIMS, Pune; teaching Managerial Economics to PGDBM students and delivered lectures on Monetary Economics to the students pursuing a course in M. A. Economics. The author has judiciously used his wide academic experience, knowledge and observation about the current economic affairs at Global and Indian level, to present updated information which can immensely benefit the students pursuing a programme in Management Studies. Mrs. Swati Chaudhari Director - S. C. D. L.

Chapter No. 1 2 3 4 5 6 7 8 9 Introduction to Managerial Economics Types of business Organizations Profit Demand Analysis Production and Costs Pricing and output determination in different markets Cost- Benefit Analysis Macro Economic Analysis Government and Private Business Reference Book TITLE Page No. 1 17 65 83 141 185 257 285 319 351

Chapter 1
Preview Introduction, Definition of Managerial Economics, Nature and Scope of Managerial Economics, Significance of Managerial Economics, Economic Problem.

INTRODUCTION Managerial Economics generally refers to the integration of economic theory with business practice. While economics provides the tools which explain various concepts such as Demand, Supply, Price, Competition etc. Managerial Economics applies these tools to the management of business. In this sense, Managerial Economics is also understood to refer to business economics or applied economics. “Managerial Economics lies on the border line of management & economics. It is a hybrid of two disciplines and it is primarily an applied branch of knowledge. Management deals with principles which help in decision making under uncertainly and improve effectiveness of organization. Economics on the other hand provides a set of propositions for optimum allocation of scarce resources to achieve the desired objectives. 1. 1. Definitions of Managerial Economics

Prof. Spencer Sigelman : Managerial Economics deals with integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management. Prof. Hague : Managerial Economics is concerned with using logic of economics, mathematics & statistics to provide effective ways of thinking about business decision problems. Prof. Joel Dean : “The purpose of Managerial Economics is to show how economic analysis can be used in formulating business polices.”



Introduction to Managerial Economics



Prof. Mansfield : “Managerial Economics attempts to bridge the gap between the purely analytical problems that intrigue many economic theories and the problems of policies that the management must face.” Mc Nair and Meriam : Managerial economics consists of the use of economic modes of thought to analyse business situations.


The definitions given above highlight the following points : i) ii) iii) iv) v) Economic theory provides the basis for the decision making process. There is some difference between the generalizations based on abstraction and actual practices. Besides economic theory, mathematics & statistics help in decision-making. An attempt is made to arrive at generalizations regarding business policies. Since decisions have repercussions on the working of firms in future, and most firms envisage to continue operations over a period of time, forward planning becomes an important element.

The problem of decision making arises whenever a number of alternatives are available For example : What should be the price of the product? What should be the size of the plant to be installed? How many workers should be employed? What kind of training should be imparted to them? What is the optimal level of inventories of finished products, raw mater spare parts, etc.? The significance of a good system of forward planning can be appreciated from the fact that it helps in selecting the plant to be installed and it is not possible to change its capacity as and when required. Also different production process require different skills which have to be provided. Similarly, based on the long-term plans, funds have to be arranged : either procured from outside or retained out of the earnings of the firm. Economics provides the solution to some of these problems to enable the firm to achieve its objective. For example, the demand for a product is influenced by factors such as (i) the distribution of income, (ii) prices of related products, and (iii) data on demand at some future point of time facilitates the task of forward planning. Similarly, the theoretical explanation of the problem of input-mix (the ratio in which machines, men and other resources are to be employed) is provided by production function along with the prices of inputs. This indirectly facilitates the choice regarding the technique of production to be employed and the plant to be installed. 2
Managerial Economics

The propositions of economics, however, require to be modified keeping in mind the constraints of availability of requisite data and the time at the decision-maker. 2. 1. Nature of Managerial Economics : It is true that managerial economics aims at providing help in decision-making by firms. For this purpose, it draws heavily on the propositions of micro economic theory. Note that micro economics studies the phenomenon at the individual’s level : behavior of individual consumers, firms. The concepts of micro economics used frequently in managerial economics are : (i) elasticity of demand, (ii) marginal cost, (iii) marginal revenue, (iv) market structures and their significance in pricing policies, etc. Some of these concepts, however, provide only the logical base and have to be modified in practice. Micro economics assists firms in forecasting. Note that macro economic theory studies the economy at the aggregative level and ignores the distinguishing features of individual observations. For example, macro economics indicates the relationship between (i) the magnitude of investment and the level of national income, (ii) the level of national income and the level of employment, (iii) the level of consumption and the national income, etc. Therefore, the postulates of macro economics can be used to identify the level of demand at some future point in time, based on the relationship between the level of national income and the demand for a particular product. For example, there is a relationship between the level of national income and demand for electric motors. Also, the demand for durable goods such as refrigerators, air-conditioners, motor cars depends upon the level of national income. Managerial Economics is decidedly applied branch of knowledge. There fore, the emphasis is laid on those propositions which are likely to be useful to the management. Managerial Economics is prescriptive in nature and character. It recommends that a thing should be done under alternative conditions. For example, If the price of the synthetic yarn falls by 50%, it may be desirable to increase its use in producing different types of textiles. Thus, managerial economics is one of the normative sciences and reflects upon the desirability or otherwise of the propositions. For example if the analysis suggests that the benefit-cost ratio of a large plant is less than that for a smaller plant and the benefit-cost ratio is used as the criterion for project appraisal it is recommended that the firm should not install a large plant. Contrast this with the positive sciences which state the propositions without commenting upon what should be done. For example, if the distribution of income has become more uneven, it is stated without indicating what should be done to correct this phenomenon. Managerial Economics, to the extent that it uses economic thought, is a science, but it is an applied science. Economic thought uses deductive logic (if X is true, then Y is





Introduction to Managerial Economics


when the price of inputs shoot up. capital budgeting etc. resource allocation. From the above it follows that managerial economics uses a scientific approach. some firms may use simple rules based on past experience. Production Function : We know that resources are scarce and also have alternative uses. merely to explain the scope of the subject. 3. 2. empirical studies may suggest that for every 1% rise in expenditure on advertising. the manager does not stop at the stage of assessing the current demand but estimates future demand as well. For instance. Alternatively. He takes into account such concepts as income elasticity and cross elasticity. The factors of production. Scope of Managerial Economics : The scope of Managerial Economics is so wide that it embraces almost all the problems & areas of the manager and the firm. the production function is pressed into service by managerial economics. methods of estimating costs. Cost Analysis : Cost analysis is yet another area studied by managerial economics. production function. While an in-depth treatment is given to these aspects in the relevant chapters. the relationship between cost & output. This is attempted in managerial economics. For example. In this way. To have confidence in the findings. there is an attempt to generalize the propositions which provide a predictive character. the forecast of cost and profit-these are very vital to a firm. 3. This is what is meant by demand forecasting. Managerial Economics 4 Managerial Economics . Furthermore. For example.5%. empirical studies try to verify whether cost curves faced by a firm are really Ushaped as suggested by the theory. determinants of cost. 1.true). the propositions deduced are subjected to empirical verification. When demand is estimated. a firm is forced to work out a combination of inputs so as to ensure that this combination becomes least cost combination. their angles are equal. the demand for the product shall increase by 0. may be combined in a particular way to yield the maximum output. It deals with demand analysis and forecasting. otherwise called inputs. inventory management advertising price system. In practice. a cursory treatment of these aspects has been attempted here. if the triangles are congruent. For example. the quality of discussions made can be improved using a systematic approach. Inputs play a vital role in the economics of production. Demand analysis and forecasting : It analyses carefully and systematically the various types of demand which enable the manager to arrive at a reasonable estimate of demand for products of his company. However. cost analysis.

is to achieve optimization. the problems of cost. advertising forms an integral part of decision-making and forward planning. To produce a commodity is one thing. If it is high. if the stock of inventory is reduced. It also goes deeper into such aspects as the need for inventory control. Resources Allocation : Scarce resources obviously have alternate uses. be used for other productive purposes. to market it is another. Price System : It has already been pointed out that the pricing system as a concept was developed by economics and it is widely used in managerial economics. While the cost of production has to be taken into account while pricing a commodity. On the other hand. for different markets is essential to the pricing of those commodities. managerial economics will use such methods as ABC analysis.touches these aspects of cost-analysis. the methods of determining the total advertisement costs and budget. Advertising : It may sound strange when we say that advertising is an area which managerial economics embraces. 6. it classifies inventories and discusses the costs of carrying them. For instance. an understanding of how a product has to be priced under different kinds of competition. 7. It is clear from these facts that the price system touches upon several aspects of managerial economics and aids or guides the manager to take valid and profitable decisions. etc. illustration. Therefore. production will be hampered. of an advertisement are the responsibility of those who get it ready for the press. Yet the massage about the product should reach the consumer before he thinks of buying it. How best can these scarce resources be allocated to competing needs? The aim. An understanding of the pricing of a product under conditions of Oligopoly is also essential. capital is unproductively tied up.. an effective knowledge and application of which is cornerstone for the success of a firm. For Introduction to Managerial Economics 5 . which might. there is such a thing as price leadership and non-price competition. While the copy. Further. Therefore. 5. a complete knowledge of the price system is quite essential to determination of price. if level of inventory is low. 4. of course. Now the problem is how much of the inventory is ideal stock. The central functions of an enterprise are not only production but pricing as well. a simple simulation exercise and some mathematical models with a view to minimize the inventory cost. Pricing is actually guided by considerations of cost plus pricing and the policies of public enterprises. Inventory Management : An inventory refers to stock of raw materials which a firm keeps. the measuring of the economic effects of advertising – these are the problems of the manager.

Linear programming. i. 3. Now the problem is how to arrive at the cost of capital. the demand and supply. 4.this purpose. when the prices of inputs increase. Significance of Managerial Economics. Sources of information on new projects. external influence on the domestic market and social and political changes in the country. etc. Capital is scarce. government policy. First. Some other areas covered by Managerial Economics are : 1. The complexity of the modern business would add complexity to the business decision . what type of sub-situation should he resort to? Or. how to effect a cost-benefit analysis. how to arrive at investment decisions under conditions of uncertainty. namely. 6 Managerial Economics . how should he arrive at an optimum combination of inputs in order to get the maximum output? Secondly. some advanced tools. Generally speaking. and it costs something. Capital Budgeting : This is another area which calls for a thorough understanding on the part of the manager if he is to arrive at meaningful decisions. therefore. the degree of uncertainty and risk can be greatly reduced if market conditions could be predicted with a high degree of reliability. Decision making under risk and uncertainty./ How Does Economics Contribute to Management?: While performing his functions.making. a manager has to take a number of decisions in conformity with the goal of the firm. However. These two areas are essential to every stage of planning. how to face up to budgeting problems.e. changing business environment. It makes use of the tools which have been developed not only be economics but by other disciplines as well. Many of the decisions are taken under the condition of uncertainty and therefore involve risk. what type of combination of inputs should he work out in order to ensure the least-cost combination? 8. two kinds of problems are of the utmost importance and concern to the manager. marketing. Uncertainty and risk arise mainly due to uncertain behaviour of the market forces. The subject matter of managerial economics covers two important areas. social benefit cost analysis etc. These areas cannot be ignored by any manager. plays a vital role in the successful business operations of a firm. Managerial economics. its assumptions and solutions. etc. are used to arrive at the best course of action for a specified end. how to ensure that capital becomes rational. Profit planning and investment analysis. production. 2. decision-making and forward planning. alternatively. methods of project appraisal. It is obvious form the foregoing discussion that managerial economics is applied economics. such as linear programming.

meaning the one who undertakes tasks). Prof. With the growing complexity of business environment.making has been widely recognized. economic theories offer clarity to the various concepts used in business analysis. machinery and buildings. First. economic theory contributes to the business analysis ‘a set of analytical methods’ which may not be directly applied to specific business problems but they do enhance the analytical capabilities of the business analyst. Economic Problem : THE SOURCE OF ECONOMIC PROBLEMS Resources and scarcity The resources of a society consist not only of the free gifts of nature. such as tools. These resources are called FACTORS OF PRPDUCTION because they are used in the process of production. both mental and physical. eliminating the minor details which might obstruct decisionmaking. both inherited and acquired. Often a fourth factor. such as tools. forests. plant and equipment. and of all sorts of man-made aids to further production. including everything man-made which is not consumed for its own sake but is used in the process of making other goods and services. machinery. All those free gifts of nature. It is sometimes useful to divide those resources into three main groups : 1. and All those man-made aids to further production. etc. ‘one of the most important things which the economic (theories) can contribute to the management science’ is building analytical models which help in recognizing the structure of managerial problems. ENTEPRENEURSHIP (from the French word entrepreneur. which enables the managers to avoid conceptual pitfalls.. such as land. which economists call LABOUR. The entrepreneur is the one who Introduction to Managerial Economics 7 . the usefulness of economic theory as a tool of analysis and its contribution to the process of decision. commonly called natural resources and known to economists as LAND. 3. Economic theories have therefore gained a wide application to the analysis of practical problems of business. mental and physical. Baumol has pointed out three main contributions of economic theory to business economics. forests and minerals. which economists call CAPITAL. All human resources. but also of human capacity. such as land. 2. Application of economic theories to explain and analyse the technical conditions and the economic environment in which a business undertaking operates contributes a good deal to the rational decision-making. is distinguished.Taking appropriate business decisions requires a clear understanding of the technical and environmental conditions under which decisions are to be taken. Secondly. and in concentrating on the main issue. Thirdly. minerals. 5.

The problem of economy is how to use the relatively limited resources 8 Managerial Economics . as are food grains. The act of making goods and services is called production. In most societies goods and services are not regarded as desirable in themselves. Meaning of Economic Problem : Now. Goods and services are thus regarded as means by which the goal of the satisfaction of wants may be reached. The total output of all commodities in one country over some period. In relation to the known desires of individuals for such commodities as better food. never to be consumed. cars or shoes. Every nation’s resources are insufficient to produce the quantities of goods and services that would be required to satisfy all of its citizens’ wants. human wants are unlimited. (When it is not distinguished as a fourth factor. the existing supply of resources is woefully inadequate. is called Gross National Product. It can produce only a small fraction of the goods and services that people desire. for all practical purposes in today’s world. Usually the end or goal that is desired is that individuals should have at least some of their wants satisfied. 6. the same means cannot be used to satisfy any other want – it becomes clear that every man begins to face the problem of economizing his means. This gives rise to one of the basic economic problems : the problem of scarcity. A car. entrepreneurship is included under labour. services are intangible. hospital care and entertainments. and anyone who consumes them to satisfy his or her wants is called a consumer. or often just National Product. and the act of using these goods and services to satisfy wants is called consumption. schooling. He organizes the other factors of production and directs them along new lines. that human wants vary in their intensity. and they have alternative uses. The wants that can be satisfied by consuming goods and services may be regarded. for example. that means or resources are relatively limited.takes risks by introducing both new products and new ways of making old products.) The things that are produced by the factors of production are called commodities. as insatiable. no great virtue is attached to piling them up endlessly in warehouses. but if used to satisfy one want. if we put together the four characteristics – namely. usually taken as a year. is valued because of the transportation that it provides – and possibly also for the flow of satisfaction because of the transportation that it provides – and possibly also for the flow of satisfaction the owner gets from displaying it as a status symbol. as they are valued because of the services they confer on their owners. holidays. Commodities may be divided into goods and services : goods are tangible. Anyone who helps to produce goods or services is called a producer. clothing. housing. Most of the problems of economics arise out of the use of scarce resources to satisfy human wants.

arises at all levels of human organization. The Government of India with an annual revenue of about Rs. Indian. etc.S. food grains. Lionel Robbins writes : “Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses. The Government of India therefore continually faces Introduction to Managerial Economics 9 . insurance. each family in relation to its wants. This is the problem of economy – how to economics or make the maximum use of limited resources. that they have alternative uses and therefore the problem of economizing them must be faced.which may be its monthly income. recreation. guests. ancient or modern. Thus whether it is the Government of India or the Government of the richest country namely the United States. therefore faces the basic economic problem – how to make the best use of the limited resources so as to secure maximum satisfaction out of them. finds that it has unlimited wants (e. tax-payment. medicines during sickness. shelter. clothing. $ 5.g.with alternative uses in the face of unlimited wants. Naturally. transport. but the resources at its disposal are relatively limited. religious and social ceremonies. European and American. industries.000/. Thus whether we are thinking of a Grampanchayat. The Indian family may be thinking in terms of Rs. expanding expenditure in respect of development that is to be brought about in various sectors like agriculture.” Economic Problem at the Family Level Almost in every community. family is the basic unit of social organization.corers has innumerable demands on its resources such as meeting mounting defense expenditure. In view of limited resources and unlimited wants. But as we have observed.000 a month may be thinking in terms of that as a fairly big amount. finds that the resources at its disposal are limited. every individual has to face the basic economic problem – namely unlimited wants and limited means with alternative uses – exactly in the same way. the problem of economy is always there. everyone will so try to use his relatively limited resources with alternative uses that he gets maximum satisfaction out of his resources.) . or of Zilla Parishad. he will try to satisfy those wants which are most urgent or intense and then those wants slightly less urgent and so on thus sacrificing the satisfaction of those wants which are lower on the scale of preference for which he may not have resources. poor or rich. whereas an average American family earning U. or of a club or hospital or university or the national government.5.1. all have to face the same basic economic problem. No family can avoid this basic economic problem.000/. education and so on and so forth. every family. education of children.00. poor or rich. Economic Problem at the Universal Level Or Economic Problem – A Universal Problem The same basic economic problem – unlimited wants and relatively limited resources . Every family. In the light of the above situation. Just as. with no limit on its increasing wants.

creed. can be produced by farming 2) 10 Managerial Economics . The problem of economy was there in ancient times and it is there before everybody at present. Economic problem does not recognize boundaries of caste. In free – market economies. The question ‘What determines the allocation of resources or resource allocation?’ have occupied economists since the earliest days of the subject. its needs are also unlimited – expanding and modernizing defense forces. schools. no nation can ever escape it. establishing military bases all over the world giving economic and military assistance to friendly countries. a city – dweller. Agricultural goods. the Federal Government of the United States. in the case of associations like clubs. 7. has to face this basic economic problem. in the case of the poor as also the rich. & mixed are explained below. culture Basic Economic Problems Seven more general questions that must be faced in all economies. Though in absolute terms. The study of how this system works is the major topic in the THEORY OF PRICE. religion. The problem of economy – unlimited wants and limited means with alternative uses – has been forever confronting mankind. It concerns the allocation of scarce resources among alternative uses (a shorter phrase. small or great. with small population or with huge population. for example. its annual revenues are enormous running into billions or trillions of dollars. exploring oceans and so on and so forth. colour . will often be used). socialist or communist. resource allocation. faces the same basic economic problem. poor or rich. In the some way. a villager. hospitals and government organizations right from the village level to the national level. 1) Seven Questions faced by all economies : What commodities are being produced and in what quantities? This question arises directly out of the scarcity of resources.the basic problem of economy of how to make the best use of its limited resources. The economic problem is a universal problem. By what methods are these commodities produced? This question arises because there is almost always more than one technically possible way in which goods and services can be produced. most decisions concerning the allocation of resources are made through the price system. a Frenchman and an American. Thus there is something ‘universal’ about the problem of economy. Every nation. the richest government. The basic problem of economy arises in the case of an aboriginal. whether they be capitalist. in the case of an Indian. And therefore even the richest Government of the United States is always confronted by the same basic economic problem – unlimited wants and limited resources with alternative uses. meeting expanding expenditure on space and military research.

or farming a large quantity of land extensively. ranging from ones using a large quantity of labour and only a few simple machines to ones using a large quantity of highly automated machines rather than another. Production is said to be inefficient if it would be possible to produce more of at least one commodity without simultaneously producing less of any other – by merely reallocating resources. The same is true of manufactured goods. one method is frugal with land but uses larger quantities of other resources. are topics in the THEORY OF PROCDUCTION. using only small quantities of fertilizer. whereas the other method uses large quantities of land but is frugal in its use of other resources. But this only pushes the question one stage back. These questions are the subject of the THEORY OF DISTRIBUTION. When they speak of the division of the national product among any set of groups in the society. can cause it to change. The commodities that are produced are said to be inefficiently distributed if it would be possible to redistribute them among the individuals in the society and make at least one person better off without simultaneously making anyone worse off. The latter is a normative concept. Such questions have been of great concern to economists since the beginning of the subject. it is natural to go on to ask whether the production and distribution decisions are efficient. and a just distribution of the national product would be one that our value judgments told us was a good or a desirable distribution. The concept of efficiency is quite distinct form the concept of justice. Having asked what quantities of goods are produced. how they are produced and to whom they are distributed. 4) How efficient is the society’s production and distribution? This questions quite naturally arises out of question 1. Questions about the efficient of production and allocation belong to the branch of economic theory called WELFARE ECONOMICS. and the consequences of these choices about production methods. 3) How is society’s output of goods and services divided among its members? Why can some individuals and groups consume a large share of the national output while other individuals and groups can consume only a small share? The superficial answer is because the former earn large incomes while the latter earn small incomes. 2 and 3. using large quantities of fertilizer. economists speak of THE DISTRIBUTION OF INCOME.a small quantity of land very intensively. labour and machinery. it is usually possible to produce the same output by several different techniques. Both methods can be used to produce the same quantity of some good. Why do some individuals and groups earn large incomes while others earn only small incomes? Economists wish to know why any particular division occurs in a free – market society and what forces. labour and machinery. Introduction to Managerial Economics 11 . including government intervention. Efficiency and inefficiency are positive concepts.

one quarter of these countries’ resources were lying involuntarily idle. or are some of them lying idle? We have already noted that the existing resources of any county are not sufficient to satisfy even the most pressing needs of all the individual consumers. Surely if resources are so scarce that there are not enough of them to produce all of those commodities which are urgently required. Why do market society’s experiences such periods of involuntary unemployment which are unwanted by virtually everyone in the society. for some reason. the managers and owners would like to be able to operate their factories. for example. nothing happens : the workers stay unemployed.Questions 1 to 4 are related to the allocation of resources and the distribution of income and are intimately connected. Their study was given renewed significance by the Great Depression of the 1930s. in a market economy. This book. there can be no question of leaving idle any of the resources that are available. M. unemployed). Yet one of the most disturbing characteristics of free – market economies is that such waste sometimes occurs. raw materials are available in abundance. and the goods that could be produced by these resources are urgently required by individuals in the community. Unemployed workers would like to have jobs. The 1970s. and have been studied under the heading TRADE CYCLE THEORY. the factories lie idle and the raw materials remain unused. has greatly widened the scope of economic theory and greatly added to our knowledge of the problems of unemployed resources. more simply. This branch of economics is called MACRO ECONOMICS. When this happens the resources are said to be involuntarily unemployed (or. this unemployment was never less than one worker in ten. 6) Is the purchasing power of money and savings constant. In recent decades. They are sometimes grouped under the general heading of MICRO ECONOMICS. and can such unemployment be prevented from occurring in the future? These questions have long concerned economists. 5) Are the country’s resources being fully utilized. the factories in which they could work are available. and it rose to a maximum of approximately one worker in four. Yet. however. and in terms of the effects on people who are unable to find work for prolonged periods of time. or is it being eroded because of inflation? The world’s economies have often experienced periods of prolonged and rapid changes in price levels. This meant that. In the USA and the United Kingdom. the course of prices has almost always been upward. Over the long swing of history. by J. The cost of such periods of unemployment is felt both in terms of the goods and services that could have been produced by the idle resources. to the way in which the price system works. A great advance was made in the study of these phenomena with the publication in 1936 of the General Theory of Employment. Keynes. price levels have sometimes risen and sometimes fallen. 1980s and 1990s saw a period of Managerial Economics 12 . Interest and Money. and the whole branch of economic theory that grew out of it. during the worst part of the depression.

more particularly in the less developed countries.accelerating inflation in Europe. slowly in others. Although a certain amount is now known in this field. not of nature. They also ask about other causes of inflation. Inflation reduces the purchasing power of money and savings. Money is the invention of human beings. a great deal remains to be discovered. the United States and in most of the world. and the amount in existence can be controlled by them. Problems of this type are topics in the THEORTY OF ECONOMIC GROWTH. Introduction to Managerial Economics 13 . It is closely related to the amount of money in the economy. Economists ask many questions about the causes and consequences of changes in the quantity of money and the effects of such changes on the price level. 7) Is the economy’s capacity to produce goods and services growing from year to year or is it remaining static? Why the capacity to produce grows rapidly in some economies. and not at all in yet others is a critical problem which has exercised the minds of some of the best economists since the time of Adam Smith.

2. Explain the Nature and Scope of Managerial Economics. 3. 14 Managerial Economics . 5. What is the Significance of Marginal Economics? What is an economics problem? “There is something Universal about and economic problem” Discuss.Exercise : 1. 4. Define Managerial Economics.

NOTES Introduction to Managerial Economics 15 .

NOTES 16 Managerial Economics .

1. But in modern times the profit motive became the only dominant motive of production. in the sense that it has become dominant only after the Industrial Revolution. other goals or objectives of firms. Types of Business organizations . Joint Stock Companies. A firm is a unit of production where production is done with the sole aim of profit maximization. Hansn : The firm may be defined as an independently administered business unit. Production with the profit motive is modern concept. Organization Goals Profit Maximization. The level at which this is done is the level of a firm.Proprietary Firms. 2. INTRODUCTION Organisation of production requires bringing together various factors of production and coordinating the efforts of all the participants in the process of production." "A firm is a business unit which hires productive resources for the purpose of producing goods and services. plant. For the sake of understanding this concept of the firm.Chapter 2 TYPES OF BUSINESS ORGANISATIONS Preview Introduction. Industry. Partnership Firms. A firm. let us study some definitions of the firm given by eminent economists. The profit motive was always a secondary motive in an agricultural economy. most of the economies of the world were agricultural economies. 3. Business Organization in new millennium. Before the Industrial Revolution. Public Sector Undertakings. "A firm is a centre of control where the decisions about what to produce and how to produce are taken. Definition of a firm as a producing unit. 1." Types of Business Organisations 17 . Co-operative Societies . sales Maximization.Non-profit organizations. Satisfying Theory.

The following features of a firm emerge from these definitions: 1) It is a centre where decisions about what. Harvey Leibenstein : A firm is " an independent organization whose destiny is determined by the magnitude of the aggregate pay off and in which the aggregate pay off depends directly on its performance and especially on the production and sale of services or goods. The decisions regarding choice of techniques and quantify of a commodity are taken by the firm. where the success of production is reviewed in its entire context and decisions are taken. how are they reached etc. how to produce etc. is a firm.) The firm is thus the unit that makes the decisions regarding the employment of factors of production and the output of commodities. Tata Engineering and Locomotive Company Ltd. who reaches decision.smallest possible unit. Therefore. public agencies etc. how and how much to produce are taken. That it is a unit of decision . Through advertisements.e. It is a centre where the means of production are hired or purchased and used for production. We take firm as a single unit . but the decisions to buy belong to the buyers. and so if we study the various features of firm as revealed by these definitions. Again. it will be seen that there is a substantial difference in all these definitions and still in their own way they describe the firm correctly. are ignored.making i. where. just as the household is assumed to seek satisfaction maximization. It is taken as our atom of behavior on the demand side." How much to consume is decided by the households. 5. Lipsey.making is our criterion. The internal problems regarding the process of decision . a firm may try to increase its sales. what form of business organization and management experts? An economist assumes that the firm is internally properly organized and is capable of taking decisions. This is so because these economists have given prominence to the questions which were more important for them or for their country or when they were writing. From the above definitions.4. for an economist. The firm may be a proprietorship firm or a partnership firm or a Multi-National Corporation. It is a centre. 2) 3) 18 Managerial Economics . "The firm is defined as the unit that uses factors of production to produce commodities that it then sells either to other firms." In the words of Prof. In keeping with preferences of the consumers. the firm is assumed to seek maximization of its profits. Again. The firm is assumed to take consistent decisions in relation to the choice open to it. the firms decide how much to produce. the concept will be more clear. to households or to the central authorities (meaning government.

every firm in a purely competitive industry. the production is done. there should be no barriers to the entry of new firms (or exit of old firm) to (or from) the industry. The firm and the industry For understanding the difference between a firm and an industry. a firm is expected to organize all the factors of production in the most profitable manner. and the sale and distribution of production is also affected. Thus. Every firm therefore enjoys the freedom to increase or decrease its output substantially by taking the price of the product as given.i. The buyers. Finally. it will be clear that a firm has to perform several functions simultaneously . Theoretically speaking. the firm is expected to make as much profits as possible. the entrepreneur was taken to be an independent factor of production. it would be advisable to understand the nature of a competitive industry. This ensures that all firms have to charge the same price. 2. To cap it all. there is a large number of firms so that the action of a single firm has no effect on the price and output of the whole industry. The buyers should not find any real or imaginary differences between the products sold by any two pairs of firms. and (c) Freedom of entry and exit.e. (b) Homogeneous product. In a competitive industry. where the means of production are collected. where all the decisions about production are taken. This is known as the condition of homogeneity. it must be making a product which is accepted by customers as being identical with that made by all the other producers in the industry.4) It is a centre. Formerly. Secondly. 5) From the above features of a firm. The mere presence of all the factors of production and a market does not guarantee production. Types of Business Organisations 19 . to sell and distribute the commodity. of course. The will be to produce is very important and it cannot be separated from the entrepreneur. A competitive industry has three basic characteristics: (a) Large number of firms. It is a centre. Even today the entrepreneur is no doubt a very important factor of production but he has become so highly indispensable that it is very difficult to separate him from the production unit of the firm because ultimately the will to produce is provided by the entrepreneur. because in modern times the firm is expected to perform so many other functions. are to decide that the product is the same. the entrepreneur becomes inseparable from the firm. sale and those regarding facing competition also. to advertise the commodity and to perform all those things which will be required to survive competition. to produce a commodity. These include decisions regarding the distribution of the product. If one studies the structure and function of modern firm the above definitions will appear to be too simple. advertising.

A plant thus produces any one product. be clear that all firms. 20 Managerial Economics . other chemicals and fuel are supplied to it. There is. Thus. Though the sugar produced by sugar factories might have different grades of quality. the conveyor system what takes the cane for crushing. The difference. steel industry. cement industry and so on. until finally sugar is filled in gunny bags. for example. on the other hand. are decisions to be taken by the firm. Entry into the industry is not free. linked together (not necessarily physically but by processes also) capable of producing a given quantity of sugar per day. It is not necessary that a firm has only one plant. we get a wide range of marked structures where there are more than one firms product. the firm is the industry or the distinction between the firm and the industry disappears under conditions of monopoly. Under monopoly.feed plant (producing cattle feed out of bagasse) . all firms producing the same i. managers. we speak of the automobile industry. The firm and the plant A plant is a technical unit of a given capacity of output. we speak of sugar plant What is it? It is nothing but an assembly of several machines.We considered competitive industry because we wanted to contrast such an industry with a monopoly.all under one management. Thus. Similarly. The decisions are taken by the firm. A sugar plant will produce sugar in co-operation with workers.e. we speak of one sugar industry. obviously in cooperation with other factors of production. we are implying one firm though there are various plants. therefore. a sugar factory (i. is an economic unit. how much of it is to be produced. is that between a technical unit and an economic unit. producing a given product. and after the necessary amounts of raw material. homogeneous product make an industry and whatever all such firms supply becomes the supply of the industry. together make an industry. a distillery). and the machinery for removing impurities and so on. The firm. to which market it should be sold and from which farmers the sugarcane should be purchased etc. under monopoly. a firm engaged in the production of sugar) may have a sugar plant. an alcohol plant (i.e. because if entry of an additional firm is allowed. it no longer remains a monopoly. basically. the crushing machinery. In practice. technicians etc.e. for example. though all cotton textile units do not produce identical textile products. it is also possible that a plant supplies goods to more than one firms. a cattle . we speak of the cotton textile industry. Between these two extremes. For example. a weighing system which weighs the sugarcane. This whole plant taken together is capable of producing a given quantity of one product sugar. What quality of sugar is to be produced. 3. however. Strictly speaking. there is only one firm producing a product. When we say one management. It should.

we study various forms of business organization. the first four types of business organizations are set up in the private sector. The public sector is owned and controlled by the State.One last word about a firm. etc. l Types of Business Organization : The main types of business organization are as follows: i) ii) iii) iv) v) vi) vii) ix) A. Life Insurance Corporation. B. Types of Business Organisations 21 . post sand telegraphs. families or groups of individuals. Bharat Heavy Electrical Ltd. Whenever we speak of a producer or an entrepreneur we imply a firm that takes decisions.our unit on the supply side is the firm. Types of Business Organisations Introduction: A business organization is concerned with how production and sale of a commodity are organized. It is characterized by private ownership in the means of production. Internally the decisions might be taken by a group of directors. etc. public corporations and departmental undertakings. They are constituted as companies. Partnership Joint Stock Company Joint Hindu Family Firms Co-operative Organizations State Enterprise/Public Enterprises Joint Sector Organizations Business Organizations of the New Millennium Private Sector : viii) Non-Profit Organizations and In a capitalist economy. Public Sector : The public sector includes public or state enterprises like railways. 4. there are also Joint Hindu Family Firms in the private sector in India and Business Organizations of the New Millennium. managers or a sole proprietor . One -man Business or Individual or Sole Proprietorship or Proprietary Firms. In addition to the first three types of business organization. economic freedoms and profit motive. The private sector is owned by private individuals. We speak of the producer or the entrepreneur. In this chapter. In India we have also a number of public enterprises like Hindustan Machine Tools.

Joint Sector : Joint sector organizations or enterprises are jointly owned by the public and private sectors. D.g. a single man called proprietor organizes a business. But day-today management is left to the private sector. It is owned. Co . etc.Capitalist Form 1) Proprietary Firms 6) Co-operative or Proprietorship Organizations 2) Partnership 3) Joint-Stock Company 4) Joint-Hindu Family Firms 5) Business Organizations of the New Millennium Let us now study the types of business organizations as given in the above chart.operative Sector : There are many co-operative organizations in the private sector. managed. e. But they are non-capitalist in nature. service societies. controlled and directed by him.. SOLE PROPRIETORSHIP OR PROPRIETARY FIRMS : (A) Definition : Individual or sole proprietorship which is also called sole trader ship or single entrepreneurship or proprietary firms is the most common. In such a unit. Co-operative credit societies. producers' cooperative societies. consumers' co-operative societies. The following chart indicates various forms of business organization: Types of Business Organization Private Sector Public Sector Joint Sector (7) State Enterprises (8) Public Private Organizations Capitalist Form Non . 1. the simplest and the oldest form of business organization. 22 Managerial Economics .C.

He alone enjoys all profits. all his private property can be attached by his creditors. tailoring etc. If he fails to clear his business debts. There is also little government interference. So no legal formalities are involved in starting such a concern by any person who is of major age. organizes production as efficiently as possible and markets the product at the highest possible prices. if his business fails. He enjoys full powers to fix the lay-out of his business firm. Organization and Control: A single person organizes and manages his business according to his experience and efficiency. (v) (vi) (vii) Legal Status: A sole trading concern cannot be legally separated from its owner or proprietor. The owner and organization are the same. Also it is simple to manage and control and Types of Business Organisations 23 . (iv) No Sharing of Profits and Losses: All the profits of business earned by the owner are enjoyed by him alone. if he is successful and suffers all losses. printing press. He assumes full responsibility for all business risks. These profits of business are not shared with other persons. (C) Merits and Demerits of Sole Proprietorship or Proprietary Firm : MERITS OF PROPRIETORSHIP OR PROPRIETARY FIRM : (i) Easily Started: Such a concern can be easily started without any legal formalities. (B) Characteristics: The definition of sole proprietorship Proprietary Firm gives its characteristics or features which are as follows: (i) Ownership by a Single Person: A single person initiates a business whose ownership lies in his hands. retail trade. whenever necessary. The life of such a concern depends upon the life of its proprietor.He fixes the amount of capital to be invested. This type of organization is found in agriculture. hires factors. (ii) (iii) Capital: The owner uses his own capital. 18 years and above. On the other hand. It is not subject to any special legislation. He need not consult any one. He may also borrow capital to invest it in his business and thereby expand it. Easy to Form: It can be easily set up. Unlimited Liability: His liability is unlimited for all his debts. hotel. He has full powers to conduct his business in any manner he likes. He is also not required to take approval or agreement from others. he has to bear them alone entirely. (his own or borrowed). i. uses his own labour and that of his family members.e. if there are losses.

His attempts to meet their needs will help him to increase his sales and profits.intensive techniques. (v) Cordial Relations: He has direct and continuous contact with his employees. Hard Work and Direct Gain: He will always attempt to work hard. (xii) Self . Thus it is suitable for small business. 24 Managerial Economics . (x) Flexibility and Elasticity : Any change in business can be easily introduced without consulting any body. So it is flexible and elastic. tastes and needs. (xi) Transferability : It is easily transferable to heirs. He can also supervise them directly. so he can personally attend to all their requirements. (viii) Winding Up: Just as a sole trader can easily start a business. He need not consult others about these problems. (vi) Efficiency. development of one's personality. Hence it is economical. It can easily and quickly adapt to changes in the market conditions. efficiently and continuously. so also he may easily wind up his business at any time. Hence the working expenses can be minimized. He would then take measures to remove them. self-reliance. method of production etc. He is not required to give publicity to the activities of his concern nor disclose his profits to the public. its location. self-confidence etc.requires a small amount of capital for generally it adopts labour . (iii) Personal Interest: He would always take personal interest in the business with a view to finding out causes of loss and waste of resources. (iv) Requirements of Consumers: He has direct contact with his customers. The number of employees employed by him is low. So he can establish cordial relations with them. This helps to enjoy maximum profits and avoid any loss for his liability is unlimited. This is because he will be in a continuous touch with them. Hence any scope for conflict between workers and himself can be avoided. (vii) Business Secrecy : He can carry on his business in secrecy. He can also get finance on personal credit. (ix) Economy in Expenses : Its overhead expense are low.Employment : It promotes self-employment. Thus he would maximize his profits. He can also make use of any new idea for his business. (ii) Prompt Action: The proprietor can take quick decisions and prompt action regarding his business. He can produce goods according to their desires.

. Unlimited Liability and Risks : It may be very risky for him to invest in a particular business. supervision and control. (ii) (iii) Lack of Skill for Efficient Management : It may not also be possible for him to attend personally to all the activities of his concern such as correspondence.(xiii) Lower Tax Burden : It is also subject to lower tax burden than other forms of business organizations. ability and skill.scale production such as purchase of raw materials at low prices. maintaining accounts. Some of his decisions may prove to be wrong. This is because he may not have heirs to run it or they may not like to continue in his business. Further his business activities may be spread in different places and he may not possess all the qualities and skill required for an efficient management. he may lose everything and also become insolvent. This is because if he adopts a wrong policy. This is because his liability is unlimited. advertisements. Hence the size of his business is small. supervision. he will have to use his private property to clear his debts. This may involve him in losses and ruin. (vii) Wrong Decisions : All the decisions about his business are taken by the sole proprietor. (xiv) Concentration of Wealth : It helps prevent concentration of wealth and income in the hands of a few persons. (vi) Weakness in Bargaining and Competition : On account of the limitations of capital. the proprietor is likely to remain weak in respect of bargaining and competition. Hence the business may not be continued. (iv) Limited Ability of Management : The limited managerial ability may make it difficult for a sole proprietor to face competition in his business which is subjected to many changes. He cannot undertake all activities alone efficiently. arrangement of finance etc. This implies that if his debts exceed his business assets and if he suffers a loss. (viii) Closure on Death : Such a concern may be closed on the death of the proprietor. It may also be difficult for him to raise additional capital by borrowing from banks. (v) No Economies of Scale : A sole trader cannot secure many of the economies of large . So the unlimited liability restricts his business activities. advantages of specialization etc. DEMERITS OF PROPRIETORSHIP OR PROPRIETARY FIRM : (i) Limited Capital : The amount of capital which an individual can command is limited. So it would be difficult for him to expand his business activities much. He has to depend mainly on his own savings. Types of Business Organisations 25 . and minimize its cost of production or running business.

" So a partnership refers to an organization owned and managed by two or more persons.Management : All the partners enjoy equal rights of management. it can be registered at any time. So every partner can participate in management. 1890. PARTNERSHIP : (A) Definition and Meaning : The Indian Partnership Act. 26 Managerial Economics . Each partner is supposed to work in the best possible manner for promoting the interest of the firm. proportion for sharing profits and losses by each of them etc. the shares of individual partners in the capital. In other words. It may or may not be registered. profession or lawful occupation. their rights and duties. all partners constitute a "firm".2. defines the partnership as "the relation between two or more persons who have agreed to share profits of a business carried on by all or any one of them acting for all." The English Partnership Act.taking. control and risk . management. (v) Joint . Thus there is joint ownership. But for the sake of convenience.Ownership : The partners are joint owners of the property of the firm. a single partner may be given right to manage the firm. It may also be formed to carry on certain trade. It indicates the names of partners. (ii) (iii) A Partnership Deed : A partnership is formally based upon a partnership deed or agreement. The persons who own the partnership concern are called "partners" Collectively. Its property must be used only for the business purpose for which the partnership was formed. Age Limit : Only persons who have attained the major status can become partners. They pool their capital and undertake all risks associated with their business. (vi) Joint . However. (vii) No Remuneration : No remuneration is paid to any partner for services rendered by him to the firm. (iv) Registration : The registration of a partnership firm is voluntary. It cannot be used by any partner for his personal purposes. 1932. defines partnership as "the relation which subsists between persons carrying on a business in common with a view to profit. if the partners so desire. (B) Characteristics or Features of a Partnership Firm : (i) Contract : It is formed voluntarily by an agreement between two or more persons carrying on a particular business for common benefit. minors cannot become partners.

Hence all partners are. Abilities and Skill : In a partnership firm. (xv) Non-Transferability of Interest : A partner cannot transfer his powers or rights to any third party to do any work of the firm on his behalf. Profits can be distributed according to the partnership agreement or the capital ratio. (xiii) Working and Dormant Partners : Some of the partners who provide only capital.(viii) Statutory Limit or Number of Partners : It consists of minimum two persons and maximum 20 persons in the case of general business and maximum 10 persons in the case of banking. held responsible for the losses or debts of the firm to the full extent of their personal assets. (xii) Combination of Capital. Thus every partner becomes a principal at one time and an agent of the firm at another time. technical skills etc. However. Every partner must be honest regarding the partnership dealings and should provide all the facts and information regarding their business to all partners. (x) Sharing of Profit and Losses : There is a sharing of profits and losses. a partner may admit another person as a new partner if other partners give their consent. some offer capital. (xvi) Principle of Agency : Every partner carries on business activities on behalf of the firm. If he cannot do it himself. Creditors are entitled to attach assets of any one partner or those of others so as to recover their dues. (ix) Business Activity : Any business selected by the partners can be undertaken. So he binds the firm and other partners for every commitment that he makes in conducting business. All of them or any of them can carry on business activity for all. some management and organizational abilities and others. if nothing is mentioned in the partnership deed. in India all partners have unlimited liability. Hence a partnership firm can be run by one or more partners acting on behalf of all partners. But. he has to retire from the partnership firm. A manager who is an employee of the firm may also be given a part of the profits. Types of Business Organisations 27 . and enjoy limited liability as in England are called Sleeping or Dormant or Special Partners while others who run and manage the concern are called Active or Working or General Partners. Profit may be shared equally by partners. (xiv) Unlimited Liability : The liability of all partners is unlimited. (xi) Mutual Confidence and Faith : A partnership is based upon mutual confidence and trust of partners in each other or one another. jointly and severally. Likewise he is bound by the business activities of the other partners.

best use of machinery etc. abilities. (C) MERITS AND DEMERITS OF PARTNERSHIP : MERITS OF PARTNERSHIP : (i) (ii) Easy to Form : A partnership firm can be easily formed.e. talents and aptitude. (v) Flexibility : It is also quite flexible and capable of adapting itself to changed circumstances of business by means of quick decisions and prompt action by the partners. Hence they can carry on their activities under secrecy so far as the outsiders are concerned. i. there would be specialization in the task of every partner. (iii) Greater Efficiency due to Division of Labour : There is a greater efficiency in the working of partnership concerns because different partners can be assigned those tasks for which they are best suited as per their qualifications. Its operations are not also subject to any restriction by a government. (viii) Business Secrecy : All the activities of partnership concerns need not be given any publicity. more funds can be raised by all partners to start a business on a large scale. (vi) Co-operation : It may elicit full co-operation from workers by keeping a close touch with them. Its formation does not involve legal formalities. it will not be difficult for a partnership concern to borrow from banks on easy terms. (iv) Expansion of Business : A partnership firm can expand its business by admitting more partners and raising more capital from them and thereby attempt to earn more profits. It may be dissolved by any partner after giving a written notice to other partners and a new partnership may be formed by the remaining partners. bulk purchases of raw materials at lower price. it can quickly adapt itself to change in demand for its product. Because of the reputation of the partners and their contacts. It is not compulsory for a partnership concern to publish its profit and loss account and its balance sheet. 28 Managerial Economics . Such partnership firms are found among builders. small factories etc. It may also be dissolved due to the death of a partner or due to an adjudication of a partner as an insolvent. The decision taking by a partnership firm does not involve any legal procedure.(xvii)Dissolution : A partnership firm may not last long. Outsiders are not given its business secrets. by increasing and decreasing its business operations and by changing its business policy. More or Additional Capital : Under the partnership. experience. (vii) Advantages of Large-scale Production : It can secure all the advantages of large scale production such as advantages of division of labour. by understanding and solving their difficulties. solicitors. Thus the organizational structure of a partnership firm is flexible. chartered accountants. Thus.

Hence the spirit of enterprise is checked. the partners may not undertake any risk in business or take any hasty step to expand business. Thus every partner benefits form the advice of other partners. In case business fails. (xiii) Dissolution : In case a partner is not happy with the working of his partnership firm. But if it succeeds. Since there is unlimited liability. Some partners are experts in management and organization. it is possible to run a partnership firm efficiently. the business status of a partnership firm is raised. Further due to unlimited liability. Thus the interest of every partner is protected. As a result of the pooling of the expert services of all partners. He can do so by giving a written notice to the other partners indicating his decision to resign from it. (ii) Types of Business Organisations 29 . Hence it will be easy for it to get loans from financers. abilities and skill.(ix) Business Risks and Rewards : Business risks are equally shared by all the partners. They hold mutual consultations and discussions on important matters. their wisdom is pooled for the benefit of the firm. This is because his activities will be binding on all other partners. he can legally dissolve it. (xi) Unlimited Liability : Since there is unlimited liability. jointly or severally. DEMERITS OF PARTNERSHIP (i) Unlimited Liability and No Risk Business : On account of the principle of unlimited liability. they will try to manage it efficiently and make their business profitable by putting the assets of the firm to the best uses so as to avoid waste. (xiv) Mutual Consent : All the business decisions are taken with mutual consent of all partners. they will enjoy profits. there is a combination of capital. A partnership firm cannot also admit more than 20 members for raising additional resources. (xii) Management and Organizational Abilities : In a partnership firm. they would suffer losses. Every partner runs a considerable risk for any one of them is. Limited on Size of Business : It is also difficult to increase the size of business on account of limited amount of capital which the partners can raise or provide from their own sources. every partner will keep a close watch on the activities of other partners so that losses are avoided and profits are maximized. Some partners offer capital. As a result. held responsible for the debts or losses of the firm. Hence. (x) Close Watch : Every partner has a right to take part in the partnership business. any bad or irresponsible partner may ruin all the partners. This limitation on the number of partners restricts the growth of a partnership form. Some of them possess technical skill.

(vi) No Trust : The activities of a partnership firm are kept secret from outsiders. JOINT .Stock Company which is called Corporation in the U.(iii) Short . Hence people may not fully trust a partnership concern.Lived : A partnership can be dissolved by any partner by giving a written notice to other partners. Such differences among partners may result in dissolution of partnership firms. So this type of business is short-lived. a joint -stock company is "an incorporated association which is an artificial legal person. Such form of business organization is necessary to undertake any business or industry on a large scale. There might by differences of opinion. Also default. As a result. a carrying a limited liability. Hence there is lack of public confidence in such concerns. Kuchhal. A. He cannot also transfer his powers or rights to any third party to do any work of the firm on his behalf. disputes etc. This is because it overcomes the drawbacks of sole proprietorship and partnership. with a perpetual succession. S. mistrust. Some partners may not behave properly. the predominant form of business organization is the Joint . (vii) No Government Control : There is no government control or supervision on the activities of a partnership concern. It is also not subject to legal restrictions. It is not required to publish its accounts. Hence they may misuse their rights and bring the firm into difficulties and ruin its business. bankruptcy or insanity of any one of the partners leads to dissolution of the firm unless a provision is made in the partnership deed to the contrary.STOCK COMPANY : Introduction : In a modern economy. (viii) Leakage of Important Information : Some of the partners may leak important information to outsiders. the honest and efficient partners will have to suffer losses. 3.stock company is a company which has a permanent paid-up or nominal share capital or a fixed amount of capital divided into shares held and transferable as stock by shareholders who are its members." As per the Indian Companies Act of 1956. Some of them may be dishonest. a joint . Hence it may be difficult to maintain business secrecy in a partnership firm. (ix) Joint Liability and Dishonest Activities of Some Partners : The activities of a partner are binding on the partnership firm. 30 Managerial Economics . (iv) Non . clashes of interest. This may happen when there are differences of opinion among the partners.Transferability : A share in a partnership firm cannot be transferred by any partner without the consent of all the partners. (v) Differences of Opinion : The partners may not agree upon certain matters of business policy. having independent legal entity. (A) Definition : In the words of Mr.

Stock Companies is given these documents. Legal Person : It is a legal or an artificial person as a result of law.e. the amount of capital to be raised etc. The Articles of Association : This gives us information about the rules and regulations and bye-laws of the company. The promoters of a company have to get it incorporated by filing with the Registrar of Companies various documents such as Memorandum of Association. (iv) Common Seal : It has a common seal to be affixed on its contracts and legal documents. After going through these documents. After this.. Types of Business Organisations 31 . Prospectus. the Registrar issues a Certificate of Incorporation. capital) of which they are the owners. namely. Those who take initiative to start it are called promoters. the company comes into existence. The Registrar of Joint . It is distinct from its shareholders and its directors. It has no physical existence.Thus a joint-stock company is a voluntary incorporated association of shareholders or stockholders who contribute to the common stock. (v) Open Membership : Its membership is open to any person in any part of a country. They share in profits and losses.stock company is a voluntary organization or association of shareholders. its objects.Stock Company : (i) Voluntary Organization : A joint . (C) Features of a Joint .stock company is compulsory. Their liability is limited to the value of shares held by them. But it functions as a separate and independent legal person. (vi) Limited Liability : Liability of shareholders is limited to the nominal value of shares held by them. The Memorandum of Association : This gives information about the company. List of Persons who have agreed to act as directors etc. Hence the registration of a joint . its place of location. (B) How Is It Formed ? : Minimum seven persons have to come together to start a joint stock company. It is managed by some directors elected by shareholders. Articles of Association. (ii) (iii) Perpetual Succession : It has a perpetual or continuous succession under the law because it continues to exist even if some shareholders or directors die or become insolvent or leave the company by transferring their shares. But all of them do not directly manage it. (i.

This may be. The remaining amount of the subscribed capital is paid after further calls from the company. 10 crores. 14 crores. Rs. Preference Shares and (iii) Deferred Shares. as a part payment of the value of their shares. (iii) Subscribed Capital : Subscribed Capital refers to that part of the issued capital which is actually subscribed by the public. This may be say. But it is managed by a Board of Directors elected by shareholders. say. (iv) Paid . 20 crores. This may be. say. (c) Types of Shares : The capital of a company can be divided into three types of shares : (i) (ii) Equity or Ordinary Shares. Rs. (i) (ii) Authorized Capital : Authorized Capital refers to the maximum amount which can be raised by a company by selling shares. (ix) Fragmented Rights of Ownership : the shareholders enjoy a fragmented right of ownership due to shares purchased by them.up Capital. Rs. namely. (i) (ii) Through the sale of shares or stocks and Through the sale of bonds or debentures. say. 16 crores. Sale of shares of stocks (b) Types of Share Capital : A company divides its share capital as : (i) (ii) Registered or Authorized Capital.up Capital refers to that part of the subscribed capital which the public directly pay-up to the company. Issued Capital and (iii) Paid . 32 Managerial Economics .stock company are annually distributed as dividends among its shareholders.(vii) Free Transferability of Shares : The shareholders are free to transfer or sell their shares to any person. (x) Dividends : The profits of a joint . (D) How is Capital Raised By a Joint Stock Company?: (a) Methods of Raising Capital : A company raises its capital in two ways. Issued Capital : Issued Capital refers to that part of the authorized capital which is issued to the public for subscription by dividing into shares. (viii) Management by Elected Board of Directors : It is owned by its shareholders. Rs.up Capital : Paid . This may be.

preference shares are classified as : (a) (b) (c) (d) (a) Simple or Non-Cumulative Preference Shares. They have also the right to vote on policy decisions of the company. they get much more than the rate of dividend paid to preference shareholders. Hence they control the affairs of their company. 33 (b) (c) (d) Types of Business Organisations . Participating Preference Shares and Redeemable Preference Shares. The ordinary shareholders have the right to vote to elect the Board of Directors of the Company. The holders of such shares get dividend only after the preference shareholders are paid out of its profits. Redeemable Preference Shares : Capital raised by issuing such shares must be paid back after a certain period of time either out of profits or by raising fresh capital by issuing new shares or by selling some of the assets of the company. Cumulative Preference Shares : Such shareholders are entitled to a fixed rate of dividend even when there are no profits in any year. These claims will stand as arrears to be paid first out of subsequent year's profit before it is paid to other types of shareholders. They are entitled to a fixed rate of dividend after paying interest on debentures and before any dividend is paid to equity shareholders. Simple or Non-Cumulative Preference Shares : People holding such shares are entitled to a fixed rate of dividend only in the year in which profits are made. after reasonable claims of these equity shareholders are met. This is because they do not get any dividend if the company does not make any profit. Hence they bear maximum risk. Cumulative Preferences Shares. However. (ii) Preference Shares : These shareholders enjoy a preferential or prior right over equity shareholders to the profit of a company. At times when profits are high. Participating Preference Shares : The holders of such shares are paid a fixed rate of dividend before it is paid to other classes of shareholders.(i) Equity or Ordinary Shares : Such shares form the main basis of the finance of a company. They are also entitled to participate in the balance of profits. They get the dividend before it is paid to other types of a certain proportion along with equity shareholders.

The holders of such shares are paid dividend last out of the profits left after meeting the claims of ordinary and preference shareholders and the reserve funds. However they have a prior claim on the assets of the company in the event of its liquidation. Hence. Of 1956. Normally they are issued to promoters of a company but they may also be issued to public. 5 to 10 years. The deferred shareholders enjoy special or preferred voting rights. A debenture is an undertaking by a company to repay the borrowed money on or before the specified date at a particular interest rate. they do not get anything. Managerial Economics 34 . (E) Types of Joint . A Debenture may be classified as (i) secured and (ii) simple. the deferred shareholders will enjoy a bigger share of profits. But the Indian Companies Act. A simple debenture is not secured against its assets or property. at a ratio fixed in advance. The capital raised by selling debentures is like taking loans form the public. But if there are no profits. say. This is done by issuing debentures or bonds. has eliminated the system of issuing deferred shares by public limited companies. A company is also free to issue convertible debentures which can be converted into equity shares after a period of time. 15 to 25 years.The preference shareholders do not enjoy normal voting rights. irrespective of profit or loss made by the company. all types of the registered companies in the private sector can be classified as : (a) (b) Public Limited Companies and Private Limited Companies.Stock Companies : On Ownership Basis. (iii) Deferred Shares : They are called the Promoters' or Management's of Founders' shares. As such. he cannot directly interfere with the activities of its management. If dividend paid to other classes of shareholders is restricted. a debenture-holder is a creditor of a company with no voting right. Sale of Bonds or Debentures – Debentures : A company may also raise additional finance by borrowing from the public for a specific period of time. say. (i) (ii) A secured debenture is secured against the assets or property of a company. at a particular rate of interest. However a private limited company can issue deferred shares also.

But a private limited company cannot appeal to the public to do so. Types of Business Organisations 35 . The share of a private limited company openly invites public to subscribe to its shares or debentures. But a public limited company must have at least three directors. But a private limited company can appoint a firm a as its manager. (F) Distinction Between Private Limited Companies and Public Limited Companies (Limited By Shares) : (1) A private limited company can be formed with two to fifty members maximum excluding employee shareholders of the company. But a private limited company is not required to publish its accounts for the information of the public.In the public sector. (2) (3) (4) (5) (6) (7) (8) (9) (10) In the case of a public limited company only an individual can be appointed as its manager. But a public limited company can do so only after getting the government's approval. A private limited company can start its business after it is registered. But it is not necessary in the case of private limited companies. A public limited company has to send its duly audited accounts to its shareholders. But the shares of public limited companies can be freely transferred on stock exchanges. Public limited companies must submit statutory reports to the Registrar of Companies. we have government companies in which 51% of the paid-up share capital is held by the government. Public limited companies are required to issue prospectus before allotting shares. But a public limited company can do so only after it gets a certificate for commencement of business. However a private limited company must send three certified copies of its balance sheet to the Registrar of Companies. But a public limited company can have any number of the members of the public but it should have a minimum 7 members. But private limited companies are not required to do so. The shares of a private limited company cannot be freely transferred on stock exchanges. A private limited company should have minimum two directors. A private limited company may increase its number of directors without the government's approval.

Its ownership is in the hands of shareholders. they would be free to sell their shares on stock exchange and invest in some other companies. They elect a Board of Directors which manages the company. 36 Managerial Economics . by providing a wide choice to shareholders. by accepting fixed deposits from the public. those who do not want to take any risk may invest in cumulative preference shares. Hence we write word "Ltd. Thus the money of a share holder is not blocked. Since the liability of shareholders is limited. it is possible for a company to raise a large amount of capital. they need not pay more than the face value of shares purchased by them. simple preference shares. equity shares. But they do not manage it directly. The equity shares may be purchased by people who want take greater risks. (G) Management of Joint . Hence even if a company suffers losses. (iv) Shares of Different Varieties : The shares of a company are of different types. (H) Merits and Demerits of Joint-Stock Companies : MERITS OF JOINT . If they do not like to keep their funds in a particular company. Hence people are induced to invest their money in such companies. Thus the savings of the people can be productively used. Thus. The policies of the company are laid down by the directors. Hence it would encourage small savers to invest in the shares of companies. These policies are executed by salaried managers and executives. risk faced by them are reduced. On the other hand.scale production is facilitated under the company form of business organization. this does not affect the company in any way. This is because it is easy for a company to raise a large amount of capital." after the name of a company.(11) A private limited company can issue different classes of shares with disproportionate voting rights. namely. This is because the sales of shares of a company by some are counterbalanced by the purchase of these shares on a stock exchange by others. cumulative preference shares etc.Stock Companies : There is separation between ownership and management in a joint-stock company. (ii) (iii) Transfer of Shares : The shares of a company are transferable whenever one likes. So the creditors of the company cannot make personnel attachments on their private property. A partnership may be converted into a private limited company to enjoy the advantages of limited liability.STOCK COMPANIES : (i) Limited Liability : The principle of limited liability is applicable to a joint-stock company. Large Amount of Capital : Large . At the same time. But there are restrictions in this respect on a public limited company.

(viii) Efficient Management : In a joint-stock company.stock company can enjoy the economics of scale such as advantages of specialization and division of labour etc. can secure jobs as managers and executives in companies. So the business activities can be undertaken with a long-term objective. It is managed by experts in different fields. (vii) Combination of Capital and Business Abilities : Many individuals possessing a large amount of capital and not having capacities to start and run a business can invest in companies. They have no personal interest in the functioning of their company. they are supposed to work in the interest of their shareholders. The shareholders are owners but they do not manage it. the ownership and management are separated.(v) Risky Enterprises : A joint-stock company can start a risky enterprise. The elected board of directors manage the company successfully because of their wide experience. Hence they may not always manage the 37 Types of Business Organisations .stock company is in the hands of salaried executives. a company can conduct research and experiments. having no capital but possessing capacities to manage a business. So even if there is a loss in the case of one company. (ix) Economies of Scale : A joint . who work under the direction of the Board of Directors. by making full use of managerial skills and abilities and other factors of production. DEMERITS OF JOINT . This is because the risks associated with a business are greatly reduced due to the limited liability of shareholders and a small value of the shares of each shareholder. Further an individual may purchase shares of different companies so as to minimize the loss still further. (vi) Less Danger of Misappropriation of funds : There is a less danger of misappropriation of funds. This is because the directors are elected by shareholders from time to time. a company continues to carry on its business even if some of the original shareholders leave the company or die or become insolvent. Other persons. (xii) Democratic Management : There is democratic management in a joint-stock company. abilities and efficiencies. (x) Continuity and Stability : Since it has a perpetual succession. (xi) Legal control : Since companies are subject to rules and regulations of the Companies Act. the individual shareholders may not be affected much. This is because the audited accounts of the companies must be published.STOCK COMPANIES : (i) Lack of Personal Interest and Inefficient Management : The actual management of a joint . (xiii) Research : Because of its continuous existence and a large amount of resources at its disposal. So it is permanent and stable in nature. This will enable it to improve the quality of its product. reduce its cost of production and thereby enjoy good profits in due course. and apply the fruits of research to industrial uses.

They buy them through their agents. there is oligarchy rather than democracy in the management of a company. in actual life. They may also purchase inputs from their friends and relatives at high prices and resort to other corrupt practices. (iv) To Risky Ventures : the directors may be inclined to start very risky enterprises which may fail. when a company is likely to make good profits. They are interested only in dividend. So shareholders are owners only in name. They are also scattered. the things are otherwise. try to promote their own interests in various ways at the cost of other shareholders. Further when the directors are dishonest. They may also claim excessive fees. the interests of shareholders are ignored with the result that a large number of them may be ruined. (ii) Indifference of Shareholders and Oligarchy : On account of their : limited liability. Hence they will involve the shareholders in losses. So those who buy such shares will suffer losses. So. Hence they may dispose of their shares at high prices by creating an impression that their company is going to make good profits when.interests and misuse of power by directors : A few big directors. This impression will induce other shareholders to sell their shares. They may employ their friends and relatives in high posts paying high salaries. Some of them might even leak out secrets of their company to rival companies. (v) Extravagance : The directors may not behave in a responsible manner. Hence the general working of a company is likely to suffer. As a result. So a few big shareholders manage to get directorships and take all decisions. (iii) Promotion of self . but on the basis of favouratism. personal relations etc. 38 Managerial Economics . many of the shareholders are indifferent. In the opposite case. influence. Hence they can get all the profits for themselves. They may spend in an extravagant way. they may commit some frauds and cheat and exploit the shareholders. who control the affairs of the company.affairs of their company efficiently. The transferability and marketability of shares is also responsible for unhealthy speculative activities on stock exchanges on the part of some directors. (vii) Unethical Practices : Directors possess inside information of the working of their company. (vi) Favouritism : The selection of the staff to work in various departments may not be made by directors or managers on the basis of merit. in fact. They may not take an active part in the affairs of their company. Further these few directors manage to remain in power by some means or the other and enjoy vast powers of management and decision making. they may try to create an impression that it would suffer losses.

Joint Hindu Family have some of the features of a partnership firm. However. This is because it is responsible for tremendous industrial progress. They are given for the personal benefit of directors and / or for the benefit of the company at the cost of the public. This causes unnecessary delay. a common head. They manage to get themselves re-elected by some means or the other. CONCLUSION : The joint-stock system has much contributed to economic progress. who is the eldest member in the family. This is because they are not suitable for many economic activities in modern times. The Hindu Law determines their rights and liabilities. the ownership of a joint family firm is not due to A contract but due to inheritance. CO-OPERATIVE SOCIETIES OR CO-OPERATIVE FORM OF BUSINESS ORGANISATIONS : Introduction : The co-operative movement started in England and Germany in the middle of the 19th century. in India. production and trade. 5. However such people may lack adequate experience and skill. Hence the male members of joint family firms are called co-parceness and not partners. They are also called Hindu Undivided Family Business (HUF). (x) Concentration of Economic Power and Wealth and Inefficient Management : Most of the important companies in a country are dominated by a few wealthy individuals. a company form of organization is not suitable as a partnership concern or even a private proprietorship concern. Hence when quick decision and prompt action are required. But now their importance has declined. this may result in strikes and lockouts.HINDU FAMILY FIRMS OR ORGANISATIONS : Such organization undertaking business activities exist in India. But. This is because there is a lot of discussion and consultation before taking any decision. there would be a concentration of wealth and economic power in their hands. In a Hindu Joint Family firm. (xi) Delay in Taking Decisions : The Board of Directors of a joint-stock company cannot take quick decisions and prompt action to meet the changes in demand for its product. Such organizations were important in the past. Hence they may not be in a position to manage the affairs of the company efficiently.(viii) Conflict : There is no close personal contact between employees and management. JOINT . Hence there is likely to be a conflict between employees and the management. it began only in 1904 after the Co-operative Societies Types of Business Organisations 39 . (ix) Political Corruption : A number of joint-stock companies may pay a large amount of money as donations to political parties. 4. all members of a family come under 'karta'. So the company's output would suffer causing thereby a loss to the shareholders. As they are elected as directors. At times.

This is done by forming a democratically controlled organization and making an equitable contribution to its capital and accepting a fair share of risks and benefits of the organization. 40 Managerial Economics . whatever be their individual share holding. Democratic Management : The members of the managing committee are elected by the members of a society on the basis of "one head" one vote". Since 1904. As per the International Labour Organization (ILO). Co-operation is a voluntary association of individuals with limited income on the basis of equal rights and responsibilities for achieving certain economic interests common to all of them. It is established to promote common economic interests of all its members and thereby promote their general welfare. It believes in the principle of "all for each and each for all". was passed. (C) Features of Co-operative Organizations : (i) Voluntary Association : A co-operative society is a voluntary association of individuals having limited means. This Act was passed mainly to provide credit to farmers and prevent them from borrowing from money-lenders. There is one vote for one member. formed to promote and protect their common economic interests. in the co-operation. "co-operation means working together for a common purpose". (iii) Its management is democratic in nature. 1904. honest means and moral values. It stresses mutual help. (iv) (v) (vi) All members enjoy equal rights and status. Its business is very often confined to the members only. the co-operative movement has made considerable progress in India. Hence. (A) Definition of Co-operation : In a wide sense. the main principle adopted is" all for each and each for all". equal status and responsibilities of members. (B) Principles of Co-operative Organizations : (i) (ii) A co-operative organization is a voluntary association.Act. (ii) (iii) Equality : A co-operative society functions on the basis of equal rights. Profit motive is not supreme.

(x) Government Control : Such societies are controlled and regulated by the government. brotherhood. (vii) Service Motive : Although a society enjoys profits. Producers' Co-operative Societies. Co-operative Credit Societies. Co-operative Housing Societies. (vi) Sharing of Risks and Profits : The members have to bear a fair share of risks and enjoy a fair share of profits from their co-operative society. self-help and mutual assistance.(iv) Equitable Contribution : The members make an equitable contribution to its capital. Individuals are free to join or leave the societies. Co-operative Farming Societies. etc. Purchases and Sale of Goods : There is no speculative buying of goods. (D) Types of Co-operative Societies : There are various types of co-operative societies such as Consumers' Co-operative Societies. etc. (a) (b) Voluntary Association : They are formed voluntarily. workers. No Evils of Capitalism : Such societies can eliminate some of the evils of capitalism and communism for they lie in between the two extreme economic systems. for it is registered under the Co-operative Societies Act. Legal Status : A co-operative society has an independent legal status. (ix) Legal Status : A co-operative society enjoys a legal status. (viii) Evils of Capitalism : It eliminates some of the evils of capitalism.. The consumers also get various goods at low prices. etc. They check the malpractices of monopolists and capitalists.g. adulteration of goods. Cooperative Service Societies. honesty and social relations among them. (c) (d) (e) Types of Business Organisations 41 . e. (v) Thrift and Self-help : It promotes thrift. exploitation of consumers. Co-operative Marketing Societies. (E) Merits and Demerits of Co-operative Societies : Merits of Co-operative Societies. its main objective is service for promoting common economic interests of the members as well as for promoting self-reliance. No Malpractices and Reasonable Prices : They can also remove malpractices in business like black-marketing. concentration of wealth and economic power in a few hands. There is also no problem of sales promotion by means of advertisement.

