Book On - Managerial-Economic PDF

MANAGERIAL
ECONOMICS
BY
Prof. Pradeep Datar

M.A. (Economics)
Published by
Symbiosis Center for Distance Learning,
Pune.
© 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.
CONTENTS
Chapter TITLE Page

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

Chapter 1
INTRODUCTION TO
MANAGERIAL ECONOMICS
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. Definitions of Managerial Economics
1. 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.
2. Prof. Hague : Managerial Economics is concerned with using logic of economics,

mathematics & statistics to provide effective ways of thinking about business decision
problems.
3. 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 1

4. 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.”
5. 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) Economic theory provides the basis for the decision making process.
ii) There is some difference between the generalizations based on abstraction and actual
practices.
iii) Besides economic theory, mathematics & statistics help in decision-making.
iv) An attempt is made to arrive at generalizations regarding business policies.
v) 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. Nature of Managerial Economics :
1. 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.
2. 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.
3. 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.
4. 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.
5. 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

true). For example, if the triangles are congruent, their angles are equal. To have confidence
in the findings, the propositions deduced are subjected to empirical verification. For
example, empirical studies try to verify whether cost curves faced by a firm are really U-
shaped as suggested by the theory. Furthermore, there is an attempt to generalize the
propositions which provide a predictive character. For example, empirical studies may
suggest that for every 1% rise in expenditure on advertising, the demand for the product
shall increase by 0.5%.
From the above it follows that managerial economics uses a scientific approach. In
practice, some firms may use simple rules based on past experience. However, the
quality of discussions made can be improved using a systematic approach. This is
attempted in managerial economics.
3. 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. It deals with demand analysis and forecasting, production
function, cost analysis, inventory management advertising price system, resource allocation,
capital budgeting etc. While an in-depth treatment is given to these aspects in the relevant
chapters, a cursory treatment of these aspects has been attempted here, merely to explain
the scope of the subject.
1. 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. He
takes into account such concepts as income elasticity and cross elasticity. When demand
is estimated, the manager does not stop at the stage of assessing the current demand
but estimates future demand as well. This is what is meant by demand forecasting.
2. Production Function :
We know that resources are scarce and also have alternative uses. Inputs play a vital
role in the economics of production. The factors of production, otherwise called inputs,
may be combined in a particular way to yield the maximum output. Alternatively, when
the price of inputs shoot up, a firm is forced to work out a combination of inputs so as to
ensure that this combination becomes least cost combination. In this way, the production
function is pressed into service by managerial economics.
3. Cost Analysis :
Cost analysis is yet another area studied by managerial economics. For instance,
determinants of cost, methods of estimating costs, the relationship between cost &
output, the forecast of cost and profit-these are very vital to a firm. Managerial Economics
touches these aspects of cost-analysis, an effective knowledge and application of which
is cornerstone for the success of a firm.
4. Inventory Management :
An inventory refers to stock of raw materials which a firm keeps. Now the problem is how
much of the inventory is ideal stock. If it is high, capital is unproductively tied up, which
might, if the stock of inventory is reduced, be used for other productive purposes. On the
other hand, if level of inventory is low, production will be hampered. Therefore, managerial
economics will use such methods as ABC analysis, a simple simulation exercise and
some mathematical models with a view to minimize the inventory cost. It also goes
deeper into such aspects as the need for inventory control; it classifies inventories and
discusses the costs of carrying them.
5. Advertising :
It may sound strange when we say that advertising is an area which managerial
economics embraces. While the copy, illustration, etc., of an advertisement are the
responsibility of those who get it ready for the press, the problems of cost, the methods
of determining the total advertisement costs and budget, the measuring of the economic
effects of advertising – these are the problems of the manager. To produce a commodity
is one thing; to market it is another. Yet the massage about the product should reach the
consumer before he thinks of buying it. Therefore, advertising forms an integral part of
decision-making and forward planning.
6. 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. The central functions of an
enterprise are not only production but pricing as well. While the cost of production has to
be taken into account while pricing a commodity, a complete knowledge of the price
system is quite essential to determination of price. For instance, an understanding of
how a product has to be priced under different kinds of competition, for different markets
is essential to the pricing of those commodities. An understanding of the pricing of a
product under conditions of Oligopoly is also essential. Pricing is actually guided by
considerations of cost plus pricing and the policies of public enterprises. Further, there
is such a thing as price leadership and non-price competition. 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.
7. Resources Allocation :
Scarce resources obviously have alternate uses. How best can these scarce resources
be allocated to competing needs? The aim, of course, is to achieve optimization. For

this purpose, some advanced tools, such as linear programming, are used to arrive at
the best course of action for a specified end. Generally speaking, two kinds of problems
are of the utmost importance and concern to the manager. First, how should he arrive at
an optimum combination of inputs in order to get the maximum output? Secondly, when
the prices of inputs increase, what type of sub-situation should he resort to? Or,
alternatively, what type of combination of inputs should he work out in order to ensure the
least-cost combination?
8. 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. Capital is scarce, and it costs something. Now
the problem is how to arrive at the cost of capital; how to ensure that capital becomes
rational; how to face up to budgeting problems; how to arrive at investment decisions
under conditions of uncertainty; how to effect a cost-benefit analysis, etc. These areas
cannot be ignored by any manager.
It is obvious form the foregoing discussion that managerial economics is applied

economics. It makes use of the tools which have been developed not only be economics
but by other disciplines as well. The subject matter of managerial economics covers
two important areas, namely, decision-making and forward planning. These two
areas are essential to every stage of planning, production, marketing, etc. Managerial
economics, therefore, plays a vital role in the successful business operations of a firm.
Some other areas covered by Managerial Economics are :

1. Linear programming, its assumptions and solutions.
2. Decision making under risk and uncertainty.
3. Profit planning and investment analysis. Sources of information on new projects, methods
of project appraisal, social benefit cost analysis etc.
4. Significance of Managerial Economics./ How Does Economics Contribute to
Management?:
While performing his functions, a manager has to take a number of decisions in conformity
with the goal of the firm. Many of the decisions are taken under the condition of uncertainty
and therefore involve risk. Uncertainty and risk arise mainly due to uncertain behaviour of the
market forces, i.e. the demand and supply, changing business environment,
government policy, external influence on the domestic market and social and political changes
in the country. The complexity of the modern business would add complexity to the business
decision - making. However, the degree of uncertainty and risk can be greatly reduced if
market conditions could be predicted with a high degree of reliability.
Taking appropriate business decisions requires a clear understanding of the technical and
environmental conditions under which decisions are to be taken. 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.
Economic theories have therefore gained a wide application to the analysis of practical problems
of business. With the growing complexity of business environment, the usefulness of economic
theory as a tool of analysis and its contribution to the process of decision- making has been
widely recognized.
Prof. Baumol has pointed out three main contributions of economic theory to business
economics. First, ‘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, eliminating the minor details which might obstruct decision-
making, and in concentrating on the main issue. Secondly, 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. Thirdly, economic theories offer clarity to the various concepts used in business
analysis, which enables the managers to avoid conceptual pitfalls.
5. 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 land, forests and
minerals, but also of human capacity, both mental and physical, and of all sorts of man-made
aids to further production, such as tools, machinery and buildings. It is sometimes useful to
divide those resources into three main groups :
1. All those free gifts of nature, such as land, forests, minerals, etc., commonly called
natural resources and known to economists as LAND;
2. All human resources, mental and physical, both inherited and acquired, which economists
call LABOUR; and
3. All those man-made aids to further production, such as tools, machinery, plant and
equipment, including everything man-made which is not consumed for its own sake but
is used in the process of making other goods and services, which economists call
CAPITAL.
These resources are called FACTORS OF PRPDUCTION because they are used in the process
of production. Often a fourth factor, ENTEPRENEURSHIP (from the French word entrepreneur,
meaning the one who undertakes tasks), is distinguished. The entrepreneur is the one who

takes risks by introducing both new products and new ways of making old products. He
organizes the other factors of production and directs them along new lines. (When it is not
distinguished as a fourth factor, entrepreneurship is included under labour.)
The things that are produced by the factors of production are called commodities. Commodities
may be divided into goods and services : goods are tangible, as are food grains, cars or
shoes; services are intangible, as they are valued because of the services they confer on their
owners. A car, for example, 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.
The total output of all commodities in one country over some period, usually taken as a year,
is called Gross National Product, or often just National Product.
In most societies goods and services are not regarded as desirable in themselves; no great
virtue is attached to piling them up endlessly in warehouses, never to be consumed. Usually
the end or goal that is desired is that individuals should have at least some of their wants
satisfied. Goods and services are thus regarded as means by which the goal of the satisfaction
of wants may be reached. The act of making goods and services is called production, and
the act of using these goods and services to satisfy wants is called consumption. Anyone
who helps to produce goods or services is called a producer, and anyone who consumes
them to satisfy his or her wants is called a consumer.
The wants that can be satisfied by consuming goods and services may be regarded, for all
practical purposes in today’s world, as insatiable. In relation to the known desires of individuals
for such commodities as better food, clothing, housing, schooling, holidays, hospital care and
entertainments, the existing supply of resources is woefully inadequate. It can produce only a
small fraction of the goods and services that people desire. This gives rise to one of the basic
economic problems : the problem of scarcity.
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.
Most of the problems of economics arise out of the use of scarce resources to satisfy human
wants.
6. Meaning of Economic Problem :
Now, if we put together the four characteristics – namely, human wants are unlimited, that
human wants vary in their intensity, that means or resources are relatively limited, and they
have alternative uses, but if used to satisfy one want, 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. The problem of economy is how to use the relatively limited resources
with alternative uses in the face of unlimited wants. Naturally, everyone will so try to use his
relatively limited resources with alternative uses that he gets maximum satisfaction out of his
resources. In view of limited resources and unlimited wants, 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. This is the problem of economy – how to economics or make the
maximum use of limited resources.
In the light of the above situation, Lionel Robbins writes : “Economics is a science which
studies human behavior as a relationship between ends and scarce means which
have alternative uses.”
Economic Problem at the Family Level
Almost in every community, family is the basic unit of social organization. Just as, every
individual has to face the basic economic problem – namely unlimited wants and limited
means with alternative uses – exactly in the same way, every family, poor or rich, Indian,
European and American, ancient or modern, finds that it has unlimited wants (e.g. food grains,
clothing, shelter, education of children, medicines during sickness, insurance, tax-payment,
guests, recreation, religious and social ceremonies, etc.) ; but the resources at its disposal
are relatively limited. Every family, poor or rich, 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. The Indian family may be thinking in terms of Rs.5,000/- which may be its monthly
income, whereas an average American family earning U.S. $ 5,000 a month may be thinking
in terms of that as a fairly big amount. But as we have observed, each family in relation to its
wants, finds that the resources at its disposal are limited, that they have alternative uses and
therefore the problem of economizing them must be faced. No family can avoid this basic
economic problem.
Economic Problem at the Universal Level Or Economic Problem – A Universal Problem

The same basic economic problem – unlimited wants and relatively limited resources
- arises at all levels of human organization. Thus whether we are thinking of a
Grampanchayat, or of Zilla Parishad, or of a club or hospital or university or the national
government, all have to face the same basic economic problem. Thus whether it is the
Government of India or the Government of the richest country namely the United States, the
problem of economy is always there. The Government of India with an annual revenue of about
Rs.1,00,000/- corers has innumerable demands on its resources such as meeting mounting
defense expenditure, expanding expenditure in respect of development that is to be brought
about in various sectors like agriculture, industries, transport, education and so on and so
forth, with no limit on its increasing wants. The Government of India therefore continually faces

the basic problem of economy of how to make the best use of its limited resources. In the
some way, the Federal Government of the United States, the richest government, faces the
same basic economic problem. Though in absolute terms, its annual revenues are enormous
running into billions or trillions of dollars, its needs are also unlimited – expanding and
modernizing defense forces, establishing military bases all over the world giving economic
and military assistance to friendly countries, meeting expanding expenditure on space and
military research, exploring oceans and so on and so forth. 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. Every nation, poor or rich, small
or great, with small population or with huge population, has to face this basic economic
problem; no nation can ever escape it.
Thus there is something ‘universal’ about the problem of economy. The basic problem
of economy arises in the case of an aboriginal, a villager, a city – dweller, in the case
of the poor as also the rich, in the case of an Indian, a Frenchman and an American,
in the case of associations like clubs, schools, hospitals and government organizations
right from the village level to the national level. The problem of economy was there
in ancient times and it is there before everybody at present. The problem of economy
– unlimited wants and limited means with alternative uses – has been forever
confronting mankind. The economic problem is a universal problem. Economic
problem does not recognize boundaries of caste, creed, colour , religion, culture
Basic Economic Problems
Seven more general questions that must be faced in all economies, whether they be capitalist,
socialist or communist, & mixed are explained below.
7. Seven Questions faced by all economies :
1) What commodities are being produced and in what quantities? This question
arises directly out of the scarcity of resources. It concerns the allocation of scarce
resources among alternative uses (a shorter phrase, resource allocation, will often be
used). The question ‘What determines the allocation of resources or resource allocation?’
have occupied economists since the earliest days of the subject. In free – market
economies, most decisions concerning the allocation of resources are made through
the price system. The study of how this system works is the major topic in the THEORY
OF PRICE.
2) 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. Agricultural goods, for example, can be produced by farming
a small quantity of land very intensively, using large quantities of fertilizer, labour and
machinery, or farming a large quantity of land extensively, using only small quantities of
fertilizer, labour and machinery. Both methods can be used to produce the same quantity
of some good; one method is frugal with land but uses larger quantities of other resources,
whereas the other method uses large quantities of land but is frugal in its use of other
resources. The same is true of manufactured goods; it is usually possible to produce the
same output by several different techniques, 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, and the consequences of these choices about production
methods, are topics in the THEORY OF PROCDUCTION.
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. But this only
pushes the question one stage back. 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, including government
intervention, can cause it to change.
Such questions have been of great concern to economists since the beginning of the
subject. 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,
economists speak of THE DISTRIBUTION OF INCOME.
4) How efficient is the society’s production and distribution? This questions quite
naturally arises out of question 1, 2 and 3. Having asked what quantities of goods are
produced, how they are produced and to whom they are distributed, it is natural to go on
to ask whether the production and distribution decisions are efficient.
The concept of efficiency is quite distinct form the concept of justice. The latter is a
normative concept, and a just distribution of the national product would be one that our
value judgments told us was a good or a desirable distribution. Efficiency and inefficiency
are positive concepts. 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 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. Questions about the efficient of production and allocation belong to
the branch of economic theory called WELFARE ECONOMICS.

Questions 1 to 4 are related to the allocation of resources and the distribution of income
and are intimately connected, in a market economy, to the way in which the price system
works. They are sometimes grouped under the general heading of MICRO ECONOMICS.
5) Are the country’s resources being fully utilized, 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, there can be no question of leaving idle any of the resources
that are available. Yet one of the most disturbing characteristics of free – market economies
is that such waste sometimes occurs. When this happens the resources are said to be
involuntarily unemployed (or, more simply, unemployed). Unemployed workers would
like to have jobs, the factories in which they could work are available, the managers and
owners would like to be able to operate their factories, raw materials are available in
abundance, and the goods that could be produced by these resources are urgently
required by individuals in the community. Yet, for some reason, nothing happens : the
workers stay unemployed, the factories lie idle and the raw materials remain unused.
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, and in terms of the effects on
people who are unable to find work for prolonged periods of time.
Why do market society’s experiences such periods of involuntary unemployment which

are unwanted by virtually everyone in the society, and can such unemployment be
prevented from occurring in the future? These questions have long concerned economists,
and have been studied under the heading TRADE CYCLE THEORY. Their study was
given renewed significance by the Great Depression of the 1930s. In the USA and the
United Kingdom, for example, this unemployment was never less than one worker in ten,
and it rose to a maximum of approximately one worker in four. This meant that, during
the worst part of the depression, one quarter of these countries’ resources were lying
involuntarily idle. A great advance was made in the study of these phenomena with the
publication in 1936 of the General Theory of Employment, Interest and Money, by J. M.
Keynes. This book, and the whole branch of economic theory that grew out of it, has
greatly widened the scope of economic theory and greatly added to our knowledge of the
problems of unemployed resources. This branch of economics is called MACRO
ECONOMICS.
6) Is the purchasing power of money and savings constant, or is it being eroded

because of inflation? The world’s economies have often experienced periods of
prolonged and rapid changes in price levels. Over the long swing of history, price levels
have sometimes risen and sometimes fallen. In recent decades, however, the course of
prices has almost always been upward. The 1970s, 1980s and 1990s saw a period of
accelerating inflation in Europe, the United States and in most of the world, more
particularly in the less developed countries.
Inflation reduces the purchasing power of money and savings. It is closely related to the
amount of money in the economy. Money is the invention of human beings, not of nature,
and the amount in existence can be controlled by them. 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. They also ask about other causes of inflation.
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, slowly in others, 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.
Although a certain amount is now known in this field, a great deal remains to be discovered.
Problems of this type are topics in the THEORTY OF ECONOMIC GROWTH.

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

NOTES
Chapter 2
TYPES OF BUSINESS ORGANISATIONS
Preview
Introduction, A firm, plant, Industry, Types of Business organizations - Proprietary Firms,

Partnership Firms, Joint Stock Companies, Public Sector Undertakings, Co-operative Societies
,Non-profit organizations, Business Organization in new millennium, Organization Goals -
Profit Maximization, sales Maximization, Satisfying Theory, other goals or objectives of firms.
INTRODUCTION
Organisation of production requires bringing together various factors of production and

coordinating the efforts of all the participants in the process of production. The level at which
this is done is the level of a firm.
Production with the profit motive is modern concept, in the sense that it has become dominant
only after the Industrial Revolution. Before the Industrial Revolution, most of the economies of
the world were agricultural economies. The profit motive was always a secondary motive in an
agricultural economy. But in modern times the profit motive became the only dominant motive
of production. A firm is a unit of production where production is done with the sole aim of profit
maximization.
1. Definition of a firm as a producing unit.
For the sake of understanding this concept of the firm, let us study some definitions of the firm
given by eminent economists.
1. Hansn : The firm may be defined as an independently administered business unit.

2. "A firm is a centre of control where the decisions about what to produce and how to
produce are taken."
3. "A firm is a business unit which hires productive resources for the purpose of producing
goods and services."
Types of Business Organisations 17

4. 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."
5. In the words of Prof. Lipsey, "The firm is defined as the unit that uses factors of production
to produce commodities that it then sells either to other firms, to households or to the
central authorities (meaning government, public agencies etc.) The firm is thus the unit
that makes the decisions regarding the employment of factors of production and the
output of commodities." How much to consume is decided by the households. In keeping
with preferences of the consumers, the firms decide how much to produce, how to
produce etc. Through advertisements, a firm may try to increase its sales, but the
decisions to buy belong to the buyers. The decisions regarding choice of techniques and
quantify of a commodity are taken by the firm. The firm is assumed to take consistent
decisions in relation to the choice open to it. The internal problems regarding the process
of decision - making i.e. who reaches decision, how are they reached etc. are ignored.
We take firm as a single unit - smallest possible unit. It is taken as our atom of behavior
on the demand side.
Again, just as the household is assumed to seek satisfaction maximization, the firm is
assumed to seek maximization of its profits.
The firm may be a proprietorship firm or a partnership firm or a Multi-National Corporation.

That it is a unit of decision - making is our criterion. Therefore, for an economist, Tata
Engineering and Locomotive Company Ltd. is a firm. Again, what form of business
organization and management experts? An economist assumes that the firm is internally
properly organized and is capable of taking decisions.
From the above definitions, 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. 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, and so if we study the various features of firm as
revealed by these definitions, the concept will be more clear. The following features of a
firm emerge from these definitions:
1) It is a centre where decisions about what, where, how and how much to produce are
taken.
2) It is a centre where the means of production are hired or purchased and used for production.
3) It is a centre, where the success of production is reviewed in its entire context and
decisions are taken.
4) It is a centre, where the means of production are collected, the production is done, and
the sale and distribution of production is also affected.
5) It is a centre, where all the decisions about production are taken. These include decisions
regarding the distribution of the product, advertising, sale and those regarding facing
competition also.
From the above features of a firm, it will be clear that a firm has to perform several functions
simultaneously - i.e. to produce a commodity, to sell and distribute the commodity, to advertise
the commodity and to perform all those things which will be required to survive competition. To
cap it all, the firm is expected to make as much profits as possible. Theoretically speaking, a
firm is expected to organize all the factors of production in the most profitable manner. If one
studies the structure and function of modern firm the above definitions will appear to be too
simple, because in modern times the firm is expected to perform so many other functions.
Formerly, the entrepreneur was taken to be an independent factor of production. 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. The mere presence of all the
factors of production and a market does not guarantee production. The will be to produce is
very important and it cannot be separated from the entrepreneur. Thus, the entrepreneur becomes
inseparable from the firm.
2. The firm and the industry
For understanding the difference between a firm and an industry, it would be advisable to
understand the nature of a competitive industry. A competitive industry has three basic
characteristics:
(a) Large number of firms, (b) Homogeneous product; and (c) Freedom of entry and exit.
In a competitive industry, 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. Every firm therefore enjoys the freedom
to increase or decrease its output substantially by taking the price of the product as given.
Secondly, every firm in a purely competitive industry, 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. This is known as the condition of homogeneity. This ensures that all firms have to
charge the same price. The buyers, of course, are to decide that the product is the same. The
buyers should not find any real or imaginary differences between the products sold by any two
pairs of firms, Finally, there should be no barriers to the entry of new firms (or exit of old firm)
to (or from) the industry.

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

The main types of business organization are as follows:
i) One -man Business or Individual or Sole Proprietorship or Proprietary Firms.
ii) Partnership
iii) Joint Stock Company
iv) Joint Hindu Family Firms
v) Co-operative Organizations
vi) State Enterprise/Public Enterprises
vii) Joint Sector Organizations
viii) Non-Profit Organizations and
ix) Business Organizations of the New Millennium
A. Private Sector :
In a capitalist economy, the first four types of business organizations are set up in the private
sector. The private sector is owned by private individuals, families or groups of individuals. It is
characterized by private ownership in the means of production, economic freedoms and profit
motive.
In addition to the first three types of business organization, there are also Joint Hindu Family
Firms in the private sector in India and Business Organizations of the New Millennium.
B. Public Sector :
The public sector includes public or state enterprises like railways, post sand telegraphs, etc.
The public sector is owned and controlled by the State. In India we have also a number of
public enterprises like Hindustan Machine Tools, Life Insurance Corporation, Bharat Heavy
Electrical Ltd. etc. They are constituted as companies, public corporations and departmental
undertakings.

C. Co - operative Sector :
There are many co-operative organizations in the private sector. But they are non-capitalist in
nature, e.g., Co-operative credit societies, consumers' co-operative societies, producers' co-
operative societies, service societies, etc.
D. Joint Sector :
Joint sector organizations or enterprises are jointly owned by the public and private sectors.
But day-today management is left to the private sector.
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 Non - Capitalist

Form 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.
1. 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, the simplest
and the oldest form of business organization.
In such a unit, a single man called proprietor organizes a business. It is owned, managed,
controlled and directed by him.
He fixes the amount of capital to be invested, (his own or borrowed), uses his own labour
and that of his family members, hires factors, whenever necessary, organizes production
as efficiently as possible and markets the product at the highest possible prices. He
assumes full responsibility for all business risks. He alone enjoys all profits, if he is
successful and suffers all losses, if his business fails.
(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. He enjoys full powers to fix the lay-out of his business
firm.
(ii) Organization and Control: A single person organizes and manages his business
according to his experience and efficiency. He has full powers to conduct his
business in any manner he likes. He need not consult any one. He is also not
required to take approval or agreement from others.
(iii) Capital: The owner uses his own capital. He may also borrow capital to invest it in
his business and thereby expand it.
(iv) No Sharing of Profits and Losses: All the profits of business earned by the owner
are enjoyed by him alone. These profits of business are not shared with other
persons. On the other hand, if there are losses, he has to bear them alone entirely.
(v) Unlimited Liability: His liability is unlimited for all his debts. If he fails to clear his
business debts, all his private property can be attached by his creditors.
(vi) Easy to Form: It can be easily set up. It is not subject to any special legislation.
So no legal formalities are involved in starting such a concern by any person who is
of major age, i.e. 18 years and above.
(vii) Legal Status: A sole trading concern cannot be legally separated from its owner or
proprietor. The owner and organization are the same. The life of such a concern
depends upon the life of its proprietor.
This type of organization is found in agriculture, retail trade, hotel, printing press, tailoring etc.
(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.
There is also little government interference. Also it is simple to manage and control and

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

personality, self-confidence etc.
(xiii) Lower Tax Burden : It is also subject to lower tax burden than other forms of business
organizations.
(xiv) Concentration of Wealth : It helps prevent concentration of wealth and income in the
hands of a few persons.
DEMERITS OF PROPRIETORSHIP OR PROPRIETARY FIRM :
(i) Limited Capital : The amount of capital which an individual can command is limited. He
has to depend mainly on his own savings. So it would be difficult for him to expand his
business activities much. It may also be difficult for him to raise additional capital by
borrowing from banks. Hence the size of his business is small.
(ii) Unlimited Liability and Risks : It may be very risky for him to invest in a particular
business. This is because if he adopts a wrong policy, he may lose everything and also
become insolvent. This is because his liability is unlimited. This implies that if his debts
exceed his business assets and if he suffers a loss, he will have to use his private
property to clear his debts. So the unlimited liability restricts his business activities.
(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, maintaining
accounts, advertisements, supervision, arrangement of finance etc. He cannot undertake
all activities alone efficiently. 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, supervision and control.
(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.
(v) No Economies of Scale : A sole trader cannot secure many of the economies of large
- scale production such as purchase of raw materials at low prices, advantages of
specialization etc., and minimize its cost of production or running business.
(vi) Weakness in Bargaining and Competition : On account of the limitations of capital,

ability and skill, the proprietor is likely to remain weak in respect of bargaining and
competition.
(vii) Wrong Decisions : All the decisions about his business are taken by the sole proprietor.
Some of his decisions may prove to be wrong. This may involve him in losses and ruin.
(viii) Closure on Death : Such a concern may be closed on the death of the proprietor. This
is because he may not have heirs to run it or they may not like to continue in his
business. Hence the business may not be continued.

2. PARTNERSHIP :
(A) Definition and Meaning : The Indian Partnership Act, 1932, 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, 1890, defines partnership as "the relation which subsists
between persons carrying on a business in common with a view to profit."
So a partnership refers to an organization owned and managed by two or more persons.

They pool their capital and undertake all risks associated with their business. Thus there
is joint ownership, management, control and risk - taking.
The persons who own the partnership concern are called "partners" Collectively, all partners
constitute a "firm".
(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. It may also be formed to
carry on certain trade, profession or lawful occupation.
(ii) Age Limit : Only persons who have attained the major status can become partners.
In other words, minors cannot become partners.
(iii) A Partnership Deed : A partnership is formally based upon a partnership deed or

agreement. It indicates the names of partners, the shares of individual partners in
the capital, their rights and duties, proportion for sharing profits and losses by each
of them etc.
(iv) Registration : The registration of a partnership firm is voluntary. It may or may not
be registered. However, if the partners so desire, it can be registered at any time.
(v) Joint - Ownership : The partners are joint owners of the property of the firm. Its
property must be used only for the business purpose for which the partnership was
formed. It cannot be used by any partner for his personal purposes.
(vi) Joint - Management : All the partners enjoy equal rights of management. So
every partner can participate in management. But for the sake of convenience, a
single partner may be given right to manage the firm.
(vii) No Remuneration : No remuneration is paid to any partner for services rendered

by him to the firm. Each partner is supposed to work in the best possible manner
for promoting the interest of the firm.
(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.
(ix) Business Activity : Any business selected by the partners can be undertaken. All
of them or any of them can carry on business activity for all.
(x) Sharing of Profit and Losses : There is a sharing of profits and losses. Profits
can be distributed according to the partnership agreement or the capital ratio. Profit
may be shared equally by partners, if nothing is mentioned in the partnership deed.
A manager who is an employee of the firm may also be given a part of the profits.
(xi) Mutual Confidence and Faith : A partnership is based upon mutual confidence
and trust of partners in each other or one another. Every partner must be honest
regarding the partnership dealings and should provide all the facts and information
regarding their business to all partners.
(xii) Combination of Capital, Abilities and Skill : In a partnership firm, some offer capital,
some management and organizational abilities and others, technical skills etc.
(xiii) Working and Dormant Partners : Some of the partners who provide only capital,
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. But, in India all partners have unlimited liability.
(xiv) Unlimited Liability : The liability of all partners is unlimited. Hence all partners
are, jointly and severally, held responsible for the losses or debts of the firm to the
full extent of their personal assets. Creditors are entitled to attach assets of any
one partner or those of others so as to recover their dues.
(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. If he cannot do it himself, he
has to retire from the partnership firm. However, a partner may admit another person
as a new partner if other partners give their consent.
(xvi) Principle of Agency : Every partner carries on business activities on behalf of the
firm. So he binds the firm and other partners for every commitment that he makes
in conducting business. Likewise he is bound by the business activities of the
other partners.
Thus every partner becomes a principal at one time and an agent of the firm at
another time. Hence a partnership firm can be run by one or more partners acting
on behalf of all partners.

(xvii)Dissolution : A partnership firm may not last long. 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. It may also be dissolved due to the death of a
partner or due to an adjudication of a partner as an insolvent.
Such partnership firms are found among builders, solicitors, chartered accountants,
small factories etc.
(C) MERITS AND DEMERITS OF PARTNERSHIP :
MERITS OF PARTNERSHIP :
(i) Easy to Form : A partnership firm can be easily formed. Its formation does not involve
legal formalities.
(ii) More or Additional Capital : Under the partnership, more funds can be raised by all
partners to start a business on a large scale. Because of the reputation of the partners
and their contacts, it will not be difficult for a partnership concern to borrow from banks
on easy terms.
(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, experience, abilities, talents
and aptitude. Thus, there would be specialization in the task of every partner.
(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.
(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, i.e. it can
quickly adapt itself to change in demand for its product, by increasing and decreasing its
business operations and by changing its business policy.
Thus the organizational structure of a partnership firm is flexible. The decision taking by
a partnership firm does not involve any legal procedure. Its operations are not also subject
to any restriction by a government.
(vi) Co-operation : It may elicit full co-operation from workers by keeping a close touch with
them, by understanding and solving their difficulties.
(vii) Advantages of Large-scale Production : It can secure all the advantages of large -
scale production such as advantages of division of labour, bulk purchases of raw materials
at lower price, best use of machinery etc.
(viii) Business Secrecy : All the activities of partnership concerns need not be given any
publicity. Hence they can carry on their activities under secrecy so far as the outsiders
are concerned. It is not compulsory for a partnership concern to publish its profit and
loss account and its balance sheet. Outsiders are not given its business secrets.
(ix) Business Risks and Rewards : Business risks are equally shared by all the partners.
In case business fails, they would suffer losses. But if it succeeds, they will enjoy
profits. Hence, 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.
(x) Close Watch : Every partner has a right to take part in the partnership business. Since
there is unlimited liability, every partner will keep a close watch on the activities of other
partners so that losses are avoided and profits are maximized. Thus the interest of every
partner is protected.
(xi) Unlimited Liability : Since there is unlimited liability, the business status of a partnership
firm is raised. Hence it will be easy for it to get loans from financers.
(xii) Management and Organizational Abilities : In a partnership firm, there is a combination
of capital, abilities and skill. Some partners offer capital. Some partners are experts in
management and organization. Some of them possess technical skill. As a result of the
pooling of the expert services of all partners, it is possible to run a partnership firm
efficiently.
(xiii) Dissolution : In case a partner is not happy with the working of his partnership firm, he
can legally dissolve it. He can do so by giving a written notice to the other partners
indicating his decision to resign from it.
(xiv) Mutual Consent : All the business decisions are taken with mutual consent of all
partners. They hold mutual consultations and discussions on important matters. Thus
every partner benefits form the advice of other partners. As a result, their wisdom is
pooled for the benefit of the firm.
DEMERITS OF PARTNERSHIP
(i) Unlimited Liability and No Risk Business : On account of the principle of unlimited
liability, any bad or irresponsible partner may ruin all the partners. This is because his
activities will be binding on all other partners. Every partner runs a considerable risk for
any one of them is, jointly or severally, held responsible for the debts or losses of the
firm. Further due to unlimited liability, the partners may not undertake any risk in business
or take any hasty step to expand business. Hence the spirit of enterprise is checked.
(ii) 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. A partnership firm cannot also admit more than 20 members for raising
additional resources. This limitation on the number of partners restricts the growth of a
partnership form.

(iii) Short - Lived : A partnership can be dissolved by any partner by giving a written notice
to other partners. So this type of business is short-lived. Also default, 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.
(iv) Non - Transferability : A share in a partnership firm cannot be transferred by any

partner without the consent of all the partners. He cannot also transfer his powers or
rights to any third party to do any work of the firm on his behalf.
(v) Differences of Opinion : The partners may not agree upon certain matters of business
policy. There might by differences of opinion, clashes of interest, mistrust, disputes etc.
Such differences among partners may result in dissolution of partnership firms.
(vi) No Trust : The activities of a partnership firm are kept secret from outsiders. It is not
required to publish its accounts. It is also not subject to legal restrictions. Hence people
may not fully trust a partnership concern.
(vii) No Government Control : There is no government control or supervision on the activities

of a partnership concern. Hence there is lack of public confidence in such concerns.
(viii) Leakage of Important Information : Some of the partners may leak important information
to outsiders. This may happen when there are differences of opinion among the partners.
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. Some partners may not behave properly. Some of
them may be dishonest. Hence they may misuse their rights and bring the firm into
difficulties and ruin its business. As a result, the honest and efficient partners will have to
suffer losses.
3. JOINT - STOCK COMPANY :
Introduction : In a modern economy, the predominant form of business organization is the

Joint - Stock Company which is called Corporation in the U. S. A. Such form of business
organization is necessary to undertake any business or industry on a large scale. This is
because it overcomes the drawbacks of sole proprietorship and partnership.
(A) Definition : In the words of Mr. Kuchhal, a joint -stock company is "an incorporated
association which is an artificial legal person, having independent legal entity, with a
perpetual succession, a carrying a limited liability."
As per the Indian Companies Act of 1956, a joint - 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.
Thus a joint-stock company is a voluntary incorporated association of shareholders or
stockholders who contribute to the common stock, (i.e., capital) of which they are the
owners. But all of them do not directly manage it. It is managed by some directors
elected by shareholders. Their liability is limited to the value of shares held by them.
They share in profits and losses.
(B) How Is It Formed ? : Minimum seven persons have to come together to start a joint -
stock company. Those who take initiative to start it are called promoters. The promoters
of a company have to get it incorporated by filing with the Registrar of Companies various
documents such as Memorandum of Association, Articles of Association, Prospectus,
List of Persons who have agreed to act as directors etc.
The Memorandum of Association : This gives information about the company, namely,
its place of location, its objects, 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 Registrar of Joint - Stock Companies is given these documents.
After going through these documents, the Registrar issues a Certificate of Incorporation.
After this, the company comes into existence.
Hence the registration of a joint - stock company is compulsory.
(C) Features of a Joint - Stock Company :
(i) Voluntary Organization : A joint - stock company is a voluntary organization or

association of shareholders.
(ii) Legal Person : It is a legal or an artificial person as a result of law. It has no

physical existence. But it functions as a separate and independent legal person. It
is distinct from its shareholders and its directors.
(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.
(iv) Common Seal : It has a common seal to be affixed on its contracts and legal
documents.
(v) Open Membership : Its membership is open to any person in any part of a country.
(vi) Limited Liability : Liability of shareholders is limited to the nominal value of shares
held by them.

(vii) Free Transferability of Shares : The shareholders are free to transfer or sell their
shares to any person.
(viii) Management by Elected Board of Directors : It is owned by its shareholders.
But it is managed by a Board of Directors elected by shareholders.
(ix) Fragmented Rights of Ownership : the shareholders enjoy a fragmented right of
ownership due to shares purchased by them.
(x) Dividends : The profits of a joint - stock company are annually distributed as
dividends among its shareholders.
(D) How is Capital Raised By a Joint Stock Company?:

(a) Methods of Raising Capital : A company raises its capital in two ways, namely,
(i) Through the sale of shares or stocks and
(ii) Through the sale of bonds or debentures.
Sale of shares of stocks

(b) Types of Share Capital : A company divides its share capital as :
(i) Registered or Authorized Capital,
(ii) Issued Capital and
(iii) Paid - up Capital.
(i) Authorized Capital : Authorized Capital refers to the maximum amount which
can be raised by a company by selling shares. This may be, say, Rs. 20 crores.
(ii) Issued Capital : Issued Capital refers to that part of the authorized capital which is
issued to the public for subscription by dividing into shares. This may be, say, Rs.
16 crores.
(iii) Subscribed Capital : Subscribed Capital refers to that part of the issued capital
which is actually subscribed by the public. This may be say, Rs. 14 crores.
(iv) Paid - up Capital : Paid - up Capital refers to that part of the subscribed capital
which the public directly pay-up to the company, as a part payment of the value of
their shares. This may be, say, Rs. 10 crores. The remaining amount of the
subscribed capital is paid after further calls from the company.
(c) Types of Shares : The capital of a company can be divided into three types of shares :
(i) Equity or Ordinary Shares,
(ii) Preference Shares and
(iii) Deferred Shares.
(i) Equity or Ordinary Shares : Such shares form the main basis of the finance of a
company. The holders of such shares get dividend only after the preference
shareholders are paid out of its profits. Hence they bear maximum risk. This is
because they do not get any dividend if the company does not make any profit. At
times when profits are high, they get much more than the rate of dividend paid to
preference shareholders.
The ordinary shareholders have the right to vote to elect the Board of Directors of
the Company. They have also the right to vote on policy decisions of the company.
Hence they control the affairs of their company.
(ii) Preference Shares : These shareholders enjoy a preferential or prior right over
equity shareholders to the profit of a company. They are entitled to a fixed rate of
dividend after paying interest on debentures and before any dividend is paid to
equity shareholders.
However, preference shares are classified as :

(a) Simple or Non-Cumulative Preference Shares,
(b) Cumulative Preferences Shares,
(c) Participating Preference Shares and
(d) Redeemable Preference Shares.
(a) 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. They get the dividend before it is paid to other types of shareholders.
(b) 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.
(c) Participating Preference Shares : The holders of such shares are paid a
fixed rate of dividend before it is paid to other classes of shareholders. They
are also entitled to participate in the balance of profits,in a certain proportion
along with equity shareholders, after reasonable claims of these equity
shareholders are met.
(d) 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.

The preference shareholders do not enjoy normal voting rights. However they have
a prior claim on the assets of the company in the event of its liquidation.
(iii) Deferred Shares : They are called the Promoters' or Management's of Founders'
shares. 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.
Normally they are issued to promoters of a company but they may also be issued
to public. If dividend paid to other classes of shareholders is restricted, the deferred
shareholders will enjoy a bigger share of profits. But if there are no profits, they do
not get anything.
The deferred shareholders enjoy special or preferred voting rights. But the Indian
Companies Act. Of 1956, has eliminated the system of issuing deferred shares by
public limited companies.
However a private limited company can issue deferred shares also.
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, 15 to 25 years, at a particular rate of
interest. This is done by issuing debentures or bonds.
A debenture is an undertaking by a company to repay the borrowed money
on or before the specified date at a particular interest rate, irrespective of
profit or loss made by the company.
The capital raised by selling debentures is like taking loans form the public.
Hence, a debenture-holder is a creditor of a company with no voting right. As such,
he cannot directly interfere with the activities of its management.
A Debenture may be classified as (i) secured and (ii) simple.
(i) A secured debenture is secured against the assets or property of a company.
(ii) A simple debenture is not secured against its assets or property.
A company is also free to issue convertible debentures which can be converted into
equity shares after a period of time, say, 5 to 10 years, at a ratio fixed in advance.
(E) Types of Joint - Stock Companies :
On Ownership Basis, all types of the registered companies in the private sector
can be classified as :
(a) Public Limited Companies and
(b) Private Limited Companies.
In the public sector, we have government companies in which 51% of the paid-up share capital
is held by the government.
(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 public limited company
can have any number of the members of the public but it should have a minimum 7
members.
(2) Public limited companies are required to issue prospectus before allotting shares.
But it is not necessary in the case of private limited companies.
(3) Public limited companies must submit statutory reports to the Registrar of
Companies. But private limited companies are not required to do so.
(4) A public limited company has to send its duly audited accounts to its shareholders.
But a private limited company is not required to publish its accounts for the information
of the public. However a private limited company must send three certified copies of
its balance sheet to the Registrar of Companies.
(5) The shares of a private limited company cannot be freely transferred on stock
exchanges. But the shares of public limited companies can be freely transferred on
stock exchanges.
(6) The share of a private limited company openly invites public to subscribe to its
shares or debentures. But a private limited company cannot appeal to the public to
do so.
(7) A private limited company can start its business after it is registered. But a public
limited company can do so only after it gets a certificate for commencement of
business.
(8) A private limited company should have minimum two directors. But a public limited
company must have at least three directors.
(9) A private limited company may increase its number of directors without the
government's approval. But a public limited company can do so only after getting
the government's approval.
(10) In the case of a public limited company only an individual can be appointed as its
manager. But a private limited company can appoint a firm a as its manager.

(11) A private limited company can issue different classes of shares with disproportionate
voting rights. But there are restrictions in this respect on a public limited company.
A partnership may be converted into a private limited company to enjoy the

advantages of limited liability.
(G) Management of Joint - Stock Companies : There is separation between ownership

and management in a joint-stock company. Its ownership is in the hands of shareholders.
But they do not manage it directly. They elect a Board of Directors which manages the
company.
The policies of the company are laid down by the directors. These policies are executed
by salaried managers and executives.
(H) Merits and Demerits of Joint-Stock Companies :
MERITS OF JOINT - STOCK COMPANIES :
(i) Limited Liability : The principle of limited liability is applicable to a joint-stock company.
Hence we write word "Ltd." after the name of a company. Since the liability of shareholders
is limited, risk faced by them are reduced. Hence even if a company suffers losses, they
need not pay more than the face value of shares purchased by them. So the creditors of
the company cannot make personnel attachments on their private property. Hence people
are induced to invest their money in such companies.
(ii) Large Amount of Capital : Large - scale production is facilitated under the company
form of business organization. This is because it is easy for a company to raise a large
amount of capital, by accepting fixed deposits from the public. Thus the savings of the
people can be productively used.
(iii) Transfer of Shares : The shares of a company are transferable whenever one likes.
Hence it would encourage small savers to invest in the shares of companies. If they do
not like to keep their funds in a particular company, they would be free to sell their
shares on stock exchange and invest in some other companies.
Thus the money of a share holder is not blocked. At the same time, this does not affect
the company in any way. 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.
(iv) Shares of Different Varieties : The shares of a company are of different types, namely,
equity shares, simple preference shares, cumulative preference shares etc. The equity
shares may be purchased by people who want take greater risks. On the other hand,
those who do not want to take any risk may invest in cumulative preference shares.
Thus, by providing a wide choice to shareholders, it is possible for a company to raise a
large amount of capital.
(v) Risky Enterprises : A joint-stock company can start a risky enterprise. 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. So
even if there is a loss in the case of one company, the individual shareholders may not be
affected much.
(vi) Less Danger of Misappropriation of funds : There is a less danger of misappropriation
of funds. This is because the audited accounts of the companies must be published.
(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. Other persons, having no capital but possessing capacities to manage a
business, can secure jobs as managers and executives in companies.
(viii) Efficient Management : In a joint-stock company, the ownership and management are
separated. The shareholders are owners but they do not manage it. It is managed by
experts in different fields, who work under the direction of the Board of Directors.
(ix) Economies of Scale : A joint - stock company can enjoy the economics of scale such
as advantages of specialization and division of labour etc. by making full use of managerial
skills and abilities and other factors of production.
(x) Continuity and Stability : Since it has a perpetual succession, a company continues
to carry on its business even if some of the original shareholders leave the company or
die or become insolvent. So it is permanent and stable in nature. So the business
activities can be undertaken with a long-term objective.
(xi) Legal control : Since companies are subject to rules and regulations of the Companies
Act, they are supposed to work in the interest of their shareholders.
(xii) Democratic Management : There is democratic management in a joint-stock company.
This is because the directors are elected by shareholders from time to time. The elected
board of directors manage the company successfully because of their wide experience,
abilities and efficiencies.
(xiii) Research : Because of its continuous existence and a large amount of resources at its
disposal, a company can conduct research and experiments, and apply the fruits of
research to industrial uses. This will enable it to improve the quality of its product,
reduce its cost of production and thereby enjoy good profits in due course.
DEMERITS OF JOINT - STOCK COMPANIES :

(i) Lack of Personal Interest and Inefficient Management : The actual management of
a joint - stock company is in the hands of salaried executives. They have no personal
interest in the functioning of their company. Hence they may not always manage the

affairs of their company efficiently. Some of them might even leak out secrets of their
company to rival companies.
(ii) Indifference of Shareholders and Oligarchy : On account of their : limited liability,

many of the shareholders are indifferent. They may not take an active part in the affairs
of their company. They are also scattered. They are interested only in dividend. So a few
big shareholders manage to get directorships and take all decisions.
So, in actual life, there is oligarchy rather than democracy in the management of a
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. So shareholders are
owners only in name.
(iii) Promotion of self - interests and misuse of power by directors : A few big directors,
who control the affairs of the company, try to promote their own interests in various ways
at the cost of other shareholders.
Further when the directors are dishonest, they may commit some frauds and cheat and
exploit the shareholders. They may also purchase inputs from their friends and relatives
at high prices and resort to other corrupt practices. They may also claim excessive fees.
(iv) To Risky Ventures : the directors may be inclined to start very risky enterprises which
may fail. Hence they will involve the shareholders in losses.
(v) Extravagance : The directors may not behave in a responsible manner. They may
spend in an extravagant way.
(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, but on the basis of favouratism, influence,
personal relations etc. They may employ their friends and relatives in high posts paying
high salaries. Hence the general working of a company is likely to suffer.
(vii) Unethical Practices : Directors possess inside information of the working of their
company. Hence they may dispose of their shares at high prices by creating an impression
that their company is going to make good profits when, in fact, the things are otherwise.
So those who buy such shares will suffer losses. In the opposite case, when a company
is likely to make good profits, they may try to create an impression that it would suffer
losses. This impression will induce other shareholders to sell their shares. They buy
them through their agents. Hence they can get all the profits for themselves.
The transferability and marketability of shares is also responsible for unhealthy speculative
activities on stock exchanges on the part of some directors. As a result, the interests of
shareholders are ignored with the result that a large number of them may be ruined.
(viii) Conflict : There is no close personal contact between employees and management.
Hence there is likely to be a conflict between employees and the management. At
times, this may result in strikes and lockouts. So the company's output would suffer
causing thereby a loss to the shareholders.
(ix) Political Corruption : A number of joint-stock companies may pay a large amount of
money as donations to political parties. They are given for the personal benefit of directors
and / or for the benefit of the company at the cost of the public.
(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.
As they are elected as directors, there would be a concentration of wealth and economic
power in their hands. They manage to get themselves re-elected by some means or the
other. However such people may lack adequate experience and skill. Hence they may
not be in a position to manage the affairs of the company efficiently.
(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.
This is because there is a lot of discussion and consultation before taking any decision.
This causes unnecessary delay. Hence when quick decision and prompt action are
required, a company form of organization is not suitable as a partnership concern or
even a private proprietorship concern.
CONCLUSION : The joint-stock system has much contributed to economic progress.