This is because they cannot afford to pay high salaries. They may not also possess skill and efficiency to run them efficiently. Inefficient Management : Members of the management of such societies may be selected on personal considerations. concessions etc. For e. rivalry. Rivalry : There may be rivalry among the members of the society to secure control over the management of societies. They try to get only the services rendered by a co-operative society and enjoy their benefits. mutual help etc. : They are not affected by debts.e. Concessions and Encouragement : The government provides various facilities to promote their growth by means of assistance. The members have right to vote. They may not be honest and competant. they are managed by elected representatives. (h) (i) (j) (k) (l) (m) Undistributed Profits : Their undistributed profits add to their capital which can be used to expand their activities. Social Values : They promote social values such as mutual sacrifice. Managerial Economics (b) (c) (d) (e) 42 . They also obtain voluntary services from their members. Hence they are relatively stable.g. Team Spirit : They are democratically managed. They stress equal distribution of wealth. Lack of zeal : Their member may not possess zeal. They do not involve many legal formalities. Such societies help develop team spirit among their members. Debt. Limited Finance : As compared to a joint-stock company. enthusiasm and urge to members and may not extend whole-hearted co-operation. Demerits of Co-operative Societies. Insolvency etc. Liability : In such a society. the low income groups can form housing societies to solve their housing problem in cities and towns. Hence their cost of operation is low. This would result in conflicts. and bring about an economic equality. i. the liability of members in limited to the extent to which they hold the shares therein. (a) Malpractices : Some of the members of a society may be unscrupulous. Service Motive : They provide various types of services to their members. quarrels and failure of the society to function properly. Hence their efficient management is difficult.(f) (g) Common Benefits : People with small means can easily form such societies to promote their common interests. They cannot also secure the services of experts and specialists nor can they get trained personnel. They may resort to malpractices to exploit weak members and to promote their personal interest. So it is financially weak. insolvency or insanity of their members. the power of a co-operative society to raise finance is limited.

at the same time. Hence they should be made more effective. But profit-making is not their main motive for. river projects. basic and key industries. Accountability : They are accountable to the public because they are accountable to the government which represents the people. managed and controlled by the departments concerned of the government or by the government bodies. Separate Funds : They are assigned separate funds to undertake their activities. they have an important role to play in improving the conditions of the poor people. electricity. Hence they might not be in a position to work efficiently. in spite of their limitations. business secrecy may not be maintained because their affairs are carried on democratically. gas etc. water. Legal Status : Each public enterprises is a separate legal entity.S. PUBLIC ENTERPRISES / PUBLIC SECTOR UNDERTAKINGS (P. (B) The Main Features of Public Enterprises : (1) (2) (3) (4) (5) State Control : They are owned. They are called "state enterprises" or "public undertakings". managed and controlled by the government – either Central or State or Local self governments. Government Control : They are subject to too much government control and regulations.U’s) : (A) Definition : The public enterprises refer to enterprises which are owned. Management : Some of them may be managed by professionals. Some of them are run on commercial principle so as to make profits. So they are influenced more by the state policy than the enterprises in the private sector. (g) (h) (i) (j) (k) However. 6. Political Parties : The political parties may use such societies to promote their interests.(f) Lack of Co-operative Spirit : Lack of co-operative spirit and Lack of knowledge of the principles of co-operation on the part of members may obstruct the growth of co-operative organizations. Some of the public enterprises enjoy autonomous status operating as per the state policy and general directives from the government. 43 (6) Types of Business Organisations . various public utility undertakings providing road transport. for it is established by law. Business Secrecy : In such societies. They include Indian Railways. Profit : Some of them may work for promoting welfare of the people rather than making profits. Limits of Expansion : Such organizations cannot extend their activities much due to limited finance and limited management skill. Limited Buyers : The sales of a co-operative society are generally restricted to a limited number of buyers. they have to promote social ends.

wrong decision. 44 Managerial Economics . They are accountable to the public through the government. rigidity in operations. delay in taking decisions. etc. 3. atomic energy etc. The main features of the Government Companies are : 1. red-tapism. are operated as private limited companies. They are commercial in nature.(C) Forms of Public Enterprises : There are three forms of organization adopted for the management of public enterprises. They are registered as private limited companies. This can be achieved. They are dynamic and quick in decision . defence industries. The civil servants are assigned the job of running them. 3. if an autonomy is given to such enterprises in their day-to-day working. Their defects are : Such departmentally-run enterprises are subject to a number of criticisms such as lack of initiative. which may be entirely owned by the government. 4. They are financed by the government by means of annual appropriations from the treasury. ignorance of consumers' requirements. 2.making. to a large extent. they can be run efficiently. It these defects are eliminated. railways. Departmental Management : There are some undertakings which are run by the government departments e. 1) 2) 3) 1) Departmental Management Company Management or management by boards and Public Corporations. The ministries concerned exercise control over them. Hence their working efficiency suffers. 2) Joint Stock Company Form of Management : Certain enterprises. politicallymotivated decisions. They are owned by the government. 2. They are managed by various departments of the government. posts and telegraphs. The main features of the Departmentally . information and broadcasting. Normally enterprises which are strategically important and which provide steady income to the government are departmentally-managed. Their financial operations are subject to a close scrutiny by the government.managed Undertakings are : 1. 5. 4.g.

the Reserve Bank of India (RBI). 2. Their attempt to eliminate some of the defects of the departmentally run enterprises. They are run like commercial concerns. etc. They are supposed to eliminate the defects of the departmentally . (D) Advantages (i. (BHL).e. the Hindustan Steel Limited (HSL).run enterprises as well as those of company type undertaking of the state. 3. the State Road Development Corporation (SRDCs). the Oil and Natural Gas Commission (ONGC). They attempt to blend the public ownership and private initiative and flexibility for they are free from bureaucracy in administration and management. The Damodar Valley Corporation (DVC). So they are free from the parliamentary control in respect of their day-to-day management t and financial operations. They enjoy internal and financial autonomy. So they are legal entities owned by the government. They are created by special acts of the parliament. 5. the State Trading Corporation (STC). Some of the corporation set up in India are the Life Insurance Corporations (LIC).e. 3) Public Corporations : Public corporations refer to autonomous organizations created by statutes or special acts of the legislature to run the nationalized to run the nationalized enterprises or newly set up public undertakings. Some of the important government companies in India are : The Bharat Heavy Electricals Ltd. the Hindustan Antibiotics Limited (HAL). 7. the Industrial Finance Corporation of India (IFCI). Their powers and functions are clearly laid down by respective acts of the parliament. the Bharat Aluminum Company Limited (BACL).5.e. Food Corporation of India etc. i. the Steel Authority of India Limited (SAIL). They take all decisions independently. they are financially independent autonomous institutions.. the Air India. Their main feature are : 1. Demerits) of Public Enterprises : Merits of Public Enterprises 1) Use of Profit : Some of the public enterprises like post and telegraphs are not run for earning profit while other enterprises like Hindustan Machine Tools (HMT) as in 45 Types of Business Organisations . Merits) and Disadvantages (i. 6. 4. They are managed by Boards of Directors appointed by the government who need not be form the cadre of civil servants. the Indian Airlines Corporation.

But the profits earned by them are utilized for improving services rendered or for further expansion of their activities. therefore. 46 Managerial Economics . Economies of Large-scale Production : On account of large-scale production. Hence the interests of consumers would be safeguarded. The government may set up a number of industries by inviting foreign skilled labour to help it to accelerate the pace of industrial development. No Wastes : All wastes of economic resources in the form of existence of excess capacity in the private sector industries. competitive advertisement etc. Hence such projects or industries are started in the public sector. It may also attract very efficient personnel and best managerial talent by offering high salaries and better service conditions.g. Labour Relations : The scope for conflicts between workers and the public enterprises would be minimum. the state enterprises may work more efficiently than private enterprises. Hence they are organized by the government on the monopoly basis to secure economies of scale. construction and management of river linking projects. they can enjoy the economies of large-scale production. Industrial Development : When a country has a few entrepreneurs and the skilled labour is limited. Public Welfare : In certain fields. the consumers may be exploited. can be eliminated if they are nationalized and run by the government. Thus profits earned by state enterprises can be used to promote general welfare. the quality of goods or services provided by the public enterprises is likely to be better. The government has. water. 3) 4) 5) 6) 7) 8) 9) 10) Check on Concentration of Economic Power and Private Monopoly : The public enterprises can help to check the concentration of economic power in the hands of a few individuals and the growth of private monopolies.India are run for making profits. If they are left to the private sector. This is because the workers are likely to be more contented due to security and justice in service. to undertake such investment in the interest of society. They will also be made available at reasonable prices. railway service etc. This is particularly the case with public utility services like electricity. Consumer Interests and Quality of Goods : As compared with the private sector enterprises. But the government can raise any amount of capital from various sources for investment in any project or an industry. Sufficient Capital : It is also quite likely that the private sector may not be in a position to raise enough capital for a project or an industry. e. 2) Nature of Investment : There are certain fields in which the private sector will not invest either because it is too risky or because the yield on such investment is too low and spread over a very long period.

In other words. Hence the government enterprises may be run with excessive social cost of operation. So the public enterprises are ultimately controlled by the people themselves. 2) 3) 4) 5) 6) 7) 8) Types of Business Organisations 47 . Also an enterprise may be located in a particular area out of the political rather than economic considerations. This would cause much loss to the public sector year after year. Hence they may cause losses to the public enterprises. This would involve a burden to the taxpayers. This may be so because all of them may not possess much business experience. 12) Ultimate Control by People : The working of the public enterprises is subject to the criticism of the people and the Members of Parliament. Lack of Incentives : Because of lack of incentives. Such a policy is detrimental to the efficient working of the public enterprises. This is because the government officials may work in a routine way. transfers and promotions. The managers may not take any risk. it would be set right. if there is anything wrong in the working of the public enterprises. No Incentive for Hard Work : The public enterprises may not create incentives for hard work for their workers. Hence right man may not be placed in the right place. Bureaucracy and Red-tapism : Bureaucracy. they may not work enthusiastically and efficiently. This is because their acts are questioned. personal initiative may be lacking and the responsibilities may be avoided. Hence its efficiency would suffer. Further bribery and corruption may predominate. Hence. The bureaucrats may not take quick action because they have followed the established procedures. Extravagance : The officials in charge of managing these enterprises may plan in a big way and spend extravagantly. Friction : There may also be an internal friction between various officials in a public enterprise. red-tapism and corruption may obstruct the growth of public enterprises. Political Considerations : Political considerations may determine appointments. Demerits of Public Enterprises : 1) Inefficient management : The government officials may take a long time in taking decisions as well as action.11) Balanced Development : They can contribute to a balanced regional development by locating public enterprises in less developed areas and thereby reduce the regional income inequalities. Rigidity : There may be rigidity in the working of the public sector enterprises due to strict rules and regulations.

In simple terms.SECTOR ENTERPRISES : In India. However the day-to-day management of the joint-sector enterprises is left in the hands of the private sector which possesses the technical and managerial expertise. 14) Prices : The public enterprises may go on increasing prices of their goods and services periodically. This would result in a decline in the welfare of the people. The Government reiterated it in its Industrial Policy decision of February. the executives in charge of the public enterprises may not take their own decisions to run them properly. 1973. This would disturb the smooth working of the government enterprises. 12) Government Interference : Due to too much interference form the government. They may not much care for the public. the joint-sector is a form of partnership between the private sector and sector and the government. The government has to guide their management and operations. Also it may reduce resources available for investment in the private sector.9) Transfers : There might be frequent transfers of the government officials. The Board of Directors would lay down the policies for the joinsector enterprises. yield to the pressure of workers' demand due to the political considerations. 48 Managerial Economics . the government and public financial institution provide a part of the capital and the other part of the capital comes from the private sector and investing public. In this. 7. 13) Workers' Interests : The workers' interests may not always be protected resulting in labour unrest. the government is adequately represented to regulate its functioning. the concept of joint-sector was accepted by the Government of India through its Industrial Licensing Policy of 1970. They may not get proper treatment from the officers in the public enterprises. Some of these disadvantages can be largely eliminated if autonomy is ensured in their internal working and proper incentives are provided for their successful working. JOINT . This would reduce economic inequalities and promote public welfare. Hence the working to the private sector industries would suffer. 10) Helplessness of Consumers : Individual consumers will be helpless when goods and services are provided by big public enterprises. 11) Personal Liberty : Extension of the public sector may result in centralization of powers and a loss of personal liberty. However the authorities may. sometimes. However on the Board of Directors of a joint-sector.

postal services. schools for the blind or the deaf..Profit organisation can be classified into public sector organisations and private sector organisations. In India. are examples of this type. also known as NGOs (non-governmental organisations) working in the fields like rehabilitation of disabled persons. i. HIV/AIDS awareness etc. etc. In both these cases profit making is not a goal. non-formal education.PROFIT ORGANISATIONS : Non .e. organisation of voluntary social workers.profit organisation into public utilities and social service organisations. The state government in India have also entered into joint ventures with the multi-national corporations. pensioners' homes. Thus a joint-sector involves a social control over industries without resorting to their nationalization. 8. NON . It is possible to classify non. Many private sector organisations are created by socially oriented people with a view to meet certain needs of the society which are not yet fulfilled.. Some organisations created by the Government in the public sector are directed towards meeting the basic needs of the people.Thus the joint-sector enterprises are controlled by the government and the private sector jointly. The following chart illustrates this classification : Non-Profit Organisation Public Sector Private Sector Public Utilities Social Service Organisations Types of Business Organisations 49 . general hospitals. etc. are examples of public utilities. Water supply. On the other hand. Hindustan Machine Tools (HMT). adult education. etc. The joint-sector can be used to promote socio-economic objectives of the government such as regional dispersal of industries. it lies between private enterprise and outright nationalization. some of the important joint-sector enterprises are Indian Telephone Industries Limited (ITI).

profit organization can take various forms like departmental establishments. as the case may be. a common characteristics is that it serves some very important need of the people which either cannot be met through the market mechanism or. and especially in more developed functioning is taken care of by the Executive Committee or the Management Council or some such committee under any other name like the business council. In modern times. At times the services are rendered free of charge and the costs are entirely borne by the funding agencies or the government. (i) (ii) Most of these organizations enjoy a certain degree of autonomy to make room for flexibility and quick decision. Some characteristics. This arrangement of voluntarism has various advantages. (iv) The beneficiaries or the users can send their suggestions / complaints for improving the performance of these organizations. autonomous boards / corporations etc. Sometimes the prices are subsidized for keeping them low and within the reach of the low income beneficiaries. supervisory board etc. In some cases. The day . Such voluntary organizations - 50 Managerial Economics . (v) Private sector organizations usually prepare their own constitution and get the organization registered under the Public Trust Acts as well as / or Societies Act.Organisation : Public sector non . if left to market mechanism. Annual accounts are audited and placed before the house concerned like the municipal corporation. The pricing policy of such organizations depends upon whether the organization is aided or funded by some other philanthropic organization. however are worth . users are likely to be exploited or go unserved. merits and demerits are as discussed earlier under public sector undertakings. Such organizations have a provision for advisory boards or committees which can provide broad guidelines for the functioning of the organization as well as for the purpose of a general monitoring. Sometimes prices / fees are discriminatory being linked to the annual income of the users. legislative assembly or the parliament. voluntary agencies are being entrusted with task which earlier were performed by the government. Whatever the type of non-profit organization. the prices just cover the costs. The members constituting such charitable social service organization constitute what is known as the General Body which meets once a year to review the report and to accept the accounts. Their organizational patterns. (iii) Normally local or regional branches / boards have the freedom to adjust their activities to the local needs of the society.

can remain in touch with the users and can monitor the way in which needs of the people are met. Types of Business Organisations 51 .(i) (ii) (ii) (iv) can provide quality service for they are run by committed social workers. The incidence of industrial sickness and closures reached unforeseen dimensions. were actually tailored by the gigantic firms with their clever manipulation. participation due to their service motive. (v) 9. mainly through the powerful electronic media. The following can be listed as the major ones : (i) With a systematic removal of barriers to trade. Widening of markets and reduction in average costs shifted the point of optimum production so high that the firms kept growing and reaping advantages of largescale production. (iv) Aggressive sales promotion and attractive marketing campaigns became an inevitable part of the firm's business strategy. (viii) Advertising. in reality. under the WTO system. reached unprecedented proportions and started designing the tastes of the consumers. (v) (vi) (vii) The process of acquisitions and mergers was accelerated out of the survival instinct of the firms. are close to the people and therefore. (ii) (iii) Mass production of personalized products replaced mass production of the yester years. mainly due to the technological developments. the firms all over the world started experiencing phenomenal changes and challenges. the markets widened suddenly and extended to global dimensions. (ix) The competition that emerged was in pleasing the consumers by apparently satisfying his need which. Relaxation of exchange controls and freedom of convertibility of currencies expanded investment opportunities and subsequent flows of capital. can take a feed back and re-adjust their methods / procedures to instill more efficiency or better quality in service. BUSINESS ORGANISATIONS OF THE NEW MILLENNIUM : By the turn of the century. can ensure peoples. can be flexible in procedure and approach and this suits the people.

etc. Even in developing economies. They are not determined by market forces. (iv) On the Basis of Principle of Pricing : In the case of the private sector.e. The prices are fixed in such a way that the profits are maximized. i. DISTINCTION BETWEEN PRIVATE SECTOR AND PUBLIC SECTOR : (i) On the Basis of Economic System : The private sector is fully owned and managed by private individuals and private firms. corporations contribute a significant percentage of manufacturing activities. Cyert and March start from this basic fact. On the Basis of Economic System : The private sector is based upon capitalism. light consumer goods industries. But the public sector is controlled by the State. The objective of social welfare is given emphasis while fixing the prices in the public sector. In the case of the public sector. Those modify the decision-making process.g. etc. This is particularly so since corporations have emerged as an important form of organization. the prices of goods and services are determined by the market forces of supply and demand. There is public ownership in the means of production. defense industries.. e. Since the interests of managers may be different from those of owners. cloth. fertilizer industry. 52 Managerial Economics . The objectives of the firm as put forth by Williamson. different hypothesis have been presented by these authors regarding the objectives of the firm. (ii) (iii) On the Basis of Motive : The private sector is profit-motivated. transistors. Simon. durable consumer goods industries. Marris. But the public sector is based upon socialism. medicines.. (vi) On the Basis of Nature of Investment : The private sector is interested mainly in the investments in those industries which provide reasonable profits in a short period. producing TV sets. (v) On the Basis of Controls : The private sector is controlled by individuals.g. SPECIFIC ORGANISATIONAL GOALS / MOTIVATION / OBJECTIVES OF FIRMS : Introduction : The decision-making of firms is guided by the goals and objectives which they seek to achieve. the emergence of corporations as an important form of organisation. There is private ownership in the means of production. iron and steel industry.. river projects.10. But the public sector invests in those industries or projects in which the private sector will not invest either because it is too risky or because the yield on such investment is very low and spread over a very long period. the marginal cost is equated to marginal revenue. 11. For maximizing profits. oil exploration etc. But the public sector is fully owned and managed by the State. Over time different assertions have been made regarding their objectives. e. the prices are administratively fixed. But the public sector is to promote social welfare by rendering various types of services to public. partnership firms and joint-stock companies. railways. posts and telegraphs.

Profit maximization as the objective of business firms has a long history in economic literature. theories. profit maximization assumption is too simple to explain the business phenomenon in the real world. preventing price competition and so on. i. Controversy over Profit Maximization : Although profit maximization has been the most widely known objective of business firms. First. a target rate of return. sales maximization. It helps in predicting the behavior of business firms in the real world and also the behavior of price and output under different market conditions. e. MC curve must cut the MR curve from below.g. profit maximizations assumption has a great predictive power. The conventional economic theory assumes profit maximization as the only objective of business firms. Let us first look into the importance of the profit maximization hypothesis and theoretical conditions of profit maximization.A) MAXIMIZATION OF PROFIT / TRADITIONAL APPROACH : Profit maximization has been the most important assumption on which economists have built price and production. It forms the basis of conventional price theory. some economists have raised doubts on the validity of this objective. The strength of this assumption lies in the fact that this assumption 'has never been unambiguously disproved'. The necessary condition requires that marginal revenue (MR) must be equal to marginal cost (MC). No alternative hypothesis explains and predicts the behaviour of firms better than the profit maximization assumption. a target market share. Types of Business Organisations 53 . Maximum Profit Conditions : There are two conditions that must be fulfilled for the profit to be maximum : (i) necessary conditions and (ii) secondary conditions. In fact.e. The fulfillment of the two conditions makes the sufficient condition. The important objections to this objective are the following. Marginal cost is the cost arising due to the production of one additional unit of output. Profit maximization is regarded as the most reasonable and analytically most 'productive' business objective. Besides. businessmen are themselves not aware of this objective attributed to them. This issue will be dealt with later. The secondary condition requires that the necessary condition must be satisfied under the condition of decreasing MR and rising MC. Marginal revenue is obtained from the production and sale of one additional unit of output. This hypothesis has however been strongly questioned. Second. it is claimed that there are alternative and equally simple objectives of business firms that explain better the real world business phenomenon.

big plant and machinery. Friedmen argues that the validity of profit maximization hypothesis cannot be judged by a priori logic or by asking the business executive. Second. only those firms survive in the long run in a competitive market which are able to make a reasonable profit. profit maximization assumption is a time-honored objective of a business firm and evidence against this objective is not conclusive or unambiguous. In developed economies. are countable in units. i. Business books of accounts do not reveal unit cost and revenue. In Defense of Profit Maximization Assumption : The conventional economic theory defends the profit maximization assumption on the following grounds. Why do modern corporations aim at a "reasonable profit" rather than attempting to maximize profits? Reasons for Aiming at "Reasonable Profits" For a variety of reasons. though not perfect. For Example HMT or TITAN would not be able to find cost of one additional wrist watch produced and the addition to its total revenue. Once they are able to make profit.Third. All other objectives are subjugated to this primary objective.. etc. "a target" or "a reasonable profit" which they strive to achieve. modern large corporations aim at making a reasonable profit rather than at maximizing the profit. But profit maximization in a technical sense.e. Joel Dean has listed the following reasons. Third. internal source contributes more than three fourths of the total finance. profit is the most efficient and reliable measure of efficiency of a firm. therefore. B) REASONABLE PROFIT TARGET : We have noted that profit maximization is theoretically the most sound and time-honoured objective of business firms. Hence firms cannot attempt to maximize their profits in the manner suggested by the conventional theory. Fourth. Most goods and services are produced in large quantities . is beset with serious computational and data problems. Instead they have "a standard". The ultimate test is its ability to predict the business behaviour and trends. they would always try to make it as large as possible. modern firms and corporations do not aim at profit maximization. turbines. Only few goods like ships. In practice. it is argued that firms do not have the necessary knowledge and a priori data to equalise MR and MC. making MC = MR.bulks and batches. First. 54 Managerial Economics . If is also the source of internal finance. profit maximization assumption has been found extremely accurate in predicting certain aspects of a firm's behaviour. planes.

Therefore. 'fair price'. the most plausible factor in managers' utility functions is maximization of the sales revenue. Customers. salary and other earnings of managers are more closely related to sales revenue than to profits. Wage-hike may lead to wage .1. 2. What consumers view as fair price may not be commensurate with profit maximization. Firms aiming at better profit prospects in the long run. (b) congenial relation between executive levels within the firm. for if public opinion turns against it and government officials start raising their eyebrows on profit figures. Other factors : Some other factors that put restraint on profit maximization include (a) managerial utility function being preferable to profits maximation for executive. Given the opportunity. Restraining trade union demands : High profits make trade unions feel that they are deprived of their due share and therefore they raise demands for wage hike. (c) maintaining internal control over management by restricting firm's size and profit. profit restrain is sometimes used as a weapon against trade union activities. 4. According to Baumol. The factors which explain the pursuance of this goal by the managers are the following. goodwill depends largely on the quality of the product and its. keeps potential competitors away. So most firms set prices lower than that conforming to the maximum profit but high enough to ensure a "reasonable profit". The firms therefore adopt a pricing and a profit policy that assures them a reasonable profit and. The reason behind this objective is the separation of ownership and management interests. This dichotomy gives managers opportunity to set their goals other than profit maximization which most owner-businessmen pursue. 3. banks and financial corporations look at sales Types of Business Organisations 55 . First. C) SALES REVENUE MAXIMIZATION : Baumol has suggested maximization of sales revenue as an alternative objective to profitmaximization. Maintaining customer goodwill : Customers' goodwill plays a significant role in maintaining and promoting demand for the product of a firm. managers choose to maximize their own utility function. particularly in case of a weak monopoly. Projecting a favourable public image : It often becomes necessary for large corporations to project and maintain a very good public image. 5. Preventing entry of competitors : Profits maximization under imperfect market conditions generally leads to a high 'pure profit' which is bound to attract competitors. Secondly.price spiral and frustrate the firms' objective of maximizing profit. and (d) forestalling the anti-trust suits. sacrifice short-run profit maximization in favour of a "reasonable profit'. corporations may find it difficult to sail smoothly. at the same time.

The behavioural theory has however been criticized on the following grounds. and so on. and J. This behaviour of firms is termed as 'Satisfaction Behaviour'. profit. bankers.. tax authorities and so on. it cannot explain the 56 Managerial Economics . managers. increasing sales revenue enhances the prestige of managers while profits go to the owners. managers find profit maximization a difficult objective to fulfill consistently over time and at the same level.revenue while financing the corporation. maximization of balanced growth rate of the firm. managers maximize both their own utility function and that of the owners.) appearing in their own utility function and those appearing in the utility function of owners (e. Another serious shortcoming of his model is that it ignores price determination which is the main concern of profit maximization hypothesis. Nor do the firms seek to maximize sales.. E) SATISFYING BEHAVIOUR : Some economists like Cyert R.e. Morris's model too does not seriously challenge the profit maximization hypothesis. etc. D) MAXIMIZATION OF FIRM'S GROWTH RATE : Prof. growing sales strengthen competitive spirit of the firm in the market and vice versa. though more rigorous and sophisticated than Baumol's sales revenue maximization. Fifthly. where data are available managers have little time and ability to process data. and managers work under a number of constraints. by maximizing these variables. trend in sales revenue is the readily available indicator of performance of the firm.often conflicting . Finally. though the behavioural theory deals realistically with the firm's activity. status. M. which means maximization of 'demand for firm's product' or 'growth of capital supply'. All of these groups have some kind of expectations . Profits may fluctuate with changing conditions. According to Morris. It fails to deal satisfactorily with oligopolistic interdependence. shareholders. The underlying assumption of 'Satisfaction Behaviour' of firms is that a firm is coalition of different groups connected with the various activities of the firm e. market share. job security.from the firm. size of the firm. Thirdly. customers.g.g. Maximization of these variables depends on the maximization of the growth rate of the firms. salaries. and the firm seeks to satisfy all of them in one way or another. Morris's theory.g.) are positively and strongly correlated with a single variable. March argue that the real business world is full of uncertainty. First. The managers can do so because most of the variables (e. workers.e. It helps also in handling the personnel problem. a 'satisfactory growth'. power. Fourthly. Morris has suggested another alternative objective i. Under such conditions it is not possible for the firms to act in terms of rationality postulated under profit maximization hypothesis. accurate and adequate data are not readily available. growth or anything else. i. G. capital. input supplier. The managers therefore seek to maximize the steady growth rate.. etc. has its own weaknesses. Instead they seek to achieve a 'satisfactory profit'.

firm's behaviour under dynamic conditions in the long run. H) THE HOMEOSTATIC THEORY Prof. though it is not certain. Some argue that where management is divorced from the ownership. the primary goal of the firm is long . The motive behind entry-prevention may be (a) profit maximization in the long run. The evidence on whether firms maximize profits in the long run is not conclusive. G) ENTRY . it cannot be used to predict exactly the future course of firm's activities. For this reason he advocates the homoeostatic theory. this theory does not deal with equilibrium of the industry. They can achieve all other subsidiary goals easily if they maximize their profits. F) LONG-RUN SURVIVAL AND MARKET SHARE GOALS : Another alternative objective of a firm . counteracting forces start operating and the desired state is re-established. According to the homeostatic approach. Securing constant market share is compatible with profit maximization. Only when some stress is applied. Some argue that only profit-maximizing firms can survive in the long run. there is some state of the system which it is designed to maintain. this theory. prevention of entry may be the major objective in the pricing policy of the firm. Such a deviation brings about changes in mood and configuration and the effects of the stress are nullified. the motive behind entry-prevention is to secure a constant share in the market. No doubt.was suggested by Rothschild. According to him. The managers therefore seek to secure their market share and long-run survival. But then. (b) securing a constant market share. too fails to deal with interdependence and interaction of the firms. the organism has a usual tendency to maintain its stability by keeping its mood and configuration stable.PREVENTION AND RISK AVOIDANCE : Yet another alternative objective of the firms suggested by some writers is to prevent entry of new firms into the industry. the organism causes a deviation from normal state.Kenneth Boulding was critical of the traditional theory on the ground that it ignored the information that could be available to the firm and assumed the availability of information which could never be available. Types of Business Organisations 57 .as an alternative to profit maximization . If any disequilibrium in this state occurs. Fourthly. the possibility of profit maximization is reduced. like other alternative hypothesis. was of no use as a guide to practical policy. Thirdly. Secondly. particularly in case of limit pricing. the firms may seek to maximize their profit in the long-run. The theory therefore. and (c) avoidance of risk caused by the unpredictable behaviour of the new entrants. Some others have suggested that attainment and retention of a constant market share is the objective of the firms.

An existing firm may face unfavorable circumstances in terms of rising costs of inputs or falling demand. Its existing asset-structure. in the short -run. it consolidates its position and gets structured with internal efficiency and managerial acumen. it breaks down. Main objections raised against the theory can be summed up as following: i) It is static theory and does not allow any change in the original state. A fall in liquidity. ii) it has nothing to say regarding normal and ideal structure of a balance-sheet which the firm tries maintain. evolutionary characters do not become apparent.In explaining the approach. The firm therefore. This is because the resources available to the firm can be utilized productivity in some other field. demand is saturated. to take another example." There is some desired quantity of all the various items in the balance sheet. When such a firm incurs losses. Even in the short-run certain fluctuations arise which actually show a lack of an adequate homeostatic mechanism. At a later stage rival firms may cause an erosion of its market mainly due to their superior techniques or marketing advantages. it may continue to operate for a while. the theory leaves out several other considerations which are relevant. But as the industry approaches maturity. has its own law of growth and survival. if a customer purchases a product. It exhibits a cycle of birth. is what it would seek to preserve. but will ultimately close down. In the early stages the firm has the advantage of a new market or a new product and can forge its way ahead with strong competitive courage and capability. But when we extend this theory to complex areas of decision-making. Any change in this structure would be responded by countervailing action. the firm. Boulding says. at such a time. I) THE LIFE-CYCLE APPROACH Like all organism. decay and death. A firm is born when there is an opportunity and a scope for its existence. Again. However. A firm adjusts its entire behavior to maintaining a given state or position. for instance. Thus. The firm's objective then becomes increasing competitive strength. The firm may survive for some time or may face decay. though these objectives become difficult to attain. the firm must spend the increased money stock to produce more finished products'. 58 Managerial Economics . growth. according to the life-cycle theory. and that any disturbance of this structure immediately sets in motion forces which will restore the status quo. With growth. too is an organism. and increases its stock of money. iii) a study of the decision taken by firms does not be what Boulding says. would prompt the firm to restore its original liquidity position. The homeostatic theory is useful as a first approximation regarding the motivation of a firm. In order to restore the status quo. This is an evolutionary approach and it does apply to all organisms living in a dynamic world. this diminishes the firms' stocks of finished product. costs of further market penetration get high and the firm aims at long-term growth and flexibility.

maximization of profits becomes a secondary objective of production and establishing monopoly becomes the primary objective. some of the competitors may be out of the business and then those who survive may be able to make profit and make up their losses. the aim of production is not to make profit but to drive away competitors. offering rewards. a producer may even prefer to incur losses and continue to reduce the price even though he cannot reduce the cost. This he will decide after finalizing the aims and objectives of the firm. 4.12. printing price lists and labels. Facing Competition: Every businessman or producer has to face competition. Some may have a desire to earn a name as a great donor others may desire to eliminate labour dissatisfaction. Maximization of Long-run profits: Modern production has become very complicated. It is very difficult to establish and maintain monopoly over the production of any commodity. it is the entrepreneur who decides about the size of the firm which he wants to manage or start. Under these circumstances. Production necessarily being on a large scale includes several things. Types of Business Organisations 59 . etc. etc. 3. Under these circumstances. Under these conditions. more than one trick are employed by the producers . Many times this craving is found among firms owned by one single individual or family. Many industrialists or businessmen have a desire to back a particular political party and to acquire political importance. political parties and elections are inevitable. Political Dominance: In a democracy. while some others may be out to provide comforts for their workers and so on. supplying these lists to retailers. Personal Ambitions: Many times a firm desires to increase its own individual importance in the business world. dumping. This involves a lot of expenditure in terms of money and time. his cost reaches the rock-bottom and further reduction in cost is not possible. For establishing monopoly. This is done on the presumption that sooner or later. such as advertising. Establishment of Monopoly : Establishment of monopoly of a particular product may even be the aim of production. a producer may survive or face competition. it becomes more desirable to keep long term maximum profit as the goal of production. OTHER GOALS OR OBJECTIVES OF FIRMS : Normally. This being a personal choice any whim of the entrepreneur or owner may be the aim of the firm. Thus. So we have to consider the other possible objectives of a firm in addition to the goals we have already discussed in a free enterprise economy. But if every producer does this. This is done in more than one way. in such an effort. This enables the producer to neglect short term marginal losses. The following are the other objectives of a firm in a free enterprise economy: 1. 5.advertising on a very large scale. selling the product at two different prices in two markets. 2. By reducing the cost of production to the minimum.

If the price appears to be too high. Even the success of a joint stock company is gauged by the rate of dividend.maximization remains the only most important motive of production because without obtaining maximum profit no firm can remain in business for ever. profit maximization must be taken to be the only goal of production. the government may interfere and fix the price. we find that all these objectives do exist. other than profit maximization. while planning production and the price strategy. So theoretically speaking. 60 Managerial Economics . Even while determining the ideal size of the unit of production. In practice. we have taken profit maximization as the only motive of production. But finally profit . Reasonableness of Price of Production Policy: In modern times. In rare cases even the consumers' boycott cannot be ruled out. it is necessary to take into account the probable effects of the strategy. Avoiding any of these may even be the objective of production. We have discussed several objectives of production. The index of the success of production is the rate of profit.6.

Exercise: 1. Write short notes on a) b) c) d) e) f) Profit maximization Prof. Types of Business Organisations 61 . Explain the features / characteristics of a cooperative organization. State its merits and demerits. 4. Point out its merits and demerits. 2. 'firm' and 'industry'? Explain 'Proprietary firm' as a form of business Organization. Explain partnership form of business organization. 3. Reasonable Rate of profit as an organization goal Satisfying behavior theory as an organization goal The Homeostatic Theory The Life Cycle Approach 5. Baumol's sales maximization goal. State its merits and demerits. What is 'plant'.

NOTES 62 Managerial Economics .

NOTES Types of Business Organisations 63 .



Managerial Economics

Chapter 3

Preview Meaning of Profit, Accounting Profit vs. Economic Profit, A brief review about the theories of profit, Measurement of profit, Profit Policies and Reasons for limiting profit, standard of limited profits. 1. MEANING OF PROFIT :

Profit means different things to different people. "The word 'Profit' has different meanings to businessmen, accountants, tax collectors, workers and economists and it is often used in a loose sense that buries its real significance. In general sense, 'profit' is regarded as income accruing to the equity holders, in the same sense as wages accrue to the labour, rent accrues to the owners of rentable assets; and interest accrues to the money lenders. To a layman, profit means all incomes that flow to the investors. To an accountant, 'profit' means the excess of revenue over all paid-out costs including both manufacturing and overhead expenses. It is more or less the same as 'net profit'. For all practical purposes, businessmen also use this definition of profit. For taxation purposes, profit or business income means profit in accountancy sense plus non-allowable expenses. Economist's concept of profit is of 'Pure Profit', also called 'economic profit' or 'just profit'. Pure profit is a return over and above the opportunity cost, i.e. the income which a businessman might expect from the second best alternative use of his resources. These two concepts of profit are discussed below in detail. Accounting Profit Vs. Economic Profit The two important concepts of profit that figure in business decisions are 'economic profit' and 'accounting profit'. It will be useful to explain the difference between the two concepts of profit. In accounting sense, profit is surplus of revenue over and above all paid-out costs, including both manufacturing and overhead expenses. Accounting profit may be calculated asAccounting profit = TR - (W + R + I + M) where W = Wages, R = Rent, I = Interest and M = cost of materials. Obviously, while calculating accounting profit, only explicit or book costs, i.e. the cost recorded in the books of accounts, are considered.


The concept of 'economic profit' differs from that of 'accounting profit.' Economic profit takes into account also the implicit or imputed costs. The implicit cost is opportunity cost. Opportunity cost is defined as the payment that would be 'necessary to drawforth the factors of productions from their most remunerative alternative employment'. In simple terms, opportunity cost is the income foregone, which a businessman could expect from the second best alternative use of his resources. For example, if an entrepreneur uses his capital in his own business, he foregoes interest which he might earn by purchasing debentures of other companies or by depositing his money with joint stock companies for a period. Furthermore, if an entrepreneur uses his labour in his own business, he foregoes his income (salary) which he might earn by working as a manager in another firm. Similarly, by using productive assets (land and building) in his own business, he sacrifices his market rent. These foregone incomes - interest, salary, and rent - are called opportunity costs or transfer costs. Accounting profit does not take into account the opportunity cost. It should also be noted that the economic or pure profit makes provision also for (a) insurable risks, (b) depreciation, and (c) necessary minimum payment of shareholders to prevent them from withdrawing their capital. Pure profit may thus be defined as 'residual left after all contractual costs have been met, including the transfer costs of management, insurable risks, depreciation and payments to shareholders, sufficient to maintain investment at its current level'' Thus. Pure profit = Total revenue - (explicit costs + implicit costs). Pure profit so defined may not be necessarily positive for a single firm in a single year - it may be even negative, since it may not be possible to decide beforehand the best way of using the resources. Besides, in economics, pure profit is considered to be a short term phenomenon - it does not exist in the long run under perfectly competitive conditions. An entrepreneur brings together various factors of production such as land, labour and capital. He ensures co-ordination between the factors and supervises the productive activity. He looks after purchase of raw materials, production, marketing, recovery of receivable and personnel. The most important function performed by an entrepreneur is, however to undertake risk and uncertainty in business. The reward which is paid to an entrepreneur for discharging this function is called Profit. In this chapter, we propose to study the emergence of profit.

(A) Gross Profit and Pure (Net) Profit
When cost of production is deducted from the total sales proceeds, the residual portion is called Gross Profit. Gross Profit = Total Receipts - Total Expenditure An entrepreneur is required to make following payments out of the Gross Profit :


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Remuneration for the factors of production contributed by the entrepreneur himselfHe must pay rent for the use of land. If the land is owned by him, he must pay notional reward for the use of land, because, he is otherwise required to pay rent if he hires land from some other person.


Depreciation and Maintenance Charges Some portion should be deducted from gross profit by way of depreciation on machinery and other assets.


Extra - Personal Profits This includes -


Monopoly Profits : If a producer is a monopolist, he may be earning monopoly profits. These are profits not because of the business skill or ability of the entrepreneur, but because he is a monopolist in his field. Monopoly profits must be deducted from gross profits to arrive at net (pure) profits. Chance Profit : An entrepreneur may earn high profits just 'by chance', say because of an outbreak of war. This is not a part of net profits.



Net Profits : When all the above payments are made out of gross profit, the residual portion is called Pure (Net) Profit. The reward which an entrepreneur gets (i) for undertaking risk and uncertainty, (ii) for co-ordinating and organizing production and (iii) for innovating is called Pure Profit.



Various theories have been developed to explain the emergence of Profit. It is worthwhile to explain some of the theories of profit. (1) Risk Taking Theory The Risk-Taking Theory was developed by the American economist Hawley. According to him, profit arises because considerable amount of risk is involved in business. Profit is, therefore, the reward for risk-taking. Hawley's theory has been criticized on several grounds. In the first place, Hawley has not classified the types of risks. Secondly, as Cawer has pointed out, profit is not the reward for risk-taking. It is the reward for riskavoiding. 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 businessmen is not able to reduce the risk in business; and therefore, is subjected to losses. (2) Uncertainty-Bearing Theory of Profit : Uncertainty-Bearing Theory of profit was developed by the American economist, Prof. F.H. Knight. He has classified the risks under the two heads. (a) Certain risks such as risk of fire, risk of theft, risk of accident etc. are less important because they can be passed on to an insurance company. An entrepreneur can take an insurance policy by paying the premium. Since such risks are covered by insurance, they are called "Insurable Risks." There are other risks which cannot be passed on to an insurance company or to the paid managers. Every business involves great amount of uncertainty and the losses arising there from cannot be estimated with precision. The prices of raw materials may suddenly increase, the supply of raw materials may be restricted and introduction of new substitutes in the market may reduce the demand for the product. When demand declines, large stocks may remain unsold in the go-down. A producer may have to face keen competition. if the market is characterised by monopolistic competition. All these factors are uncertain and losses arising there from cannot be insured with any insurance company. These risks and losses must be borne by the entrepreneur himself. According to Prof. Knight, profit is, therefore, the reward for uncertainty-bearing.


Uncertainty theory of profit has gained wide popularity since its publication. After the Industrial Revolution, production is carried out on a large scale and in anticipation of demand. Producers take into account the tastes and fashions of the people and produce the goods accordingly. Sudden change in the tastes and fashions may affect the demand for products. If a particular fashion is receded in the background, goods may not be sold at all. The losses arising out of such uncertainty cannot be estimated with precision. According to Prof. Knight, profit is, therefore, a reward of uncertainty. 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 of Profit. Innovation Theory was developed by Joseph Schumpeter. According to him, profit is the reward paid to an entrepreneur for his innovative endeavours.


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Schumpeter has made distinction between invention and innovation. A scientist may make an invention, but this invention is exploited on a commercial basis by an entrepreneur. 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. According to Schumpeter, profit is the reward for innovation. Schumpeter's 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 shortrun. But the super normal profits will attract new firms to the industry. If new firms enter the industry, the super-normal profits would be shared between the existing as well as the new firms. In the long run, super normal profits would, therefore, disappear. It is said that profits are caused by innovation and disappear by imitation. Schumpeter's theory is, therefore, to be taken to a limited extent. (4) Dynamic Theory of Profit The Dynamic Theory of Profit was developed by the renowned economist, J.B. Clark. Prof. Clark points out that the whole world is dynamic. Changes after 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. a) b) c) d) e) Changes in the quantity and quality of human needs; Changes in the techniques of production Changes in the supply of capital Changes in organization of business 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.


Profits in a Static Society According to Prof. Clark, profit cannot arise in a static society. In a static society there are no changes. Population is stable and the demand is stationary. Since the demand is limited, output is also limited. The general price level and factor prices being stable; the cost of production is constant. The selling price and the margin of profit are also constant. A producer has to produce a limited quantity of goods and it is sold immediately, the moment it is produced. Since demand is constant, a producer does not run the risk of uncertainty. In static society, there are no inventions and producers are not required to make innovations. Producers in a static society have not to face any changes in the tastes, fashions and output. They produce a given quantity and sell it in a routine manner. A producer in a static society works like a paid manager. He performs only the routine duties and gets normal profit. The normal profit which he gets may be called 'Wages for Management'. According to Prof. Clark, a producer in a static society gets only normal profits, because pure profit does not arise. Conclusion Prof. Clark's Dynamic Theory of Profit has been criticized on several grounds. He has classified the changes under five categories but has overlooked many other important changes. In this dynamic world, the Government policy may suddenly change. A change in the Monetary Policy of the Central Bank may bring about an expansion or contraction in the supply of money. This may lead to an expansion or contraction in the supply of capital. Ultimately it may affect the fortunes of business. Prof. Clark has overlooked such important factors. 3. MEASUREMENT OF PROFIT :

Our discussion of profit so far, has made it clear how difficult it is to have a simple definition of profit that is acceptable to all. The measurement of profit is also equally difficult. For one thing, the economic concept of profit-and loss and the legal concept of profit-and-loss are not the same. This is especially difficult when it comes to the measurement of net profit. For calculating net profit, it is necessary to deduct all costs from the total revenue. But the inclusiveness of costs itself involves many difficulties. All these problems, therefore, deserve a more careful and detailed analysis. (A) Economic Profit and Accounting Profit : Let us take an example to understand the difference between the economic concept of profit and the accounting concept of profit. Suppose an individual starts at his residence the business of repairing scooters. At the end of the year, he gets a total revenue of Rs.1,50,000/-. Out of this, let us say, he spent Rs.50,000/- on the wages of his helper, tools and spare parts, etc. What remains is a sum of Rs.l,00,000/-. Apparently, one would be tempted to conclude that this is his profit. But it is not so. The place that is available to him might have saved him a sum of, say Rs.30,000/-. In other words, the place of work might have an opportunity cost. His own transfer earnings may be say 70
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Rs.60,000/-. Had he borrowed the money capital, the interest would have been say Rs.l0,000/-. Besides, a provision will have to be made for the wear and tear of the tools and instruments, i.e. a certain amount will have to be deducted for depreciation. Thus, calculated, the total costs would be (i) Helper's wages, spares etc. Rs.50,000 + (ii) Rent Rs.30,000 + (iii) Entrepreneur's management wages : Rs.60,000 + (iv) Interest : Rs.l0,000 + (v) Depreciation Rs.5,000. This takes the total cost equal to Rs.l,55,000 against the total revenue of Rs.l,50,000 showing a let net loss of Rs.5,000. The loss in the above example does not become apparent because the entrepreneur uses some of the factors owned by himself and therefore, the remunerations to these are not actually paid. It should be obvious from the above example that these difficulties may not arise in respect of large industrial units. In such units, ownership is with the shareholders while the management is entrusted to the salaried managers. Thus, most of the costs enter the account books and the accounting and economic concepts of costs in such cases come closer. According to the financial accounting principle, the assets of a concern have claims from two sides : from the owners and from the lenders. Therefore, in any business unit, Assets = Liabilities + Proprietorship Therefore, Assets - Liabilities = Proprietorship or the net worth The balance sheet of any concern shows, during a given period, the total liabilities and the net worth after these are deducted. Similarly, the profit and loss account or the income statement shows the changes in the balance sheet of the unit from the beginning of the year and those at the end of the year is the net income or profit. The funds statement is based on this profit and loss statement. This statement indicates the financial standing of the business concern. The funds statement shows the amount of cash available and how it has been invested. While preparing all these statements, the accountant has to include items, the truth about which can be tested. But in doing so, many difficulties arise. For example, while preparing the balance-sheet, the cost of the asset that is taken is the one at which the asset was purchased. The current value of the asset is not considered. Similarly the changes in the value of money are ignored. It is also incorrect as is done in financial accounts, to calculate net profits by deducting from the total revenue of year the total costs incurred during that year. The economic concept of net profit will have to be altogether different. In the valuation of any asset, the economist is guided by the concept of opportunity cost. For example, the accounting method will take into account the original price of a machine; but in the economic concept, the replacement cost of the machine would be used. For valuation of


the machine, further alternatives would be to take the price of a similar machine, if the same is not available; or to consider the total expected return of the machine and from that calculate the present worth of the machine. We are familiar with the various cost concepts. Thus, the differences in the profit concepts arise out of the differences in cost concepts. The modern method used for valuation is based on the cash flow technique. It will also be necessary to remember that the sum total of all the individual machines added together will not be the correct value of the total establishment. This is because the goodwill enjoyed by the concern will also have to be included in its total worth. This is how the economic and the accounting approaches differ and make measurement of profit more complicated. (B) Factors Leading to Differences in the Economic and the Traditional Concepts of Valuation The above discussion makes it clear how valuation of asset is important in the measurement of profits. Let us now consider those factors which underline the differences in the economic and the accounting approaches to the problem. These factors are : (a) Depreciation, (b) Inventory Valuation and (c) the unaccounted value changes in the assets and the liabilities. a) Depreciation : Depreciation is the loss in value caused by the continuous use of an asset. Every durable asset has a certain life at the end of which it has got to be replaced. For such a replacement, a provision in the form of depreciation is required to be made. There are various methods of calculating this depreciation. Following are the important ones among them.


Staright Line Method This is the simplest method of all. What is done is the life of an asset is first estimated and then the share of one year in the total value of the asset is deducted. What remains is taken as the value of the asset for the next year. In this way, at the end of the life-time of the asset, the firm will have collected an amount equal to the value of the asset. If, for example, the price of a machine is P, the scrap-value at the end of its life-time is S and the life of the machine is Y years, then the amount of depreciation (D) will be given by the formula : D = P – S Y


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If P = Rs.25,000/-; S = Rs.5,000/- and Y = 20 years, the annual amount of depreciation will be 25,000 – 5,000 = 2000. This means that the 20 annual allotment towards, depreciation will have to be Rs.2000 only.


Diminishing Balance Method In this method, the amount of depreciation is large in the initial years. Suppose the annual amount of depreciation is taken as 10 per cent of the value of the machine. Then, in the first year the depreciation will be 10 per cent of the value of the machine; but during the second year, it will be l0 per cent of the total value minus the depreciation fund created during the first year. By this method, the value of the machine will never become zero and the amount of depreciation will go on diminishing.

(iii) Annuity Method In this method, equal annual amounts are first calculated for the length of the life of an asset. However, along with the annual allotment, the interest that can be earned is also calculated.

(iv) Service Unit Method Instead of considering the life of an asset in years, the actual working hours can be taken. This is the basis of service unit method. If a machine can work for l,000 hours, then the value of the machine divided by l,000 will be the hourly rate of depreciation. The total number of hours for which the machine was actually used during a given period can thus give us the amount of depreciation during that period. The original value of machine minus depreciation will give its value for the remaining period. Whatever method used for the valuation of assets, in the accounting sense, some problems remain unsolved. Thus, for instance, every asset has a limited life and at the end of it, the asset needs to be replaced. At the time of replacement, new and more efficient machines may be available. If such new machines are to be purchased, how much money will be required and at what rate depreciation will have to be provided cannot be decided before hand, by any of these methods. This makes measurement of profit difficult. (b) Inventory Valuation Another difficulty that is encountered is in respect of inventory valuation. This difficulty would not arise if the prices of all products and the level of all production were constant. But this never happens. The raw materials are purchased at different prices. The costs of production also change from time to time. This makes the


valuation of of stocks of finished products very difficult. Let us first consider the two most widely used methods of inventory valuation. i) First-In-First Out Method (FIFO) : In this method, it is assumed that goods which entered the firm's stock first were used first. Then, in this assumption, the cost of producing the given output is estimated. Last-In-First Out Method (LIFO) : In this method, the cost of production is calculated on the assumption that the material which was last to enter the inventory of the company was used first.


It is obvious that a change in the use from either of the two methods mentioned above to the other one must lead to a change in estimate of profit. There would be a great divergence between the profits estimated by these two methods especially when the above mentioned changes in prices etc. are very rapid. The profit would appear to be abnormally high if it is calculated on the basis of FIFO in times of inflation and abnormally low in times of deflation. The methods, however, are in use due to their convenience from accounting point of view. It is thus, clear that by either method, it is difficult to state precisely the value of the inventory. This is mainly because of the changes in the value of money. Taking a stable value of money, i.e. valuation at constant prices would also not serve the purpose. Thus, due to these difficulties in the valuation of inventories, the measurement of profit is rendered difficult. (c) The Unaccounted Value Changes in the Assets and the Liabilities Besides the above two factors which create difficulties of valuation, there is a third category of changes in the value of assets and liabilities that poses a challenge to valuation. The research that is undertaken to improve the quality of the product, the expenses on improving the efficiency of management etc. increase the value of the establishment. These costs create assets, which cannot be precisely valued. They do increase profits but cannot be expressed in terms of money, and therefore, measurement of changes in the value of assets becomes difficult. Thus, it is clear, how difficult the precise measurement of profits is. By simply using historical cost the profits are likely to be either inflated or deflated. It is, therefore, necessary to calculate costs and profits at constant price to take utmost care in calculating depreciation, to take cognizance of modern methods like cost flow techniques, management accounting and so on, and to use opportunity costs wherever necessary. Even then, a correct amount of profit may not be found out. But we shall be close to the correct estimate. The calculation of profit will also vary according to the purpose for which the calculation is required. 74
Managerial Economics



By and large, we say that an entrepreneur aims at maximum profits. But 'how much' profit should be taken as the maximum ? This is a difficult question to answer. A scientific thought to this question must provide a guidance on the following two lines : (a) What profit should an entrepreneur expect in any enterprise, and (b) How far is profit influenced by factors, which are external to the firm. It must be understood at the outset that the freedom of an entrepreneur to decide his rate of profit depends on the nature of the market and other constraints including legal provisions, business conventions, consumer resistance and so on. Profit is usually expressed as gross profit, or as net profit or as a per cent return to capital invested. In modern business, the common practice is to express profit as a per cent net return to capital. (a)

Profit Expectations : The profit that an entrepreneur should expect can be subjected to a number of criteria. The following four criteria are widely accepted :
i) The rate of profit should be sufficient to attract share capital if felt necessary. When new shares are to be issued for expansion, the old shareholders should not have a feeling of having suffered a capital loss. New shares must therefore be sold at a price that gives the old shareholders a satisfaction that they are in possession of sound shares. Their rate of profit should be enough to command a good price for the new issue of shares. The rate of profit should be comparable to that in similar companies. Many times, there are many independent units under the same management. In all these siter-concerns, the rates of profitability should be comparable. The profit rate should be comparable to the profit rates in the past. The profits should be large enough to allow for a plough-back for business expansion. It is, however, necessary to see that reinvestment of profits does not cause a dwindling in the reasonable rate of profit.


iii) iv)


External Factors : Besides the criteria mentioned above, there are certain external factors that influence the profitability of a firm in modern times. These factors are :
i) Full Employment : Under conditions of full employment, maintenance of cordial labour relations is of utmost importance. Excessive profits, under such circumstances, become an invitation to labour unrest. Care should be taken to keep profits within reasonable limits.




Potential Rivals : In any business, the possibility of emergence of rival firms must be taken into consideration. Abnormal profits attract rivals and wipe out profits. To keep away the rivals, it becomes necessary to control profits. Whether this will be possible depends upon many factors, but an effort should be made to abide by this rule. Consumers' Confidence : It is also necessary to maintain the confidence of the consumers in the reasonableness of the firm's prices. Those entrepreneurs who are tempted to exploit the situation of reaping huge profits usually lose the sympathies of their customers. It pays in the long-run to overcome such temptations and continue to enjoy the confidence of the customers. Political Climate : In modern times, entrepreneurs are also required to take note of the political climate in the country. This is especially true where a firm supplies products to government departments, or public enterprises. Charges of profiteering and exploitation may invite public inquiries and this will cause a great deal to the firm. It is, therefore, advisable to keep profit rates low and create an image of a firm with fair dealings.
Thus, profit policy involves many important considerations and all the factors noted above go into the formulation of a sound profit policy.





We have already studied that modern firms and corporations may not aim at profit maximization. Instead they set 'a standard', 'a target' or 'a reasonable profit' which they strive to achieve. We have also studied the reasons for aiming at ‘Reasonable Profits’ in the previous chapter. Let us now look into the policy questions related to setting standards or criteria for reasonable profits. The important policy questions are : a) b) What are the criteria for determining the profit standard? How should 'reasonable profits' be determined? Let us now briefly examine the policy implications of these questions. a) Standards of Reasonable Profits :

When firms voluntarily exercise restraint on profit maximization and choose to make only a 'reasonable profit', the questions that arise are : (i) what form of profit standard should be used, and (ii) how should reasonable profits be determined ?


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But when purpose is to discourage the potential competitors. The reason.e. Of all the forms of profit standards. This is based on a belief that market forces allocate funds more efficiently and the individual is the best judge of this resource use. provided competitors' cost curves are similar. Capital attracting standard An important criterion of profit standard is that it must be high enough to attract external capital. retained earnings which are under the exclusive control of the management are likely to be wasted on low-earning projects within the company. On the other hand." Profit 77 . b) Setting the Profit Standard The following are the important criteria that are taken into account while setting the standards for a 'reasonable profit'. It depends on 'the relative abilities of management and outside investors to estimate earnings prospects. equity and preference shares) affects the cost of capital and thereby the rate of profit. Plough back standard is however socially less acceptable than capital-attracting standard. But one cannot say for certain as to which of the two allocating agencies is actually superior.e. This standard of profit is used when maintaining liquidity and avoiding debt are main considerations in profit policy. (b) percentage of sales.Forms of Profit Standard The profit standards may be determined in terms of (a) aggregate money terms. 'Plough back' standard In case a company intends to rely on its own sources for financing its growth. the total net profits of the enterprise usually receive the greatest attention. unpredictable. it is more desirable that all earnings are distributed to stockholders and they should decide the further investment pattern. the proportions of bonds. if stocks are being sold in market at five times their current earnings. These standards may be determined with respect to the whole product line or for each product separately. For example. or (c) percentage return on investment. There are however certain problems that are associated with this criterion : (i) capital structure of the firms (i. (ii) whether profit standard has to be based on current or long run average cost of capital as it varies widely from company to company and may at times prove treacherous i. it is necessary that the firm earns a profit of 20 percent on the book investment. that. then a target rate of return on investment is the appropriate profit standard. then the most relevant standard is the aggregate profit that provides for an adequate "plough-back" for financing a desired growth of company without resorting to the capital market.

When average of 'normal earnings of a group of firms is used. (ii) discouraging growth of competition.Normal earnings standard Another important criterion for setting standard of reasonable profit is the 'normal' earnings of firms of an industry over a normal period. provided it succeeded in (i) attracting external capital. then only comparable firms and normal periods are chosen. In fact. different standards are used for different purposes because no single criterion satisfies all the conditions and all the people concerned. A standard is therefore chosen after giving due consideration to the prevailing market conditions and public attitudes. (iii) keeping stockholders satisfied. However. Company's own normal eanrings over a period of time often serve as a valid criterion of reasonable profit. 78 Managerial Economics . none of these standards of profit is perfect.

5. 2.H. Give a brief review about the theories of profit. 6. 8. Write notes on: (a) Profit Policy (b) Standards of reasonable profit (c) Reasons for limiting profits. Distinguish between gross and net profit. Explain how profit can be measured in practice. Profit 79 . 3. 4. How would you distinguish between Accounting Profit and Economic Profit? "Profit is a reward of the entrepreneur for innovation" Discuss. Critically evaluate F. 7. Knight's Uncertainly Bearing Theory of Profit.Exercise : 1. State and explain Dynamic Theory of Profit.

NOTES 80 Managerial Economics .

NOTES Profit 81 .

NOTES 82 Managerial Economics .

Individual Demand and Market Demand. Nor does ‘Demand’ mean ‘need’. when the price of milk is Rs. say per day. In Economics ‘Demand’ means ‘desire backed by adequate purchasing power’ or enough money to purchase desired goods. In fact. Introduction to Index Numbers. Unless the price per unit of the commodity is stated. ‘demand’ means specific quantity of a commodity actually purchased or bought. in Economics. ‘Demand’ in Economics also means ‘demand per unit of time’. Thus.000 liters when the price of milk is Rs. a person demands (i.50. the concept of demand will not be clear. 15 per litre. Or at an individual level. Demand Analysis 83 . since quantity purchased will depend upon price of the commodity in question. quantity actually purchased) for milk per months is 1. ’Demand’ does not mean simple desire. actually purchases) one litre of milk per day (or 30 litres of milk per month). Thus. Measurement and its uses. 1) CONCEPT OF DEMAND In Economics. Law of demand. demand (i. Elasticity of demand. Determinants of Demand.e. it can be said that in Pune. clothing and shelter will have absolutely no influence on the production of those three goods. For example a beggar’s need for more bread. however urgently they may be needed by a beggar.Chapter 4 DEMAND ANALYSIS Preview Introduction: Concept of demand. it follows that ‘demand means at a specific price’. Demand Forecasting-methods/ techniques of demand forecasting. per year and so on. Further. per month. a poor man’s desire to have a motor-car or middle class person’s desire to have an air-conditioned bunglow in a city or suburb will not have any influence on the production of cars and bunglows.e. 15 per litre.

INCOME : Income is an equally important determinant of demand. 15 per litre. Omission of price per unit of a commodity. with the increase in income one can buy more goods. Though not generally mentioned in any book. Similar is the case with demand for cigarettes by non-smokers and smokers.e.50. 15 per litre. TASTES AND HABITS : Demand for many goods depend on the person's tastes. whereas a non-vegetarian who has liking for chicken or fish may demand it even at a high price. The above examples should make the concept of demand clear. 15 per litre in village A. in India and so on. depend on an individual's tastes. etc. 84 Managerial Economics ii) iii) . at the price of Rs. Obviously. a larger quantity is demanded at a lower price than at a higher price.Other examples explaining the concept of demand may be as follows : In India. or unit of time or of specific market would leave the concept of demand vague. tobacco. actually bought) per day. say demand in a village.e. when the price of wheat is Rs.000 litres demanded (actually purchased) per day.000 litres of milk are demanded (actually purchased) per day. Demand for several products like ice-cream. in Mumbai. Thus. In Maharashtra at an average price of Rs. now the full statement of the concept of demand would be as follows: At a price of Rs. a rich consumer usually demands more goods than a poor consumer. etc. A strict vegetarian will have no demand for meat at any price. 15 per litre. chocolates. Thus. a) Factors Influencing Individual Demand An individual's demand for a commodity is generally determined by factors such as : i) PRICE OF THE PRODUCT : Price is always a basic consideration in determining the demand for a commodity. betel.50. habits and preferences. it would be logical to mention specific market in which buying and selling transactions are taking place. 100 litres of milk are demanded (i. Determinants Of Demand : Demand for a commodity depends on a number of factors. In Mumbai. demand (i. 4. along with price and unit of time. 50 lakh litres of milk are demanded (actually Purchased) per day. at the price of Rs. is a matter of habit. People with different tastes and habits have different preferences for different goods. In Pune. 1. Normally. 15 per Kg. actual quantity that is purchased) for wheat per year is 40 lakh tones. in Pune. Demand for tea. behl-puri.

For example. they are called substitutes. Thus. Complementary goods are always in joint demand. etc. pen and ink. washing powder. Similarly. When in order to satisfy a given want. two or more goods are needed in combination. Or. Factors Influencing Market Demand : vi) b) The market demand for a commodity originates and is affected by the form of change in the general demand pattern of the community of the people at large. market demand for the product tends to be high and vice versa. If the substitutes are relatively costly. these goods are referred to as complementary goods. Demand Analysis 85 . peas and beans. v) CONSUMER'S EXPECTATIONS : A consumer's expectations about the future changes in the price of a given commodity also may affect its demand. shoes and socks. For example.. toilet-soap. are complementary to each other. When a want can be satisfied by alternative similar goods. tea and sugar. sarees and blouses. Thus. gun and bullets etc. the demand for its complementary product will tend to increase and vice versa. Similarly a steep rise in the price of petrol will cause a decrease in demand for petrol driven motor cars and its accessories. however. groundnut oil and til oil. ADVERTISEMENT EFFECT : In modern times. demand for many products like tooth-paste. The demand for a commodity depends on the relative prices of its substitutes. When he expects its prices to fall in future. if a given commodity is a complementary product. is partially caused by the advertisement effect in a modern man's life. jowar and bajra etc. are substitutes of each other. Similarly. tea and coffee.iv) RELATIVE PRICES OF OTHER GOODS : SUBSTITUTES AND COMPLEMENTARY PRODUCTS : How much the consumer would like to buy of a given commodity. when the price of one commodity decreases. The following factors affect the common demand pattern for a commodity in the market. he will tend to buy more at present.. For example. the preferences of a consumer can be altered by advertisement and sales propaganda. also depends on the relative prices of other related goods such as substitutes or complementary goods to a commodity. the demand for a commodity is also affected by its complementary products. processed foods. its demand will be relatively high when its related commodity's price is lower than otherwise. he will tend to buy less at the present prevailing price. if he expects its price to rise in future. car and petrol. albeit to a certain extent only. then there will be more demand for the commodity in question at a given price than in case its substitutes are relatively cheaper. a fall in the price of cars will lead to an increase in the demand for petrol. 1) PRICE OF THE PRODUCT : At a low market price.

the demand for the former will tend to decrease and that for the latter will increase. sex ratio has its impact on demand for many goods. Thus. growth of population is an important factor. NUMBER OF BUYERS IN THE MARKET AND THE GROWTH OF POPULATION : The size of market demand for a product obviously depends on the number of buyers in the market. demand for many comforts and luxury items will tend to be higher than otherwise. etc. A large number of buyers will constitute a large demand and vice versa. LEVEL OF TAXATION AND TAX STRUCTURE : A progressively high tax rate would generally mean a low demand for goods in general and vice-versa. which as a result of innovations. 3) 4) 5) 6) AGE STRUCTURE AND SEX RATIO OF THE POPULATION : Age structure of population determines market demand for many products in a relative sense. then the market demand for milk. the market demand for many products of common consumption tends to be greater than in the case of unequal distribution.Ds) has made audio & video cassettes obsolete. definitely become obsolete. Managerial Economics 7) 8) 9) 86 . For example. An adverse sex ratio.goods and services required by children .2) DISTRIBUTION OF INCOME AND WEALTH IN THE COMMUNITY : If there is equal distribution of income and wealth. females exceeding males in number (or. GENERAL STANDARDS OF LIVING AND SPENDING HABITS OF THE PEOPLE : When people in general adopt a high standard of living and are ready to spend more. when a large section of population shifts its preference from vegetarian foods to non-vegetarian foods. . the advent of latest digital media like Compact Disks (C. i. present market demand would be more as most of them would like to hoard the commodity.will be much higher than the market demand for goods needed by the elderly people. males exceeding females as in Mumbai). A high growth of population over a period of time tends to imply a rising demand for essential goods and services in general. Similarly. The reverse happens if a fall in the future price is expected. But a highly taxed commodity will have a relatively lower demand than an untaxed commodity .if that happens to be a remote substitute. INVENTIONS AND INNOVATIONS : Introduction of new goods or substitutes as a result of inventions and innovations in a dynamic modern economy tends to adversely affect the demand for the existing products. toys. If the population pyramid of a country is broad-based with a larger proportion of juvenile population. school bags etc.e. COMMUNITY'S COMMON HABITS AND SCALE OF PREFERENCES : The market demand for a product is greatly affected by the scale of preferences by the buyers in general. FUTURE EXPECTATIONS : If buyers in general expect that prices of a commodity will rise in future. For example. would mean a greater demand for goods required by the female population than by the male population (or the reverse).

and (ii) the market demand schedule. thus. per month or per annum) is referred to as an individual demand schedule. there is a greater demand for sweets. INDIVIDUAL DEMAND SCHEDULE A tabular list showing the quantities of a commodity that will be purchased by an individual at various prices in a given period of time (say per day. salwar-kameej etc. cakes. For example. during Diwali holidays. etc. vehicles and white goods. crackers. Similarly. fans. the general demand pattern will be affected. two types of demand schedules : (i) the individual demand schedule. (per kg. there is a greater demand for cold drinks. Demand is manipulated through selling efforts. Price of X in Rs. and during Christmas.) 30 25 20 15 10 Quantity Demanded of X per week (in Kg. Of course. DEMAND SCHEDULE : A tabular statement of price-quantity relationship is known as the demand schedule. When these factors change. festivals. For example. there is always a limit. 12) CUSTOMS : Demand for certain goods are determined by social customs. causing a change in the market demand as a whole. are based on current fashions. per unit of time. per week. 2. sweets and confectioneries are in more demand. There are. demand for commodities like jeans. coolers. 13) ADVERTISEMENT AND SALES PROPAGANDA : Market demand for many products in the present day are influenced by the sellers' efforts through advertisements and sales propaganda. shirts. demand for umbrellas and raincoats are seasonal. For example.) 2 4 6 10 16 Demand Analysis 87 . in summer.10) FASHIONS : Market demand for many products is affected by changing fashions. 11) CLIMATE OR WEATHER CONDITIONS : Demand for certain products are determined by climatic or weather conditions. It narrates how much amount of a commodity is demanded by an individual or a group of individuals in the market at alternative prices. air conditioners etc.

thus. 88 Managerial Economics . the market demand schedule is constructed by the horizontal additions of quantities at various prices shown by the individual demand schedules. CHARACTERISTICS OF DEMAND SCHEDULE 1) The demand schedule does not indicate any change in demand by the individual concerned. but merely expresses his present behaviour in purchasing the commodity at alternative prices. the market demand schedule also depicts an inverse relationship between the price and quantity demanded. represents the total market demand at various prices. the demand schedules of all individual consumers of a commodity can be compiled and combined to form a composite demand schedule. most of the demand schedules show an inverse relationship between price and quantity demanded. It seeks to illustrate the principle that more of a commodity is demanded at a lower price than at a higher one. Theoretically. It follows that like an individual demand schedule. In fact. Price in Rupees (per unit) Units of Commodity X Demanded per day by Individuals A+ 4 3 2 1 1 2 3 5 B+ 3 4 5 9 C+ 3 5 7 10 Quantity Demanded in the market for X = 7 11 15 24 Apparently. The derivation of market demand from individual demand schedules is illustrated in the table given below.This illustrates a hypothetical (purely imaginary) demand schedule of an individual consumer Mr A for commodity X. It shows only the variation in demand at varying prices. Here it is assumed that the market is composed only of three buyers. A market demand schedule. 2) 3) MARKET DEMAND SCHEDULE It is a tabular statement narrating the quantities of a commodity demanded in aggregate by all the buyers in the market at different prices in a given period of time. representing the total demand for the commodity at various alternative prices.

the quantity demanded is measured on the horizontal axis (X-axis) and the price per kg. DERIVATION OF MARKET DEMAND CURVE Market demand curve is derived by the horizontal summation of individual demand curves for a given commodity. by plotting the market demand schedule graphically. d and e are obtained on the graph. various points like a. a demand curve is drawn. represents an individual demand curve. When price-quantity information of a demand schedule is plotted on a graph. Likewise. Conventionally. given above. It slopes downwards from left to right. THE DEMAND CURVE : A demand curve is a graphical presentation of a demand schedule. b. Figure given on the next next illustrates this: Demand Analysis 89 . In this figure. Corresponding to the price-quantity relations given in the demand schedule. a demand curve is drawn by representing the price variable on the Y-axis and the demand variable on the X-axis. c. given below illustrates the demand curve based on the data contained in Table. The demand curve has a negative slope. which is called the demand curve. Y D 30 Price (Per Kg.4. representing an inverse relationship between price and demand. the market demand curve may be drawn. is measured on the vertical axis (Y-axis). Demand curve thus depicts the picture of the data contained in the demand schedule.) a b c d e D X 2 4 6 8 10 12 14 16 Quantity Demanded 25 20 15 10 5 O Individual Demand Curve The figure. Fig. These points are joined and the smooth curve DD is drawn.

e. i. It simply states that demand varies inversely with change in price. 5. 90 Managerial Economics . indicating a larger quantity demanded at a lower price and a smaller quantity demanded at a higher price. the demand falls) as the price rises. Or briefly stated. larger is the quantity demanded. the higher the price of a commodity. the market demand curve too has a downward slope indicating an inverse price-quantity relationship." In other words. assumes that other determinants of demand are constant and only price is the variable and influencing factor.e. Essentially. The conventional law of demand.. The law of demand expresses the nature of functional relationship between two variables of the demand relation. the smaller is the quantity demanded and lower the price. demand varies inversely with price. the demand for a commodity expands (i. and vice-versa. relates to the much simplified demand function : D = f(P) Where.. viz. quantity demand rises when the price falls. D represents demand. It. P the price and f connotes a functional relationship. other things remaining unchanged. the law of demand emphasises that. The relation between price and quantity of demand is usually an inverse or negative relation. the price and the quantity demanded. the demand rises) as the price falls and contracts (i.e. however. however. Statement of the Law The law may be stated thus : "Other things being equal.Y Price (Per Unit) A’s Demand Y B’s Demand Y C’s Demand Y Market Demand D(A) + D(B) + D(C) = D(Market) O XO XO Quantity Demanded of X XO X Derivation of Market Demand Curve It may be observed that the slope of the market demand curve is an average of the slopes of individual demand curves. THE LAW OF DEMAND : The general tendency of consumers' behaviour in demanding a commodity in relation to the changes in its price is described by the law of demand.