This is because it is responsible for tremendous industrial progress, production and trade.
4. JOINT - HINDU FAMILY FIRMS OR ORGANISATIONS :
Such organization undertaking business activities exist in India. They are also called
Hindu Undivided Family Business (HUF). In a Hindu Joint Family firm, all members of a
family come under 'karta', a common head, who is the eldest member in the family.
The Hindu Law determines their rights and liabilities.
Such organizations were important in the past. But now their importance has declined.
This is because they are not suitable for many economic activities in modern times.
Joint Hindu Family have some of the features of a partnership firm. However, the ownership
of a joint family firm is not due to A contract but due to inheritance. Hence the male
members of joint family firms are called co-parceness and not partners.
5. 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. But, in India, it began only in 1904 after the Co-operative Societies

Act, 1904, was passed. This Act was passed mainly to provide credit to farmers and
prevent them from borrowing from money-lenders. Since 1904, the co-operative movement
has made considerable progress in India.
(A) Definition of Co-operation : In a wide sense, "co-operation means working together for
a common purpose". Hence, in the co-operation, the main principle adopted is" all for
each and each for all".
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.
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.
(B) Principles of Co-operative Organizations :
(i) A co-operative organization is a voluntary association.
(ii) It is established to promote common economic interests of all its members and
thereby promote their general welfare.
(iii) Its management is democratic in nature. There is one vote for one member.
(iv) All members enjoy equal rights and status.
(v) Its business is very often confined to the members only.
(vi) Profit motive is not supreme. It stresses mutual help, honest means and moral
values. It believes in the principle of "all for each and each for all".
(C) Features of Co-operative Organizations :
(i) Voluntary Association : A co-operative society is a voluntary association of

individuals having limited means, formed to promote and protect their common
economic interests.
(ii) Democratic Management : The members of the managing committee are elected
by the members of a society on the basis of "one head" one vote", whatever be their
individual share holding.
(iii) Equality : A co-operative society functions on the basis of equal rights, equal
status and responsibilities of members.
(iv) Equitable Contribution : The members make an equitable contribution to its capital.
(v) Thrift and Self-help : It promotes thrift, self-help and mutual assistance.
(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.
(vii) Service Motive : Although a society enjoys profits, its main objective is service for
promoting common economic interests of the members as well as for promoting
self-reliance, brotherhood, honesty and social relations among them.
(viii) Evils of Capitalism : It eliminates some of the evils of capitalism, e.g., exploitation of
consumers, workers, concentration of wealth and economic power in a few hands, etc.
(ix) Legal Status : A co-operative society enjoys a legal status, for it is registered
under the Co-operative Societies Act.
(x) Government Control : Such societies are controlled and regulated by the
government.
(D) Types of Co-operative Societies :

There are various types of co-operative societies such as Consumers' Co-operative
Societies, Producers' Co-operative Societies, Co-operative Credit Societies, Co-
operative Service Societies, Co-operative Farming Societies, Co-operative
Marketing Societies, Co-operative Housing Societies, etc.
(E) Merits and Demerits of Co-operative Societies :

Merits of Co-operative Societies.
(a) Voluntary Association : They are formed voluntarily. Individuals are free to join or
leave the societies.
(b) 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. They
check the malpractices of monopolists and capitalists.
(c) Purchases and Sale of Goods : There is no speculative buying of goods. There is
also no problem of sales promotion by means of advertisement.
(d) No Malpractices and Reasonable Prices : They can also remove malpractices
in business like black-marketing, adulteration of goods, etc. The consumers also
get various goods at low prices.
(e) Legal Status : A co-operative society has an independent legal status.

(f) Common Benefits : People with small means can easily form such societies to
promote their common interests. They do not involve many legal formalities.
(g) Team Spirit : They are democratically managed, i.e. they are managed by elected
representatives. The members have right to vote. Such societies help develop team
spirit among their members.
(h) Social Values : They promote social values such as mutual sacrifice, mutual help
etc. and bring about an economic equality. They stress equal distribution of wealth.
(i) Service Motive : They provide various types of services to their members. They also
obtain voluntary services from their members. Hence their cost of operation is low.
(j) Liability : In such a society, the liability of members in limited to the extent to
which they hold the shares therein.
(k) Concessions and Encouragement : The government provides various facilities to
promote their growth by means of assistance, concessions etc. For e.g. the low
income groups can form housing societies to solve their housing problem in cities
and towns.
(l) Debt, Insolvency etc. : They are not affected by debts, insolvency or insanity of
their members. Hence they are relatively stable.
(m) Undistributed Profits : Their undistributed profits add to their capital which can be
used to expand their activities.
Demerits of Co-operative Societies.

(a) Malpractices : Some of the members of a society may be unscrupulous. They may
resort to malpractices to exploit weak members and to promote their personal interest.
This would result in conflicts, rivalry, quarrels and failure of the society to function properly.
(b) Limited Finance : As compared to a joint-stock company, the power of a co-operative
society to raise finance is limited. So it is financially weak.
(c) Inefficient Management : Members of the management of such societies may be selected
on personal considerations. They may not be honest and competant. They may not also
possess skill and efficiency to run them efficiently. Hence their efficient management is
difficult. They cannot also secure the services of experts and specialists nor can they get
trained personnel. This is because they cannot afford to pay high salaries.
(d) Rivalry : There may be rivalry among the members of the society to secure control over
the management of societies.
(e) Lack of zeal : Their member may not possess zeal, enthusiasm and urge to members
and may not extend whole-hearted co-operation. They try to get only the services rendered
by a co-operative society and enjoy their benefits.
(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.
(g) Business Secrecy : In such societies, business secrecy may not be maintained because
their affairs are carried on democratically.
(h) Government Control : They are subject to too much government control and regulations.
Hence they might not be in a position to work efficiently.
(i) Limits of Expansion : Such organizations cannot extend their activities much due to
limited finance and limited management skill.
(j) Limited Buyers : The sales of a co-operative society are generally restricted to a limited
number of buyers.
(k) Political Parties : The political parties may use such societies to promote their interests.
However, in spite of their limitations, they have an important role to play in improving
the conditions of the poor people. Hence they should be made more effective.
6. PUBLIC ENTERPRISES / PUBLIC SECTOR UNDERTAKINGS (P.S.U’s) :

(A) Definition : The public enterprises refer to enterprises which are owned, managed and
controlled by the government – either Central or State or Local self governments. They
are called "state enterprises" or "public undertakings". They include Indian Railways,
river projects, basic and key industries, various public utility undertakings providing road
transport, water, electricity, gas etc.
(B) The Main Features of Public Enterprises :

(1) State Control : They are owned, managed and controlled by the departments
concerned of the government or by the government bodies.
(2) Management : Some of them may be managed by professionals.
(3) Accountability : They are accountable to the public because they are accountable
to the government which represents the people.
(4) Separate Funds : They are assigned separate funds to undertake their activities.
(5) Legal Status : Each public enterprises is a separate legal entity, for it is established
by law. Some of the public enterprises enjoy autonomous status operating as per
the state policy and general directives from the government. So they are influenced
more by the state policy than the enterprises in the private sector.
(6) Profit : Some of them may work for promoting welfare of the people rather than
making profits. Some of them are run on commercial principle so as to make
profits. But profit-making is not their main motive for, at the same time, they have to
promote social ends.

(C) Forms of Public Enterprises :
There are three forms of organization adopted for the management of public enterprises.
1) Departmental Management
2) Company Management or management by boards and
3) Public Corporations.
1) Departmental Management : There are some undertakings which are run by the
government departments e.g. posts and telegraphs, railways, defence industries,
information and broadcasting, atomic energy etc.
Normally enterprises which are strategically important and which provide steady
income to the government are departmentally-managed.
The main features of the Departmentally - managed Undertakings are :

1. They are managed by various departments of the government.
2. The civil servants are assigned the job of running them.
3. The ministries concerned exercise control over them.
4. They are financed by the government by means of annual appropriations from
the treasury.
5. They are accountable to the public through the government.
Their defects are : Such departmentally-run enterprises are subject to a number

of criticisms such as lack of initiative, rigidity in operations, ignorance of consumers'
requirements, red-tapism, delay in taking decisions, wrong decision, politically-
motivated decisions, etc. Hence their working efficiency suffers.
It these defects are eliminated, they can be run efficiently. This can be achieved, to
a large extent, if an autonomy is given to such enterprises in their day-to-day
working.
2) Joint Stock Company Form of Management : Certain enterprises, which may

be entirely owned by the government, are operated as private limited companies.
The main features of the Government Companies are :

1. They are owned by the government.
2. They are commercial in nature. They are dynamic and quick in decision - making.
3. They are registered as private limited companies.
4. Their financial operations are subject to a close scrutiny by the government.
5. Their attempt to eliminate some of the defects of the departmentally run
enterprises.
Some of the important government companies in India are : The Bharat Heavy
Electricals Ltd., (BHL), the Hindustan Steel Limited (HSL), the Hindustan Antibiotics
Limited (HAL), the Bharat Aluminum Company Limited (BACL), the Steel Authority
of India Limited (SAIL), etc.
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.
Their main feature are :

1. They are created by special acts of the parliament. So they are legal entities
owned by the government.
2. They enjoy internal and financial autonomy, i.e. they are financially independent
autonomous institutions. So they are free from the parliamentary control in
respect of their day-to-day management t and financial operations. They take
all decisions independently.
3. Their powers and functions are clearly laid down by respective acts of the
parliament.
4. They are run like commercial concerns.
5. They attempt to blend the public ownership and private initiative and flexibility
for they are free from bureaucracy in administration and management.
6. They are supposed to eliminate the defects of the departmentally - run
enterprises as well as those of company type undertaking of the state.
7. They are managed by Boards of Directors appointed by the government who
need not be form the cadre of civil servants.
Some of the corporation set up in India are the Life Insurance Corporations (LIC),
the State Road Development Corporation (SRDCs), the State Trading Corporation
(STC), The Damodar Valley Corporation (DVC), the Reserve Bank of India (RBI), the
Oil and Natural Gas Commission (ONGC), the Air India, the Indian Airlines Corporation,
the Industrial Finance Corporation of India (IFCI), Food Corporation of India etc.
(D) Advantages (i.e. Merits) and Disadvantages (i.e. 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

India are run for making profits. But the profits earned by them are utilized for
improving services rendered or for further expansion of their activities.
Thus profits earned by state enterprises can be used to promote general welfare.
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. The government has, therefore, to undertake
such investment in the interest of society, e.g. construction and management of
river linking projects.
3) 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. But the government can
raise any amount of capital from various sources for investment in any project or an
industry. Hence such projects or industries are started in the public sector.
4) Public Welfare : In certain fields, the state enterprises may work more efficiently
than private enterprises. This is particularly the case with public utility services like
electricity, water, railway service etc. If they are left to the private sector, the
consumers may be exploited. Hence they are organized by the government on the
monopoly basis to secure economies of scale.
5) Economies of Large-scale Production : On account of large-scale production,
they can enjoy the economies of large-scale production.
6) Consumer Interests and Quality of Goods : As compared with the private sector
enterprises, the quality of goods or services provided by the public enterprises is
likely to be better. They will also be made available at reasonable prices. Hence the
interests of consumers would be safeguarded.
7) Labour Relations : The scope for conflicts between workers and the public
enterprises would be minimum. This is because the workers are likely to be more
contented due to security and justice in service.
8) Industrial Development : When a country has a few entrepreneurs and the skilled
labour is limited. The government may set up a number of industries by inviting
foreign skilled labour to help it to accelerate the pace of industrial development. It
may also attract very efficient personnel and best managerial talent by offering high
salaries and better service conditions.
9) No Wastes : All wastes of economic resources in the form of existence of excess
capacity in the private sector industries, competitive advertisement etc. can be
eliminated if they are nationalized and run by the government.
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.
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.
12) Ultimate Control by People : The working of the public enterprises is subject to
the criticism of the people and the Members of Parliament. Hence, if there is
anything wrong in the working of the public enterprises, it would be set right. So the
public enterprises are ultimately controlled by the people themselves.
Demerits of Public Enterprises :

1) Inefficient management : The government officials may take a long time in taking
decisions as well as action. Hence the government enterprises may be run with
excessive social cost of operation. This may be so because all of them may not
possess much business experience.
2) No Incentive for Hard Work : The public enterprises may not create incentives for
hard work for their workers. The managers may not take any risk. This is because
their acts are questioned.
3) Bureaucracy and Red-tapism : Bureaucracy, red-tapism and corruption may
obstruct the growth of public enterprises. The bureaucrats may not take quick
action because they have followed the established procedures. Hence they may
cause losses to the public enterprises. This would involve a burden to the taxpayers.
4) Lack of Incentives : Because of lack of incentives, personal initiative may be
lacking and the responsibilities may be avoided. This is because the government
officials may work in a routine way. In other words, they may not work enthusiastically
and efficiently.
5) Extravagance : The officials in charge of managing these enterprises may plan in
a big way and spend extravagantly. This would cause much loss to the public
sector year after year.
6) Friction : There may also be an internal friction between various officials in a public
enterprise. Hence its efficiency would suffer.
7) Political Considerations : Political considerations may determine appointments,
transfers and promotions. Hence right man may not be placed in the right place.
Such a policy is detrimental to the efficient working of the public enterprises. Further
bribery and corruption may predominate. Also an enterprise may be located in a
particular area out of the political rather than economic considerations.
8) Rigidity : There may be rigidity in the working of the public sector enterprises due
to strict rules and regulations.

9) Transfers : There might be frequent transfers of the government officials. This would
disturb the smooth working of the government enterprises.
10) Helplessness of Consumers : Individual consumers will be helpless when goods
and services are provided by big public enterprises. They may not much care for
the public. They may not get proper treatment from the officers in the public
enterprises.
11) Personal Liberty : Extension of the public sector may result in centralization of
powers and a loss of personal liberty. Also it may reduce resources available for
investment in the private sector. Hence the working to the private sector industries
would suffer.
12) Government Interference : Due to too much interference form the government,
the executives in charge of the public enterprises may not take their own decisions
to run them properly.
13) Workers' Interests : The workers' interests may not always be protected resulting
in labour unrest. However the authorities may, sometimes, yield to the pressure of
workers' demand due to the political considerations.
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.
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. This
would reduce economic inequalities and promote public welfare.
7. JOINT - SECTOR ENTERPRISES :
In India, the concept of joint-sector was accepted by the Government of India through its
Industrial Licensing Policy of 1970. The Government reiterated it in its Industrial Policy
decision of February, 1973.
In simple terms, the joint-sector is a form of partnership between the private sector and
sector and the government.
In this, 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.
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. However on
the Board of Directors of a joint-sector, the government is adequately represented to
regulate its functioning. The Board of Directors would lay down the policies for the join-
sector enterprises. The government has to guide their management and operations.
Thus the joint-sector enterprises are controlled by the government and the private sector
jointly.
The joint-sector can be used to promote socio-economic objectives of the government
such as regional dispersal of industries, etc.
Thus a joint-sector involves a social control over industries without resorting to their
nationalization, i.e. it lies between private enterprise and outright nationalization.
In India, some of the important joint-sector enterprises are Indian Telephone Industries
Limited (ITI), Hindustan Machine Tools (HMT), etc.
The state government in India have also entered into joint ventures with the multi-national
corporations.
8. NON - PROFIT ORGANISATIONS :

Non - Profit organisation can be classified into public sector organisations and private
sector organisations. Some organisations created by the Government in the public
sector are directed towards meeting the basic needs of the people. 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. In both these cases profit -
making is not a goal.
It is possible to classify non- profit organisation into public utilities and social service
organisations. Water supply, postal services, general hospitals, etc., are examples of
public utilities. On the other hand, organisation of voluntary social workers, also known
as NGOs (non-governmental organisations) working in the fields like rehabilitation of
disabled persons, pensioners' homes, adult education, non-formal education, schools
for the blind or the deaf, HIV/AIDS awareness etc., are examples of this type. The
following chart illustrates this classification :
Non-Profit Organisation
Public Sector Private Sector
Public Utilities Social Service Organisations

Organisation : Public sector non - profit organization can take various forms like
departmental establishments, autonomous boards / corporations etc. Their organizational
patterns, merits and demerits are as discussed earlier under public sector undertakings.
Some characteristics, however are worth noting.
(i) Most of these organizations enjoy a certain degree of autonomy to make room for
flexibility and quick decision;
(ii) 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;
(iii) Normally local or regional branches / boards have the freedom to adjust their activities
to the local needs of the society;
(iv) The beneficiaries or the users can send their suggestions / complaints for improving
the performance of these organizations;
(v) Annual accounts are audited and placed before the house concerned like the
municipal corporation, legislative assembly or the parliament.
Private sector organizations usually prepare their own constitution and get the organization
registered under the Public Trust Acts as well as / or Societies Act. 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.
The day - to - day 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, supervisory board etc.
Whatever the type of non-profit organization, a common characteristics is that it serves

some very important need of the people which either cannot be met through the market
mechanism or, if left to market mechanism, users are likely to be exploited or go unserved.
The pricing policy of such organizations depends upon whether the organization is aided
or funded by some other philanthropic organization. At times the services are rendered
free of charge and the costs are entirely borne by the funding agencies or the government,
as the case may be. Sometimes the prices are subsidized for keeping them low and
within the reach of the low income beneficiaries. Sometimes prices / fees are discriminatory
being linked to the annual income of the users. In some cases, the prices just cover the
costs.
In modern times, and especially in more developed countries, voluntary agencies are
being entrusted with task which earlier were performed by the government. This
arrangement of voluntarism has various advantages. Such voluntary organizations -
(i) can provide quality service for they are run by committed social workers,
(ii) can ensure peoples, participation due to their service motive,
(ii) can be flexible in procedure and approach and this suits the people,
(iv) are close to the people and therefore, can remain in touch with the users and can
monitor the way in which needs of the people are met,
(v) can take a feed back and re-adjust their methods / procedures to instill more efficiency
or better quality in service.
9. BUSINESS ORGANISATIONS OF THE NEW MILLENNIUM :
By the turn of the century, mainly due to the technological developments, the firms all
over the world started experiencing phenomenal changes and challenges. The following
can be listed as the major ones :
(i) With a systematic removal of barriers to trade, under the WTO system, the markets
widened suddenly and extended to global dimensions.
(ii) Relaxation of exchange controls and freedom of convertibility of currencies expanded

investment opportunities and subsequent flows of capital.
(iii) Mass production of personalized products replaced mass production of the yester
years.
(iv) Aggressive sales promotion and attractive marketing campaigns became an inevitable
part of the firm's business strategy.
(v) 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 large-
scale production.
(vi) The incidence of industrial sickness and closures reached unforeseen dimensions.
(vii) The process of acquisitions and mergers was accelerated out of the survival instinct
of the firms.
(viii) Advertising, mainly through the powerful electronic media, reached unprecedented
proportions and started designing the tastes of the consumers.
(ix) The competition that emerged was in pleasing the consumers by apparently satisfying
his need which, in reality, were actually tailored by the gigantic firms with their
clever manipulation.

10. 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. There is private ownership in the means of
production. But the public sector is fully owned and managed by the State. There is
public ownership in the means of production.
(ii) On the Basis of Economic System : The private sector is based upon capitalism.
But the public sector is based upon socialism.
(iii) On the Basis of Motive : The private sector is profit-motivated. But the public
sector is to promote social welfare by rendering various types of services to public.
(iv) On the Basis of Principle of Pricing : In the case of the private sector, the prices
of goods and services are determined by the market forces of supply and demand.
The prices are fixed in such a way that the profits are maximized. For maximizing
profits, the marginal cost is equated to marginal revenue.
In the case of the public sector, the prices are administratively fixed. They are not
determined by market forces. The objective of social welfare is given emphasis
while fixing the prices in the public sector.
(v) On the Basis of Controls : The private sector is controlled by individuals, partnership
firms and joint-stock companies. But the public sector is controlled by the State.
(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, e.g., light consumer goods industries, durable consumer goods industries,
etc., producing TV sets, medicines, cloth, transistors, etc. 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, e.g., defense industries, river projects, iron and
steel industry, fertilizer industry, railways, posts and telegraphs, oil exploration etc.
11. 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. Over time different assertions have been made regarding their objectives. This
is particularly so since corporations have emerged as an important form of organization.
Even in developing economies, corporations contribute a significant percentage of
manufacturing activities. The objectives of the firm as put forth by Williamson, Marris,
Simon, Cyert and March start from this basic fact, i.e. the emergence of corporations as
an important form of organisation. Since the interests of managers may be different from
those of owners, different hypothesis have been presented by these authors regarding
the objectives of the firm. Those modify the decision-making process.
A) MAXIMIZATION OF PROFIT / TRADITIONAL APPROACH :
Profit maximization has been the most important assumption on which economists have
built price and production, theories. This hypothesis has however been strongly
questioned. This issue will be dealt with later. Let us first look into the importance of the
profit maximization hypothesis and theoretical conditions of profit maximization.
The conventional economic theory assumes profit maximization as the only objective of
business firms. Profit maximization as the objective of business firms has a long history
in economic literature. It forms the basis of conventional price theory. Profit maximization
is regarded as the most reasonable and analytically most 'productive' business objective.
The strength of this assumption lies in the fact that this assumption 'has never been
unambiguously disproved'.
Besides, profit maximizations assumption has a great predictive power. 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. No alternative hypothesis explains and
predicts the behaviour of firms better than the profit maximization assumption.
Maximum Profit Conditions :
There are two conditions that must be fulfilled for the profit to be maximum : (i) necessary
conditions and (ii) secondary conditions.
The necessary condition requires that marginal revenue (MR) must be equal to marginal
cost (MC). Marginal revenue is obtained from the production and sale of one additional
unit of output. Marginal cost is the cost arising due to the production of one additional
unit of output.
The secondary condition requires that the necessary condition must be satisfied under
the condition of decreasing MR and rising MC. i.e. MC curve must cut the MR curve from
below. The fulfillment of the two conditions makes the sufficient condition.
Controversy over Profit Maximization :
Although profit maximization has been the most widely known objective of business
firms, some economists have raised doubts on the validity of this objective. The important
objections to this objective are the following.
First, profit maximization assumption is too simple to explain the business phenomenon
in the real world. In fact, businessmen are themselves not aware of this objective attributed
to them.
Second, it is claimed that there are alternative and equally simple objectives of business
firms that explain better the real world business phenomenon, e.g. sales maximization,
a target rate of return, a target market share, preventing price competition and so on.

Third, it is argued that firms do not have the necessary knowledge and a priori data to
equalise MR and MC. Hence firms cannot attempt to maximize their profits in the manner
suggested by the conventional theory.
In Defense of Profit Maximization Assumption :
The conventional economic theory defends the profit maximization assumption on the
following grounds.
First, only those firms survive in the long run in a competitive market which are able to
make a reasonable profit. Once they are able to make profit, they would always try to
make it as large as possible. All other objectives are subjugated to this primary objective.
Second, profit maximization assumption has been found extremely accurate in predicting
certain aspects of a firm's behaviour. Friedmen argues that the validity of profit
maximization hypothesis cannot be judged by a priori logic or by asking the business
executive. The ultimate test is its ability to predict the business behaviour and trends.
Third, profit maximization assumption is a time-honored objective of a business firm
and evidence against this objective is not conclusive or unambiguous.
Fourth, though not perfect, profit is the most efficient and reliable measure of efficiency
of a firm. If is also the source of internal finance. In developed economies, internal source
contributes more than three fourths of the total finance.
B) REASONABLE PROFIT TARGET :

We have noted that profit maximization is theoretically the most sound and time-honoured
objective of business firms. But profit maximization in a technical sense, i.e. making MC
= MR, is beset with serious computational and data problems. Most goods and services
are produced in large quantities - bulks and batches. Only few goods like ships, planes,
turbines, big plant and machinery, etc., are countable in units. Business books of accounts
do not reveal unit cost and revenue. 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.
In practice, therefore, modern firms and corporations do not aim at profit maximization.
Instead they have "a standard", "a target" or "a reasonable profit" which they strive to achieve.
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, modern large corporations aim at making a reasonable profit
rather than at maximizing the profit. Joel Dean has listed the following reasons.
1. Preventing entry of competitors : Profits maximization under imperfect market
conditions generally leads to a high 'pure profit' which is bound to attract competitors,
particularly in case of a weak monopoly. The firms therefore adopt a pricing and a
profit policy that assures them a reasonable profit and, at the same time, keeps
potential competitors away.
2. Projecting a favourable public image : It often becomes necessary for large
corporations to project and maintain a very good public image, for if public opinion
turns against it and government officials start raising their eyebrows on profit figures,
corporations may find it difficult to sail smoothly. So most firms set prices lower
than that conforming to the maximum profit but high enough to ensure a "reasonable
profit".
3. 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.
Wage-hike may lead to wage - price spiral and frustrate the firms' objective of
maximizing profit. Therefore, profit restrain is sometimes used as a weapon against
trade union activities.
4. Maintaining customer goodwill : Customers' goodwill plays a significant role in
maintaining and promoting demand for the product of a firm. Customers, goodwill
depends largely on the quality of the product and its, 'fair price'. What consumers
view as fair price may not be commensurate with profit maximization. Firms aiming
at better profit prospects in the long run, sacrifice short-run profit maximization in
favour of a "reasonable profit'.
5. Other factors : Some other factors that put restraint on profit maximization include
(a) managerial utility function being preferable to profits maximation for executive,
(b) congenial relation between executive levels within the firm, (c) maintaining internal
control over management by restricting firm's size and profit, and (d) forestalling the
anti-trust suits.
C) SALES REVENUE MAXIMIZATION :

Baumol has suggested maximization of sales revenue as an alternative objective to profit-
maximization. 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. Given the opportunity,
managers choose to maximize their own utility function. According to Baumol, the most
plausible factor in managers' utility functions is maximization of the sales revenue.
The factors which explain the pursuance of this goal by the managers are the
following. First, salary and other earnings of managers are more closely related to
sales revenue than to profits. Secondly, banks and financial corporations look at sales

revenue while financing the corporation. Thirdly, trend in sales revenue is the readily
available indicator of performance of the firm. It helps also in handling the personnel
problem. Fourthly, increasing sales revenue enhances the prestige of managers while
profits go to the owners. Fifthly, managers find profit maximization a difficult objective to
fulfill consistently over time and at the same level. Profits may fluctuate with changing
conditions. Finally, growing sales strengthen competitive spirit of the firm in the market
and vice versa.
D) MAXIMIZATION OF FIRM'S GROWTH RATE :

Prof. Morris has suggested another alternative objective i.e., maximization of balanced
growth rate of the firm, which means maximization of 'demand for firm's product' or 'growth
of capital supply'. According to Morris, by maximizing these variables, managers maximize
both their own utility function and that of the owners. The managers can do so because
most of the variables (e.g., salaries, status, job security, power, etc.) appearing in their
own utility function and those appearing in the utility function of owners (e.g. profit, capital,
market share, etc.) are positively and strongly correlated with a single variable, i.e. size of
the firm. Maximization of these variables depends on the maximization of the growth rate
of the firms. The managers therefore seek to maximize the steady growth rate.
Morris's theory, though more rigorous and sophisticated than Baumol's sales revenue
maximization, has its own weaknesses. It fails to deal satisfactorily with oligopolistic
interdependence. Another serious shortcoming of his model is that it ignores price
determination which is the main concern of profit maximization hypothesis. Morris's
model too does not seriously challenge the profit maximization hypothesis.
E) SATISFYING BEHAVIOUR :
Some economists like Cyert R. M. and J. G. March argue that the real business world is
full of uncertainty, accurate and adequate data are not readily available; where data are
available managers have little time and ability to process data; and managers work
under a number of constraints. Under such conditions it is not possible for the firms to
act in terms of rationality postulated under profit maximization hypothesis. Nor do the
firms seek to maximize sales, growth or anything else. Instead they seek to achieve a
'satisfactory profit', a 'satisfactory growth', and so on. This behaviour of firms is termed
as 'Satisfaction Behaviour'. 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.g., shareholders, managers, workers, input supplier, customers, bankers, tax
authorities and so on. All of these groups have some kind of expectations - often conflicting
- from the firm, and the firm seeks to satisfy all of them in one way or another.
The behavioural theory has however been criticized on the following grounds. First, though
the behavioural theory deals realistically with the firm's activity, it cannot explain the
firm's behaviour under dynamic conditions in the long run. Secondly, it cannot be used to
predict exactly the future course of firm's activities. Thirdly, this theory does not deal with
equilibrium of the industry. Fourthly, like other alternative hypothesis, this theory, too
fails to deal with interdependence and interaction of the firms.
F) LONG-RUN SURVIVAL AND MARKET SHARE GOALS :

Another alternative objective of a firm - as an alternative to profit maximization - was
suggested by Rothschild. According to him, the primary goal of the firm is long - run
survival. Some others have suggested that attainment and retention of a constant market
share is the objective of the firms. The managers therefore seek to secure their market
share and long-run survival, the firms may seek to maximize their profit in the long-run,
though it is not certain.
G) ENTRY - 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 motive behind entry-prevention may be (a) profit
maximization in the long run, (b) securing a constant market share, and (c) avoidance of
risk caused by the unpredictable behaviour of the new entrants. The evidence on whether
firms maximize profits in the long run is not conclusive. Some argue that where
management is divorced from the ownership, the possibility of profit maximization is
reduced. Some argue that only profit-maximizing firms can survive in the long run. They
can achieve all other subsidiary goals easily if they maximize their profits.
No doubt, prevention of entry may be the major objective in the pricing policy of the firm,
particularly in case of limit pricing. But then, the motive behind entry-prevention is to
secure a constant share in the market. Securing constant market share is compatible
with profit maximization.
H) THE HOMEOSTATIC THEORY

Prof.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. The theory therefore, was of no use as a guide to practical
policy. For this reason he advocates the homoeostatic theory.
According to the homeostatic approach, there is some state of the system which it is
designed to maintain. If any disequilibrium in this state occurs, counteracting forces
start operating and the desired state is re-established. the organism has a usual tendency
to maintain its stability by keeping its mood and configuration stable. Only when some
stress is applied, the organism causes a deviation from normal state. Such a deviation
brings about changes in mood and configuration and the effects of the stress are nullified.

In explaining the approach, Boulding says," There is some desired quantity of all the
various items in the balance sheet, and that any disturbance of this structure immediately
sets in motion forces which will restore the status quo. Thus, if a customer purchases a
product, this diminishes the firms' stocks of finished product, and increases its stock of
money. In order to restore the status quo, the firm must spend the increased money
stock to produce more finished products'. A firm adjusts its entire behavior to maintaining
a given state or position. Its existing asset-structure, for instance, is what it would seek
to preserve. Any change in this structure would be responded by countervailing action. A
fall in liquidity, to take another example, 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. But when we extend this theory to complex areas of decision-making, 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, ii) it has nothing to say
regarding normal and ideal structure of a balance-sheet which the firm tries maintain. iii)
a study of the decision taken by firms does not be what Boulding says. Even in the
short-run certain fluctuations arise which actually show a lack of an adequate homeostatic
mechanism.
I) THE LIFE-CYCLE APPROACH

Like all organism, the firm, too is an organism, according to the life-cycle theory. The
firm therefore, has its own law of growth and survival. It exhibits a cycle of birth, growth,
decay and death. A firm is born when there is an opportunity and a scope for its existence.
An existing firm may face unfavorable circumstances in terms of rising costs of inputs or
falling demand. When such a firm incurs losses, it may continue to operate for a while;
but will ultimately close down. This is because the resources available to the firm can be
utilized productivity in some other field. 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. With growth, it consolidates its position and gets structured with
internal efficiency and managerial acumen. At a later stage rival firms may cause an
erosion of its market mainly due to their superior techniques or marketing advantages.
The firm's objective then becomes increasing competitive strength. But as the industry
approaches maturity, demand is saturated, costs of further market penetration get high
and the firm aims at long-term growth and flexibility, though these objectives become
difficult to attain. The firm may survive for some time or may face decay, at such a time.
This is an evolutionary approach and it does apply to all organisms living in a dynamic
world. However, in the short -run, evolutionary characters do not become apparent. Again,
the theory leaves out several other considerations which are relevant.
12. OTHER GOALS OR OBJECTIVES OF FIRMS :
Normally, it is the entrepreneur who decides about the size of the firm which he wants to
manage or start. This he will decide after finalizing the aims and objectives of the firm. 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.
The following are the other objectives of a firm in a free enterprise economy:
1. Personal Ambitions: Many times a firm desires to increase its own individual
importance in the business world. Many times this craving is found among firms
owned by one single individual or family. This is done in more than one way. Some
may have a desire to earn a name as a great donor others may desire to eliminate
labour dissatisfaction, while some others may be out to provide comforts for their
workers and so on. This being a personal choice any whim of the entrepreneur or
owner may be the aim of the firm.
2. Political Dominance: In a democracy, political parties and elections are inevitable.
Many industrialists or businessmen have a desire to back a particular political
party and to acquire political importance.
3. Facing Competition: Every businessman or producer has to face competition. By
reducing the cost of production to the minimum, a producer may survive or face
competition. But if every producer does this, his cost reaches the rock-bottom and
further reduction in cost is not possible. Under these circumstances, a producer
may even prefer to incur losses and continue to reduce the price even though he
cannot reduce the cost. This is done on the presumption that sooner or later, 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. Under these conditions, the aim of
production is not to make profit but to drive away competitors.
4. Establishment of Monopoly : Establishment of monopoly of a particular product
may even be the aim of production. For establishing monopoly, more than one trick
are employed by the producers - advertising on a very large scale, dumping, selling
the product at two different prices in two markets, offering rewards, etc. It is very
difficult to establish and maintain monopoly over the production of any commodity.
Thus, in such an effort, maximization of profits becomes a secondary objective of
production and establishing monopoly becomes the primary objective.
5. Maximization of Long-run profits: Modern production has become very complicated.
Production necessarily being on a large scale includes several things, such as
advertising, printing price lists and labels, supplying these lists to retailers, etc. This
involves a lot of expenditure in terms of money and time. Under these circumstances,
it becomes more desirable to keep long term maximum profit as the goal of production.
This enables the producer to neglect short term marginal losses.

6. Reasonableness of Price of Production Policy: In modern times, while planning
production and the price strategy, it is necessary to take into account the probable
effects of the strategy. If the price appears to be too high, the government may
interfere and fix the price. In rare cases even the consumers' boycott cannot be
ruled out. Avoiding any of these may even be the objective of production.
We have discussed several objectives of production, other than profit maximization.
In practice, we find that all these objectives do exist. But finally profit - maximization
remains the only most important motive of production because without obtaining
maximum profit no firm can remain in business for ever. The index of the success of
production is the rate of profit. Even the success of a joint stock company is gauged
by the rate of dividend. So theoretically speaking, profit maximization must be
taken to be the only goal of production. Even while determining the ideal size of the
unit of production, we have taken profit maximization as the only motive of production.
Exercise:
1. What is 'plant', 'firm' and 'industry'?
2. Explain 'Proprietary firm' as a form of business Organization. State its merits and demerits.
3. Explain partnership form of business organization. State its merits and demerits.
4. Explain the features / characteristics of a cooperative organization. Point out its merits
and demerits.
5. Write short notes on

a) Profit maximization
b) Prof. Baumol's sales maximization goal,
c) Reasonable Rate of profit as an organization goal
d) Satisfying behavior theory as an organization goal
e) The Homeostatic Theory
f) The Life Cycle Approach

NOTES
NOTES

NOTES
Chapter 3
PROFIT
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 as-
Accounting 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.
Profit 65
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 :
(a) Remuneration for the factors of production contributed by the entrepreneur
himself-
He 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.
(b) Depreciation and Maintenance Charges
Some portion should be deducted from gross profit by way of depreciation on machinery
and other assets.
(c) Extra - Personal Profits
This includes -
i) 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.
ii) 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.
(d) 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.
2. THEORIES OF PROFITS :
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 risk-
avoiding. An entrepreneur is required to minimize his, risk, if he cannot eliminate it
totally. A successful entrepreneur is he who earns good profits by eliminating the risk.
Profit 67
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."
(b) 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.
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 short-
run. 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) Changes in the quantity and quality of human needs;
b) Changes in the techniques of production
c) Changes in the supply of capital
d) Changes in organization of business
e) 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.
Profit 69
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
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
Profit 71
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.
i) 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 :
P – S
D =
Y
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.
(ii) 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
Profit 73
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.
ii) 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.
4. PROFIT POLICY :
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.
ii) 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.
iii) The profit rate should be comparable to the profit rates in the past.
iv) 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.
(b) 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.
Profit 75
ii) 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.
iii) 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.
iv) 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.
5. REASONABLE PROFIT TARGET :
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) What are the criteria for determining the profit standard?

b) 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 ?
Forms of Profit Standard
The profit standards may be determined in terms of (a) aggregate money terms, (b) percentage
of sales, or (c) percentage return on investment. These standards may be determined with
respect to the whole product line or for each product separately. Of all the forms of profit
standards, the total net profits of the enterprise usually receive the greatest attention. But
when purpose is to discourage the potential competitors, then a target rate of return on investment
is the appropriate profit standard, provided competitors' cost curves are similar.
b) Setting the Profit Standard
The following are the important criteria that are taken into account while setting the standards
for a 'reasonable profit'.
Capital attracting standard

An important criterion of profit standard is that it must be high enough to attract external
capital. For example, if stocks are being sold in market at five times their current earnings, it
is necessary that the firm earns a profit of 20 percent on the book investment.
There are however certain problems that are associated with this criterion : (i) capital structure
of the firms (i.e. the proportions of bonds, equity and preference shares) affects the cost of
capital and thereby the rate of profit, (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.e. unpredictable.
'Plough back' standard -

In case a company intends to rely on its own sources for financing its growth, 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. This standard of profit is
used when maintaining liquidity and avoiding debt are main considerations in profit policy.
Plough back standard is however socially less acceptable than capital-attracting standard.
The reason, that, it is more desirable that all earnings are distributed to stockholders and they
should decide the further investment pattern. This is based on a belief that market forces
allocate funds more efficiently and the individual is the best judge of this resource use. On the
other hand, retained earnings which are under the exclusive control of the management are
likely to be wasted on low-earning projects within the company. But one cannot say for certain
as to which of the two allocating agencies is actually superior. It depends on 'the relative
abilities of management and outside investors to estimate earnings prospects."
Profit 77
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. Company's own normal eanrings over a period of
time often serve as a valid criterion of reasonable profit, provided it succeeded in (i) attracting
external capital, (ii) discouraging growth of competition, (iii) keeping stockholders satisfied.
When average of 'normal earnings of a group of firms is used, then only comparable firms and
normal periods are chosen.
However, none of these standards of profit is perfect. A standard is therefore chosen after
giving due consideration to the prevailing market conditions and public attitudes. In fact, different
standards are used for different purposes because no single criterion satisfies all the conditions
and all the people concerned.
Exercise :
1. Give a brief review about the theories of profit.
2. Critically evaluate F.H. Knight's Uncertainly Bearing Theory of Profit.
3. Distinguish between gross and net profit.
4. How would you distinguish between Accounting Profit and Economic Profit?
5. "Profit is a reward of the entrepreneur for innovation" Discuss.
6. State and explain Dynamic Theory of Profit.
7. Explain how profit can be measured in practice.
8. Write notes on: (a) Profit Policy (b) Standards of reasonable profit (c) Reasons for limiting
profits.
Profit 79
NOTES
NOTES
Profit 81
NOTES
Chapter 4
DEMAND ANALYSIS
Preview
Introduction:
Concept of demand, Individual Demand and Market Demand, Determinants of Demand, Law
of demand, Elasticity of demand, Measurement and its uses. Demand Forecasting-methods/
techniques of demand forecasting. Introduction to Index Numbers.
1) CONCEPT OF DEMAND
In Economics, ’Demand’ does not mean simple desire. Thus, 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.
Nor does ‘Demand’ mean ‘need’. For example a beggar’s need for more bread, clothing and
shelter will have absolutely no influence on the production of those three goods, however
urgently they may be needed by a beggar.
In Economics ‘Demand’ means ‘desire backed by adequate purchasing power’ or enough
money to purchase desired goods.
In fact, in Economics, ‘demand’ means specific quantity of a commodity actually purchased
or bought.
Further, since quantity purchased will depend upon price of the commodity in question, it
follows that ‘demand means at a specific price’. Unless the price per unit of the commodity is
stated, the concept of demand will not be clear.
‘Demand’ in Economics also means ‘demand per unit of time’, say per day, per month, per
year and so on.
Thus, it can be said that in Pune, demand (i.e. quantity actually purchased) for milk per
months is 1,50,000 liters when the price of milk is Rs. 15 per litre.
Or at an individual level, a person demands (i.e. actually purchases) one litre of milk per day
(or 30 litres of milk per month), when the price of milk is Rs. 15 per litre.
Demand Analysis 83
Other examples explaining the concept of demand may be as follows :
In India, demand (i.e. actual quantity that is purchased) for wheat per year is 40 lakh tones,
when the price of wheat is Rs. 15 per Kg.
Though not generally mentioned in any book, along with price and unit of time, it would be
logical to mention specific market in which buying and selling transactions are taking place,
say demand in a village, in Pune, in Mumbai, in India and so on.
Thus, now the full statement of the concept of demand would be as follows:
At a price of Rs. 15 per litre in village A, 100 litres of milk are demanded (i.e. actually bought)
per day.
In Pune, at the price of Rs. 15 per litre, 1,50,000 litres of milk are demanded (actually purchased)
per day.
In Mumbai, at the price of Rs. 15 per litre, 4,50,000 litres demanded (actually purchased) per day.
In Maharashtra at an average price of Rs. 15 per litre, 50 lakh litres of milk are demanded
(actually Purchased) per day.
The above examples should make the concept of demand clear. Omission of price per unit of
a commodity, or unit of time or of specific market would leave the concept of demand vague.
Determinants Of Demand :
Demand for a commodity depends on a number of factors.
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. Normally, a larger quantity is demanded at a lower price than
at a higher price.
ii) INCOME : Income is an equally important determinant of demand. Obviously, with the
increase in income one can buy more goods. Thus, a rich consumer usually demands
more goods than a poor consumer.
iii) TASTES AND HABITS : Demand for many goods depend on the person's tastes, habits
and preferences. Demand for several products like ice-cream, chocolates, behl-puri, etc.
depend on an individual's tastes. Demand for tea, betel, tobacco, etc. is a matter of habit.
People with different tastes and habits have different preferences for different goods. A
strict vegetarian will have no demand for meat at any price, whereas a non-vegetarian
who has liking for chicken or fish may demand it even at a high price. Similar is the case
with demand for cigarettes by non-smokers and smokers.
iv) RELATIVE PRICES OF OTHER GOODS : SUBSTITUTES AND COMPLEMENTARY
PRODUCTS : How much the consumer would like to buy of a given commodity, however,
also depends on the relative prices of other related goods such as substitutes or
complementary goods to a commodity.
When a want can be satisfied by alternative similar goods, they are called substitutes.
For example, peas and beans, groundnut oil and til oil, tea and coffee, jowar and bajra
etc., are substitutes of each other.
The demand for a commodity depends on the relative prices of its substitutes. If the
substitutes are relatively costly, then there will be more demand for the commodity in
question at a given price than in case its substitutes are relatively cheaper.
Similarly, the demand for a commodity is also affected by its complementary products.
When in order to satisfy a given want, two or more goods are needed in combination,
these goods are referred to as complementary goods. For example, car and petrol, pen
and ink, tea and sugar, shoes and socks, sarees and blouses, gun and bullets etc. are
complementary to each other. Complementary goods are always in joint demand. Thus,
if a given commodity is a complementary product, its demand will be relatively high when
its related commodity's price is lower than otherwise. Or, when the price of one commodity
decreases, the demand for its complementary product will tend to increase and vice
versa. For example, a fall in the price of cars will lead to an increase in the demand for
petrol. Similarly a steep rise in the price of petrol will cause a decrease in demand for
petrol driven motor cars and its accessories.
v) CONSUMER'S EXPECTATIONS : A consumer's expectations about the future changes
in the price of a given commodity also may affect its demand. When he expects its
prices to fall in future, he will tend to buy less at the present prevailing price. Similarly, if
he expects its price to rise in future, he will tend to buy more at present.
vi) ADVERTISEMENT EFFECT : In modern times, the preferences of a consumer can be
altered by advertisement and sales propaganda, albeit to a certain extent only. Thus,
demand for many products like tooth-paste, toilet-soap, washing powder, processed
foods, etc., is partially caused by the advertisement effect in a modern man's life.
b) Factors Influencing Market Demand :
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. The following factors affect
the common demand pattern for a commodity in the market.
1) PRICE OF THE PRODUCT : At a low market price, market demand for the product
tends to be high and vice versa.
Demand Analysis 85
2) DISTRIBUTION OF INCOME AND WEALTH IN THE COMMUNITY : If there is equal
distribution of income and wealth, the market demand for many products of common
consumption tends to be greater than in the case of unequal distribution.
3) 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. For example, when a large section of population shifts its preference from
vegetarian foods to non-vegetarian foods, the demand for the former will tend to decrease
and that for the latter will increase.
4) 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,
demand for many comforts and luxury items will tend to be higher than otherwise.
5) 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. A large number of buyers will constitute a large demand and vice versa.
Thus, growth of population is an important factor. A high growth of population over a
period of time tends to imply a rising demand for essential goods and services in general.
6) AGE STRUCTURE AND SEX RATIO OF THE POPULATION : Age structure of population
determines market demand for many products in a relative sense. If the population pyramid
of a country is broad-based with a larger proportion of juvenile population, then the market
demand for milk, toys, school bags etc. - goods and services required by children - will
be much higher than the market demand for goods needed by the elderly people. Similarly,
sex ratio has its impact on demand for many goods. An adverse sex ratio, i.e. females
exceeding males in number (or, males exceeding females as in Mumbai), would mean a
greater demand for goods required by the female population than by the male population
(or the reverse).
7) FUTURE EXPECTATIONS : If buyers in general expect that prices of a commodity will
rise in future, etc. present market demand would be more as most of them would like to
hoard the commodity. The reverse happens if a fall in the future price is expected.
8) LEVEL OF TAXATION AND TAX STRUCTURE : A progressively high tax rate would
generally mean a low demand for goods in general and vice-versa. But a highly taxed
commodity will have a relatively lower demand than an untaxed commodity - if that
happens to be a remote substitute.
9) 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, which as a result of innovations, definitely become
obsolete. For example, the advent of latest digital media like Compact Disks (C.Ds) has
made audio & video cassettes obsolete.
10) FASHIONS : Market demand for many products is affected by changing fashions. For
example, demand for commodities like jeans, shirts, salwar-kameej etc. are based on
current fashions.
11) CLIMATE OR WEATHER CONDITIONS : Demand for certain products are determined by
climatic or weather conditions. For example, in summer, there is a greater demand for cold
drinks, fans, coolers, air conditioners etc. Similarly, demand for umbrellas and raincoats
are seasonal.
12) CUSTOMS : Demand for certain goods are determined by social customs, festivals, etc.
For example, during Diwali holidays, there is a greater demand for sweets, crackers,
vehicles and white goods; and during Christmas, cakes, sweets and confectioneries are
in more demand.
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. Demand is manipulated through selling efforts. Of course, there is always a
limit.
When these factors change, the general demand pattern will be affected, causing a
change in the market demand as a whole.
2. DEMAND SCHEDULE :
A tabular statement of price-quantity relationship is known as the demand schedule. It narrates

how much amount of a commodity is demanded by an individual or a group of individuals in the
market at alternative prices, per unit of time. There are, thus, two types of demand schedules :
(i) the individual demand schedule, and (ii) the market demand schedule.
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, per week, per month or per annum) is
referred to as an individual demand schedule.
Price of X in Rs. (per kg.) Quantity Demanded of X per week (in Kg.)
30 2
25 4
20 6
15 10
10 16
Demand Analysis 87
This illustrates a hypothetical (purely imaginary) demand schedule of an individual consumer
Mr A for commodity X.
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.
2) It shows only the variation in demand at varying prices.
3) It seeks to illustrate the principle that more of a commodity is demanded at a lower price
than at a higher one. In fact, most of the demand schedules show an inverse relationship
between price and quantity demanded.
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. A market
demand schedule, thus, represents the total market demand at various prices.
Theoretically, the demand schedules of all individual consumers of a commodity can be

compiled and combined to form a composite demand schedule, representing the total
demand for the commodity at various alternative prices. The derivation of market demand
from individual demand schedules is illustrated in the table given below. Here it is assumed
that the market is composed only of three buyers.
Price in Rupees Units of Commodity X Demanded Quantity