There is an inverse relationship between price and quantity demanded. quantity demanded tends to rise. Price of Commodity X (in Rs. Usually. incidentally. the corresponding quantity demanded for that commodity increases and viceversa. Further.) per unit 5 4 3 2 1 Quantity Demanded per week 10 20 30 40 50 This table represents a hypothetical demand schedule for commodity X. the demand curve geometrically represents the mathematical demand function : Dx = f (Px) Demand Analysis 91 . From the given market demand-curve one can easily locate the market demand for a product at a given price. DD is a downward sloping demand curve indicating an inverse relationship between price and quantity demanded. thus : i. (Here. the demand curve being a straight line is a linear demand curve. as the price of a commodity decreases. We can read of from this table that with a fall in price at each stage. economists draw a demand curve to give a pictorial presentation of the law of demand.EXPLANATION OF THE LAW OF DEMAND The law of demand is usually referred to the market demand. a demand curve is drawn as shown in Figure given below. The law of demand can be illustrated with the help of a market demand schedule. Demand Curve Y 5 Price (Per Unit) D 4 3 2 1 O 10 20 30 40 50 Quantity Demanded of X D X In this figure.e. When the data of table are plotted graphically.

The given price change is assumed to be final at a time. it is essential that the number of buyers and their preferences should remain constant. It will hold good only if certain conditions are given and constant. That is to say. Thus. habits and preferences should remain constant. NO CHANGE IN THE PRICES OF RELATED GOODS : Prices of other goods like substitutes and complementary goods remain unchanged. the consumer's preferences would change which may invalidate the law of demand. he may buy more even at a higher price. 1) NO CHANGE IN CONSUMER'S INCOME : Throughout the operation of the law. it is always stated with "other things being equal". so that the levels of income of the consumers remain the same. NO EXPECTATIONS OF FUTURE PRICE CHANGES OR SHORTAGES : The law requires that the given price change for the commodity is a normal one and has no speculative consideration. invalidating the law of demand. The law of demand is. there will be additional buyers in the market.ASSUMPTIONS UNDERLYING THE LAW OF DEMAND The above stated law of demand is conditional. If the level of a buyer's income changes. Managerial Economics 2) 3) 4) 5) 6) 7) 8) 92 . based on the following ceteris paribus assumptions. Otherwise. NO CHANGE IN FASHION : If the commodity in question goes out of fashion. It relates to the change in price variable only. the buyers do not expect any shortages in the supply of the commodity in the market and consequent future changes in the prices. NO CHANGE IN THE DISTRIBUTION OF INCOME AND WEALTH OF THE COMMUNITY : There is no redistribution of income either. thus. so that the total market demand may not contract with a rise in price. NO CHANGE IN SIZE. assuming other determinants of demand to be constant. This necessitates that the size of population as well as the age-structure and sex-ratio of the population should remain the same throughout the operation of the law. AGE-COMPOSITION AND SEX RATIO OF THE POPULATION : For the operation of the law in respect of total market demand. If the prices of other related goods change. a buyer may not buy more of it even at a substantial price reduction. NO CHANGE IN CONSUMER'S PREFERENCES : The consumer's tastes. if population changes. the consumer's income should remain the same. NO CHANGE IN THE RANGE OF GOODS AVAILABLE TO THE CONSUMERS : This implies that there is no innovation and arrival of new varieties of products in the market which may distort consumer's preferences.

the demand expands and it contracts when the price rises. it may be observed. umbrellas etc. demand also rises. Price (Per Unit) Exceptional Demand Curve Demand Analysis 93 . Cases in which this tendency is observed are referred to as exceptions to the general law of demand. though. The demand curve for such cases will be typically unusual. for instance. the validity of the law of demand or the inference about inverse relationship between price and quantity demanded depends on the existence of these conditions or assumptions. very rarely.9) NO CHANGE IN GOVERNMENT POLICY : The level of taxation and fiscal policy of the government remain the same throughout the operation of the law. the law of demand presumes that except for the price of the product. But sometimes. may cause changes in consumers' income or changes commodity taxes (sales tax or excise duties) may lead to distortions in consumer's preferences. of course. changes in income tax. that with a fall in price. It will be an upward sloping demand curve as shown in Figure given below. This is a paradoxical situation or a situation which is apparently contrary to the law of demand. Apparently. all other determinants of its demand are unchanged. Otherwise. EXCEPTIONS TO THE LAW OF DEMAND OR EXCEPTIONAL DEMAND CURVE : It is almost a universal phenomenon of the law of demand that when the price falls. demand also falls and with a rise in a price. It is described as an exceptional demand curve. 10) NO CHANGE IN WEATHER CONDITIONS : It is assumed that climatic and weather conditions are unchanged in affecting the demand for certain goods like woollen clothes. In short.

SPECULATION : When people speculate in changes in the price of a commodity in the future.. Johney Walker Scotch Whiskey are another outstanding illustration. 94 Managerial Economics . Rolls Royce cars. Such upward sloping demand curves are unusual and quite contradictory to the law of demand as they represent the phenomenon that 'more will be demanded at a higher price and vice versa". vegetable ghee. pucca rice. CONSUMER'S PSYCHOLOGICAL BIAS OR ILLUSION: When the consumer is wrongly biased against the quality of a commodity with the price change. similarly. which may be categorised as follows : 1) GIFFEN GOODS: In the case of certain inferior goods called Giffen goods. cake. on the contrary. they will not contract their demand with the given price rise. as against superior commodities like good potatoes. The upward sloping demand curve. is the demand and when the price rises to OP2' demand also expands to QQ2. Thus.In this fugre. thus. refers to the exceptions to the law of demand. he may contract his demand with a fall in price. the upward sloping demand curve expresses a direct functional relationship between price and demand. cheap bread. thinking that the goods may be of bad quality. quite often less quantity will be purchased than before because of the negative income effect and people's increasing preference for a superior commodity with the rise in their real income. they may purchase more for the purpose of hoarding. some people tend to buy more shares when the prices are rising. they may not act according to the law of demand at present. DD is the demand curve which slopes upward from left to right. QQ1. Some sophisticated consumers do not buy when there is a stock clearance sale at reduced prices. and have a 'snob appeal'. and purchased only by rich people for using them as 'status symbol'. the terms 'changes in quantity demanded' and 'changes in demand' have different meanings. pure ghee. It appears thus that when OP1 is the price. CHANGES IN QUANTITY DEMANDED AND CHANGES IN DEMAND: 2) 3) 4) 6. so they can make a good fortune in future. when people are convinced that the price of a particular commodity will rise still further. These are generally ostentatious articles. certain commodities are demanded just because they happen to be expensive or prestige goods. Probably. when prices of such articles like say diamonds rise. in the hope that the rising trend would continue. Say. their demand also rises. In economic analysis. such as foodstuffs like cheap potatoes. a few appropriate examples of inferior goods may be listed. In the stock exchange market. as introduced by Robert Giffen when the price falls. Thus. There are a few such exceptional cases. etc. basmati rice. ARTICLES OF SNOB APPEAL : Sometimes.

while changes in demand are reflected through shifts in the demand curve. and Variation in demand is the connotation of the law of demand. The terms "expansion" and "contraction" of demand. A change in demand due to causes other than price is called increase or decrease in demand. D.The term 'changes in quantity demanded' or variation in demand relates to the law of demand. movement from a to b in the following figure. price remaining unchanged. when a lesser quantity is demanded with a rise in price. demand expands from OQ to OQ1. be distinguished from increase or decrease in demand. it is incorrect to say that demand decreases when price increases or demand increases when price decreases. Thus. eg: movement from a to c in the diagram. a change in demand due to change in price is called expansion or contraction. we may say that the quantity demanded of a commodity increases when it's price decreases. for instance. For "increase" and "decrease" in demand refers to "changes in demand" caused by the changes in various other determinants of demand. The former is used for indicating increase in demand. Demand Analysis 95 . should. It suggests that when the price decreases from OP to OP1. Expansion and contraction refer to the same demand curve. A downward movement from one point to the another on the same demand curve implies expansion of demand. Similarly.): EXTENSION AND CONTRACTION OF DEMAND A variation in demand implies "expansion" or "contraction" of demand. In short. In graphical exposition. Thus the terms "expansion" & "contraction" are used in stating the law of demand. While an upward moment from one point to another on the same demand curve implies contraction of demand. A) EXPANSION OR (Changes in Q. or the quantity demanded decreases when it's price increases. Changes in quantity demanded in relation to the price are measured by the movement along the demand curve. But. there is contraction of demand. When with the fall in the price with the commodity is brought. there is expansion of demand. It expresses a functional relationship between quantity demanded and price. The terms" changes in quantity demanded essentially means variation in demand referring to " expansion" or "extension" or "contraction" of demand which are quite distinct from the terms "increase" or "decrease" in demand. however. It refers to the changes in quantities purchased by the consumer on account of changes in price only. while the later is used for indicating changes in demand. expansion or contraction of demand is shown by the movement along the same demand curve. demand expands when the price falls and it contracts when the price rises.

the demand curve is shifted to the right. Similarly. Thus increase and decrease in demand are shown by shifting the demand curves. an increase in demand means that more is now demanded than before. Further. expansion or contraction implies a movement on the same demand curve which means the demand schedule remains the same. other than the price. thus implies an increase or decrease in demand. When more of a commodity is bought than before at any given price. In this case. The terms" increase" or "decrease" in demand are graphically expressed by the movements from one demand curve to the another. at each and every price. Thus. In other words. In short. In other words. likewise. A change in demand. shows that when price rises from OP to OP2 demand contracts from OQ to OQ2. the movement 96 Managerial Economics Co nt ra ct io n a Ex pa ns ion b D . there is increase in demand. thus. a change in quantity demanded in response to the change in price is explained by the terms expansion or contraction of demand. the change in demand is denoted by the shifting of the demand curve. an "increase" in demand signifies either that more will be demanded at given price or the same will be demanded at a higher price. "a decrease in demand signifies either that less will be demanded at given price or the same quantity will be demanded at a lower price. B) INCREASE AND DECREASE IN DEMAND (Changes in Demand): These two terms are used to express changes in demand. the movement of demand curve from DD to D1D1 shows an increase in demand. In the case of an increase in demand. when with price remaining unchanged less of a commodity is bought than before. there is decrease in demand.Price (Per Unit) c Quantity Demanded of X Expansion and Contraction of demand The fig. In the following figure (A). Changes in demand are result of the change in the conditions or factors determining demand.

Change in the supply or demand supply of the complementary goods and change in their prices. Change in fashions and customs. Change in the supply of the substitutes and in their prices. habits and preferences. In this case. movement from point a to c. Some of the important changes are: 1) 2) 3) 4) 5) 6) 7) 8) Change in Income Change in the pattern of income distribution. Thus an increase or decrease in demand is brought about by many kinds of changes. Y D1 D Price (Per Unit) Price (Per Unit) Y D D2 Increase P a b D1 Decrease P c a D D2 D O Q (A) Q1 X O Q2 (B) Q X Increase & Decrease in demand In the above fig. Change in tastes. Advertisement and Publicity persuasion. indicates that the price remains same at the OP.from point a to b indicates that the price remains the same at OP. but more quantity OQ1 is now demanded. the movement of demand curve from DD to D2D2 show a decrease in demand. as in Fig B. Thus increase in demand is QQ1. a decrease in demand is depicted by the shifting of the demand curve towards it's left. REASONS FOR CHANGE (Increase or Decrease in Demand) A change in demand occurs when the basic conditions of the demand change. Change in population. Demand Analysis 97 . Similarly. thus. but less quantity OQ2 is now demanded than before. instead of OQ. Here decrease in demand is QQ2.

In the present chapter. "Price elasticity" refers to the degree of responsiveness of demand for a commodity to a given change in its price. In some cases the variation is extremely wide. sometimes demand is greatly responsive to changes in price. depending on whether the amount demanded increases much or little for a given fall in price. the price elasticity coefficient can be measured : The percentage change in quantity demanded e = –––––––––––––––––––––––––––––––––––––– The percentage change in price 98 Managerial Economics . The extent of variation in demand is technically expressed as elasticity of demand.7. A) ELASTICITY OF DEMAND : PRICE ELASTICITY OF DEMAND The term "elasticity of demand". According to Marshall. when used without qualifications is commonly referred to as price elasticity of demand. Economists usually consider three important kinds of elasticity of demand : (1) Price elasticity of demand. as many kinds of elasticities of demand as its determinants. This is a loose interpretation of the term. "Cross elasticity" refers to the responsiveness of demand for a commodity to a given change in the price of a related commodity . In a strict logical sense. in some others it may just be nominal. thus. and diminishes much or little for a given rise in price. we shall study them one by one. the elasticity (or responsiveness) of demand in a market is great or small. ELASTICITY OF DEMAND : INTRODUCTION Demand for goods varies with price. the concept of elasticity of demand should measure the responsiveness of demand for a commodity to changes in its determinants. That means. at other times. "Income elasticity" refers to the degree of responsiveness of demand for a commodity to a given change in the income of the consumer. The coefficient of price elasticity of demand may.substitute or complementary product. it may not be so responsive. thus. Since the relative change of variables can be measured either in terms of percentage change or as proportional change. B) PRICE ELASTICITY OF DEMAND The extent of the change of demand for a commodity to a given change in price. But the extent of variation is not uniform in all cases. (2) Income-elasticity of demand and (3) Cross-price elasticity of demand or just cross elasticity. however. be defined as the ratio of the relative change in demand to the relative change in price. other demand determinants remaining constant. There are. is termed as the price elasticity of demand.

thus. ê Q = Q2 . It is measured as the difference between new demand (say Q2) and the old demand (Q1) Thus. that is. It is measured as the difference between new Price P2' and the old price (P1) Thus.P1 The above formula. let us consider the following information from the demand schedule : Price of Tea (Rs.) 10(Q1) 9(Q2) ∴ P êQ= Demand Analysis 99 . the price elasticity formula can be stated as : e= êQ êP : Q P êQ P X = Q êP êQ P X e= ê P Q Q = the original demand (Say Q1) = the original price (Say P1) the change in demand.) 20 (P1) 22 (P2) Quantity Demanded (Kg. in fact. relates to point-price elasticity of demand.Q1 êP= the change in Price. To illustrate the use of the formula.Price elasticity of demand can also be measured alternatively as Net change in Quantity demanded Net change in price e = –––––––––––––––––––––––––––––– : –––––––––––––––– Original Quantity demanded Original price Representing it in symbols. ê P = P2 . the coefficient signifies very small or marginal changes only.

20 = 2. What it means is simply this that a relatively larger change in demand is caused by a smaller change in price. and P = P1 = 20 ê Q = 09 .Thus. one may obtain various numerical values of coefficients of price elasticity. inelastic demand does not mean that demand is totally insensitive. Using the above formula. depending on the degree of responsiveness of the demand for a commodity to a given change in its price. the numerical coefficient of price elasticity can be measured from any such given data. minus signs are ignored) Therefore e= êQ X ê P 1 X = 2 = 1 P Q 20 10 ∴ e This means. It only means that the relative change in demand is less than that of price. and when it is exactly one (or unity). Similarly. we will find that its value ranges from zero to infinity. and it is inelastic when the numerical coefficient is less than one. we may mention the following five types of price elasticity of demand : 1) 2) 3) 4) 5) Perfectly elastic demand Perfectly inelastic demand Relatively elastic demand Relatively inelastic demand Unitary elastic demand when e = ∝ when e = O when e = >1 when e = <1 when e = 1 100 Managerial Economics . It means demand responds to a lesser extent only. we mean that demand responds greatly or relatively more to a price change. the elasticity of demand is equal to one or unity. and Q = Q1 = 10 (Here. TYPES OF PRICE ELASTICITY : DEGREE OF ELASTICITY OF DEMAND Demand may be elastic or inelastic. When the elasticity coefficient is greater than one. Treating this concept in a more elaborate manner. does not imply that the consumers are fully responsive to a price change. demand is said to be elastic. It however. the demand is unitary elastic. ranging from zero to infinity. depending upon the magnitude and proportional change involved in the data on demand and prices. Apparently. Measuring numerical coefficient of price elasticity in different cases.10 = 1. ê P = 22 . By elastic demand.

the demand is infinite. the degree of elasticity determines the sahpe and slope of the demand curve. however. When demand is perfectly elastic. elasticity of demand can be ascertained from the slope of the demand curve. the demand curve will be a horizontal straight line. The numerical coefficient of perfectly elastic demand is infinity (e = . This figure indicates that at price OP. the consumer stops buying it. as can be obtained. Demand Analysis 101 . the demand for the product of a firm in a perfectly. α) In fact. that at the ruling price of OP. while a slight rise in price would mean a zero demand. an infinite quantity. Perfectly. elastic demand is a case of theoretical extremity. i.1) Perfectly Elastic Demand (e = α) An infinite demand at the given price is a case of perfectly elastic demand. and that at a slightly higher price he would buy nothing. buyers tend to have an infinite demand for its product in the market. perfectly elastic demand or the horizontal demand curve (as shown in Figure above). a person would buy as much of the given commodity. the demand curve in Figure A given below implies. Thus. In the case of a perfectly elastic demand. with a slight or infinitely small rise in the price of the commodity. The slope of demand curve reflects the elasticity of demand. since at the given price (say OP in Figure shown above).e. from the firm's point of view implies that it can sell as much as it produces at the ruling market price. (A) Y e=α α Price (Per Unit) P D D O X Quantity Demanded Types of Price Elasticity of Demand In economic theory. Thus. It is hardly encountered in practice. competitive market is assumed to be perfectly elastic. Theoretically.

the demand is said to be relatively elastic. In this case. the demand curve would be a straight vertical line as in Figure B shown above. then it is called a perfectly inelastic demand. thus. that is to say. inelastic demand has. The numerical value of relatively elastic demand 102 Managerial Economics . the quantity demanded remains the same OQ only.2) Perfectly Inelastic Demand (e = 0) (B) Y e= 0 D Price (Per Unit) P1 P2 P3 O D X Q Quantity Demanded When the demand for a commodity shows no response at all to a change in price. a commodity of absolute necessity like salt seems to have perfectly inelastic demand for most consumers. Perfect inelasticity is again a theoretical consideration rather than a practical phenomenon. This figure indicates that whether the price moves from Op1 to OP2 or Op3. whatever the change in price the demand remains the same. Perfectly. 3) Relatively Elastic Demand ( e > l ) (C) Y e>1 Price (Per Unit) D P1 P2 D X Q1 Q2 Quantity Demanded O When the proportion of change in the quantity demanded is greater than that of price. zero elasticity (e = 0). However.

the demand expands just by Q1 Q2 which is relatively small in proportion to the change in price. Thus. i.e. elasticity is greater than one. rather a flatter demand curve as shown in Figure(C) above. rather a steeper. the demand expands by Q1 Q2 which is relatively large in proportion to the change in price. A relatively inelastic demand will be represented by a rapidly sloping. êQ e = ê P ÷ =<1 Q P Therefore. The numerical value of relatively inelastic demand lies between zero and one. it is a more realistic concept. Hence. 4) Relatively Inelastic Demand ( e < l ) (D) Y e<1 D Price (Per Unit) P1 P2 D O Q1 Q2 X Quantity Demanded When the proportion of change in the quantity demanded is less than that of price.e. i. elasticity is less than one. the concept "relatively inelastic" or 'less elastic" demand is the same as what Marshall presented as elasticity being less than unity. In this Figure(C) above when the price falls by P1 P2. the demand is considered to be relatively inelastic. In Figure (D) when the price falls by P1 P2. Demand Analysis 103 . what Marshall called as elasticity of demand being greater than unity referred to 'relatively elastic' demand or 'more elastic' demand.lies between one and infinity. This is also a very realistic concept. êQ e = ÷ ê P =>1 Q P Therefore. demand curve as shown in Figure (D) above. as many commodities can have more elastic demand. A relatively elastic demand will be represented by a gradually sloping..

5) Unitary Elastic Demand (e = 1) (E) Y D Price (Per Unit) e=1 1 P1 P2 D O Q1 Q2 X Quantity Demanded When the proportion of change in demand is exactly the same as the change in price. The numerical value of unitary elastic demand is exactly 1.. when the price falls by P1 P2. The different kinds of price elasticity of demand discussed above have been summarised in Table A on the next page. the demand is said to be unitary elastic. 104 Managerial Economics . as shown in Figure (E ) above. This is a theoretical norm. which helps to distinguish between elastic and inelastic demand in general. êQ e = Q ÷ P ê P = 1 Hence. the demand curve would be a rectangular hyperbola asymptotic to the two axis. elasticity is equal to unity. In Figure (E). the demand expands by Q1 Q2 which is in the same proportion to change in price. In the case of unitary elastic demand.

= New Quantity Demanded – Old Quantity Demanded X 100 Average Quantity Demanded New Price – Old Price X 100 Average Price % Change in Price = (2) Point Elasticity Method The calculation of the coefficient of price elasticity has been already discussed in the previous sub unit using the ratio : êQ e = –––– Q êP ÷ –––– P P –––– ê P ∴ êQ e = –––– ÷ Q Demand Analysis 105 . Quantity demanded changes by a larger percentage than does price. e=O e>1 e<1 e=1 C) MEASUREMENT OF ELASTICITY There are five different methods of measuring price elasticity of demand.Table A PRICE ELASTICITY OF DEMAND (Definition e = Percentage change in the quantity demand : Percentage change in price) Numerical Value e=α Terminology Perfectly (or infinitely elastic) Perfectly (or completely) inelastic Relatively elastic Relatively inelastic Unitary elastic Description Consumers have infinite demand at a particular price and none at all at even slightly higher than this given price. Quantity demanded changes by a smaller percentage than does price.(1) Percentage Method (2) Point elasticity Method (3) Total outlay Method (4) Point Geometric Method and (5) Arc elasticity Method. Demand remains unchanged whatever may be the change in price. Quantity demanded changes by exactly the same percentage as does price. (1) Percentage Method : The following formula is used e= % Change in Quantity Demanded % Change in Price % Change in Q.D.

the total outlay remains unchanged. demand is relatively elastic (see Table C below). demand is unitary elastic (e = 1). because the demand changes in the same proportion as the price. Alfred Marshall suggested that the easiest way of ascertaining whether or not demand is elastic is to examine the change in the total outlay of the consumer or the total revenue of the seller. elasticity of demand is greater than unity. when the price and total outlay move in opposite directions.) 80 80 80 Elasticity of Demand – } e=1 } (unitary) (2) When with a rise in price. the total outlay rises. Table C TOTAL OUTLAY METHOD Price (per unit) (Rs.) 100 80 160 Elasticity of Demand – } e<1 } (Elastic) 106 Managerial Economics . In short.) Original Change 1 Change 2 5 8 1 Quantity demanded (Units) 16 10 80 Total Outlay (or revenue) (Rs. This happens because the proportion of change in demand is relatively greater than that of price. The total outlay remains constant in the case of unitary elastic demand. the total outlay falls.) Original Change Change 5 8 4 Quantity demanded (Units) 20 10 4 Total Outlay (or revenue) (Rs. Total outlay (or Total Revenue) = Price per unit x Quantity demanded Dr. or with a fall in price. Marshall laid down the following propositions : 1) When with a change in price.∴ êQ P e = –––– ÷ –––– êP Q (3) Total Outlay Expenditure or Revenue Method Dr. This is illustrated in Table B given below : Table B TOTAL OUTLAY METHOD Price (per unit) (Rs.

thus. with any change in price. the total revenue remains unaltered. from the behaviour of the total outlay or the total revenue. and with a fall in price. In the case of unitary elastic demand. However. It can indicate only the type of elasticity. To get the exact numerical value.) Original Change Change 5 8 2 – }e<1 } (Inelastic) We may now summaries the total outlay method as follows : Price (per unit) 1. we have to resort to the ratio method or the point method. however. 2. 3. Briefly.(3) When with a rise in price. demand is relatively inelastic (see Table D below). but not its exact numerical value. This happens because the proportion of change in demand is relatively less than the proportion of change in price. the total outlay also rises. when the price and total outlay move in the same direction. In the case of inelastic demand. elasticity of demand is less than unity.) 65 80 28 Elasticity of Demand Price (per unit) (Rs. the total revenue would change in the same direction as the price changes. we can conclude about the nature of change in the consumer's total outlay or the seller's total revenue. we can infer the nature of price elasticity of demand. less exact. Increases Decreases Increases Decreases Increases Decreases Total Outlay Constant Constant Decreases Increases Increases Decreases Types of Elasticity e=1 (Unitary) e> 1 (Relatively elastic) e<1 (Relatively inelastic Thus. from a given price elasticity. Table D TOTAL OUTLAY METHOD Quantity demanded (Units) 13 10 14 Total Outlay (or revenue) (Rs. the total revenue would change in the opposite direction of the price change. Likewise. But when there is elastic demand. the total outlay falls. the economic significance of the total outlay or the total revenue method is that it tells more directly Demand Analysis 107 . The total outlay method of measuring elasticity is.

L stands for lower segment and U for the upper segment. we may again put that Lower segment of the demand curve below the given point Upper segment of the demand curve above the point L or. (4) Point Geometric Method Dr. it divides the straight-line demand curve into two segments (parts). Point elasticity = Price (Per Unit) Point Method Price (Per Unit) Point Method 108 Managerial Economics .what happens to the total outlay or revenue as a practical guide for determining a price policy and its effect on demand and revenue. Let the straight-line demand curve be extended to meet the two axes. thus. to remember through symbols. stands for point elasticity. as shown in Figure shown below. For brevity. measured by the ratio of the lower segment of the curve below the given point to the upper segment (the upper part) of the curve above the point. When a point is taken on the straight-line demand curve (like point P in Fig below). Alfred Marshall also suggested another method called the geometrical method of measuring price elasticity at a point on the demand curve. The simplest way of explaining the point method is to consider a linear (straight-line) demand curve. The point elasticity is. we may put it as e = ––– U where. e.

By nature. comfort or necessary goods. we find that PB = 4 cm. The formula is (Q0 – Q1) (Q0 + Q1) e=– x 2 ÷ 2 (P0 + P1) (P0 – P1) (Q0 – Q1) X (Q0 + Q1) (P0 – P1) (P0 + P1) ∴ e=– x Here. FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND : Whether the demand for a commodity is elastic or inelastic will depend on a variety of factors. goods may be classified into luxury. In general. and PA = 2 cm. PA is the upper segment. the demand curve is non-linear. AB is a straight-line demand curve. then draw a tangent at the given point.5. The major factors affecting elasticity of demand are : 1..In the Figure on the previous page. demand for Demand Analysis 109 . Q0 = Original demand Q1 = New demand P0 = Original price P1 = New price There can be different answers to elasticity of demand ranging from zero to infinity. the elasticity at point P = 3 2 = 1. however. Thus. PB is the lower-segment. Nature of Commodity Certain goods by their very nature tend to have an elastic or inelastic demand. extending it to intercept both the axes (See figure) Point elasticity at point P in Figure is measured as (5) PB PA Arc Elasticity Method : This method is used to measure elasticity of demand on an arc of the demand curve. e= L U = PB PA If after actual measurement of the two parts of the demand curve. 8. If. P is a given point.

g. hence demand tends to be inelastic in their case. Thus. Gold Spot. the redistribution of income in favour of low-income people may tend to make demand for some goods relatively inelastic. the demand will be somewhat inelastic. Number of Uses Single-use goods will have generally less elastic demand as compared to multi-use goods. its demand will tend to be elastic. Mangola.D. have a wide range of substitutes and therefore they have a more elastic demand in general. is generally inelastic.luxuries and comforts is relatively elastic and that of necessaries relatively inelastic. therefore. Their demand will. which are relatively low priced and bought in bulk. 6. onions. a small change in price will have an insignificant effect on their demand. the demand for food grains. however. With a fall in price. sets. Similarly. salt etc. while commodities like tea. there are divisible goods like potatoes and onions. But the former's demand is inelastic as compared to the latter's.g. his demand for overall commodities tends to be relatively inelastic. etc.g. 3. In their case. so a small variation in price will not have much effect on their demand.. is highly inelastic as there are no close or effective substitutes for these commodities. players etc. potatoes.V. 2. D. e. for commodities like coal or electricity having a composite demand. then their demand will be elastic. cloth. also possible that the demand for a commodity which has a variety of uses may be elastic in some of the uses. these commodities may be demanded greatly for various uses.. sugar. the demand pattern of a millionaire is rarely affected even by significant price changes. the larger the income of a consumer. demand for salt.. Colour T. Similarly. 4. Height of Price and Range of Price Change There are certain white goods like costly luxury items or bulky goods such as double door refrigerators. coal used by railways and by consumers as fuel. elasticity is relatively high. However. Proportion of Expenditure Items that constitute a smaller amount of expenditure in a consumer's family budget tend to have a relatively inelastic demand. a cinegoer who sees a film every fortnight is not likely to give it up when the ticket rates are raised. for example. Fanta. if the price change is large enough. Availability of a Substitute Where there exists a close substitute in the relevant price range. 5. For example. for example. Consumer's Income Generally. It is. vegetables. Limca etc.. be inelastic.V. etc. which are highly priced in general. and may be inelastic in some other uses. e. But one who sees a film every 110 Managerial Economics . coffee or beverages such as Thums Up. Thus. e. But in respect of a commodity having no substitute.

ball-point pen and refills. Time In the short period. Durability of the Commodity In the case of durable goods. then these are demanded more. are purchased only once. e. 10. V. Influence of Habit and Customs There are certain articles which have a demand on account of conventions. 11. milk. motorcycles. 8.V.D. in the long run. sets etc.V.g. e. motor cycles. their habits may change and so too the demand pattern. Thus. elasticity is less. demand in general will be less elastic. hence their price elasticity will be less. players. it becomes more elastic.g. in the long run. demand is relatively elastic. (iv) durable goods take some time to exhaust their utility. lapse of time results in their wearing out. T. the demand generally tends to be inelastic in the short run. kerosene candles. T.g. e. it has to be satisfied. habituated goods etc. Complementary of Goods Goods which are jointly demanded have less elasticity. sets etc. sugar. In the long run. but. while in the long period. (ii) consumers may expect a further change. In the case of consumption goods which are urgently and immediately required. broomstick.g. e. on the other hand. 9. haircut etc. but gradually. 12. Recurrence of Demand If the demand for a commodity is of a recurring nature. its price elasticity is higher than that of a commodity which is purchased only once. furniture. This is because (i) it takes some time for the news of price change to reach all the buyers. customs or habit with which these articles are closely associated and in these cases.. In the case of perishable commodities. So is the case with matches. But the demand for cassettes or Compact Disks may remain relatively elastic. Possibility of Postponement When the demand for a product is postponable. vegetables etc.C. Demand Analysis 111 . their demand will be inelastic. For instance. (v) demand for certain commodities may be postponed for some time.alternate day perhaps may cut down the number of films seen per week. 7. so they may not react to an immediate change in price. Mangal Sutra to a Hindu bride or cigarettes to a smoker or alcohol to an alcoholic have inelastic of demand. have inelastic demand for this reason. cheap or small expenditure items tend to have more demand inelasticity than expensive or large expenditure items. it will tend to be price-elastic. motor cycle and petrol etc. (iii) people are reluctant to change their habits all of a sudden. For example life saving drugs during sickness.

when there is a bumper crop it can be sold only by cutting down prices substantially. Its importance in International Trade If demand for Indian goods in foreign countries is inelastic. 112 Managerial Economics . there will not be any significant rise in revenue. Hence. which have an inelastic demand. 2. it implies that higher farm incomes depend. 3. generally taxes are levied on commodities like petrol. 4. with a little marginal profit. For instance. when he finds that demand for their industry's product is fairly elastic. He finds that it will be profitable to raise prices. PRACTICAL SIGNIFICANCE OF THE CONCEPT OF ELASTICITY OF DEMAND : The concept of elasticity of demand has a wide range of practical application in economics and business. Otherwise. among other things. washing machines etc. That is. India can raise the price of its commodities substantially and still export the same quantity at a higher price. for policy-makers. Its importance to Economists The concept is highly useful to the economists in understanding and solving many problems. it is better to lower their prices so that. upon restriction of the supply of foodgrains and other farm products. white goods like refrigerators. their sales will be more. have an inelastic demand. steel. Importance to Government In determining fiscal policy. if their demand is more elastic. The union leader. Its Importance to the Trade Unionists The concept of price-elasticity is useful to trade union leaders in wage bargaining. particularly foodgrains. then it will contract very much with a rise in price as a result of added taxation (like sales tax or excise duty).9. Since agricultural products. Tax imposition on commodities for getting a substantial revenue becomes worthwhile only if taxed goods have an inelastic demand. And in the case of products having a highly elastic demand. That is why. hence their total revenues. Thus. the total income of farmers will be lower inspite of a bigger crop. Its importance to the Businessman The elasticity of demand for the product he produces is the prime concern of every producer. It guides him in determining the price policy for his product. provided the demand is inelastic. will ask for a high wage for workers and suggest the producer to cut the price and increase sales which will compensate for his loss in total profit. getting larger amount of money and higher profit from their exports. alcohol. and thus the total profit will be large. the concept of elasticity of demand is very important to the government. cigarettes. 5. thus. 1. The Finance Minister has to consider the elasticity of demand while selecting commodities for taxation. hence the total revenue yield would not be much different from the earlier one. the concept is useful in solving the mystery as to how farmers may remain poor despite a bumper crop.

Thus. Income elasticity of demand for a product shows the extent to which a consumer's demand for that product changes consequent upon a change in his income. Income elasticity of demand can be defined as the ratio of proportionate change in the quantity demanded of the commodity to a given proportionate change in income of the consumer. during 1970’s. in international trading transactions. (A) MEASUREMENT OF INCOME ELASTICITY The formula for measuring income elasticity of demand can be stated thus : Formula 1 : Ey = Proportionate change in quantity demanded ––––––––––––––––––––––––––––––––––––– Proportionate change in consumer's income Example : A 20% rise in income causes a 30% increase in demand for a product 'X". thus getting higher amount of profit by exporting the same amount of jute manufactures as before. petroleum oil-exporting countries formed OPEC. thus making enormously larger profits than before.Thus. trading nations make an effort to know the degree of elasticity of demand for their goods in foreign countries with a view to fix prices of export goods at a level that would give exporting countries maximum profit. India’s oil bill rose nearly ten times though importing the same quantity as before from the Middle East. we can now switch over to another determinant of demand viz. a monopolistic organization of oil-exporting countries and raised the price of crude oil from 3 dollars per barrel to nearly 30 dollars per barrel and still could export the same quantity as before. 10. what will be the income elasticity of demand for 'X" ? Demand Analysis 113 . during 1950’s when demand for Indian jute manufactures in foreign countries was highly inelastic. realizing this fact Government of India raised the price of jute manufactures by practically trebling export duty on these goods forcing foreign importers to pay nearly three times the price as compared to old price and yet selling same quantity as before. including price. income and consider elasticity of demand by holding all other determinants. All this could happen because of the highly inelastic demand for crude oil produced in the Middle East countries which are the main supplier of crude oil to the world. Similarly. For example. constant. INCOME ELASTICITY OF DEMAND : As indicated in the beginning. This made the Middle East oilproducing Arab countries very rich as petroleum has as yet no substitute.

l.per month he spends Rs.1800/.per month on sugar when his income is Rs. What will be the income elasticity of demand for sugar in this case? Solution : According to the above formula 84 .60/.per month.8 ∴ positive) 114 Managerial Economics .84 on sugar.Y1 Ey = ––––––– ÷ –––––– Q2 + Q1 Y2 + Y1 In this formula Q1.8 6 >1 (Income elasticity of demand in this case is 1.5 Formula 2 A second formula which is mathematically more rational is suggested as under : Q2 .Solution : According to formula mentioned above : Ey = 30 –– 20 = 1.1500 –––––––––– 1800 + 1500 300 ––––––– 3300 3300 –––––– 300 11 –––––– 1 = ÷ = x = x = ∴ Ey = 11 ––––– = 1. is the initial consumer expenditure on any commodity 'X" (which represents the demand for the product 'X") and Q2 is the new expenditure on the same commodity after a change in income. Example : A consumer spends Rs. When his income increases to Rs. Y1 denotes initial income and Y2 stands for changed or new income.Q1 Y2 .500/ .60 Ey = ––––––– 84 + 60 24 ––––––– 144 24 ––––– 144 1 –––––– 6 ÷ 1800 .

the income elasticity of demand is negative. vanaspati. Unit elasticity of demand is considered to be a dividing line between necessaries and comforts. but less than one. High Income Elasticity As opposed to the above category. income elasticity of demand is very low in respect of commodities like salt. washing soap etc. precious stones. paintings. The income elasticity for different products differs widely.e. we get high income elasticity of demand for products which satisfy the consumers' comforts and luxuries. Low Income Elasticity of demand : When the income elasticity of demand for a product is positive i. we can classify income-elasticity into the following types : 1. 4) 5) C) Uses of the Concept of Income Elasticity of Demand The concept of income elasticity of demand is useful in many areas of economic policy formulations as well as analyses of various situations. Income . Demand for salt is an example of this type. Both these cases are noted below. Demand Analysis 115 . jewellery. Such a variety of relatively less income elasticity or incomeelasticity of demand suggests that the commodity concerned must be necessary.elasticity of demand tends to be very high in respect of luxury articles like gold.e.B) Types of Income Elasticity of Demand According to the value of income elasticity of demand. Zero Income Elasticity : When a change in income has no effect upon the quantity demanded of a product. Besides the type of a commodity i.e. whether it is a necessary or comfort or luxury. This is because as income increases the percentage of income spent on necessaries goes on diminishing. the proportion of a consumer's income spent on the commodity is also a major factor influencing income elasticity of demand. kerosene.1) when demand for the product increases in the same proportion in which income increases. As against this. In other words. Negative Income Elasticity : When the demand for a product decreases as income increases and conversely where demand for a product increases as there is fall in income. the income elasticity of demand would be zero. matches. Unit Income Elasticity : Income elasticity of demand will be equal to unity (i. 3. according to the Engel's Law of family expenditure. cars etc. greater than zero. The demand for inferior goods is of this type. we say that the income elasticity of that demand is relatively less. 2. the income elasticity of demand for articles of comforts and luxuries is greater than unity. In other words the income elasticity of demand for necessaries will be less than unity : while the income elasticity of the demand for comforts will be more than unity.

The rate of growth of India's exports therefore has remained relatively low. A country exporting agricultural products and articles of necessity faces an income-elastic demand. Consequently. For example. is income-elastic. the planners have to set targets of production in terms of physical quantities for various sectors of the economy. certain necessaries will continue to be demanded. we can find out how much will be the increase in the demand for a given product.1) Economic Development : In case of economic development. This would make the physical targets more realistic and would serve to maintain physical balances . Foreign Trade : In the area of foreign trade. the planners can estimate the possible increase in demand for the product as a result of the targeted rate of growth of the economy. Similarly. industrial policy etc. With the help of income elasticity. Economic Fluctuations : Economic fluctuations are the characteristic features of a capitalistic economy. during the phase of depression. commodities are seldom independent of one another. When economic development is being planned. India's demand for imports like electronics.a difficult task for the planners. coffee and spices. Phases of prosperity and depression alternate in such an economy. consumer durable etc. compared to a country which is exporting articles of luxury. This difference influences terms of trade. a country needs to take into account the income elasticity of demand for its imports as well as exports. India has been an exporter of jute. Economic Planning : The concept of income elasticity of demand is of great help to the planners who are planning for the economy as a whole. Demand Forecasting : Firms are required to forecast the demand for their product. where the concept is useful. when notional income is increasing. As noted above. tea. labour policy. CROSS ELASTICITY OF DEMAND : In practice. 2) 3) 4) 5) 11. Income elasticity of demand serves as a guide in the matter of balance of payments disequilibrium also. the rate of growth of India's imports has remained high. necessaries are commodities with very low income elasticities. The concept of income elasticity can be a very useful guide in finding out what products would be demanded during the phase of prosperity. the firm can forecast the demand for its product by using income elasticity of demand for that product as a guide. but the demand for all these commodities is incomeinelastic. Among the wide range of 116 Managerial Economics . Thus we have been facing the problem of an increasing trade deficit in India during the last few years. As against this. With the help of statistical information regarding trends in growth of income as well as changes of distribution of income. by considering the income elasticity of demand for that product. machinery. The list of areas where income elasticity of demand is useful can be increased further by mentioning public finance.

we can group these products either as substitutes or as complements or as a third group of goods which are neutral. Conversely. It will thus be clear that the cross elasticity of demand for substitutes varies between zero and infinity. we can say : Ec = Percentage change in quantity demanded of 'X' ––––––––––––––––––––––––––––––––––––––––– Percentage change in the price of 'Y' If we assume the two commodities X and Y are substitutes of each other and that the price of Y rises but that of X remains constant.products that we see at the market. the concept of cross elasticity of demand can be used. On the basis of the relationship. it causes a fall in the demand for refills as well as for ball-point pens. For example. the cross elasticity in such a case will be negative. When the price of refills rises. It means that the slightest rise in the price of Y will cause an almost infinite rise in the demand for X and the slightest fall in the price of Y will reduce the demand for X to almost zero. on the other hand. A change in the price of one commodity will not affect the quantity demanded of the other commodity. if the price of Y falls leaving the price of X unchanged. Cross elasticity can also be measured by another formula as given below Ec = OX2 – OX1 OX2 + OX1 : PY2 – PY1 PY2 + PY1 In this formula QX2 is the new demand for X. PY2 is the new price of Y and PY1 is the original price of Y. since Y has become costlier. Cross elasticity of demand may be defined as the ratio of proportionate change of quantity demanded of commodity 'X' to a given proportionate change in price of the related commodity 'Y'. we find that most of these goods are related. because both are demanded together. similar to the one we noted earlier. With the help of formula. the cross elasticity of demand will be infinity. In the context of the relationship between goods. the cross elasticity of demand will be zero. Demand Analysis 117 . QX1 is the original demand for X. the quantity demanded of x will decrease because the consumers will now substitute Y for X since Y has become cheaper than before. If the relationship between X and Y is that of complementary. If X and Y are perfect substitute for each other. the quantity demanded of X will increase because the consumers will substitute X for Y. If. two goods are not substitutes at all. ball-point pens and refills are complementary goods. A rise in the price of Y will mean not only a decrease in the quantity demanded of Y but also a decrease in the quantity demanded of X because both are demanded together.

It is zero when X and Y are not related to each other or do not possess any substitutability : they are independent of each other. In the third case. Solution : Ec = OX2 – OX1 OX2 + OX1 220 – 200 –––––––– 220 + 200 220 – 200 –––––––– 220 + 200 : PY2 – PY1 PY2 + PY1 12 – 10 –––––––– 12 + 10 12 +10 –––––––– 12 – 10 22 ––– 2 = : = X 20 Solution : Ec =–––––––– 420 ∴ Ec = 11 21 X The cross elasticity of demand is positive and X and Y are substitutes. It is negative when X and Y are complimentary goods. the entrepreneur can judge the effect of his pricing policy on the quantities demanded of the products of others and vise versa on the basis of the cross elasticity of demand. In that case. a rise in the price of Y (price of X remaining constant) will cause an increase in the quantity demanded of X. substitutability among several commodities. 118 Managerial Economics . the sale of a firm’s product commodity X rises to 220 kg. in practice. Perfect complementarity is equally rare. from 200 kg. The cross elasticity is positive when X and Y are good substitutes (and almost infinity when X and Y are almost substitutes). Find out the cross elasticity and state the relationship between commodities X and Y. Example : Because the price of Y increases from Rs. In practice.12 per kg.10 to Rs. In the second case. broadly speaking. they will not be two different commodities at all.e. infinite cross elasticity of demand cannot be found.Commodities X and Y will be the perfect substitutes only when they are totally identical. 12.. a rise or fall in the price of Y (price of X remaining unchanged) does not affect the quantity demanded of X at all. But. USES OF CROSS ELASTICITY OF DEMAND : Perfect substitutes are seldom found in practice. there is complimentarity or competition i. In the first case. zero or negative. Therefore. a rise in the price of Y (the price of X remaining unchanged) will cause a decrease in the quantity demanded of X. Under such circumstances. per week. the cross elasticity of demand can thus be positive.

with the help of the available resources. They can base their forecasts on the judgment or foresight of their experienced staff. Predictions of future demand for a firm's product or products are called demand forecasts. A budget includes the cost and expected revenues.13. As individual may forecast his job prospects. (3) Stabilization of Employment and Production Demand for a product changes according to seasons or business cycles or tastes etc. Every business unit has to prepare a budget. the supply. These objectives can be fulfilled with the help of accurate demand forecasts. However. however. When a firm is small in size it may not need or afford an organized forecasting system. a consumer may forecast an increase in his income and therefore purchases. Forecasts are made either through experience or through statistical methods. as a firm increases in size and produces a number of products and uses modern techniques of production. Demand Forecasting is the method of predicting the future demand of a firm's product. demand forecasts may be based on judgment of the experienced staff of a business concern or on scientific analysis (with the help of statistics). (B) Necessity of Forecasting Demand As mentioned above. it can be possible to produce according Demand Analysis 119 . DEMAND FORECASTING : (A) Meaning and Importance A forecast is a guess or anticipation or a prediction about any event which is likely to happen in the future. it becomes necessary for the firm to forecast the demand for its various products. (2) Preparation of a Budget Scientific forecasts are useful to the entrepreneur to take business decision. Forecasts are necessary for : (1) Fulfillment of objective of the Plans Every business unit. Such forecasts are more accurate and thus help the firm to produce efficiently. similarly a firm may forecast the sales of its product. in a more scientific manner. Expected revenues can be estimated only on the basis of demand forecasts. industry or the government starts with certain pre-decided objectives.. Forecasts have become a part of business management of most of the firms. it is possible to estimate the demand for a firm's product. cannot be changed suddenly if however.

Budgeting policies and Warehouse and Inventory Control. (5) Other Uses Demand forecasts are also useful to a firm. sociological the expected demand. Demand forecasts become useful in such cases. a) Short-period These forecasts are for a period of one year and are based on the judgment of experienced staff of the firm. Long period forecasts are important to decide about whether a new factory is to be established. Thus. (C) Factors Influencing Demand Forecasts A number of factors affect the demand forecasts. 120 Managerial Economics . at a future date. (4) Expansion of firms When a firm has to decide whether it should expand or not and to what extent it should expand. or capital needs are to be raised. these factors outline the scope of demand forecasting. with the help of these forecasts. a new product can be introduced. it has to consider the expected demand for its product. have to be considered for forecasting the demand over a very long period. price policy. the political situation in the country. the changes in the international trade. credit policy and marketing and distribution of the firm's product. Each of these factors has to be studied together with the other factors while forecasting demand. changes in traditions. Short period forecasts are important for deciding the production policy. b) Long-period forecasts These are forecasts for a period of 5 to 10 years and are based on scientific analysis and statistical methods. Time-Period Forecasts can be for a short-period. c) Very-long period forecasts These are for a period of over 10 years. like age of marriage. 1. So also the employment policy can be decided in advance. long period or very long (secular) period. Secular factors like growth of population. 2) Level of Forecasts Forecasts can be made at the level of the firm or the industry or the nation. Within this short period the sales promotion policies of the firm or the tax-policies of the government do not change. This can avoid wastage of scarce resources of the firm. development of the economy. for long-term investment decision.

a) A firm A firm forecasts the sales of its products. 4) Established Products and New Products Established goods. the present demand. Product-specific demand forecasts give the forecasts of each of the products produced by the firm. the level of competition. Demand Analysis 121 . 3) General and Specific Forecasts Forecasts can be of a general type. the number of substitutes to the product. These are based on statistical data and market survey. It is derived from the demand for the product produced by the capital goods. are goods which are already established in the market. the markets are known. b) An Industry Forecasts at this level are prepared by the trade association. information about these products is not known. Specific demand forecasts give specific information. different methods are used for forecasting demand. specific demand forecasts give the forecasts each of the markets for the firm's he markets for the firm's product. Thus depending on whether the product is an established or new product. These are not very useful to a firm. spare parts) is a derived demand. giving a total picture of the demand for all the products of a firm or demand from all the markets of the firm's product. New products are those which are yet to be introduced in the market. This demand is highly fluctuating. 5) Product-Classification For the purpose of Demand Forecasting products can be classified as a) b) a) Capital Goods and Consumer goods Durable goods and Perishable goods The demand for capital goods (machinery. It bases its forecasts on the forecasts of the industries and the nation. c) The Nation These forecasts are national level forecasts and are based on indices such as national income and national expenditure. information about these goods is available. These forecasts are available to all the firms of the industry. Area.

Macro-level forecasts are used in national economic planning. An increase in income leads to an increase in the demand for consumer goods. Micro level forecasts are at the level of the firm or industry. the nature of competition. These forecasts make use of macro-level information. and these forecasts make use of information regarding the macro-variables. These are forecasts about general business conditions. Thus. 6) Other Factors The level of uncertainty. 122 Managerial Economics .e. on the market for the product and on the time-period. These factors depend on the type of product. We are concerned with these types of forecasts. macro or micro level. like government expenditure. (e. i. Weather forecasts are important for the firms producing raincoats. then the demand falls. mixers etc.The demand for consumer goods depends on the incomes of the consumers. demand forecasts and methods of forecasting demand will be different. D) Techniques or Methods of Forecasting Demand The methods of forecasting demand depend upon. because people will postpone their consumption of these goods (e. the aggregate demand etc. We shall first study the methods of forecasting the demand for established goods and then for new goods. Thus. washing machines. tastes and preferences and fashion have to be considered while forecasting demand for readymade garments.) b) The demand for durable goods can be postponed. savings. whether the product is an established good or a new good. refrigerators. Soaps etc. As mentioned above. rainy-shoes and umbrellas. Sugar. but a fall in the income does not immediately lead to a decrease in the demand for consumer goods.g. Thus if prices of these goods increase. and on the level of forecasts. the methods of forecasting demand for established goods and for new goods are different.g.) The demand for perishable goods like vegetables and fruits depends on the current incomes and current demand. Food grains. depending on the type of product. the elasticities of demand for the product are important factors which have to be considered while forecasting the demand for a product. the number of substitutes to a product.

finance managers come together and make use of this information to finalise the forecasts. directly or indirectly. then they are contacted through mail or now-a-days they can be contacted on 'internet' and the information regarding their expected expenditure is collected. 1) Opinion-Polling Method This method tries to collect information. sales manager. and forecasts are based on this information. Depending on how this information is collected. Limitations 1) 2) 3) Individual consumers are not sure of their purchase Plans It is difficult and costly to contact all the consumers Useful only in the short period 2) Collective Opinion method Large firms have an organised sales department. The salesmen have technical training about how to collect the information from the buyers. This method is also useful when the consumer is another firm. Demand Analysis 123 . 1) 2) Interview and Survey Approach (short period forecasts) Projection Approach (long period forecasts) (I) Interview and Survey Approach : (for short Period Forecasts) To anticipate the expected sales of a commodity. we have different sub-methods of this survey approach. Many times the production manager. it is necessary to collect the information regarding the expected expenditures of the consumers. The interview and survey approach.(a) Methods of Forecasting Demand for Established Goods Information about established goods is available and so forecasts can be based on this information. There are two basic methods of forecasting the demand for established goods. tries to collect this information. These forecasts are based on information which is more certain and thus forecasts based on this information may be more accurate. in different ways. If consumers cannot be contacted personally or directly. This is possible through the market research department of the firm or through the wholesalers and retailers. This method is useful when the product and consumers come into direct contact or when the number of consumers is small. from the prospective consumers.

A few consumers are contacted. the sample is not a random sample. accurate forecasts are made very often. The sample selected must be a random sample. and thus. Information is collected from the consumers in the sample and forecasts are based on this information.Limitations 1) 2) 3) This method based on value-judgement and has no scientific basis Useful only in the short period It is difficult and costly to contact all the consumers. so that when the results are generalized for the population. These forecasts are then generalized for the whole population. the forecasts will be more accurate. If however. This is possible through the advanced statistical methods. 124 Managerial Economics . Sometimes. may be less accurate. (3) Sample-Survey Method The total number of consumers for a firm's product is called the population. (5) Composite Management Opinion The opinions of the experienced persons with the firm are collected and a committee or the general manager of the firm analyses this information and forecasts the demand for the firms product. it is not possible to contact each and every consumer. Consumers do not co-operate by giving a correct idea of their expected purchases. the forecasts will have no scientific basis. c) (4) Panel of Experts Panel of experts consists of either persons from within the firm or from outside. This method is quick. the consumers themselves make unplanned purchases. but is not based on scientific analysis and thus may not give very accurate results. When the number of consumers is very large (size of population is large). These experts come together and forecast the demand for the firm's product. easy and saves time and cost. Limitations a) b) Information collected may not be accurate. forecasts are made on the basis of statistical information and with the use of scientific methods. this forms the sample. If forecasts are based on judgement of these experts.

Once a relationship is established. in our example). if we collect the past data about the sales and advertisement expenditure of a firm. with the help of Regression Techniques. the least square method or the maximum likelihood method (correlation). in our example) and some dependent variables (sales. the past data regarding the factors affecting demand can be collected. we get this functional relationship as a straight-line AA. This can be done with the help of statistical methods. it is possible to project this into the future. it is possible to express this in the form of a scatter diagram. as shown below : Y A Sales A O Advertisement Expenditure X Now. For example.e. it is possible to get the best fit. There are some independent variables (Advertisement expenditure. past data is collected. This is a scatter diagram. (1) (2) Correlation and Regression Analysis Time series Analysis In both these methods. In the above diagram. a trend is observed then a functional relationship (correlation) is established between the variables. a best possible functional relationship between the variables. 1) Correlation and Regression Analysis As mentioned above. The relationship (cause effect) between these variables is the correlation and the technique of establishing Demand Analysis 125 . This is done with the help of Regression. i. It is possible to express this on a graph. the past experience is projected into the future.(II) Projection Approach (for long period forecasts) In this method. like.

and in the same year the demand/sales of cassettes have increased. Number of students and the demand for text books. if we know the changes in Y (income) we can predict or project the changes in consumption. this might not happen. we have a specific functional relationship C = a + . Correlation does not necessarily mean that there is a cause effect relationship between the two variables Eg. may have a direct relationship. the incomes of consumers have increased. in a particular year. 126 Managerial Economics . It is based on the assumption that the relationship between the dependent and independent variables will continue to hold in the future. can we conclude that there is a direct (positive) correlation between income and demand for cassettes ? Even though it appears that there is a positive correlation between income and demand for compact disks. In simple correlation. it is just chance that in that year both income and demand for compact disks increased. Limitations a) Assumption made is that the correlation between the two variables will continue in future also. we can use this relationship to estimate the demand for the future. this relationship no longer holds good in future. For example Simple Correlation C = f(Y) where C is the consumption (Demand). but when the text-books change. we have a relationship between two variables and a relationship between more than two variables is multiple correlation.8y Then. If the past correlation is assumed to remain the same in the future. Time-series Analysis is similar to correlation analysis.this relationship is regression.g. Suppose. There is no cause-effect relationship and thus forecasts based on this relationship will not be correct. and thus forecast the demand for the product. from past-experience. E. and Y is the consumers income. b) 2) Time-Series Analysis Demand forecasts for a period of more than 2-3 years are based on Time-Series Analysis. suppose.

indirect methods of forecasting are used to estimate the demand for new products.) 3) Growth Pattern Method If there is some relationship between the new good and an already established good. 2) Substitution Method Some new goods are substitutes of already established goods. forecasting demand of such new goods becomes difficult. However.V. Limitations a) b) The new products should have been evolved from existing product. Joel Dean suggests the following methods. we can study the growth pattern of all the toothpaste in the market. new goods are goods which are new to the market. Limitations a) b) This method is very time-consuming and has limited use.'s could be based on the assumption that. the existing firms react in different ways (changes in price.. not available. T. 1) Evolutionary Method Some new goods evolve from already established goods. thus the information about black and white T.Vs are substitutes of already established Colour & Black & White T. and make use of this information to forecast the demand for the new toothpaste. it has been evolved from black and white T.V.C. The information regarding these new goods is therefore. It ignores the problem of how the new product differs from the established product. Thus. When a new substitute is added to the market. the demand for coloured T. The demand forecasts of such new goods can be based on the information about the already established goods from which it is evolved. Limitations (a) (b) Some new products have many uses and each use has a different substitutability.'s can be used to estimate the demand for coloured T.V. Demand Analysis 127 . firms producing these goods find it necessary to estimate the future demand for their product.V. It is possible to estimate the demand for the new good by studying how the established good has grown.'s. Since most new goods are substitutes of already established goods.D. advertisement etc.(b) METHODS OF DEMAND FORCASTING NEW PRODUCTS As mentioned above. New L. this method has wide-uses.Vs. Thus. Thus. This is useful for the forecasts of the new goods at a later stage of growth.

4) Opinion-Polling Method The expected consumers/buyers are directly contacted and their opinion about the new product is gathered. therefore. 128 Managerial Economics . Useful only in the short period 5) Sample-Survey Method The new product is first introduced in some sample-markets and the results seen in the sample market are generalised for the total market. 6) Indirect Opinion-Polling Method The opinions of the consumers are indirectly collected through dealers who are aware of the needs of the consumers. If the number of expected consumers is very large. Limitations a) b) c) Individual consumers are not sure of their purchase plans It is difficult and costly to contact all the consumers. A new drug. should be a correct representation of the toal. and forecasts may not be accurate. This is very useful method and is used by many firms to estimate the demand for their new product. has no scientific basis. The following are the criteria which need to be considered before forecasting the demand for a product. C) Criteria for a Good Demand Forecast A forecast is said to be good when the expected demand is close to the actual demand. is to be introduced in the market. so that the forecasts are good. Limitations a) b) The sample chosen. A firm has to choose the best method of forecasting. the firm concerned will contact the doctors and gather their opinion about the drug. then a sample is selected and the results obtained from the sample are generalised for the population. Limitations a) b) Based on value judgement. for example. before it is introduced in the market. Limited scope. However. Tastes and preferences differ from market to market. the success of this method depends on the judgement of these dealers.

the forecasts must be available to the firms on time. accuracy of forecasts will mean a lot of money. While incurring costs on forecasting. marketed or consumed etc. the forecasts should take into account all the possible factors affecting the forecasts. INTRODUCTION TO INDEX NUMBERS : 1) MEANING OF INDEX NUMBERS Index number is defined by the classical economist Edgeworth as : "a number by its variations to indicate the increase or decrease of a magnitude not susceptible to accurate measurements. Economy : Economy or the cost-factor is very important in demand forecasting. a firm should weigh the costs and benefits. They should be understood by the executives who are going to make use of it. Plausibility : Forecasts should be plausible. Firms prefer simple and easy method for forecasting the demand for their product. The two 'different situations' may refer to two different periods or two different places. in such cases. Flexibility : Forecasts should be adjustable. but will not make much difference to the return. Also. because good forecasts require both time and money. The group of variables may be phenomena like the price of commodities. But because they are very complex. they should be durable. so that the firms can make the necessary arrangements to produce and supply their product in the markets. An index number compares one group of related variables with another Demand Analysis 129 . b) c) d) e) f) g) 14.a) Accuracy : Forecasts must be as close to reality as possible. Durability : Forecasts require a lot of time and money. If however. these methods are not acceptable by most firms. thus they should be such that they can be used for a long period. Acceptability : Advanced statisical techniques are available to the firms for forecasting demand. If accurate forecasts are going to give very high returns. There is no point in spending so much money and time if the forecasts do not give a real picture of the market demand. then it is worth spending more money on forecasting demand. Availability : Sufficient and upto-date data must be available for the forecast to be good. the quantity of goods produced. the index number is a statistical device for measuring differences in the magnitude of a group of related variables over two different situations. The relationship between the variables should be stable. a slight degree of inaccuracy would not matter and it will save money at the same time." In fact. for the forecasts to be durable. Business means a lot of uncertainty and to accommodate this uncertainty.

the level of production in different years and so on. wages. exports. index numbers are always expressed in the form of percentages. and it measures the price changes of all such commodities collectively. Allen states. Thus. they are relatively measured in terms of percentage by the technique of index numbers. Price Indices A price index number is a sort of average of the individual price relative to a set of commodities. They are indispensable to economists. production. imports and cost of living etc. commodity prices. businessmen. compared with the base year index which is always assumed to be 100. Index numbers are described as "economic barometers". in a relative sense. Index numbers measure changes in accordance with a reference base or comparison base expressed as 100. price indices measure and permit compariason of the prices of certain goods. price indices may further be classified as : (1) (2) Wholesale price index numbers. shipping freights. It is interesting to note that such indices published in India are known as Economic Advisers Index Numbers of Wholesale Prices. Therefore. economists and social workers to measure changes in prices. Thus. index numbers are applied to the measurement of the general movement of prices. As R. wages. Price indices may either be of : (1) Wholesale prices or (2) retail prices. consumption. 2) CLASSIFICATION OF INDEX NUMBERS From the point of view of "what they measure". and a) b) Retail price index numbers Consumer price index numbers or cost of living index numbers Wholesale price index numbers measure the changes in the general price level of a country. sales. security prices. production. Thus. we may have index numbers comparing the prices of a specified group of commodities at different times or in different countries or localities. cost of living. index numbers may broadly be classified as : "Price Indices. policy-makers and statesmen alike. 1. 130 Managerial Economics . the range of index number is very great and they can indicate changes in variables such as wage rates. Since changes in such variates are not easily capable of direct quantitative measurement. employment etc. or between places. The comparison may be between periods of time. Thus. planners. index numbers are generally used by businessmen. Quantity indices and Special purpose indices. volume of output. it is a coefficient or relative measure of movement of a statistical variation from a standard giving a general trend.D. Thus. Because an index number is a measurement of relative and not absolute changes in the variable over a period. sales and profits.

which have bearing on various economic aspects. Thus. 2. Therefore. Government of India. commerce and industry. The middle-class cost of living index numbers. The working class cost of living index numbers are published by the Labour Bureau. and The working class cost of living index numbers However. Moreover the common man is "largely affected by the retail prices than the whole-sale price level in the country. agricultural production and so on and so forth. standard of living) of a class of people over a period of time. the first two are ad hoc enquiries and the data are compiled after making family budget enquiries. There are three prominent types of cost indices available in India.. these indices are popularly known as cost of living index numbers. treasury bills etc. The growth rate and the direction in which an economy is moving is shown by how much is being produced and whether the present production level has gone up or gone down as compared to the previous levels. Cost of living index numbers are of great practical use to trade. Production indices are highly useful as indicators of the level of output in the economy. Quantity Indices A quantity index number expresses the relative average of the volume of production in different sectors of an industry. There are indices of industrial production. Demand Analysis 131 . Ministry of Labour. and Labour Bureau Index Number of Retail Prices (Rural Cedntre) Consumer's price index numbers are the specialised forms of retail price indices in which only prices of those commodities are considered which enter into the consumption of different classes of people. In India such indices are available in the form of : (1) (2) (3) Index Number of Security Prices Labour Bureau Index Number of Retial Prices (Urban Centre). (1) (2) (3) Cost of living index numbers of the employees of the Central Government.e. bonds and government securities. Wage policies are laid down and wage disputes may be settled on the basis of these indices. stocks and shares. Consumers' price index numbers are compiled to measure the changes in the cost of maintaining a consumption pattern (i.Retail Price Index Numbers are compiled to measure the changes in retail prices of various commodities such as consumption goods. quantity index numbers measure and permit comparison of the volume of goods produced or distributed or consumed. The index of production is the leading type of quantity index number.

since most of the later problems will depend upon the purpose. 132 Managerial Economics .e. If so desired. assigning proper weights to different items. 4) PROBLEMS OF CONSTRUCTION OF INDEX NUMBERS The construction of an index number involves the consideration of the following major problems : (1) Purpose of Index Number It is absolutely necessary that the purpose of the index number should be clearly and unambiguously defined. etc. in statistical terms) are shown as a percentage variation from the base. to remove ambiguity or bias. Thus. The choice of commodities whose prices are to be taken into account' The collection of data. The index number for the base year prices is always denoted as 100. the construction of a price index number involves the following steps : a) b) c) d) e) The choice of the base year. For instance. i. Prices of the selected group of commodities for the given years that are to be compared are noted. there are import-export indices. A base year is selected and the price of a group of commodities in that year are noted.3. To study the various special kinds of problems such index numbers are compiled. price quotations. stock-exchange share price indices. Changes in the prices of the given years (current years. for the selected group of items in the base year and the current year. Special Purpose Indices A large variety of index numbers used for specific purposes may be included under this heading. 3) PRINCIPLES AND PRACTICAL STEPS INVOLVED IN THE CONSTRUCTION OF A PRICE INDEX NUMBER THE BASIC PRINCIPLES INVOLVED IN CONSTRUCTION OF A PRICE INDEX NUMBER ARE : 1) 2) 3) 4) 5) The object of the index number be determined. labourproductivity indices. and Averaging the data so as to express the prices of the given years as percentage of the prices of the base year.

against the base year's norm (100). it is important that one knows what one wants to measure and how to make use of the given measure. (3) SELECTION OF ITEMS Selection of items is another problem. the former is called current period and the latter base period. therefore. a base period at the peak of a boom or inflation makes the index numbers appear unusually low at most other periods. the indices related to such a base year present distorted figures and conclusions. a base at the trough of economic depression makes all the indices appear unusually high. habits and traditions of the people. Indeed. Once the purpose is clear. they should be cognizable. price level in the case of a price index number) for the current period. consumer's price index number. For instance.g. they should be such as are not likely to vary in quality over two different periods and places. The base year should be a normal economic year. The base period.. is the basis of comparison. famines etc. and 133 Demand Analysis .such as. Suppose the price levels of two time periods. the required representative items are to be selected according to the purpose and type of the index number. the economic and social important of the various items of consumption should also be considered. the scope will be determined on the basis of the object. Selection of the base year needs to be done with utmost care. war. it is also necessary to determine the scope of the index number . a) b) c) d) items should be representative of the tastes. There should not be any erratic forces in operation like political upheavals. It should neither be a year of economic crisis nor of unprecedented boom. etc. the rest of the procedure is easy to apprehend. Usually. One must be sure of which type of index number is to be computed . the regional coverage or the place. the relative changes for all the other years are compared. Out of unwieldy list of commodities. the quantity index number and then proceed accordingly. floods. the frequency of compilation.whether it is wholesale price index number. Similarly. Conversely. (2) SELECTION OF BASE PERIOD Base period is a point of reference for comparison to measure the relative changes in the level of a phenomenon (e. In selecting items the following points are to be considered.Before collecting data and making calculations. that of 1994 with that of 1990. If by change an abnormal or inappropriate base year is chosen.

However. Another problem associated with the price quotation is the frequency of price quotation. government agents etc. Rational or logical weighting means some criteria have to be fixed for assigning weights. it is impossible to give a comprehensive definition to the term "rational weights". (4) PRICE QUOTATIONS Collection of price quotations for the commodities selected is a somewhat more difficult problem. chambers of commerce. which he thinks fit or reasonable. The system of weighting may be either arbitrary or rational. a reasonable number of commodities should be selected. therefore. one quotation per week for each commodity is considered sufficient. how often the price quotations should be obtained. It is not possible. business firms. A selection of representative markets is to be made. The purpose of weighting is to make the index truly representative of the population it is to measure. on weekly or monthly basis. Select an agency which is most reliable. But if a monthly base is considered. 134 Managerial Economics . To check the accuracy of price quotations supplied by an agency. news correspondents. from shop to shop. (5) PROBLEM OF WEIGHTING The items included in the index numbers are not of equal importance.e) the items must be fairly large in number. because reliability greatly depends on the adequacy of the number. As a general working rule. In fact. viz. a more frequent quotation may be desirable. Arbitrary or chance weighting means that the statistician is free to assign weights to different items. So the different items included in the index number must be weighted according to their importance. For instance. The price of a commodity varies from market to market and even at one market. money and labour. a decision regarding rational weights depends on the purpose of the index number and the nature of the data related to it. obtain such quotations from more than one reporting agency. Weights which are perfectly rational for one investigation may be equally unsuitable for another. Usually. The right selection of items presents the real difficulties. There may be a number of such agencies. consistent with economy in time. trade associations. the Economic Advisers Index Number of Wholesale Prices in India is a weekly index number and is based on price quotations obtained every Friday. in the case of weekly index numbers. to obtain price quotations from all the markets where a commodity is bought and sold. simplicity and accuracy of measurement. That is.

a) An index number deals with averages . (9) DIFFICULTY IN USAGE An economic statistic an has to be very careful in using the index numbers for economic analysis. (a) (b) (c) (d) Many new commodities may come into existence and the old may disappear. (7) SELECTION OF FORMULA A large number of formulae has been devised for constructing index numbers. for computing weighted averages of price relatives. a comparison of either price level or quantity levels from two separate and distant points of time becomes difficult. fashion and other factors may change the consumption pattern of the people and indices compiled for a period of time may become incomparable. tastes. earning and spending of an average number of people. Thus. (8) THE PROBLEM OF DYNAMIC CHANGES In a dynamic economy. The quality and quantity of commodities may change from time to time. The device of a particular formula will depend upon the information available and the accuracy desired. it cannot deal with one individual's money and changes in its purchasing power since an individual may not be affected by a rise or fall in the price level to the extent indicated by the index number. e. over a period of time. education. due to changes in fashions. Income. the problem is to select an average which summarises the changes in the component items adequately. The following points must be borne in mind in this regard. For arithmetic mean is simple to calculate. Usually.g. more and more new goods appear in the market while old goods often disappear. Since it deals with averages. Therefore. the arithmetic mean is employed for constructing the index numbers. there is a continuous change in the nature of consumption and commodities which adds to the difficulties of comparison and the construction of index numbers over a period of time. the quality of a l09.the average tastes and habits. outlook of the people and technological advancement. They are simple aggregate indices. In the modern world. etc. weighted aggregate indices and Laspeyre's formula. Demand Analysis 135 . A new and more modern samples of comparable items have to be included. every decade or so. most index number series are to be revised periodically.model motor car is quite different from that of a 1990 model.(6) SELECTION OF AN AVERAGE Since an index number is a technique of averaging all the changes in a group of values over a period of time. Paasche's formula.

Moreover. Ilersic said that. the index number is seriously limited in its utility. Therefore. Index numbers do not provide a reliable basis for comparison of international prices. As items included in the index number of different countries differ in pattern and quality. and a rise in the price index may be due to an improvement in quality and not to a rise in prices but very often there is no information on this point. in comparing the purchasing power of money over time and space. There can be errors not only in the collection of data but also in the selection of the base. Any such error means inaccuracy in the construction of index numbers. thereby making comparison even more difficult." (3) Disregard qualitative change – The index numbers of prices or production may not take into account variations in quality. Naturally. If proper and adequate samples are not selected. selection of representative items and selection of appropriate weights.e. so that differences in changes in the value of money between two countries may be measured. the index number can simply be regarded as a mere approximation indicating the rising or falling trends. the cost of living index number of textile workers cannot be used to measure changes in the value of money of the middle-class group. due to the fact that one cannot conceive of absolute accuracy in their construction. A wholesale price index cannot be compared with a cost of living retail price index. Similarly. Thus. which may be significant. (2) Sample-based – An index number is generally based on samples.b) An index number constructed for one purpose may not be useful for another. the problem of computing an index number is the problem of describing a universe from the sample. comparison is not possible. 136 Managerial Economics . LIMITATIONS OF INDEX NUMBERS The following are the limitations of index numbers : (1) Approximation – They are only approximate indicators of the relative changes. As a result of all these difficulties. "the index numbers are often unrepresentative as they are usually based on imperfect data. In the face of these difficulties and inaccuracies in its construction. c) 6. The base years will also not be the same. a superior commodity will cost more at any given time than an inferior commodity. there are various methods of averaging the use of different types of averages by different countries in the computation of index numbers gives different results. i. then the computed indices may not be truly representative.

They are not intentionally comparable. Thus. the results may be misleading and inaccurate. (6) Limited Scope – An index number is useful for the purpose for which it is designed. Unless a proper method is used in a given situation.(4) Arbitrariness – Weights are assigned arbitrarily. Hence its use is limited to a particular phenomenon only. (5) Differences – An index number can be calculated in so many different ways and different methods give different answers. Demand Analysis 137 . indices constructed for one purpose should not be used for other purposes where they may not be fully appropriate and given erroneous conclusions.

(g) Techniques of demand forecasting for new products. (h) Expansion and Increase in demand (i) Exceptional demand curve (j) Cross elasticity of demand (k) Income elasticity of demand (l) Index Numbers. (a) Total outlay Method of measuring elasticity of demand (b) Demand Forecasting.Exercise : 1. (f) Increase and decrease in demand. What is demand in Economics ? Explain the determinants of market demand. 5. 3. 4. What is price elasticity of demand ? What are its types? Explain the methods of measurement of price elasticity of demand. (c) Determinants of demand (d) Criteria for good demand forecasting (e) Significance or Practical uses of price elasticity of demand. State and explain the law of demand. 2. 138 Managerial Economics . Write short notes on.

NOTES Demand Analysis 139 .

NOTES 140 Managerial Economics .

law of demand and elasticity of demand and demand forecasting. Incremental and Sunk Costs. Individual and Social Cost. Law of Variable proportion and Laws of Returns to Scale. The two aspects which are stressed under production function are : Production and Costs 141 . the flow of output increases form the given input.e. market demand curve. I. Law of Supply and Elasticity of Supply. Short Run Cost. 1. Short Run Cost Curves and their use on decision making. Economies Diseconomies of scale.n). With the technological advances.e. Fixed Cost and Variable Cost. The Traditional Concept of Equilibrium of a firm). Theory of production means nothing but study of production function. Avoidable and Unavoidable Costs.e. Thus the production function expresses the relationship between the quantity of output and the quantities of various inputs used for the production. Break Even Point (i. Cost Concepts Accounting (actual) Costs. Common and Traceable Costs. Now we will shift our attention to the study of supply side of the product pricing i. P3 ---. Explicit and Implicit Cost. Pb. PRODUCTION FUNCTION : Production function is the relation between Input and output. The production function is the name given to the relationship between the rates of input of productive services and the rate of output of a product. Historical (past) and Replacement (present) Costs. Economic Cost. Determinants of Cost. By production or the act of production involves "transformation of inputs into output". By output we mean supply of product which depends upon cost of production which again depends upon input price & relationship between input and output which is called production function.Chapter 5 PRODUCTION AND COSTS Preview Meaning of Production function. In our study of demand side the demand was expressed as Da = f (Pa. individual demand curve. "Theory of Production" and cost. Opportunity costs. INTRODUCTION Uptill now we have studied demand analysis i.

it is a phase of constant returns. K. The inputs or the factors of production can be classified into fixed and variable inputs. The practical observation of the production function indicates 2 normal relationships : 1) When the quantity of a variable input increases while other inputs remain fixed. plant & machinery. Input price depends upon demand for factors of production which ultimately depends upon marginal productivity of the factor. That means theory of production is related to factor prices such as wage. As output increases the fixed inputs used per unit of output declines. Laws of Return to Scale : Where quantities of all factors is varied Optimum combinations of inputs. It means. When input and output increase in the same proportion. The variable inputs are those inputs whose quantity changes along with a change in the output. aggregate wages. Managerial Economics 2) 142 . Macro aspect i. The demand for factors is derived from marginal productivity curve which is actually taken in economics as a part of theory of distribution. Production function can be algebraically expressed as : Q = f (N. In the short run a firm uses fixed inputs such as land. T) Where Q = Quantity of output N. T = quantities of factors (Inputs) f = unspecified form of functional relationship between 'N. T where through mathematical methods we can work out quantitative measure of this relationship. The fixed inputs are those which do not change in quantity irrespective of the level of output. The cost of production is also influenced by input prices. Input and output do not increase in the same proportion. the variable inputs are required more & more to increase production. It means.1) 2) Maximum quantity of output that can be produced from any chosen quantities of various inputs Minimum quantities of various input that are required to yield a given quantity of output The production function can be studied in three ways : 1) 2) 3) Law of Variable proportion : Where quantities of some factors is kept fixed but the other factors is varied. rate of interest which is a micro aspect. This is a phase of increasing returns to the variable input. building.e. L. K. K. L. share of profit in national income are related to production function. there is a direct relation between variable input and output. There may be a phase when output increases faster than increase in a particular variable input. L. the output also increases.

It can explain inter . It follows that the expansion of a firm requires more funds to employ more inputs. Therefore. if the firm wants to increase output in what proportion it should increase its various inputs can be judged from the observed behaviour of production function.2. The production function explains the degree of substitution and complementarity of different factors of production.making in practical business. This stage is called disguised unemployment which is supposedly present in the agricultural sector in countries like India. The theory of production function can also explain the possibility of disguised unemployment. Production function tells management the budget constraint for increase in output. As generally output cannot be increased without an increase in the input. When we excessively employ only one factor in the production of a certain commodity. It can explain why the reward to the factors and the rate of industrial growth are not same at all the places in all the countries. Such disguised unemployment indicates that it is possible to divert surplus labour to other sectors where their marginal product would be greater than zero. The use of better methods of production. reorganization of production activity and creating more incentives and motivation to produce more can help a firm to produce such upward shift. we can study the behaviour of production function under different conditions. As production function is an engineering concept. From this the firm can select its expansion path. it gives policy guidance to both management and government about the priority in the development process. A firm which wants to maximize the efficiency with given prices of inputs should try to find out the optimum proportion between fixed and variable input. The firm can judge how far it is worthwhile and profitable to increase output. Thus the concept of production function supplemented with other tools of economic analysis is relevant for rational decision . This can be discovered with the help of production function. Production and Costs 2) 3) 4) 5) 6) 143 .firm. we reach a stage when the marginal product of that factor becomes zero or negative. Because. PRACTICAL IMPORTANCE OF PRODUCTION FUNCTION : The concept of production function is practically significant and useful for the following reasons : 1) Production function gives us idea of the optimum level of the output and the optimum employment of the variable inputs. such upward shift in production function involves technological progress and indicates the possibility to generate surplus. inter regional or international differences in the productivity. The management should endeavour to produce an upward shift in production function which can definitely improve its financial performance under the given market conditions. It means.

P. Average Product : It is the total product that a firm produces in a given time period divided by the quantity of a variable factor that is used to produce it. the output also increases in the same proportion. M. "Marginal Product" and "Average Product" are related in a simple mathematical way which can be explained with the help of table given under the law of variable proportion. = –––––––––––––––––– ∆ Variable factor units 3. The returns to scale are constant. It means. A. According to Stigler. it is the relationship between "Input and output" and further this relationship can be studied with reference to two laws : A. Marginal Product : The change in total product caused as a result of one additional unit of variable factor employed in combination with fixed factors is called marginal product. ––––––––––––––––– Variable factor Units 2. 144 Managerial Economics . B. ∆ T. = T. 1. We have also said that in the simplest form. the production function is "the name given to relationship between rates of input of productive services to the rates of product output and it is economist’s summary of technological knowledge". P. Law of variable proportion Laws of returns to scale In case of former quantities of some factors are fixed while that of others are varied and in case of later all factors are variable.Linear Homogeneous Production Function This is a particular production function which assumes constant returns to scale. marginal product and average product is : All these measures " Total product". the change in scale of production does not have any effect on efficiency of the firm. Before discussing law of variable proportion let us consider the following definitions which will help in understanding the law. Alternative way of describing relationship between total product. It states that if all inputs are increased in the same proportion. Total Physical Product : Total quantity of output produced in physical units by a firm during a period of time. P. P.

beyond a certain point the resulting increments of product will decrease. This is the second time span in which business decisions are made. (G. The Law Of Diminishing Returns or The Law of Variable Proportion.making for a firm. Short Run : It is period of time during which at least one of the firms input can not be varied. the ratio of employment of the variable factor to that of the fixed factor goes on increasing as the quantity of the variable factor is increased. In other words. In other words steel plant has a commitment to its present plant for 4 years. These are the three time spans for decision . Statement of the Law : 1) As equal increments of one input are added. Except level of technology. i. But for steel making firm short run lasts for 4 years even as 4 years is the time it takes to change furnace and built separate plant. keeping the quantities of other factors fixed. This law examines the production function with one factor variable. (b) Long run and (c) Very long run.It is necessary to make clear distinction between (a) Short run. it refers to the input output relation when the output is increased by varying the quantity of one input. Long Run : It is the period of time long enough to make all the changes that a firm wants to make within limits of existing or present production function. At any given time a firm is less than perfectly flexible which means when firm enters in Industry. Stigler) 145 Production and Costs . everything else changes in the long run. Since under this law. Very Long Run : It is the period of time long enough that the whole new technology can be introduced and production function itself is changed. the marginal product will diminish". this is known as the law of variable proportions. The law of variable proportions is the new name for the famous "Law of Diminishing Returns" of classical economics. add more furnaces etc. building. 3.e. It is not possible to tell how long short run will last. Or The Laws of Returns : Introduction : Law of variable proportion occupies an important place in economic theory. For a small house painting firm it may be for 2 days because two days are enough to buy more equipment and hire more workers / painters. constant. we study the effects on output variations in factor proportions. the inputs of other productive services being held. the proportion between the variable factor and the fixed factor is altered.. When new technology is introduced and production function itself changes then it is a case of a very long run. it comes with certain size or capacity and commitment. keeping the quantity of the other factors constant. It has commitment to buy contain minimum material inputs or have leased land for some years or firm has some fixed obligations at any given time and therefore we say it is a less than perfectly flexible. When the quantity of one factor is varied.

This assumption may not always be true. we can alter the factor proportions and know its effects on output. cause output to increase. Homogeneous nature of units of variable factor is assumed. While discussing the Law of Returns money and monetary value of output is not at all taken into consideration.2) As the proportion of one factor in a combination of factors is increased. Only physical relationship between factor inputs and output of products is considered. 4) 5) 6) Explanation of the Law of Diminishing Returns (Variable proportion) with the help of a table : 146 Managerial Economics . It is only in this way that. (P. keeping the quantity of other factors fixed and further it states that the marginal product and average product will eventually decline. Benham) An increase in some inputs relative to other fixed inputs will. There must be some inputs whose quantity is kept fixed. in a given state of technology. The law does not apply to those cases where the factors must be used in fixed proportions to yield a product. after a point. (F. Samulson) 3) It is obvious form the above definitions of the Law of variable proportions (or the law of diminishing returns) that it refers to the behaviour of output as the quantity of one factor is increased. It there is improvement in technology. first the marginal and then the average product of that factor will diminish". A. but after a point the extra output resulting from the same additions of extra inputs will become less and less". Assumptions of the Law of Variable Proportion : The law of variable proportion (or diminishing returns) as stated above holds good under the following conditions : 1) 2) 3) The state of technology is assumed to be given and unchanged. It is assumed that units of variable factor are divisible in to smaller homogeneous units. then marginal and average product may rise instead of diminishing. The law is based upon the possibility of varying the proportions in which the various factors can be combined to produce a product.

3 13. P. remains constant when M. and A. 5 and 6 are employed we notice that in their case. The A.. when A.3 12. falls.5 14. P. P.5 10. 20. P. It will be noticed from the table that when 1 to 4 workers are employed. is zero. P. When workers 4. P. P. Also. But first to decline is the marginal product.07 Marginal Product (units) 5 10 15 20 20 20 15 10 5 4 3 0 -9 } } Increasing Returns Constant Returns } Diminishing Returns Negative Returns Average Marginal Relationship : Observations of the table : The above table shows that eventually the total product also starts declining. This is the phase when the 'Law of Constant Returns' is in operation. 147 Production and Costs . P.5 10 12.Fixed Factor (say land & Capital F F F F F F F F F F F F F Variable Factor (Labour units) 1 2 3 4 5 6 7 8 9 10 11 12 13 Total Product (units) 5 15 30 50 70 90 105 115 120 124 127 127 118 Average Product (units) 5 7. when A.0 15 15 14. 20. becomes negative when T. is 20. P. P. P. This is the phase of 'Increasing Returns'. is maximum M. M. P. is decreasing. the marginal product goes on increasing. are equal.4 11.5 9. is less than A. The relationship between them is as follows : 1) 2) 3) 4) 5) 6) 7) As long as average product is rising. equals A. M. Total product is maximum when M. marginal product would be larger than the average product. that M. P.

Curve Stage I Stage II Stage III S A. Thus. P. This is the phase of 'Diminishing Returns'.P. is increasing.P.P. P. = O.P. Diagrammatic illustration of the law of diminishing returns (variable proportion) Three stages of the Law of Variable Proportions or diminishing returns The following figure is a diagrammatic presentation of the Laws of Returns roughly representing the figures in the table given before. for sometime the Law of Increasing Returns.P. when M. Thus.) is in operation in the third phase. we observe that the 'Law of Diminishing Marginal Returns' (M. P.8) Form 7 to 11 workers. M. This phase may also be called the phase of 'Diminishing Marginal Returns'. Y H F T.P. 148 Managerial Economics . Curve M Units of Variable factor (labour) employed M. if one factor of production (Land or Capital) is held constant and other factor is varied. the Law of Returns states that. T. it is noticed that though T. the M. P... P. goes on decreasing. A. Curve X Three stages of the law of diminishing returns (variable proportions) point H is the maximum point of T. then the Law of Constant Returns and finally the Law of Diminishing Returns come into operation.

Let us consider the example through the table mentioned in the three stages of law of variable proportion. P. P. M.It will be observed from the figure that the T. P. increases at an increasing rate. P. M. P. of the variable factor in negative and the M. curve starts declining earlier than the A. P. which means that M. of the variable factor is negative during this stage. A. P. P. P. P. is highest as shown by point H).P. P. P. curve goes below the X axis. P. curves also rise and then decline. continues to increase at a diminishing rate until it reaches its maximum point H where the second stage ends. Corresponding vertically to this point of inflexion. P. increases at a diminishing rate i. rises. Stage II : Diminishing Returns In stage II.e. Explanation of the Various Stages 1) Increasing returns : In the beginning. P. The point F where the total product stops at an increasing rate and starts increasing at a diminishing rate is called the 'point of inflexion'. Stage II is important because the firm will seek to produce in its range. P. in this stage increases but in a later part it starts declining but remains greater than the A. is maximum. machinery (capital) Production and Costs 149 . M. the T.e. P. This stage is known as the 'stage of diminishing returns' as both the A. to a point increases at an increasing rate. continues to rise. after which it slopes downwards. continuously fall during this stage. P. P. From the point F onwards during the Stage 1. since the M. the quantity of fixed factor is abundant relative to the quantity of the variable factor. and A. P. P. Stage III : Negative Returns In stage III T. which are explained below : Stage I : Increasing Returns In this stage T.e. P. declines and therefore T. P. This stage is called the stage of negative returns. i. the T. of the variable factor increases throughout this stage. T. up to the point F. P. Through out the three stages fixed variable i. so that the A. curve. curve goes on rising but its slope is declining which means that from point F onwards the T. and M. In this stage both the M. P. It should be noted that the M. The behaviour of the output when the varying quantity of one factor is combined with a fixed quantity of other can be divided into three distinct stages. and M. slope of the total product curve T. The stage I ends where the AP curve reaches its highest point S. P. curve goes on increasing to a point and after that it starts declining. As a result M. As more and more units of variable factors are added to constant quantity of fixed factor then fixed factor gets more intensively & effectively utilized and production increases at a rapid rate. In the figure from the origin to the point F. curve slopes downwards. P. Stage 1 is known as the stage of 'increasing returns' because A. of the variable factor is zero (when T.e. is increasing i. falls but it is positive.

In such a situation. The large number of variable factors impairs the efficiency of the fixed factor. 3) Negative returns : In this stage. In our example this is set in by hiring 13th worker. 150 Managerial Economics . the factors of production are imperfect substitutes for on another.e. The total product reaches 50 units per day when the 4th worker contributes to the production. Total product increases but gain form 7th worker is not as great as gain from 6th worker. Fuller utilization of capital is possible due to the addition of a variable factor. why fixed factor be not taken in accordance to the availability of variable factor. When the fourth worker joins it is possible to use the full potential of the capital.e.e. Corresponding vertically is the point H which is the highest point of the TP curve. they are indivisible. 2) Diminishing returns : The peculiar feature of this stage is that the marginal product falls through out the stage and finally touches to zero. In the table given on page 147. substitution is not possible and diminishing returns occur. This law does not apply to all conditions in agriculture. Explanation to this can be given as once the point is reached at which variable factor is sufficient to ensure full utillisation of fixed factor. Limitation of the Law of Diminishing Returns : There are a number of exceptions to this law. of workers increase as a firm expands its production. Fixed factor is scarce and variable factor then fixed factor would not have remained scarce. then further increase in variable factor will cause MP as well as AP to fall because fixed factor has now become inadequate (as against it was abundant earlier) relative to the quantity of variable factors. The paucity of fixed could have been made up by such perfect substitutes. the third stage is set in by hiring 7th worker who adds only 15 units per day as compared to 20 units per day added by the 6th worker. Moreover increasing returns can also be attributed to the principle of division of labour of specialization of work. A worker contributes 5 units per day to the firms output. Joan Robinson. The total product falls from 127 units to 118 units. In stage two fixed factor is scarce as compared to variable factor. According to Mrs. The answer is that fixed factors are fixed i. a famous economist. One worker cannot take full advantage of the capabilities of capital. The number of machinery cannot be changed in the short run. If one of the variable factor added to the fixed factor were perfect substitute deficiency of fixed could have been made up but elasticity of substitute between factors is not infinite.remains constant. a reduction in the units of the variable factor will increase the total output. The excessive variable factor as compared to less fixed factor results in a fall of total output. Here stage II ends. negative because total product starts falling. The question may arise that if fixed factor is abundant as compared to variable factor. the stage of diminishing returns occur. marginal product falls below 'X' axis i. The variable factor i. no.

the marginal product will increase for a time. better quality seeds. Production and Costs 151 . That is.e. Scientific rotation of crops. Application of the Law of Diminishing Returns : The law of diminishing returns applies to agriculture. the law has universal application and operates in all fields of productive activity where one or more fixed factors are combined with one or more variable factors. however are the changes which take place in agriculture. P. the marginal product will initially increase but will ultimately diminish. because land if fixed. However. An increase in the scale means that all inputs or factors are increased in the same proportion. (ii) New Soil : When new land (soil) is brought under cultivation. increased used of capital. fertilizers. P. this law assumes no change in the technique of production. we shall now study the behaviour of output in response to changes in scale..P. In other words. modern implements. will give more than proportionate return. will in fact increase. therefore. From society's point of view as Recardo assumed and other factors are variable. Labour) Now. we have seen the behaviour of output by keeping the quantity of one or some factors fixed and changing the quantity of other (e. Thus. M. The early stage is an exception to the law of variable proportion. and A. The study of changes in output as a result of changes in the scale forms the subject matter of "returns to scale".) when factor proportions are changed. are an exception to the law.g. the law also operates in industries like mining. New methods of cultivation. 4. but later the marginal return will decrease.(i) New methods of cultivation : As mentioned earlier. fisheries and also in building industries. better irrigation facilities. (iii) Insufficient Capital : If capital is not sufficient. we will undertake the study of changes in output when all factors of production or inputs are increased together. Increase in the scale thus occurs when all factors or inputs are increased keeping factor proportions unchanged. if an industrial enterprise capital is kept fixed and other factors are increased. thus the law of diminishing returns does not operate in the beginning. variable proportion) we have studied the behaviour of output (T. The marginal product under these conditions. Thus. Returns to Scale or Laws of Returns to Scale : Under the law of diminishing returns (i.

Kaldor and Lerner. returns to scale are said to be increasing.The Laws of Returns to Scale : Y Marginal Product Constant Returns To Scale Sc ale ing as cre De Re tu rn s To ns tur Re Inc re as ing To ale Sc X O Scale or Proportion 1) Law of Increasing Returns to Scale : Meaning : If the increase in all factors leads to more than proportionate increase in output. 2) Law of Constant Returns to Scale : Meaning : If we increase all factors of production (i. and output increases by 40% then the increasing returns to scale will be prevailing. This is because of greater specialization of labour and machinery. returns to scale are decreasing.e. if all factors are doubled. then eventually diminishing returns to scale will occur. if doubling or trebling of all factors causes a doubling or trebling of output. Thus. Diminishing returns to 152 Managerial Economics . scale) in a given proportion and the output increases in the same proportion. then the returns to scale are increasing. 3) Law of Diminishing or Decreasing Returns to Scale : Meaning : If the increase in all factors leads to a less than proportionate increase in output. If for instance. returns to scale are said to be constant. if the diameter of a pipe is doubled. Mrs. This phenomenon according to Prof. These factors are available in large and lumpy units and can therefore be used with utmost efficiency at only larger output. Another reason for increasing returns is because of the indivisibility of some factors. and output increases by more than double. returns to scale are constant. the flow of water through it is more than doubled. production function of the first degree'. In mathematics. This reason is given by Prof. all inputs are increased by 25%. Joan Robinson. Baumol also occurs because of dimensional relations. When a firm goes on expanding all its inputs. the case of constant returns to scale is called ' linear and homogeneous production function' or 'homogeneous. Thus. For example.

These economies are classified as internal and external economies. a number of economies of scale accrue to the firm. Its products are constantly in demand. In the initial stages small . decides to produce on a small scale till it gets a 'real feel of the market'. Naturally. When the firm has expanded to a too gigantic size. means that the firm starts suffering from the diseconomies of scale. Meanwhile. It is worthwhile to explain the economies at length : Internal economies are those advantages of large . As a result. construct factory building. This in other words. therefore. coordination and control. All these expenses are debited to the profit and loss account for the first operating year. They are broadly classified under the following heads: Production and Costs 153 . Till this adjustment is made. the firm has to spend on preliminary expenses. lead to a high average cost and losses. therefore. it is difficult to manage it with the same efficiency as previous. a) Diseconomies of Small .scale production may. production is on a small scale because the product is not yet known in the market. The workers appointed in the factory take some time to adjust themselves to the techniques of production. the average cost of production is high. there is lot of wastage of raw materials and power. Every new firm.scale production which accrue to a firm on account of its superior techniques and management.scale production with reference to the Laws of Returns. If the total expenditure incurred during the first year is taken into account. the firm is fairly established in the market. (b) (c) b) Economies of Scale: But with the passage of time. install machinery and provide other infrastructural facilities. however. In the initial stages.Scale Production: Any firm which is newly established operates on a small scale in the initial stages. The workers also acquire proficiency in producing high quality goods. Ultimately. A lot of time is wasted in erecting the factory.scale eventually occur because of increasing difficulties of management. Production on a small scale is. the firm decides to increase the scale of production. The firm is not sure whether the entire production would be sold. (a) A new firm is required to acquire land. the average cost of production works out to be very high in the initial stages. found to be disadvantageous on the following grounds. ECONOMIES AND DISECONOMIES OF SCALE : Introduction : An attempt is made in this sub -unit to outline the economies of large . 5.

On account of new machines. marketing and finance. therefore. (d) Financial Economies : A firm which is producing on a large scale can avail the benefits of cheaper finance. banking. (e) Risk and Uncertainty : A firm which produces on a large scale can earn large profits. It is also possible in a big firm to avail the benefits of specialization and division of labour. A big firm enjoys high reputation and its products are in constant demand in the market. It can build up huge reserves out of undistributed profits. If in a particular region. many such firms are concentrated they may promote some common activities. easily and on much favourable terms.rating can raise new capital quickly. in such a region facilities of etc. On the other hand. big. For example. These firms may manufacture spare parts on a large . c) External Economies : The above advantages of large . post .(a) Technical Economies : A firm that produces goods on a large scale can install improved and up . Bulk buying enables a firm to procure the materials at a lower cost. production. may be developed and all the firms can take the benefits of these services.scale is required to buy raw materials on a large scale. (c) Managerial Economies : A firm producing on a large scale can afford to hire the services of expects in various fields such as purchases. These experts utilize their knowledge and experience towards maximization of machinery. A big firm can negotiate with transport operators and can secure concessional freight rates for transportation of raw materials and finished products. A firm which has acquired reputation and a high credit . therefore. These activities may bring several benefits for all the firms. a firm is able to effect a substantial reduction in the cost of production. Capacity of such a firm to sustain losses is.scale production may accrue to an individual firm because they arise out of the superior technique and management of the firm. a smaller firm with slender reserves cannot withstand the losses incurred in the business. in an industry. The big firms can buy the spare 154 Managerial Economics . A firm making purchases on a large scale acquires a strong bargaining power in the market. Quality of goods produced by such a firm is. a number of new firms dealing in ancillary products are developed in this region. superior. What is more important is that. (b) Commercial Economies : A firm that produces on a large . It can secure favorable credit terms from the suppliers.

various firms concentrated in a particular region can start a Research Institute. In course of a firm's expansion.scale production may cause overproduction and this may result in losses. Internal and External Diseconomies : As a firm expands beyond a certain limit. Let us note these disadvantages of large . The top executive may find it impossible to look into even the broad functioning of various departments. All such economies are called external economies. urge. efficiency. The internal diseconomies of large . (iii) No direct contact with customers is possible. Similarly. A large establishment with thousands of employees makes work impersonal and the relations between the employers and employees becomes formal. This fact causes strains on industrial relations. a stage may be reached when the firm becomes too large to manage. It may face several problems just because its size has become very large.scale production.scale production can be summarized thus : (i) (ii) Management and supervision becomes difficult and waste of time and material results. Co-ordination of various activities becomes impossible. Large firms cannot easily adapt to ups and downs in business. The benefits of this research can be passed on to all the firms.scale production may involve imports of raw materials and exports of products. It would. it becomes unmanageable and unwieldy. With increase in the number of salaried administrative. This may result in cut-throat competition.Scale Production : Large . strikes. the cost would be higher. Production and Costs 155 .parts at a lower cost. For want of a personal touch. managerial and sales staff. (vii) Large . Because these salaried employees have to stake in the company. lockouts and such other eventualities causing stoppage of work or obstructions to work increase. quarrels. be profitable for big firms if they buy the parts from small firms. (iv) (v) (vi) Large . personal touch with dealers and customers is lost. This may disturb the healthy atmosphere and may cause indiscipline. tastes of consumers are ignored. integrity and inventiveness disappear and their place is taken by disinterestedness. therefore. Products are standardized and no specialized services to consumers are possible. punctuality. If the big firms produce the spare parts themselves. Large producers have to fight for capturing and maintaining markets. and rivalries. A very large number of workers may cause factions and groupism amongst them. Delegation of responsibilities and decentralization of very large number of work can not be stretched too far. routine dealings and work to rule. So. d) Diseconomies of Large .scale production may encounter certain diseconomies and disadvantages.

Moreover." Hence. A seller's willingness to supply a commodity. The ability of a seller to supply a commodity. the minimum or cost price the seller must get and the prevailing market price or the price 156 Managerial Economics . Similarly. another determining factor is the will of the seller. supply is what the seller is able and willing to offer for sale. For instance. depend on the difference between the reservation price.rates increase. strain on civic amenities like drinking water. Overcrowding of cities. Expansion of industry and overcrowding of industrial units in a locality also causes diseconomies which can be called external diseconomies. however. The competition among firms to secure raw materials and other resources for itself causes their prices to rise. distribution channels and so on. Thus. and problems of housing. with increase in demand for resources.(viii) There are additional elements of risk due to possibilities of war. They affect efficiency of labour. medical care and law and order are some of the consequences. It is always referred to in relation to price and time. the above statement becomes meaningful if it is said "at the price of Rs. raw materials. however." Here. Thus. Similar external diseconomies flow from concentration of industries in certain localities. a dairy .20. 6. but productivity per worker goes down.'s daily supply of milk is 500 liters. timely deliveries of finished products and an overall strain on the whole industrial system. Secondly. sanitation etc. public health. One must say. traffic congestion. Supply is a relative term. additional resources which become available are naturally of a lower quality compared to those already employed. supply during a given period of time means the quantities of goods which are offered for sale at particular prices. changed international relations and so on. a statement such as : "the supply of milk is 500 liters" is meaningless in economic analysis. stocks is the determinate of supply. a firm has to appoint whosever are available rather than who are suited for the work. The same applies to machinery spare parts. "the supply at such and such a price and during a specific period. not only wage . the best workers are selected first and as more and more workers are required. depends on the stock available with him. per liter. both price and time are referred to with the quantity of milk supplied. availability of quick transport. education. pollution of air and water. the supply of a commodity may be defined as the amount of the commodity which the sellers (or producers) are able and willing to offer for sale at a particular price. during a certain period of time. a) SUPPLY ANALYSIS : Meaning of Supply : In economics. For example. A statement of supply without reference to price and time conveys no economic sense.

The change in the supply may be in the form of the increase or decrease in supply. More commodity is supplied at a higher price and less commodity is supplied at a lower price. The important determinants of supply are : 1) Price : Price is the single largest factor influencing the supply of a commodity. he will withhold his stock at present and so there will be less supply now. supply always means supply at a given price. The changes in these factors lead to changes in the supply of the commodity. such as agricultural products.which is offered by the buyer for that commodity. the higher the price. If the ruling market price is greater than the seller's reservation price. Even expectations about the future price affect the supply. In short. Under such circumstances the supply of the commodity which these factors help to produce may tend to increase and vice versa. the seller refuses to sell. even at the rising prices. If a dealer expects the price to rise in the future. A change in these natural conditions will cause a change in the supply. They are known as the determinants of supply. fiscal policy. etc. their supply decreases during the drought conditions. so the supply of the agricultural products will increase. influencing the supply.. more investment is encouraged due to better returns. Factor Prices and their Availability : When the factors of production are easily available at low prices. he (the seller) is willing to sell more. On the other hand. At different prices. Normally. Government's Policy : The government's economic policies like industrial policy. the quantity supplied cannot be increased. Natural Conditions : The supply of some commodities. the greater the supply and vice versa. as goods cannot be brought in time to the market. The change in the quantity supplied in response to the change in price is known as the variation in supply. So. influence the supply. There are several factors other than the price. a good monsoon will produce a good harvest. For instance. depends on the natural environment or climatic conditions like rainfall. State of Technology : The improvement in the technique of production leads to increased productivity and results in an increase in the supply of manufactured goods. If the industrial licensing policy of the government is liberal. etc. These other factors are given below. But at a price below the reservation price. more firms are encouraged to enter into registrations and 157 2) 3) 4) 5) 6) Production and Costs . temperature. Transport Conditions : The difficulties in transport may cause a temporary decrease in the supply. the supply may be different. b) Determinants of Supply : There are a number of factors influencing the supply of a commodity.

10 12 14 16 Quantity Supplied (in '000 per week) 10 13 20 25 158 Managerial Economics . Explanation of the Law . its supply will tend to decrease. THE LAW OF SUPPLY : The law of supply reflects the general tendency of the sellers in offering their stock of a commodity for sale in relation to the varying prices. a fall in the cost of production tends to increase the supply.high custom duties may decrease the supply of the imported goods but it would encourage the domestic industrial activity. suggests that the supply varies directly with the change in price. a larger amount is supplied at a higher price than at a lower price in the market. So. 7) Cost of Production : If there is a rise in the cost of production of a commodity. thus. the farmers may grow more of wheat and less of rice. An increase in tax such as excise duties will reduce the supply while granting of subsidy will increase the supply. The law can be explained and illustrated with the help of a supply schedule as well as a supply curve. based on imaginary data. Statement of the Law : The law of supply may be stated as follows : Other things remaining unchanged. the price of jaggery (gur) will also tend to rise. So the supply of rice will decrease. Prices of other Products : The prices of substitutes or related products also influence the supply of a commodity. the supply curve tends to shift leftward. if the prices of fountain pens rise. as follows : Price of Ballpen (per unit) Rs. the prices of ink will also tend to rise. It has been observed that usually sellers are willing to supply more with a rise in prices. with the rise in the cost of production. So. The law. so that the supply of domestic products may increase. the supply of a commodity expands with a rise in its price and contracts with a fall in its price. 8) 7. It describes seller's supply behaviour under given conditions. Conversely. If the price of wheat rises. If the price of sugar rises. Again.

are also unchanged. interest. It implies that the factor prices. such as wages. the sellers will not find it worthwhile to produce more and supply more. the seller would supply more even at falling prices. the law of supply is valid only if the cost of production remains constant.. the level of supply will change. Assumptions Underlying the Law of Supply : The law of supply is conditional. if the cost of production is reduced. the upward sloping curve also depicts a direct relation between price and quantity supplied. since we have stated it under the assumption : "other things remaining unchanged". it is assumed that the scale of production is held constant. Fixed scale of production : During a given period of time. rent etc. No change in technique of production : The technique of production is assumed to be unchanged. From the supply schedule. With the improvements in technique. 2) 3) Production and Costs 159 . If the cost of production increases along with the rise in the price of product. but there is no change in the cost of production.Y Supply Curve Price Per Unit S 16 14 12 10 S O 5 10 15 20 25 X Quantity Supplied (Units) X axis = Units of Ball Pen Y axis = Price per Unit When the data of Table are plotted on a graph. a supply curve can be drawn as shown as shown in Figure. Therefore. it appears that the market supply tends to expand with the rise in price and vice versa. irrespective of the changes in the price of the product. Similarly. If there is a changing scale of production. This is essential for the cost to remain unchanged. It is based on the following ceterius paribus assumptions : 1) Cost of production is unchanged : It is assumed that the price of the product changes.

so that more would be supplied even at a lower price. however.4) Government policies are unchanged : Government policies like taxation policy. No speculation : The law also assumes that the sellers do not speculate about the future changes in the price of the product. producers might transfer their resources to the other product which is more profit . a few exceptions to this law. despite the rising prices. 5) 6) 7) Exceptions to the Law of Supply (Backward .yielding due to rising prices.. are assumed to be constant. a reduction in transport cost implies lowering of cost of production. Under this situation. The prices of other goods are held constant : The law assumes that there are no changes in the prices of other products. It may be observed. It is also known as an exceptional supply curve.sloping Supply Curve) : The law of supply states that supply. Supply of labour and savings are two such exceptions commonly pointed out by the economists. an increase in or totally fresh levy of excise duties would imply an increase in the cost or in case there is fixation of quotas for the raw materials or imported components of a product. they may not expand supply with the present price rise. that the supply tends to fall with a rise in prices at a point. If the price of some other product rises faster than that of the product in consideration. then such a situation will not permit the expansion of supply with a rise in prices. For instance. Otherwise. If. trade policy. tends to rise with a rise in price is a universal phenomenon. sellers expect prices to rise further in future. more of the product in consideration may not be supplied. in these cases. as such a thing happens only in some exceptional cases like labour supply or savings. etc. however. There are. This paradoxical situation of supply behaviour is represented by a backward sloping or regressive supply curve over a part of its length as shown in the following Figure. No change in transport costs : It is assumed that transport facilities and transport costs are unchanged. Y 200 S1 Wage Rate 180 160 150 M S O 50 55 60 65 X Leisure Quantity Supplied of Labour in hours Backward Sloping Supply Curve of Labour 160 Managerial Economics .

he works for 60 hours and gets Rs. and gets Rs.8. he will decrease his savings and investment when the rate of interest rises and increase his savings and investment when the rate of interest falls. 7. the amount on investment required to reach the same amount of interest yields is obviously less. the quantity supplied rises. If. the volume of investment required declines.hours the worker is willing to work at a given wage rate. 150 per hour. 11. a worker might work for a lesser number of hours than before.800.500. To illustrate the point.000. thus. For instance. 1. the movement from point a to b on the supply curve shows expansion and b to a shows contraction of supply. The change in the quantity in accordance with the price change is. the worker works for 50 hours per week and gets Rs. 200.700 and at Rs. at Rs. when it is Rs. it is called expansion of supply.In figure the curve SMS1 represents a backward . the quantity supplied declines. which is contrary to the usual law of supply. when the wage rate is Rs. 180. In this case. As exception to the law is also seen in the case of persons who want to have a fixed income from their investment.000 and at 20 per cent. Production and Costs 161 .100 per year require an investment of Rs. Here. with a rise in price. 8. a person wants to earn Rs. Thus.rate is regarded as the price of labour and the labour supply is determined in terms of labour . it is called contraction of supply. 160 per hour. 12.sloping supply curve for labour as a commodity. If with a fall in price. In figure. he works for 65 hours and gets Rs.500. as the rate of interest rises. he will require an investment of Rs. called either as "expansion" (or extension) or "contraction" of supply and refers to the same supply curve. As interest rates rises. he works for 60 hours per week. the wage . say. EXPANSION AND CONTRACTION IN SUPPLY : The law of supply refers to the change in supply due to a change in price. It is observed that as wages increase.

pests. If the cost of production increases because of higher wages to workers or higher price of raw materials. there will be a decrease in supply. 2) 162 Managerial Economics . In figure A. when the supply increases from OQ to OM. earthquakes. the supply changes with the change in the cost of production. B price. then it is called decrease in supply. Supply also Depends on Natural Factors : There might be a decrease in the supply due to floods. when at price OP. and can be shown on different supply curves. This can be shown by leftward shifts which need not be parallel. the supply becomes OK instead of OQ. in which case it is called increase in supply. Absence of the above calamities or an exceptionally good as well as a timely monsoon might increase supply. It cannot be shown on the initial supply curve. The important ones among them are : 1) Cost of Production : Given the price. There might be less supply forthcoming in the market without a change in price.9. Likewise. If the cost of production falls due to any of the above reasons. it means a decrease in supply. Later on. The Causes of Change in Supply : There are many causes which bring about a change (increase or decrease) in the conditions of supply. the supply will increase. A Fig. but the supply curve shifts to the right as S1S1 curve. etc. Sometimes. INCREASE AND DECREASE IN SUPPLY : These two terms are introduced to explain the change in supply without any change in price. at price OP. The change in supply due to causes or determinants other than price is called "decrease" or "increase" in supply. there might be more supply forthcoming in the market without a change in Y Y Price (Per Unit) Price (Per Unit) S S1 a P S S1 O Q M X b S2 S P S2 S O K Q X b a Quantity Supplied (Increase In Supply) Quantity Supplied (Decrease In Supply) Fig. at the same price. it is called increase in supply. the supply is QQ. in figure B. paucity of rainfall.

the supply is said to inelastic. An improvement in the technique of production might go a long way in increasing the supply. there is little change in quantity supplied. a) Elasticity of supply may be defined as the ratio of the percentage change or the proportionate change in quantity supplied to the percentage or proportionate change in price : Thus. introduction of highly sophisticated machines increases the supply of goods. sales. with a little change in price (rise or fall). ELASTICITY OF SUPPLY : Supply changes due to change in price. It may also be deliberately reduced by government policies. Business Combines : The producers also might reduce the supply by entering into an agreement among themselves through their business combines like trust. with a view to raising prices in the market. with a small fall in price. es = Percentage change in Quantity Supplied ------------------------------------------------------------------------------------Percentage change in price Elasticity of supply can also be measured alternatively as Net change in Quantity Supplied ---------------------------------------------------------------. 4) 5) 6) 10. with a considerable change in price. the supply is said to be elastic. there is a very small expansion of supply. the supply is said to be less elastic. when there is a big contraction of supply or with a small rise in price.3) Change in Technique of Production : This has an important influence on supply. when there is a big expansion of supply. there is a considerable change in quantity supplied (expansion or contraction) the supply is said to be elastic. More precisely. cartel or business syndicate. For instance. Development of Transport : Improvement in means of transport obviously increases the supply of goods as they facilitate the movement of goods from one place to another. Policy of Government also Influences Supply : Taxes on production. When. import duties and import restrictions may reduce supply. there is very little contraction of supply or with a big rise in price. with a big fall in price.÷ Original Quantity Supplied Net change in Price --------------------------------------------------Original Price es = Production and Costs 163 . The extent of change in supply in accordance with the change in price is called elasticity of supply. If. When.

6 1000 164 Managerial Economics . as a result of a change in the price of a commodity from Rs. For example. if. the total Quantity supplied of the commodity by the sellers is increased from 1. thus elasticity of supply formula can be stated as : ê QS êP es = -------------.200 units.x -------------êP QS QS = The Original Quantity Supplied êQ = Net change in Quantity Supplied P = The original Price êP = Net change in Price. 45 per unit.= 1.x 5 40 -------------. es = -------------. 40 to Rs. then the elasticity of supply may be calculated as under : 200 es = -------------.x ---------------QS êP = êQS P Therefore.÷ ---------------QS P êQS P -------------.000 units to 1.Representing it in symbols.

(es < 1). Different types of supply elasticity's have been illustrated in the following Figure. (Per Unit) (Per Unit) Elasticity of Supply . The (b) represents the supply curve of infinite elasticity. Similarly. represents a relatively inelastic supply. (Per Unit) (Per Unit) Elasticity of Supply .There are. Irrespective of the price. relatively inelastic or may have perfect elasticity or inelasticity. Production and Costs 165 . the producer would be supplying OQ quantity (es = 0).Usual Cases In the above figure in panel (a) the curve SS represents the supply curve of unit elasticity. (es > 1). (es = α). various degrees of elasticity of supply. It may be relatively elastic. in panel (b). the curve S1. Any variation in price will be accompanied by an equally proportionate variation in the amount supplied (es = 1). and S2 represents elastic supply.Extreme Cases The panel (a) of Figure represents the supply curve of zero elasticity. At OP price. thus. the producer would be supplying any amount of the commodity.

In panel (2) TB > OB. Price (Per Unit) F Price (Per Unit) F Measurement of Point Elasticity of Supply To find out the elasticity on the supply curve at point P as in the above Fig. es > 1 point P. es = ∆Q –––––– Q x P –––––– ∆P The coefficient of elasticity of supply(ies) may vary between zero to infinity. as es < 1 at point P. the elasticity of supply at point P is measured by the ratio of the distance along the tangent (drawn to the curve at the point) from the point P on the supply curve to the point where it intersects the horizontal axis and the distance along the tangent from the point P on the supply curve to the point where it intersects the vertical axis. and (2) the point method. draw a tangent TF to the supply curve SS at point P intersecting the horizontal axis at T. 166 Managerial Economics . therefore. therefore. The Point Method : On a given supply curve.b) Measurement of Elasticity of Supply : There are two methods of measuring elasticity of supply : (1) the ratio method. The elasticity of supply at point P is measured as : TB Es = –––––– OB In panel (1) TB < OB. Draw a perpendicular PB form point P and intersecting at point B on the horizontal axis..

shorter the time-span. because these natural factors are beyond the control of 3) 5) 6) Production and Costs 167 . etc. Rise in price of houses may bring only gradual response from the supply side of houses. Thus. etc. while gods produced on a large scale have a relatively elastic supply. considerably affect the elasticity of supply of agricultural goods. generally more responsive would be the supply side of the commodity to changes in price. old wines. it may take quite some time for their supply to expand in response to rise in their prices. telex etc. Thus. as it takes some time to build new houses. they can easily transfer the resources from one product to the other so that the supply may become more elastic. response of supply in response to change in their prices would be fairly quick. changes in price of cloth would take relatively longer time for supply to respond. than if that community possesses technology consisting of modern automatic spinning and weaving machines. old and original handwritten manuscripts. fertility of the soil. such as : 1) Nature of commodity : In the case of some commodities like antiques. Generally. The supply of agricultural goods is relatively inelastic. high artistic works. monsoon. and longer the time-span. that may cause no response from supply side in one or two hours or even one or two days(except in the case of commodities like shares and internationally traded goods like gold. 2) Level of Technology : Higher level of technology in a country generally helps to bring about a relatively quicker response from the supply side to change in their prices. In the case of such commodities price changes will have no influence on their supply. Natural Factors : Natural factors like climate. old stamps. In the case of houses. In respect of commodities like cloth and other factory-made goods of daily consumption. if price of a commodity rises. 4) Scale of Production : Goods produced on a small scale have a relatively inelastic supply.c) Factors Determining Elasticity of Supply : The elasticity of supply of commodities depends on a number of factors. etc. Size of the Firm and the Number of products produced : When the big firms produce a variety of products at a time. Time Element : Time element is very important factor in determining elasticity of supply. less responsive will be the supply side. their supply remains fixed or constant as they cannot be reproduced in their original form or shape. paintings and statutes. silver and other valuable metals in case of which future trading takes place on telephone. if a community depends for its cloth only on handloom technology..).

(ii) interest on borrowed capital. Types of Costs : 1) Accounting Costs : Accounting costs are the costs of production of the firm. must cover these costs and normal profits. Accordingly costs may be classified as : (a) Production costs. profits depend on the costs of production and the prices of products. 168 Managerial Economics . (vi) depreciation of capital goods. or else. The real cost is the opportunity cost of production (see below).man. he cannot afford to continue production. necessary to have a clear idea about the concept of the cost of production. (v) replacement and repairing charges of machinery. wage cost and interest cost (b) Selling costs. and they enter the accounts books of the firms. It is therefore. A firm aims at maximizing its profits. These are the explicit costs. These are money costs or expenses of production. Nominal cost is the money cost of production. Immobility of factors causes inelasticity of supply. making the supply of agricultural commodities less elastic. supply will be more elastic. given the market price of the firm's. 7) Mobility of Factors : In those industries where there is a high degree of mobility of factors of production. (iv) cost of raw materials. He must make sure that the price of the product. (iii) rent or royalty paid to owners of land which is borrowed by the firm. taxes etc. We have seen that the basic factor underlying the ability and willingness of firms to supply a product in the market is the cost of production. Money costs and real costs do not coincide with each other. COST CONCEPTS : Meaning and Importance : The cost of production of an individual firm has an important influence on the market supply of a commodity. The product prices are determined by the interaction of the forces of demand and supply. These costs are paid for by the producer and are also known as entrepreneur's costs. including material costs. It is also called expenses of production. These accounting costs are important from the point of view of the producer. and (vii) normal profits of the manufacturer (amount sufficient to induce him to continue production). The seasonal nature of cultivation is the main contributory factor. These costs include : (i) wages to labour. including costs of advertising and (c) Other costs. product. including insurance charges. Thus. Costs may be nominal costs or real costs. the amount a firm is willing to supply in the market will depend on the cost of production. 11.

The commodity that is sacrificed is the opportunity cost of the commodity produced. Thus. (b) (c) The same measure of cost may not be correct for each of these purposes. then it means that the production of some alternative commodities are foregone. 2) Economic costs : The economist's idea of cost is based on the fact that resources are scarce and have alternative uses.How do we measure the cost of inputs? Economists might want to discuss the production behaviour of firm for a number of reasons : (a) To predict how the firm's behaviour will respond to a given change in the conditions it faces. by economic costs is meant those payment which must be received by resource . Thus if resources are used for the production of some commodities. but is commonly known as opportunity cost. the opportunity lost of not being able to produce some other product. The opportunity cost of these resources to a firm is the value in their next best alternative use. that resource used in its production could have produced. Only if we assume that. is therefore. To find out how well the firms use scarce resources. The economic costs are based on a common principle that is sometimes called user cost.owners in order to ensure that they will continue to supply the resources for production. the economist's definition will be useful for problems like (a). Resources can be used for a number of purposes. Thus. Production and Costs 169 . 3) Opportunity Costs (Alternative or Transfer costs) Since productive resources are limited. implicit costs and normal profits together form the full costs of a firm (economic costs). To help the firm make the best decisions it can in achieving its objectives. The opportunity cost of a product. the production of one commodity can only be at the cost of another. economists define the cost of production of a particular product as the value of the foregone alternative products. Economists know exactly how to define costs in order to solve problems like (b) and (c). Explicit costs. the businessman (accountant) uses the same concept of costs.

(i) Specific : It does not apply to productive services which are specific. 20 lakh in project A is 9 per cent. if a consumer uses Rs. it would have been invested in project B (next best alternative use of Rs. he cannot use this money to buy a microwave oven. zero. but to the society it will cost something in the form of bad . (b) Limitations : There are. Thus. It is useful in the determination of values internally and internationally. therefore. some limitations in its application. This concept is. the opportunity cost of buying a washing machine is the opportunity cost of not being able to buy a microwave oven. the economic profits to a firm can be calculated with the help of implicit costs of a firm. (ii) (iii) Wrong . The implicit costs distinguish the accounting costs from the economic costs. The opportunity cost principle has a wide application in economic theory. Factors are not homogeneous : Units of productive services are not homogeneous. however. therefore.000 per unit. (a) measuring profits. (iv) Individual and Social Costs : A product may cost the firm Rs. he has forgone the opportunity of buying a microwave oven. Similarly. 20 lakhs are invested in project A at a 10 per cent rate of return. Thus. It is also used to understand income distribution. if Rs. Therefore we can say that the opportunity cost of producing X having considered Px in terms of Y given Py is = Px Py (a) Significance of Opportunity Costs : The concept of opportunity costs is an important tool to measure the implicit costs of a firm. (c) forming capital budget and (d) alternatives available to the firm. and these costs are imputed on the basis of the opportunity cost principle.Assumption : The theory is based on the assumption of perfect competition which rarely exists. 5. 20 lakh) at 9 per cent rate of return. used for. (b) policy decision of the firms.Example Thus. this obstructs their transfer. By buying a washing due to the smoke 170 Managerial Economics . A specific factor has no alternative use. Its opportunity (transfer) cost is. and if this amount was not invested in project A. which is the value of this amount in its next best alternative use. 20. Then the opportunity cost of Rs.000 to buy a washing machine.

and soot that this firm let out. This creates problems for measuring opportunity costs. i. From the point of view of the firm. like. These are firm's accounting expenses. rent on own land used by the firm.pocket costs. the firm often uses resources which the firm itself owns. or incomes it must earn. (a) Explicit Costs : The money payment. the theory of opportunity costs. we can say that economic costs are those payments a firm must make. normal profits are also costs. Implicit costs are ignored while calculating the expenses of production. Implicit costs are calculated on the basis of the opportunity cost principle. to owners of factors of production to attract these resources away form other uses.payments which the self . These are expenditure costs. The entrepreneur must be sure of normal profits if he is to continue in business. the salary of the proprietor. The costs of 'self owned' resources which are employed by the firm are nonexpenditure or implicit costs. are called explicit costs. payments made for resources purchased or hired by the firm. Thus. since implicit costs are non. the salaries and wages paid to the employees.owned and employed resources could have earned in their next best alternative use. Thus. these costs have to be calculated or imputed. prices of raw materials. electricity etc. Production and Costs 171 . like.expenditure costs and actual payment is not made. and payments into depreciation and sinking fund accounts. is the most widely used theory of cost at present. These costs do not enter the account books of a firm. (c) Normal Profits as a cost : Explicit costs. raw materials. (b) Implicit Costs : But in addition. implicit cost and normal profits together form the full costs o a firm (economic costs). These payments or incomes may be either explicit or implicit.e. Conclusion : Inspite of these limitations. Thus. fixed or overhead costs. To the firm the implicit cost are the money .of . 4) Explicit and Implicit Costs : Costs of production have also been classified as explicit and implicit costs. transport services. explicit costs are out . which a firm makes to those 'outsiders' who supply labour services. or the interest on the entrepreneur's own investment.

management. like labour. These costs remain fixed till the capacity output is reached. and salaries of top managers who are permanent employees. The difference between the fixed and variable costs disappears in the long period. By closing the showroom it can 172 Managerial Economics . wages etc. E.(d) Economic (or Pure). But to the economist 'profits' means total revenue minus all costs (i. Fixed costs do not change with change in production. electricity charges. Variable costs. If a firm's total revenue is more than all the economic costs. We shall now discuss some important types of costs of production. receiving a return just large enough to keep him in his present job.C. because by definition. = T.C ) : This distinction between fixed and variable costs is relevant in the short period only. It is not a cost.: A firm decides to close it's showroom. Variable costs include costs of raw material. F.C. when an economist says that a firm is just covering its costs. land. however all factors are variable and so all costs are variable. the term cost has varied meanings. In the long period. i) Fixed Costs and Variable costs ( F. Therefore. This residue is economic or pure profit.C. (Total Cost). he means that all explicit and implicit costs are being covered and that the entrepreneur is therefore.e. In the short period. raw material. explicit costs. Other Production Costs : As discussed above. however. Variable costs are those costs which vary with the level of output. + V. Costs which can be avoided due to contraction of the firm are called avoidable costs and the costs which cannot be avoided because of contraction are unavoidable costs. land. Fixed costs include costs on capital. then the residue is to the entrepreneur. Profits : From the above discussion of accounting and economic costs. electricity. are fixed and some factors. some factors. and V.g. The costs which remain fixed irrespective of the level of output are called fixed costs. it becomes clear that economists and accountants use the term 'profits' differently. it is a return more than the normal profits required to keep the entrepreneur in his present line of production. ii) Avoidable and Unavoidable costs : At times a firm faces a problem of retrenchment or contraction. like capital. By 'profits' the accountant means total revenue minus explicit costs. change with the change in production. implicit costs and normal profits). machinery. Costs on fixed factors are called fixed costs and costs on variable factors are called variable costs. etc are variable.C.

there are some costs which are traceable to a particular product of a multiple product firm. Some costs are common to all the products of multiple product firm. electricity charges etc. Now. these are Sunk costs. when it was initially purchased. However. Over a period. These are costs which increase only through expansion and are incremental costs. It might set up a new factory or introduce a new product. Maintenance charges Operational charges. salaries of publishers etc are common to both these products. most firms are multiple product firms. Installation charges. Costs which increase because of expansion of a firm are called incremental costs. and costs which have to be borne whether there is expansion or not are called Sunk costs. it has to continue to employ the salesman who move from place to place. Production and Costs 173 . However. These are common costs. the raw material used or a cutter used for the magazine or newspaper can be specific to a particular product. instead of purchasing the machine a firm decided to hire a machine (not expansion). these are common costs. However. these are avoidable costs. wages to workers in the showroom. iii) Incremental and Sunk Costs : At times the firm undertakes expansion. and a time comes when it becomes necessary to replace the asset. the salaries of these salesman cannot be avoided because of contraction of the firm. these are traceable costs.e.avoid the rent of the showroom. However. v) Historical and replacement costs: Cost of purchase of a capital asset. if a firm wants to purchase a machine. consider a press. For example. For example. it has to bear the following costs: 1) 2) 3) 4) Cost of purchase. some costs like a cost of printer. these become unavoidable costs. say. the value of every asset depreciates. 1994 is the historical cost of the asset. i. it does not have to bear the cost of purchase and the maintenance or installation charges. by hiring a machine the firm cannot avoid operational charges. firms producing more than one product. these are called traceable costs. These costs have to borne by the firm whether there is expansion or not. publishing a newspaper and a monthly magazine. iv) Common and Traceable costs : Today.

for our present study we shall concentrate on firms fixed and variable costs. a) Total Fixed Costs (TFC): Some factors like machinery. we will make use of cost curves as shown on next page.The cost of the asset when it is to be replaced say in the year 2004. whereas some costs do not change (because some factors like machinery. spare parts and labour change as the output changes. so TC also increases as production increases. Thus. In the short period some costs are fixed and some are variable. do not change). The TFC curve is a horizontal straight line parallel to X axis. is the replacement cost of the asset. capital remain fixed in the short period. To understand the meaning of these costs and relationship between them. electricity. This is the total cost of production. We have a rising TVC curve. land. TC = TFC + TVC The TFC is constant. We shall now study the short run costs with reference to total marginal and average costs. This distinction between FC and VC depends on the time period. (because some factors like labour change). we talk of fixed costs and variable costs in the short run. c) Total Costs (TC) : The sum of total fixed costs and total variable costs is the total cost. the total cost of all these factors is the total fixed costs. They are the same for any level of production (see figure mentioned below). TFC's do not change in the short period. The cost on these factors is the total variable costs. The TC curve is also a rising curve and the vertical distance between the TVC and TC curve. The total variable costs increase with increase in production(see fig shown on next page). vi) Short run and Long run costs: All the costs discussed previously are important. Firms Cost curves : (A) Short run Cost Curves: Short run is a period within which some costs change. for any level of production is the same and is equal to TFC(see the figure shown on next page). but TVC increases as production increases. b) Total Variable Costs: (TVC) : Some factors like raw material. However. capital. 174 Managerial Economics .

e) Average Cost of Production (AC): Average cost is the cost per unit of output produced which is calculated as: AC = TC / Units of output OR AC = AFC + AVC The AVC curve is also a U shaped curve. Production and Costs 175 . AVC is the per unit variable cost of production which is calculated as AVC = TVC / Units of Output The AVC curve is a U shaped curve. which means that. which means that initially.d) Average Fixed Costs(AFC) and Average Variable Cost (AVC) : AFC is the per unit fixed cost of production which is calculated as: AFC = TFC / Units of Output Since TFC is constant as production increases. initially AVC decreases as output increases and later AVC increases as output increases (see fig shown below). AC decreases as output increases and later AC increases as output increases (see the fig shown next page). the AFC decreases as production increases (see fig shown below).

MC = MVC Also. but ultimately the MC starts decreasing with increase in Output (as shown in the above fig). MC is therefore. It is calculated as. The relationship between TVC and MC is the same as the relationship between TC and MC because TVC changes at the same rate as TC. the MC curve cuts both the AVC and AC curves at their respective lowest points. this also means that TC (and TVC) initially increases at a decreasing rate and later it increases at an increasing rate. but MFC = 0.Cost Units of outputs f) Marginal Cost: The marginal Cost is the change in total cost caused due to one additional unit of output produced. therefore.5 5 3. MC = ∆ TC / ∆ Output The MC curve is a U shaped curve which implies that the MC decreases as output increases initially.75 8 Marginal Costs 8 –– 5 4 3 4 9 Managerial Economics . MC = MVC + MFC. Units of output 1 0 1 2 3 4 5 176 Total Fixed Costs 2 15 15 15 15 15 15 Total Variable Costs 3 0 5 9 12 16 25 Total Costs (2) + (3) 4 15 20 24 27 31 40 Average Fixed Costs (2) : (1) 5 –– 15 7. the rate of change of total cost. Thus.5 4 4 5 Average Costs (5) + (6) 7 –– 20 12 9 7. since TFC is constant. the relationship between AVC and MC is the same as the relationship between AC and MC.75 3 Average Variable Costs (3) : (1) 6 0 5 4.

run average cost curves with the help of the Law of Variable Proportion. because the variable factors are used only to assist the fixed factors. upto same level of output the AC (AFC + AVC) also declines as output increases. Thus. (i) The fixed factors are used up. Thus fixity of factors causes the AC to rise sharply over larger output. even though AFC falls continuously as output increases.shaped curve. Further.shaped and this is explained by the Law of Variable Proportion. factors of production are not perfect substitutes of each other. therefore. The total fixed cost is fixed as output increases. after reaching a minimum. In the initial stages the AVC also declines as output increases. The average variable cost falls initially till the normal capacity of the machine is used both the AFC and AVC and so the AC rises as output increases. This rise in AVC more than offsets the fall in AFC and the AC (AFC + AVC) starts rising as output increases. so the AFC declines as output increases. DETERMINANTS OF COSTS : The determinants of demand have already been discussed in the Chapter "Demand Analysis and Forecasting. the variable factor cannot be used instead of the fixed factor. the AVC increases steeply. We can explain the short .shaped? The average cost (AC) is made up of average fixed cost (AFC) and average variable cost (AVC). the AVC also increases sharply. the AFC falls steeply and thus AC falls steeply. thus if the fixed factor is used up. so Production and Costs 177 . (ii) An initial fall in AC as output increases. The marginal cost and average cost falls as output increase. One can conclude that the short run AC curve is U . (ii) But after a certain stage. 12. However." The idea was to identify the more important determinants of demand.(B) Why Short Run Average Cost Curves are U . and it cannot be offset by the slow fall in AFC over larger output. gives the AC curve a U . in the initial stage of production because : (i) The fixed factor is used in a better and better way in the initial stage of production therefore. which operates only in the short . and further production is possible only with more of variable factors. and then a rise in AC as output increases further. the AC will register a sharp rise because. Thus. the AC falls steeply. the TVC cost increases sharply as output increases.

the size of the plant and technology. and the sum of these separate functions pluralistically yields the complex function.denotes the size of the plant T . the technology used broadly constitute the cost. O .input relationship. the rate of output.input relationship is a seperate function. the cost function may be written as : Cost = f (I. However. Now the cost . the rate of output. Therefore. Generally speaking the prices of inputs. of inputs.e. These constituents of cost help one to conceive cost behaviour as a single comprehensive cost function which expresses the complex relationship of cost to its many constituents. Similarly. the cost output relationship is another separate function. When the factors which influence or constitute cost are spelt out.denotes the state of technology.denotes the rate of output. Cost .Input Relationship : In the cost . Now. the more important determinants of cost have to be identified. consider the first determinant in this complex function. O = AL K1α α Where. Consider now the cost . cost is a function of prices. For example. it is the prices of various inputs which make up the cost. the size of the plant. O = the amount of output A = a constant L and K denote labour and capital α and 1. P.are the production co – efficient or elasticities α 178 Managerial Economics . Each component of this complex function is a separate function by itself. how fast or slow the fixed plant is utilized. For example. P . and we are able to arrive at a realistic picture of cost behaviour in the future. it is possible to identify the more important factors of cost which influence cost pattern or cost behaviour.that each determinant might be taken care of at the time of a forecast. it is possible to build up the cost function. O. that is input. i. In other words.. and so on.denotes the prices of such inputs as labour and capital material. so that each determinant might be forecast.T) Where I .input relationship. There are so many factors which determine cost that is virtually impossible to enumerate them.

capital and materials. they go on substituting one factor for another till all the costlier factors are replaced by the factors which are cheaper. If labour is costly and the price of materials is constant. if labour is costly.cost combination of inputs is determined. This would be absurd because labour and materials cannot be substituted for each other. for example. For example. the size of a plant. in the short run. depend upon their prices. The ingenuity of the managerial economist arises when he goes beyond this limitation and find out whether there is some factor influencing labour and materials alike. raw materials and labour. When we analyse how and why the cost varies. if materials are costly. The quantities which are bought. In other words. a capital .cost combination of factors or inputs. This is known as the process of substitution. On the other hand. for it becomes necessary to find substitutes. On the other hand. so do wages because these factors. if capital is costly. etc. are subject to the forces of demand and supply. a cost function is developed on the same lines on which the production function is developed. These input The objective of the production function is twofold : to arrive at the least cost combination and to achieve the maximum output. the least . and long . In other words. multiplied by their quantities. But what happens when capital is constant and the price of labour or the price of materials rises ? it is difficult to analyse this situation because labour is costly. This time period is a crucial factor in any analysis of costs. the cost . phenomenon. a relation of substitution between labour and capital is established. these factors adapt themselves to changed conditions.input function is one of the complex functions of cost analysis. and is generally broken into two parts. the producer cannot use less of labour and more materials. In the cost function.Now. this is a short . the labour intensive technique is adopted. The purpose of this substitution is to enable the management to arrive at the least . however. It has often been claimed that. Production and Costs 179 . however. determine the cost. namely. In other words.input function can also be written as C = f (La Kb Mc) where C denotes the cost which is a function of L (labour) and a the price of the factor labour. the state of technology.intensive technique would be used. These facts indicate that the cost . only certain factors. the producer goes in for a capital intensive technique. labour. for example the raw materials vary in price. namely. Cost . in the short . research receives an b the price of capital and Mc denotes materials and the price of materials. This process is known as the marginal rate of substitution. In the costing of inputs. It has already been indicated that producers generally try to combine the factors of production in such a way as to minimize cost. short . K denotes the quantity of capital. and this process goes on till a stage is reached at which further substitution is not In the long . what we have in mind is to determine how costs vary over a period of time. certain factors do not change. vary and not all. In other words.Output Relationship : Cost generally vary with the level of output.

the firm will tend to stabilize this level of output. variable costs. equilibrium of the firm will be established where its output maximizes its money profits. In other words. Table indicates the movements of total cost and total revenue as the level of output which corresponds to the longest vertical distance between total revenue and total cost. Point D in the figure. 13. and the marginal cost.profits is assumed to be the objective of the firm. what is needed is a study of the total cost. the latter being less than the former. of course. The relationship between the total cost the average Costs. the firm will try to attain that level of output which fetches maximum profits. However.fixed cost. For the purpose of the cost . TR = TC which means the firm is making neither profits nor losses. are of several kinds . We have already considered the behaviour of costs in relation to variations in the output of a firm. Once this level is attained. However. At OA level of output. in the business and in the long .output analysis. Since maximizing money . the total cost is the summation of fixed and variable costs. both in the short . Now we shall consider the behaviour of revenue of a firm. The TR curve originates form point O since total revenue is zero when production is zero. BREAK EVEN POINT : The Traditional Concept of Equilibrium of a Firm Equilibrium of the Firm : By total Revenue and Total Cost Curves : We have noted that. To simplify our analysis. Since profit is the difference between total revenue and total cost. the total fixed cost. Total cost is more than revenue until OA level of output is reached. This is known as a 'break . The TR and TC curves in figure are total revenue and total cost curves respectively.volume profit analysis. The following figure illustrates the equilibrium of a firm with the help of Total Revenue (TR) and Total Cost (TC) curves.even chart' or Cost . to maximize this difference becomes the objective of a firm. average costs and marginal costs. the marginal cost. a firm is required to incur fixed costs even when its level of production is zero. a firm will be said to be in equilibrium when it tends to stabilize at a given level of output and is reluctant either to increase or to decrease its output. the average cost. Fixed and variable costs have already been dealt with. 180 Managerial Economics . and the average fixed costs is illustrated in table given previously.And so one arrives at an analysis of short-run cost behaviour and long-run cost behaviour. we shall assume that the firm is producing one product only.

it is most widely used in business to find out total profits of a firm. (ii) Secondly. the price per unit of the commodity cannot be shown in the same diagram. To ensure that EF is the longest vertical distance between TR and TC. Hence. OB is the profit maximizing level of output and at this level of output the firm will be in equilibrium.e. But this method has two limitations : (i) The longest vertical distance between TC and TR curves is difficult to find out at a glance. But still we cannot precisely show the price as a particular distance. TR and TC are again equal. JK/LM are the parallel lines and E and F are the points of tangency. is therefore. It is true that TR : Units produced would be the price per unit. OC level of output is again a no. EF is the total profit at OB level of output. In fig. proves to be more useful. If output is increases beyond OC the firm will incur losses which will increase as output is increased beyond OC. In fig. TR curve rises above the TC curve and the gap between the two goes on increasing.profit no -loss level of output. This widening of the gap between the two curves indicates increasing profits. These two points (E and F) are on the straight line BFE which is drawn perpendicular to the X axis. As output increases beyond the level OA. where EF is the total profit and EF is the longest possible vertical line that can be drawn between the two curves TR and TC as drawn here. profits will decline. Point G.Y K Total Cost & Total Revenue TC G TR E J D L H F M O A B Output (Units) C X Equilibrium of a firm with the help of TR &TC method which is a point of intersection of TR and TC curves. i.even point.even point. Of all theses tangents. Production and Costs 181 . by the curves of marginal revenue and marginal cost. is the second break . we can draw a number of tangents to the TR and TC curves. The vertical distance between TR and TC curves indicates total profits. This vertical distance is longest at OB level of output. known as the break . the method is not very significant especially in the context of problems in the theory of value we are required to discuss with the help of equilibrium of the firm. the points of tangency are on a straight line drawn perpendicular to X axis. Besides. therefore. Instead.. If production increases further. This method can illustrate the equilibrium of the firm. BE : OB is the price. We have to draw many tangents to the two curves before we come across a pair of tangents which are parallel to each other. we have to find a pair of lines which are parallel to each other and at the same time. Hence. the equilibrium as based on marginal analysis. In order to decide the largest vertical distance between TC and TR. At point G.