(per unit) per day by Individuals Demanded in the
market for X
A+ B+ C+ =
4 1 3 3 7
3 2 4 5 11
2 3 5 7 15
1 5 9 10 24
Apparently, the market demand schedule is constructed by the horizontal additions of quantities
at various prices shown by the individual demand schedules. It follows that like an individual
demand schedule, the market demand schedule also depicts an inverse relationship between
the price and quantity demanded.
4. THE DEMAND CURVE :
A demand curve is a graphical presentation of a demand schedule. When price-quantity

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

+ + =
O XO XO XO X
Quantity Demanded of 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. Essentially, the market demand curve too has a downward slope
indicating an inverse price-quantity relationship, i.e. quantity demand rises when the price
falls, and vice-versa.
5. 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. The law of demand expresses the nature
of functional relationship between two variables of the demand relation, viz., the price and the
quantity demanded. It simply states that demand varies inversely with change in price.
Statement of the Law
The law may be stated thus : "Other things being equal, the higher the price of a
commodity, the smaller is the quantity demanded and lower the price, larger is the
quantity demanded." In other words, the demand for a commodity expands (i.e., the demand
rises) as the price falls and contracts (i.e. the demand falls) as the price rises. Or briefly
stated, the law of demand emphasises that, other things remaining unchanged, demand
varies inversely with price.
The conventional law of demand, however, relates to the much simplified demand function :
D = f(P)
Where, D represents demand, P the price and f connotes a functional relationship. It, however,
assumes that other determinants of demand are constant and only price is the variable and
influencing factor. The relation between price and quantity of demand is usually an inverse or
negative relation, indicating a larger quantity demanded at a lower price and a smaller quantity
demanded at a higher price.
EXPLANATION OF THE LAW OF DEMAND
The law of demand is usually referred to the market demand. The law of demand can be
illustrated with the help of a market demand schedule, thus : i.e. as the price of a commodity
decreases, the corresponding quantity demanded for that commodity increases and vice-
versa.
Price of Commodity X (in Rs.) per unit Quantity Demanded per week
5 10
4 20
3 30
2 40
1 50
This table represents a hypothetical demand schedule for commodity X. We can read of from
this table that with a fall in price at each stage, quantity demanded tends to rise. There is an
inverse relationship between price and quantity demanded. Usually, economists draw a demand
curve to give a pictorial presentation of the law of demand. When the data of table are plotted
graphically, a demand curve is drawn as shown in Figure given below. (Here, incidentally, the
demand curve being a straight line is a linear demand curve.
Demand Curve
Y
D
5
Price (Per Unit)
1 D
X
O 10 20 30 40 50
In this figure, DD is a downward sloping demand curve indicating an inverse relationship
between price and quantity demanded.
From the given market demand-curve one can easily locate the market demand for a product
at a given price. Further, the demand curve geometrically represents the mathematical demand
function : Dx = f (Px)
Demand Analysis 91
ASSUMPTIONS UNDERLYING THE LAW OF DEMAND
The above stated law of demand is conditional. It will hold good only if certain conditions are
given and constant.
Thus, it is always stated with "other things being equal". It relates to the change in price
variable only, assuming other determinants of demand to be constant. The law of demand is,
thus, based on the following ceteris paribus assumptions.
1) NO CHANGE IN CONSUMER'S INCOME : Throughout the operation of the law, the

consumer's income should remain the same. If the level of a buyer's income changes, he
may buy more even at a higher price, invalidating the law of demand.
2) NO CHANGE IN CONSUMER'S PREFERENCES : The consumer's tastes, habits and

preferences should remain constant.
3) NO CHANGE IN FASHION : If the commodity in question goes out of fashion, a buyer

may not buy more of it even at a substantial price reduction.
4) NO CHANGE IN THE PRICES OF RELATED GOODS : Prices of other goods like

substitutes and complementary goods remain unchanged. If the prices of other related
goods change, the consumer's preferences would change which may invalidate the law
of demand.
5) 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. That is to say, the buyers do not expect any shortages in the supply of
the commodity in the market and consequent future changes in the prices. The given
price change is assumed to be final at a time.
6) NO CHANGE IN SIZE, AGE-COMPOSITION AND SEX RATIO OF THE POPULATION :

For the operation of the law in respect of total market demand, it is essential that the
number of buyers and their preferences should remain 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. Otherwise, if population changes,
there will be additional buyers in the market, so that the total market demand may not
contract with a rise in price.
7) 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.
8) NO CHANGE IN THE DISTRIBUTION OF INCOME AND WEALTH OF THE

COMMUNITY : There is no redistribution of income either, so that the levels of income of
the consumers remain the same.
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. Otherwise, changes in
income tax, for instance, may cause changes in consumers' income or changes
commodity taxes (sales tax or excise duties) may lead to distortions in consumer's
preferences.
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,
umbrellas etc.
In short, the law of demand presumes that except for the price of the product, all other
determinants of its demand are unchanged.
Apparently, 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.
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, the
demand expands and it contracts when the price rises. But sometimes, it may be observed,
though, of course, very rarely, that with a fall in price, demand also falls and with a rise in a
price, demand also rises. This is a paradoxical situation or a situation which is apparently
contrary to the law of demand. Cases in which this tendency is observed are referred to as
exceptions to the general law of demand. The demand curve for such cases will be typically
unusual. It will be an upward sloping demand curve as shown in Figure given below. It is
described as an exceptional demand curve.
Price (Per Unit)
Exceptional Demand Curve
Demand Analysis 93
In this fugre, DD is the demand curve which slopes upward from left to right. It appears thus
that when OP1 is the price, QQ1, is the demand and when the price rises to OP2' demand
also expands to QQ2. Thus, the upward sloping demand curve expresses a direct functional
relationship between price and demand.
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". The upward sloping demand curve, thus, refers to the exceptions to the law of demand.
There are a few such exceptional cases, which may be categorised as follows :
1) GIFFEN GOODS: In the case of certain inferior goods called Giffen goods, as introduced
by Robert Giffen when the price falls, 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. Probably, a few appropriate examples
of inferior goods may be listed, such as foodstuffs like cheap potatoes, cheap bread,
pucca rice, vegetable ghee, etc., as against superior commodities like good potatoes,
cake, basmati rice, pure ghee.
2) ARTICLES OF SNOB APPEAL : Sometimes, certain commodities are demanded just
because they happen to be expensive or prestige goods, and have a 'snob appeal'.
These are generally ostentatious articles, and purchased only by rich people for using
them as 'status symbol'. Thus, when prices of such articles like say diamonds rise, their
demand also rises; similarly, Rolls Royce cars, Johney Walker Scotch Whiskey are
another outstanding illustration.
3) SPECULATION : When people speculate in changes in the price of a commodity in the
future, they may not act according to the law of demand at present. Say, when people
are convinced that the price of a particular commodity will rise still further, they will not
contract their demand with the given price rise; on the contrary, they may purchase more
for the purpose of hoarding. In the stock exchange market, some people tend to buy
more shares when the prices are rising, in the hope that the rising trend would continue,
so they can make a good fortune in future.
4) CONSUMER'S PSYCHOLOGICAL BIAS OR ILLUSION: When the consumer is wrongly
biased against the quality of a commodity with the price change, he may contract his
demand with a fall in price. Some sophisticated consumers do not buy when there is a
stock clearance sale at reduced prices, thinking that the goods may be of bad quality.
6. CHANGES IN QUANTITY DEMANDED AND CHANGES IN DEMAND:
In economic analysis, the terms 'changes in quantity demanded' and 'changes in demand'
have different meanings.
The term 'changes in quantity demanded' or variation in demand relates to the law of demand.
It refers to the changes in quantities purchased by the consumer on account of changes in
price only. Thus, we may say that the quantity demanded of a commodity increases when it's
price decreases, or the quantity demanded decreases when it's price increases. But, it is
incorrect to say that demand decreases when price increases or demand increases when
price decreases. For "increase" and "decrease" in demand refers to "changes in demand"
caused by the changes in various other determinants of demand, price remaining unchanged.
Changes in quantity demanded in relation to the price are measured by the movement along
the demand curve, while changes in demand are reflected through shifts in the demand curve.
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.
A) EXPANSION OR EXTENSION AND CONTRACTION OF DEMAND

(Changes in Q. D.):
A variation in demand implies "expansion" or "contraction" of demand. When with the fall
in the price with the commodity is brought, there is expansion of demand. Similarly,
when a lesser quantity is demanded with a rise in price, there is contraction of demand.
In short, demand expands when the price falls and it contracts when the price rises.
Thus the terms "expansion" & "contraction" are used in stating the law of demand.
The terms "expansion" and "contraction" of demand, should, however, be distinguished

from increase or decrease in demand. The former is used for indicating increase in
demand, while the later is used for indicating changes in demand, and Variation in demand
is the connotation of the law of demand. It expresses a functional relationship between
quantity demanded and price. a change in demand due to change in price is called
expansion or contraction. Expansion and contraction refer to the same demand curve. A
change in demand due to causes other than price is called increase or decrease in
demand.
In graphical exposition, expansion or contraction of demand is shown by the movement

along the same demand curve. A downward movement from one point to the another on
the same demand curve implies expansion of demand, for instance, movement from a to
b in the following figure. It suggests that when the price decreases from OP to OP1,
demand expands from OQ to OQ1. While an upward moment from one point to another
on the same demand curve implies contraction of demand, eg: movement from a to c in
the diagram.
Demand Analysis 95
Co
nt
ra
ct
io
c
n
Price (Per Unit)
Ex
a pa
ns
ion
b
D
Expansion and Contraction of demand

The fig. shows that when price rises from OP to OP2 demand contracts from OQ to OQ2.
In short, a change in quantity demanded in response to the change in price is explained
by the terms expansion or contraction of demand. Further, expansion or contraction
implies a movement on the same demand curve which means the demand schedule
remains the same.
B) INCREASE AND DECREASE IN DEMAND (Changes in Demand):

These two terms are used to express changes in demand. Changes in demand are
result of the change in the conditions or factors determining demand, other than the
price. A change in demand, thus implies an increase or decrease in demand. When
more of a commodity is bought than before at any given price, there is increase in
demand. Similarly, when with price remaining unchanged less of a commodity is bought
than before, there is decrease in demand.
In other words, an "increase" in demand signifies either that more will be demanded at
given price or the same will be demanded at a higher price. Thus, an increase in demand
means that more is now demanded than before, at each and every price. likewise, "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.
Thus increase and decrease in demand are shown by shifting the demand curves.
The terms" increase" or "decrease" in demand are graphically expressed by the
movements from one demand curve to the another. In other words, the change in demand
is denoted by the shifting of the demand curve. In the case of an increase in demand, the
demand curve is shifted to the right. In the following figure (A), thus, the movement of
demand curve from DD to D1D1 shows an increase in demand. In this case, the movement
from point a to b indicates that the price remains the same at OP, but more quantity OQ1
is now demanded, instead of OQ. Thus increase in demand is QQ1. Similarly, as in Fig
B, a decrease in demand is depicted by the shifting of the demand curve towards it's left.
Y Y
D
D1 D2
D
Price (Per Unit)
Price (Per Unit)

Increase
a b Decrease
P c a
D1 P
D
D D2
O Q1 X O Q X
Q Q2
(A) (B)
Increase & Decrease in demand
In the above fig, thus, the movement of demand curve from DD to D2D2 show a decrease
in demand. In this case, movement from point a to c, indicates that the price remains
same at the OP, but less quantity OQ2 is now demanded than before. Here decrease in
demand is QQ2.
REASONS FOR CHANGE (Increase or Decrease in Demand)
A change in demand occurs when the basic conditions of the demand change. Thus an
increase or decrease in demand is brought about by many kinds of changes. Some of
the important changes are:
1) Change in Income
2) Change in the pattern of income distribution.
3) Change in tastes, habits and preferences.
4) Change in fashions and customs.
5) Change in the supply of the substitutes and in their prices.
6) Change in the supply or demand supply of the complementary goods and change
in their prices.
7) Change in population.
8) Advertisement and Publicity persuasion.
Demand Analysis 97
7. ELASTICITY OF DEMAND :
INTRODUCTION
Demand for goods varies with price. But the extent of variation is not uniform in all cases. In
some cases the variation is extremely wide; in some others it may just be nominal. That
means, sometimes demand is greatly responsive to changes in price; at other times, it may
not be so responsive. The extent of variation in demand is technically expressed as elasticity
of demand. According to Marshall, the elasticity (or responsiveness) of demand in a market is
great or small, depending on whether the amount demanded increases much or little for a
given fall in price; and diminishes much or little for a given rise in price.
A) ELASTICITY OF DEMAND : PRICE ELASTICITY OF DEMAND

The term "elasticity of demand", when used without qualifications is commonly referred
to as price elasticity of demand. This is a loose interpretation of the term. In a strict
logical sense, however, the concept of elasticity of demand should measure the
responsiveness of demand for a commodity to changes in its determinants.
There are, thus, as many kinds of elasticities of demand as its determinants. Economists
usually consider three important kinds of elasticity of demand : (1) Price elasticity of
demand, (2) Income-elasticity of demand and (3) Cross-price elasticity of demand or just
cross elasticity.
"Price elasticity" refers to the degree of responsiveness of demand for a
commodity to a given change in its price.
"Income elasticity" refers to the degree of responsiveness of demand for a
commodity to a given change in the income of the consumer.
"Cross elasticity" refers to the responsiveness of demand for a commodity to a given
change in the price of a related commodity - substitute or complementary product.
In the present chapter, we shall study them one by one.
B) PRICE ELASTICITY OF DEMAND
The extent of the change of demand for a commodity to a given change in price,
other demand determinants remaining constant, is termed as the price elasticity
of demand. The coefficient of price elasticity of demand may, thus, be defined as the
ratio of the relative change in demand to the relative change in price.
Since the relative change of variables can be measured either in terms of percentage
change or as proportional change, the price elasticity coefficient can be measured :
The percentage change in quantity demanded

e = ––––––––––––––––––––––––––––––––––––––
The percentage change in price
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, thus, the price elasticity formula can be stated as :
êQ êP
e= :
Q P
êQ P
= X
Q êP
êQ P
∴ e= X
ê P Q
Q = the original demand (Say Q1)
P = the original price (Say P1)
êQ= the change in demand. It is measured as the difference
between new demand (say Q2) and the old demand (Q1)
Thus, ê Q = Q2 - Q1
êP= the change in Price. It is measured as the difference
between new Price P2' and the old price (P1)
Thus, ê P = P2 - P1
The above formula, in fact, relates to point-price elasticity of demand, that is, the coefficient
signifies very small or marginal changes only.
To illustrate the use of the formula, let us consider the following information from the
demand schedule :
Price of Tea (Rs.) Quantity Demanded (Kg.)
20 (P1) 10(Q1)
22 (P2) 9(Q2)
Demand Analysis 99
Thus,
ê P = 22 - 20 = 2, and P = P1 = 20
ê Q = 09 - 10 = 1, and Q = Q1 = 10
(Here, minus signs are ignored)
êQ P
Therefore e= X
ê P Q
1 20
= X
2 10
∴ e = 1
This means, the elasticity of demand is equal to one or unity.

Using the above formula, the numerical coefficient of price elasticity can be measured
from any such given data. Apparently, depending upon the magnitude and proportional
change involved in the data on demand and prices, one may obtain various numerical
values of coefficients of price elasticity, ranging from zero to infinity.
TYPES OF PRICE ELASTICITY : DEGREE OF ELASTICITY OF DEMAND

Demand may be elastic or inelastic, depending on the degree of responsiveness of the
demand for a commodity to a given change in its price.
By elastic demand, we mean that demand responds greatly or relatively more to a price
change. It however, does not imply that the consumers are fully responsive to a price
change. What it means is simply this that a relatively larger change in demand is caused
by a smaller change in price. Similarly, inelastic demand does not mean that demand is
totally insensitive. It only means that the relative change in demand is less than that of
price. It means demand responds to a lesser extent only.
Measuring numerical coefficient of price elasticity in different cases, we will find that its
value ranges from zero to infinity. When the elasticity coefficient is greater than one,
demand is said to be elastic; and it is inelastic when the numerical coefficient is less
than one; and when it is exactly one (or unity), the demand is unitary elastic.
Treating this concept in a more elaborate manner, we may mention the following five
types of price elasticity of demand :
1) Perfectly elastic demand when e = ∝
2) Perfectly inelastic demand when e = O
3) Relatively elastic demand when e = >1
4) Relatively inelastic demand when e = <1
5) Unitary elastic demand when e = 1

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

2) Perfectly Inelastic Demand (e = 0)
(B)
Y
e= 0 D
Price (Per Unit)

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

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

5) Unitary Elastic Demand (e = 1)
(E)
Y
1
e=1
D
Price (Per Unit)

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

Table A
PRICE ELASTICITY OF DEMAND
(Definition e = Percentage change in the quantity demand : Percentage change in price)
Numerical Terminology Description

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

êQ P
∴ e = –––– ÷ ––––
êP Q
(3) Total Outlay Expenditure or Revenue Method

Dr. 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.
Total outlay (or Total Revenue) = Price per unit x Quantity demanded
Dr. Marshall laid down the following propositions :
1) When with a change in price, the total outlay remains unchanged, demand is unitary
elastic (e = 1).
The total outlay remains constant in the case of unitary elastic demand, because the demand
changes in the same proportion as the price. This is illustrated in Table B given below :
Table B
TOTAL OUTLAY METHOD
Quantity Total Outlay Elasticity of

Price (per unit) demanded (or revenue) Demand
(Rs.) (Units) (Rs.)
Original 5 16 80 –
Change 1 8 10 80 } e=1
Change 2 1 80 80 } (unitary)
(2) When with a rise in price, the total outlay falls, or with a fall in price, the total outlay
rises, elasticity of demand is greater than unity. This happens because the proportion of
change in demand is relatively greater than that of price. In short, when the price and
total outlay move in opposite directions, demand is relatively elastic (see Table C below).
Table C
TOTAL OUTLAY METHOD

(Rs.) (Units) (Rs.)
Change 8 10 80 } e<1
Change 4 4 160 } (Elastic)

(3) When with a rise in price, the total outlay also rises, and with a fall in price, the total
outlay falls, elasticity of demand is less than unity. This happens because the proportion
of change in demand is relatively less than the proportion of change in price. Briefly,
thus, when the price and total outlay move in the same direction, demand is relatively
inelastic (see Table D below).
Table D
TOTAL OUTLAY METHOD

(Rs.) (Units) (Rs.)
Change 8 10 80 }e<1
Change 2 14 28 } (Inelastic)
We may now summaries the total outlay method as follows :
Price (per unit) Total Outlay Types of Elasticity

1. Increases Constant e=1
Decreases Constant (Unitary)
2. Increases Decreases e> 1
Decreases Increases (Relatively elastic)
3. Increases Increases e<1
Decreases Decreases (Relatively inelastic
Thus, from the behaviour of the total outlay or the total revenue, we can infer the nature
of price elasticity of demand. Likewise, from a given price elasticity, we can conclude
about the nature of change in the consumer's total outlay or the seller's total revenue. In
the case of unitary elastic demand, with any change in price, the total revenue remains
unaltered. But when there is elastic demand, the total revenue would change in the
opposite direction of the price change. In the case of inelastic demand, the total revenue
would change in the same direction as the price changes.
The total outlay method of measuring elasticity is, however, less exact. It can indicate
only the type of elasticity, but not its exact numerical value. To get the exact numerical
value, we have to resort to the ratio method or the point method. However, the economic
significance of the total outlay or the total revenue method is that it tells more directly
Demand Analysis 107

what happens to the total outlay or revenue as a practical guide for determining a price
policy and its effect on demand and revenue.
(4) Point Geometric Method
Dr. 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. Let the straight-line demand curve be extended to meet the two axes, as
shown in Figure shown below. When a point is taken on the straight-line demand curve
(like point P in Fig below), it divides the straight-line demand curve into two segments
(parts). The point elasticity is, thus, 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.
For brevity, we may again put that -
Lower segment of the demand curve below the given point

Point elasticity =
Upper segment of the demand curve above the point
L
or, to remember through symbols, we may put it as e = –––
U
where, e, stands for point elasticity, L stands for lower segment and U for the upper
segment.
Price (Per Unit)
Price (Per Unit)
Point Method Point Method

In the Figure on the previous page, AB is a straight-line demand curve, P is a given
point. Thus, PB is the lower-segment, PA is the upper segment.
L PB
e= =
U PA
If after actual measurement of the two parts of the demand curve, we find that PB = 4 cm.
and PA = 2 cm., the elasticity at point
3
P = = 1.5.
2
If, however, the demand curve is non-linear, then draw a tangent at the given point,
extending it to intercept both the axes (See figure)
PB
Point elasticity at point P in Figure is measured as
PA
(5) Arc Elasticity Method : This method is used to measure elasticity of demand on an arc
of the demand curve. The formula is
(Q0 – Q1) (P0 – P1)

(Q0 + Q1) (P0 + P1)
e=– x ÷
2 2
(Q0 – Q1) (P0 + P1)
∴ e=– x X
(Q0 + Q1) (P0 – P1)
Here,
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.
8. FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND :
Whether the demand for a commodity is elastic or inelastic will depend on a variety of factors.
The major factors affecting elasticity of demand are :
1. Nature of Commodity
Certain goods by their very nature tend to have an elastic or inelastic demand. By nature,
goods may be classified into luxury, comfort or necessary goods. In general, demand for
Demand Analysis 109

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

alternate day perhaps may cut down the number of films seen per week. So is the case
with matches, sugar, kerosene candles, broomstick, haircut etc. Thus, cheap or small
expenditure items tend to have more demand inelasticity than expensive or large
expenditure items.
7. Durability of the Commodity

In the case of durable goods, the demand generally tends to be inelastic in the short run,
e.g., furniture, motor cycles, T.V. sets etc. In the case of perishable commodities, on the
other hand, demand is relatively elastic, e.g. milk, vegetables etc.
8. Influence of Habit and Customs

There are certain articles which have a demand on account of conventions, customs or
habit with which these articles are closely associated and in these cases, elasticity is
less, e.g. Mangal Sutra to a Hindu bride or cigarettes to a smoker or alcohol to an
alcoholic have inelastic of demand.
9. Complementary of Goods
Goods which are jointly demanded have less elasticity, e.g. ball-point pen and refills,
motor cycle and petrol etc. have inelastic demand for this reason.
10. Time
In the short period, demand in general will be less elastic, while in the long period, it
becomes more elastic. This is because (i) it takes some time for the news of price change
to reach all the buyers; (ii) consumers may expect a further change, so they may not react
to an immediate change in price; (iii) people are reluctant to change their habits all of a
sudden, but gradually, in the long run, their habits may change and so too the demand
pattern; (iv) durable goods take some time to exhaust their utility. In the long run, lapse of
time results in their wearing out, then these are demanded more; (v) demand for certain
commodities may be postponed for some time, but, in the long run, it has to be satisfied.
11. 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. For instance, motorcycles, V.C.D.
players, T.V. sets etc. are purchased only once, hence their price elasticity will be less.
But the demand for cassettes or Compact Disks may remain relatively elastic.
12. Possibility of Postponement