182 Managerial Economics . 5. Explain The Law of Variable proportion with the help of three stages. (j) Determinants of cost of production (k) Short run cost curves. State and explain Law of Supply? What are its exceptions? What is elasticity of Supply? What are the types of elasticity of Supply? Write short notes on : (a) Methods of measurement of elasticity of supply (b) Diseconomies of large scale production (c) Opportunity Cost and Actual Costs (d) Explicit & Implicit Cost (e) Past and Present Cost (f) Fixed and Variable Costs (g) Avoidable and Unavoidable Costs (h) Incremental & Sunk Cost (i) Increase and decrease in quantity supplied and increase and decrease in supply. 2. 4.Exercise : 1. 3. Explain with illustration the Laws of Returns to Scale.

NOTES Production and Costs 183 .

NOTES 184 Managerial Economics .

Determination of Price and Output under Monopolistic Competition. INTRODUCTION Demand and Supply are the powerful forces operating in any market. In Mumbai. Pure and Perfect Competition. Distinction between perfect competition and Monopoly.. Introduction to Cost Pricing. It is a place. An attempt is. therefore. Zaveri Bazar is the market for gold and silver ornaments.Pancha . Wholesale textile business in Mumbai is concentrated in Swadeshi Market. 1) What is 'Market'? In the traditional sense. Oligopoly and Duopoly (Features).Ratna and Prasad Chambers. Meaning of Market. In the previous chapters. Traditional view. Dalal Street in Mumbai is known for the Bombay Stock Exchange. constitute the Mumbai Money Market. made in the following few paragraphs to define the term 'market' and explain the nature of competition. market is a place where buyers and sellers meet each other to effect a business transaction. therefore. They act and react upon each other and determine the price of a product. Pricing Methods / Pricing Practices. Price in Short run and long rung. Several examples of market in Pune can be given for exmple Mahatma Phule Market is a retail market in vegetables whereas.Chapter 6 PRICING AND OUTPUT DETERMINATION IN DIFFERENT MARKETS Preview Introduction. Monopolistic Competition (Features). Determination of Price and Output (Equilibrium Under Monopoly). Mulji Jetha Market and Mangaldas Market. Equilibrium of Firm and Industry Under Perfect Competition. Gultekdi Market Yard is a wholesale market in vegetables. Imperfect Competition. These areas. Similarly. we have already studied the nature of Demand and Supply. The diamond market in Mumbai is located in two sky-scrapers at Opera House viz. most of the Indian and foreign banks are concentrated near Horniman Circle and Nariman Point in Mumbai. Determination of Price and output under perfect Competition. Modern View. stocks. Pricing and Output Determination in Different Markets 185 . It is the largest capital market in shares. a street or a building where a number of shops dealing in a particular commodity are located.Monopoly. In this chapter we propose to study the market where these forces are constantly at work. Classification of Markets based on the Notion of Competition. .

Meaning of the term market. the term market is understood in a different sense. Ahmedabad has specialized in the manufacture of textiles. the buyers and sellers may be away form each other. the renowned French economist. Banaras in silk. Surat has specialized in diamond polishing. In course of time. Recently. and is not acceptable to the economists. In economics. the entire world may be described as a single market. traditional. 3) Modern View Above examples would indicate how various markets are developed at various places in a country. Coimbatore in South India has developed a big market in spinning. prices in different parts of a country. 2) National Markets Like a particular street in a city. According to him. according to the modern view. 186 Managerial Economics . as understood in the above sense is. but they may be able to establish contacts through communication. the entire city may sometimes specialize in the production of a particular commodity.debentures and government securities. prices prevailing in different parts of a country would tend to equality. It is clear that modern economists have considerably widened the scope of the term 'market'. the city acquires the status of a national market. they may be able to talk to each other over telephone or through the post-office and finalize the transaction of sale or purchase. however. It will be seen from these examples that the market for a particular commodity is concentrated in a particular building or a street in a city. Thus. When buyers and sellers are in close contact with each other. it is not necessary for the sellers to exhibit their products at a particular place or a building. would tend to equality easily and quickly. so as to finalize the transactions. and Kolkata whereas hosiery market is centered in Ludhiana. The goods may be stored in a warehouse. If they are able to speak with each other. The buyers and sellers may be away form each other and yet they may constitute a market over telephone or through internet. According to Jevons. The same view has been expressed by Cournot. an eminent English economist. If this meaning is accepted. Similarly. Kashmir in shawls and Faridabad in bangle-making industry. (a) (b) (c) It is not necessary that market for a commodity should always be located on a particular street or in a building. and the buyers and sellers may be away form each other by thousands of miles still. Thus. The market for leather goods is concentrated in Kanpur.

Edward Chamberlin of Harward University have done a pioneering analysis of imperfect competition. a distinction is made in economic theory between pure competition and perfect competition.4. The dream of the Classical economists is. exactly alike in quality. An individual seller cannot. rice produced in different parts of India is classified under different standard grades such as Resham Basamati. a) Large Number of Buyers & Sellers (Firms) The number of buyers and sellers operating under pure competition is very large. It has been pointed out that the real world is full of imperfect competition. Classification of Market based on the Nature of Competition : MARKET Perfect Competition Imperfect Competition Pure Perfect Monopoly Duopoly Oligopoly Monopolistic Monopsony Competition Competition in the market can be either perfect or imperfect. Usually. (A) Pure and Perfect Competition : Usually. The concept of perfect competition is much broader in scope than pure competition. b) Homogeneous Products The products sold by different sellers under pure competition are homogeneous i. The position of an individual seller is like a drop in the ocean. a product which is capable of being standardized is sold by the sellers. however. Price of a product is determined by the interaction of total demand and total supply in the market. Every seller and a buyer under pure competition is a Price-Taker and not a Price-Maker. Mrs. it is beyond the capacity of an individual seller or a buyer to determine or influence the price. hardly realized in practice. It includes all the features of pure competition plus some more features of the two forms. The Classical economists assumed the existence of perfect competition. let us discuss first the features of pure competition. Based on their analysis. therefore. Even if he increases or reduces his demand. For example. Joan Robinson of the Cambridge University and Prof. it does not make any effect on the total demand in the market. Similarly. In particular. fix the price nor can he change it by his individual action. competition in the market is classified as under. Pricing and Output Determination in Different Markets 187 . Naturally. no single buyer can fix the price or change it by his action. Kamod. and all their analysis is based on this assumption.e.

large number of buyers and sellers. therefore. For example. every seller knows the total quantity supplied and sold on a particular day or during a week.e. Ambemohor etc. Similarly. i. new firms are. Since there are no hindrances to the entry of new firms and exist of existing firms. no seller should discriminate between buyers. This means that perfect competition does exhibit the above features of pure competition viz. every buyer knows what is happening in the other corner of the market. Much. (C) Perfect Competition : It has been already remarked that the concept of perfect competition is broader than pure competition. it is assumed that the cost of transportation does not exist for carrying goods from one place to another. and not to the black and ugly people. b) No Discrimination Under perfect competition. no buyer would discriminate between sellers. a worker would migrate 188 Managerial Economics . In addition to these. c) Free Entry & Free Exit of Firms Another important feature of pure competition is that there is free entry and exit of firms. d) Mobility of Factors of Production Various factors of production are assumed to be perfectly mobile from one place to another and from one occupation to another. Similarly. is willing to pay the required price. perfect competition exhibits the following features. As a result. He cannot say that he would sell his product only to white and handsome people. exactly alike in quality. Since every buyer is buying the standard variety. He cannot say that he would buy only from a particular seller and that he would not buy from others. For example. the number of total firms under pure competition always remains very large. He is interested in ensuring that all the rice in the bag is homogeneous. A buyer has no reason to discriminate between sellers so long as every seller is charging the same price. c) No Cost of Transportation Under perfect competition. he does not bother to know as to which particular farmer has grown that rice. opened from time to time. An entrepreneur who has the necessary capital and skill can start any business of his choice. homogeneous products and free entry and exist of firms. visiting his shop. a) Perfect Knowledge All the buyers and sellers operating under perfect competition have perfect knowledge of the market conditions. an existing producer is free to close down his business if he so chooses. some firms are going out of the industry.Kali. Similarly. In every industry. The seller must deliver the goods so long as every buyer.

each firm is a price-taker under perfect competition. e) Automatic Price Mechanism The most significant feature of perfect competition is the existence of an automatic price mechanism. no seller would discriminate between buyers and no buyer Pricing and Output Determination in Different Markets 189 .from industry can be diverted to another industry if the return on investment is going to be higher. (OP0) under perfect competition. Thus the demand curve of the firm is perfectly elastic under perfect competition. MARKET Price (Per Unit) Price (AR) FIRM DM SM PM SM EM DM QM OP0 AR Perfectly Elastic Demand Curve X Output (Units) X O Quantity Demanded/Supplied O In the fig DM DM is the market demand curve and SM SM is the market supply curve. Thus. Price of a product is determined by the interaction of total demand and total supply in the market. Then buyers and sellers have perfect knowledge of the conditions prevailing in different parts of the market. This price is accepted by every firm. by self-interest and profit-motive. It is assumed that all the factors of production are perfectly mobile and that there are no hindrances to their movement. Mobility of factors of production is guided under perfect competition. the principle so nicely elaborated by Adam Smith in his Book. EM is the point of market equilibrium where market demand and a market supply are equal to OQM. no individual seller or a buyer can fix or influence the price. This gives the equilibrium price in the market (OPM). the number of firms in the industry is very large. The price is determined in the market and every firm has to accept this price. A single firm action does not affect the market supply. (A) Determination of Price And Output Under Perfect Competition : INTRODUCTION Perfect Competition is said to exist when the number of buyers and sellers operating in the market is very large. The forces of demand and supply are very powerful and always remain outside the control of an individual seller or a buyer. Each firm is very small in size. 'Wealth of Nations'. All the sellers are selling homogeneous products which are exactly alike in quality. Moreover. (D) Demand Curve under Perfect Competition : Under perfect competition. Since there are many sellers and many buyers. Price mechanism is not only automatic but is delicate.

Determination of equilibrium price can be explained with the help of the following demand and supply schedule and demand and supply curves. Similarly. This is called Equilibrium Price. demand and supply play an equally important role in determining the price. Price is determined by the interaction of demand and supply. Demand and Supply are powerful forces which constitute the essence of price-mechanism under perfect competition. The price mechanism determines the price and output of various products. Per metre) 250 240 230 220 210 Quantity Demanded (million metres) 19 20 22 25 30 Quantity Supplied (million metres) 28 26 22 17 10 The above demand schedule can be shown with the help of the following diagram. therefore. Equilibrium Price Y D S Price per unit P S O M E D X Quantity Demanded/Supplied 190 Managerial Economics . no buyer or seller can fix the price of a product. That is to say. Demand for & Supply of Textiles Price (Rs. It is. nor can he influence it by his own action. They act and react upon each other and determine the price at the equilibrium point. General Rule Of Price Determination : Under Perfect Competition. Under perfect competition. a seller has no reason to refuse to sell to a particular buyer who is willing to pay the required price. no buyer would hesitate to buy form a particular seller who is charging the same price.would discriminate between sellers. generally. worthwhile to explain the working of the price mechanism under perfect competition.

Changes in Equilibrium Price : The equilibrium price. Under perfect competition.axis and the price is shown on the Y. For example. In figure original equilibrium price is shown at point E i. but demand being constant. The supply is shown by the supply curve SS. during a slack season.axis. price of cotton textiles would rise. the equilibrium price would change. if some festival is forthcoming. the cotton crop may be affected on account of natural calamities. The demand curve and the supply curve balance each other at point E. demand for a product would increase. determined by the interaction of demand and supply need not remain constant. Changes in supply would also influence the equilibrium price. It can change with every change in the relative positions of demand supply. Demand for a product may increase on account of a festival. changes in supply and changes in both. Similarly. therefore. growth of population or on account of some other factor.per metre and at this price quantity OM would be sold in the market. demand may fall. but supply being constant. But on account of a higher demand curve Pricing and Output Determination in Different Markets 191 . OP. (A) Changes in Demand Y Changes in Demand D D1 S Price Per Unit P1 P F E S O M M1 D D1 X Quantity Demanded/Supplied In figure changes in demand are shown by different demand curves DD and D1D1. the equilibrium price would. and SS is the supply curve representing the quantity supplied at different prices. Supply of cotton in this case is reduced. price would rise. In all the three cases. The supply being constant. DD is the demand curve showing total demand at different prices. It is worthwhile to see how changes in demand.In the figure quantity demanded and sold is shown on the X. be Rs.230/. There is a third possibility. This point is called on Equilibrium point. in a particular year. demand and supply may both change simultaneously. price would fall. For example. affect the equilibrium price.e.

D1D1 a different picture would emerge. Thus it is clear that supply being constant. (B) Changes in Supply Similarly. demand being constant. The new price would. therefore. OP is. S1S1 is the new supply curve which shows a reduction in the supply. DD is the demand curve and SS is the original supply curve. i. the equilibrium price. OP1 would. therefore. and at the same time. Now. Changes in Supply Y D S1 S Price Per Unit P1 P E1 E S1 S M1 M D X O Quantity Demanded/Supplied In figure. This means that the total supply has diminished from OM to OM1. be the new price. a new equilibrium price would be established. therefore. The new demand curve D11 intersects the supply curve at point F. This would be clear form the following figure. These curves balance each other at point E. price has risen from OP to OP1. be OP1. The new supply curve S1S1 intersects the demand curve at a new equilibrium point E1.axis. every change in supply would change the price. (C) Changes in Demand and Supply The third possibility is that demand and supply both may change simultaneously. 192 Managerial Economics .e. On account of these changes. equilibrium point. every increase in demand would lead to a rise in the equilibrium price. D ↑ E. This is clear form the following figure. the quantity is shown on the X-axis and the price is shown on the Y.

Changes in Demand and Supply
Y D D1 S S1

Price Per Unit

P1 P



D1 S S1 O M M1 D X

Quantity Demanded/Supplied In figure, DD is the original demand curve and SS is the original supply curve. They balance each other at point E. The equilibrium price is, therefore, OP. Now D1D1 is the new demand curve which shows a higher demand, and S1S1 is the new supply curve. The new equilibrium price would, therefore, be OP1.

Laws of Demand, Supply & Price :
From the foregoing discussion the following laws of demand, supply and price can be stated : (d) Under perfect competition, price of a product is determined by the interaction of total demand and total supply in the market. This is called 'Equilibrium Price.' If demand increases, supply being constant, the price would rise. If demand falls, supply being constant, price would fall. If supply is reduced, demand being constant, price would rise and if supply increases, demand being constant, the price would fall. If a change occurs in demand and supply simultaneously, a new equilibrium price is established.




Price in the Short Run and Long Run :
The above laws of demand, supply and price, however, constitute the general framework of price determination. As Marshall has elegantly pointed out, time element plays an important role in determination of price. Marshall has classified the period of time under four heads; but for the sake of simplicity we can reduce this classification of period only under three heads viz.

Pricing and Output Determination in Different Markets



Market Period (ii) Short Run, and (iii) Long Run.

It is worthwhile to see how price is determined in the market, in market period, Short period and the Long run or period. (i)

Market Period :
According to Marshall, market period relates to few hours or few days. Perishable goods such as fish, eggs, leafy vegetables etc. are sold in this market. The supply of these goods on any particular day is fixed. It cannot be increased or decreased within the market period. At the same time, such goods being perishable, their supply cannot be held back from the market. The entire supply is to be disposed off on the same day; because it cannot be stored or preserved. In such circumstances, price would be determined according to the total demand in the market. If on a particular day, more customers come to buy, the supply would be less and the supply being constant, price would rise. Thus, in the short run, determination of price in the market period is shown in the following figure : Price in Market Period
Y D2 D D1 S

Price Per Unit

P2 P P1 D2 D D1 O S X

Quantity Demanded/Supplied In figure, SS is the supply curve representing perfectly inelastic or a fixed supply in the market period. Since supply cannot be increased or decreased in a very short period, the supply curve is vertical to the X-axis. Demand is shown by different demand curves, i.e. DD, D1D1 and D2D2. Accordingly, OP would be the price if demand is shown by the curve DD. If on the next day, only a few customers come, demand would be shown by D1D1 and the price would fall to OP1. If on some other day, demand is higher it would be shown by D2D2 and the price would rise to OP2. Thus, price in the market period is determined from the demand side, and supply plays a passive role. 194
Managerial Economics


Short-Run :
In the short-run, supply of goods can be adjusted to the demand to some extent, because, some factors remain fixed, whereas other factors can be changed in the short - period, the price in the short period is thus determined with the help of the active role of both supply as well as demand. Y S

Price Per Unit



Q Quantity Demanded/Supplied

In figure, the supply curve is positively sloping, the equilibrium price is OP at which quantity supplied equantity demanded equals OQ. (iii) Long - Run : In the Long - run, supply of goods can be adjusted to the demand, Dr. Marshall has taken an example of durable goods, which are sold in the long run. Durable goods such as wheat, rice, oil, textiles etc. can be stored for some time. Their supply can be increased or reduced according to the demand. Since the supply is adjustable, supply curve is horizontal to the X-axis. The sellers of durable goods are unwilling to sell unless they recover a minimum price. This price is based on the cost of production. Producers of durable goods would not, therefore, sell unless the cost of production is recovered. If the price is less, they would hold back the supply from the market. On the other hand, if they are getting the minimum expected price which covers the cost of production, they would be prepared to sell more. i.e., they would increase the supply at the same price. Determination of price in the long run is shown in the following diagram :

Pricing and Output Determination in Different Markets


Price Per Unit

Long Run Normal Price D1 D11



D11 D O Quantity Demanded/Supplied In figure the supply curve is horizontal to the X-axis because it is adjustable to demand. Here, price of the product would be OP which covers the cost of production. In this case, an increase or decrease in demand would not influence the price because it is based on the cost of production. If less people come, a small quantity would be supplied and if more people come, a larger quantity would be sold at the same price. It will be seen that in the long run, supply plays a dominant role and demand is passive in determining the price. D1 X

Conclusion :
Under perfect competition, price is determined by the interaction of total demand and total supply in the market. The price which is so determined is called the Equilibrium Price. The equilibrium price may change on account of changes in the relative positions of demand and supply. The most significant point to be emphasized here is that the time element plays an important role in determination of price in the short and long run. In the short run demand is active, whereas in the long run supply is active in determining the price. By introducing the importance of time element, Dr. Marshall has made a significant contribution to the theory of value. (B) Equilibrium of Firm And Industry Under Perfect Competition INTRODUCTION In the previous sub-unit, we have studied how price of a product is determined by the interaction of demand and supply. We have also seen the important role played by the time element in the theory of value. We have thus studied the rules of price determination under perfect 196
Managerial Economics

competition. However, we have not yet studied how a firm or an industry would maximize its profits. An attempt is, therefore, made in this chapter to explain how equilibrium position of a firm or an industry is reached under perfect competition.

Firm And Industry :
Before explaining the equilibrium of a firm or an industry it is necessary to revise the distinction between a firm and an industry. Any business unit organized under one ownership and management is called a firm. The firm may be organized as a sole proprietorship, partnership or a joint stock company. The form of organization can be anything. It is necessary that the business should be owned and managed by one management. An industry is a group of firms dealing in the same line of business. The ownership and management of each firm may be different; but since all such firms are engaged in the production of the same commodity, they are collectively called an industry. Thus Swadeshi Mills in Mumabi is a firm dealing in textiles. Similarly, Shriram Mills is another firm and Kohinoor Mills is still another firm dealing in textiles. But when we take into account all the textile firms in India we describe them collectively as the cotton textile industry of India.

Concept of Equilibrium :
The term equilibrium is frequently used in economic theory. Thus, there is an equilibrium of a consumer, an equilibrium of a firm or an equilibrium of an industry. Since the concept occupies a central position in the theory of value it is necessary to know the meaning of the term equilibrium. A consumer who spends his income on various goods may derive satisfaction from the consumption of those goods. When consumer maximizes his satisfaction he is said to be in equilibrium. In the case of a firm, equilibrium is reached when the firm's profits are maximized. The ultimate aim of every firm is to maximize its profits. Accordingly, the firm tries to reach the stage of maximum profit by adjusting its output. In the initial stages, when production is on a small scale, the margin of profit is small. But when the scale of production is increased the average cost goes on diminishing and the margin of profit goes on increasing. After some time, the disadvantages of large-scale production begin to operate. As a result, the difference between the selling price and the cost goes on diminishing. Even though the margin of profit is reduced, there is still some addition to the total profits. It is, therefore, worthwhile to carry on production for some more time. Finally, a point is reached when cost of production exceeds the selling price. From this point, losses begin to occur. Every firm would, therefore, stop to produce. At this point, the total profit is maximum and the firm is said to be in equilibrium. Like a firm, an industry can also achieve its equilibrium when all the firms in the industry are in equilibrium.

Pricing and Output Determination in Different Markets


Equilibrium of Firm :
There are two methods to study the equilibrium of a firm. Viz. (a) (b) Total Cost and Total Revenue method, and Marginal Cost and Marginal Revenue method.

Before we examine these methods, it is worthwhile to know the assumptions on which our analysis is based : (i) (ii) It is presumed that a firm is managed as a sole proprietary concern. This would enable us to study the behaviour of an individual. Every individual proprietor aims at profit maximization and he exhibits rational economic behavior.

(iii) It is also assumed that the firm is producing only one commodity. It is possible to consider a firm producing more commodities, but in that case, our analysis would become more complicated. For the sake of simplicity we, therefore, assume that the firm is producing only one commodity. Equilibrium of a firm with Marginal Cost and Marginal Revenue Method The total cost incurred to produce a given quantity is called the Total Cost (TC). Now, the addition made to the total cost on account of production of one more unit of output is called the Marginal Cost (MC). Similarly, the revenue received from the sale of a given output is called Total Revenue (TR) and the addition made to the total revenue on account of sale of one more unit is called Marginal Revenue (MR). (i) (ii) Marginal Revenue should be equal to Marginal Cost i.e. MR = MC The marginal cost curve should cut the marginal revenue curve from below at the equilibrium point.

Firm's equilibrium, arrived at by this method is shown in the following diagram : Equilibrium of a Firm MR = MC









Output 198
Managerial Economics

In figure, MC is the marginal cost curve and MR is the marginal revenue curve. Similarly, AC is the average cost curve and AR is the average revenue curve. When OM output is produced, MC and MR curves balance each other at point E. At this point the firm's profits are maximum and the firm is in equilibrium. If smaller output is produced than OM the marginal cost is smaller than marginal revenue, which means that addition to the cost is less than addition to the revenue by producing more output. This means that there is scope to earn more profits be increasing output. Output will, therefore, be increased from OL to OM. When production is OL, average cost is LH and average revenue is LG. Profit per unit is HG. Since there is marginal profit, output will be carried on upto OM. After the point OM, marginal cost would exceed the marginal revenue; and the firm's profit will begin to fall, because more is added to cost than to revenue by increasing output. For example, if ON output is produced, KN is the average cost and SN is the average revenue. There is a profit per unit to the extent of SK, which is less than QD (profit per unit at output OM). Therefore, it would not be worthwhile to produce ON output. The firm should stop production when its output is OM, and its profits are maximum.

Equilibrium of Firm under Perfect Competition :
The conditions equilibrium of a firm are applicable to all the types of markets. i.e. they are applicable to perfect competition, monopoly, monopolistic competition etc. These conditions are i) MR = MC and ii) MC Curve must cut MR curve from below. An attempt is made below to examine the equilibrium of a firm under perfect competition. Equilibrium under Perfect Competition

Cost / Revenue

X Output (units) Under perfect competition, no firm can fix the price or influence it by its own action. Price is determined by the interaction of total demand and total supply in the market. Under these circumstances the firm has to satisfy both the conditions to achieve its equilibrium, viz.,

Pricing and Output Determination in Different Markets


Short . P1 L1 is the average revenue curve . all of them would be in equilibrium. But in the short-run it will not be possible for them to start new firms. the curve PL shows marginal revenue as well as average revenue. Therefore. When price is OP. at point Q the firm is in equilibrium and OM' is the ideal output. it is worthwhile to follow Dr. In particular. The general rule of firm's equilibrium under perfect competition is shown in the figure. Super . (iv) (i) When the firm is obliged to stop production. Here average cost is M'G and profit is equal to GQ. Marshall's classification of time . This firm is earning supernormal profit equal to P1QGH. marginal cost curve cuts the marginal revenue curve from below. Therefore. Since all the firms in the industry are working more or less under the same cost conditions. The fact that the existing firms are earning super-normal profits may attract new producers to the industry. Op1 is the price. 200 Managerial Economics .(i) (ii) Its marginal revenue should be equal to marginal cost. The curve MC shows the marginal cost. In figure. and Marginal cost curve should cut the marginal revenue curve from below. When the firm earns only normal profits.period into short-run and long-run.Run Equilibrium Although we have discussed the general rule of firm's equilibrium under perfect competition. at point R.MC is the marginal cost curve which intersects the average revenue curve at point Q from below. the firm will be in equilibrium when its output is OM and the price is OP.Normal Profits : In figure. (iii) When the firm begins to incur losses. we would like to see how a firm achieves its equilibrium in the following circumstances : (i) (ii) When the firm earns supernormal profits.

Short-Run Equilibrium of a Firm Y MC Q AC L1 (AR) = MR Price Cost / Revenue P1 F H P E R G L (AR) = MR P2 S L2 (AR) = MR O M2 M M1 X Output (units) (ii) Normal Profit : In figure. every firm has to incur some fixed costs on account of bank interest. therefore. because at this marginal cost curve intersects the marginal revenue curve from below. Here. (iii) Losses : In figure. are in equilibrium. a firm would produce more even if it incurs a loss equal to the fixed costs. the firm is in equilibrium at point R and the ideal output is OM. Every firm. a firm can only reduce its variable cost on account of raw materials. every firm takes an optimist view that "half a glass of water is better than nothing". depreciation. OP is the price and PL is the average and marginal revenue curve. the entire industry is in equilibrium at point R. Here. Thus the firm is incurring a loss P2SEF. the firm is making losses because the average revenue of SM2 is less than the average cost of EM2. This is because. when output is OM2. In other. if they continue to produce more. if a firm decided to close down production it can save variable costs. rent etc. words. Therefore. decides to continue to produce so long as it is able to recover its variable costs. This form is earning only the normal profit. but it cannot save fixed costs. both the firm and the industry. which are incurring losses. It is obvious that greater production would mean a grater loss. firms cannot stop their production and cannot avoid losses. insurance. Thus. Pricing and Output Determination in Different Markets 201 . Like this firm. wages and power. there would be no reason for new producers to enter this industry. Since all the firms under perfect competition are working more or less under the same cost conditions. if the price falls to OP2 the firm will be in equilibrium at point S. all the firms would have to incur losses. But at this point. If the firm desires to continue to produce. Some of the firms. it must incur this minimum loss. By stopping the production. Thus in the short-run. But in practice. even if production is stopped. may think of closing down the production.

here the firm is neither able to stop its fixed cost. This price does not cover even the average variable cost. Even in the short-run the firm will have to stop its production.down Production : Closing . 202 Managerial Economics . In the long-run one more thing is. In the long run. i. and a reduction in supernormal profit. under perfect competition in the long-run a firm is in full equilibrium when MR = MC = AC = AR = Price If the price is more than the average cost. necessary. marginal revenue. In the fairly long run. This would be clear form the above figure. price has fallen to P4. price OP3 and output OM2.(iv) Closing . In the short-run a firm reaches its equilibrium when MR = MC. The firm will. however. nor the average variable cost. the firm can change the composition of various factors of production. Because. Thus. have to stop its production at point D.down Production Price Cost / Revenue Output (units) If the price falls further and is less than the average variable cost. Long . therefore. It also finds time to buy new machinery or to implement new techniques of production. In the above figure. This principle is also applicable to the long-run equilibrium. all firms would. the marginal cost. the firm may earn supernormal profits and this would attract new firms to the industry. therefore. average cost and average revenue should all be equal. the firm cannot afford to carry on its production.Run Equilibrium In the long-run every firm gets sufficient time to adjust its output in relation to the demand.e. Entry of new firms would result in a greater production.

This means that equilibrium is established by total supply and total demand in the industry. When ideal size of output is achieved. for equilibrium of the industry size of production should be stabilized at a certain point. if the price is less than the average cost. The price is also fixed by total demand and total supply of the industry. In the following figure. The firm is. marginal cost. If they earn super-normal profits or incur losses. therefore. Similarly. marginal revenue and price are all equal at point E. Conversely. marginal cost will be equal to marginal revenue and the firm would earn only normal profit. Thus. There should be no tendency for firms to increase or curtail their output. the industry as a whole is in equilibrium. it would lead to an entry or exit of firms.earn only the normal profit. The firm's equilibrium under perfect competition in the long run is shown in the following diagram. ultimately. and not by any single firm. in equilibrium in the long run when its output is OM and price is OP. Y Long . when output is stabilized at the optimum point. All the firms would earn normal profits. if demand is less than the supply. Such changes in the output can not take place when the industry is in equilibrium. It is. therefore. Equilibrium of the industry is determined by total demand and total supply. If demand is more than the supply. production may be increased.Run Equilibrium of a Firm Price Cost / Revenue P AR = MR = Price M Output (units) X Equilibrium of Industry When all the firms engaged in an industry are in equilibrium. there is no temptation for new firms to enter the industry and there should be no reason for existing firms to go out of the industry. equilibrium of the industry would be disturbed. output may be curtailed. losses would occur and this may drive some of the firms out of the industry. necessary that. Pricing and Output Determination in Different Markets 203 .

Buyers and sellers do not possess perfect knowledge and the products sold are no more homogeneous. In the long-run equilibrium of an industry. there should be no close substitutes for the product of the monopolist. the following conditions must be satisfied : (i) (ii) (b) One firm producing in the market. where there is only one producer. Impure Monopoly Impure or simple monopoly exists in the market of a commodity. the industry as a whole is also in equilibrium. imperfect competition is further classified under the following heads : 1) Monopoly 2) Monopolistic Competition 3) Monopsony 4) Oligopoly 5) Duopoly 1) Monopoly : The other extreme type of market. (B) Imperfect Competition : In the real world. Depending on the number of sellers operating in the market. Managerial Economics (ii) 204 . perfect competition is seldom realized. markets all over the world have become imperfect on account of several factors. where there is only one producer of the commodity. They are often differentiated as to their size. because in the long run every firm is earning only the normal profit. The number of buyers and sellers is also small. design and colour. output is stabilized at an optimum or ideal size and there is no entry or exit of firms. (c) The following features are seen under simple or limited monopoly : (i) Single Producer : For monopoly to exist only one producer should be in the market. What we experience is the imperfect competition in its several forms. the Government or a Joint-stock Company. The commodity produced should have no substitute. it is called Monopoly. the distinction between the firm and the industry does not exist under monopoly. is the one where there is absence of any competition. is equal to marginal revenue. (a) Pure and Perfect Monopoly For pure monopoly to exist.Conclusion It will be seen form the foregoing discussion that a firm maximizes its profit and achieves an equilibrium position when its marginal cost. No Close Substituties : To avoid any possibility of competition in the market. This is a situation. This means that the cross-elasticity of demand for the monopolists product is low. a partnership firm. Since there is only one producer. The producer may be an individual. and the commodity has no close substitute. When all the firms in an industry are in equilibrium. In the 20th century.

or change it. Indeed. The demand curve for a firm (which means the industry under monopoly) is downward sloping. Since there is the only producer and a seller he can fix the price of his product. supply of cooking gas and electricity and such other public utilities are usually managed as monopolies. It is beyond the scope of an individual seller to influence the price by his own action. under monopoly there is only one seller who is free to fix the price. In order to maximize his profit. On the other hand. On the other hand. Y AR/Price AR/Demand Curve O X Units of output The Demand Curve Under Monopoly Under monopoly.(iii) Barriers to entry of firms : The basis of monopoly is the barriers or restrictions of new firms into the market. all buyers are put at the mercy of the monopolist. It is the monopolist who is the price-maker in the market. it is a case of an Artificial Monopoly. (iv) Demand Curve under Monopoly : the above features explain the demand curve or the average revenue (AR) curve under monopoly. Many times. (a) Under perfect competition. there is only one seller who controls the entire supply in the market. he may raise the price frequently. He may exploit the consumers by charging an exorbitant price. Since there are no sellers. if a producer acquires monopoly on the basis of Patent Laws. 205 Pricing and Output Determination in Different Markets . No individual seller or buyer is able to fix or change the market price. these can either be natural barriers or artificial barriers. Such monopolies are called Natural Monopolies. there are many buyers and many sellers. (d) Distinction between Perfect Competition and Monopoly : Monopoly differs from perfect competition in the following important respects. monopolies are created under Law. The price under perfect competition is fixed by the interaction of total demand and total supply in the market. the buyers have no alternative than to buy from the monopolist. whenever he likes. Urban transport.

Since there is only one seller. total output in the society is larger and the price charged is also reasonable. and he can raise the price any time. But under monopoly. Under perfect competition there is free entry and free exit of firms. and so the MR curve is below the AR curve The conditions of equilibrium are the same as under perfect competition. The demand curve (AR curve) is therefore. Under monopoly. however. given the output. a firm can therefore fix the price of its product. i. Ultimately. (c) (d) (e) (f) (e) Determination of Price and output (Equilibrium Under Monopoly) : Marginal Cost and Marginal Revenue : Under monopoly. and the customers have no other alternative than to buy from the same monopolist. downward sloping under monopoly. a firm can earn only the Normal profits in the long run. Under perfect competition. the entry of new firms being prohibited. If it earns supernormal profits. If a particular firm charges a slightly higher price the customers would turn to other sellers. because the monopoly of railways has been entrusted to the Indian Railways. there is only one seller. 206 Managerial Economics . and all of them are selling homogeneous products. the firm would earn only the normal profit. average cost is much lower than the price. the monopolist can earn supernormal profits in the long run. the monopolist can earn supernormal profit in the long run. average revenue and price.e. average cost is much lower than the price. firm and industry is the same under monopoly. Since there many firms operating under perfect competition. marginal revenue. For example. there will be entry of new firms and this profit would be shared by all the firms. total output is smaller and the price charged is unreasonable. Since under monopoly.(b) Under perfect competition there are many firms in an industry. Under perfect competition a firm attains its equilibrium when marginal cost is equal to average cost. Under perfect competition every seller is charging the same price in the long run and is making normal profits. the firm is a price-marker. but under monopoly the distinction between firm and industry receeds in the background. But under monopoly entry of new firms is prohibited. in India no new firm can be started to deal in railways. But under monopoly. There are no hindrances to the new producers who desire to enter the industry. But under monopoly.

A monopolist making sub-normal profits will remain in production in the short-run so long as its AVC is A monopolist can make either normal profits or supernormal profits in the short-run. OQ1 is the equilibrium output and OP1 is the equilibrium price. E1 is the point of equilibrium. Thus. AC = A1Q1 AR = A1Q1 207 Pricing and Output Determination in Different Markets . Y Price Cost / Revenue Normal Profits MC A1 AC P1 E1 AR MR O Q1 Output (units) Normal Profits X In the figure.MR = MC and MC curve cuts MR curve from below. there are three possibilities as shown below. in the short-run under monopoly. Y AR MR MR O AR X Output (units) Short .

the firm makes Super. E2 is the point of equilibrium. OQ2 is the equilibrium output. OP2 is the equilibrium price. the firm makes normal Profits.AC = AR. AC = A2Q2 AR = R2Q2 AR > AC. Sub-Normal Profits Covering AVC Price Cost / Revenue 208 Managerial Economics .Normal profits equal to the area given by P2R2A2C2. Super-Normal Profits Price Cost / Revenue A2 Output (units) In the above figure.

AC = C0Q0. AR = R0Q0. AVC = R3Q3 AR < AC. OQ0 the equilibrium equilibrium under Monopoly A firm under monopoly may make normal profits in the long-run. Pricing and Output Determination in Different Markets 209 . therefore. but the conditions of equilibrium are the same as in the short-run. OQ3 is the equilibrium output. The LRAC is flatter than the short-run average cost curve. E0 is the point of equilibrium.normal profits equal to P0R0C0P. He can discriminate between buyers and charge different prices to different customers. This is called Price Discrimination or Discriminating Monopoly. it tries to make super-normal (abnormal) profits in the long-run. it continues to produce in the short-run because AVC are covered. There is a second alternative open to the monopolist. a monopolist fixes the price of his product so as to maximize his profit. be made to explain how price discrimination is practiced by the monopolist. An attempt should. A Fig showing Long Run Equilibrium under Monopoly Y LRMC Price Cost / Revenue Po P Ro LRAC Co Eo AR MR O MC Qo Output (units) (f) Price Discrimination Under Monopoly : INTRODUCTION By following Trial and Error method. AR > AC so the firm makes super . the firm makes sub-normal profits equal to C3A3R3P3. however. Long . OP3 is the equilibrium price. AC = A3Q3 AR = R3Q3. OP0 equilibrium price.In the figure. Even though the firm makes losses. E3 is the point of equilibrium.

for the similar operation of a rich patient. All the viewers see the same movie. cooking gas supply companies are allowed under Law to charge different prices to different classes of consumers. a monopolist can charge different prices to different segments of markets so as to maximize his profit. The monopolist may charge a lower price to the poor and middle class people whereas he may charge a higher price to the rich customers. Charging different prices to different customers for the same product is called Price Discrimination. but the fees charged to different patients are different. In 210 Managerial Economics . (2) When is Price Discrimination Possible? Charging different prices to different customers is rendered possible in the following circumstances : (a) Legal Sanction : Public utilities such as railway or electric supply companies. Similarly. whereas another market segment may be inhabited by the rich. Similarly. But they have to pay different fares for traveling by II class. Examples of price discrimination are many. this difference is negligible. As a matter of fact. Similarly. I class or AC class. Difference in the prices charged is. second class and air-conditioned class passengers.(1) What is Price Discrimination? Instead of charging a uniform price to all the consumers a monopolist may divide the market into different classes of people. whereas he may charge a lower fee to a poor client for a similar court litigation. but they have to pay a higher price for occupying a seat in the first class or balcony. different prices are charged by a cinema house for different classes of viewers. Although there is some difference in the comforts provided to different classes of customers. an advocate may charge very high fees to a rich client. Thus. however. A surgeon may charge Rs. 10000/. the passengers in different compartments reach the destination at the same time. an electricity company can charge lower rates for domestic consumption and higher rates for commercial consumption. whereas he may charge Rs. Thus a surgeon may charge a lower fee for operation of a poor patient than a rich patient for similar operation. The skill used in both the operations is the same. 5000/. Railway companies also charge different fares to first class. substantial. One market segment may consist of poor.for operating a middle class patient. (b) Nature of Commodity : Price discrimination is possible where personal service sold to the customers cannot be resold. (c) Geographical Barriers : If two markets are separated from each other on account of geographical barriers it may enable a monopolist to charge different prices in two different markets.

If buyers in one market know that the price charged in another market is lower. This will lead to equality of price in both the markets and price discrimination would no more be possible. a firm is in equilibrium when its marginal cost is equal to marginal revenue. No possibility of resale of the product. (3) Conditions of Price Discrimination The foregoing discussion should explain the situations when price discrimination is possible. Sometimes. but the difference in price being negligible they may not go to the other market. For price discrimination to be successful the following conditions should be fulfilled : (a) The two markets in which the product is sold should be kept separate. Price discrimination may not be possible if elasticity of demand is the same in both the markets. In other words. Market must be imperfect. (b) (c) (4) When is it Profitable? Having known the conditions of price discrimination. There should be no contact between buyers in the two markets. The elasticity of demand in different markets should be different. This would make our analysis complicated but it does not affect the basic principle of equilibrium. It is likely that the customers may know that a lower price for bertter quality of goods. markets are separated by raising the protection wall and different custom duties are charged on the imports from different countries. it is worthwhile to know when it is profitable to the trade. (5) Conditions of equilibrium under price-discrimination (a) MR = MC (B) MRA = MRB where A and B are two markets. One more assumption is that the elasticity of demand in two different markets is different. they would buy the product in another market and sell it in their own market. The principles which apply to the equilibrium of a firm are also applicable in this case.e. viz. i. Ignorance of consumers thus enables the monopolist to charge different prices. An additional assumption to be made here is that the monopolist is selling his product in two different markets. (d) Ignorance of Buyers : Price discrimination is possible if the consumers in one market do not know that a lower price is charged in another market. it is necessary to study the position of equilibrium when the monopolist maximizes his profit. Pricing and Output Determination in Different Markets 211 . It is likely that the customers may know that a lower price is being charged in another market. This may enable the monopolist to charge different prices in different markets. the consumers may exhibit an irrational feeling that they are paying a higher price for better quality of goods.

therefore. E2 is the point at which MC = MR which is related to MR2. OQ2 is the output sold in market B and at price OP2. OQ is the total output of the firm. total profit earned by the monopolist is maximum and he is in equilibrium. E is the point of equilibrium where MR = MC. The monopolist would. The volume of sales in market A would remain more or less the same. The monopolist would. 212 Managerial Economics . responsive to the changes in price. this loss would be compensated by an increase in sales in market B. on account of reduction in the price. on account of reduction in the price would increase the sales. the monopolist would have to divert the supply form market A to market B. therefore. A pertinent question that arises here is that how long supply would be transferred form market A to market B ? the answer to this question is that the supply would be diverted so long as the marginal revenue earned in market B is higher than the marginal revenue earned in market A. In figure 3.e. raise the price in market A and would reduce it in market B. If sales in market A are slightly reduced on account of higher price. let us understand when price discrimination would be profitable. The volume of sales in market A would remain more or less the same. The transfer of supply from market A to market B would be stopped when marginal revenue in both the markets is equal. On the other hand. At this point. This is to be sold in the two markets at different prices. Let us presume that the monopolist sells his product in market A and market B. His sales in this market would not be affected because demand is inelastic. a slight reduction in the price would increase the sales. Demand in market A is inelastic or rigid and demand in market B is very elastic i. In Market B. but sales in market B will increase. raise the price in market A and would reduce it in market B.On the basis of these assumptions. Under such circumstances the monopolist would raise the price in market A. Naturally. market A with relatively inelastic demand and market B with relatively elastic demand. (6) Equilibrium under Discriminating Monopoly Y Price /Cost/Revenue Price /Cost/Revenue Y Price /Cost/Revenue Y MC C P1 E1 AR1 MR 1 P2 E2 E MR AR2 MR 2 O Q1 X O Q2 X Output O Q X Output Output Market A Market B Total A+B (figure 3) Consider two markets. the demand in market B being elastic. but sales in market B will increase.

Under the third degree. and the sales in market A are lower than the sales in market B. he may classify the customers into the rich. it is called Dumping. Thus. it leaves some surplus to other consumers who are relatively better off than others in that group. (7) Dumping Where monopolist is charging a higher price in the home market and a lower price in the international market. middle class and poor customers. Under the second degree of price discrimination the monopolist does not charge different prices to individual customers. by the Government of India.In Market A. different prices are charged in different markets. The price in market A is higher than the price in market B. Therefore. he classifies the customers into certain groups according to the level of their incomes. increases because of price-discrimination. He charges different prices to different groups of people. The example is provided by dumping where a lower price is charged in the international market and a higher price is charged in the home market. E1 is the point at which MC = MR which is related to MR1. Instead. The Indian exporters are selling their products abroad at lower prices. If the monopolist is unable to recover his losses he is given a subsidy or an Export Bounty. In Dumping. This does not leave any consumer's surplus to the buyers. C. The losses they incur in foreign markets are converted in the home market where higher price is charged. however. there are three degrees of price discrimination. The total revenue to the firm. the monopolist charges the highest price. The incentive of export bounties has contributed to higher exports and earnings of foreign exchange. OQ1 is the output sold in market A sold and at price OP1. the losses incurred in the international market are compensated in the home market. I class and Air-conditioned class passengers. Pigou. According to him. An example of this degree is provided by a surgeon or a barrister who charges the maximum fees. OQ = OQ1 + OQ2. dumping is encouraged with a view to promoting the exports. (8) Degrees of Price Discrimination The degrees of price discrimination have been elegantly shown by Prof. 213 (b) (c) Pricing and Output Determination in Different Markets . A. The example of this type is provided by a railway company that charges different fares to II class. Under this degree. Thus. In India. (a) Under the first degree. The weapon of dumping is successfully handled by the monopolist. the lowest price which the poorest customer from every group can bear is charged.

the product so introduced in the market is not new. They different. Professor Chamberlin has elegantly shown the methods used by such monopolistic producers. adds to the profit of the monopolist. Lux may be used by one popular actress. therefore. This is called Product Differentiation.Features (i) Fairly Large Number of Firms The number of sellers operating under this type of competition is larger than under oligopoly but less than under perfect competition. sells bathing soaps under different trade marks such as Lux and Rexona. This competition is. style. Every seller has to compete with others to increase his sales. When such monopolistic producers are competing amongst themselves. design and colour. by changing the outward appearance of the product. For example. As a matter of fact. Hindustan Lever Ltd. he acquires monopoly of that product. and adds to the total output than the output under pure monopoly. it does not differ in quality and the process of manufacture. the general public is made to believe that it is a new product. Such price discrimination. Since every seller is selling a standardized product for a long time. called cut-throat competition and the methods followed are called 'Beggar thy Neighbour tactics'. Basic contents and ingredients in both the soaps are the same. The same old product is sold under a different trade name. (a) (b) (c) adds to the power of the monopolist. It is worthwhile to outline the salient features and the methods of monopolistic competition. every seller tries to distinguish his product from the products manufactured by others. the sellers have to find out different methods to maintain their sales and profit. It is also practiced under dumping where different prices are charged in international and the home market. Most of these methods are hazardous and each seller tries to be rich at the cost of others. 2) Monopolistic Competition . He claims that his Research and Development Department has developed a new product after considerable research. Thus. There may be 20-25 sellers engaged in the same line of business. whereas Rexona may be used by another popular actress Managerial Economics 214 . They are producing commodities which are close substitutes for each other. The competition being very keen. Basically.(9) Conclusion Thus a monopolist can practice price discrimination by charging different prices to different customers. (ii) Product Differentiation Under monopolistic competition. it is called monopolistic competition. But the people are fooled by stating that it is a product different than the old one.

Pricing and Output Determination in Different Markets 215 . (v) Elastic Demand The Average Revenue Curve of a firm under monopolistic competition is not parallel to the X-axis as it is under condition of perfect competition. a firm’s product does have close subsitutes. under monopolistic competition. not in their contents. throughout the year. a single uniform price cannot be established in the market characterised by monopolistic competition. radio. similar products which are differentiated by brand names and advertisements are sold at different prices. there would a sizable increase in the sales of the firm. On the contrary. on the other hand. hoarding. Whether he likes it or not. or transport costs or ignorance of market. Under monopoly. So it is not possible for a firm to sell an infinite amount of the product at the ruling price as it is assumed to happen under perfect competition. Every producer enjoys the freedom to price his own product. Every producer therefore attempts to spend more than his rivals. he has to spend huge amounts on publicity. Under monopolistic competition. (iii) Selling Costs Every producer operating under monopolistic competition spends huge amounts on publicity. Such a method of product differentiation helps the producers under monopolistic competition to increase their total sales. Differences thus exist only in outward appearance. the Average Revenue Curve of the firm is steep because there are no close substitutes for the product. This is because when others are spending. if a firm reduces the price of its product while prices of rival products are unchanged. He follows all the media of advertising such as press. Every effort is made to keep the product before the eyes of the consumers. the products of all firms are not identical. (iv) Multiplicity of Prices Due to factor-immobilities. Thus. neon signs etc. the Average Revenue Curve of a firm is not parallel to the X-axis as it is under perfect competition. he cannot afford to lag behind in the race. buyers can have preferences. the AR Curve faced by a firm under monopolistic competition is shallow indicating a highly elastic demand. Therefore. Under perfect competition. television. the Average Revenue Curve cannot be steep. this freedom is within certain limits. Because. Every producer has his own price-policy. this freedom is not available to an individual firm.from the films. and therefore. sites. Therefore.

Price reduction is sometimes carried to such an extent that it takes the form of a price war. In these days. The Scindia Steam Navigation Company Limited was started by Seth Walchand Hirachand on the 19th June 1919. Babul. the company made good progress. He purchased a second-hand ship called S. This enables a producer to achieve a substantial increase in sales within a short-time. the British shipowners reduced the freight charges. shipping industry was controlled by the British and the British ship-owners did not like that an Indian company should come up to share the profits. Instead of reducing the price. therefore. S. however. They thought that the Scindia would not be able to withstand the shocks of the price war. Naturally. harmful to all the sellers because it reduces the profits of all. In course of time. they hand over small gift articles to the buyers who buy the product. In order to extinguish the Scindia Steam. The gift scheme is operative only for a limited period and it is advertised in the newspapers on a large scale. Since many customers participate in the contest it results in an automatic increase in sales within a short time. acquired more fleet and began to compete with the British Shipping Companies. Producers working under cut-throat competition have. to a buyer who buys the tooth-paste. In order to attract new customers. found out a novel method of increasing the sales. The reduction in freight rate went to such an extent that the British shipowners began to advertise in the newspapers that they were prepared to carry the cargo from Bombay to Rangoon free of charge. In order to increase the sales. Loyally and started the voyage. a particular company may hand over a tooth-brush free. Promise. The Scindia too was required to reduce its freight. 216 Managerial Economics .(vi) Price War Another method followed to extinguish the rivals from the market. but the Scindia could manage in such critical times and could come up as the nation's largest shipping company in the private sector. a particular producer may reduce the price of his product. For example. other producers are required to reduce their prices in order to retain their customers. is a reduction in the selling price. Companies like Nescafe or Cadbury organize cross-word competitions. Cibaca etc. An essential condition for submitting an entry form in the crossword contest is that a certain number of used wrappers are to be attached to the entry form. there are many tooth-paste manufacturing companies such as Colgate. Palmolive. An example of price war is provide by the Indian shipping industry. (vii) Gift Articles Price war is. Close-up.

Government departments may institute raids on the prosperous producer. Some of these methods may be described in brief. the methods followed under cut-throat competition are hazardous. different brands of alcohol. who has snatched away the engineer. harmful and immoral. are produced under the conditions of monopolistic competition. They may get hold of the Union Leader in the prosperous company. is able to produce high quality products. cigarettes. therefore. help the rivals to gain control over the market. (1) Determination of Price and Output under Monopolistic Competition : The foregoing account would indicate how monopolistic competition is characterized by product differentiation. This may lower his reputation and he might be extinguished form the market. different brands of body talcum powder. a number of unfair methods are used to extinguish the rivals from the market. Products like tooth paste. by paying them higher salaries. tooth brush. snatch away key persons from his factory. when the Chief Production engineer is snatched away the quality of goods is deteriorated and the firm loses its control on the market. contains elements of both monopoly as well as competition and therefore it is called monopolistic competition. They pass on false information to the government departments. Thus. fixing the price he has to take into (b) (c) Pricing and Output Determination in Different Markets 217 . detergents. Thus. Before. selling costs. Every producer operating under monopolistic competition is selling his product under a particular brand or trade name. The rivals may try to lower the reputation of the prosperous producer. may gain control on the market. the market form with characteristics noted above. soaps. sales tax and income tax. Thus. and may ask him to arrange a strike. Other producers who cannot compete with him may. The other producer.(viii) Unfair Methods Under cut-throat competition. (a) A producer who maintains a skilled and qualified staff. This would affect the production schedule of the prosperous company and at the same time. price war and unfair methods. On the basis of quality he can capture the whole market within a short time. It is worthwhile to see how price of a product is determined under monopolistic competition. A firm which has prospered becomes a target of attack by the rival producers. cosmetic etc. They may make several allegations that the prosperous producer is evading excise duty.

This would be clear form the following diagram : Short . Here. is free to fix his price. remain constant. fixed in this manner. This profit is supernormal. Short-run Equilibrium under Monopolistic Competition Under monopolistic competition. if the competitors have reduced their respective prices. A producer who has introduced a new product in the The producer may be required to reduce his price. therefore. Similarly. A firm's profit is maximum and the firm is in equilibrium when its marginal cost is equal to marginal revenue. he cannot fix it without taking into account the prices charged by rivals. An existing firm can also incur losses in the short. under monopolistic competition. worthwhile to see how price is fixed and the equilibrium position is reached under monopolistic competition in the short-run. It is. The price.account the prices of substitutes. If the position of demand and cost is unfavorable. would necessarily fix the price which is lower than the price charged by his rivals. however. The profit is shown by the shaded area.Run Equilibrium Under Monopolistic Competition : Profit In figure. the price is OP and the total profit is TSPP'. The price policy under monopolistic competition is thus dependent on the prices charged by other rival firms. equilibrium of a firm is arrived at in the same manner as under other forms of competition. AC is the average cost curve and MC is the marginal cost curve. the firm may incur losses as shown below : 218 Managerial Economics . may not. The prices charged by rivals enable him to fix his price. Although an individual producer. MR is the marginal revenue curve and AR is the average revenue curve.

Thus. and the excess profits would be shared between existing and new firms. because new firms may be attracted to the industry. AC is the average cost curve and it is higher than the average revenue curve AR. Long-run Equilibrium under Monopolistic Competition The supernormal profit earned by a firm may not last long.Losses under Monopolistic Competition Y MC T S E AR MR O X Output AC P P1 In figure. The marginal revenue curve is. therefore. therefore. The following figure would show how the firm would earn normal profits under long-run equilibrium. in the short-run a firm working under monopolistic competition can earn supernormal profit as well as incur a loss or may earn normal profits. elastic. disappear in the long-run. Long Run Equilibrium under Monopolistic Competition Y Cost/Price/Revenue MC T AC P E AR MR X O M Output Pricing and Output Determination in Different Markets 219 . Another characteristic of long term equilibrium is that a number of substitutes are available in the market. The supernormal profits earned in the short-run would. Here the firm would incur a loss of STPP'.

The average cost curve touches the average revenue curve at point T. we would. MC is marginal cost curve and AC is the average cost curve. Thus. At this price and output the firm's profit is maximum and it is in equilibrium. However. 220 Managerial Economics . The number of sellers is large and there is free entry and exit of firms. We have now to see how and when the equilibrium of all the firms is reached. but are differentiated from each other. For the sake of simplicity of analysis. OM is the ideal output and OP is the price. whereas under monopolistic competition output is much less. Similarly. The share of every firm in the total sales is equal. All firms are working with same efficiency. the supernormal profits earned in the short-run will disappear in the long-run. All the firms would then earn only the normal profit as shown in figure. MC = MR. therefore. difficult to analyse the conditions of group equilibrium where different firms are selling different products. AR is the average revenue curve and MR is the marginal revenue curve. (3) Comparison of Long-run Equilibrium under Perfect Competition and Monopolistic Competition Both under perfect competition and under monopolistic competition the firm makes normal profits in the long-run. Naturally. It is therefore. output is very large. make the following assumptions : (a) (b) (c) (d) Competing firms are selling more or less the same product. The only difference is that under perfect competition. Under these assumptions. This will compel the old existing firms to reduce their prices. This is seen clearly in figure. let us see how group equilibrium is reached.In figure. the long-run group equilibrium would be reached. At point E. These products are not homogeneous. when all the firms are earning normal profit. (2) Group Equilibrium under Monopolistic Competition We have seen how equilibrium of a firm is reached under monopolistic competition. This position is similar to the one prevailing under perfect competition. The new firms would charge a lower price so as to secure some customers. Under monopolistic competition the number of sellers is large and each seller is selling his product under a particular Trade name. the price-output situation is different in the two cases. If these firms are earning supernormal profits in the short-run new firms may be attracted to the industry. Another point of distinction is that under perfect competition an inefficient firm is thrown out of the industry whereas under monopolistic competition even an inefficient firm can survive.

average revenue is falling) MRm (marginal revenue is below the average revenue. Full capacity used up because equilibrium output is optimum output. (ARp = AC . Firm makes normal profits. 4. OPm equilibrium price is more than OPp price under perfect competition. 8. ARp = MRp (i. Perfect Competition 1. Firm makes normal profits. Pricing and Output Determination in Different Markets 221 . Waste of capacity is equal to Qm Qp because equilibrium output is less than optimum output.LRAC 7. 4. OQp > OQm Output under perfect competition is more than output under monopolistic competition. (also optimum output because LRMC is minimum at this output). (ARm = AC = E1Qm) at OQm output. 6.Y RMC Cost/Price/Revenue RAC Pm Pp E1 Ep ARp = MRp Em MRm O Qm Qp Output ARm X The description of the figure showing the comparison between Long run equilibrium under perfect competition and monopolistic competition is as below. Firm is in full . 8. OQp equilibrium output.Ep Qp) at OQp output. 3. average revenue equals marginal revenue) 2.e.) Em equilibrium where LRMC = MRm OQm equilibrium output (less than optimum output OQp) OQm < OQp Output under monopolistic competition is less than under perfect competition. 2. 7.e." Firm not in full equilibrium. 1. 5. 5. "Wastes of competition. OPp equilibrium price is less than price OPm under monopolistic competition. Ep equilibrium where LRMC = MRp 3. 6. Monopolistic Competition ARm (i.equilibrium ARp = MRp = LRMC .

The following are the features of Oligopoly : (i) Small number of Producers : The small number of firm dominates the market of the commodity. An extreme case of Oligopoly is Duopoly since Duopoly is an extension of an oligopoly market.Control : Firms under oligopoly / duopoly are mutually dependent. However. that. 3) Monopsony Another type of imperfect competition is called Monopsony. the long . computers are firms which differentiate amongst their products. The buyer is influential and determines the price of the product. He may exploit the sellers by offering a very low price. there are restrictions to the entry of new firm into the industry. generally produce homogeneous products. (iv) Advertisement : If product differentiation exists. where only two firms exist in the market. Price . firms producing automobiles. A few firms exist in the industry. However. In Duopoly. it becomes necessary to advertise the firms product. entry is not impossible under Oligopoly / Duopoly but it is difficult. therefore. Monopsony is the opposite form of Monopoly. the number of firms is two. Under Monopsony. (ii) (iii) Restrictions to Entry : Under Duopoly and Oligopoly. This is done to convince the buyers about the superiority of the product over the products of rival firms. there are many sellers but only one buyer. (v) 222 Managerial Economics .run price is lower and output is higher under perfect competition as compared to under monopolistic competition. 4) Oligopoly and Duopoly : Oligopoly is a type of imperfect market. Since there is only one buyer the CCI can influence the prices of cotton. Product may be homogenous or there may be product differentiation : Duopolistic or Oligopolistic firms producing raw materials or intermediate products. copper or any other metal. This means that firm under Oligopoly are mutually dependent on each other. the production of coal. Each firm has a large share of market supply. all firms action results in a reaction of other firms in the market.We can the conclude. An example of monopsony in India is provided by the Cotton Corporation of India who purchases all cotton grown by the farmers. it is not necessary to discuss its features separately. if the products are homogeneous advertisement may take the form of informative advertisement. Thus all firms actions results in the reaction by other firms. as for example. These restrictions are generally financial or technological in nature. whereas. These firms are also dependent on each other.

If one firm reduces the price of its product.Duopoly are mutually dependent. the demand curve under Oligopoly. if a firm increases the price of its product. To start with. The first firm will therefore. If any firm tries to increase the price of its product above OP. the demanded curve (KD2) is therefore. is a kinky demand curve. that prices tend to be sticky or rigid under oligopoly / duopoly. The first firm will again reduce its price. If however. lose its customers. The quantity demanded of the firms' product would increase less than proportionately. This results in a large fall in the quantity demanded of the firm which increases the price of its product. This explains that prices tend to be rigid at OP under Oligopoly / Duopoly. Thus. Price tends to be rigid at the kink. This process can continue till the price falls even below the cost of production. therefore. other firms will also reduce their prices and there would be a price war. other firms will not react. there is a tendency that one of the firms not reducing its price to start with. Similarly. relatively inelastic.war. other firms will follow. (vi) Demand Curve under Oligopoly / Duopoly : Y D1 P Price (AR) K D2 O Quantity Demanded X Demand Curve under Oligopoly Since firms under Oligopoly . Pricing and Output Determination in Different Markets 223 . a firm reduces the price of its product. The demand curve (D1K) is thus relatively elastic. The above explanation leads us to the conclusion. the first firm will not increase its price. there is a situation of action and reaction by firms. Thus. K. the other firms will again follow. other firms will not follow. This situation is called a price .

e. Paul Sweezy's model is perhaps the most popular one and hence we shall consider that one model only. Oligopoly prices therefore are found to be rigid. is preferred to a price competition. If he raises the price his rivals would not follow suit and would do the same thing quickly.More about Equilibrium under Oligopoly : Oligopoly. service. Producers of differentiated products in oligopoly are actually free to set their own prices. This model provides an explanation of price . Y D P AR. sales . This is so because a price-cut initiated by any one firm can trigger off a chain of reactions. why price is not changed. See figure given here. at a price higher than the customary one. Ultimately all stand to lose.war may start. A characteristic feature of oligopoly is that any change in the output or price of one firm almost always provokes retaliation from other producers.promotion etc.rigidity. is a market structure in which a small number of large firms producing either homogeneous or differentiated products dominate an industry. DD1 is the demand curve which is more elastic in the portion DP1 and less elastic in the portion P1D1. demand is seen to be highly elastic. Various models have been suggested to demonstrate the equilibrium and price . Prof.MC P1 H MC1 MC D1 R Q Output MR O X Figure showing Oligopoly Equilibrium: Kinked demand curve model 224 Managerial Economics . the demand is seen to be highly inelastic. i. while at a price lower than the ruling one. A price . The individual oligopolist sees the situation somewhat like this. Under such circumstances non-price competition on the basis of quality design. As a result. All the firms may come together to form a cartel or they may openly or tacitly accept the price leadership of the largest firm or firms may enter into non-price competition or a situation of price rigidities may prevail. as we have already noted. In this diagram. A price-cut once introduced is not reversible.MR.and output determination under oligopoly. But experience shows that they try to maintain status quo. This reaction can take many forms.

are produced in oligopolistic conditions. MC1 cut the discontinuous portion HR of the MR curve so as to give the same equilibrium output OQ. These issues are as follows : (a) (b) (c) (a) Selling Costs Non . MR = MC.The equilibrium condition is the profit maximizing condition i. Due to such differences in profitability. for example. A determinate economic explanation as a guide to policy is therefore not possible though broadly one can describe how output and pricing policies are determined by the oligopolists. the price would be determined by the joint MC and MR curves of all firms taken together. If the product is homogeneous. Some firms may earn profits and other may earn only normal profits. Selling Costs can Pricing and Output Determination in Different Markets 225 . Rivals use advertising quality changes. At times. competition. A change in the price is usually effected by the price . It is this gap HR that explains price-rigidity. All the firms would then adjust their individual supplies to the cartel price as given. and if it is a perfect cartel. The marginal revenue curve (MR) is discontinuous between points H and R.leader and others follow suit.Price Competition Wastes of Monopolistic Competition Selling Costs : (i) Meaning : Selling cost is the cost of increasing the sales of the firm. we can find out the profit maximizing output. a range a prices may move together. a single model cannot explain its price and output equilibrium.e. bathing soaps. in India. The price therefore remains unchanged at OP though costs rise or fall. Miscellaneous Issues in Monopolistic Competition : Having discussed the determination of price and output under monopolistic competition we are now required to study some miscellaneous issues. According to the usual condition MC = MR. Price Leadership is another possibility when there is one big or established firm. If the second option of a cartel is chosen by the oligopolists. washing soaps. To conclude. etc. cartels do not last long. Thus. Non-price competition makes things more complex. It is the cost which the firm bears in order to try to increase the demand for its product. Note that the DD1 curve is the AR curve. one price may get fixed. we can say that oligopoly is more common but since it can take various forms. it sets the price and others accept that price for adjusting their supplies. If products are differentiated.range. therefore. cigarettes. But this arrangement also cannot satisfy all. electric fans. and a particular grade of the product is priced between a certain price . profits are pooled together and are then distributed. Marginal cost curves like MC. therefore.

cost on exhibitions. thus the ASC curve is a U-shaped expenditure. in order to promote its sales. thus any expenditure which the firm makes. cost on attractive wrappings.managers and sales. It is the producers who have to make the consumers aware of their needs. This is done through selling costs. a large amount is used for promoting sales and the firm can employ experts to increase its sales or Managerial Economics 226 .shaped : Y Selling Cost O S1 Quantity Sold X As the sales of the firm increase. Selling costs include not only cost on advertisement (which forms a large part of selling costs).representatives. (ii) Selling . Sales promotion includes not only taking 'orders' for their goods but also creating demand for their goods.cost curve is U .. gifts. the average selling cost (ASC) first decreases (upto OS1 sales). but also salaries of sales .competition. Many times the consumers do not know what they need. and then the ASC increases (after OS1 sales). Total Selling Cost ––––––––––––––– Quantity Sold ASC = ASC decreases upto OS1 sales because of (i) Economies of specialization : As output and sales increase. Selling costs is a feature of an imperfect market condition. is selling cost. it is assumed that the consumers have perfect knowledge about the market and thus the concept of selling costs is not relevant under perfect competition. show . Under conditions of perfect .be looked at the cost borne by the firm to convince the consumer to demand one commodity instead of another. In effect it means that the cost borne by the firm to 'create' demand for its product is the selling cost. etc.

it can advertise through mass media. The ASC increases. and so the expenditure on sales increases but sales do not increase much. Counter . slowly has an impact on the minds of the consumers and the sales increase. increases. If a consumer likes a particular (2) Pricing and Output Determination in Different Markets 227 . initially it does not influence the minds of the consumers. where the fashion and styles charge. like clothes. ASC increases beyond OS1 sales because of (i) Difficulties in trying to influence the buyers' preferences : Once the weak consumers are influenced.expenditure increases. also have to resort to advertisement. like machines. (ii) (iii) Factors influencing selling costs : (1) (2) Type of Product : With product differentiation. the psychology of the consumers. his competitors are affected and they try to defend themselves by advertising their product.advertisement by competitors : Once a producer reaches a high level of sales. the sale . Other factors : The number of competitors. Technology changes : Firms producing commodities. So. the original demand curve DD shifts to the right to D1D1. These methods of promoting sales are expensive but the sales increase to an extent that the average selling cost (ASC) decreases. (1) The demand curve shifts to the right : Selling costs result in higher quantity being demanded at every price. have to bear large selling costs. but this is of the informative type. it is difficult to influence the more 'hardened' consumers (who are already using another brand of the product). cosmetics. The demand curve becomes relatively inelastic (Steeper) : Selling Costs result in consumer preferences being stronger. Introduction of new goods : Firms producing commodities. The ASC therefore. The producer now has to spend more money to increase the sales. But repeated advertising. And ASC decreases. (3) (4) (iv) Selling Cost and the Demand (Average Revenue) Curve of the firm : There are two effects of the selling costs on the demand curve of a firm. the elasticity of demand and promotional elasticity of a product also affect the selling costs of a firm. (ii) Economies of repetition : As a firm advertising.

The demand becomes relatively inelastic (Steeper). a charge in the price of the product will not affect the quantity demanded of the product. The reduction in price may go to such an extent that it may become a price war.brand of a product. (b) Non .Price Competition : We have seen earlier that under monopolist competition the sellers reduce their prices in order to attract new customers. Y Price per unit X Quantity Demanded Effect of Selling Costs on the Demand Curve of a firm The average cost curve of the firm.on to the consumers in the form of a higher price of the product. Since this type of competition is based on price reduction. the demand for the firm's product becomes relatively inelastic. it is called ' price competition'. In the figure the original demand curve DD is less steeper (less inelastic) than the new demand curve D1D1. This is possible because through selling costs. 228 Managerial Economics . moves upwards to AC1 because of selling costs as shown in the following figure : Y Average Cost O Production (v) Effect of Selling costs on the Price of the Product : X The selling costs are initially borne by the producers. AC. because consumer preferences become stronger. by the consumer. but ultimately they are passed .

the sales of this bread have surpassed the sales of all other breads in the Indian market. nobody raises any objection if a producer spends too much amount on advertising. they contained the photographs of the actors and actresses in the popular T. It is true that spending large amounts on advertising or gift articles amounts to losses. Mahabharat. however harmful to all the sellers. Most of the producers operating under cut-throat competition. The children. various breads are manufactured and sold by companies like Hindustan. A customer who receives the article is permanently attracted to the product. An essential condition is that the entry form to be submitted in the contest. Initially the stickers contained pictures of various models of cars. In the first place. But this loss is preferable to the loss incurred on account of price-reduction. For example.reduction they. use some other methods. Instead of competing by price . Modern Bakery. The Bakeman bread at once captured the market because from the very beginning the company was giving stickers along with the bread. Crossword Contests : Some producers organize crossword contests or painting contests for children.Price competition is. Since every Bakeman bread was accompanied by a free sticker. rather than effecting a reduction in price. Bharat Bakery. The (ii) Pricing and Output Determination in Different Markets 229 . On the other hand. radio or television. This does not mean that advertising is done through newspapers. toothpaste manufacturers in India give a free toothbrush along with the toothpaste to the buyers. There is a vital difference between the two types of losses. Since any expenditure on sales promotion is included in the selling costs. If expenditure on advertising is fruitful its benefit is permanent. prefer to spend more on advertising. the losses incurred on account of price reduction are permanent. therefore. If the producers find that the expenditure on advertising does not promote sales. is to be accompanied by a certain number of used wrappers companies like Nescafe or Cadbury organize such contests. etc. series viz. the producers under monopolistic competition spend on the following schemes of sales promotion. developed a hobby of collecting these stickers. But when price is reduced it cannot be increased immediately. it is called 'Non-Price Competition'. Blue Diamond. A few years ago a new bread was introduced by Bakeman Company. Similarly. Thereafter.V. reduction in price is against the business ethics. Non-Price Competitions is usually practiced through advertising or gift articles. (i) Gift Articles : To promote sales. When they compete on grounds other than the price. therefore. a producer may hand over a gift article to the buyers who purchases the product at the usual price. therefore. Kwality. they can curtail it. Similarly.

by giving free gift articles or by organizing crossword contests. If idle capacity is fully used. (ii) (iii) Unemployment : Idle capacity under monopolistic competition leads to unemployment. Excess Capacity : Under imperfect competition. In particular. Lack of Specialization : Under monopolistic competition there is little scope for specialization or standardization. the price of the product remains unaltered. the installed capacity of every firm is large. Since production capacity is not properly capacity under perfect competition is fully utilized leading to full employment of factors of production. only a few standardized products may be produced. Much of this expenditure is wasteful from the social point of view. the winner of the first prize can visit Singapore or Honkong at the cost of the Company. producers can reduce the price. wasteful expenditure on cross transport could be avoided. unemployment of workers leads to poverty and misery in the society. (c) Wastes of Monopolistic Competition : Monopolistic competition results in the waste of resources in the following manner : (i) Selling Costs : Products under monopolistic competition are spending huge amounts on advertising and publicity. It is argued that instead of producing too many similar products. (iv) Cross Transport : Under monopolistic competition expenditure is incurred on cross transportation.companies which organize such contests also award prizes to the winners. an inefficient firm is thrown out of the industry. If these goods are sold locally. Goods produced in Ahmedabad are sold in Chennai and goods produced in Chenni are sold in Ahmedabad. (v) (vi) 230 Managerial Economics . Thus. Product differentiation practiced under this competition leads to wasteful expenditure. This would be beneficial to the consumers and the society at large. but it is not fully utilized. it is called Non-Price Competition. But under monopolistic competition inefficient firms continue to survive. less than the output which is socially desirable. Inefficiency : Under perfect competition. Total output is. the problem of unemployment can be solved to some extent. Since in this type of competition. It is argued that instead of spending so much amount on publicity. This would ensure better allocation of resources and would promote economic welfare of the society. therefore. the producers are able to achieve a tremendous increase in their sales. For example.

the price is set to cover costs. at times. etc. Sometimes profit is expressed as a percentage of costs. reasonableness of pricing that would create a good image of the firm. inefficiency is worshipped and efficiency is dispensed with. He then estimates overhead costs. PRICING METHODS OR PRICING PRACTICES INTRODUCTION As already discussed. Standard costs are based on the forecasts made on the basis of the assumption that the efficiency. Actual costs are costs actually incurred in the production period. Maintaining one's share of the market is another such objective. The pricing policy of a firm must therefore conform to the composite objective accepted by a firm. In the first one. aims at meeting or preventing competition as a goal. This is a norm which can be monitored and hence is accepted as an important one. Expected costs are based on forecasts of production and prices. Supposing allocable to X and divides it by 10. they follow the principle of Ethical Pricing. labour. demand etc. One such pricing objective is stability. overheads and a certain percentage of profit.. 1) FULL COST OR COST PLUS PRICING According to this method. i. A certain target rate of return on capital provides a guarantee of a floor limit. For example. For the profit make-up to be included in costs.. material. a formula is usually evolved. let us say.e. Pricing and Output Determination in Different Markets 231 . cost is the decisive factor. The aforesaid principles act as pointers to a proper pricing policy. various other consideration are involved. while in the second one. By simple arithmetic. Basically there are two methods of deciding the selling price : 1) Full Cost Pricing and 2) Marginal Cost Pricing. expected costs or standard costs. This can be ensured by following certain guidelines or 'pricing objectives'. and are actually being pursued by firms. Costs to be included in the price are normally actual costs. Finally. labour costs and material cost. Several such pricing objectives have been suggested. will be normal. firms pursue a variety of objectives with different weightages to different objectives. a producer produces 10 units of product X. The method of pricing to be chosen is a major decision. A decline in the market share can be taken as an indication of falling popularity of the product. Firms tend to keep-prices stable and short-run fluctuations in costs. This approach underlines a long-run view of the pricing policy. various practices are followed. Pricing policy also. when private firms help the government in carrying out socio-economic programmes like supply of medicines or school books or nutrition's food etc.Thus under imperfect competition. Target Return on Capital is another objective adopted by firms. sales. This gives per unit overhead. are not allowed to influence the price. prices.

The cost-plus method assumes that costs can be allocated to individual products. necessary adjustments in price are made accordingly. costs depend upon production (because costs change as level of production change) and price is said to depend upon costwhich completes the circle ! (2) (3) (4) (5) Justification of cost plus pricing In spite of the above mentioned inadequacies.28. Inadequacies of Cost Pricing (1) This method ignores demand. The price the consumer is willing to pay is important for purposes of calculating profits. a price based on cost is one-side. Rs. incremental costs rather than full costs should be taken as a basis. Sales depend upon price.1. we have taken. the price of product X per unit will be Rs. as is clear form the example. But in personal interviews many businessmen say that they follow this method because 232 Managerial Economics . This assumption. If. Whatever price is fixed is bound to invite reactions form rival firms. labour cost increase. businessmen may not strictly adhere to the cost plays formula. production depends upon sales. the method is widely used for several reasons which are : (1) In practice. but is ignores the nature of competition in the market. This is also known as basic price because as and when any of the cost component charges. This is not always logical.+ 10 + 5 + 3 = Rs. Whatever the method of deciding costs and profit make-up. Also to base future prices on present or past costs is equally illogical. It also ignores the future possibilities of competition as a result of the price policy.labour. The price the consumer is willing to pay has no relation with costs. But this the method ignores. it is not scientific. Many costs are common and cannot be traced to individual products. the cost plus the profit gives what is known as cost plus or full cost price. Though relating profit to costs is easy. and profit mark-up is 12% of costs.10 and 5. for instance. is unrealistic. This method is easy to operate. Cost plus pricing suffers from the fallacy of circular reasoning. Supposing they are Rs. Thus. Many times this formula gives a comparative picture of prices of different products. For planned expansion. Profit should be related to investment. It considers full costs. material cost. the per unit increase in labour costs can be added to the basic price to give the selling price of the product.10.

this method is suitable. the product can remain in the market. (3) (4) (5) (6) (7) Role of Cost-plus Pricing (1) For product Tailoring : Many times there already exists a great deal of competition in the field where a firm wishes to enter. When there is competition in the product market. The firms want to ensure that they are earning profits which they feel are 'fair'. own profit and what remains is the cost of production. by following full-cost method. This is known as product-tailoring. or even the principal objective of all firms. For Refusal Pricing : When products are supplied according to specifications given by the customer. This can be done by adding the profit mark-up to the cost. This is so because the bulk buyers are mostly business concerns who may otherwise decide to produce the commodity 233 (2) (3) Pricing and Output Determination in Different Markets . there is no profiteering and no exploitation of the consumer. can be fixed on the basis of this method. in the sense that cost plus a reasonable profit is taken as price. Otherwise. If an average level of production is taken into account for calculating price. A product that first in such a cost by its design. In practice. For Monopsony Pricing : When there is only one or very few buyers for a product. minimum price can be decided by full cost method. As such a common level of prices has already been established in the market. while supplying school uniforms. Under such circumstances.this method sounds just. etc. For pricing new products. firms are uncertain about the shape of their demand curve and about the return to capital appears to be logical. the firm can conclude that it cannot afford to produce that product. For example. the producers can first determine the price and work back by calculating the retailers marginal distribution costs. this method ensuring fair return to capital appears to be logical. If the new product fetches a price that covers full cost. In the long run. it is desirable to charge full cost price only. is then selected for production. and costs are more or less the same for all the firms. cost plus pricing can introduce a particular level of prices and avoids a price-war. It is possible that the faith that in the long run only normal profit can be earned might be at the roots of popularity of this method. minimum price below which the offer cannot be accepted. this method is secure in the sense that excessive profits during prosperity compensate for the losses during depression.. (2) Profit maximization is not the only.

e. the press may think of starting a new weekly. a firm produces many commodities and.. the method is cost plus pricing. (1) Excess Capacity : The reason for adding a new product to the product-time is usually to increase profits or to increase competitive strength. Opportunities to produce Multiple Products : A firm gets an opportunity to produce multiple products due to the following reasons. a press printing a daily newspaper installs new machinery which can print 1 lakh copies. In other seasons. let us suppose. Pricing of Multiple Products The economic theory assumes that a firm produces only one homogeneous commodity. (3) 234 Managerial Economics . in Managerial Economics. may occur in the fields of management. the machinery and other factors may remain unemployed. This means half the capacity of the machine is unused. excess capacity. This provides an opportunity to produce some other commodities during off season. For instance.. it is necessary to take cognizance of this fact and examine the problem of pricing multiple products. the demand for umbrellas.e. a firm may use its excess capacity (i. telephone. i. This is done to simplify the analysis. Cyclical Changes : When demand fluctuates as a result of business cycles. i. The existence of such an excess capacity provides an opportunity to add new products to the line. the firm suffers. For example. is considered as the proper basis. unused capacity to produce) if it is there. cost of service. Similar. when demand increases and decreases alternatively. But. A simple example will make this point clear.e. (4) For Public Utility Pricing : When the Government (or a private company) supplies public utilities like electricity. The printing press should charge at 'full cost' rates otherwise the University may decide to print the books in its own press if rates quoted are high. To utilize this excess capacity. water. In the above example.. to the people. therefore. etc. The producers of such products. excess capacity in technical factor is considered. the university wants to get some books printed. the commodity is in demand in a particular seasons. These ups and downs in business are more accentuated in respect of durable consumers' goods and luxuries. in practice. To attain this goal.themselves. Even when an element of profit this included in price. may add some new products which are not affected (or less affected) by these ups and downs in demand. fortnightly etc. (2) Seasonal Variations : Some times the demand is specific to certain seasons. Suppose. distribution etc.

order of preferences is prepared for addition to the product-line. For example. percentage return to investment and total money profits are the each unit to profit is a better measure of profitability. income of the consumers. this excess capacity may be utilized by accepting outside jobs like printing of visiting cards. In selecting new product. new techniques. (5) (6) Policy of Adding Products In a dynamic business world.the most profitable getting priority. New products are therefore. hand-bills etc. Old techniques then become outmoded. (1) Standards of Profitability : The products to be selected are to be considered in order of profitability . percent return to additional investment is a desirable measure of profitability.. Contribution of each unit to total profits. For example. Hence. in practice. the policy of adding new products becomes important. If. should the addition product is made to bear its share of common costs? If the new product is to be adopted temporarily. the handloom industry had to introduce a variety of designs to increase its competitive strength. new products are being added on a large scale. the former concept of profit will be appropriate. the latter concept will be suitable. the problem of measurement of profit arises. availability of raw material. the following problems arise. Here. no the other hand. Now. it may be necessary to drop old products and add new products to the line. printing of books and publication are two processes which can be integration if the publisher purchases a printing press.(4) Secular Shifts : When there are secular changes in conditions of demand and supply like changes in the tastes of the consumers. discovered which can be produced with the help of tile machinery. in the face of competition of mill cloth. if the press remains idle for some period of the year. receipt books. It is not possible to forecast the profit contribution of a product throughout its life. Once the concept of profit is finalized. at hand. monopoly power does not last long and competition forces firms to introduce new products. But such forecasts are usually made for a period of 3 to 5 years and on that basis. after printing all the books he is publishing. etc. etc. the question is what concept of profit should be adopted? Should the firm use 'incremental profit' as a test? That is. Research : Research creates new methods of production. Pricing and Output Determination in Different Markets 235 . but id the new product is to be added permanently. Vertical Integration : Vertical integration of different production processes also offers an opportunity for increasing the number of products.

Complementarity is an important part of this strategy. This establishes the company's reputation and the customers rely on the company for all their requirements Besides the above considerations. but not readymade garments. cookers. For example. a firm producing electronic appliances can add more electronic appliances only. If a firm is already producing household appliances like choppers. (e) Common raw materials : It is obviously economical to add a product that uses the same raw materials being used for existing products or that which uses the by products of existing products. common processes of production. (b) Distinctive know-how : When a company has some distinctive know-how.(2) Product Strategy : Profit is just one consideration in the policy of adding new. irons etc. etc. are additional considerations which are important in the product strategy.. If products in a product-line are complementary to one another. etc. For example. and make the range a s complete as possible. mixers. Some times. common distribution channels. a company producing medicines can add a few cosmetics. (f0 Benefit to present product lint : Managerial Economics 236 . A textile mill can start the production of towels and bed-sheets or raw cotton blankets. They are : (a) Interrelation of demand characteristics : New products and existing products may have a demand relationship of either complementarity or of alternative character. it is desirable to add heaters. (c) Common production facilities : We have already seen that new products utilizing existing production facilities and excess capacity are desirable.. if an electric supply company starts the production of electrical appliances like fans. common raw material. For example. For example. toasters. (d) Common distribution channels : It is also desirable to select a new product that can be brought to the market through the existing distribution channels. A firm may decide to produce alternatives to retain its goodwill and it may also win over new customers if it successfully establishes a reputation as a firm producing up-to date alternatives. in case of complementary goods 'we supply the whole range' is a good motto for the firm. This 'strategy' has to be evolved with an eye on the policies of rival firms. it is desirable to establish the reputation that the firm supplies all alternatives. Similarly. But there are other objectives as well and a strategy of choosing new products has to be evolved. geysers.. the demand for these appliances increases the demand for electricity. they create demand for one another. etc. which keeps in view all these objectives.. for a company producing paints and varnishes. (3) Criteria for New Products : What has been referred to above as additional consideration can be considered in details as criteria for choosing new products. it is desirable that it produces all types and shades of paints. it is desirable to add products that can be based on the same know-how.

the need arises for dropping old products. This criterion suggests the benefits accruing to the old products (i) of demand inter-relationship. This may happen with respect to joint products or alternative products. the problem of determining costs of individual articles is of great practical importance. i. What are the choices? : When the profit s or sales of a product are found unsatisfactory. joint products are produced together (meat and raw hides and skins). i. They are mainly useful for computing enterprise profits. one of the two can be increased by keeping the other constant. Sometimes due to product improvements effected by rival companies. (1) How does the problem arise? : Sometimes the choice of the product proves wrong Sometimes some other company is merged with a company when the products of that company which are unprofitable also come into the product line. (ii) of research for new products. the company may try to improve distribution or reduce costs of production or improve the quality of the product. the cost of each can be found out by keeping one product Pricing and Output Determination in Different Markets 237 .heads that do not vary with a decision are nevertheless allocated to individual products. (ii) the method of allocation is scientific.. If this is the case. Policy of Dropping Products The policy of dropping old products is as important as that of adding new products. (iii) No distinction is made between joint and alternative products. but arbitrary.e. Here we have to consider the benefit of new products the established ones. In all these circumstances. When all these efforts are rendered useless the only alternative is dropping the products. The analysis of the economic characteristics of the managerial problems and of the production process can help rectify these defects. the existing products become out dated. Jointness of Products : The problem of allocation arises when costs are common. As we have already seen. But these product-costs supplied by conventional cost accounting are. and (iii) of market surveys for new products.So far we have considered the benefits of existing products to new products. to stop its production. In the case of joint products there are two possibilities : one that the proportions of joint products are variable. and (iv0 there is no recognition of the significance of controllability of the product mix in estimating costs. (2) Cost of Multiple Product In a firm producing many products. Bulk sales or buying from others and selling under the firm's label can also be tried. The accounting allocation of production cost is useful only for a few-business decisions. according to Joel Dean defective in several respects : (i) Over .e.

the allocation has to be arbitrary. the costs can be estimated by the use of the concept of opportunity costs. the problem wit cost allocating arises where costs are not traceable. (case of dressed chicken and eggs as we saw earlier). However. however.g.constant and observing how much is the increase in costs by increasing the production of the other product. The some method may be applied by taking together all traceable costs. When products are alternative. the cost of dressed chicken is the earnings foregone of eggs that could be sold. in case of multiple products.g. Such methods can be found for joint products with variable proportions and alternative products. is not a difficult problem. The most closely associated traceable cost can be selected as the basis of the allocation of common cost. product-mix can be controlled. This can be done in various ways : (1) Share in common costs can be estimated by proportions in traceable costs. e. like meat and skins. In the second possibility. 2) GOING RATE PRICING While full-cost pricing takes into account the cost of production.. without reference to demand. Allocation of Variable Overheads : The only problem that now remains is allocating short run common overhead costs which are variable. For example. it is not possible to find out individual product costs. as no logical method of allocation can be thought of. e. To sum up. e. In case of joint products with fixed proportions. where the proportions are fixed. The firm does have control over its own price and output. In other cases.. if direct labour cost is traceable and is 10% of the common can also be treated allocable. more logical methods of allocation than those followed in accounting practices are desirable. the cost of electricity (common cost) can be estimated individually by taking into account the machine hours worked for the product. (2) (3) Any of these or a different method can be accepted. adding direct labour and direct material to find proportion in total costs.g.. Thus the jointness of production. In such cases. the going rate pricing emphasizen the market conditions. When products are in joint supply. the product-mix is difficult to control when the proportions are fixed. the firm adjusts its own pricing finding and allocation of costs 238 Managerial Economics . The problem then is easy. as the output of one product can be increased by keeping the other constant.

Going-rate pricing. This is obviously because of the fact that a firm cannot accept the responsibility of controlling costs. as we saw. is the answer. they are not the same. however. a firm can stabilize its production or output. where costs are difficult of measurement. approaching the problem form the opposite end. the action can Pricing and Output Determination in Different Markets 239 . The marginal cost pricing appears to suggest that price charged should be equal to the marginal cost.e. is not a policy that could by followed on a permanent and a longterm basis. A firm's equilibrium can be explained by comparing marginal revenue and marginal cost at each level of output. Going-rate pricing is. In cases. fuel costs. In other words. This method of pricing is simple to grasp and can be of help where the products have reached a mature stage. Hence cost control is a problem in this method. taxes are just a few examples worth mentioning. This course of action must have some impact upon total cost and total revenue. This method seeds to maintain price-stability and allows changes in costs where necessary. it involves a course of action. some firm may follow this policy. In many cases. The incremental principle is commonly used in business decisions. B) Marginal Cost Pricing One of the most sound pricing practice is the full-cost pricing which we discussed in great detail. What marginal cost pricing suggests is that it sets the lower limits a firm can set a price that ensures the targeted or possible level of profitability. increase in revenue exceeds incremental cost or increase in costs. where a price leader exists and he charges a price in keeping with what the followers are charging. However. Where marginal revenue just covers marginal cost. the one we saw earlier was a method of cost-plus pricing. customers as well as rival firms prefer a stable price. a firm may accept a certain price as a going rate price and then adjust its costs by providing for a certain margin of profits. Are they the same? Strictly very difficult. this method id adopted. This policy must entail losses and this fact can be ascertained by a look at the diagrams explaining equilibrium of a firm. Many elements of costs are such as are hardly within a firm's control. When a firm takes any decision. According to the incremental principle. Transport costs. all the time. The second approach to pricing which calls for our attention now is marginal pricing. The method of pricing we are discussing is 'marginal' cost pricing while the sub-title we have given is 'incremental' cost pricing. While the one we are discussing here is a method of price-minus costing. this method is exactly opposite the above one. Where demand is elastic and where price competition is likely to set in motion a price-war. In such a situation. Thus. for instance. It is possible that both these quantities would be negative. In a way. Marginal analysis occupies an important position in the classical economic theory. a course of action may involve a fall in cost as well as a fall in revenue. a firm may begin its calculations form price rather than from costs. the decision can be considered sound if incremental revenue i. What price should be charged? One that is given by the average revenue curve (or the demand curve) at the equilibrium level of output.

Many business do not possess the knowledge of finding out marginal cost and marginal revenue. fixed costs are ignored. marginal cost pricing is found to be very convenient. This is obviously justified if a fall in revenue is less than the fall in costs. In spite of this technical difference. As against this. This method has been criticized on the following counts. When fixed costs are high. the firm stands to lose. (1) (2) In practice. in the same way. Wisdom. In the context of pricing. this method faces many difficulties. Due to uncertainties involved on both sides. The firm can take a full-life perspective and can plan to cover full costs over a long period. there always arises a discrepancy between planned profits and actual profits. In this method of pricing. Again. Orders are not turned down because the price offered does not cover average cost. Adherence to marginal cost pricing puts the firm to losses because overhead costs are not covered by this price. Such changes are not liked by the buyers. marginal cost would be the proper expression to denote the method. Pricing has to take into account. lies in 240 Managerial Economics . When costs are rising. therefore. (3) (4) (5) (6) The criticism is not fully warranted. Moreover. We have seen that this holds goods only when c0sts are diminishing. Marginal cost pricing helps the firm to become more aggressive at the market. though not necessarily satisfactory. future costs and prices. It is pointed out that a strict adherence to marginal cost pricing leads to frequent price changes. which takes place due to variable costs only. because marginal cost represents addition to total cost. the cost of operating this method is very high. Where full-cost pricing is difficult for reasons noted earlier. Fixed costs must be incurred even with zero production level. The points that this method will put the firm to losses is based on the assumption that MC > AC. distribution and credit sales and purchases. MC > AC. This is because the operation involves the creation of a machinery that calculates and monitors demand elasticity's. For a firm producing different products. business discussion usually ignores the difference and the two terms are used interchangeably. Whatever excess of price over average variable cost is available can be used for meeting profit requirements and contribution towards fixed costs. sales forecasts etc. full-cost principle may suggest that one should not produce so long as all the costs are fully covered. is a charge in total revenue following a unit change in output. Marginal cost pricing avoids this possibility. full-cost pricing is likely to make the price uncompetitive. A price-cut is usually irreversible and in the absence of a necessary upward revision of prices. Marginal revenue. they create problems in planning. marginal cost refers to the change in total revenue following a unit change in total revenue following a unit change in output.

though the approach is intuitive. however. Their intuitive prices prove to be successful. the price cannot be entirely left to the intuition of the entrepreneur. This method has the potential of providing a scientific base for pricing policy. and price is varied to see the reactions. (B) Experimental Pricing : In search of an optimum price. variety of practices in pricing. in oligopolistic structure. the firm takes some cognizance of the demand for the product. (A) Intuitive Pricing : This psychological and subjective approach to pricing is surprisingly very common. Pricing and Output Determination in Different Markets 241 . Others. make adequate change in price. Usually a sample of test markets is selected. The approach can be variously applied. In practice. Price based on pure lunch can be taken as a starting point. the price of another firm. therefore. or at least. However. and proceeds. would be a short-term policy. Let us consider the major approaches. These reactions are observed and then a price that maximizes profits is fixed. the firm fixes its price equal to. The success of pricing policy can be judged by whether the price that the firm needs and that which the buyers want is the same. Price-leader usually has a large share in the market or an established reputation or a sound profit history. This is hardly possible and requires a great deal of knowledge on the parts of both sellers and buyers.error method. (C) Imitative Pricing As the name itself suggests. we come across a very wide.and . This method is widely used in respect of new products. Some managements can guess correctly the future treads in demand and competition. Thus. this method has got to be applied with caution. This. to fix a price by a trial. Other known as price . Marginal cost pricing therefore should be viewed as measure of suggesting the floor-price of a product and as a guide for modifying profit-maximizing price when market conditions so demand. This is experimental pricing. A firm that initiates a change in price in the price-leader. the two come very close. We have already noted the possible price-leadership situation in the context of oligopoly. as the term itself suggests.followers. These approaches are not alternatives but can act as complementary or supplementary to one another. 4) SOME OTHER APPROACHES Full-cost marginal-cost are the two basic methods we noted so far.producing when incremental costs are covered. At the other end. or in some proportion of. where buyers cannot be separated. price based on full cost is taken as a basis. Intuitive pricing. This priceestimate can then be modified according to the market conditions and the nature of competition. to pricing which lie at the basis of actual pricing practices. is a response or a reaction to the feel of the market. hope to gain by the leader's experience without risking their own market share.

They are : (a) Skimming Price : The entry of a new product into the market is usually preceded by a great deal of research and promotional expenditure. Pioneering Price Every product has a life-cycle : a product is new. but in the long-run profits can be earned. Once this fact is accepted. (A) Single Product Pricing 1. (b) 2. Subsequently price can be reduced to reach lower income customers. This is because. competition is keener. the demand initially is not likely to be price-elastic. Especially in retail trade or in other manufacturing areas where monopolistic competition exists. and 242 Managerial Economics . prices are kept imitative so as not to disturb the inter-firm competitive structure. this policy is helpful. Price in Maturity After the take-off a product reaches maturity stage. We shall now try to provide practical guidelines evolved by people through their business experience. 5) SOME GUIDELINES FOR FIXATION The foregoing discussion concerned some of the approaches to pricing.Imitative pricing perhaps is the easiest method to follow and finds popularly in many fields. A firm can decide to skim the cream of the market by charging a high price. substitutes are available and preference for the product becomes weaker. the firm can gradually raise the price. Where large-scale production is likely to reduce costs considerably. The disadvantage of this method is that it sacrifices flexibility and leaves no room for adjustments as per local conditions. Penetration Price : Alternatively a firm can begin by charging a very low price to penetrate the market. These guidelines are important in bridging the gap between theoretical prescriptions and practical applications. market saturation with weakened preference and a higher ratio replacement sales to new sales. The firm can then conveniently concentrate on non-price competition. but after some time stagnation and decline phases follow. it clicks and gets established. In the short-run the firm may make losses. There aspects of maturity therefore become relevant for reckoning : (a) (b) technical maturity reflected in increasing standardization with set prototypes and less product variation. two possible approaches emerge for a pioneering price. During this stage. after capturing a large part of the market. For a new product.

During this stage. These are a few guidelines for single product.a problem of product line pricing arises. which is a higher one. Backward Cost Pricing When competition is keen and quality as well as price are consequential to the buyers. 5. Firms may decide to respond to these fluctuations by reducing off-season prices and raising prices when conditions are brisk.price reputation by keeping the price unchanged throughout recession and prosperity. A wide variety of products including electrical appliances automobiles are subjected to this type of pricing. Therefore. a product experiences fluctuations in demand. However. Prestige pricing is another tactic. by cause the market is flooded with competitive products.e.price is determined first and by working backward. Refusal Pricing Many products are such as to serve specific needs of the users. On the price-tag two prices ate printed with upper one.and . Under such circumstances. Psychological Consideration Many times producers resort to tactics which actually exploit the consumers psychologically. So. where the firm is producing a single product. cost plus limits as floor price are ascertained. a firm may decide to maintain its quality. price should be set carefully by taking into account estimated elasticity of demand. the product design can be arrived at. competitive degeneration as well as the possibilities of non-price competition. Pricing and Output Determination in Different Markets 243 . (B) Product Line Pricing A modern firm produces a wide range of products. crossed. he seller just refuses to supply the such cases. 6. when a firm is producing many products-and such firms are many . Surgical equipment is an example of this type. therefore. High price and profiteering cannot be followed . 3. at less than this. The consumer get a feeling that price is lowered by the company and therefore sales get boosted. A high price is maintained where buyers attach prestige considerations to the product. Double-pricing is one such tactic. i.(c) stability of production methods. Customary prices are charged in respect of commodities having kinked demand curves. No price-reduction is possible. the problem of pricing these multiple products in a product line is of vital importance. Alternatively. Cyclical Price : In course of its life. market shares and price-structures. 4. a selling .

But this does not recognize the extent of composition in the market or the elasticity of demand. two wrist-watches with the same machines can be sold at a difference of a hundred rupees. Prices that are systematically related to the stage of the market and the competitive development of individual members of the product line : Every product has to pass through three stages : It is introduced reaches the height Managerial Economics (b) (c) (d) (e) 244 .1000/. Prices the are proportional to incremental costs : Without considering common costs only incremental costs may be taken into account and prices may be fixed in proportion of three products . B and C costs are increasing by Rs. This removes the defect of arbitrariness in the first method.000/. By dividing the expected revenue from each by the units of that product. The more complicated the process and design of the product the more are opportunities for such discrimination. we get the price. differences in elasticity are taken maximum advantage of. E. E. various alternatives are possible.g. This may not be the same for all the products in the line.3. Prices with profit margins proportional to conversion costs : Conversion cost is the cost of converting raw material into final product. Elastic demand has to escape with a low profit margin while inelastic demand can be burdened with a high profit margin. the price differences in the case of A and B grade sugar cannot be much. Rs.000/-. Firms can take advantage of the ignorance of customers or a desire for distinction or just the laziness of customers. This is the cost plus price we have discussed earlier. Alternative Policies of Price Relationship In pricing products in a line.respectively. Price that produce contribution margins that depend upon the elasticity of demand of different market segments : The market is divided into segments according to elasticity. With this profit added to costs the price can be fixed.and Rs. the milk collected by a dairy can be pasturised and bottled or can be powdered and filled into tins.A.4. Important among them are : (a) Price that are proportional to full cost : According to this policy common costs are allocated to individual products. If these costs are 4:6 then the profit also may be divide in the proportion 4:6.1. Traceable costs are then added to them and then by6 adding a profit mark-up the selling price is fixed.g. These provide opportunities for changing different prices. The conversion costs of these two are obviously different. In this method. the expected revenue form the three products will be distributed over these in the proportion 4:3:1. But with different cases and dials.

This analogy explains the price policy under consideration most eloquently. Young children have a share in costs. the following factors need to be considered : (a) Demand Relationship in the Product Line : Products in the same line have many types of demand relationships. What each product should earn is dependent upon the nature of the competition in the market and the elasticity of demand for each product. different models of a radio set produced by the same company. whichever is chosen.g. The cost estimate to be used here will be dependent on the objectives 245 (b) (c) Pricing and Output Determination in Different Markets . 2. An old product should have a law price. proportions of sales of various products in the line) and a corresponding total revenue and total cost. But the total cost of the family is covered by the total family earnings.e. This is so because as price changes. S.g. Factors to be considered in pricing Of the alternative pricing policies suggested above. torches and cells produced by the same company. Capital and technical difficulties in starting a new firm etc. They may be alternative products e. The number of competing firms the firm's share in the total market supply and differences in the nature of competing products indicate the extent of competition.of popularity then lags behind. The competition also depends upon the costs of entry. Competitive Differences : All markets where products form one product line are sold do not have the same degree of competition. Similarly. costs will also change. It is possible that different products in a line are in different stages. e. Cost Estimates : Each set of process will produce a particular product-mix (i. the less the possibility of emergence of competition. The old members of the family earn just enough for their upkeep or live by the pension they get for the work done when they were in this price. That set of price is the best which fetches the maximum profit. Freeman compares a product line with a family. A new product has to be low-priced. the more. They may be complementary products. A new product can be introduced in the market by taking advantages of these demand relationships. A product that is on the top of popularity can bear a high price. or this is why a company producing tooth past introduces it s tooth brush (complementary) and tooth powder (alternative) as well. E. Differences in the elasticity of demand provide an opportunity for increasing profits by taking advantage of the ignorance of customers or their craze for distinction. This is how new models of radio-sets are introduced. because supply changes. demand changes and so does the total revenue. That is why Mr. obvious are the opportunities of increasing profitability by charging high prices. the costs of acquiring new patents.

Sometimes the objective is to bring prestige to the entire line.Line Pricing (1) Pricing Products that Differ in Size : It is desirable to charge different prices for different sizes of a product? Price can be the same if costs and satisfaction accruing to the consumer are the same.10 or Rs. if a shirt of 75 cm is charged at Rs.24. Some Problems of Product . (3) Charm Prices : There has been a belief in the business would that prices ending in odd figures give a feeling that they are reasonable and they appear to be less than what they actually are. If using excess capacity is the objective.g. it is desirable to have a systematic pattern.g. what price should be charge ? As already seen. This increases sales. the price of a 20ml.45. E. incremental costs are relevant and a nominal profit will be considered satisfactory. If price competition is the objective the firm produces low quality products and charges minimum prices. Pricing Special Designs : When a product is custom made or prepared on special order and specifications. This has an appearance of equity.40 and that of 80 cm is charged at Rs. if the customer himself is a producer. their prices will be determined in accordance with the objectives of the firm.95. taken together. full cost should be included. This increases the sale of low and medium priced products. While pricing alternative sizes. Alternatively. E. profits are subject to letal restriction. If for example.25. E. what businessmen calla 'parity price' or what economist call 'opportunity cost' should be charged.of the firm.g. Managerial Economics (4) 246 . Then some high price products are kept deliberately. (2) Pricing Products that Differ in Quality : When there are products of different quality in a product line.50. It is these cheap ties that really fetch profit. in the case of footwear for adults. than that of 85 cm should be charged Rs. If a company prices its quality neckties at Rs.9. This enables the firm to project its image as 'a firm charging reasonable prices'. But if it is decided to vary prices according to sizes. Rs.95 are charged in place of Rs. This is why prices like Rs. This saves packing costs and encourages demand.50 each it can sell cheap ties in large numbers. bottle of hair oil should be less than the price of two bottles of 100 ml. costs do not differ much and it is not the that a man wearing a bigger shoe simply because their feet are of different sizes. 3. full cost price is desirable. it is advantageous to reduce the price as the size increases.

To cover such costs concessional prices can be charged in the off-season. it is possible to attract spectators who are not habituals. It is possible to win new customers by keeping price low at a time when demand is less. The price policy should be such as to enble consumers at all levels to buy and make use of the goods and services produced by the public enterprise. competition from private enterprises. Because of the irregularity of demand and the risk of obsolescence. All these factors make the price policy of public enterprises really significant as well as difficult Responsibility for pricing : In a Private company. Even when the government. The price policy of a public enterprise should be such as to enble it to operate at the lowest cost possible and maximise efficiency.g. Pricing Repair Parts : Many firms producing spare parts earn more than firms producing the whole machine. Pricing and Output Determination in Different Markets 247 . the broad principles of the price policy are laid down by the Board of Directors representing the general body of shareholders. The government has the ultimate responsibility to decide about the way a public undertaking will conduct its affairs. of course. the department and the managers". inter-enterprises relationship. management has the responsibility of fixing prices for the goods the company produces. In public enterprises the pricing function is "diffused over the minister. For instance. etc.(5) Charging Different Prices at Different Times : When the demand is seasonal at least fixed costs are required to be borne in the off-season. the price of spare parts are required to be kept high. It will have to calculate costs and benefits to the various sections of the community and The price policy in a public enterprise shall have to consider the requirements of foreign trade. through the minister concerned. This is particularly so when the quantum of profits which the undertaking has to earn is to be decided. The same group may later be habituates and may start visiting regular shows. (6) (6) Pricing in Public Sector Undertakings (PSU) The price policy of public enterprises has special significance: i) ii) iii) iv) v) The price fixed by a public enterprise should be such as to enable it to raise adequate resources for re-investment. It is desirable to distinguish between parts that can be produced easily which must be sold at a competitive price and parts requiring specialized techniques that can be sold at a high price. fans in winter and blankets in summer can be sold at concessional prices. when matinee shows are screened at lower charges. though. E.

The pricing problem becomes more significant and highly complicated when a public enterprise operates under conditions of monopoly. This is indeed a great advantage for capital intensive projects. Essentially. such government undertaking may opt for a low price structure. if among other things.housing. the price policy of the public enterprise will depend upon the profit target fixed by the government. the management in under a bias for full utilization of resources or maximum production of the commodity or service. unequal conditions of competition in favour of public enterprises. the Indian Airlines Corporation (till recently) and the Electricity Boards are monopolies." unless the Government creates. A private monopoly will generally aim at profit maximizing price but a public enterprise may or may not follow such a policy. For instance. it is the lowest possible costs which determine the prices in the long run. Moreover a government enterprise can get hold of cheap capital either through government subscription or under government guarantee. In general. Government enterprises working under competitive conditions are: Ashoka Hotel and Janpath Hotel and the shipping Corporation Ltd. In these cases. or provide generous medical facilities and consumer amenities than a private enterprise may be willing to do. larger production up to the full capacity will be accompanied by declining costs. On other hand. 1) On the demand side. and the Fertiliser Corporation of India are operating in a seller's market. public enterprises are generally set up with large capacities even from the beginning and naturally. In such cases. the possibility of inter-unit competition does not exist or is only nominal.profit policy in a PSU. At the same time. Managerial Economics 2) 3) 248 .decides about the general price. the government decides the price policy while the managers of particular enterprises decide the price structure within the general framework of the government's price policy. public enterprises may get hold of some or all factors at lower prices. the actual details of the price structure will have to be worked out by the managers of the undertaking. The Railways. spend more heavily on employees. For example a public enterprise may engage large labour force. government enterprises may have the advantages of bulk contracts of purchases and concessions available to government. Generally. openly or covertly. the main problem is one of maintaining conditions of full competition between the public and private sector units. These features may relate to the demand side or on the supply side." On the cost and supply side. Features of pricing in public enterprises In order to appreciate the pricing policy in public enterprises in India. A public enterprise may attract demand because of its special strength. therefore. Hindustan Steel Ltd. the public enterprise enjoying a high degree of monopoly power may opt for a high price structure. it is necessary to understand the distinctive features of pricing of public enterprises. Public enterprises may incur some social costs which private enterprise may not bear at all or may shift to other agencies.

Each undertaking has been following a price policy conditioned by certain internal and external circumstances. This leads to delay in taking important decisions and higher costs naturally follow. public enterprises may have to incur higher costs because they are subject to certain external pressures. Or complementary resources may not have been developed and may subject an enterprise to unfavorable cost conditions. ii) iii) Guidelines on Pricing Policy The Government of India has issued three guidelines on Pricing Policies for the public sector enterprises. Or the Government may decide to over-capitalise the enterprise from the start and hence may force the enterprise to have heavy overhead capital in the early periods. criticism by members of parliament. they are very careful in their expenditure. a public enterprise may be forced to go slow in its construction work. viz. No profit basis – Some Government enterprises have been required by law or by the Memorandum and Articles of Association to follow a "no..loss" price policy. Some of the following features of price polity are to be met with in India. accepted the principle of selling the ships in the Vishakhapatanam shipyard at a price approximately equal to the cost of building a similar ship in the United Kingdom. Price Policies of Public Enterprises in India Government undertakings in India have not developed any precise and uniform policy of pricing. a) Public enterprises should be economically viable units and an all out effort should be made to increase their efficiency and to establish their profitability at the earliest. 5) Thus there are many distinctive features of pricing in government enterprises which are not generally met with in private enterprises. Moreover.profit no. were some of the public enterprises whose profits were ploughed back for expansion. i) Profit as the basis of price policy – public enterprises in India generally follow a policy of profitability. etc. The Hindustan Antibiotics and the Hindustan Insecticides have been following this rule. The Indian Railways and the Reserve Bank of India are two important Government undertakings which contribute considerable amounts to the general exchequer. 249 Pricing and Output Determination in Different Markets .General and public criticism in press.Hindustan Antibiotics. These corporations have been marketing their products on "no profits no loss basis. Hindustan Machine Tools. audit by the Comptroller and Auditor. The Hindustan Shipyards Ltd. Profits of a public enterprise indicate its efficiency (apart from its monopoly character) as well as serve important sources of self-financing." Import-parity Price – Those public enterprises whose products are in direct competition with imported goods have adhered to a policy of import .parity prices. As a result.4) Public enterprises are subject to the investigations by parliamentary committees. For instance. Sindri Fertilizers.

c) (7) Pricing in co-operative societies In India. the co-operative sector has expanded considerably in the last 50-70 years. several cooperative institutions have made their mark. stands between that in the public sector and the same in the private sector. Production in the co-operative sector. The Government intends to generate more profit by the use of its monopoly power. Like the public sector. absence of marketing skills. coal. the prices of such products and services should be rationalized in a manner as to cover total costs and bring about a fair margin of return by means of general improvements in efficiency and greater utilization of capacity. the prices of infrastructural services and basic industrial and agricultural inputs. therefore. Similarly the price of indigeneous crude oil was revised. for most of its part. aluminium. Of late there are signs of the emergence of a professionally managed co-operative sector. has come under criticism for the lack of professionalism. In general. alcohol. have to be regulated /administered in line with economic costs to prevent a spiralling effect on prices. production of sugar etc.b) Public enterprises which produce goods and services in competition with the domestic producers. transport. At the 250 Managerial Economics . However co-operative management in India. For instance. steel. The critics however believe that instead of absorbing the rise in costs by improving efficiency and productivity. According to the Bureau of Public Enterprises (1986-87). "it has been accepted in principle that prices of products produced and services rendered by public enterprises should be so determined that at a satisfactory level of capacity utilization these enterprises not only cover their costs of production. Pricing of products/services in these co-operative organizations now needs our attention. the co-operative sector also has to fulfill certain social objectives and a purely commercial approach is. ruled out." With this policy. fertilizers. has been adopting the rather easy method of raising administered prices. The critics further state that this is in direct conflict with the guidelines on pricing policy laid down by the Government. and Public enterprises which operate under monopolistic and semi-monopolistic conditions. the pricing of their products should be on the basis of the landed cost of comparable imported goods which would be the normal ceiling. in a way. coal. petroleum products. These price escalations are motivated by the desire to earn more revenue for the Government. the govt. molasses. In the areas of food processing. the Government took a number of decisions in raising the prices of steel. the normal market forces of demand and supply will operate and their productivity will be governed by the prices prevailing in the market. There may be situations where profitability in the strict sense of the term may be somewhat of secondary importance. petroleum products and fertilizers. but also generate a reasonable amount of surplus"" Profit making in public enterprises is considered quite consistent in public purpose. lack of productive efficiency and cost-heavy structures. milk production. such as transport.

some co-operative organizations are operating in competition with private sector organizations and are expected to remain economically viable. in some cases. Sometimes the subsidy is available in a lumpsum and sometimes it is paid in thus form of rebate per unit of the product sold. the pricing policy of co-operative societies conforms to the norms of public sector pricing where the situation so demands. the price is an important independent variable and lower the price the greater is going to be the demand. Distribution of food grains. This levy sugar quantity was purchased by the government at a low price and was distributed through fair . Such societies are therefore based on 'average cost minus subsidy per unit basis. it can resort to price discrimination. As a case of discriminating prices one can cite the example of dual pricing of sugar which was followed in India. In cases where the number of users is much larger than the number of members. the government imposed a certain percentage of levy on sugar factories most of which are in the co-operative sector. In keeping with the law of demand. Alternatively.price shops at remaining sugar produced by the factories. the price is fixed to equal average maintenance of certain quality of products/services. Demand. they have to face market competition and have to set competitive prices or leave the prices to the market forces. cost-plus pricing is followed. full-cost pricing (or price equating average cost) is followed.based Pricing : In many producers 'co-operatives pricing is required to follow the dicates of demand.same time. Weavers' societies. I this case. while in the latter case. This is applicable to societies where goods/services are of an essential nature and the benefits of the services are required to be distributed among the users in the form of cheap or fair priced availability of goods/services. if the society enjoys a certain amount of monopoly. As such. some profit is ensured for the organization. Sometimes. In cases where all the beneficiaries are only the members of the co-operative society. as in case of handloom fabrics. handicrafts societies or farm-service societies are examples of this type. 2) Subsidized pricing : Many co-operative societies are following certain social objectives. preserving traditional skills. 1) Cost-based pricing : In many cases. The credit and micro-credit societies belong to the former category. In some cases cost-plus pricing method is followed in this case. Discrimination can be as between and the rest of the society or as between different uses or as between different places. Such societies have objectives like providing employment. In the first case the price is said to equal the average cost. they were given the freedom to price sugar in such a way as to compensate for the loss they incurred in selling the levy sugar to the government and also to charge a costplus price and supply 251 3) Pricing and Output Determination in Different Markets . lift irrigation services are examples of this type. pricing aims at covering the total cost. The society would therefore be free to charge a high price and get a limited demand or charge a low price and get a higher demand. supplying cheap inputs or supplying onsumers products ay fair prices.

it has to price its product on the basis of going rate and many times such a rate has got to be comparable to imported products. sealed bids are sell the bagasse in their factories by following this method. 252 Managerial Economics . When there exists competition among the local producers. For example. the price has got to be comparable to the range of prices of similar products produced by other firms. The pricing methods discussed above are subject to regulations and rules framed by the government. societies producing milk and milk products. cotton and cotton-yarn. sugar. 4) Competitive Pricing : When a society is embarking upon a new venture. Sometimes. or those producing mango pulps or orange syrups and squashes have to set prices which are comparable to other firms' prices of their existing products. This is because the commodities concerned have either the potential of generating cost-push inflation or they are essential consumption goods which can exclude poor consumers when the goods are priced high. co-operatives like Anand Milk Union Ltd. For example. the prices charged by co-operatives need an approval of the stat government. (amul) can afford to follow such practices. etc. This is especially true in respect of prices of commodities like milk. It is necessary to remember that such commercial and competitive practices can be followed by a very small number of co-operatives which are competitive enough both in terms of quality as well as cost of production.the sugar to the market as free sale sugar. Other pricing practices like penetrating price and price skimming are also at a loss in the beginning for penetrating the market and then raise the price when the favourable conditions at the market so as to earn maximum possible profit. in this regard. in many cases. CO-operatives are in the jurisdiction of the state government in India and.

Exercise : 1. 3. Pricing and Output Determination in Different Markets 253 . (f) Short run cost curves (g) Imitative pricing (h) Intuitive pricing (i) Customary prices (j) Features of oligopoly (k) Non-price competition (l) Pricing in public sector undertakings (m) Cost plus pricing (n) Pricing in cooperative societies (o) Changes in equilibrium price. 5. How is the price of a product determined under conditions of perfect competition in the short run and in the long run? Explain how price is determined under monopoly? What is price discrimination? When is it possible and profitable? How is the price determined under monopolistic competition in both the short and long run ? Write Short notes on : (a) Perfect Competition (b) Monopoly (c) Monopsony (d) Selling costs (e) Wasteges of competition. 4. What guidelines for price fixation can be suggested? 2.

NOTES 254 Managerial Economics .

NOTES Pricing and Output Determination in Different Markets 255 .

NOTES 256 Managerial Economics .

the cost-benefits can be adopted on a macro level either at the level of the economy as whole. or those who cannot pay for it. the cost-benefit analysis refers to finding out the worth of investment and enable ranking of optional investments by using any one of the methods (or more than one methods in combination). However. in its broader sense. in a very narrow sense. the good becomes divisible so far as its use is concerned. are excluded from its use. Private versus Public Goods. Overall Resource Allocation -Steps in Cost-Benefit Analysis-Justification for the use of Cost-Benefit Analysis. A good may be priced in the market and only those may be allowed the use of it who pay its stipulated price. would just be limited to finding out the benefit cost ratio which happens to be a measure inter alia. as a part of a five year plan. Thus. PUBLIC GOODS VS PRIVATE GOODS : The Product Divisibility There are certain goods the availability of which to users can be decided in a discriminatory manner. In this way. It should be obvious that anybody contemplating investment must try to judge its cost benefits. or for the public sector activity where such a partial or overall analysis is more important a guide for the government as well as for the business world. regarding the 'broader' sense has a reference to a micro level decision. INTRODUCTION The cost-benefit analysis. in the broadest sense. 1. Those who do not agree to pay its market price. To put it differently. cost benefit analysis refers to the analysis undertaken to judge any project f investment whether government or private and find out its worth and facilities its comparison with other available opportunities of investment.Chapter 7 COST BENEFIT ANALYSIS Preview Introduction. its divisibility of a good and the Cost Benefit Analysis 257 . In this sense. to analyse various investment opportunities and to find out the worth of each of them. such a good may be priced and the principle of exclusion may be applied to its use. whether by a private or by a public sector undertaking. the ability to price a good. Government Investment. But whatever has been said here. However.

through their demand. People voluntarily decide to pay for the supply of good which can be priced and to which the exclusion principle applies because those who do not pay can be excluded from its use. such decisions cannot be taken through market mechanism. An individual cannot ask to be left undefended by the defence arrangement of the state. As seen above. The indivisibility characteristic is also stated to mean that each individual has an access to the entire amount of public good. This is referred to as the problems of free riders . all go together. whether or not it is to be supplied at all. the supply of the service will still be there. Once the country is protected against foreign aggression. preferences. some members of the society cannot be prevented from its consumption. very few would pay voluntarily. For example. The decisions regarding these goods are. It cannot be priced in the market in order to deprive some members of the society from its use or its benefits. every individual would argue that even if he does not pay for it. an individual does not voluntarily agree to pay the market price for the milk. In some cases a consumer cannot surrender the use of a service even if he wants to.such as through taxation. The indivisible goods. are called pure public goods. provided some other members have the access to its use. the buyers would decide. A typical example would be the defence service. or refuse the benefit of a reduction in air pollution or that of street lighting etc. and in case it is to be supplied. And this creates a problem of raising the necessary finances in their case. it may be that in the case of a certain good. The society has to decide the way in which these decisions will be taken and financed and these decisions need not be unanimous. whose benefits cannot be priced. A section of the society cannot be excluded from enjoying the benefit of this protection. In the case of a good which cannot be priced. since very few individuals beneficiaries will be ready to pay for it voluntarily. So he would rather avoid the payment and let others contribute for providing the defence service. to which the principle of exclusion does not apply. the market would refuse to supply him the required quantity. in the case of defence service. As a result the provision of such a good or service has to be made through compulsory contributions by the members of the society . then they will also decide about the quantity of its supply. for example. therefore. there is to be some form of compulsion in providing the necessary finance. is indivisible. But we have seen that this exclusion principle can not be applied to the indivisible goods. every citizen is more or less equally protected and benefited. On the other hand. Pure private goods. hoping that through the contributions and efforts of others the service will be there. The defence service. are completely 258 Managerial Economics .which means that everybody would like to have the benefit of the good without sharing the cost of its supply and so the necessary finances cannot be raised on a voluntary basis. and therefore. left to the government agencies. His use of it does not reduce its availability to others. Under the influence of this argument. But in the case of an indivisible good. Tuning in of a radio or TV programme by one does not deprive anyone else from enjoying the same programme. in other words.exclusion principle. If.

Such economic effects may also be called spill-over effects. In order to get an answer to this question we have to consider the following additional factors: i. the main criterion of indivisibility is that the good in question should be equally available to to all the members of the society (or a section there of) irrespective of the ability or willingness of the individual members to pay for it. This is a cost to society but not to the individual undertakings like the power house or the railways. An example of the externalities in the form of an Cost Benefit Analysis 259 . however.divisible and to them the principle of exclusion applies in full measure. for example. This conclusion implies that the pure public goods must be in the hands of public sector only. be relatively less protected. People living near the political boundaries of a country may. The term externalities refers to the economic effects which flow from the production or use of the good to other parties or economic units. the railways using a lot of coal in firing the steam locomotives put the residential and other areas near the railway loco-shades to a lot of sufferings on account of smoke nuisance. The political and social considerations such as the philosophy that the economy should not be dominated by private monopolies. Similarly. Externalities Another important characteristic of pure pubic goods is the existence of externalities. any one who disagrees to pay (or cannot pay) the requisite price would be excluded from their consumption. Thus. iii. neighbourhood effects or third party effects. The financing of the concerned activity has to be through public expenditure and not through market pricing. It. Similarly. Additional characteristics of pure public and pure private goods. Such an externality may be an economic gain or an economic loss to other economic units and would be referred to as pecuniary externality. This causes a divergence between the "internal" (or "private") and "social" marginal costs (or benefits) of the goods in question. (This is in contrast with a technological externality in which the consumption/ production levels of an economic unit affects those of others in the economy. for obvious reasons.) This affects the prices in the economy which in turn transmit their effects on to production and consumption decisions of other economic units. does not prove as to which sector (Public or Private) should provide the pure private goods. Thus. People living near public parks are actually more benefited even when the parks are accessible to all the members of the society. ii. In the market. driving the smoke-emitting buses and trucks in the cities add to the social cost of these transport facilities. The level of the efficiency at which the public and private sectors may be expected to operate and productive resources at disposal of the two sectors. It must be noted that the indivisibility of a good does not necessarily imply that every citizen of the society has actually an equal share in its benefits. a powerhouse using coal would cause a lot of ash-throwing in the neighbourhood through its chimneys.

A good example of it is the tuning in of your radio set. and so on. and non-market-external effects When the external effects cannot be priced in the market with reference to the demand and supply behaviour. Marginal Cost A likely characteristic of a pure public good is that its marginal cost would be zero or close to zero. there will be no difference between private and social marginal costs of supply. It would follow that such public goods as have non-market external effects should be preferably in the hands of the public authorities (provided they can run these undertakings efficiently) since they can decide about the creation and location of industries producing public goods irrespective of their commercial profitability of the same. Therefore. it follows that those amongst pure public goods which have non-market external effects would qualify for inclusion in the public sector. It means that through the market mechanism.economic gain would be the benefits of social overhead like a road to areas and the industries served by it. Still another example is that of a bridge over which an additional vehicle may pass without any additional cost to the society. be representing the social cost of supplying the goods and so even if it is left in the hands of private sector. (However. Thus. Other relevant considerations could be the cost conditions (discussed below). In its case. These externalities are of two types: i. The government might decide to step in where 'merit wants' are concerned. Those pure public goods which have market external effects may be left in the hands in private sector from this point of view. in our above example. a pure private good is supposed not to have any externalities. its supply would be at the socially optimum level. it is highly difficult to apportion the economic gains of the new road amongst its beneficiaries. therefore. By contrast. social and political philosophy. the provision of pure private goods should be entrusted to the private sector. therefore. the use of a pure public good by one more member of the society does not reduce its availability to the others. individual economy units cannot be protected from the economic loss (or cannot be excluded from the economic gain) resulting from the public good in question. The market pricing would. ii. To put it differently. the pricing of economic benefits of a road would not be strictly satisfying the rule of exclusion. But on account of various reasons this may not be adhered to in every case. Thus. be 260 Managerial Economics . other beneficiaries would be left out. remember that even then the characteristics of indivisibility of pure public goods still tells us that they should be in the hands of the public sector only). It must. Ordinarily. market-external effects. they are termed ‘non-market-external effects’. resource availability. It means that an additional member of society can be benefited by its use without appreciably adding to its total cost. Even if it was possible to identify some of the beneficiaries such as those who actually use the road. however.

steps above. When it comes to the choice between public and private sectors for the provision of goods possessing this characteristic. in fact. then it may be termed a public good. 2. Being lumpy. considerations similar to the ones mentioned above in the case of 'Marginal cost' characteristic apply. Investment analysis is very important but very difficult due to the elements of uncertainty. One cannot say that we can keep on adding to the number of vehicles that may use the same bridge. and in the opposite case. as discussed above. then the average cost is likely to be much more. on the other hand. Steps involved in the costbenefit analysis are. and so on. Besides there are capital constraints and social costs and benefits involved. The difference between goods is mostly of degree and not of kind. Similarly. IMPURE PUBLIC GOODS It would be noticed that it is highly difficult to come across which fully satisfy all the characteristics of the pure public goods. Similarly.for which either the society should agree to monopolistic type of private enterprise or should go in for public sector. The cost -benefit analysis as a method for investment analysis can proceed along the following steps: Cost Benefit Analysis 261 .remembered that mostly this principle applies in reality. For example. only to a limited extent. In general most goods possess elements of both 'publicness' and 'privateness'. a private good. changing value of money etc. Also it may be added that a large number of members of the society may not be able to enjoy the benefits of the public good without adding to the cost of its supply. Pure public goods which possess this characteristic have a strong case for inclusion in the public sector since public goods are indivisible also. Such goods which are neither pure public goods nor pure private goods are called impure public goods (also called quasi-public goods or quasi-private goods). the provision of the public goods may be increased or decreased for budgetary reasons or due to extraneous factors. If the elements of 'publicness' are predominant in the mixture of characteristics of a good. the average costs of operating a sewerage system would be much less if it serves a wide area than when it serves only a portion of the city. besides.. there are capital constraints and social costs and benefits involved. the argument is basically in the favour of large-scale production . In the case of private goods. it is highly difficult to come across pure private goods. Decreasing Average cost Another likely characteristic of pure public goods is that it would be subject to the law of decreasing costs. it would be subject to the economies of scale. If the public good is provided in small units. STEPS IN COST BENEFITS ANALYSIS : The cost-benefits analysis is a technique used for analyzing investment and for rating the alternative investment opportunities as well as for ranking such opportunities on the basis of the rate of return to investment. the steps involved in capital budgeting and then in analysing various projects from the point of view of an individual investor. we cannot have the same defence budget if our population keeps on increasing.

Whatever the case. This can be done with the help of projected cash outflows and inflows from each project and then comparing them out on merit. building. This would enable the investor to compare the rates of return along with the risks involved.. each of them has to be examined in terms of its feasibility. He can also borrow ideas from the established and reputed investors within and outside the country. Feasibility of implementation includes technical feasibility. one has to choose a few project alternatives for further scrutiny by carefully including the good or sound projects promising a high rate of return. If and where critical values are involved. After the alternatives are formulated. including costbenefit analysis. with a blue print and all details of requirements in terms of land. Appraisal and Selection of the Project : Appraisal of feasible projects refers to their assessment in terms of economic viability.. raw materials.e. For this purpose various measures used for evaluating the investment worth. the availability of land.e. It should be obvious that some of the projects identified and selected for scrutiny could be dropped at this stage because they are not feasible on anyone or more of the feasibilities listed here. the investor can get the necessary information from development organizations who are engaged in developing project profiles. can be adopted. labour and technocrats etc. raw materials fuel. i. Through this step of screening. one can proceed further. In doing so. prospects of employment generation.i.. he has to keep in mind the size of the investments he has contemplated and his own expertise and interest. Formulation of the Project : Once a list of projects chosen for scrutiny is ready. each measure would produce several outcomes. development of backward areas/ social groups etc.e. It is possible that he has some new project ideas. with prices of each. and management feasibility . For this purpose. financial feasibility. those of the selected projects which are viable as well as within the investment limit contemplated by the investor are selected..i. plant and machinery. The next thing he has to take into account is the capacity likely to be created and possible utilization of the capacity over time and the prices at which the products could be sold over the time -span considered ads the life of the project. economic feasibility . and power. This sort of comparison is of crucial importance because one determinate mathematical solution is not available and one has to be guided by one's subjective evaluation of the risk involved as well as one's attitude towards Managerial Economics 2) 3) 4) 262 . plant and machinery. availability of finance in time and at reasonable rates and for desired time periods.1) Identification of a Project : The first thing an investor has to do is to search various investment opportunities for the purpose of finally selecting one of them. availability of management personnel for implementing and running the project smoothly and professionaly..e. and technical know-how. Comparison of Cash-Flow : Projects which pass the third test of feasibility are then put to best comparing the cash-flows by using the cost-benefit ratio (or any of the other measures discussed above). i.

By going through the exercise of finding out such divergence it becomes the duty of the government to formulate adequate policies aimed at minimizing such cases of divergence. we can enumerate the following arguments: 1) Social Costs and Benefits : As discussed in a subsequent section. But in respect of long term projects. after ascertaining the quality and quantity are as per norms assumed and the marketing of the product industrial relations. While implementing the project after it being commissioned. JUSTIFICATION FOR THE USE OF COST-BENEFIT ANALYSIS : 6) 3. However.compilation audit of the project is the last step. It can also incorporate other consideration besides the monetory returns. it is necessary to monitor the project on a regular basis. This is possible by resorting to a modified version to reconcile the conflicting interests. Such an appraisal provides opportunity for rectifying any mistakes and improving upon the performance. the government has to intervene. repayment of loans and payments of dividend follow the norms anticipated while formulating the project. the business activities even in a market-driven economy. This can be done by re-calculating the measure of investment worth with a view to find out the actual worth and compare it with the anticipated worth at the stage of anticipated worth estimated at the formulation stage. the reader must have realized that all these measures use the rate of return as the criterion for deciding the acceptance or rejection of an investment project as well as for ranking of the projects. it is only the cost -benefits analysis which provides as insight into the private as well as social costs and benefits involved. for assessing the worth of an investment. therefore. This includes ensuring the projected time period involved is observed in practice. The selected projects will then be implemented in accordance with the blue prints already prepared. In justification of the cost-benefits analysis. This is possible by resorting to a discussed in detail. One may select a project promising high returns with high uncertainty or low profitability with low risk level. it is in the interest of private firms to look for social benefits and costs involved in their private project and take necessary measures to reconcile the conflicting interests. We have also noted the distinction between private and social costs and benefits. Mid-term Project Evaluation: A post. We have discussed above various techniques of measuring the worth of investment. as and when necessary. 5) Selection and Implementation: Keeping in view the funds available for investment one or more of the projects can be selected for implementation.acceptance of risk. This would enable the investor to find out whether the expected results have been realized or not and then find out the causes responsible for divergence between the expected and the realized results. However. amid-term appraisal is always desirable. regulate and even control. At the macro level it is necessary to minimize the divergence between public and private costs and benefits. 263 Cost Benefit Analysis .

Such a decision would lead some of the funds unutilized. the pecuniary (ie monetary)considerations may not be proper guides for acceptance or rejection of a project. i. Social Scale of Preferences : A private firm guided by its own private cost and benefit is likely to ignore the social scale of preferences involving social investments and social urgencies. it can act as limping partner and thwart the pace of development. When guided by the cost-benefits analysis rather than by a leap in the dark(i. But this cannot be an excuse for discarding them. Under such circumstances. As against this. a proposal with a smaller rate of return but a larger size of investment would get rejected. This is possible only with the broad-based or a comprehensive cost-benefit analysis. In such a case. Certain Uncertainty Vs. But the investor would always endeavour to minimize uncertainty. the rate of return related to all the investible funds available with the company rather than funds actually invested would be a better guide to investment policy..e. the long stranding tradition of then company or the ideas and the values inherited by a company over the long period of its existence are some such examples. in this exercise he would come across a certain lucrative return whose occurrence ma be rendered uncertain due to the rapidity in the changes of technology and /or changes in the market conditions. Overall Profitability : A strict adherence to the rate of return criterion would lead to the choice of a smaller investment proposal with a higher rate of return. It is necessary to remember that the development of the economy presupposes the development of the entire society and if no heed is paid to the needs of the deprived unorganized sector. It is for this reason rather than for any other form of social obligation that the business sector has to care for social fall-outs of their activities. In fact the overall profitability. some projects would involve uncertainty which can be incorporated in the measure adopted. The prestige of the business firm. Uncertain Certainty : uncertainty is an important element in case of any business in the modern dynamic competitive world. purely subjective valuations). The cost benefit analysis is a measuring rod that can be used for recognizing and incorporating the social scale of preferences into the appraisal of an investment proposal. the investor would prefer an uncertainty which is certain i. the moral of the employees. the reputation or the image of the firm in the market. Such a criterion can be evolved with the help of cost-benefit analysis. Managerial Economics 3) 4) 5) 264 .2) Intangible Factors : many times certain intangible factors enter into the consideration of project appraisal and such factors are not unimportant.e. as disused earlier. Such a neglect would accentuate the gap between the organized sector and the unorganized sector in a dualistic developing economy. There are ways like shadow/pricing which can be adopted for computing costs or benefits of such intangible factors. estimable. This (latter) then becomes a case of certain uncertainty.. It is true that these ultra-financial criteria are difficult to quantify.e. The investor therefore is faced with a choice between certain uncertainty and uncertain certainty.

the monetory policy. Natural calamities. a scrupulously carried out cost benefit analysis on a continuing basis has become as important prerequisite.. Unforeseen Circumstances : in spite of all the efforts at a systematic planning of future steps and the incorporation of uncertainty in the investment analysis. While preparing the cost-benefit analysis. cognizance has got to be taken of the implications of these policies upon the costs as well as the benefits accruing to the firm. are such examples. COST-BENEFIT ANALYSIS: PRIVATE AND SOCIAL : 7) 8) 4. Such calamities not only demand urgent steps and expenses to make good the losses but also a quick quantification of such losses. the latter is recognized as economic costbenefit analysis to be contra-distinguished from financial cost-benefits analysis which his analogous to private cost. Such a regularity of analyzing costs and benefits not only helps to review the performance but also provides basis for acquisitions and mergers etc. For this purpose cost-benefit analysis can be of great help. Besides the industrial policy. the MRTPA & policies under the act. there are other policies like the import-export policy. We also saw that the economic concept of opportunity cost is more relevant than the accounting concept of total cost or individual resource cost.benefit analysis. In India we have the industrial policy announced by the government of India and modification changes in the same are announced from time to time. which have become a familiar event in the present context of liberalization. Future Disposable value : The cost. Cost Benefit Analysis 265 . This fact about the State policy as it effects the performance of industries justifies the cost benefits analysis. inter alia. Under such circumstances. when we come to the distinction f\between private and social cost-benefit analysis. no firm can rule out the possibility of handing over or taking over or purchasing a share in investment of some other firm. the fiscal policy etc. wars. This is why. which have a bearing on an industry's performance. Further in view of the fact that there is a divergence between private and social costs and benefits. contingencies and eventualities may occur which were unforeseen at the time of the launching of the project. in fact such policies are viewed as instruments of performing these tasks. the policies formulated by the government contain correctives for narrowing down the gaps between the private and the social costs/benefits.6) National Industrial Policy : Every country has its own set of economic policies including the industrial policy. mass riots etc. With intense global competition and highly dynamic changes taking place in the business world. We have noted earlier that economics and accounting concepts of costs are different.benefit analysis is the right measure for deciding the worth of an investment project and such an exercise is needed to be undertaken with a certain periodicity like a year or two years. This enables the firm to find out the current worth of the project and also enables it to project the future worth over a period of time.