When the demand for a product is postponable, it will tend to be price-elastic. In the
case of consumption goods which are urgently and immediately required, their demand
will be inelastic. For example life saving drugs during sickness, habituated goods etc.
Demand Analysis 111

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

Thus, 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,
thus getting higher amount of profit by exporting the same amount of jute manufactures
as before.
Similarly, during 1970’s, petroleum oil-exporting countries formed OPEC, 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,
thus making enormously larger profits than before. This made the Middle East oil-
producing Arab countries very rich as petroleum has as yet no substitute. For example,
India’s oil bill rose nearly ten times though importing the same quantity as before from
the Middle East. 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.
Thus, in international trading transactions, 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.
10. INCOME ELASTICITY OF DEMAND :
As indicated in the beginning, we can now switch over to another determinant of demand viz.
income and consider elasticity of demand by holding all other determinants, including price,
constant. 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.
(A) MEASUREMENT OF INCOME ELASTICITY
The formula for measuring income elasticity of demand can be stated thus :
Proportionate change in quantity demanded

Formula 1 : Ey = –––––––––––––––––––––––––––––––––––––
Proportionate change in consumer's income
Example : A 20% rise in income causes a 30% increase in demand for a product 'X",
what will be the income elasticity of demand for 'X" ?
Demand Analysis 113

Solution : According to formula mentioned above :
30
Ey = –– = 1.5
20
Formula 2
A second formula which is mathematically more rational is suggested as under :
Q2 - Q1 Y2 - Y1
Ey = ––––––– ÷ ––––––
Q2 + Q1 Y2 + Y1
In this formula Q1, 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. Y1 denotes initial income and Y2 stands for changed
or new income.
Example : A consumer spends Rs.60/- per month on sugar when his income is Rs.l,500/
- per month. When his income increases to Rs.1800/- per month he spends Rs.84 on
sugar. What will be the income elasticity of demand for sugar in this case?
Solution : According to the above formula

84 - 60 1800 - 1500
Ey = ––––––– ÷ ––––––––––
84 + 60 1800 + 1500
24 300
= ––––––– ÷ –––––––
144 3300
24 3300
= ––––– x ––––––
144 300
1 11
= –––––– x ––––––
6 1
11
= ––––– = 1.8
6
∴ Ey = >1
(Income elasticity of demand in this case is 1.8 ∴ positive)

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

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

products that we see at the market, we find that most of these goods are related. On the basis
of the relationship, we can group these products either as substitutes or as complements or
as a third group of goods which are neutral. In the context of the relationship between goods,
the concept of cross elasticity of demand can be used. 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'. With the help of
formula, similar to the one we noted earlier, we can say :
Percentage change in quantity demanded of 'X'

Ec = –––––––––––––––––––––––––––––––––––––––––
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, the quantity demanded of X will increase because the
consumers will substitute X for Y, since Y has become costlier. Conversely, if the price of Y
falls leaving the price of X unchanged, the quantity demanded of x will decrease because the
consumers will now substitute Y for X since Y has become cheaper than before.
Cross elasticity can also be measured by another formula as given below
OX2 – OX1 PY2 – PY1

Ec = :
OX2 + OX1 PY2 + PY1
In this formula QX2 is the new demand for X, QX1 is the original demand for X; PY2 is the new
price of Y and PY1 is the original price of Y.
If X and Y are perfect substitute for each other, the cross elasticity of demand will be infinity.
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. If, on
the other hand, two goods are not substitutes at all, the cross elasticity of demand will be
zero. A change in the price of one commodity will not affect the quantity demanded of the
other commodity. It will thus be clear that the cross elasticity of demand for substitutes varies
between zero and infinity.
If the relationship between X and Y is that of complementary, the cross elasticity in such a
case will be negative. 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. For example, ball-point pens and refills are complementary goods. When the price
of refills rises, it causes a fall in the demand for refills as well as for ball-point pens, because
both are demanded together.
Demand Analysis 117

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

13. 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. Forecasts are made either through experience or through statistical
methods. As individual may forecast his job prospects, a consumer may forecast an
increase in his income and therefore purchases, similarly a firm may forecast the sales
of its product.
Predictions of future demand for a firm's product or products are called demand
forecasts.
Demand Forecasting is the method of predicting the future demand of a firm's
product.
(B) Necessity of Forecasting Demand

As mentioned above, demand forecasts may be based on judgment of the experienced
staff of a business concern or on scientific analysis (with the help of statistics).
When a firm is small in size it may not need or afford an organized forecasting system.
They can base their forecasts on the judgment or foresight of their experienced staff.
However, as a firm increases in size and produces a number of products and uses
modern techniques of production, it becomes necessary for the firm to forecast the
demand for its various products, in a more scientific manner. Such forecasts are more
accurate and thus help the firm to produce efficiently, with the help of the available
resources. Forecasts have become a part of business management of most of the firms.
Forecasts are necessary for :
(1) Fulfillment of objective of the Plans
Every business unit, industry or the government starts with certain pre-decided
objectives. These objectives can be fulfilled with the help of accurate demand
forecasts.
(2) Preparation of a Budget
Scientific forecasts are useful to the entrepreneur to take business decision. Every
business unit has to prepare a budget. A budget includes the cost and expected
revenues. Expected revenues can be estimated only on the basis of demand forecasts.
(3) Stabilization of Employment and Production

Demand for a product changes according to seasons or business cycles or tastes
etc., the supply, however, cannot be changed suddenly if however, it is possible to
estimate the demand for a firm's product, it can be possible to produce according
Demand Analysis 119

to the expected demand. This can avoid wastage of scarce resources of the firm.
So also the employment policy can be decided in advance, with the help of these
forecasts.
(4) Expansion of firms

When a firm has to decide whether it should expand or not and to what extent it
should expand, it has to consider the expected demand for its product, at a future
date. Demand forecasts become useful in such cases.
(5) Other Uses

Demand forecasts are also useful to a firm, for long-term investment decision.
Budgeting policies and Warehouse and Inventory Control.
(C) Factors Influencing Demand Forecasts

A number of factors affect the demand forecasts. Each of these factors has to be studied
together with the other factors while forecasting demand. Thus, these factors outline the
scope of demand forecasting.
1. Time-Period
Forecasts can be for a short-period, long period or very long (secular) period.
a) Short-period
These forecasts are for a period of one year and are based on the judgment of
experienced staff of the firm. Within this short period the sales promotion policies
of the firm or the tax-policies of the government do not change. Short period forecasts
are important for deciding the production policy, price policy, credit policy and
marketing and distribution of the firm's product.
b) Long-period forecasts
These are forecasts for a period of 5 to 10 years and are based on scientific analysis
and statistical methods. Long period forecasts are important to decide about whether
a new factory is to be established, a new product can be introduced, or capital
needs are to be raised.
c) Very-long period forecasts

These are for a period of over 10 years. Secular factors like growth of population,
development of the economy, the political situation in the country, the changes in
the international trade, sociological factors, like age of marriage, changes in traditions,
have to be considered for forecasting the demand over a very long period.
2) Level of Forecasts
Forecasts can be made at the level of the firm or the industry or the nation.

a) A firm
A firm forecasts the sales of its products. It bases its forecasts on the forecasts of
the industries and the nation.
b) An Industry
Forecasts at this level are prepared by the trade association. These are based on
statistical data and market survey. These forecasts are available to all the firms of
the industry.
c) The Nation
These forecasts are national level forecasts and are based on indices such as
national income and national expenditure.
3) General and Specific Forecasts

Forecasts can be of a general type, 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. These are not
very useful to a firm. Specific demand forecasts give specific information. Product-specific
demand forecasts give the forecasts of each of the products produced by the firm. Area,
specific demand forecasts give the forecasts each of the markets for the firm's he markets
for the firm's product.
4) Established Products and New Products

Established goods, are goods which are already established in the market; information
about these goods is available, the present demand, the number of substitutes to the
product, the level of competition, the markets are known.
New products are those which are yet to be introduced in the market, information about
these products is not known.
Thus depending on whether the product is an established or new product, different methods
are used for forecasting demand.
5) Product-Classification
For the purpose of Demand Forecasting products can be classified as -
a) Capital Goods and Consumer goods
b) Durable goods and Perishable goods
a) The demand for capital goods (machinery, spare parts) is a derived demand. It is
derived from the demand for the product produced by the capital goods. This demand
is highly fluctuating.
Demand Analysis 121

The demand for consumer goods depends on the incomes of the consumers. An
increase in income leads to an increase in the demand for consumer goods, but a
fall in the income does not immediately lead to a decrease in the demand for
consumer goods; (e.g. Sugar, Food grains, Soaps etc.)
b) The demand for durable goods can be postponed. Thus if prices of these goods
increase, then the demand falls, because people will postpone their consumption
of these goods (e.g. washing machines, refrigerators, mixers etc.)
The demand for perishable goods like vegetables and fruits depends on the current
incomes and current demand.
Thus, depending on the type of product, demand forecasts and methods of forecasting
demand will be different.
6) Other Factors
The level of uncertainty, the nature of competition, the number of substitutes to a product,
the elasticities of demand for the product are important factors which have to be considered
while forecasting the demand for a product.
These factors depend on the type of product, on the market for the product and on the
time-period.
Thus, tastes and preferences and fashion have to be considered while forecasting demand
for readymade garments. Weather forecasts are important for the firms producing raincoats,
rainy-shoes and umbrellas.
D) Techniques or Methods of Forecasting Demand

The methods of forecasting demand depend upon, whether the product is an established
good or a new good, and on the level of forecasts, i.e. macro or micro level.
Macro-level forecasts are used in national economic planning. These are forecasts about
general business conditions, and these forecasts make use of information regarding the
macro-variables, like government expenditure, savings, the aggregate demand etc.
Micro level forecasts are at the level of the firm or industry. These forecasts make use of
macro-level information. We are concerned with these types of forecasts.
As mentioned above, the methods of forecasting demand for established goods and for
new goods are different. We shall first study the methods of forecasting the demand for
established goods and then for new goods.

(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.
1) Interview and Survey Approach (short period forecasts)
2) Projection Approach (long period forecasts)
(I) Interview and Survey Approach : (for short Period Forecasts)
To anticipate the expected sales of a commodity, it is necessary to collect the
information regarding the expected expenditures of the consumers.
The interview and survey approach, tries to collect this information, in different
ways, and forecasts are based on this information. Depending on how this information
is collected, we have different sub-methods of this survey approach.
1) Opinion-Polling Method
This method tries to collect information, directly or indirectly, from the prospective
consumers. This is possible through the market research department of the firm or
through the wholesalers and retailers.
If consumers cannot be contacted personally or directly, 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.
This method is useful when the product and consumers come into direct contact or
when the number of consumers is small. This method is also useful when the
consumer is another firm.
Limitations
1) Individual consumers are not sure of their purchase Plans
2) It is difficult and costly to contact all the consumers
3) 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. Many times the
production manager, sales manager, finance managers come together and make
use of this information to finalise the forecasts.
These forecasts are based on information which is more certain and thus forecasts
based on this information may be more accurate.
Demand Analysis 123

Limitations
1) This method based on value-judgement and has no scientific basis
2) Useful only in the short period
3) It is difficult and costly to contact all the consumers.
(3) Sample-Survey Method
The total number of consumers for a firm's product is called the population. When
the number of consumers is very large (size of population is large), it is not possible
to contact each and every consumer. A few consumers are contacted, this forms
the sample.
Information is collected from the consumers in the sample and forecasts are based
on this information. These forecasts are then generalized for the whole population.
This is possible through the advanced statistical methods.
Limitations
a) Information collected may not be accurate.
b) The sample selected must be a random sample, so that when the results are
generalized for the population, accurate forecasts are made very often, the
sample is not a random sample.
c) Consumers do not co-operate by giving a correct idea of their expected
purchases. Sometimes, the consumers themselves make unplanned
purchases.
(4) Panel of Experts

Panel of experts consists of either persons from within the firm or from outside.
These experts come together and forecast the demand for the firm's product. If
forecasts are based on judgement of these experts, the forecasts will have no
scientific basis, and thus, may be less accurate.
If however, forecasts are made on the basis of statistical information and with the
use of scientific methods, the forecasts will be more accurate.
(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. This method is quick, easy and saves time and cost,
but is not based on scientific analysis and thus may not give very accurate results.

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

and some dependent variables (sales, in our example). The relationship (cause
effect) between these variables is the correlation and the technique of establishing
Demand Analysis 125

this relationship is regression. If the past correlation is assumed to remain the
same in the future, we can use this relationship to estimate the demand for the
future.
In simple correlation, we have a relationship between two variables and a relationship

between more than two variables is multiple correlation.
For example Simple Correlation

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

that the relationship between the dependent and independent variables will continue
to hold in the future.

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

If there is some relationship between the new good and an already established good. It
is possible to estimate the demand for the new good by studying how the established
good has grown. Thus, we can study the growth pattern of all the toothpaste in the
market, and make use of this information to forecast the demand for the new toothpaste.
Limitations
a) This method is very time-consuming and has limited use.
b) This is useful for the forecasts of the new goods at a later stage of growth.
Demand Analysis 127

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

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

group in a relative sense. The comparison may be between periods of time, or between
places. Thus, we may have index numbers comparing the prices of a specified group of
commodities at different times or in different countries or localities, the level of production
in different years and so on.
Index numbers measure changes in accordance with a reference base or comparison
base expressed as 100. Thus, index numbers are always expressed in the form of
percentages, compared with the base year index which is always assumed to be 100.
Because an index number is a measurement of relative and not absolute changes in the
variable over a period, it is a coefficient or relative measure of movement of a statistical
variation from a standard giving a general trend. Thus, index numbers are applied to the
measurement of the general movement of prices, cost of living, wages, production,
consumption, employment etc. Since changes in such variates are not easily capable of
direct quantitative measurement, they are relatively measured in terms of percentage by
the technique of index numbers.
As R.G.D. Allen states, the range of index number is very great and they can
indicate changes in variables such as wage rates, shipping freights, security
prices, commodity prices, volume of output, sales and profits. Therefore, index
numbers are generally used by businessmen, economists and social workers to
measure changes in prices, wages, sales, production, stocks, exports, imports
and cost of living etc.
Index numbers are described as "economic barometers". They are indispensable to
economists, businessmen, planners, policy-makers and statesmen alike.
2) CLASSIFICATION OF INDEX NUMBERS

From the point of view of "what they measure", index numbers may broadly be classified
as : "Price Indices, Quantity indices and Special purpose indices.
1. Price Indices
A price index number is a sort of average of the individual price relative to a set of
commodities, and it measures the price changes of all such commodities collectively.
Thus, price indices measure and permit compariason of the prices of certain goods.
Price indices may either be of : (1) Wholesale prices or (2) retail prices. Thus, price
indices may further be classified as :
(1) Wholesale price index numbers, and
(2) a) Retail price index numbers
b) 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. It is interesting to note that such indices published in India are known as Economic
Advisers Index Numbers of Wholesale Prices.

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

3. Special Purpose Indices
A large variety of index numbers used for specific purposes may be included under this
heading. To study the various special kinds of problems such index numbers are compiled.
For instance, there are import-export indices, stock-exchange share price indices, labour-
productivity indices, etc.
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) The object of the index number be determined.

2) A base year is selected and the price of a group of commodities in that year are
noted.
3) Prices of the selected group of commodities for the given years that are to be
compared are noted.
4) The index number for the base year prices is always denoted as 100.
5) Changes in the prices of the given years (current years, in statistical terms) are
shown as a percentage variation from the base.
Thus, the construction of a price index number involves the following steps :
a) The choice of the base year;
b) The choice of commodities whose prices are to be taken into account'
c) The collection of data, i.e. price quotations, for the selected group of items in the
base year and the current year;
d) assigning proper weights to different items. If so desired, to remove ambiguity or
bias; and
e) Averaging the data so as to express the prices of the given years as percentage of
the prices of the base year.
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, since most of the later problems will depend upon the purpose.

Before collecting data and making calculations, it is important that one knows what one
wants to measure and how to make use of the given measure. Once the purpose is
clear, the rest of the procedure is easy to apprehend.
One must be sure of which type of index number is to be computed - whether it is

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

e) the items must be fairly large in number, because reliability greatly depends on the
adequacy of the number.
The right selection of items presents the real difficulties. As a general working rule, a
reasonable number of commodities should be selected, consistent with economy in
time, money and labour, simplicity and accuracy of measurement.
(4) PRICE QUOTATIONS

Collection of price quotations for the commodities selected is a somewhat more difficult
problem. The price of a commodity varies from market to market and even at one market,
from shop to shop. It is not possible, therefore, to obtain price quotations from all the
markets where a commodity is bought and sold. A selection of representative markets is
to be made.
There may be a number of such agencies. viz. business firms, chambers of commerce,
news correspondents, trade associations, government agents etc. Select an agency
which is most reliable. To check the accuracy of price quotations supplied by an agency,
obtain such quotations from more than one reporting agency.
Another problem associated with the price quotation is the frequency of price quotation.
That is, how often the price quotations should be obtained, on weekly or monthly basis.
Usually, in the case of weekly index numbers, one quotation per week for each commodity
is considered sufficient. For instance, the Economic Advisers Index Number of Wholesale
Prices in India is a weekly index number and is based on price quotations obtained every
Friday. But if a monthly base is considered, a more frequent quotation may be desirable.
(5) PROBLEM OF WEIGHTING

The items included in the index numbers are not of equal importance. So the different
items included in the index number must be weighted according to their importance. The
purpose of weighting is to make the index truly representative of the population it is to
measure.
The system of weighting may be either arbitrary or rational. Arbitrary or chance weighting
means that the statistician is free to assign weights to different items, which he thinks fit
or reasonable. Rational or logical weighting means some criteria have to be fixed for
assigning weights. However, it is impossible to give a comprehensive definition to the
term "rational weights". Weights which are perfectly rational for one investigation may be
equally unsuitable for another. In fact, a decision regarding rational weights depends on
the purpose of the index number and the nature of the data related to it.

(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, the problem is to select an average which summarises the changes
in the component items adequately. Usually, the arithmetic mean is employed for
constructing the index numbers. For arithmetic mean is simple to calculate.
(7) SELECTION OF FORMULA

A large number of formulae has been devised for constructing index numbers. They are
simple aggregate indices, weighted aggregate indices and Laspeyre's formula, Paasche's
formula. etc. for computing weighted averages of price relatives. The device of a particular
formula will depend upon the information available and the accuracy desired.
(8) THE PROBLEM OF DYNAMIC CHANGES

In a dynamic economy, 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.
(a) Many new commodities may come into existence and the old may disappear.
(b) The quality and quantity of commodities may change from time to time, e.g. the
quality of a l09- model motor car is quite different from that of a 1990 model.
(c) Income, education, fashion and other factors may change the consumption pattern
of the people and indices compiled for a period of time may become incomparable.
(d) In the modern world, due to changes in fashions, tastes, outlook of the people and
technological advancement, more and more new goods appear in the market while
old goods often disappear, over a period of time. Thus, a comparison of either price
level or quantity levels from two separate and distant points of time becomes difficult.
Therefore, most index number series are to be revised periodically, every decade or
so. A new and more modern samples of comparable items have to be included.
(9) DIFFICULTY IN USAGE
An economic statistic an has to be very careful in using the index numbers for economic
analysis. The following points must be borne in mind in this regard.
a) An index number deals with averages - the average tastes and habits, earning and
spending of an average number of people. Since it deals with averages, 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.
Demand Analysis 135

b) An index number constructed for one purpose may not be useful for another. A wholesale
price index cannot be compared with a cost of living retail price index. Similarly, 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.
c) Index numbers do not provide a reliable basis for comparison of international prices, so
that differences in changes in the value of money between two countries may be measured.
As items included in the index number of different countries differ in pattern and quality,
comparison is not possible. The base years will also not be the same. Moreover, 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, thereby making comparison
even more difficult.
As a result of all these difficulties, the index number is seriously limited in its utility, i.e. in
comparing the purchasing power of money over time and space. In the face of these
difficulties and inaccuracies in its construction, the index number can simply be regarded
as a mere approximation indicating the rising or falling trends.
6. LIMITATIONS OF INDEX NUMBERS
The following are the limitations of index numbers :
(1) Approximation –
They are only approximate indicators of the relative changes, due to the fact that one
cannot conceive of absolute accuracy in their construction. There can be errors not only
in the collection of data but also in the selection of the base, selection of representative
items and selection of appropriate weights. Any such error means inaccuracy in the
construction of index numbers.
(2) Sample-based –
An index number is generally based on samples. Thus, the problem of computing an

index number is the problem of describing a universe from the sample. If proper and
adequate samples are not selected, then the computed indices may not be truly
representative. Therefore, Ilersic said that, "the index numbers are often unrepresentative
as they are usually based on imperfect data."
(3) Disregard qualitative change –
The index numbers of prices or production may not take into account variations in quality,
which may be significant. Naturally, a superior commodity will cost more at any given
time than an inferior commodity, 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.

(4) Arbitrariness –
Weights are assigned arbitrarily.
(5) Differences –
An index number can be calculated in so many different ways and different methods give
different answers. Unless a proper method is used in a given situation, the results may
be misleading and inaccurate.
(6) Limited Scope –

An index number is useful for the purpose for which it is designed. Hence its use is
limited to a particular phenomenon only. Thus, indices constructed for one purpose
should not be used for other purposes where they may not be fully appropriate and given
erroneous conclusions. They are not intentionally comparable.
Demand Analysis 137

Exercise :
1. What is demand in Economics ? Explain the determinants of market demand.
2. State and explain the law of demand.
3. What is price elasticity of demand ? What are its types?
4. Explain the methods of measurement of price elasticity of demand.
5. Write short notes on. (a) Total outlay Method of measuring elasticity of demand (b) Demand
Forecasting. (c) Determinants of demand (d) Criteria for good demand forecasting
(e) Significance or Practical uses of price elasticity of demand. (f) Increase and decrease
in demand. (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.

NOTES
Demand Analysis 139

NOTES

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

1) Maximum quantity of output that can be produced from any chosen quantities of various
inputs
2) 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) Law of Variable proportion : Where quantities of some factors is kept fixed but
the other factors is varied.
2) Laws of Return to Scale : Where quantities of all factors is varied
3) Optimum combinations of inputs.
The cost of production is also influenced by input prices. Input price depends upon demand for
factors of production which ultimately depends upon marginal productivity of the factor. The
demand for factors is derived from marginal productivity curve which is actually taken in
economics as a part of theory of distribution. That means theory of production is related to
factor prices such as wage, rate of interest which is a micro aspect. Macro aspect i.e. aggregate
wages, share of profit in national income are related to production function.
Production function can be algebraically expressed as :
Q = f (N, L, K, T)
Where Q = Quantity of output
N, L, K, T = quantities of factors (Inputs)
f = unspecified form of functional relationship between 'N, L, K, T where through mathematical

methods we can work out quantitative measure of this relationship.
The inputs or the factors of production can be classified into fixed and variable inputs. The
fixed inputs are those which do not change in quantity irrespective of the level of output. As
output increases the fixed inputs used per unit of output declines. In the short run a firm uses
fixed inputs such as land, building, plant & machinery. The variable inputs are those inputs
whose quantity changes along with a change in the output. It means, the variable inputs are
required more & more to increase production. 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, the output
also increases. It means, there is a direct relation between variable input and output.
2) Input and output do not increase in the same proportion. There may be a phase when
output increases faster than increase in a particular variable input. This is a phase of
increasing returns to the variable input. When input and output increase in the same
proportion, it is a phase of constant returns.