. uses the terms Marginal Social Damage (MSP) and Marginal Private Damage MPD to denote social and private costs of externalities like pollution and goes further to clarify the divergence between the two and the costs of abatement of damage involved for the private enterprise and the society as a whle and advocates public intervention for reconciling the two abatement costs. It was Karl Marx who emphatically refuted this belief. if the social aspect of its operation is neglected.' one man's food is another man' poison'. This is of course partially true. Managerial economics. What he meant was. Pigou. Prof. for instance. a firm has to take cognizance of social obligations as well.It was well-known Cambridge economist. promotion of regional balance in course of economic development. But individuals tend to limit their frame of reference to the present. and even irrelevant in the modern business environment. Social Goals : In a market economy. A. What we have referred to as 'externalities' arise and lead to a conflict of interests which needs to be resolved. on the other hand. Partial Contradiction between Interests : The classical advocated of near-complete economic freedom believed that if every individual member of the society was allowed freely to maximise his interest. are different. The firm’s cost-benefit analysis would remain incomplete. arises the distinction between private and social valuations of costs and benefits. Modern economists treat the social costs and benefits as externalities of private investment and production decisions. It is necessary to remember that the modern business management understands that. this pathbreaking work not only placed the 'Welfare Economics' branch of economics on the right pedestal it deswerved. maximum social benefit would be automatically achieved. in its own long-term interest.C. way back in 1920 in his book economics of welfare'. but also triggered off pioneering line of thinking in the area of private Vs. It is also possible that the pursuit of social objectives may go against personal or a private firm's interest. the macro-economic objectives of economic stabilization. Samuelson. reduction in the distribution of income. are important. the 'divergence' noted above starts from the divergence. A firm is guided by its own private motives and endeavours to make its own investment economically viable. who discussed at length the divergence between (what he called) Marginal Private Net Product and Marginal Social Net Product (MPNP and MSNP). in terms of the well-known dictum. economic development itself alleviation of poverty etc. employment generation. relates this divergence to the cost-benefit analysis. a firm in the private sector basically aims at maximization of money profits. At the level of the society as whole. Industrialization and concentration of industrial activity at Managerial Economics ii) 266 . But whatever the firm does may entail externalities which may ne in the contravention of socially desirable goals. necessary to understand the distinction between private and social cost-benefit analysis. social accounting of resource allocation emerging through the market mechanism. as a social science more concerned with the application of economic principles to management practices. i) Private Vs. Social goals. between objectives only. Prof. Hence. Its is therefore.

we can say that there is a partial contradiction as between private and social interests. while a U. accidents. the World Bank. though they are difficult to measure. is computed at the shadow rate. What is the cost of sufferingd by the people due to pollution ? how to value the damage to the priceless heritage of Taj caused by all the industrial units in tis vicinity? For overcoming this difficulty. emergence of slums. Therefore. one method suggested by experts for valuing social costs and benefits was to value these costs and benefits at the world prices.friendly generates social benefits for which no social cost has been incurred. in 1975 suggested a synthesis of the two approaches. strain on civic amenities and several health hazards. they can be found out by taking into account the prices received in case of benefits and the prices paid in case of costs incurred. the problem of valuation of items which are not traded remains unresolved. nor can we ignore the damage being done by the factories at and around Agra to Taj Mahal. iii) Valuation of costs and Benefits : A fundamental difference between the private and the social costs and benefits arises due to the problem of finding out the values involved. One can not forget the Bhopal gas tragedy entailing social suffering for years on end.tradeable ones at the shadow prices. agency advsed to use shadow prices (i. All these are social costs not included in any of the firm's account -books. the tradeable items would be valued at the corresponding world prices. According to the World Bank 's approach. In India. Private firms tend to be unmindful of both costs and benefits for the society arising out of their pursuits of self-interest. resource costs) for the same purpose. The above examples clearly show that a private project may involve.N. which are open to public. the planning commission has evoled sech methods and announces the shadow exchange rates and shadow wage rates from time to time. a garden etc. Therefore. and the non. In adopting both these methods foreign exchange earnings as well as expenses or uses of foreign exchange are valued at the shadow exchange rae(and not at the official or market rate). In respect of the formar. the problem of valuation arised due to the difficulties in quantifying the costs and benefits. when a private project involves construction of a swimming pool. So far as the private costs and benefits are concerm\ned. Cost Benefit Analysis 267 . the labour cost. while at other times a private benefits would be less than social benefits. social exceeds private benefit. certain social costs and benefits. traffic congestions. Siumilarly. a play field. On the other hand. We must pay enough attention to the social costs and benefits involved. alongwith private costs and benefits.e. Plantation programmes undertaken for making one's own factory environment . Systematic methods for calculating shadow prices have been evoled in most of the developing locality leads to several social costs in terms of air and water pollution. However when it comes to comparison with social costs and benefits. Sometimes social costs exceed private costs. too.

as is done by Prof. This can be done by using various investment appraisal techniques. for the purpose of judging the acceptability or otherwise of any project and /or ranking of alternative investment opportunities on the basis of their worth. reduction of regional disparities etc. However. the social benefits would be discounted to incorporate the undesirable effects on society It is necessary to remember that the points of difference between the private and the social cost-benefits analysis relate to (a) the estimates of costs and benefits. on he basis of the weighted average cost of capital as the discount rate. these two are vlued at the world or shadow prices and then various measures of finding out the worth of investment can be adopted. in both these analysis. the techniques or methods of assessing the investment worth remain the same. Again.. In respect of the social costs and benefits. private costs and benefits valued at their respectivew market prices are taken into account. in finding out social benefits and costs. In the private cost-benefit analysis.He then proceeds to illustrate his point with the help of a diagram. let us take the example of pollution. due attention is paid to the social objectives like employment generation. one can use the Pay Back period method or the Internal Rate of Return Method or the Net Present Value Method etc. the weighted average cost of capital for the project can be used for discounting. Therefore. Samuelsonm. For a better understanding of the divergence between private and social costs. on the other hand. if a project is located in a backward region or provides employment to unskilled workers in large numbers. for finding out the present valuve. In the social cost-benefit accounting. For example. our concern is to know the cost to the society. one cant trun to the rates at which the government could have got the funds from international financial institutetions. The government. If a project. is producing goods which are luxuries or are likely to create health hazards. and (b) the discount or hurdle rates used. the funds here would be the equivalent of those employed in a private project under review. 268 Managerial Economics . in this way. one can take the investment decision. then the social benefits of such a project are compounded to incorporate these benefits. undertakes social investmensts. This rate could be treated as the rate of discount for finding out the present cost of the private project to the society. By this procedure. in other words. The figure to follow on the next page shows the divergence and suggests the correction of such a divergence. on behalf of the society.iv) Methods of valuation : In the valuation of costs and benefits. one has to use a discount rate. In case of the private cost-benefit analysis.

the MPD and MSD are equal. so that the gap between the two would be bridged and the equilibrium level will correspond to the standard level of OQ2 which might be judged as the safe limit of pollution.e. how much the firm will have to pay to reduce pollution per tonne of pollution for every increment of out put. 5.) P E T B Marginal Private Damage (MPD) O Q2 Q1 R X Pollution Quantity (per tonne) In the above diagram. the equilibrium point will be at E. It should be noted that at this equilibrium level of output of pollution. which is higher.Figure Showing Divergence between Marginal. the factory willhave to pay a penalty plus a pollution tax on a continuing basis. As a result. If this standard limit is crossed. Marginal Social Damage (MSD) and the marginal private damage (MDP) lines indicate the incremental damage done to the society by the pollution produced by a factory. The MCA line shows the marginal cost of abatements. If a pollution standard is imposed by the government. they are therefore. i. Private and Social Costs and it's Correction Pollution Standard Inposed Y C Marginal Cost of Abatment (MCA) Marginal Social Damage (MSD) S Z Marginal Cost and Damage per tonne (Rs. they are counted by the firm. are the external economies and diseconomies resulting fro the firm's activities. while the MSD line. Without any intervention by the pollution control authority. Cost Benefit Analysis 269 . MPD (dotted line) shows the damage including the done. The social costs and benefits. shows the total social damage including sufferings of the people living around or passing by and inhaling polluted air.however. Policies to Reconcile Private and Public Costs and Benefits : AS we saw earlir. the MPD line moves upward and ultimately the factor's own MPD plus tax/penalty would make MPD= MSD. marginal private damage is QT but marginal social damage is Q1S which is at least three times the private damage. known as 'externalites'. the firm will strike equilibrium at pint P where marginal private cost and marginal private benefit would be balanced. the private costs and benefits ae 'internal' to a firm and as external diseconomies or economies of the activites going on in the firm itself.

in advanced countries. in cases of firms or persons causing damage. polio. the government orders to keep the damage under specified limits which are judged to be safe. SAmulson. social costs. Private Action providing Correctives: In most of the developing countries. The time involved and the affected people and pay compensation to motivate the company to negotiate with the afffectd eople and pay compensation to the people. has three limitations: i) the negitiatied compensation would be less than warranted by the damage.If a factory is polluting the water or air of a locality."……… the general remedy for externalities".typhoid.danger from drunken drivers or gargantuan trucks etc. the MPD corresponds to the MSD because of the incentive to improve (or a disincentive to degenenrate).e. i) Negotiation: One such remedy is negotiation . we saw that when pollution standards are imposed. private approaches may also succeed. i. plague etc.As some exmples of the negative externalities. Such action may be in terms of a direct control or financial penalties. Such safe limits are 270 Managerial Economics . these he calls negative economies. As positive externalities. an action on that part of the government would be necessary in such cases. where the legal and judiciary systems are transparent.however. the local residents can use the company and place a claim fo compensation. All these externalities are suggestive of a market failure or an inefficiency on the part of free markets. Liability Rules: where tha law clearly lays down reules regarding liability of the person/s causing damage. However. the radio or TV signals that we get free of charge or the benefits of widespread public health measures that have eradicated epidemics such as small-pox. Interms of the diagram of divergence between private andsocial costs/benefits. the affected people can always take resourse to judicial intervention and demand compensation. Samulson mentions the air and water pollution. This corrective . i) It is observed that in most of the countries. governments rely on direct controls in t matter of combating health and safety-related externalization including pollution.' is that the externality must be somehow internalized". Prof. The court may order a compensation which would fully (or partly) bridge the gap between MPD and MSD. risks from unsafe factories or nuclear power plsnts. and iii) the number of firms as well as that of the affected people must be limited. he cities the examples of radical inventions. ii) Government Action: A more effective solution to the problem of internalizing these externalities is an intervention by the government in the form of some action against the generation of social costs. ii) the loss o damage must be indentifiable . observes Prof.

and if it does. the big defaulters escape and the small ones penalty.e. These limitations are: i) for choosing a minimum standard. iii) The enforcement of control is not effective enough. They may opt to pay the firm and continue doing he damage because this is a cheaper option. the law fails to distinguish between large firms and small firms. or else they could be bribed to ignore the default. very few governments have given them atrial. The pertinent question however is does this solution work in practice? This brings us to the practical problems and limitation standards involved in the imposition of these and subsequent penalties. more hazardous and less harmful pollutants. In fact. Such a road roller application of standards cannot work. v) finally.ii) secondly. the private firms/persons will never reach the required standards. The rate of taxation will have to be high enough to induce the firm to adhere to the standards rather then pay the tax. the legislative bodies should have the political will to follow this course of action. and so on. Cost Benefit Analysis 271 . in the diagram we have already seen how such a standard -setting works. But these considerations are unattractive to the politicians on whose initiative rests the tax-measure legislation. the government has to perform a cost-benefit analysis for which it must have full data regarding damage and abatement costs. I. it would confirm its failure to control the dmage caused by the externality concerned. in which case the factory will ah veto be cloe\sed down unless it invents and adopts a new pollution-free-technology. For one thing. the taxmeasure should be economical. may be because they think it difficult to impose and collect them. under such a system of rules. in practice. ii)strictly speaking the standard willl have to be zero.publicized and those who exceed these limits are penalized. Such a situation is almost impossibleto obtain. The success of this tax measure lies in damage -control but this means the tax would notyield any revenue. in general. This measure also suffers from certain limitation: i) though economists have advocated these taxes. The pollution under control (PUC) certificate to be kept ready for examination by environment. iv) The enforcing officials themselves must be above suspicion. iii) finally. the cost of collection should be reasonable.andshould be cartain. not fetch revenue to the treasury but to hit the target of bringing round these guilty of showering externalities on the society. Moreover. there is basic conflict of objectives whichstrenthens the inaction referred to in the preceding limitation. unless the penalty imposed exceeds the cost of removing the short-comings. ii) Externality taxes : Another way suggested by economists is the imposition of an emission tax or an externality tax.

Under such circumstances many of the economic operations might need a fine-tuning. inflation. at any given time. In a dynamic global modern economy. Infact. However. business fluctuations etc. therefore. Such an action/policy instrument becomes necessary when the economy is either going to slow or it is going in the wrong direction. called upon to intervene and take necessary legislative and regulatory measures for assisting the smooth change-over. Fine Tuning of the Economy: The functioning of the economy. Weeding out Economic Evils: Unemployment. However.6. in a modern economy. the government is not supposed to simly watch what is happening in the economy as a whole. Therefore. COST BENEFITS ANALYSIS AND OVERALL RESOURCE ALLOCATION : We saw that in a market economy where consumers and producers are enjoying maximum economic freedom. But the system demands that these changes must be brought about promptly and properly. Speeding up the pace of the Economy: Every government has a set of well. These instruments would serve to stimulate the right types of forces and to discourage or suppose the undesirable trends in the economy. A macro-economic policy and a governmental intervention is needed to give a stimulus to forces declared objectives. The State is. for adjusting the economy to such shocks and abrrations. such situations are likely to occur from time to time and they need to be corrected in time. The need for such a policy can be stated as follows: i) Correctives fir shocks and disturbances: Inspite of the fact that the market mechanism functions automatically. after carefully outlining the objectives of such a policy. the role of the government as a producer gets limited. the government has to plan macro-economic policy. the free enterprise system does not automatically adjust itself to the variety of shocks and dusturnaces which are bound to appear in an open economy. are the economic evils which need to be eradicated by adopting the right types of macroeconomic policy instruments. Structural Changes in the Economy: The very dynamism of the economy makes it necessary to adopt structural changes in the economy. could be going through deviations from the normal and competent course. This task can be performed by macro-economic policy instruments. there are several obstacles and frictions in switching over to the new order. the complexities of economic relations have increased so much that the government has to remain on its toes so that no undesirable set of actions is undertaken by any of the economic palyers. awell thought-out policy has got to be formulated.defined and declared objectgives that the economy would be expected to attain but by itself the economy may taker a long time to attain these objectives. ii) iii) iv) v) 272 Managerial Economics .

Here. is perhaps necessary. Production of cigarettes. however. Finally. But when it comes to comforts and luxurious.See the following figure as an illustrsation. Our objective would be to understand the functioning of the cost-benefit analysis as such and then to find out qualifiacations which can be added to this analysis for applying it in the formulation of a macro economic policy aiming at maximizing social benefit. the same can not be said . the curve Cost Benefit Analysis 273 .there is no way of quantifying it. This is because one man's food. welfare consideration follows the net wealth consideration. For acheiveing the maximization of net wealth. let us start by assuming that economic welfare as part of total community welfare can be maximized by maximizing net wealth. However. to maximize the difference between benefits and costs. A little elaboration. Production and trading of several commodities can be cited as an exmple of this type. as the saying goes.condition for wellbeing can be applied and accepted in respect of necessaries of life and of efficiency. given the amount of available resources. Moreever. In the first plcace. Maximum oyutput that can be produced during a year issubject to the constraint of production possibility which demarcates the boundary or the frontier which cannot be crossed. Welfare is the resultant of a state contenment and fulfillment which itself is the result of the feeling of satisfaction. dividing welfare parameters involve value judgements which may vary from society to society and from one set of objectives to another . Since satisfaction is a state of mind. a summation of maximum individual welfare does not automatically lead to maximum social welfare. we are concerned with economic welfare whch is assumed to be maximized by satisfying as many of human wants as possible.e. liquor or drug-trafficking are examples of this type.[A] Cost-Benefit Considerations at the Macro Level The cost-benefit analysis is expected to provide an approach to the implementation of macro-economic policy which happens to be the responsibility of the government. on the macro-level. This approach has been found to be useful in handling the problems related to the welfare objectives. For satisfying wants we need the production and/ or acquisition of economic goods and services. With a view to understand the working of the cost-benefit principles. Therefore total welfare of an individual or of the society comprises of various human activities which lead to welfare. This is because thecost-benefit analysis is basically devised to maximize the net wealth i. full utilization of all the resources is necessary. the satisfaction of wants as a pre. There are. satisfaction can result from many non-economic activities. Thirdly.Secondly many economic activities generate wealth but do not lead towelfare. is another man's poison. In this diagram. various qualification to assumptions that maximization of net wealth maximizes social benefit. Ths is because the addition to total level of wealth which we called net wealth is nothing but the net value of producers' and consumer's goods and services produced by the economy during a given period -usually one year. at this juncture.

By doing this output can be maximized and employment (which means harnessing the productive resources for producing a given level of output) can also be maximized. For maximization of output. since the production has been stabilized at point C when it is possible to move forward to any other point like D and E. like thepoint E. point D indicates the possible combination as OM amount of commodity Y plus ON amount of Commodity X. the economy can produce OB amount of commodity X or OA amount of commodity Y. Y A E C Commodity Y M D O N B X Commodity X Figure showing Production Possibility Curve Alternatively. we have to utilize fully all the resources available to us which means discarding any position like the one shown by point C and trying to reach the boundary by aiming at any combination of X and Y of our choice. or a combination of both X and Y. point C in the diagram indicates under utilization of resources. the limit AB can be rached only by using the resources fullu. would show the maximum possible amount of output with varying resources. we shall have to reach a point which 274 Managerial Economics . any other point on the AB curve. It should also be clear that the terms maximization of output or maximization of net wealth imply reaching any point on the production possibility frontier AB. As against this. If we want to produce more than what the production possibility curve demands. point C in the diagram indicates under utilization of resources. the economy can produce a combination of X and Y as given by all the points on the curve AB or inside the curve AB. By using all the resources. In this diagram. In the same way. With the resources being given and limited.AB is the frontier which is known as the production possibility curve or the production possibility frontier. For example. As against this. It should therefore be clear what we mean by full utilization of resources. we assume that the economy has an option of producing either commodity X(shown along the X-axis) or commodity Y(shown along the Y-axis).

(B) ADVANTAGES OF COST . The measurement of a trade . under the assumption noted above. In this case. the problem does not arise because the money value of costs and benefits associated with the achievement of alternative targets can be explicitly pointed out. by assuming a definite correlation between wealth and economic welfare. the principle can suggest measures to maximise the difference between the total benefit and the total cost. This would be possible only by raising the productive capacity of the economy.would lie on another and outer production possibility curve which would lie beyond AB and away from the point of origin O. Such a shift in the production possibility curve indicates economic growth.BENEFIT ANALYSIS : The policy objective of maximizing the difference between cost and benefit has various advantages which can be noted briefly as follows : i) It aims at maximization of social welfare through maximization of net wealth. on the assumption that any move that increases net wealth can increase social benefit and. the cost of a policy measure can be explicitly identified and can be incorporated in the total cost of the project. In following this principle. By adopting a suitable discounting method. The problem of assigning costs and benefits to various targets does not arise in this between different targets is always a difficult problem. The costbenefit analysis. By using this analysis we can show the measures necessary for attaining maximum net wealth and optimal policy aiming at this goal. in turn. In this approach. This is because. For achieving economic growth we shall have to maximize the output in the existing conditions of resource-availability. ii) iii) iv) v) vi) vii) Cost Benefit Analysis 275 . can increase social welfare. This enables us to measure objectively the trade-off. Even when a target is partially attained. either by finding out or mobilizing additional resources or by increasing the productive efficiency of the existing resources. the costs and benefits can be calculated and whatever change has taken place in the net wealth can be ascertained at that point of time. the costs and benefits as arising in different periods of time in future can be estimated. can serve as a guide for macro economic policy. the problem of infinite target value does not arise.

Whatever applies to costs also applies to benefits i. However economists like A. Everyone at present carries thousands of exchanges which alone enable him to live comfortably.benefit analysis as discussed above obviously suffers form certain limitations. Market has become the pivotal point in modern capitalist and mixed economies. 276 Managerial Economics . Increasing division of labour or specialization has been taking place in both developing and developed countries. distribution is given and has to be kept as it is. the analysis assumes away all difficulties involved in the calculation of present and future cost as well as private and social cost. This means everyone is at present producing goods and services (including labour of various types) for the market. we say that there has emerged ''Market System' or 'Market Economy'. i) Critics have pointed out that this analysis is applicable in a partial equilibrium framework. The cost benefit analysis is applied on another assumption that the existing pattern of distribution of income. In fact. Overall Resource Allocation : Market System or Market Economy (or Market Mechanism or Price Mechanism) comes into existence when custom gives place to competition and practically everyone begins to produce goods and services for the market with a view to make maximum profit out of the production for the market. We have already seen that this is not so. It is when market becomes the pivotal or central folcrum of the economy and influences allocation of resources and distribution of income and wealth. calculation of present and future benefits as well as private and social benefits involves similar difficulties.(C) LIMITATIONS OF COST . Another limitation of the analysis is that it ignores the effect of diminishing marginal utility of additional wealth or income with every incremental dose of income or wealth being added to the existing total. Harberger have shown that it can be applied to the general equilibrium analysis as well. a change in income distribution does lead to a change in net wealth and further in social welfare. The exactness and usefulness of this analysis is limited by the fact that it is based on the assumption that maximization of net wealth can ensure maximization of social welfare. All prices have become closely interrelated and influence all other prices. ii) iii) iv) v) vi) 7.BENEFIT ANALYSIS : The cost . Market System or Market Economy may be said to come into existence when freely fluctuating prices in the market begin to influence allocation of the community's resources and distribution of income and wealth produced in the community During modern times we get what is called 'Market System' or 'Market Economy'.e. C. By assuming the positive correlation between wealth and welfare..

Thus if consumers begine to prefer TV sets than radio sets. since producers are free to use their resources as they like. Thus more TV sets and relatively less radio sets will be produced for the market. Assumption of Market (or Price) Mechanism There are certain assumptions on which operation of the market (or price) mechanism is based. to a level where profits in both TV manufacturing and radio manufacturing industries become equal. This gives consumers what they prefer more. on the basis of price changes.competition among consumers and among producers. Consumers. Market (or price) mechanism is explained above with a simple model of only two commodities. each consumer and producer knowing fully well what is taking place in the market and hoe prices are moving. This also means that market mechanism brings about most efficient use of the community's resources. Changes in free fluctuating prices act as signal to producers. prices of TV sets will go on rising more relatively to prices of radio sets. and as they are motivated to make maximum profit. Each consumer knows what is in his best interest and acts rationally to secure maximum satisfaction. Under market mechanism. Thus market or price mechanism is supposed to help solve the basic economic problem . There is perfect competition in the market . express their preferences through to make the most efficient use of community's resources and how to derive the maximum satisfaction from the community's resources. Market or price mechanism operates along the same principle even when there are many commodities and services. who are free to spend their income as they please.Market mechanism or freely fluctuating price mechanism is another system of solving the basic economic problem before the community: In this system all the persons are supposed to enjoy personal freedom as consumers and producers and are free to use their resources as they please without any legal or other restrictions or barriers. Naturally this results in maximization of welfare of the community everyone getting what he wants. to the production of goods according to the changing preferences of consumers. The important assumptions are as follows: i. ii. they will divert their resources from production of radio sets to the production of TV sets. People express their preferences through prices. Cost Benefit Analysis 277 . They switch their resources. Shift of resources from production of radio sets to production of TV sets will go on until more TV sets in the market and relatively less radio sets there will bring down the prices of TV sets and raise the prices of radio sets as there are fewer radio sets available.

iii. Criticism of Market or Price mechanism But in actual life market or price mechanism does not operate as smoothly and efficiently as described in the above model. Absence of competition often gives rise to monopoly which can prevent entry of outside units in its line of production and manipulate prices by creating artificial scarcities. Every individual should therefore be left free to carry on his economic activities as a consumer and as a producer and so on without being dictated by any one else including the government. 8. There is never perfect mobility of factors of production. ii. FOUNDATIONS OF MARKET SYSTEM OF ECONOMY The market system of economy (also known as Laissez Faire capitalism or simply capitalism) is built on the following foundations: i. This is because the above assumptions are not always and fully valid and do not obtain in real world.and influencing and 278 Managerial Economics . The competition among consumers and producers assumed in the above model is often absent. Freely Fluctuating Price Mechanism : The sovereign consumers express their demands and preferences through freely operating prices or through price mechanism. Some factors of production are specific and can produce only certain goods and not other goods though the prices of the latter may rise. a consumer with his complete freedom to spend his income as he likes is sovereign as a consumer dictating to producer what goods he prefers and therefore should be produced. especially in the case of labour. Consumer's Sovereignty : The above assumption implies that in a market system of economy. Freely operating price mechanism thus acts as a signaling system indicating to various producers . Different factors of production even if there is competition will find it difficult to move from industry to industry in search of higher profits as depicted in the above model. Thus consumers do not always know what is in their best interest and do not always act rationally. Different factors of production have perfect mobility and they can move easily and quickly from one industry to any other in search of higher profits.that they prefer TV sets to radio and radio sets to gramophone and so on . Every individual knows what is in his interest and no one does that well than himself. the best judge of self-interest : In the market system or capitalist economy.iii. it is assumed that every individual is the best judge of his personal interest. There is also not full knowledge among consumers and producers about market conditions and happenings. Individual.consumers' preferences . This means the market system of economy is characterized by consumer's sovereignty.

it follows that when all individuals attain maximum satisfaction of their own. share and other financial assets and such other tangible and intangible goods). and producers compete among themselves for getting factors of production to produce goods and services to be sold to consumers at competitive prices.e self-interest) is the most powerful motive which will bring out the best effort by every individual. The government has no role to play as a producer of goods and services except to a very limited extent where private enterprise may not be interested. Harmony between Individual Interests and Interests of the community : Since in the market systems (or private enterprise economy or capitalism) each individual is free to strive to maximize his personal satisfaction of which he is the best judge.bringing about allocation of limited resources of the community in accordance with consumers' preferences. vii. iv. viii. Private Profit Motive : In the market system of economy most of the goods and services are produced by individual producers who enjoy perfect freedom as producers without being dictated in this regard by anyone else including the government. vi. buildings. The chief or major foundation of the market system or private enterprise economic system is that among all motives to human activities. v. There is thus no clash between interest of an individual and that of community. most of the goods and services are produced by individual producers or groups of individual producers. And therefore under this system all production is carried on by individual producers with a view to maximize their personal profit. Private Enterprise : In the market system in economy. private profit motive (i. Institution of Private Property : Another major foundation of the market system of economy is the institution of private property (i.e. That is why the market system is also known as private enterprise economy. factories. In this system consumers compete among themselves for goods and services in the market by offering competitive prices to get them. precious metals like gold and silver. Existence of Competition : Open and free competition among consumers and producers may be said to be the very soul of the market system of economy. Cost Benefit Analysis 279 . community made up of those individuals would automatically attend the maximum satisfaction or welfare. exclusive right to own and enjoy one's property in land.

ix. and if there is no clash between interest of an individual and welfare of the community. Non-Interference by the State (or Laissez Faire) : If under the market system every individual acting for his personal interest or personal profit can automatically ensure maximum welfare. The above are the foundations (that means the assumptions) on which the 'Market System' (also known as Market Economy or Capitalism) stands or functions. not only of himself but also that of the community. 280 Managerial Economics . People should free to carry on their economic activities as consumers and as producers. if freely functioning price-mechanism with its competitive system can automatically ensure maximum welfare of the consumers and most in the State or government trying to interfere in the economic activities of the people telling to do this and not to do that and so on. and no clash of interest between welfare of consumers and that of producers.

2. Cost Benefit Analysis 281 . Give an idea about government investment in the context of Indian economy. 4. 3. how resource allocation and income distribution takes place in a free enterprise economy. 5. Explain with illustration.Exercise : 1. What are the foundations of Market Economy? Compare and Contrast Private and Social Cost-Benefit. Explain fully the distinction between Public goods and Private goods.

NOTES 282 Managerial Economics .

NOTES Cost Benefit Analysis 283 .

NOTES 284 Managerial Economics .

total investment.i. Macro-economics deals with the major economic issues. labour Macro Economic Analysis 285 . unemployment.The Keynesian Macro Economic Theory ." In short.Income determination. Similarly. Are the crucial economic aggregates. Macro-economics deals with the market for all goods as a whole.Macro Polices of Full Employment. exchange rates. It is concerned with the macro-economic problems such as the growth of output and employment. exchange rates. it concerns the overall dimensions of economic life. balance of payments. Economic Stabilization. disregarding details at the particular level . inflation. house-holds and government is seen in total. etc are the subject matter of Micro economics.Chapter 8 MACRO ECONOMIC ANALYSIS Preview Macro Economics . macro-economics deals with the major economic issues.. In macro-economic analysis the behaviour of economic agents such as firms. According to Prof. problems and policies of the present times. National income. trade cycles. etc.e. Consumption and Investment Function. savings. national income. Inflation . micro level. money. the balance of payments. MICRO ECONOMICS INTRODUCTION Macro-economics is the study of the aggregate behaviour of the economy as a whole. the rates of inflation. problems and policies of the present times. It is considered as the product or commodity market in general. etc. An individual consumer. Ackley: "Macro economics deals with economic affairs 'in the large'. particular market for a given commodity. operation of a firm. Business Fluctuations.

National Income : Macro . financial market is taken as a whole which covers money market.economic tools and technique of economic analysis one can understand the working of the economic system in a better way. theory of trade cycles and economic growth. Empirical Evidences : Macro . With the help of national income statistics and accounting one can understand and evaluate the growth performance of an economy over a period of time. Likewise. inflation etc. Economics of Keynes serves as the foundation centre for the modern economics. It suggests a best of policy measures. The subject matter of macro-economics includes the theory of income and employment. faced by the country in modern times.economic studies have unique theoretical and practice significance. capital market and all banking and non-banking institutions taken together. He suggested that macro economic behaviour should be studied separately. He said that. Prior to Keynesian revolution in economic thinking in the 1930s. poverty. Behaviour in total is quite different then what we may try to infer by summation of individual behaviour. Its policies are general. IMPORTANCE OF MACRO . 1) Macro . inequality. Keynes prescribed macro-economics as a policy . Prof. Managerial Economics 2) 3) 4) 286 . M. income policy.economics provides an exploration to the Functioning of an Economy in general: Using macro . monetary policy. It does not examine individual behaviour. inflation. Macro . to deal with complex economic problem like is taken as a whole for the entire labour force in the economy.studies are based on empirical evidences of the theoretical issues. J. theory of money and banking.oriented science to deal with the problems like unemployment.economics is more realistic. Keynes in 1936 published The General Theory of Employment. saving is a private virtue but it is a public vice in a matured economy cause deficiency of demand leading to depression. Interest and Money which revolutionized the whole economic thinking. for instance. such as fiscal policy.orientation : Macro .economics teaches the computation. use and application of national income data.economics is a policy . etc.oriented science. Policy . the classical economists had concentrated more on micro-economic approach and macro behaviour was also described as mere summation of individual observations.ECONOMIC STUDIES Macro . It follows that the scope of macro-economics is confined with the behaviour of the economy in total. etc. It relates to the economy-wide total or aggregates and problems of general nature.

and the term 'investment' connoting aggregate real investment. 'consumption' implying total consumption of the community. Prof. many of the strategic variables in the Keynesian theory. like consumption function.economic tools and mode of its general equilibrium analysis. Macro Economic Analysis 287 . Keynes presumed an economic model as a short-period model in his analysis. thus. 'saving' implied total savings in the economy. It allows for changes. Keynes rejected the classical dogma of full employment equilibrium by invalidating Say's Law of markets. In contrast to the classical theory. which dealt with the segregated behaviour of individual economic entities (such as a particular consumer's demand behaviour. the functioning of economic system is viewed as a whole or in an aggregate sense. M. Interest and Money (popularly known as 'The General Theory'). 'income' for national income. One can have a better idea of a dynamic perspective in the real economic would in the light of macro . interest rates etc. It studies and suggests solutions to the issues and problems from the dynamic view point. a particular firm's production behaviour. as they would change very little in the short period. In macro-economic analysis. published in 1936. Macro-economic Analysis: The economic analysis by Keynes is a macro-economic analysis. This is in contrast to the classical micro-economic approach. He believed in the short-run philosophy of life. To him. we come across concepts like aggregate demand and aggregate supply. we are all dead'. propounded a macroeconomic theory of income and employment that highlighted the real nature of the determinants of income in a modern economy. The basic concepts underlying the Keynesian theory are interpreted in aggregative terms only. Short . 'output' meant aggregate national output. Dynamic Science: Macro .economics which have utmost practical relevance.5) Income and Employment Theory and Monetary Theory: Economics of employment and income and monetary economics are the major fields of macro . Planning and policy making is not possible without the base of the understanding of these two fields. in the system). As such. Thus. The General Theory of Employment. 6) The Keynesian Macro Economic Theory : INTRODUCTION: In his book. the Keynesian theory is demand-oriented. the economics of Keynes is also referred to as 'Aggregative Economics'. 'employment' for total employment. It stresses effective demand as a crucial factor in determining the level of income and employment. He. J. Since it deals primarily with short-term phenomena in economic life. etc. are assumed to be constant. 'in the long run. in his General Theory.economics is a dynamic science. Thus.Period Analysis: Keynes realistically adopts the short-term variables.

Keynes argued that the postulates of the classical theory are applicable to a special case of full employment only and not to general cases. if the aggregate expenditure flow decreases. capital. if the total expenditure flow in an economy increases. income flow also decreases likewise. As the flow of expenditure varies.e. In a money economy. on account of his short-period analysis of the problem. GNP is appropriately used for measuring the community's total income during the short run. Thus. That is to say. He criticized classical economists for their unrealistic assumption of full employment equilibrium condition in their economic models. under . The flow of expenditure. is determined by the level of effective demand. meant for consumption as well as investment. He claimed his theory to be general in the sense that it deals with all levels of employment and in all cases. the employment of workers along with the exploitation of other given resources such as land.bound. in any economy.employment or full employment. And. Keynesian. as one man's expenditure becomes another man's income in the economic system. Keynes pointed out that the level of income and output in an economy is determined by the level of employment (i. so depreciation allowances. are to be considered only in the long-run analysis. the level of income also varies accordingly. its generality implies its universal applicability. It is general in the sense that it is not time . It takes a general view of the economic system as a whole.) Which. Its approach and analysis are general. analysis being macro-economic. Keynesian tools of analysis are applicable at any point of time. it contains generality in approach. replacement etc. Because he felt that in the short period. Keynes treated national income as Gross National Product (GNP). It applied equally well to economies with less than full employment. Again. effective demand is revealed by the total expenditure incurred by the people on real goods and services. have no significant relevance. repairs. in turn. etc. The Principle of Effective Demand : The gist of Keynesian analysis of income determination lies in the principle of effective demand. 288 Managerial Economics . the flow of income will also increase in the same proportion. rather than Net National Product (NNP). So. in turn. It thus follows that Total Expenditure = Total Income. etc. Generality of Approach: Keynes' theory is general. He observed that there is always less than full employment in the economy.Again. determines the flow of income. full employment is only a rare phenomenon.

determines the level of output and income in the economy. or low level of income. Following Keynes. in modern times. the level of effective demand has to be raised. however. it is the outcome of government's value judgment and policies. therefore. that the level of employment is fundamentally determined by consumption and investment. thus. It must. The level of effective demand determines the level of employment which. thus. as total output comprises consumption goods and capital or investment goods. a capitalist economy is actually a mixed economy due to that. to ease the unemployment problem. there are two basic determinants of effective demand in an economy. increase only when the total demand either from consumption side or from the investment side increases. But. as in the case of public sector. from the Keynesian dictum that the level of employment and income depends on the level of effective demand in an economy. These are consumption and investment. And. government expenditure is also a significant determinant of effective demand in a modern economy. however. It follows. Modern economists. in turn. Obviously. Investment expenditure of private firms. Macro Economic Analysis 289 . restrict our analysis to the consumption and investment. represents the total expenditure on the total output produced. C I G = = = Consumption expenditure of the households. Thus. which is described as national income. expressing the total demand for consumption goods and capital goods. it also follows that the lack of effective demand implies unemployment and corresponding poverty. so the national expenditure consists of expenditure on consumption goods plus investment goods. we shall. define effective demand as: Effective demand = C + I + G. based on political and social considerations rather than economic forces. he considered consumption and investment expenditure of the community relating to private individuals and enterprises only. If must be borne in mind that the investment and employment activities in the private sector are induced and not autonomous. elements of effective demand relating to the private sector only. As such. Where. the expenditure flow in the community consists of consumption expenditure and investment expenditure. at any equilibrium level of employment. Again. It thus denotes the value of total output of the community. free from government intervention. Since Keynes sought to explain the point of effective demand in a capitalist economy.In real terms. In short. Income and employment. be noted that government expenditure is autonomous. national income equals national expenditure. and to raise the level of income and economic prosperity. thus. Government's expenditure on consumption and investment goods. Effective demand.

Thus. Hence. is defined as. the aggregate supply function refers to a schedule of the various minimum amounts of proceeds or revenues which must be expected to be received by the entrepreneur class from the sale of output resulting at various levels of employment.e. capital. sales proceeds. the entrepreneur will be induced to provide that particular level of employment. Every prudent entrepreneur must at least seek to recover the total cost of production. Each level of employment (of labour) necessitates certain quantities of the other factors of production like land. Keynes stated that effective demand is determined by the interaction of the aggregate supply function and the aggregate demand function. the supply schedule of that commodity shows the varying level of quantities of the commodity the seller offers for sale at alternative prices. etc. obviously. According to Keynes. including normal profit. Price here means the amount of money received from the sale of output. Only if the sales proceeds are high enough to cover the total costs of production at a given level of employment and output. which are known as cost of production. Keynes measured the whole of output of the economy in terms of the amount of laboour employed with a given marginal productivity. the volume of employment in an economy is determined by the entrepreneur's considerations of the aggregate demand price and the aggregate supply price at that particular level of employment. raw materials. i. the entrepreneur must get some minimum amount of sales revenue to cover the total costs incurred at a given level of employment. the aggregate supply schedule for the economy as a whole refers to the response of all entrepreneurs in supplying the whole of the output of the economy. This minimum price of revenue proceeds that the entrepreneurs must get from the sale of output. said that the level of output varies with the level of employment. associated with different levels of employment. each level of employment would involve certain money costs (including profits). He. We may illustrate the Keynesian aggregate supply function hypothetically as in following Table : 290 Managerial Economics . Aggregate Supply Function (ASF): The "supply price" for any given quantity of commodity refers to that price at which the seller is willing to or induced to supply that amount in the market. thus. That is to say. Thus. All these factors of production are to be paid according to the prevailing factor prices.e. each level of employment results in a certain level of output of commodities. to assist the labour employed. using technical terminology. i.. Similarly. "aggregate supply price schedule" or "aggregate supply function". Thus. real income along with the money income generated in the process of investment expenditure. using employment as a single measure of total output of the economy. the supply price of employment can be determined in terms of labour cost.Analysis of The level of Effective Demand (Factors Determining Effective Demand) : Since the level of activity in an economy is a matter of demand and supply.

on an average to be paid per year. It can be seen that to employ one lakh workers during the year. and so on. Rs.100 crores from the economy by selling the resulting output. the minimum expectation of sales proceeds is Rs. entrepreneurs should expect to get a minimum of Rs.000.000) (W) 10 10 10 10 10 10 Aggregate Supply Price (ASF) (in crores of Rs. is.200 crores. Thus.10.The Aggregate Supply Function Level of employment (in lakhs of workers) (N) 1 2 3 4 5 6 Money wages (per annum in 1. Rs. Following figure illustrates the ASF curve drawn by the graphical representation of data contained in previous table. Similarly.) (N x W) 100 200 300 400 500 600 In the table it is assumed that money wages. Graphical Presentation : The numerical schedule of aggregate supply price of employment may be plotted graphically and the cruve so derived is called ASF curve. for two lakh workers to be employed. the schedule shows for each alternative level of employment how much minimum sales proceeds must be raised by the entrepreneurial class to undertake to level of employment. crores Minimum Receipts/Income ASF Y Q Employment (N) (In lakhs of workers) Macro Economic Analysis 291 .

Suppose. the relationship between employment (N) and marginal productivity should be traced. To determine the shape of the curve ASF. It depends on the productivity of labour. the level of employment cannot exceed Q level (i. But. the ASF curve is an upward sloping curve. However. assumed in previous figure. This means that if the total money expenditure is doubled. and (ii) when prices are constant. the community's total outlay (national expenditure) which is measured at these constant prices and the level of employment and income.In the figure.ASF curve . but it is not very easy to conclude about its shape. the ASF curve will be non-linear and upward sloping. the steepness of the ASF curve depends on the technical production conditions. the aggregate demand function refers to the schedule of maximum sales proceeds which the entrepreneurial community actually does expect to be received from the sale of different quantities of output. cannot be linear. It is interesting to note that modern economists measure the aggregate supply function in terms of real income or value of total output by measuring GNP rather than the level of employment as Keynes did. Thus. at the full employment level. The Shape of ASF Curve : As has been seen in previous figure. The value of marginal product (VMP) is called marginal productivity which is obtained by multiplying the marginal physical product (MP) of labour with price of output (P). the aggregate supply function will be a vertical straight line. the aggregate supply function . however. the actual ASF curve which relates to changes in prices of all outputs and inputs. the economy reaches full employment when all its 6 lakh workers are employed.axis measures the expected minimum sales proceeds. such proportionate relationship is rarely found. in any case. employment and income will also double and vice versa. Again. The linear ASF curve was assumed by Keynes for the sake of simplicity in analysis. Aggregate Demand Function (ADF) : In the Keynesian terminology. In reality. in our illustration. the X . is a much simplified case. thus. That means. however. will be determined by the aggregate production functions of all firms in the economy and money wages. because we have assumed a constant wage rate. Apparently. It is based on the assumption that : (i) the money price of all outputs and inputs is constant.will become perfectly inelastic at a point where the economy is at a full employment level. In a technical sense. ASF is obtained by aggregating the expected total revenue functions of all the firms. capital and other resources employed by the economy. change in the same proportion.axis represents the level of employment and the Y . It is linear. if the wage rate is changing (increasing) or costs of employment are rising with an increase in employment. Indeed the aggregate supply price is correlative with the employment level. the linear ASF curve. whatever the expectations of minimum sales proceeds. The curve ASF represents the aggregate supply function. Thus. then the ASF curve will become vertical at point Z as shown in the figure.600 in our example). resulting at 292 Managerial Economics . The actual shape of the ASF curve.e.

the expectation of sales revenue. Macro Economic Analysis 293 . A much simplified presentation of aggregate demand function may be illustrated through the following hypothetical table. with an increase in the level of employment. for the given level of output and employment by the entrepreneurs. the expenditure flow in the economy as a whole. Thus. and vice versa. It shows that the aggregate demand price is the direct or increasing function of the volume of employment. In following figure. In a free capitalist economy. the aggregate demand schedule shows the aggregate demand price for each possible level of employment. the curve ADF represents the aggregate demand schedule. Thus. i. expected sales receipts. what these sectors are expected to spend in the next period is viewed as the aggregate demand price.depends upon the total expenditure flow of the economy.the maximum sales proceeds expected for a given level of output . The aggregate demand function may be represented graphically as in following figure. Now. thus. Evidently. households and firms are the two major economic sectors which spend on consumption and investment. The aggregate demand price .e.) 175 250 325 400 475 550 The aggregate demand schedule links real income or output (which Keynes measured in terms of the quantity of employment) and spending decisions. the quantum of maximum sales revenue expected from the output produced is described as the demand price of a particular level of employment.various levels of employment. The Aggregate Demand Function (Schedule) Level of Employment (N) (in lakhs of workers) 1 2 3 4 5 6 Expected minimum sales proceeds (expected Total Expenditure ADF) (in crores of Rs. which is determined by the spending decisions of the community as a whole. There is a positive correlation between the level of employment and the demand price. the aggregate demand price tends to rise.

we shall. The aggregate demand schedule represents the expectation of maximum receipts of the entrepreneurs at each possible level of employment. i. the level of employment will go on increasing. Equilibrium Level of Employment . Needless to say.The Point of Effective Demand : The intersection of the aggregate demand function with the aggregate supply function determines the level of income and employment. The process will continue till receipts become equal to cost. too. expected sales revenue by the entrepreneur for the output associated with different levels of employment. however. when costs exceed receipts. It can be non-linear. Thus. is called the aggregate demand price schedule or the aggregate demand function. This is what we can observe by comparing the two functions as represented in the following table. 294 Managerial Economics . Its shape and slope depend on the assumptions and nature of data related to the aggregate demand schedule. it may be recalled that the statement showing the varying levels of aggregate demand prices. the employment level will tend to decrease.e. thus follows that so long as receipts exceed costs. For the sake of simplicity.Maximum Expected Receipts (Anticipated Total Expenditure) ADF = f (N) Volume of Employment (In lakhs) The ADF curve drawn in the above figure is linear. It. consider linear functions only. The aggregate supply schedule represents costs involved at each possible level of employment.

Y ASF (A) Z E a b ADF & ASF Y (B) ASF E ADF ADF R ADF & ASF N1 N Nf Volume of Employment (N) O X O N Volume of Employment X Effective Demand Macro Economic Analysis 295 . Panel (B shows non-linear AD and AS curves. In the given schedule above. At this point. In graphical terms. though non-linear curves are more realistic. Following figure has two panels. We have preferred linear curves for the sake of simplicity of analysis. so that 4 lakh workers' employment is the equilibrium amount. it is Rs.400 crores which is the entrepreneur's expected minimum as well as maximum sales proceeds. This is the point of effective demand. The economy reaches equilibrium level of employment when the aggregate demand function becomes equal to the aggregate supply function. the level of employment tends to increase.) (ADF) Comparison Direction of change in employment (DN) 1 2 3 4 5 6 100 200 300 400 500 600 175 250 325 400 475 550 ADF > ASF ADF > ASF ADF > ASF AD = AS ADF < ASF ADF < ASF Increase Increase Increase Equilibrium Decrease Decrease So long as the aggregate demand price (ADF is greater than the aggregate supply price (ASF). the amount of sales proceeds which entrepreneurs expect to receive is equal to what they must receive in order to just appropriate their total costs.) (ADF) Aggregate Demand Function (in crores of Rs.The Equilibrium Level of Employment Employment (in lakhs of workers) (N) Aggregate Supply Function (in crores of Rs. Panel (A) depicts linear AD and AS curve. the point of effective demand and equilibrium of the economy can be represented in the following figure.

on the previous page the two curves ADF and ASF intersect at point E.e. because he assumed a static macro-economic model of the economy. indicating that costs remain less than the revenue. But. This is how Keynes explains the points of under . he speaks little about the aggregate supply function. the sales proceeds which entrepreneurs expect to receive at the point of aggregate demand function where it is intersected by the aggregate supply function. thus. the entrepreneurs would be induced to provide increasing employment till both of them are equalized. implying losses to the entrepreneurs. Thus. the equilibrium between the aggregate demand function and the aggregate supply function can.e.e. is called the point of equilibrium which determines the actual level of employment and output. the entrepreneurs would earn the highest normal profits as their sales proceeds equal their total costs at this point. it is only at point E where ADF = ASF and the normal profit is maximum that the equilibrium level of employment is ON. In fact. is called the effective demand because it is at this point that the entrepreneurs' expectation of profits will be maximized. i. ASF > ADF. indicating that total costs exceed total revenue expected. and often does. it does not imply that the economy is necessarily having full employment at this equilibrium point. only if the investment spending is appropriately adequate to fill the gap emerging between income and consumption in relation to full employment. firstly. Usually. the aggregate supply prices become higher than aggregate demand price. the investment outlay is insufficient to fill the gap between income and consumption. It should be noted that though E is the point of equilibrium. because then ASF would exceed ADF. actually only ON number of men will be employed where the aggregate demand function (ADF) equals the aggregate supply function (ASF). i. Keynes did not make a detailed study of the ASF. hence ADF = ASF at less than full employment. Diagrammatically. secondly. i. ADF > ASF. assumes the aggregated supply function as given in the short run. since ADF > ASF by ab. which ruled out the possibility of t5echnological and other changes of a dynamic nature and. for a further rise in employment. Of these two determinants of the level of effective demand.In the Figure (A). it may be concluded that employment in an economy will increase till ADF = ASF. ADF = ASF at full employment level.employment equilibrium in a real economy. But after the point of intersection of the aggregate demand function and the aggregate supply function. Thus. point E. According to Keynes. this is scarcely found in practice. ON1 number of workers will provide some possibility of maximising profits by increasing the employment further. which is called the point of effective demand. To him. Thus. Keynes' effective demand. Especially. take place at a point less than full employment. it goes without saying that so long as the aggregate demand function lies above the aggregate supply function. however. any number of men exceeding ON cannot be employed. the point of effective demand. whereas. the value OR. so that entrepreneurs would incur losses and refuse to employ that particular number of workers. when the aggregate demand prices are equal to the aggregate supply prices. Thus. he was concerned with the short period analysis during which prevailing conditions are unlikely to change. changes in 296 Managerial Economics .

as given by the ADF. In the equilibrium model. It represents money expenditure of all buyers on domestically produced goods to the level of aggregate employment. was adequately dealt with by the classical (and neo-classical) economists in developing the marginal productivity theory of distribution. with any given aggregate supply function. for only if aggregate demand is large enough will all resources be used. the higher will the employment be. is described as "effective demand". assumed a given ASF curve for the economy. concentrated on the analysis of aggregate demand function. the aggregate demand schedule is a vital factor in his employment theory. Since the aggregate supply function is assumed as given. Stonier and Hague observe that another important reason why Keynes did not pay much attention to the analysis of ASF is that he was mainly concerned with solving the problem of unemployment caused by the cyclical phase of the Great Depression in the mid-thirties. the aggregate demand function signifies a functional relationship between total expenditure and total income of the community. He. The greater the aggregate demand is at the point where it is equal to aggregate supply. His main task was to show hot to use the given unutilised resources and create more employment and income. the equilibrium level of employment is determined by the actual level of aggregate demand with a given aggregate supply function. The volume of total expenditure. ADF is known by the sum total of expenditure of all the buyers in the economy. But. thus. the level of effective demand represents an equilibrium level of expenditure at which entrepreneurial expectations are just being realised. In short. Keynes. it was unnecessary for him. In view of the mounting unemployment. where it is intersected by the ASF.employment determinants. and rather neglected. the Keynesian economics may also be called the economics of spending. simply ignoring it in the further analysis of income . Thus. he felt that the problem of ASF and especially the optimum use of the given resources. In fact. it is the aggregate demand function which becomes "effective" in determining the level of employment. so that the amount of labour hired and investment incurred in the economy are unlikely to vary at this point. Kenyes' theory stated that. Effective demand is the point where the actual total expenditure of the community equals the aggregate required sales receipts and their expectations by the entrepreneurial class as a sales receipts and their expectations by the entrepreneurial class as a whole.technical conditions and technological advancement can occur only in the long period. The aggregate demand schedule shows how much money the community is expected to spend on the products resulting a t various levels of employment. it was aggregate demand which was not adequately analysed. It must be noted that this relationship between expenditure and income traced in the Keynesian model is behavioural. therefore. in the past. in the short run. ADF is the schedule which indicates the alternative expenditure totals in relation to alternative levels of employment in the economy. That is to say. that is why his theory is sometimes regarded as a theory of aggregate demand. Again. thus. This implies that in order to raise the level Macro Economic Analysis 297 . Apparently. to examine the problem of optimum use of the given resources. the essence of Keynes' theory of employment and income is found in his analysis of the aggregate demand function.

It implies that if consumption is constant and investment is increases. It can be said that the level of employment which depends on effective demand also depends on the volume of consumption expenditure. the higher will be the level of employment. it requires an increase in the effective demand by raising the level of aggregate demand. employment will increase. if investment is constant and consumption increases. Increase or decrease in both consumption and investment will cause an increase or decrease in the levels of employment respectively. the diagram reveals the point that a higher aggregate demand function leads to a higher level of employment. Y ASF E2 R2 Receipts/Income ADF2 E1 R1 ADF1 O N2 N1 Level of Employment X In the above figure. with a given aggregate supply function schedule. Thus. Introduction to Consumption Function and Investment Function : According to Keynes. the higher the aggregate demand function curve. Thus. In short.the "effective" element of effective demand . the fundamental idea of the 298 Managerial Economics .depends on two factors : (i) the consumption function (or the propensity to consume). and (ii) the investment function (or the inducement to invest). Thus. the aggregate demand function . This consideration is based on the fact that effective demand is the sum of expenditure on consumption on investment in a community. Similarly.following figure illustrates this point. curve ADF1 (representing the aggregate demand function) indicates an employment level up to ON1 at point E1 of the effective demand. the point of effective demand at which the aggregate demand function intersects the aggregate supply function is the point of macro-economic equilibrium. employment will increase. While curve ADF2 is at a higher level and shows a higher level of employment ON2 at point E2 of effective demand. effective demand equals the total expenditure on consumer goods plus investment goods. consumption and investment are the main determinants of effective demand. and in turn the level of employment and income. Indeed. In graphical terms.of employment in any economy.

namely. The estimates or the expectations of profitability of new investment by the entrepreneurs are technically termed as the Marginal Efficiency of Capital. investment demand should be increased because consumption demand is relatively a stable component of the aggregate "effective demand". inducement to invest is determined by the business community's estimates of the profitability of investment in relation to the rate of interest on money for investment. observed that as income increases. Consumption function. Since consumption increases less than income. when the marginal efficiency of capital is greater than the rate of interest. consumption also increases. Effective demand for investment or the investment demand function is more complex and more unstable than the consumption function. the greater is the inducement to invest. Thus. Thus. according to the Keynesian theory. Consumption Function : The consumption appears to be a significant factor. Thus. but less proportionately. But the induce expectations about the profitability of business. denotes the consumption demand in the aggregate demand of the community. Secondly. effective demand which determines the level of employment in an economy is determined by the size of aggregate demand expenditure or the aggregate demand function. which depends on the size of income and the share that is spent on consumption goods. (i) the marginal efficiency of capital and (ii) the rate of interest. the amount of community's consumption varies in a regular manner with aggregate income. thus. Keynes. or the propensity to consume. determining the level of effective demand in an economy. According to Keynes. In short. therefore. argued that in order to sustain the level of income and employment in the economy. The propensity to consume is schedule showing the various amounts of consumption corresponding to different levels of income. on the basis of a fundamental psychological law. Thus. The volume of investment in an economy depends on the inducement to invest on the part of the business community. denoting an addition to real capital assets as well as the accumulated wealth of the society. we mean a schedule of functional relationship. by consumption function. there is always a widening gap between income and consumption as income expands. Investment Function : Investment Function or the inducement to invest is the second but crucial factor of effective demand. which is composed of consumption and investment functions. Accordingly. Macro Economic Analysis 299 . indicating how consumption reacts to income variations. he also states that the propensity to consume is relatively stable in the short run and.Keynesian economics is that an increased level of employment can only be achieved and maintained by an increased level of expenditure on either consumption or investment or both. by investment is meant only real investment. the crucial factor in employment . there are two factors determining the investment functions.income theory is the investment function. Keynes.

the lower will be the rate of interest. The supply price of a capital asset can be easily calculated and it is more or less a definite quantity. The first factor pertains to the demand aspect. Keynes. Thus. assuming money supply to be constant. the money supply. it is to be compared with the rate of interest. and (ii) the quantity of money (or the money supply). i. and the second. which is highly uncertain. because it does not change all of a sudden and it is relatively a stable phenomenon. the rate of interest is the second important determinant of the investment function. formulates his own theory of interest called "liquidity preference theory of interest". specially due to the speculative motive. entrepreneurs keep a fair margin between the two variables. it follows that the investment function is largely influenced by the behaviour of the marginal efficiency of capital which is a fluctuating variable in the short 300 Managerial Economics . It is the liquidity preference function which is a highly fluctuating phenomenon. Thus. in general. The rate of interest. Thus. namely. depends upon two factors : (i) the liquidity preferences function. It denotes the desire of the people to hold money or cash balance as the most liquid assets. Keynes defined marginal efficiency of capital as the highest rate of return over cost expected form producing an additional (or marginal) unit of a special asset. To him. thus. the total demand for money is the aggregate demand for each under the three motives. The marginal efficiency of capital is estimated to be greater if the difference between the prospective yield and the supply price of a capital asset is larger. regarded that the rate of interest is relatively a stable factor in the short run. thus. is not very significant in the short run. Hence. of the price of borrowing money. Keynes. (ii) the precautionary motive. the liquidity preference function determines the demand for money. Thus. and does not change violently. In this sense. and (ii) the supply price or the replacement cost of that asset. however.Thus. the higher the liquidity preference. mentioned that the marginal efficiency of capital is a highly fluctuating phenomenon in the short run and has a tendency to decline in the long run. and (iii) the speculative motive. Keynes. the other factor. according to Keynes. higher will be the rate of interest and the lower the liquidity preference. According to Keynes there are three different motives for holding cash for liquidity preference : (i) the transactions motive. He stated that liquidity preference is an important factor affecting the rate of interest. entrepreneurs do make their own estimates on the marginal efficiency of new capital assets by taking these two factors into account. Once the marginal efficiency of capital is estimated. the rate of interest can be directly related to the liquidity preference function. to the supply aspect. the marginal efficiency of capital and the rate of interest combine to influence the rate of investment in an economy. estimated by taking two factors into account: (i) the prospective yield of a particular capital asset. Nevertheless. while the prospective yield is a very indefinite factor as it relates to future.e. The marginal efficiency of capital is. Thus. however. the rate of interest.

It is to be noted here that we have so far considered consumption and investment expenditure of the community relating to private individuals and enterprises only. because the original Keynesian Theory of Employment has considered consumption and investment expenditure only. In fact. as it depends on the policies of the existing government which are largely influenced by political and social rather than economic factors. main phases of business cycles and their causes. however. They influence business decisions tremendously and set the trend of future business. we may formulate effective demand thus : Effective demand = C + I + G. In today’s world. employment and production. where. is the most significant factor determining the inducement to invest. fluctuations in the marginal efficiency of capital are the fundamental cause of trade cycles and income fluctuations in a capital economy. the marginal efficiency of capital with a given rate of interest. to be more realistic. particularly those pertaining to forward planning. This part of the chapter is in fact devoted to a brief discussion of. the period of depression reduces the business opportunities. booms and as Keynes believed. The period of prosperity opens up new and larger opportunities for investment. Investment outlay in the private sector. modern economists give due recognition to government expenditure as an important factor of effective demand. A profit maximizing entrepreneur must therefore analyse the economic environment of the period relevant for his important business decisions. and does not take government expenditures into account. government expenditure is day be day increasing. in the economic activities form essentially the economic environment of a country. and it cannot be ignored in estimating the effective demand in a community. On the contrary. and thereby promotes business. But. that government expenditure is autonomous. Macro Economic Analysis 301 . and Government's spending for consumption as well as investment. BUSINESS FLUCTUATIONS INTRODUCTION Business fluctuations. Thus. It should be noted. Thus. C I G = = = Consumption outlay for the households.

wages. 2. investment.." Keynes.Definition of a Business or Trade Cycle The term "trade cycle" in economics refers to the wave-like fluctuations in the aggregate economic activity. Cyclical fluctuations are recurrent in nature. viz. the peak and the trough are not movement. bank credits. Though cycles differ in timing and amplitude. A trade cycle is defined in various ways by different economists. stresses two indices namely. According to Haberler. that is to say. prices. such as. trade cycles are ups and downs in economic activity. The upward and downward movements in these magnitudes show different phases of a business cycle. output and income. Mitchell defined trade cycle as “a fluctuation in aggregate economic activity”. Expansion Peak 302 Managerial Economics . prosperity and depression.. particularly in employment. production. they have a common pattern of phases which are sequential in nature. etc. In other words.e. prices and unemployment." The following features of a trade cycle are worth noting : (a) (b) (c) (d) (e) A trade cycle is wave . the various phases of trade cycle may be enumerated as follows : 1. A trade cycle is characterized by the presence of crisis. But considering the intermediate stages between prosperity and depression. for measuring the upswing and downswing of the business cycles. PHASES OF BUSINESS CYCLES The ups and downs in the economy are reflected by the fluctuations in aggregate economic magnitudes. thus. Expansion and contraction in a trade cycle are cumulative in effect. points out that "A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages. the downward movement is more sudden and violent than the change from downward to upward. Basically there are only two phases in a cycle. "The business cycle in the general sense may be defined as an alternation of periods of prosperity and depression. of good and bad trade. For instance. i. Trade cycles are all-pervading in their impact. altering with periods of bad trade characterized by falling prices and high unemployment percentages. employment. (f) Keynes.

wholesale and retail prices. When the growth rate goes below the steady growth rate.high and low. register a rapid decline.trend in the economy slows down and eventually stops. profits.e. Trough is the phase during which the down . the economy enjoys the period of prosperity . per capita output and a rise in standard of living. employment.3. A figure showing phases of Business Cycle The phase of recession begins when the downward slide in the growth rate becomes rapid and steady. investment. Recession Trough Recovery and expansion. aggregate demand. The span of depression spreads over the period growth rate stays below the secular growth rate or zero growth rate in a stagnated economy. 4. and downward slide in the economic activities from the peak. prices. etc. though the realized growth rate may still remain above the steady growth line.. The line of cycle moving above the steady growth line marks the beginning of the period of 'expansion' or 'prosperity' in the economy. In a stagnated economy. So long as growth rate exceeds or equals the expected steady growth rate. employment. The phase of peak is generally characterized by slacking in the expansion rate. the highest level of prosperity. and the economic activities once again Macro Economic Analysis 303 . 5. it makes the beginning of depression in the economy. The five phases of a business cycle have been presented in the figure. the total output. sales. The growth rate eventually slows down and reaches the peak. decline during the subsequent periods. bank credits. The steady growth line shows the growth of the economy when there are no economic fluctuations. etc. the phase of expansion is characterized by increase in output. prices. employment. bank advances. Business Fluctuations. The various phases of business cycles are shown by the line of cycle which moves up and down the steady growth line. Output. depression begins when growth rate is less than zero. i.

And. Purchasing power continues to flow in and out of all kinds of economic activities. Actual demand stagnates or even decreases. Cost of living increases at a rate relatively higher than the increase in household income. The first and most pronounced impact falls on the demand for new houses. review their consumption. the business cycles continue to recur as stated above. input prices increase rapidly leading to increase in cost of production. increase in demand is halted. It even starts decreasing in some sectors. a discrepancy between output supply and demand arises. But. construction-labour tends to halt. Inventories of both input and output increase. Following this.. There is general expansion of credit. between supply and demand is so slow that it goes unnoticed for some time. but later it spreads to other industries also. This marks reaching the Peak. So long as the conditions permit. The growth of discrepancy. Initially. Labour market becomes seller's market. the expansion continues. demand for cement. etc. This trend subsequently appears in other durable goods industries like automobiles. If economic fluctuations are not controlled by the government. employment. when it exceeds this rate.Point and Recession Once the economy reaches the peak. Idle funds find their way to productive investment since stock prices increase due to increase in profitability and dividend. etc. unaware of this fact continue to maintain their existing levels of production and investment. iron and steel. for the reason stated above. Trough is the period of most severe strain on the economy. the economy once again enters the phase of expansion and prosperity. Let us now describe in some detail the important features of the various phases of business cycle. Debtors find it more and more convenient to pay off their debts. the persistence of the problem makes the 304 Managerial Economics . This situation might appear in a few industries at the first instance. Consumer's resistance gets momentum. inputs start falling short of their demand. however. prices increase and overtake the increase in output and employment. flats and apartments. Turning . In the later stages of prosperity. and also the causes of turning points. As a result. Prosperity : Expansion and Peak The prosperity phase is characterized by rise in the national output. Hence additional workers can be obtained by bidding a wage rate higher than the prevailing rates. particularly the wage earners and fixed income class. rise in consumer and capital expenditure rise in the level of employment. Consequently. it enters the phase of recovery though the growth rate may still remain below the steady growth rate. refrigerators. Additional workers are hard to find. But producers suddenly realize that their inventories are piling up. Producers. As a result. following the multiplier process. on the other hand. Hence consumers. furniture. it might be taken as a problem arisen out of minor mal-adjustment. Bank advances grow rapidly even thought bank rate increases. A similar situation appears also in other input markets.register an upward movement. When the economy registers a continuous and repaid upward trend in output.

economic activities slide down their normal level. orders placed for new equipments. rather. The producers anticipating better future try to maintain their capital stock and offer jobs to some workers here and there. At this point. Borrowings for investment decreases. bank credit shrinks. and hence. They do so also because they feel encouraged by the halt in decrease in price in the trough phase. temporary and casual workers are removed in a bid to bring demand and supply in balance. The process of reverse of (of negative) multiplier gets underway. As a result. Prices of consumer and capital goods decline steadily. On the other hand.producers believe that they have indulged in 'over-investment'. How is the process reversed? The factors reverse the downswing vary form cycle to cycle like factors responsible for business cycle vary form cycle to cycle. Replacement of worn-out capital is postponed. wages. the process of recession is complete and the economy enters the phase of depression. At this stage. production and employment decline resulting in further decline in demand for both consumer and capital goods. share prices decrease. Investments start declining. all economic activities touch the bottom and the phase of trough is reached. Depression and Trough During the phase of depression. Consequently. the discrepancy between demand and supply continues to grow. Consumers in their turn expect a further decrease in price. Generally. Since demand for inputs has decreased. the process of depression is complete. (The process is exactly reverse of expansion). input prices. The level of national income and expenditure declines rapidly...g. At the depth of depression. This is the turning point and the beginning of recession. the process begins in the labour market. The cancellation of orders for the inputs by the producers of consumer goods creates a chain -reaction in the input market. raw materials and other inputs are cancelled. Demand for bank credit reaches its low ebb and banks experience mounting of their cash balances. e. Investment in stock becomes less profitable and least attractive. Consumers on their part expecting no further decline in price begin to spend on their postponed consumption and Macro Economic Analysis 305 . interest etc. unemployment gets generated along with a fall in wage rates. Even the expenditure on maintenance is deferred in view of excess production capacity. This ultimately causes demand recession. When investments are curtailed. future investment plans are given up. Workers lose their jobs. When this process gathers speed. The decline in investment leads to decline in income and consumption. Demand for labour ceases to increase. postpone their purchases. Because of widespread unemployment. show a gradual decline leading to a simultaneous decrease in the incomes of wage and interest earners. The growth rate becomes negative. workers offer to work at wages less than the prevailing rates. it takes the form of irreversible recession. Producers of capital gods and raw materials cancel their orders for their input. producers lower down the price in order to get rid of their inventories and also to meet their obligations. Weaker firms are eliminated from the industries. Debtors find it difficult to pay off their debts.

as the factors of production become more fully employed wages and other input prices move upward rapidly. Wage income rises. Over a period. Besides. When prices fall during recession the prices of raw materials and that of other inputs fall faster than the prices of finished products. gasoline. Individuals who had postponed their plans to construct houses undertake it now. wages and other factor . some profitability always remains there. "Inflation occurs when the general level of prices and costs is rising . As prices. With this process catching up. some undertake both. the economy enters the phase of expansion and prosperity. Following this recovery in production and income. though cautiously and slowly. Businessmen realize quick turn over and an increase in profitability. The Recovery As the recovery gathers momentum. For all these reasons. Investors therefore. demand for both consumer and capital goods. As a result. a number of related developments begin to take place.correcting process within the price mechanism. The cycle is thus complete.rising prices for bread. cars. bank credit becomes easily available and at a lower rate. Due to increase in income and consumption. though gradually. become discriminatory between alternative investments.up the depleted capital stock. rentals 306 Managerial Economics . there is a self . security prices move up and interest rates move downward. consumers start buying more and more of durable goods and variety items. INFLATION The Meaning of Inflation In the words of Prof. These activities generate construction activities in both consumer and capital good sectors. Producers start replacing the worn . stock prices begin to rise for the simple reason that fall in stock prices comes to an end and an optimism is underway in the stock market. which tends to increase after the trough. The phase of depression comes to an end over time. On the other hand. Samuelson. As employment increases despite wage rates moving upward the total wage income increase at a rate higher than employment rate. start increasing. Consequently.hence demand picks up. more and more employment is generated in the construction sector. lest cost of construction mounts up. Hence the optimism generated in the stock market gets strengthened in the commodity market. Since banks have accumulated excess cash reserves. depending on the speed of recovery. Hence. rising wages. Consequently. so does the consumption expenditure. investment picks up and employment gradually increases. they speed up the production machinery. Therefore. the process of multiplier gives further impetus to the economic activities. some firms plan additional investment. and the phase of recovery gets underway.prices increase.out capital and making . land prices. the economic activities get accelerated. Businessmen start increasing their inventories. Bankers having accumulated excess liquidity (idle cash reserve) try to salvage their financial position by the private investors. Speculative increase in prices give indication of continued rise in level. some undertake renovation programmes.

Thus. The Factors from Demand Side (i) Increase in Public Expenditure : There may be an increase in the expenditure of the government because of wars or for developing the economy. It is not limited to one or two sectors or geographical localities of a country. though every period of inflation indicates price . every price . 1. Inflation is characterized by an excess of demand or an increase in costs or usually both. let us outline the characteristics of inflation as they emerge form the above . Inflation occurs over a period of time. inflation goes on feeding itself and it is not self-limiting. In other words. from the demand side and from the supply side. This demand is in addition to the normal demand. in the sense that one cannot be sure regarding the timing and intensity of inflation. It is a continuous process. which leads to a price rise.rise.on capital goods". which leads to rise in prices. Rather. Inflation is a sustained and appreciable rise in prices. According to Milton Friedman. go on changing (and causing changes) over a period of time.e. inflation is "process of a steady and sustained rise in the prices". (iv) (v) True inflation or pure inflation starts only after reaching the full employment level. (ii) (iii) Inflation is a general and a dynamic phenomenon. This increase in government expenditure means an increase in the total demand. It is dynamic in the sense that its severity. Many more definitions of inflation can be given.rise is not inflationary. it takes within its stride the entire country and all the sectors of the economy. temporary price rise in some sectors may occur due to some causes but they may not necessarily be indicative of inflation. cause an increase in costs. This increases the (ii) Macro Economic Analysis 307 .mentioned (and other similar) definitions of inflation : (i) Inflation is a phenomenon of rising prices. Increase in Private Expenditure : When optimism prevails in the business world. Once started. Instead of going into all these definitions. (vi) The Causes of Inflation The causes of inflation can be studied from two sides. It cannot be anticipated. i. Factor prices when rise. nature etc. However. businessmen are eager to spend more money on capital goods. inflation marks rising commodity prices as well as factor prices.

they are in a position to spend more. the paucity of credit facilities. This increases the demand for consumer's goods. may be re-invested in various assets. Therefore. But bottlenecks are created and this makes it difficult to make these factors available at the right time and place. there is a reduction in production or hurdles may be created in the expansion of product6ion. but the transport facilities required to transport these raw materials to the production site are not available. the unreliability of transport and several other difficulties may arise and make production impossible or difficult. people are left with more money. A part of the amount obtained in this manner. production will suffer. labour unrest and strikes. there is an increase in the demand for the both types of goods. businessmen increase their investment and this leads to an increase in the demand for capital goods. It is responsible for increase in prices to the extent that this repayment of loans leads to an increase in the total demand. The increase in the demand for both.demand for capital goods.rise. (v) (vi) 2. for actual production. Therefore. exports increase and the prices of commodities in the country increase. but the rest of it. and in turn. as well as the prices of commodities. in this case. Managerial Economics (ii) 308 . brings about an increase in the demand for consumer's goods. iron ore and coal are available at mines. may be spent on consumer's goods and services. more purchasing power is placed at the disposal of the people. Bottlenecks : At times. Changes in Expectation : In the context of the price . the expectations of the people play a very important role. as their supply cannot be increased instantaneously. For example. This reduces the total supply and causes a rise in price. Factors form Supply Side (i) Scarcity of the Factors of Production : If one or more factors of production are in short supply. (iii) Increase in Foreign Demand : When there is an increase in foreign demand for the goods manufactured in a country. This increases their expenditure. (iv) Reduction in Taxation : If there is a reduction in the taxes levied by the government. Transportation then becomes a bottle-neck. consumer's and producers' goods leads to the rise in prices. and thus. Repayment of Internal Debts : When the government repays old loans. they will start purchasing commodities which they will require in the future. This may cause an increase in prices. which can be spent. This is because there is an increase in the income of the people who work in capital goods' industries. all the factors are or may be available. When people expect a rise in prices. Similarly. If the consumers think that there will be an increase in prices in the future.

there is no change in the costs of production. (ii) Effects on Distribution. Switchover of Business : During a period of rising prices. As long as there is no full employment and inflation is proceeding at a slow rate. interest and wages can rise due to a number of reasons. and (iv) Non . This process continues undisturbed till the full employment level is reached. because of several reasons. Excess of rains. (v) Consequences of Inflation Effects or Consequences of Inflation can be studied under (i) Effects on Production. which in turn reduces the rate of capital accumulation. Macro Economic Analysis . Rise in Costs : Rise in costs due to an increase in factor prices is another cause from the supply side. The value of foreign capital is reduced. they will purchase and stock large quantities of these commodities. which results in reduction in investment and in turn. the textile industry (cotton and jute) the oil industry. (iv) Hoarding by Merchants : When traders and merchants know that there is a short supply of any commodity. also suffer. To undertake production. cyclones. and tempts entrepreneurs to increase investment. one has to begin with 309 2. But prices continue to rise. the propensity to save is reduced. This rapid inflation is very dangerous to the smooth working of any economy. which results in larger profits. As some of the factors of production are unemployed. and this results in the reduction of savings. speculation and stockpiling appears to be more profitable. Rent. But once the full employment level is reached or crossed. and there is flight of capital from the country. These commodities then go underground and are not available in the open market. investment in the field of production goes on decreasing. This may lead to inflation. This results in the reduction of production and this leads to a rise in the prices.economic Effects. may substantially reduce the total annual production. drought. (iii) Other Effects.based industries such as the sugar industry. reduces production. Hyperinflation is perhaps the worst from the point of view of production. inflation may be helpful. The value of money falls.. Thus. This increases total production and employment. there is a shortage of other commodities too and this leads to a rise in prices. prices start rising rapidly and there is true inflation.(iii) Natural Calamities : There are several natural calamities which may reduce production. Effects on Production The effects of inflation on production are very important. Agricultural production suffers and all other agro . Inflation affects production in the following manner : 1. Through Investment : During a period of rising prices. The Central Bank may raise interest rates or unions may cause a wage . 1. etc.rise. earthquakes.

price-rise. 4. production may even decrease. Similarly. houses etc ). This distortion of the price mechanism is another adverse effect on production. are put to great hardships. there is a scarcity of goods and services on a very large scale. the owners of factors of production who are in short supply (eg. the working class. the middle class and others who belong to fixed income group. strikes. This is very troublesome. On the contrary. 2) Effects on Distribution : The effects of inflation on various groups of people on society can be summarized as follows: 310 Managerial Economics . Poor Quality of Output: During a period of rising prices. Distortion of prices: The expansion of currency creates several hurdles in the pricing system. production decreases further. Owners of land. Thus. They are not even in a position to satisfy their basic needs because they do not have the required purchasing power. the demand for luxuries go on increasing. plots. As the income of the rich increases. Instead. This makes entrepreneurs more and more reluctant to accept any risks in production. there is an atmosphere uncertainty in every field. This results in decrease in production. inferior commodities flood the market. As supply always follows demand. 5. and several other types of agitations to secure higher wages. this change in the composition of production is said to be undesirable. and makes it weak. Change in the Composition of Production: Rising prices also influences the composition of production. These opportunities of making easy money. they become frustrated. Uncertainty : During a period of rising prices. 3. So. those who get large profits and easy money become rich.obtaining a license. there is no growth in production. if one indulges in purchase and sales of products property and other types of assets one can perhaps earn equal or even more profits. get huge profits because of rising prices. Thus. which leads to further shortages and thus. because anything and everything that is produced. But if prices rise very fast. tempt capitalist to invest their capital in these activities rather than undertake production. 6. and avoid all the headaches mentioned above. This results in the deterioration of the quality of production. During the period of rising prices. It's essential to have a properly functioning price mechanism in order to have smoothly functioning production system. Because of this. Public Unrest: When the pangs of price. is sold. the production of luxury articles increases and that of necessities decreases. and go to the other end and maintain good relations with labour. and there are demonstrations.rise are felt by the labourers. 7. It is most undesirable to spend the resources of a country in producing luxury articles before producing adequate necessities.

raw materials and machinery. For e. lag behind prices. So here again. there is a tendency of stockpiling by the traders. invest in assets earning guaranteed returns. Pensioners mainly belong to this class. prices rise further. A borrower is benefited as the value of money when he borrowed it. deposits in banks etc. are put to heavier losses. The investors belonging to the first category are put to a loss. As prices rise. the fixed income earners suffer great hardships. thereby putting wage earners to a great loss. In most cases. 2) In share or equity capital which do not give guaranteed returns. the rich invest in equity shares as their capacity to take risk is more. If the rate of growth of inflation is very high. whose savings are limited. The prices of stocks of finished products hoarded by these businessmen go on increasing continuously. In this way. Investors as a class: Normally. in the race between the rise in prices and the rise in wages. long term. The wage and salary earners: Those who get fixed income in terms of money. companies make huge profits declare large dividends. they can secure dearness allowances or a rise in wages or salaries. This leads to a continuous rise in profits. The supply of agricultural goods is normally inelastic. If workers are well organized. expenses to be incurred on wages. The fortune unorganized labour is extremely pitiable. the small farmers are benefited least because they do not have large quantities of b) c) d) e) Macro Economic Analysis 311 . merchants and manufacturers are the people who benefit more during inflation. Moreover. The entrepreneurs as a Class: The traders. the income of farmers as a class increases. Moreover. the share in the national income of the entrepreneurial class as a whole. But even in this field. their real income increases. : Bonds. The case of borrowers is exactly the opposite. are put to losses during inflation. Those whose income is permanently fixed. But even then. and when it was returned. The middle class people. the prices of agricultural goods increase sharply and quickly. In the mean time. and they get huge profits on these goods by selling them in the black market. This is a common experience in developing countries. is more than when he repays it. the rich have an advantage. the rise in prices is more rapid. So it is not possible to increase production immediately. Debentures. but those in the second category may stand to gain profits.g. Inflation is the great opportunity for them to make huge profits. as a result of inflation. Thus. Because of rising prices. whenever there is a price-hike. investors are found to invest their money in the following two ways: 1) In such assets which give fixed and guaranteed returns per year. goes on increasing. The farmers: During periods of inflation. and thus. the value of money goes on decreasing with lapse of time. creditors are put to losses because there is difference in the value of the unit of currency when it was loaned out.a) The creditor and debtor: During periods of inflation.

People who are already suffering from rising prices.Economic Effects : There are several political and social effects. If the price of the steel furniture is very high. But the prices of those goods whose supply is inelastic. But. Thus. smuggling activities increase. and most of the financial institutions fall in trouble. and those who hold important positions. large investments have to be made in the Public sector. Inflation mostly affects the schemes to improve educational. to check imports. Morality and business ethics are violated and people do not hesitate to do 312 Managerial Economics . Those who toil and moil continue to become poorer. cannot be overburdened by increasing the taxation. Reduction in development expenditure: Inflation has very bad effect on Economic planning and public expenditure. b) c) d) e) 4) Non. and the invested amounts become less and less valuable which makes it difficult to raise loans.agricultural goods as marketable surplus. go on amassing wealth. research and other social welfare programs. the available steel will be used for the manufacture of steel furniture. banks. This endangers the very existence of the economy. This disturbs the entire price structure as well as the distribution system in the economy. 3) Other Consequences : a) Financial institutions: When inflation is limited. the large farmers get the maximum possible advantage. But as soon as prices begin to rise at a faster rate. Additional deficit financing is likely to increase inflation further. This puts an end to harmony and understanding in society.. During periods of Economic planning. insurance companies and other financial institutions get advantages because their activities are boosted. it becomes imperative for the government to reduce its expenditure on development plans. The saving capacity of the people is reduced. people loose faith in the currency and the currency cannot function as a currency at all. This creates several problems in the balance of payments. the savings of the people are reduced. But the expenditure of the Government increases with rising prices. These are very serious and may continue to be in existence for a very long period of time. The gap between the rich and the poor widens. rise more. exports dwindle as the prices of domestic goods rise. the prices of all goods rise. even though the manufacture of railway wagons and rails may be more necessary. If restrictions are imposed. Foreign Trade: Foreign goods become cheaper and imports increase. medical aid. For e. Price structure: During inflation.g. Effect on Currency: If inflation rises very rapidly. and simultaneously. Several expansion programs have to be dropped.

of late. Economists and the government have. fight against recession world over are the major stabilisation problems.economic policies. MACRO POLICIES INTRODUCTION Business cycles i.1930s assigned a big role to the government in economic growth. gambling and other social evils become rampant. We have discussed below the major macro economic stabilisation policies which are relevant to the current problems of the world. Therefore. fluctuations in the economic activities. economic and political evils. countries have set full employment as an important goal in their macro . Keynes. favouritism etc. The problems similar to those faced in the different phases of the trade cycle are being faced by the world in modern times. dacoity. the government interventions with the economy all over the world increased in a big way. The experience of the Great Depression and Keynesian revolution in mid . pointed out that full employment in practice is a rare phenomenon. The desire to amass wealth and become rich as early as possible gives rise to bribery. Accepting Keynesian argument.e. cause not only harm to business but also misery to human beings by creating unemployment and poverty. For developed countries maintaining the growth rate to. employment and preventing business fluctuations. The major stabilisation problem in the developing countries is the problem of controlling prices and preventing growth rate from sliding further down. Thefts. Macro Economic Analysis 313 . Once the seeds of corruption are sown corruption spreads very easily and becomes all. Demonstrations. The free enterprise economies not only entered the production of commodities and services but also adopted a number of fiscal and monetary measures to control and regulate the economy and prevent violent economic fluctuations. corruption. arson and looting becomes very common and there is difficulty in maintaining law and order. The classical economists assumed that full employment is automatically attained by a free and competitive market economy in the long run. This gives rise to several social. however.pervasive. Political stability in the country is endangered.anything unscrupulous to become rich quickly. 1) Full Employment Full employment is the commonly accepted goal of macro economic policy in a developed country. The governments in many developing countries like India assumed the role of a key player in economic growth. Actually an economy attains equilibrium at under employment level. employment and stabilization. felt concerned with the business cycles and suggested various ways and means to control the economic fluctuations..

In the technical language of macro . The two most important and widely used economic policies to achieve economic stability are (i) fiscal policy. It also implies preventing over and under . full employment is viewed as an equilibrium situation in which the sum of the demands in all labour markets tends to be equal to the sum of the supplies. increases the flow of funds into the private economy. and public expenditure increases private incomes and thereby the private expenditure.adjusting forces of the economy. (iii) encouraging free competitive enterprise with minimum interference with the functioning of the market economy." He. Keynes also provides an alternative definition of full employment in that it is "a situation in which aggregate employment is inelastic in response to an increase in the effective demand for its output. it amounts to withdrawal of funds from the private use. Taxation is a measure of transferring funds from the private purses to the public coffers. and (ii) monetary policy. a) Fiscal Policy : The 'fiscal policy' refers to the variations in taxation and public expenditure programmes by the government to achieve the predetermined objectives. Thus. Stabilisation does not mean rigidities. suggested that an economic policy aiming at achieving full employment. though.' Fiscal or budgetary policy is regarded as a powerful instrument of economic stabilization.employment. the taxation and public expenditure policies are also jointly called as 'budgetary policy. Public expenditure. 2) Economic Stabilisation Stabilisation broadly means preventing the extremes of ups and downs or booms and depression in the economy without preventing factors of economic growth to operate. efficient utilization of labour and other productive resources as far as possible. The importance of fiscal policy as an instrument of economic stabilization rests on the fact that government activities in modern economies are greatly enlarged. or of supply over demand. therefore. in many of these markets. it should permit a reasonable degree of flexibility for 'self . should be designed to uplift the effective demand appropriately. and government 314 Managerial Economics . of course. on the other hand.economic analysis. taxation reduces private disposable income and thereby the private expenditure. there is the likelihood of an excess of demand over supply.' The major objective of stabilization policies are : (i) (ii) preventing excessive economic fluctuations. Since tax-revenue and public expenditure form the two sides of the government budget.

it is known as 'counter . etc. Therefore. Briefly speaking. The traditional instruments through which Central Bank carries out the monetary policies are : Quantitative Credit Control Measures such as open market operations. to and form the public. The fiscal and monetary policies may be alternatively used to control business cycles in the economy.25 per cent. One of the primary objectives of monetary policy is to achieve economic stability. The selective credit controls are intented to control the credit flows to particular sectors without affecting the total credit. ranging from 10 . All these instruments when operated by the Central Bank reduce (or enhance) directly and indirectly the credit creation capacity of the commercial banks and thereby reduce (or increase) the flow of funds from the banks to the public. fiscal policy is considered to be more effective than monetary policy because the former directly affects the private decisions while the latter does so indirectly.cyclical fiscal policy'. b) Monetary Policy : Monetary policy refers to the programme of the Central Bank's variations. If fiscal policy of the government is so formulated that it during the period of expansion. Bank rate is the rate at which Central Bank discounts the commercial banks' bills of exchange or first class bill. Moral suasion is a persuasive method to convince the commercial banks to behave in accordance with the demand of the time and in the interest of the nation. securities. changes in the Bank Rate (or discount rate). and also to change the composition of credit from undesirable to desirable pattern. open market operation by the Central Bank is the sale and purchase of government bonds. though monetary policy is considered to be more effective to control inflation than to control depression. Central Banks use also various selective credit control measures and moral and expenditure account for a considerable proportion of GNP.vault. always desirable to adopt a proper mix of fiscal and monetary policies to check the business cycles. . treasure bills. the government may affect the private economic activities to the same extent through variations in taxation and public expenditure. and changes in the statutory reserve ratios. It is however. The statutory reserve ratio is the proportion of commercial banks' time and demand deposits which they are required to deposit with the Central Bank or keep cash . In addition these instruments. Macro Economic Analysis 315 . in the total supply of money and cost of money to achieve certain predetermined objectives.

3. M. 5. 6. various phases of Business Cycle. Explain the nature and scope of Macro economics. 2. 316 Managerial Economics . Explain the Causes of Inflation. What are the consequences of Inflation? Explain Macro Economic Polices with special emphasis on a) Full Employment and b) Economic Stabilization. 7. Explain with an illustration. Define Macro Economics. Explain J.Exercise : 1. Write Short notes on : a) Factors determining Effective Demand b) Consumption Function c) Investment Function d) Fiscal Policy e) Monetary Policy. 4. Keynes' analysis of income determination in the context of the principle of Effective Demand. Define Inflation. 8.

NOTES Macro Economic Analysis 317 .

NOTES 318 Managerial Economics .

INTORDUCTION In our discussion of business decisions regarding production.Chapter 9 GOVERNMENT AND PRIVATE BUSINESS Preview Introduction. Economic Liberalization. Policy Planning as a guide to overall business development. the government can enact the laws against production. the government affects private business also in its capacity of a competitor in the input market.D.). etc. The government holds tremendous authority not only to influence the private business decisions but also to control and regulate. Another form of government intervention with private business is formulation and implementation of various kinds of economic policies such as fiscal policy. commercial policy. The interference raises several questions: Is government intervention with free enterprise inevitable? Government and Private Business 319 . we assumed the existence of a 'free enterprise system' in which there is the least interference by the State with the choices. Need for government intervention in the market. MRTP Act.S. monetary or credit policy. exchange control policy. By using its powers. Price controls in India. investment etc. Support prices and Administered Prices. All these activities and policies of the State are the various forms of intervention with the free enterprise system. which affect the private business activities.g. the private business activities. Disinvestment of PSU in India. The real life situation is however quite different even in the free enterprise economies..need and methods. in previous chapters.. can prevent the entry of private entrepreneurs to certain industries through its Industrial Policy. can limit the growth of private firms beyond a certain limit (e. Besides. directly and indirectly. Protection of consumers' interest. pricing. sale and consumption of certain goods. Process of Disinvestment . and can nationalize the industries whenever it thinks necessary and desirable.Causes of Price rise in India. preferences and decisions of the individuals regarding their economic pursuits. Price Controls(Indian Experience). P. industrial licensing policy. Public sector industries being owned and managed by the government get a preferential treatment in the allocation of scarce input. let alone the State-controlled economies.

medical care. of market economy or capitalism) : (i) Inequalities of Income and Wealth : One of the serious limitations of market mechanism is that it results in extremely unequal distribution of income and wealth. Thus. INTERVENTION: The need for government intervention with the functioning of free market mechanism has arisen out of failure of free market economy expected to ensure (i) that all those who are willing to work at prevailing wage rate get employment. (iii) that factors of production are optimally allocated between the various market mechanism results in unequal distribution of income and wealth and their concentration in the hands of a few people in society. etc. will begin to absorb the inefficient ones. whereas those who have no productive resources or mental abilities do not get much share in annual national income and wealth.e. clothing. while the poor who constitute majority continue to remain poor.e. (ii) that all those who are employed get their living in accordance with their contribution to the total output. shelter. And the number of such people in any society is generally so great that they constitute the majority. In a free competitive economic system. the efficient ones who are always few because of uneven distribution of organizational abilities among people.If yes. 1) NEED FOR GOVT. The rich go on becoming richer. their productivity). and (iv) production and distribution pattern of national product is such that all get sufficient income to meet their basic needs . (ii) Emergence of Monopolies: It is observed from the economic histories of the United States and West European countries that competition which is the heart of market mechanism itself gives rise to monopolies. If for example there are a number of producers of a commodity. (i. Shortcomings of Market System/ Limitations or Defects of Market System : Following are the important limitations of the market mechanism (i. The final result is that only one (absolute 320 Managerial Economics . those with productive resources or intellectual abilities find it easy to obtain rising income and wealth. The world has however experienced that the free enterprise system has failed to orgainse the economy which would satisfy the above requirements. what should be the limit of government intervention or the limit of government economic activities? How can the public and private sector in a mixed economy work in cooperation and coordination with each other? How and to what extent do the government’s economic policies affect the private business ? We shall answer some of these questions in this part of the book. education.. These economic inequalities give rise to social and political unrest disturbing social and political peace in the country. The failure of the free market economy is attributed to its following shortcomings.

if such a step gives maximum profit. Often these monopolies purposely keep certain factors of production idle creating artificial scarcities of their products with a view to raise prices to the maximum. J. Often there is over-production in some industries and there is under-production in certain other industries. (iii) Failure to Provide Full Employment : It was assumed that under competitive conditions. It is inconceivable that the modern complex economy involving millions of commodities and millions of consumers and producers would always work smoothly. there appear what may be called wastages of competition. These factors could have been used to produce much needed wealth for the poorer sections of the society. Thus under monopoly there is tremendous wastages of productive resources. it is rarely that some sort of balance would be achieved between demand for thousands of commodities and their supply. market system or market economy suffers from time to time from economic depressions. Keynes however showed that due to several rigidities (especially wage rigidities due to emergence of trade unions in the labour market). Also. two (duopoly) or a few (oligopoly) units in the industry remain. Thus the labour force which could have produced much needed wealth lies unemployed and is wasted.monopoly). (v) Wastages of Market Economy : As we have seen. In such an economy where millions of consumers and millions of producers are taking their own independent decisions. we have seen that competition often gives rise to monopolies. Thousands of units in the same industry take independent decisions regarding production. these monopolies establish political lobbies and through corruption and other favors to legislators get suitable legislation passed thus protecting their own interests and sacrificing the interests of vast body of consumers. M. During period of depression various factors of production lie unutilized. This imbalance gives rise to frictional disturbances and cyclical booms and depressions. Secondly. (iv) Instability : Market economy or private enterprise economy is a planless economy. Thus market mechanism does not ensure full employment of labour force. it so happens that the economy may get established at the level of less than full employment. Market economy is bound to be characterized by great instability. These units naturally begin to enjoy monopolistic power exploiting both consumers and workers. market mechanism or price mechanism would automatically bring about and establish equilibrium at the level of full employment. In those lines of production where competition exists. Government and Private Business 321 .

This means that very little attention is paid to the welfare of the society. tremendous technological progress has taken place. Art. music and literature all come to be judged by their financial success and not on the basis of their inherent quality or merit. 322 Managerial Economics . (vii) Poverty in the midst of Plenty : In a market economy. in a competitive regime. literature and so on. The vast masses of people living on bare minimum wages prevailing under competitive conditions cannot get continually rising share in the increasing productivity and production of wealth in the commodity. (vi) Indifference to and Sacrifice of Social Welfare : In a market economy or free enterprise economy. get preference over production of mass consumption goods needed by poorer sections of the community. inspired by private profit motive. This would mean that great amount of labour and other resources employed for advertisement are wasted. over and underproduction and vast expenditure on advertisements necessitated by cut-throat competition among rival firms. money becomes the yardstick of measuring success in every field . production of goods and services is all guided by the aim of securing maximum private profit. On the contrary capitalism abounds in wastages due to unemployment. Their production is neglected in preference to production of luxury and semi-luxury goods for richer sections of society. This has tremendously increased productive powers of the economy and production of various goods and services. While some advertisements are truly informative most are misleading and it is possible that the final effect of advertisement by rival parties is neutralized. (viii) Undesirable Psychological and Social Effects : Capitalism with emphasis on private profit motive and money making has great adverse social. That is how in capitalism luxury and semi-luxury goods. cultural and psychological effects. Goods are produced for which there is greater demand. Hundreds of producers of a similar commodity spend vast amounts on advertisement. music. there are wastages of advertisement. Since rivals are advertising. the claim that under free enterprise system or market system competition leads to the most efficient use of community's various productive resources is not valid. which richer sections of the community can afford to buy because they have the necessary purchasing power.Also. In a free enterprise economy. But due to the institution of private property and law of inheritance and succession (which are basic features of free enterprise system of economy). In capitalism. rich become richer who continue to exploit the vast poor masses. there is thus observed the existence of contradictory position of poverty in the midst of plenty.

Africa and Latin America. it also suffers from very serious limitations or evils. therefore. At any given time. The expanding demand is due to the rapid growth of our population.precisely from the start of the Second World War . affecting both its own working and that of other countries. have been exploiting backward countries in Africa and Asia through great multi national corporations and through the sale of arms and ammunition to both the opposing parties or countries (Arabs versus the Jews. Giant multi national corporations try to subvert national governments opposed to their interests by sabotage and various other methods. rapid economic development. Supply of goods and services too has been rising but the rise in supply has not been proportionate and matching the rise in demand. Government and Private Business 323 . bottlenecks in transport and power and shortages of various inputs. cooperation and consideration for the welfare of others. rising money income. Let us emphasize some of the causes behind the inflationary rise in prices in India in recent years. etc. (ix) Exploitation of Backward Countries and World Rivalry : The developed capitalist countries. use of backward technology. there is demand and supply imbalance. love. this is due to monsoon. combativeness and immorality suppressing good human instincts like kindness. etc.partly through ever-mounting demand on the one side and inadequately rising supply on the other. Concluding Remarks: It would thus be seen that while free enterprise economy or market system has some solid achievements to its credit. India versus Pakistan. disturbances and violence which go against economic development of poor and backward countries in Asia.Emphasis on private profit motive and on money-making arouses in capitalist regime instincts of acquisitiveness. rising volume of black money and continuous rise in demand for goods and services due to periodic wars. Developed capitalist countries are putting restrictions on exports from developing or backward counties thus hampering their rapid economic development. 2) PRICE CONTROLS IN INDIA CAUSES FOR RISE IN PRICES IN INDIA: A strong inflationary pressure has been built into the Indian economy for a long time . expansion in money supply and liquidity in the country. All this has led to international rivalry.) just because the defence industries owned by rich capitalists in Western countries should make rising profits. unscrupulousness. with a view to make higher and higher profits.

(iv) Uncontrolled growth of population . The total expenditure of both Central and State Governments including Union Territories had risen from nearly Rs.000 crores in 2003 approximately. builders and corrupt politicians and government servants estimated at Rs. Mounting Government expenditure financed through deficits pushes up the money supply in the country and consequently pushes up the public demand for goods and services.400 crores in 19992000 an more than Rs. Mounting government expenditure implies a growing demand for goods and services and thus.000 crores in 1997-98. and nearly Rs. especially those dealing with licensing. thus exerting continuous pressure on prices. registration. smugglers. continuous increase in government expenditure has the effect of putting in large money income in the hands of the general public and causing the fire of inflation. reckless expenditures and unauthorized over-drafts. collection of taxes. big programmes of economic development involving huge investments have been undertaken.It is the continually rising population in India which is responsible for the persistent gap between demand and supply.740 crores in 1950-51 to Rs.sensitive goods.Government expenditure has been steadily increasing over the years.37000 crores in 1980-81. Deficit Financing and increase in money supply .5. 69. edible oils. is an important factor for the rise in price. etc. extensive hoarding and black marketing in many essential and inflation . The Government of India has been responsible for the inflationary situation in the country through its policy of deficit financing and state governments contributed their share through their persistent financial indiscipline.00. such as sugar. Managerial Economics 324 .It is well-known that there is a large accumulation of unaccounted money in the hands of income-tax evaders. Beside. etc. DEMAND PULL FACTORS (i) Mounting Government Expenditure .6. 11.the Government of India is responsible for adopting deficit financing as a method of financing economic development. It is difficult to estimate the amount of black money or the precise influence of this money in pushing up prices but there is no denying the fact that one of the important factors responsible for inflationary pressures in recent years is the existence and the active role of black money. (ii) (iii) Role of Black Money . In a predominantly agricultural economy like India.A. in almost all consumer goods and services. There is considerable slush money with politicians and Government servants. A large part of the unaccounted money is used in buying and selling of real estate in urban areas.

diesel.PUSH FACTORS If supply of goods and services can be increased to correspond with every increase in demand. we may refer to violent fluctuations in food grains output.B. strikes and lock-outs and shortage of transport facilities are major factors for lower rate of production of manufactured goods. to a large extent. market arrivals have also tended to be erratic.. A good example is the Railways which have been regularly raising fares and freight rates in the last few years.In this connection. (i) Fluctuation in output and supply . With ever rising demand for manufactured products. (ii) Taxation. (iii) Administered price .The public sector enterprises too were continuously raising the prices of their products and services which generally constitute raw materials for other industries. Likewise.Cost-push factors consist mainly of rise in wages. With increased credit facilities from the cooperative societies and commercial banks. In fact. pushing up the price level further. rose whenever the production of food grains and other consumer goods declined or was stagnant. The 325 Government and Private Business . the producers are in a position to push up the prices of their products.Serous inflationary pressures were also created because of the sharp hike in the price of crude oil since September 1973 and the consequent upward revision of the prices of oil and oil-based goods. COST . At one time. and hoarding and speculation of food grains by traders and blackmarketeers. as a factor in rising costs . steel. however. the government imposed fresh commodity taxes and gave an opportunity to the trading classes to raise the prices. With every budget. often more than the levy of the taxes. They hold on to their stock in anticipation of higher prices. there was 130 per cent increase in all fuel prices by the OPEC. hoarding was done only by middlemen but now farmers have also joined the traders in this vicious game. Power breakdowns. In this connection the government and the public sector were also responsible. Likewise. the upward pressure on agricultural prices is also due to large hoarding by farmers. profit-margins and rise in other costs. (iv) Hike in oil prices and global inflation . for pushing up the price level in the country. there has been regular upward revision of several administered prices such as those of petrol. Prices. did not increase adequately in certain periods. etc. Such huge fluctuations in the output of food grains in certain years was a major factor in the rise of food grains prices as well as general prices. coal. In 1980 alone. Every rise in administered prices adds fuel to the inflationary potential in the country. Apart from fluctuations in production. cement. we may also refer to the fact that the supply of manufactured goods. price level will tend to be stable. even small farmers have now more holding capacity.

We can cite specific cases.T.large and persistent fiscal deficits over the years resulting in excessive growth in money supply and liquid resources with the community: there was automatic monetization of fiscal deficit. nor was it able to import the necessary quantity from foreign countries. The 9/11 attack on W. electricity. cloth.C. Causes for inflationary pressure in the 90's and after 2000 All the causes we have discussed above are basic causes for the existence of general inflationary pressure in the Indian economy and they have been present and active over the last many years. In 1973. petroleum products. and even onions and potatoes due to shortfalls in domestic production.gulf-surcharge which raised the prices of petroleum products to an unprecedented level in one single jump is major cause for rise in price during 1990-91. the buildup of inflationary pressure during the Nineties was mainly attributable to: (a) Higher fiscal deficit .S. OTHER FACTORS The failure of the Government policy on the price front at various times was a serious factor in the inflationary rise in prices. and A sharp increase in procurement prices of cereals and consequent rise in the issue price. vanaspati. The immediate cause for the pressure on prices since. (U. this was the basis of the rise in money supply and liquid resources with the general public at that time.S. Sharp reserve money (RM) during the three years (1993-96) due to large inward remittances and heavy accumulation of net foreign exchange assets with RBI. etc. According to the Government. 1990.A.). C. The Government of India has generally followed a highly vacillating and anti-peasant policy in fixing procurement prices. and allied forces invading Afghanisthan. This measure completely upset the normal trade and the price of open market wheat shot up. soap. the Government nationalized the wholesale trade in wheat along with a threat to introduce a similar measure for rice. was the Gulf War and the consequent shortages and increase in the prices of administered items such as coal. edible oils. fertilizers. U.sensitive commodities like pulses. etc. Managerial Economics (b) (c) (d) (e) 326 . for the benefit of the traders. Nor are the controls properly enforced thus giving great scope for rampant black-marketing to exist.S. as mentioned earlier. At the same time. and allied forces global recession etc. Iraq and take-over of the Iraq by U. Supply-demand imbalances . the government did not fail to procure adequate amount of food grains for the public distribution system. This is equally true in fixing and controlling prices of such essential goods as sugar.

Since the price situation is the outcome of shortages in basic goods and services and a rapid growth in money supply and bank credit. These measures. It was only since 1990-91 that the Government of India has appreciated the importance of reducing fiscal deficit.3) PRICE CONTROLS IN INDIA : A wide range of measures are being adopted to ensure stable conditions as well as to prevent speculators form taking an undue advantage of the conditions of scarcity.this has been a major instrument of inflation . The main thrust has been to restrict bank-credit against inflation sensitive goods and to influence the cost and availability of commercial bank credit. Demand Management (i) Fiscal measures . oil-seeds and oils. (ii) Monetary measures . Again in January 1984. to postpone fresh recruitments to Government job etc. The RBI relies heavily on selective credit controls on bank loans against food grains. sugar and textiles so as to discourage speculative hoarding.The Government of India has generally insisted on controlling its own expenditure and keeping in check both its revenue deficit and fiscal deficit . the Government of India announced a package of programmes to curtail public expenditure. for example. along with monetary measures helped to contain the volume of monetary measures helped to contain the inflationary pressure on price since 1995-96.control. moderating monetary and credit expansion and consequently helped in bringing down the rate of inflation. In July 1974. cotton. The cash reserve ratio (CRR) was raised from 6 to the statutory maximum of 15 per cent gradually. The Government of India since 1991-92 restricted its borrowing from RBI through the issue of ad hoc treasury bills and thus reduced the issue of new currency. Government and Private Business 327 . the Government of India promulgated three ordinances to limit the disposable money incomes in the hands of consumers through freezing wages and salaries on the one side and dividend incomes on the other. During the Eighties and Nineties. various types of measures relating to money supply.The monetary policy of RBI consists of extensive use of general and selective credit control measures. monetary policy has been directed essentially to prevent any excessive increase in liquidity and at the same time to ensure that the genuine credit requirements of the industrial sector and the priority sectors are adequately met. pricing and distribution of commodities are pressed into service. 'in mopping up excess liquidity in the economy. These steps resulted in a large measure.

Prices of other important goods like cloth. etc. oils and other commodities of mass consumption. RBI uses its monetary policy to achieve a judicious balance between the growth of production and control of the general price level. SLR and open market operations to increase bank credit and expansion of business activity (in times of business recession) or to contract bank credit and check business and speculative activity (in periods of inflation). The Government has announced higher support prices for groundnut. Let us touch some of the important aspects of this policy. sugar. (b) (c) (d) 328 Managerial Economics . The Government has prepared medium and long-term plans to step up the production of oilseeds in the country. In the short period. Problem of oilseeds and edible oils .In general. (a) Fixation of Maximum Prices . paper. large releases from official stocks and widening and streamlining of the network of public distribution. the Government has been relying on imports of edible oils. the Government attempts to prevent an undue increase in the prices of essential commodities. CRR. cement. sugar.the last two crops offer the maximum scope for augmenting the supply of edible oil in the country. vanaspati. at reduced or confessional import duties. Under this system. the weaker sections of the community are supplied these goods through fair price shops.. the State Governments have been asked to fix the wholesale and retail prices of food grains.The Government has adopted a system of dual prices in the case of goods like sugar. wheat. Through increase in domestic supplies. On the commodity front the Government has generally focused its attention in securing greater control over the prices of rice. Supply Management Supply management is related to the volume of supply and its distribution system. Increase in Supplies of Food grains . In this connection.In recent years. the Government also fixes minimum procurement prices for major crops on the recommendation of the Agricultural Prices Commission (APC). soybean and sunflower seed .For elimination the incentive for hoarding and speculative activity in food grains. are also controlled.. at controlled prices and the rest and allowed to purchase their requirements at higher prices from the open market. The system of dual prices . tea and sugar have been responsible for rise in the general price level. steep rise in the prices of edible oils along with those of pulses. we should refer to the steps taken by the Government to increase the production of all other agricultural products. Generally RBI uses Bank Rate.The Government attempts to increase supplies of food grains and other essential goods in times of internal shortage through larger imports. Further. etc.

produced wholly or largely in the public sector such as steel. pulses etc. There are two basic objectives of administered prices. sugar. i) ii) Adoption of OGL (Open General License) import policy for importing sugar. 329 (ii) Government and Private Business .00. imported edible oils (palm oil). Great reduction in excise duties on a numbers of items expected to accelerate the speed of industrial revival and raise industrial growth. The Government has set up a network of fair price shops numbering nearly 4.(e) Public Distributions System (PDS) and consumer protection .To check prices and to eliminate hoarding and speculative activity in food grains trade. Secondly. kerosene. rice. Control over Private Trade in Food grains . coal and petroleum products. Firstly it helps to hold down prices. wholesale dealers in food grains were licensed in many States. PDS has been strengthened and extended to rural areas. The Government also fixes the rates and charges of public utilities like railways and state electricity boards. Adjustment in trade and tariff policies in the Central Government Budgets to ensure their domestic prices of Industrial products remain competitive. But whenever the PDS is hard pressed due to inadequate supply. it provides essential commodities to low income groups at relatively low prices.An important aspect of the Government's policy was strengthening of the PDS. this has special significance during a period of shortages and rising prices. The Food Corporation of India has helped a lot to buy in surplus areas and sell in deficit areas and thus moderate the differences in prices.000 which cover a population of over 5million and which distribute wheat. prices of essential goods tend to rise. The public distribution system serves two purposes. soft coke and controlled cloth. fertilizer. and to ensure economic prices to uneconomic units so that the latter too can earn profits. Other relevant measures by Government of India to control inflation. Administered prices are normally set on the basis of cost plus a stipulated margin of profit. (f) g) iii) (1) Administered Prices : The Government of India follows administered price policy in respect of commodities which are either vital industrial raw materials. The products and services produced by the public sector in India constitute important raw materials for other industries and are subject to serious output and price fluctuations. Limits were also fixed beyond which traders and producers could not hold stock without declaration. : (i) to fix and maintain the prices of essential raw materials so to avoid cost and price escalation.

Originally started with the price of steel. and (b) it does not discourage the producers from expanding production and investment in the particular sector. the change in price may come much later than change in cost. This does not mean that the benefit of subsidy and low price should go even to those who do not require it. besides. The level at which agricultural prices should be stabilized is important from the point of view of production and consumption.Whenever there is a change in cost. As the administered prices are often inadequate to meet cost escalation. sugar. purchase. This is particularly important as the volume of production has increased considerably under the influence of the "green revolution". the change in administered prices may not be proportionate to change in cost and. even though it was meant to benefit the weaker sections. Dual pricing is a form of short cut price control and it enabled the Government to acquire essential goods at lower controlled prices for its own use. (2) The System of Dual Prices : It is a commonly accepted principle in India that the basic needs of the weaker sections of the community should be met and for this the Government should subsidies the prices of certain basic goods. their production. Such a policy is (a) in the interest of the vulnerable sections. The retail prices should be fixed in such a way that the interests of the consumers are safeguarded and at the same time there is no scope for hoarding Managerial Economics (b) 330 . and cheaper varieties of cotton cloth. the administered price is also changed. this has been a major criticism against administered prices in India. At the same time the burden of subsidy should not fall on the producers of these basic goods but should be spread on the community as a whole. basis industries like fertilizers and cement were unable to generate sufficient financial resources for modernization and expansion. sale and distribution. In fixing food grain prices. movement. In fact. dual pricing was extended to many other essential goods such as major food grains. three aspects may be kept in mind : (a) The Government should fix and guarantee such procurement prices for various food grain as will provide suitable incentives to the producers. The present policy of the Government is to adjust administered prices to enable public sector units to earn sufficient profits and over a period of time give up the system of administered prices. (3) SUPPORT / PROCUREMENT PRICES : A proper price policy will have to include measures directed towards cereals. pulses and oil-seeds viz. As the Government is generally slow and sluggish in its actions. edible oils.

sugar. (4) Public Distribution System : Rationale of PDS : The distribution of essential commodities through fair price shops at government . among other things. the changes in production costs. the Commission takes into account. 331 Government and Private Business . pulses and oilseeds are of a notional nature and are not backed by an organized system of official procurement. an efficient management of the supplies of essential consumer goods is necessary.controlled prices has come to be known as public distribution system. Moreover. kerosene. therefore. but to all basic consumption goods as for instance pulses. In these case also. have to play a major role in ensuring supplies of essential consumer goods of mass consumption to people at reasonable prices. their prices are subject to large seasonal variation.and speculation. While making recommendations to the Government regarding revision of minimum procurement and support prices. oil and vanaspati. etc. procuring sufficient quantities of rice and wheat for running the public distribution system. cloth. the inter-crop balance and the terms of trade between agriculture and other sectors of the economy. Another is that support prices for coarse grains. particularly to the weaker sections of the community. as most of these commodities are agriculture-based. The interests of both farmers and general consumers have been well protected. The basic framework for determining support prices for major cereals has been relatively fair. The Commission is guided in recent years by the three-fold objectives of (a) (b) (c) raising productivity through assured remunerative prices to farmers . support prices should be rationally determined (as in the case of wheat and rice) and should be made effective through public purchases and public distribution. The Government of India announces support prices on the recommendations of the Agricultural Prices Commission. and promoting a desirable inter-crop balance. 1) In order to maintain stable price conditions. (c) Holding the price line covers not only to cereals. Food zones are abolished and inter-state movement of the food grains is the monopoly of the Food Corporation of India. But there are a number of distortions: One is the announcement of higher minimum prices by state Government to satisfy local interests. redesignated as Commission for Agricultural Costs and Prices. There are various reasons for the setting up of the public distribution system in India. Public distribution system will.

5) PROTECTION OF CONSUMER INTEREST: The consumer who is often considered as the king is practically enslaved by the aggressive and dominant market manipulations by the large-sized corporations.g. Both Central and state Governments have made arrangements to procure essential commodities and supply them through the public distribution outlets. they would receive supplies of essential commodities at reasonable prices. This is why Prof. FCI undertakes the necessary operations. Since distribution is a highly complex matter. e. Bharat Petroleum. In the case of food grains. soft coke. kerosene. Hindustan Petroleum.Galbraith favoured the organization of the advantage of the producers. The Food Corporation of India (FCI) and other institutions have been set up to buy agricultural goods at prices that would ensure minimum profit for the farmers. The production of controlled cloth has now been generally entrusted to the National Textile Corporation (NTC) and distributed through the National Consumers Co-operative Federation (NCCF).this would mean that in critical times. It is necessary to devise a scheme to buy such commodities at prices which ensure a certain minimum profit to the farmers. The PDS has become a stable and permanent feature of India's strategy to control prices.K.come to the market soon after the harvest when prices are depressed. edible oils and vanaspati. The State Trading Corporation (STC) has been entrusted with the responsibility of importing and distributing edible oils. they also help in stabilizing agricultural process. match boxes. J. etc. A consumer's interest has several facets and 332 Managerial Economics . etc. FCI undertakes these operations. these goods would be supplied through public channels to consumers especially the weaker sections of the community . Kerosene is being handled by the public sector corporations like Indian Oil Corporation (IOC). controlled cloth. exercise books for children.both food grains and raw materials . tea. 3) Goods to be included in the public distribution system.State trading and buffer stock operation on the one side and public distribution on the other are essential in the case of agricultural products. reduce fluctuations in prices and achieve an equitable distribution of essential consumer goods among the people. This he termed countervailing power. toilet soap and washing soap. Supplies to the public distribution system. sugar. 2) A large proportion of agricultural products . only the most essential goods of mass consumption should be brought under the public distribution system. At the same time. The tug-of-war between monopoly producers and scattered consumers obviously works to the advantage of the producers. cereals. In regard to sugar.

its protection amounts to empowering the consumer. ii) iii) iv) v) Consumers protection involves protection from unfair trade practices for the purpose of promoting sales and making money at the cost of the consumers health and wellbeing. Right to a competitive Price: Wherever possible. quantity. education and organizational ethics. A consumer's interests or rights as enunciated by The Consumer Protection Act 1986 are as follows: i) Protection from Hazardous Commodities: A consumer is within his right to demand protection against the marketing of goods and services which are hazardous to life and property. The direct way with which we are concerned here is an effective intervention in the price system and in the supply of commodities by undertaking legal measures. so that he can protect himself against unfair trade practices like being misguided and cheated. on the one hand accepts the freedom of retailers from the exploitative conditions imposed by the producers and on the other hand. The consumer Protection Act. Such an option is difficult to achieve. Right to Information regarding Protection: By passing an act the interests of the consumers cannot be protected unless the consumers have full knowledge of the protection given to them. especially where the consumers are spread over a vast area and where they lack in awareness. in order to protect the consumer's interest. at best. contains the monopoly powers of the producers. It is under these conditions that the government is called upon to step in. state and central levels for the redressal of consumer protection act which provides for reliefs and compensation to the consumers wherever deemed appropriate. Therefore. But due to various limitations it is lengthy and tedious process. Right to be Heard: The establishment of appropriate forums at various levels aims at hearing the grievances of the consumers. This right. potency. 1986. can announce a set of concessions and facilities for their development. One way of protecting the interest of the consumers is the formation of their co-operatives. Government and Private Business 333 . the consumer must be assured of an access to a variety of goods and services at a competitive price. It is therefore. The act provides for the settings up of quasi-judicial bodies at the district. Right to Information: A consumer has a right to the information regarding the quality. in India is such an effort. a) False representation of the quality. grade. quantity. purity. the government. necessary to educate the consumers in this protection given to them. necessary to educate the consumers in this regard. standard and the price of goods and services as the case may be. It is therefore. Such an empowerment can be achieved by the consumers themselves by organizing together and further by creating consumer's cooperatives. Such practices include.

it involves various steps by way of creating machinery. 334 Managerial Economics . e) false representation regarding affiliation or authorized dealership. the Negotaible Instrument Act. Similarly. a great Social Reformer. d) False claims regarding sponsorship. b) False claims regarding the quality. procedures for enforcing the laws and actions for penalizing the defaulters andcompensating the sufferers. created the need for maintaining inspection/ supervision personnel. and goods which are found defective must be treated as an infringement of his freedom of choice. like AGMARK or ISI seal. approval.composition.. shortcoming or inadequacy in the quality. grade or effectiveness of a service. As such as aggrived parties. of the product. the consumers can take resourse to filing suits in the relevant course. this whole issue of consumer protection is shrouded with complexities and demands the government to undertake the responsibility of safeguarding the interests of the consumers not only as consumers but also as ordinary citizens of the land. In this context. This is a part of the normal functions of the government and it is in conformity with the government's responsibility in the dispensation of natural justice.also contain provisions regarding protection accorded to the consumers in cases relevant under the Act concerned. Under the various Acts. can be taken by the government. it is essential to implement fhe suggestions and recommendations given by a committee headed by Anna Hazare. Protection of a consumer’s freedom to buy the goods and services of his choice is necessary. reconditioned or old goods as new goods. we have discussed some of the provisions/ considerations of this Act.monitoring the performance and penalizing the defaulters. Therefore. protection against deficiency in the product or service implying a fault. the Banking Regulation Act. etc. Because the Consumer Protection Act is specially intended and framed for this purpose. the consumer has to be provided with an access to the machinery evolved for or already existing to the redressal of his grievances. and g) giving as untested or unrealistic guarantee regarding the quality /performance of the goods /services. style. removed. As such. It is necessary to remember that in respect of the protection of consumer's interests. the Consumer Protection Act is not only act concerned. action is required to be taken against the producers/ sellers of substandard goods and services. performance uses or benefits which the goods really do not possess. Obviously. For this purpose action based upon certain standards should be laid down. the Indian ContractAct. nature or performance has got to be accorded. This in turn. the Compines Act etc. in accordance with the provisions in this regard. f) misleading representation concerning the need for or the usefulness of goods/services. imperfection. c) False representation regarding re-built. In fact. the Sale of Goods Act. Needless to say that this is a major and pervasive intervention in the system of marketing and pricing.

2. gun powder. Raw hides and skins. 3. Sugar. including detonating fuse. hazardous chemicals and overriding environmental reason and items of elitist consumption. The main aim of the new industrial policy was: (a) to unshackle the Indian industrial economy form the cobwebs of unnecessary bureaucratic control. Asbestos and asbestos based products. Motor cars. Electronic aerospace and defense equipment. 12. Petroleum (other than crude) and its distillation products. 13. and other wood based products such as particle board. Coal and Lignite. 10. (c) Foreign technology policy. (b) (c) (d) All these reforms of industrial policy led the government to take a series of initiatives in respect of policies in the following areas : (a) Industrial licensing. 8. 6. Tanned or dressed fur skins. to introduce liberalization with a view to integrate the Indian economy with the world economy. and. and (e) MRTP Act. decorative veneers. safety fuse. Narasimha Rao announced the new industrial policy in July 1991. Industrial explosives. to remove restrictions on direct foreign investment as also to free the domestic entrepreneur form the restriction of MRTP Act. The policy aimed to shed the load of the public enterprises which have shown a very low rate of return or are incurring losses over the years. 15. 5. the role of the government was to be changed from that of only exercising control to one of providing help and guidance by making essential procedures fully transparent and by eliminating delays.6) THE NEW INDUSTRIAL POLICY (1991) : The Congress Government led by Mr. Plywood. (b) Foreign investment. medium density fiber board. Cigars and cigarettes of tobacco and manufactured tobacco substitutes. Distillation and brewing of alcoholic drinks. all types. 9. 7. Animal fats and oils. 4. Industries reserved for the small scale sector will continue to be so reserved. Paper and Newsprint except bagasse-based units. 14. nitrocellulose and matches. Drugs and Pharmaceuticals (according to Drug Policy). 16. (A) Industrial Licensing to be abolished for all projects except for a short list of industries related to security and strategic concerns. Hazardous chemicals. Entertainment Electronics Government and Private Business 335 . (d) Public sector policy. leather. 17. chamois leather and patent leather. social reasons. 11. List of Industries in Respect of which Industrial Licensing will be Compulsory 1. block board. Industrial Licensing Policy In the sphere of industrial licensing.

In respect of cities with population greater than 1 million. Foreign Investment In order to invite foreign investment in high priority industries. will continue to be reserved for the public sector. Domestic Dish Washing Machines. 4. Coal and lignite. requiring large investment and advanced technology. Mining of copper. Foreign Technology With a view to injecting the desired level of technological dynamism in Indian industry. (C) In projects where imported capital goods are required. The compulsory licensing provisions would not apply in respect of the small-scale units taking up the manufacture of any of the above items reserved for exclusive manufacture in small sector. 7. Colour TVs. Programmable Domestic Washing Machines. sulphur. molybdenum and wolfram. List of Industries to be reserved for the Public Sector 1. chrome ore. manganese ore.2 crore. industries other than those of a non-polluting nature such as electronics. White goods (Domestic Refrigerators. up to a maximum value of Rs. gypsum. 3.(VCRs. In ore cases. imports of capital goods will require clearance form the Secretariat of Industrial Approvals (SIA) in the Department of Industrial Development according to availability of foreign exchange resources.D. 2. Defense aircraft and warships. 8. gold and diamond. tin. Mineral oils. Players. 5. government would provide automatic approval for technology agreements related to high priority industries 336 Managerial Economics . it has been decided to provide approval for direct foreign investment upto 51 per cent foreign equity in such industries. there will be no requirement of obtaining industrial approvals from the Central Government except for industries subject to compulsory licensing. Railway transport. Tape Recorders). Mining of iron ore. Atomic Energy. computer software and printing will be located outside 25 kms of the periphery. C. Minerals specified in the Schedule to the Atomic Energy (Control of production and use) Order. 18. Air conditioners). automatic clearance will be given in cases where foreign exchange availability is ensured through foreign equity. lead. (B) Areas where security and strategic concerns predominate. (D) In locations other than cities of more than 1 million population. zinc. 1953. or if the CIF value of imported capital goods required is less than 25% of total value (net of taxes) of plant and equipment. 6. Arms and ammunition and allied items of defense equipments. except in prior designated industrial areas. Microwave ovens.

within specified parameters. The priority areas for growth of public enterprises in the future will be the following : (a) (b) (c) Essential infrastructure goods and services.Public enterprises which are chronically sick and which are unlikely to be turned around would. Such enterprises will be provided a much greater degree of management autonomy through the system of memoranda of understanding. (i) BIFR . (ii) Government and Private Business 337 . There are a large number of chronically sick public enterprises incurring heavy losses. Manufacture of products where strategic considerations predominate such as defence equipment. The 1991 Industrial Policy has adopted a new approach to public enterprises. financial institutions. a part of the government's shareholding in the public sector would be offered to mutual funds. part of Government holdings in the equity share capital of these enterprises will be disinvested in order to provide further market discipline to the performance of public enterprises. (d) Government will strengthen those public enterprises which fall in the reserved areas or are generating goods or reasonable profits. the general public and workers. foreign testing of indigenously developed technologies. operating in a competitive market and serving little or no public purpose. No permission will be necessary for hiring of foreign technicians. Disinvestment . The following measures are being adopted. This has inhibited their ability to regenerate themselves in terms of new investments as well as in technology development. The result is that many of the public enterprises have become a burden rather than being an asset to the Government. Technology development and building of manufacturing capabilities in areas which are crucial in the long term development of the economy and the long term development of the economy and where private sector investment is inadequate. Competition will also be induced in these areas by inviting private sector participation. Public Sector Policy Public enterprises have shown a very low rate of return of the capital invested. In the case of selected enterprises. be referred to the Board for Industrial and Financial Reconstruction (BIFR) for formulation of revival / rehabilitation schemes. A social security mechanism is to be created to protect the interests of workers likely to be affected by such rehabilitation packages. Exploration and exploitation of oil and mineral resources.In order to raise resources and encourage wider public participation.

The basic purpose fo dereservation of these items was to increase the flow of investment in these industries. Towards this end. ranging between 100 to 120 milions. Instead. Leather and good quality shoes have a tremendous export postential and the small scale units are ill equipped to provide quality goods for the international markets. emphasis will be on controlling and regulating monopolistic. (i) The pre-entry scrutiny of investment decisions by so-called MRTP companies will no longer be require. the government has decided to de-reserve these items so that their production improves as response to the market. With the growing complexity of industrial structure and the need for achieving economies of scale for ensuring higher productivity and competitive advantage in the international market. The thrust of policy will be more on controlling unfair or restrictive business practices.) and raw hides and skins and patent leather. amalgamation and takeover and appointment of certain directors. merger. refrigerators. air conditioners. etc. the demand for the white goods like washing machine. the Government decided in December 1996 to include 16 categories of industries in respect of which 338 Managerial Economics . (iv) There would be greater trust on performance imnprovement and managements would be granted greater autonomy through Memorandum of Understanding (MOU) and would be held accountable. white goods (which include refrigerators. MRTP ACT. instead of remaining shackled by the bureaucratic process of liscenceing. air conditioners is growing and these items are no longer viewed as luxury goods. the Government wants to push up their exports. restrictive and unfair trade practices rather than making it necessary for the monopoly houses to obtain prior approval of Central Government for expansion.(iii) Boards of public sector companies would be made more professional and given greater powers. In pursuance of the liberalization policy towards foreign investment. washing machines. more especially when the government is providing loans to businee executives and other senior officials to buy cars. With the growth of a large middle class. These three items were : motor cars. (ii) Further Liberalization by de-reservation : a) The Government decided in April 1993 remove three more items from the list of 18 industries reserved for compulsory licensing. Regardsing raw hides and skins and patent leather. Similary the demand for motor cars by the upper middle class and the affluent sections is also growing. establishment of new undertakings. To provide a boost to th motor car and white goods industries. the interference of the Government through the MRTP Act has to be restricted.

absorption of modern technology and full utilization of capacity. geophysical and related instruments and apparatus. meteorological. and To reform and modernize the financial sector so that it can more efficiently serve the needs of the economy. basic metals and alloy industries. To improve the performance and rationalize the scope of the public sector. water transport and storage and warehousing services have also been included. The main aim of the major policy initiative is to facilitate foreign direct investment in infrastructure sector. policy towards foreign capital. core and priority sectors. manufacture of navigational. export oriented industries. The strategy visualized for the purpose gave increasingly greater scope for the private sector This shift in favour of the private sector encompassed a wide range of measures demanding a reformulation of several policies like the industrial licensing policy. which are covered by the umbrella of economic reforms. Besides. The basic thrust of these changes is that there will be no case-by-case approval for various proposals lying before the government. land transport. Manmohan Singh the then Finance Minister.automatic approval would be accorded to foreign equity participation up to 51 per cent.. The real all-pervading beginning of economic reforms were however witnessed since the installation of the P. policy regarding rationalization and technology upgradation etc. and those having significant export potential. This additional list of industries eligible for automatic approval up to 51 per cent foreign equity cover a wide range of industrial activities in the capital goods and metallurgical industries. also added another list of nine industries for which automatic approval upto 74 per cent would be allowed.V. 7) ECONOMIC LIBERALISATION: The first phase of economic reforms is believed to have begun in 1985 when Rajiv Gandhi enunciated the uppermost goals of the new economic policy as improvement in productivity. ports. export import policy. ropeways. harbors. To utilize foreign investment and technology to a much grater degree than in the past. however. linkage with agro and farm sectors. Government and Private Business 339 . construction and maintenance of roads. not-conventional energy sources. who enumerated the objectives of the new Economic Policy as under: a) b) c) d) To increase the efficiency and international competitiveness of industrial production. construction and maintenance of power plants. b) The government. The nine industries are mining services related to oil and gas fields services. mining (up to 50 per cent). electric generation and transmission. Narsimha Rao's Congress Government in Mid-1991 The reins of the reforms were in the hands of Dr.

The Monopolies asn Restrictive Trade Practices Act was amended and modified so that the big industrial houses do not need a prior permission of the Government either for expansion or for establishing a new undertaking. Industrial Policy was thoroughly reformed so as to provide unhindered and uninhibited access to new initiatives by the domestic as well as foreign private sector. This required a greater tax-effort. For this purpose. thereby narrowing down the scope of the public sector. trading companies too could have 51% foreigners held equity if they were primarily engaged in export trade.For achieving these long-term objectives. All these aimed at strengthening the financial sector and making it more competitive Social Sector Policy was guided by the needs of human development. insistence of credit rating and scaling down of interest rates and more autonomy to the financial institutions. spread of education through formal and nonformal streams. For foreign collaborations. the government undertook to instill internal and external confidence in to the economy by adopting stabilization measures. increase foreign exchange earnings. up to 51%. Housing Finance Companies. a more realistic administered price structure. children and the privileged sections of the society. Diract Foreign Investment. avail of marketing techniques. immunization and other health measures and special attention to the welfare of woman. It aimed at revitalized efforts at poverty alleviation. Measures as recommended by both the Narasimha Committees(1991 and 1998) and accepted by the Government included a restructuring of controls by the RBI and the SEBI. CO-operative Banks . defence production and internal energy and such other industries related to protection of environment and internal security. a reduction in subsidies and a better fiscal discipline. several reforms and changes were made in the policy. ii) iii) iv) v) 340 Managerial Economics .Foreign Banks. Expecting the industries of strategic: importance in the areas of defence. and Stock exchanges. was permitted in export=oriented industrial units.revamping of housing programmes. Financial Sector Reforms based on stricter monitory policy first and then a reversal to a liberal policy. employment guarantee initiatives. norms of capital adequacy. embraced a wide range of industrial areas including the Reserve Bank.5% to 4% of GDP by mid-nineties. supply of safe drinking water. industrial licensing was abolished. This was sought to be achieved by following a phased programme of de-regulation. Areas of industrial activity reserved for the public sector were opened to the private sector. Mutual Funds Insurance Companies. This involved raising the income level through both tax and non-tax revenues and controlling public expenditure. The policy regarding Foreign Capital was recast so as to attract foreign capital. Sheduled Banks. the major ones beings as follows: i) Fiscal Policy Reforms aimed at reducing the overall public sector defict from 12.

a progressive reduction in the budgetary support to public sector. b) rehabilitation of sick units through BIFR (Board for Industrial and Financial Reconstruction). was substituted. the private sector was given more freedom and greater scope in the interest of improving the overall performance of the economy as a whole. In other words. and d) a policy of disinvestment. the rates of industrial growth have fallen. wherever necessary. as if to mock reforms! 8) THE PROCESS OF DISINVESTMENT: NEED AND METHODS vii) With economic liberalization. A preview of the deals of liberalisation is not very encouraging from certain angles. all quantitative restrictions on imports were removed and a system of price-based system of duties. a discipline to make public sector undertaking (PSUs) more competitive and cost-effective and making all PSUs self-reliant (no losses to be incurred) With these ends in view. Greater scope for the private sector may mean incremental disinvestment which connotes the expansion of PSUs can be left to some private company. Besides. It has opened up new avenues for enterprise and has attained some success in terms of global linkages of the Indian economy.automatic permission was granted subject to a ceiling on royalty payment of 5% of domestic trade of 8% of export trade or a lumpsum of Rs. agriculture remains neglected. a) Need for Disinvestment Over a period of four decades beginnings with the 1950s. the measures taken included a) reduction in the number of industries reserved for the public sector from 17to 8. However. c) a close monitoring to ensure profitability. so as to remove most of the protection granted to Indian industries and to make then internationally competitive import and export duties were readjusted in keeping with the WTO agreement with effect from April 2001. It may also mean denationalization of the public sector units taking private sector as a partner. vi) Trade Policy was modified. the scope of public sector was continuously expanding. unemployment and development have attained higher magnitude. Public Sector Policy underwent an overhaul. regional as well as personal income disparities have widened and poverty. greater autonomy to units which needed to continue in the public sector. in phases. 1 crore. disinvestment is a part of the process of privatization. The new involved a more realistic review of earlier policy. due to various reasons like lack of public sector's funds. several steps for protecting the interests of the employees were taken which included VRS packages. non- Government and Private Business 341 . retaining programmes etc.

The need for disinvestment can arise due to any one or more of the following reasons: i) Phased Privatization: Larger scope for the private enterprise menas a shrinking of the public to the private sector. With the onset of the New Economic Policy oriented towards providing an upper hand to the private sector. Re-allocation of Resources: Conceptually. But the cream of such expertise is always attracted by the private sector by offering them lucrative. flexible and potentially progressive working conditions. The public sector in India has continuously been under criticism ofr its lack of a professional approach. thereby paving the way for improving the performance of the economy as a whole. a rise in the salary bill due to the Fifth Pay Commission's recommendations. the Government of India was keen on reducing the overall deficit of the public sector to 4% of GDP. Substitute for Taxation: If we take into account the ground-level need in the midst of present difficulties faced by the Government of India. If this expertise is to be available to the public sector.interest on the part of private sector in undertaking long-term investment projects and so on. efficiency and competitive strength requires the association of professional and management experts with the PSUs (public sector undertakings). By selling stocks the public sector could encash part of its investment and hence. Reducing deficit: As noted earliar. Disinvestment provided an opportunity of selling stocks and raising funds. As a part of this. in the new business environment. the term disinvestment. This step.A. the process of disinvestment which meant selling of the shares of a PSU to private corporates and individuals started. Professionalism: Ina highly dynamic modern world. was expected to improve the productive efficiency of the PSUs. for the employees. For this purpose it needed funds which would help bridge the gap. This is done through disinvestment. the process of disinvestment amounts to reallocation of resources between the private and the public sectors. the disinvestment programme Managerial Economics ii) iii) iv) v) vi) 342 . mainly due to the fact that most of these units are headed by administrative experts rather than management experts. rising prices of goods purchased plan projects which needed capital support were therefore. the public sector must offer a share in ownership to the private sector. starved of investible funds. Capital Support to Plans: Non-Plan expenditure has been continuously increasing due to a number of reasons like higher rates of D. a reversal of the erstwhile policy of public-sector-dominance was set in motion. Desinvestment accruals are a part of the capital receipts and can be diverted to the capital needs of the plan projets.

apparently is viewed by the government as a substitute of greater tax-effort and curtailment of subsidies both of which are being opposed by parties in the coalition. the temporarily. is likely to bring about certain noticeable changes in the terms of revamping of managerial practices. the private sector will be the real owner in matters of policy decisions and operational control. co-operative societies or corporate organizations. it is not likely to be very effective in achieving the objective of greater operational efficiency and higher level of competitiveness. jointly exercise their voting rights and jointly participate in the exercise of control. 'Selling family silver for getting a series of square meals over a number of days appears to be a softer option for tiding over. in itself. to banks. the finanacial crisis. In the present method we are concerned with partial ownership transfer. The methods followed are as under: 1) Partial Transfer of Ownership: Disinvestment mostly is through this method of ownership transfer under which the ownership is transferred fully or partly.e. In India. It provides for a sizeable ownership transfer. cost-effectiveness and the units capacity to generate profits. to mutual funds) corporations or individuals including workers who are given a share up to 5% of the total equity. 74% is transferred to the effective in achieving while the government retains 26% with itself. majority of the ownership i. Government and Private Business 343 . the proposals of creating a joint ownership are contemplated on the following three lines: i) Transfer of 25% of shares to the private sector (i. ii) iii) So far as the first variant is concerned. As saving clause. In this case. b) Methods of Disinvestment Disinvestment. Government's veto power is reserved only for ensuring that the firm's operation is consistent with the macroeconomic objectives. In case of the third variant. Micro-decisions are left fully in the hands of the private sector. At the same time the majority voting rights remain with the government.e. The second variant transfers almost half ownership and as such. for the simple reason that the stakes are higher for the private sector. Ownership can be transferred by selling a part of the shares to individuals. usually there is provision for veto a power with the government is respect of major decisions. Such a transfer results in the creation of joint sector where the public sector and the private sector jointly hold the stocks. is a method of privatization. This type of transfer ensures government control with private partnership that enables the unit of avail of the guidance and advice of the private sector. Government may retain 51% of the equity with itself and transfer 49% to similar private sector patners/s.

an issue with a premium and a policy of allotment intending buyers may apply and will be allotted shares.2) Total Denationalization: The second method involves a complete sellout of a PSU to a private corporate organization. /it would 344 Managerial Economics . the same can be handed back to the private may be domestic or foreign or a collaboration concern. Liquidation: By going through the procedure laid down by the constitution/MOU of the PSU. Finally. After its complete recovery and rehabilitation. it can buy the entire unit with all assets and liabilities. Provision of bank finance for enabling the workers to buy the assets can be made. it is possible (though conceptually only!) that the unit was sick and was taken over by the state. 1) Sale of Stocks and Allotment: Like any other company a PSU can announce not a new issue but existing shares . The employees would continue getting wages as before plus a divided from the companies pool of distributed profits.e. a PSU is incurring losses due to mismanagement in the public sector. A Private buyer may buy it and use the assets so purchased for the same type of production or for some other variety of production Management buy-out: As a special case of de-nationalization. the same unit can be denationalized. Disinvestment without privatization: one more method of disinvestment which is mainly designed to overcome the capital paucity is to sell part of the equity to other public sector organization mainly from the financial system. with a specific objective. i. and the Unit Trust of India and so on. either in favour of the employees or in favour of other public sector institutions etc. the General Insurance Corporation of India. Once the objective is fulfilled. or they can form a joint companies act. can be the Life Insurance Corporation of India. it is possible that the unit which earlier existed in the private sector was nationalized. Such a step can be taken under a number of possible situations. If a private body corporate comes forward with confidence to set things right. a PSU can be sold to the employees of the project. In keeping with the goals to be predetermined. the Industrial Development Bank of India. the government may announce its decision of going into liquidation in case of the unit concerned. The buyers of stocks. the PSU concerned can decide upon a premium over and above the face value and can also decide the mode of allotment. actual implementation of the decision to part with ownership either partially or wholly. There are various methods of implementation for achieving this end. Secondly. All the assets could be sold to the employees organization which could be formed as a worker's cooperative. 3) 4) 5) c) Methods of Implementation: Once the decision is taken regarding the option of disinvestment to be choose a method of disinvestment. Firstly. in such cases.

record and a reputation in the market.include the proportion to be allotted to individuals.arrangements phased transfer of management. Such a buyer may then be contacted and the terms and conditions may be finalized. When the company is to be handed over to the employees. its mode. a systematic plan can be prepared and worked out. However. the same to be sold to institutions and so on. managerial whether the entire sum is to be paid in a lump sum or whether it is to be paid partly or wholly in a foreign currency or whether payment to be made is through installments. The highest bid may be accepted. resident or non-resident. Such an offer may be accepted. policy regarding managerial/supervisory staff. 2) Negotiating joint ownership: when a part of equity is to be made over to a prospective Where the ownership is to be partially transferred to other public sector institutions. i. this can be qualified with other conditions like technical know. are to be well planned and then the whole plan has got to be implemented. the government may announce its intention to sell a given amount of shares to a particular class of buyers (e. individuals. the government department concerned or the PSU itself may probe into the world-wide corporate sector for finding a prospective partner. market reputation and so on. Under this method.e. the quota given to each such institution is fixed in consultation with these institutional buyers as well as the central bank of the country. 6) Systematic Denationalization: Such a step involves a phased programme. Pre-planned Transfer: In cases of types (4) and (5) discussed above. These terms and conditions would include the payment in foreign or domestic currency. such a buyer has got to be identified and then the terms and conditions of partial transfer of ownership are to be negotiated. This method can be adopted where specialized products are involved are a few reputed accountability.Generally. institutional: domestic or/ and foreign etc. It is possible that a prospective buyer offers a second best price but has a very good track. the whole deal must be transparent and a fairly reasonable price must be negotiated. the mode of allotment . Informal Approach: Informally. and such a deal would be subject to the approval of the public authorities concerned like the disinvestment committee and parliament. all details like price per share amount of down payments. When an agreement is reached and is duly signed. stocks are dispensed with in lots and then the promoters or 3) 4) 5) Government and Private Business 345 . Open auction: Another method is the auction method. the form of oraganisation to be adopted etc. powers etc.) and may invite bids or offers. the process of disinvestment is carried out in accordance with the agreement. etc.

the Commission has recommended : no disinvestment.e. the procedure is analogous to any private company going into liquidation.the business house concerned would elect/select a board of directors and take over the responsibility. and closure and sale of assets (for 4 units) As against a total budgeted estimate of Rs. workers and general public. Till March 1998.38. disinvestment deferred.320 crores form PSUs till March 2000. The 1991 Industrial Policy Statement envisaged the disinvestment of a part of the government sharholding in selected PSUs to provide financial discipline and improve their performance. the Government realized only Rs. methodology and hiring for investment in each PSU. Repercussions on demand are also expected through a change in the expectations of the consumers.Indian experience: Considering the performance and shortcomings of the Public Sector Undertakings. share-prices are to be valued through assessors and share holder being the government.20.307 crores during 1991-92 and 2000-01. In other 12 cases. Financial / Investment Institutions.these recommendations include trade sale (6 units).2. Government failed to raise the budgeted disinvestment in the capital market. It is likely that such a measure may provide resources to the tune of Rs. Many reasons may by ascribed for this failure. So far the Commission has given its recommendations on 41 PSUs . it receives payment in installments and on the basis of the price decided by the assessor/expert committee appointed for this task. 38. realizing a total amount of Rs. Upto 20% of the government equity in 31 selected enterprises was offered to Mutual Funds. the government has gone in for a programme of disinvestment of public sector enterprises. encourage wider public participation and promote greater accountability. but the most important is the non- 346 Managerial Economics . Obviously. d) Disinvestment of Public sector share holding. In the 1991-92 budget. the Government referred 50 PSUs to the Commission for its advice.320 crores i. the Government has carried out various rounds of disinvestment of equity shareholding. strategy.4 per cent of the budgeted amount.500 crores to the Government to reduce its deficit. Disinvestment of PSU Shares : In pursuance of Industrial policy Statement of 1991.20. 7) Liquidation: Incase of liquidation. The Government of India set up the Disinvestment Commission in August 1996 to advise it on the extent. the government announced the intention of partial disinvestment in selected PSUs in order to raise resources. strategic sale (18 units) and offer of shares (5 units). A phased out programmers is preferred because a sudden transfer may send shock waves in the stock market as well as among the working classes and the employees. Asset values are low.

acceptability of the shares of PSUs in the capital market.10.000 10.800 9.371 1.000 5.306 Receipts Actual 3.500 2. 19 other PSUs had been given clearance earlier.500 4. Report on Currency and Finance (1998-99) and Economic Survey (2002-2002. The Government hopes to complete the disinvestment process in Indian Airlines. Air India.038 1.000 4.843 168 380 910 5. STC and SCI. 2000 gave a clearance for disinvestment to 11 PSUs including IBP.000 crores form disinvestment during the year. BESIDES THE 11 PSUs cleared.913 Nil 4. All this is being done to fulfill the objective of raising Rs. ITDC. Crores Year 1991-91 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000 2000-2001 Total Source : Disinvestment Budgeted estimate 2.500 3.000 58.829 1. Year wise Receipts from Disinvestment of PSUs Rs.006 10. MMTC.) The Cabinet Committee on Disinvestment in its meeting held on June 23. The token privatization to the extent of 8 .000 7.320 RBI. Government and Private Business 347 .10 per cent of the shares of PSUs did not enthuse the Indian / foreign investors to buy these shares because they could hardly exercise any control on PSUs. BALCO and IPCL within the financial Year 2000-01.869 20.

what are its consequences? Briefly outline various measures taken by the government to control the problem of rapidly growing prices in India. Explain the policy of economic liberalization as followed in India.Exercise: 1) 2) 3) What is the need for government's intervention in a free enterprise market economy? Explain the causes of price rise in India. Write notes on : a) b) c) d) e) f) g) h) Support prices Administered prices Public Distribution System (PDS) Price controls Consumer Protection Act Methods of implementing the policy of disinvestment Disinvestment of Public Sector Undertakings in India Limitations of market system 4) 5) 348 Managerial Economics .

NOTES Government and Private Business 349 .

NOTES 350 Managerial Economics .

Introduction to Positive Economics .REFERENCE BOOKS FOR FURTHER READING 1) 2) 3) Economics .Richard Lipsey A study of Managerial Economics .D.Samuelson.Gopalkrishna Reference Books 351 .

NOTES 352 Managerial Economics .

NOTES Reference Books 353 .

NOTES 354 Managerial Economics .

411016. No. 5. 4. 1. 2. Ensure to place the bar code label on each assignment sheet. Please do not send any other communication along with your assignment. 14. 13. Pune . 2. 6. Total Marks :____________/100 Important Notes : 1. 7.Place Bar Code Label Here SYMBIOSIS CENTER FOR DISTANCE LEARNING (SCDL) Atur Centre. 3. The date of receipt of the assignment shall be the date when the assignment was received at SCDL. 4. Of Assignment : (Question Response Record . 15. Model Colony. 10. Please ensure that your Correct Registration Number is mentioned on the Assignment Sheet. ASSIGNMENT SHEET (To be attached with each Assignment)  Full Name of Student : ________________________________________________________________ (First Name) (Last Name) Registration Number : Subject of Assignment : Date of Subm. Gokhale Cross Road. 9. 1068. Question Number Responded On Page Number of Assignment Marks  12. without which SCDL will not accept the assignments. 11.To be completed by students) Sr. 3. Signature of the Evaluator Name of the Evaluator Date : ____________________ Signature of the Student Date : ___________________ . 8.

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