2. 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. 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. This can be discovered with the help of production function.
2) Production function tells management the budget constraint for increase in

output. As generally output cannot be increased without an increase in the input. It
follows that the expansion of a firm requires more funds to employ more inputs. The firm
can judge how far it is worthwhile and profitable to increase output.
3) The production function explains the degree of substitution and complementarity

of different factors of production. From this the firm can select its expansion path. It
means, 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.
4) The management should endeavour to produce an upward shift in production

function which can definitely improve its financial performance under the given
market conditions. Because, such upward shift in production function involves
technological progress and indicates the possibility to generate surplus. 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.
5) The theory of production function can also explain the possibility of disguised
unemployment. When we excessively employ only one factor in the production of a
certain commodity, we reach a stage when the marginal product of that factor becomes
zero or negative. This stage is called disguised unemployment which is supposedly
present in the agricultural sector in countries like India. Such disguised unemployment
indicates that it is possible to divert surplus labour to other sectors where their marginal
product would be greater than zero. Therefore, it gives policy guidance to both management
and government about the priority in the development process.
6) As production function is an engineering concept, we can study the behaviour

of production function under different conditions. It can explain inter - firm, inter -
regional or international differences in the productivity. 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.
Thus the concept of production function supplemented with other tools of economic
analysis is relevant for rational decision - making in practical business.

Linear Homogeneous Production Function
This is a particular production function which assumes constant returns to scale. It states
that if all inputs are increased in the same proportion, the output also increases in the same
proportion. It means, the change in scale of production does not have any effect on efficiency
of the firm. The returns to scale are constant.
According to Stigler, 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". We have also said that in the simplest form, it is the
relationship between "Input and output" and further this relationship can be studied
with reference to two laws :
A. Law of variable proportion
B. 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.
Before discussing law of variable proportion let us consider the following definitions which will
help in understanding the law.
1. Total Physical Product : Total quantity of output produced in physical units by a firm
during a period of time.
2. 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.
∆ T. P.
M. P. = ––––––––––––––––––
∆ Variable factor units
3. 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.
T. P.
A. P. = –––––––––––––––––
Variable factor Units
Alternative way of describing relationship between total product, marginal product and average
product is : All these measures " Total product", "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.

It is necessary to make clear distinction between (a) Short run, (b) Long run and (c)
Very long run. These are the three time spans for decision - making for a firm. At any given
time a firm is less than perfectly flexible which means when firm enters in Industry, it comes
with certain size or capacity and commitment. 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.
Short Run : It is period of time during which at least one of the firms input can not be varied.
It is not possible to tell how long short run will last. 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. 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, building, add more furnaces etc. In other
words steel plant has a commitment to its present plant for 4 years.
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. This is the second time span in
which business decisions are made. Except level of technology, everything else changes in
the long run. When new technology is introduced and production function itself changes then
it is a case of a very long run.
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.
3. The Law Of Diminishing Returns or The Law of Variable Proportion. Or The

Laws of Returns :
Introduction :
Law of variable proportion occupies an important place in economic theory. This law examines
the production function with one factor variable, keeping the quantities of other factors fixed. In
other words, it refers to the input output relation when the output is increased by varying the
quantity of one input. When the quantity of one factor is varied, keeping the quantity of the
other factors constant, the proportion between the variable factor and the fixed factor is altered;
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. Since under this law, we study the effects on
output variations in factor proportions, 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.
Statement of the Law :

1) As equal increments of one input are added; the inputs of other productive
services being held, constant, beyond a certain point the resulting increments of
product will decrease, i.e., the marginal product will diminish". (G. Stigler)

2) As the proportion of one factor in a combination of factors is increased, after a
point, first the marginal and then the average product of that factor will diminish".
(F. Benham)
3) An increase in some inputs relative to other fixed inputs will, in a given state of
technology, cause output to increase; but after a point the extra output resulting
from the same additions of extra inputs will become less and less". (P. A.
Samulson)
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,
keeping the quantity of other factors fixed and further it states that the marginal product and
average product will eventually decline.
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) The state of technology is assumed to be given and unchanged. It there is improvement

in technology, then marginal and average product may rise instead of diminishing.
2) There must be some inputs whose quantity is kept fixed. It is only in this way that, we
can alter the factor proportions and know its effects on output.
3) The law is based upon the possibility of varying the proportions in which the various
factors can be combined to produce a product. The law does not apply to those cases
where the factors must be used in fixed proportions to yield a product.
4) Homogeneous nature of units of variable factor is assumed.
5) It is assumed that units of variable factor are divisible in to smaller homogeneous units.
This assumption may not always be true.
6) While discussing the Law of Returns money and monetary value of output is not at all
taken into consideration. Only physical relationship between factor inputs and output of
products is considered.
Explanation of the Law of Diminishing Returns (Variable proportion) with the help of
a table :

Fixed Variable Total Average Marginal
Factor Factor Product Product Product
(say land (Labour units) (units) (units) (units)
& Capital
}
F 1 5 5 5 Increasing
F 2 15 7.5 10 Returns
F 3 30 10 15
F 4 50 12.5 20 Constant
F
F
F
5
6
7
70
90
105
14.0
15
15
20
20
15
} Returns
F
F
F
F
F
F
8
9
10
11
12
13
115
120
124
127
127
118
14.3
13.3
12.4
11.5
10.5
9.07
10
5
4
3
0
-9
} Diminishing
Returns
Negative
Returns
Average Marginal Relationship :
Observations of the table :
The above table shows that eventually the total product also starts declining. But first to
decline is the marginal product. The relationship between them is as follows :
1) As long as average product is rising, marginal product would be larger than the average
product.
2) M. P. is less than A. P., when A. P. is decreasing.
3) The A. P. remains constant when M. P. and A. P. are equal. Also, when A. P. is maximum
M. P. equals A. P.
4) Total product is maximum when M. P. is zero.
5) M. P. becomes negative when T. P. falls.
6) It will be noticed from the table that when 1 to 4 workers are employed, the marginal
product goes on increasing. This is the phase of 'Increasing Returns'.
7) When workers 4, 5 and 6 are employed we notice that in their case, that M. P. is 20, 20,
20. This is the phase when the 'Law of Constant Returns' is in operation.

8) Form 7 to 11 workers, it is noticed that though T. P. is increasing, the M. P. goes on
decreasing. This is the phase of 'Diminishing Returns'. This phase may also be called
the phase of 'Diminishing Marginal Returns'. Thus, we observe that the 'Law of Diminishing
Marginal Returns' (M. P.) is in operation in the third phase.
Thus, the Law of Returns states that, if one factor of production (Land or Capital) is held
constant and other factor is varied, for sometime the Law of Increasing Returns, then the Law
of Constant Returns and finally the Law of Diminishing Returns come into operation.
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.
F
T.P., T.P. Curve
A.P.,
M.P.
Stage I Stage II Stage III
A.P. Curve
X
M
Units of Variable factor
(labour) employed
M.P. Curve
Three stages of the law of diminishing returns (variable proportions) point H is the maximum
point of T. P. when M. P. = O.

It will be observed from the figure that the T. P. curve goes on increasing to a point and after
that it starts declining. A. P. and M. P. curves also rise and then decline. M. P. curve starts
declining earlier than the A. P. curve. 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,
which are explained below :
Stage I : Increasing Returns

In this stage T. P. to a point increases at an increasing rate. In the figure from the origin to the
point F, slope of the total product curve T. P. is increasing i.e. up to the point F, i.e. T.P.
increases at an increasing rate, which means that M. P. rises. From the point F onwards
during the Stage 1, the T. P. curve goes on rising but its slope is declining which means that
from point F onwards the T. P. increases at a diminishing rate i.e. M. P. falls but it is positive.
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'. Corresponding vertically to this point of inflexion,
M. P. is maximum, after which it slopes downwards.
The stage I ends where the AP curve reaches its highest point S. Stage 1 is known as the
stage of 'increasing returns' because A. P. of the variable factor increases throughout this
stage. It should be noted that the M. P. in this stage increases but in a later part it starts
declining but remains greater than the A. P. so that the A. P. continues to rise.
Stage II : Diminishing Returns

In stage II, the T. P. continues to increase at a diminishing rate until it reaches its maximum
point H where the second stage ends. In this stage both the M. P. and A. P. of the variable
factor is zero (when T. P. is highest as shown by point H). Stage II is important because the
firm will seek to produce in its range. This stage is known as the 'stage of diminishing returns'
as both the A. P. and M. P. continuously fall during this stage.
Stage III : Negative Returns

In stage III T. P. declines and therefore T. P. curve slopes downwards. As a result M. P. of the
variable factor in negative and the M. P. curve goes below the X axis. This stage is called the
stage of negative returns, since the M. P. of the variable factor is negative during this stage.
Explanation of the Various Stages
1) Increasing returns : In the beginning, the quantity of fixed factor is abundant relative to
the quantity of the variable factor. 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.
Let us consider the example through the table mentioned in the three stages of law of
variable proportion. Through out the three stages fixed variable i.e. machinery (capital)

remains constant. The variable factor i.e. no. of workers increase as a firm expands its
production. A worker contributes 5 units per day to the firms output. The total product
reaches 50 units per day when the 4th worker contributes to the production. Fuller
utilization of capital is possible due to the addition of a variable factor. One worker cannot
take full advantage of the capabilities of capital. When the fourth worker joins it is possible
to use the full potential of the capital. Moreover increasing returns can also be attributed
to the principle of division of labour of specialization of work. The question may arise that
if fixed factor is abundant as compared to variable factor, why fixed factor be not taken in
accordance to the availability of variable factor. The answer is that fixed factors are fixed
i.e. they are indivisible. The number of machinery cannot be changed in the short run.
2) Diminishing returns : The peculiar feature of this stage is that the marginal product falls
through out the stage and finally touches to zero. Corresponding vertically is the point H
which is the highest point of the TP curve. Here stage II ends.
In the table given on page 147, 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. Total
product increases but gain form 7th worker is not as great as gain from 6th worker.
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, 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. In stage two
fixed factor is scarce as compared to variable factor. According to Mrs. Joan Robinson,
a famous economist, the factors of production are imperfect substitutes for on another,
the stage of diminishing returns occur. Fixed factor is scarce and variable factor then
fixed factor would not have remained scarce. The paucity of fixed could have been made
up by such perfect substitutes. 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, substitution is not possible and diminishing returns occur.
3) Negative returns : In this stage, marginal product falls below 'X' axis i.e. negative because
total product starts falling. In our example this is set in by hiring 13th worker. The total
product falls from 127 units to 118 units. The large number of variable factors impairs the
efficiency of the fixed factor. The excessive variable factor as compared to less fixed
factor results in a fall of total output. In such a situation, a reduction in the units of the
variable factor will increase the total output.
Limitation of the Law of Diminishing Returns :

There are a number of exceptions to this law. This law does not apply to all conditions in
agriculture.

(i) New methods of cultivation :
As mentioned earlier, this law assumes no change in the technique of production. Scientific
rotation of crops, better quality seeds, modern implements, fertilizers, better irrigation
facilities, however are the changes which take place in agriculture. The marginal product
under these conditions, will in fact increase. New methods of cultivation, therefore, are
an exception to the law.
(ii) New Soil :

When new land (soil) is brought under cultivation, the marginal product will increase for
a time; thus the law of diminishing returns does not operate in the beginning.
(iii) Insufficient Capital :

If capital is not sufficient, increased used of capital, will give more than proportionate
return, but later the marginal return will decrease. The early stage is an exception to the
law of variable proportion.
Application of the Law of Diminishing Returns :
The law of diminishing returns applies to agriculture, because land if fixed. From society's
point of view as Recardo assumed and other factors are variable. However, 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.
Thus, if an industrial enterprise capital is kept fixed and other factors are increased, the
marginal product will initially increase but will ultimately diminish.
Thus, the law also operates in industries like mining, fisheries and also in building industries.
4. Returns to Scale or Laws of Returns to Scale :
Under the law of diminishing returns (i.e. variable proportion) we have studied the behaviour of
output (T. P., M.P. and A. P.) when factor proportions are changed. That is, we have seen the
behaviour of output by keeping the quantity of one or some factors fixed and changing the
quantity of other (e.g. Labour)
Now, we will undertake the study of changes in output when all factors of production
or inputs are increased together. In other words, we shall now study the behaviour of
output in response to changes in scale. An increase in the scale means that all inputs
or factors are increased in the same proportion. Increase in the scale thus occurs
when all factors or inputs are increased keeping factor proportions unchanged. The
study of changes in output as a result of changes in the scale forms the subject matter
of "returns to scale".

The Laws of Returns to Scale :
Y
Constant Returns To Scale

Marginal Product
ale
De
Sc
cre
To
as
ing
s
rn
tu
Re
Re
tur
ing
ns
as
To
re
Sc
Inc
ale
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, returns to scale are said to be increasing. Thus, if all factors are doubled,
and output increases by more than double, then the returns to scale are increasing.
If for instance, all inputs are increased by 25%, and output increases by 40% then the
increasing returns to scale will be prevailing. This is because of greater specialization of
labour and machinery. This phenomenon according to Prof. Baumol also occurs because
of dimensional relations. For example, if the diameter of a pipe is doubled, the flow of
water through it is more than doubled. Another reason for increasing returns is because
of the indivisibility of some factors. These factors are available in large and lumpy units
and can therefore be used with utmost efficiency at only larger output. This reason is
given by Prof. Mrs. Joan Robinson, Kaldor and Lerner.
2) Law of Constant Returns to Scale :
Meaning : If we increase all factors of production (i.e. scale) in a given proportion

and the output increases in the same proportion, returns to scale are said to be
constant. Thus, if doubling or trebling of all factors causes a doubling or trebling of
output, returns to scale are constant. In mathematics, the case of constant returns to
scale is called ' linear and homogeneous production function' or 'homogeneous, production
function of the first degree'.
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, returns to scale are decreasing. When a firm goes on expanding all its
inputs, then eventually diminishing returns to scale will occur. Diminishing returns to

scale eventually occur because of increasing difficulties of management, coordination
and control. When the firm has expanded to a too gigantic size, it is difficult to manage
it with the same efficiency as previous. This in other words, means that the firm starts
suffering from the diseconomies of scale.
5. ECONOMIES AND DISECONOMIES OF SCALE :
Introduction :
An attempt is made in this sub -unit to outline the economies of large - scale production with
reference to the Laws of Returns.
a) Diseconomies of Small - Scale Production:

Any firm which is newly established operates on a small scale in the initial stages.
Production on a small scale is, however, found to be disadvantageous on the following
grounds.
(a) A new firm is required to acquire land, construct factory building, install machinery
and provide other infrastructural facilities. A lot of time is wasted in erecting the
factory. Meanwhile, the firm has to spend on preliminary expenses. All these
expenses are debited to the profit and loss account for the first operating year. If the
total expenditure incurred during the first year is taken into account, the average
cost of production works out to be very high in the initial stages.
(b) The workers appointed in the factory take some time to adjust themselves to the
techniques of production. Till this adjustment is made, there is lot of wastage of raw
materials and power. Naturally, the average cost of production is high.
(c) In the initial stages, production is on a small scale because the product is not yet
known in the market. The firm is not sure whether the entire production would be
sold. Every new firm, therefore, decides to produce on a small scale till it gets a
'real feel of the market'. In the initial stages small - scale production may, therefore,
lead to a high average cost and losses.
b) Economies of Scale:
But with the passage of time, the firm is fairly established in the market. Its products are
constantly in demand. The workers also acquire proficiency in producing high quality
goods. As a result, the firm decides to increase the scale of production. Ultimately, a
number of economies of scale accrue to the firm. These economies are classified as
internal and external economies. It is worthwhile to explain the economies at length :
Internal economies are those advantages of large - scale production which accrue
to a firm on account of its superior techniques and management. They are broadly
classified under the following heads:

(a) Technical Economies :
A firm that produces goods on a large scale can install improved and up - to - date
machinery. On account of new machines, a firm is able to effect a substantial
reduction in the cost of production. It is also possible in a big firm to avail the
benefits of specialization and division of labour. Quality of goods produced by such
a firm is, therefore, superior.
(b) Commercial Economies :

A firm that produces on a large - scale is required to buy raw materials on a large -
scale. Bulk buying enables a firm to procure the materials at a lower cost. A firm
making purchases on a large scale acquires a strong bargaining power in the market.
It can secure favorable credit terms from the suppliers. A big firm can negotiate with
transport operators and can secure concessional freight rates for transportation of
raw materials and finished products. A big firm enjoys high reputation and its products
are in constant demand in the market.
(c) Managerial Economies :

A firm producing on a large scale can afford to hire the services of expects in
various fields such as purchases, production, marketing and finance. These experts
utilize their knowledge and experience towards maximization of profits.
(d) Financial Economies :

A firm which is producing on a large scale can avail the benefits of cheaper finance.
A firm which has acquired reputation and a high credit - rating can raise new capital
quickly, easily and on much favourable terms.
(e) Risk and Uncertainty :

A firm which produces on a large scale can earn large profits. It can build up huge
reserves out of undistributed profits. Capacity of such a firm to sustain losses is,
therefore, big. On the other hand, a smaller firm with slender reserves cannot
withstand the losses incurred in the business.
c) External Economies :
The above advantages of large - scale production may accrue to an individual firm because
they arise out of the superior technique and management of the firm. If in a particular
region, many such firms are concentrated they may promote some common activities.
These activities may bring several benefits for all the firms, in an industry. For example,
in such a region facilities of transport, banking, post - office etc. may be developed and
all the firms can take the benefits of these services. What is more important is that, a
number of new firms dealing in ancillary products are developed in this region. These
firms may manufacture spare parts on a large scale. The big firms can buy the spare

parts at a lower cost. If the big firms produce the spare parts themselves, the cost would
be higher. It would, therefore, be profitable for big firms if they buy the parts from small
firms. Similarly, various firms concentrated in a particular region can start a Research
Institute. The benefits of this research can be passed on to all the firms. All such economies
are called external economies.
d) Diseconomies of Large - Scale Production :
Large - scale production may encounter certain diseconomies and disadvantages. In

course of a firm's expansion, 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.
Let us note these disadvantages of large - scale production.
Internal and External Diseconomies :
As a firm expands beyond a certain limit, it becomes unmanageable and unwieldy.

The top executive may find it impossible to look into even the broad functioning of various
departments. Delegation of responsibilities and decentralization of very large number of work
can not be stretched too far. Co-ordination of various activities becomes impossible. A very
large number of workers may cause factions and groupism amongst them. This may disturb
the healthy atmosphere and may cause indiscipline, quarrels, and rivalries. 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.
With increase in the number of salaried administrative, managerial and sales staff, personal
touch with dealers and customers is lost. Because these salaried employees have to stake in
the company, efficiency, urge, punctuality, integrity and inventiveness disappear and their
place is taken by disinterestedness, routine dealings and work to rule.
The internal diseconomies of large - scale production can be summarized thus :

(i) Management and supervision becomes difficult and waste of time and material results.
(ii) For want of a personal touch, strikes, lockouts and such other eventualities causing
stoppage of work or obstructions to work increase.
(iii) No direct contact with customers is possible. So, tastes of consumers are ignored.
Products are standardized and no specialized services to consumers are possible.
(iv) Large - scale production may cause overproduction and this may result in losses.
(v) Large producers have to fight for capturing and maintaining markets. This may result in
cut-throat competition.
(vi) Large firms cannot easily adapt to ups and downs in business.
(vii) Large - scale production may involve imports of raw materials and exports of products.

(viii) There are additional elements of risk due to possibilities of war, changed international
relations and so on.
Expansion of industry and overcrowding of industrial units in a locality also causes

diseconomies which can be called external diseconomies. The competition among
firms to secure raw materials and other resources for itself causes their prices to rise. Moreover,
with increase in demand for resources, additional resources which become available are naturally
of a lower quality compared to those already employed. For example, the best workers are
selected first and as more and more workers are required, a firm has to appoint whosever are
available rather than who are suited for the work. Thus, not only wage - rates increase, but
productivity per worker goes down. The same applies to machinery spare parts, raw materials,
distribution channels and so on.
Similar external diseconomies flow from concentration of industries in certain

localities. Overcrowding of cities, traffic congestion, pollution of air and water, strain on civic
amenities like drinking water, public health, sanitation etc. and problems of housing, education,
medical care and law and order are some of the consequences. They affect efficiency of
labour, availability of quick transport, timely deliveries of finished products and an overall strain
on the whole industrial system.
6. SUPPLY ANALYSIS :
a) Meaning of Supply :
In economics, supply during a given period of time means the quantities of goods which
are offered for sale at particular prices. Thus, 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.
Supply is a relative term. It is always referred to in relation to price and time. A

statement of supply without reference to price and time conveys no economic sense.
For instance, a statement such as : "the supply of milk is 500 liters" is meaningless in
economic analysis. One must say, "the supply at such and such a price and during a
specific period." Hence, the above statement becomes meaningful if it is said "at the
price of Rs.20. per liter, a dairy - farm's daily supply of milk is 500 liters." Here, both price
and time are referred to with the quantity of milk supplied.
Secondly, supply is what the seller is able and willing to offer for sale. The ability
of a seller to supply a commodity, however, depends on the stock available with him.
Thus, stocks is the determinate of supply.
Similarly, another determining factor is the will of the seller. A seller's willingness
to supply a commodity, however, depend on the difference between the reservation price,
the minimum or cost price the seller must get and the prevailing market price or the price

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

high custom duties may decrease the supply of the imported goods but it would
encourage the domestic industrial activity, so that the supply of domestic products
may increase. An increase in tax such as excise duties will reduce the supply
while granting of subsidy will increase the supply.
7) Cost of Production : If there is a rise in the cost of production of a commodity, its

supply will tend to decrease. So, with the rise in the cost of production, the supply
curve tends to shift leftward. Conversely, a fall in the cost of production tends to
increase the supply.
8) Prices of other Products : The prices of substitutes or related products also

influence the supply of a commodity. If the price of wheat rises, the farmers may
grow more of wheat and less of rice. So the supply of rice will decrease. Again, if
the prices of fountain pens rise, the prices of ink will also tend to rise. If the price of
sugar rises, the price of jaggery (gur) will also tend to rise.
7. 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. It describes seller's supply behaviour
under given conditions. It has been observed that usually sellers are willing to supply more
with a rise in prices.
Statement of the Law :

The law of supply may be stated as follows :
Other things remaining unchanged, the supply of a commodity expands with a rise
in its price and contracts with a fall in its price.
The law, thus, suggests that the supply varies directly with the change in price. So, a larger
amount is supplied at a higher price than at a lower price in the market.
Explanation of the Law ;
The law can be explained and illustrated with the help of a supply schedule as well as a
supply curve, based on imaginary data, as follows :
Price of Ballpen (per unit) Quantity Supplied

Rs. (in '000 per week)
10 10
12 13
14 20
16 25

Y Supply Curve
Price Per Unit

16
14
12
10 S
X
O 5 10 15 20 25
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.
From the supply schedule, it appears that the market supply tends to expand with the rise in
price and vice versa. Similarly, the upward sloping curve also depicts a direct relation between
price and quantity supplied.
Assumptions Underlying the Law of Supply :

The law of supply is conditional, since we have stated it under the assumption : "other things
remaining 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,
but there is no change in the cost of production. If the cost of production increases along
with the rise in the price of product, the sellers will not find it worthwhile to produce more
and supply more. Therefore, the law of supply is valid only if the cost of production
remains constant. It implies that the factor prices, such as wages, interest, rent etc., are
also unchanged.
2) No change in technique of production : The technique of production is assumed to be

unchanged. This is essential for the cost to remain unchanged. With the improvements
in technique, if the cost of production is reduced, the seller would supply more even at
falling prices.
3) Fixed scale of production : During a given period of time, it is assumed that the scale
of production is held constant. If there is a changing scale of production, the level of
supply will change, irrespective of the changes in the price of the product.

4) Government policies are unchanged : Government policies like taxation policy, trade
policy, etc., are assumed to be constant. For instance, 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, then such a situation
will not permit the expansion of supply with a rise in prices.
5) No change in transport costs : It is assumed that transport facilities and transport

costs are unchanged. Otherwise, a reduction in transport cost implies lowering of cost of
production, so that more would be supplied even at a lower price.
6) No speculation : The law also assumes that the sellers do not speculate about the
future changes in the price of the product. If, however, sellers expect prices to rise further
in future, they may not expand supply with the present price rise.
7) The prices of other goods are held constant : The law assumes that there are no
changes in the prices of other products. If the price of some other product rises faster
than that of the product in consideration, producers might transfer their resources to the
other product which is more profit - yielding due to rising prices. Under this situation,
more of the product in consideration may not be supplied, despite the rising prices.
Exceptions to the Law of Supply (Backward - sloping Supply Curve) :
The law of supply states that supply, tends to rise with a rise in price is a universal phenomenon.
There are, however, a few exceptions to this law. Supply of labour and savings are two such
exceptions commonly pointed out by the economists. It may be observed, in these cases,
that the supply tends to fall with a rise in prices at a point. 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. It is also known as an exceptional supply curve, as
such a thing happens only in some exceptional cases like labour supply or savings.
Y S1
200
180 M
Wage Rate
160
150
S
O X
50 55 60 65
Quantity Supplied of Leisure

Labour in hours
Backward Sloping Supply Curve of Labour

In figure the curve SMS1 represents a backward - sloping supply curve for labour as a commodity.
Here, the wage - rate is regarded as the price of labour and the labour supply is determined in
terms of labour - hours the worker is willing to work at a given wage rate. It is observed that as
wages increase, a worker might work for a lesser number of hours than before. To illustrate the
point, say, when the wage rate is Rs. 150 per hour, the worker works for 50 hours per week
and gets Rs. 7,500; when it is Rs. 160 per hour, he works for 60 hours per week, and gets
Rs.8,800; at Rs. 180, he works for 65 hours and gets Rs. 11,700 and at Rs. 200, he works for
60 hours and gets Rs. 12,000.
As exception to the law is also seen in the case of persons who want to have a fixed income
from their investment. As interest rates rises, the amount on investment required to reach the
same amount of interest yields is obviously less. For instance, a person wants to earn Rs.100
per year require an investment of Rs. 1,000 and at 20 per cent, he will require an investment
of Rs.500. Thus, as the rate of interest rises, the volume of investment required declines. In
this case, 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, which is contrary to the
usual law of supply.
8. EXPANSION AND CONTRACTION IN SUPPLY :
The law of supply refers to the change in supply due to a change in price. If, with a rise in
price, the quantity supplied rises, it is called expansion of supply. If with a fall in price, the
quantity supplied declines, it is called contraction of supply. The change in the quantity in
accordance with the price change is, thus, called either as "expansion" (or extension) or
"contraction" of supply and refers to the same supply curve.
In figure, the movement from point a to b on the supply curve shows expansion and b to a
shows contraction of supply.

9. INCREASE AND DECREASE IN SUPPLY :
These two terms are introduced to explain the change in supply without any change in price.
Sometimes, there might be more supply forthcoming in the market without a change in
Y
Y
S S2
Price (Per Unit)
Price (Per Unit)

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

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

es = ---------------------------------------------------------------- ÷ ---------------------------------------------------
Original Quantity Supplied Original Price

Representing it in symbols, thus elasticity of supply formula can be stated as :
ê QS êP
es = -------------- ÷ ----------------
QS P
êQS P
= -------------- x ----------------
QS êP
êQS P
Therefore, es = -------------- x --------------
êP QS
QS = The Original Quantity Supplied
êQ = Net change in Quantity Supplied
P = The original Price
êP = Net change in Price.
For example, if, as a result of a change in the price of a commodity from Rs. 40 to Rs. 45
per unit, the total Quantity supplied of the commodity by the sellers is increased from
1,000 units to 1,200 units, then the elasticity of supply may be calculated as under :
200 40
es = -------------- x -------------- = 1.6
5 1000

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

b) Measurement of Elasticity of Supply :
There are two methods of measuring elasticity of supply : (1) the ratio method, and
(2) the point method.
∆Q P
es = –––––– x ––––––
Q ∆P
The coefficient of elasticity of supply(ies) may vary between zero to infinity.
The Point Method :
On a given supply curve, 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.
Price (Per Unit)
Price (Per Unit)
F
F
Measurement of Point Elasticity of Supply

To find out the elasticity on the supply curve at point P as in the above Fig., draw a tangent TF
to the supply curve SS at point P intersecting the horizontal axis at T. Draw a perpendicular
PB form point P and intersecting at point B on the horizontal axis.
The elasticity of supply at point P is measured as :
TB
Es = ––––––
OB
In panel (1) TB < OB, therefore, as es < 1 at point P. In panel (2) TB > OB, therefore,
es > 1 point P.

c) Factors Determining Elasticity of Supply :
The elasticity of supply of commodities depends on a number of factors, such as :
1) Nature of commodity : In the case of some commodities like antiques, old wines, old
stamps, old and original handwritten manuscripts, etc. their supply remains fixed or
constant as they cannot be reproduced in their original form or shape. In the case of
such commodities price changes will have no influence on their supply.
In the case of houses, high artistic works, paintings and statutes, etc. it may take quite
some time for their supply to expand in response to rise in their prices.
In respect of commodities like cloth and other factory-made goods of daily consumption,
response of supply in response to change in their prices would be fairly quick.
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. Thus,
if a community depends for its cloth only on handloom technology, 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.
3) Time Element : Time element is very important factor in determining elasticity of supply.
Generally, shorter the time-span, less responsive will be the supply side; and longer the
time-span, generally more responsive would be the supply side of the commodity to
changes in price.
Thus, if price of a commodity rises, 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, silver and other valuable metals in case of which
future trading takes place on telephone, telex etc.).
Rise in price of houses may bring only gradual response from the supply side of houses,
as it takes some time to build new houses.
4) Scale of Production : Goods produced on a small scale have a relatively inelastic

supply, while gods produced on a large scale have a relatively elastic supply.
5) Size of the Firm and the Number of products produced : When the big firms produce
a variety of products at a time, they can easily transfer the resources from one product
to the other so that the supply may become more elastic.
6) Natural Factors : Natural factors like climate, monsoon, fertility of the soil, etc.,
considerably affect the elasticity of supply of agricultural goods. The supply of agricultural
goods is relatively inelastic, because these natural factors are beyond the control of

man. The seasonal nature of cultivation is the main contributory factor, making the supply
of agricultural commodities less elastic.
7) Mobility of Factors : In those industries where there is a high degree of mobility of

factors of production, supply will be more elastic. Immobility of factors causes inelasticity
of supply.
11. 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. 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. A firm aims at maximizing its
profits; profits depend on the costs of production and the prices of products. Thus, given the
market price of the firm's; product, the amount a firm is willing to supply in the market will
depend on the cost of production. It is therefore, necessary to have a clear idea about the
concept of the cost of production.
Costs may be nominal costs or real costs. Nominal cost is the money cost of production. It is
also called expenses of production. The real cost is the opportunity cost of production (see
below). Money costs and real costs do not coincide with each other.
Types of Costs :
1) Accounting Costs :
Accounting costs are the costs of production of the firm. These are money costs or
expenses of production. These costs are paid for by the producer and are also known as
entrepreneur's costs. These are the explicit costs, and they enter the accounts books of
the firms. These costs include : (i) wages to labour, (ii) interest on borrowed capital, (iii)
rent or royalty paid to owners of land which is borrowed by the firm, (iv) cost of raw
materials, (v) replacement and repairing charges of machinery, (vi) depreciation of capital
goods, and (vii) normal profits of the manufacturer (amount sufficient to induce him to
continue production).
Accordingly costs may be classified as : (a) Production costs, including material costs,
wage cost and interest cost (b) Selling costs, including costs of advertising and (c)
Other costs, including insurance charges, taxes etc.
These accounting costs are important from the point of view of the producer. He must
make sure that the price of the product, must cover these costs and normal profits, or
else, he cannot afford to continue production.

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

Example
Thus, if Rs. 20 lakhs are invested in project A at a 10 per cent rate of return, and if this
amount was not invested in project A, it would have been invested in project B (next best
alternative use of Rs. 20 lakh) at 9 per cent rate of return. Then the opportunity cost of
Rs. 20 lakh in project A is 9 per cent, which is the value of this amount in its next best
alternative use.
Similarly, if a consumer uses Rs. 20,000 to buy a washing machine, he cannot use this
money to buy a microwave oven. By buying a washing machine, he has forgone the
opportunity of buying a microwave oven. Thus, the opportunity cost of buying a washing
machine is the opportunity cost of not being able to buy a microwave oven. 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. The implicit costs distinguish the accounting costs from the economic
costs. Thus, the economic profits to a firm can be calculated with the help of
implicit costs of a firm, and these costs are imputed on the basis of the opportunity
cost principle. This concept is, therefore, used for, (a) measuring profits, (b) policy
decision of the firms, (c) forming capital budget and (d) alternatives available to the
firm.
The opportunity cost principle has a wide application in economic theory. It is

useful in the determination of values internally and internationally. It is also used to
understand income distribution.
(b) Limitations :
There are, however, some limitations in its application.
(i) Specific : It does not apply to productive services which are specific. A specific
factor has no alternative use. Its opportunity (transfer) cost is, therefore, zero.
(ii) Factors are not homogeneous : Units of productive services are not homogeneous,
this obstructs their transfer.
(iii) Wrong - Assumption : The theory is based on the assumption of perfect competition
which rarely exists.
(iv) Individual and Social Costs : A product may cost the firm Rs. 5,000 per unit, but
to the society it will cost something in the form of bad - health due to the smoke

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

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

avoid the rent of the showroom, wages to workers in the showroom, electricity
charges etc. these are avoidable costs. However, it has to continue to employ the
salesman who move from place to place; the salaries of these salesman cannot be
avoided because of contraction of the firm; these become unavoidable costs.
iii) Incremental and Sunk Costs :
At times the firm undertakes expansion. It might set up a new factory or introduce
a new product. 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.
For example, if a firm wants to purchase a machine, it has to bear the following costs:
1) Cost of purchase.
2) Installation charges.
3) Maintenance charges
4) Operational charges.
Now, instead of purchasing the machine a firm decided to hire a machine (not expansion),
it does not have to bear the cost of purchase and the maintenance or installation charges.
These are costs which increase only through expansion and are incremental costs.
However, by hiring a machine the firm cannot avoid operational charges. These costs
have to borne by the firm whether there is expansion or not; these are Sunk costs.
iv) Common and Traceable costs :

Today, most firms are multiple product firms, i.e. firms producing more than one
product. Some costs are common to all the products of multiple product
firm. These are common costs. However, there are some costs which are
traceable to a particular product of a multiple product firm; these are called
traceable costs.
For example, consider a press, publishing a newspaper and a monthly magazine,

some costs like a cost of printer, salaries of publishers etc are common to both
these products; these are common costs. However, the raw material used or a
cutter used for the magazine or newspaper can be specific to a particular product;
these are traceable costs.
v) Historical and replacement costs:

Cost of purchase of a capital asset, when it was initially purchased, say,
1994 is the historical cost of the asset. Over a period, the value of every asset
depreciates; and a time comes when it becomes necessary to replace the asset.

The cost of the asset when it is to be replaced say in the year 2004, is the
replacement cost of the asset.
vi) Short run and Long run costs:
All the costs discussed previously are important. However, for our present study we
shall concentrate on firms fixed and variable costs. This distinction between FC
and VC depends on the time period. In the short period some costs are fixed and
some are variable. We shall now study the short run costs with reference to
total marginal and average costs. To understand the meaning of these costs
and relationship between them, we will make use of cost curves as shown on next
page.
Firms Cost curves :
(A) Short run Cost Curves:

Short run is a period within which some costs change, (because some factors like
labour change), whereas some costs do not change (because some factors like
machinery, capital, do not change). Thus, we talk of fixed costs and variable costs
in the short run.
a) Total Fixed Costs (TFC):
Some factors like machinery, land, capital remain fixed in the short period, the total
cost of all these factors is the total fixed costs. TFC's do not change in the short
period. They are the same for any level of production (see figure mentioned below).
The TFC curve is a horizontal straight line parallel to X axis.
b) Total Variable Costs: (TVC) :
Some factors like raw material, electricity, spare parts and labour change as the
output changes. The cost on these factors is the total variable costs. The total
variable costs increase with increase in production(see fig shown on next page).
We have a rising TVC curve.
c) Total Costs (TC) :
The sum of total fixed costs and total variable costs is the total cost. This is the
total cost of production.
TC = TFC + TVC
The TFC is constant, but TVC increases as production increases, so TC also
increases as production increases. The TC curve is also a rising curve and the
vertical distance between the TVC and TC curve, for any level of production is the
same and is equal to TFC(see the figure shown on next page).

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; the AFC decreases as production
increases (see fig shown below).
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, initially AVC decreases as
output increases and later AVC increases as output increases (see fig shown below).
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, which means that initially, AC decreases as
output increases and later AC increases as output increases (see the fig shown next
page).

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. MC is therefore, the rate of change of total cost. It is calculated as,
MC = ∆ TC / ∆ Output
The MC curve is a U shaped curve which implies that the MC decreases as output
increases initially, but ultimately the MC starts decreasing with increase in Output
(as shown in the above fig). this also means that TC (and TVC) initially increases at
a decreasing rate and later it increases at an increasing rate. 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, since TFC is constant.
MC = MVC + MFC, but MFC = 0, therefore, MC = MVC
Also, the relationship between AVC and MC is the same as the relationship between
AC and MC. Thus, the MC curve cuts both the AVC and AC curves at their respective
lowest points.
Units Total Total Total Average Average Average Marginal

of Fixed Variable Costs Fixed Variable Costs Costs
output Costs Costs (2) + (3) Costs Costs (5) + (6)
(2) : (1) (3) : (1)
1 2 3 4 5 6 7 8
0 15 0 15 –– 0 –– ––
1 15 5 20 15 5 20 5
2 15 9 24 7.5 4.5 12 4
3 15 12 27 5 4 9 3
4 15 16 31 3.75 4 7.75 4
5 15 25 40 3 5 8 9

(B) Why Short Run Average Cost Curves are U - shaped?
The average cost (AC) is made up of average fixed cost (AFC) and average variable cost
(AVC).
The total fixed cost is fixed as output increases, so the AFC declines as output increases.
In the initial stages the AVC also declines as output increases. Thus, upto same level of
output the AC (AFC + AVC) also declines as output increases. However, even though
AFC falls continuously as output increases, the AVC increases steeply, after reaching a
minimum. This rise in AVC more than offsets the fall in AFC and the AC (AFC + AVC)
starts rising as output increases.
We can explain the short - run average cost curves with the help of the Law of Variable
Proportion.
The marginal cost and average cost falls as output increase, 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, the AFC falls steeply and thus AC falls steeply.
(ii) The average variable cost falls initially till the normal capacity of the machine is
used up, because the variable factors are used only to assist the fixed factors, the
AC falls steeply.
But after a certain stage, the AC will register a sharp rise because,
(i) The fixed factors are used up, and further production is possible only with more of
variable factors, the TVC cost increases sharply as output increases, therefore, the
AVC also increases sharply, and it cannot be offset by the slow fall in AFC over
larger output. Thus fixity of factors causes the AC to rise sharply over larger output.
(ii) Further, factors of production are not perfect substitutes of each other; thus if the
fixed factor is used up, the variable factor cannot be used instead of the fixed factor.
Thus, both the AFC and AVC and so the AC rises as output increases.
An initial fall in AC as output increases, and then a rise in AC as output increases

further, gives the AC curve a U - shaped curve. One can conclude that the short run
AC curve is U - shaped and this is explained by the Law of Variable Proportion,
which operates only in the short - run.
12. DETERMINANTS OF COSTS :
The determinants of demand have already been discussed in the Chapter "Demand Analysis
and Forecasting." The idea was to identify the more important determinants of demand, so

that each determinant might be taken care of at the time of a forecast. Now, the more important
determinants of cost have to be identified, so that each determinant might be forecast, and we
are able to arrive at a realistic picture of cost behaviour in the future. There are so many factors
which determine cost that is virtually impossible to enumerate them. However, it is possible to
identify the more important factors of cost which influence cost pattern or cost behaviour.
When the factors which influence or constitute cost are spelt out, it is possible to build up the
cost function. Generally speaking the prices of inputs, the rate of output, the size of the plant,
the technology used broadly constitute the cost. In other words, cost is a function of
prices, of inputs, the rate of output, the size of the plant and technology.
Therefore, the cost function may be written as :
Cost = f (I, O, P,T)
Where
I - denotes the prices of such inputs as labour and capital material.

O - denotes the rate of output, i.e., how fast or slow the fixed plant is utilized.
P - denotes the size of the plant
T - denotes the state of technology.
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.
Each component of this complex function is a separate function by itself; and the sum of
these separate functions pluralistically yields the complex function. For example, consider
the first determinant in this complex function, that is input. Now the cost - input relationship is
a seperate function. Similarly, the cost output relationship is another separate function; and
so on. Consider now the cost - input relationship.
Cost - Input Relationship :
In the cost - input relationship, it is the prices of various inputs which make up the cost. For
example,
α α
O = AL K1-
Where, O = the amount of output
A = a constant
L and K denote labour and capital
α
α and 1- are the production co – efficient or elasticities

Now, the cost - 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.
K denotes the quantity of capital, b the price of capital and Mc denotes materials and the
price of materials. These input factors, namely, labour, capital and materials, multiplied by
their quantities, determine the cost. The quantities which are bought, however, depend upon
their prices.
It has already been indicated that producers generally try to combine the factors of production
in such a way as to minimize cost. In other words, they go on substituting one factor for
another till all the costlier factors are replaced by the factors which are cheaper. This is known
as the process of substitution. The purpose of this substitution is to enable the management
to arrive at the least - cost combination of factors or inputs; and this process goes on till a
stage is reached at which further substitution is not possible. This process is known as the
marginal rate of substitution.
In the costing of inputs, a cost function is developed on the same lines on which the production
function is developed. The objective of the production function is twofold : to arrive at the least
cost combination and to achieve the maximum output. In the cost function, the least - cost
combination of inputs is determined. For example, if labour is costly, the producer goes in for
a capital intensive technique. On the other hand, if capital is costly, the labour intensive
technique is adopted. In other words, a relation of substitution between labour and capital is
established. 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, the producer
cannot use less of labour and more materials. This would be absurd because labour and
materials cannot be substituted for each other. 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. If labour is costly and the price of materials is constant, a capital
- intensive technique would be used. On the other hand, if materials are costly, research
receives an impetus, for it becomes necessary to find substitutes. These facts indicate that
the cost - input function is one of the complex functions of cost analysis.
Cost - Output Relationship :

Cost generally vary with the level of output. When we analyse how and why the cost varies,
what we have in mind is to determine how costs vary over a period of time. This time period is
a crucial factor in any analysis of costs, and is generally broken into two parts, namely, short
- run, and long - run factors. It has often been claimed that, in the short - run, certain factors
do not change; for example, the size of a plant, the state of technology, etc. In the long - run,
however, these factors adapt themselves to changed conditions. In other words, in the short -
run, only certain factors, vary and not all; for example the raw materials vary in price; so do
wages because these factors, namely, raw materials and labour, are subject to the forces of
demand and supply. In other words, this is a short - run phenomenon.

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

Y
K TC
Total Cost & Total Revenue

E G
TR
J
M
D F
O X
A B C
Output (Units)
Equilibrium of a firm with the help of TR &TC method

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

Exercise :
1. Explain The Law of Variable proportion with the help of three stages.
2. State and explain Law of Supply? What are its exceptions?
3. What is elasticity of Supply? What are the types of elasticity of Supply?
4. 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. (j) Determinants of
cost of production (k) Short run cost curves.
5. Explain with illustration the Laws of Returns to Scale.

NOTES

NOTES

Chapter 6
PRICING AND OUTPUT DETERMINATION
IN DIFFERENT MARKETS
Preview
Introduction, Meaning of Market, Traditional view, Modern View, Classification of Markets

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

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

(a) It is not necessary that market for a commodity should always be located on a particular
street or in a building.
(b) The buyers and sellers may be away form each other and yet they may constitute a
market over telephone or through internet.
(c) When buyers and sellers are in close contact with each other, 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'.
If this meaning is accepted, the entire world may be described as a single market.

4. 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. The Classical economists assumed
the existence of perfect competition, and all their analysis is based on this assumption. The
dream of the Classical economists is, however, hardly realized in practice. It has been pointed out
that the real world is full of imperfect competition. In particular, Mrs. Joan Robinson of the Cambridge
University and Prof. Edward Chamberlin of Harward University have done a pioneering analysis of
imperfect competition. Based on their analysis, competition in the market is classified as under.
(A) Pure and Perfect Competition : Usually, a distinction is made in economic theory
between pure competition and perfect competition. The concept of perfect competition is
much broader in scope than pure competition. It includes all the features of pure competition
plus some more features of the two forms; let us discuss first the features of pure competition.
a) Large Number of Buyers & Sellers (Firms)

The number of buyers and sellers operating under pure competition is very large.
The position of an individual seller is like a drop in the ocean. An individual seller
cannot, therefore, fix the price nor can he change it by his individual action. Similarly,
no single buyer can fix the price or change it by his action. Even if he increases or
reduces his demand, it does not make any effect on the total demand in the market.
Price of a product is determined by the interaction of total demand and total supply
in the market. Naturally, it is beyond the capacity of an individual seller or a buyer
to determine or influence the price. Every seller and a buyer under pure competition
is a Price-Taker and not a Price-Maker.
b) Homogeneous Products
The products sold by different sellers under pure competition are homogeneous i.e.
exactly alike in quality. Usually, a product which is capable of being standardized
is sold by the sellers. For example, rice produced in different parts of India is
classified under different standard grades such as Resham Basamati, Kamod,

Kali, Much, Ambemohor etc. Since every buyer is buying the standard variety, he
does not bother to know as to which particular farmer has grown that rice. He is
interested in ensuring that all the rice in the bag is homogeneous, i.e. exactly alike
in quality.
c) Free Entry & Free Exit of Firms

Another important feature of pure competition is that there is free entry and exit of
firms. An entrepreneur who has the necessary capital and skill can start any
business of his choice. In every industry, new firms are, therefore, opened from
time to time. Similarly, an existing producer is free to close down his business if he
so chooses. As a result, some firms are going out of the industry. Since there are
no hindrances to the entry of new firms and exist of existing firms, the number of
total firms under pure competition always remains very large.
(C) Perfect Competition : It has been already remarked that the concept of perfect
competition is broader than pure competition. This means that perfect competition does
exhibit the above features of pure competition viz. large number of buyers and sellers,
homogeneous products and free entry and exist of firms. In addition to these, perfect
competition exhibits the following features.
a) Perfect Knowledge
All the buyers and sellers operating under perfect competition have perfect knowledge
of the market conditions. For example, every seller knows the total quantity supplied
and sold on a particular day or during a week. Similarly, every buyer knows what is
happening in the other corner of the market.
b) No Discrimination
Under perfect competition, no seller should discriminate between buyers. He cannot
say that he would sell his product only to white and handsome people; and not to
the black and ugly people. The seller must deliver the goods so long as every
buyer, visiting his shop, is willing to pay the required price. Similarly, no buyer
would discriminate between sellers. He cannot say that he would buy only from a
particular seller and that he would not buy from others. 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, it is assumed that the cost of transportation does not
exist for carrying goods from one place to another.
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. For example, a worker would migrate

from industry can be diverted to another industry if the return on investment is going
to be higher. 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, by self-interest and profit-motive, the principle so
nicely elaborated by Adam Smith in his Book, 'Wealth of Nations'.
e) Automatic Price Mechanism
The most significant feature of perfect competition is the existence of an automatic

price mechanism. Price of a product is determined by the interaction of total demand
and total supply in the market. Since there are many sellers and many buyers, no
individual seller or a buyer can fix or influence the price. The forces of demand and
supply are very powerful and always remain outside the control of an individual
seller or a buyer. Price mechanism is not only automatic but is delicate.
(D) Demand Curve under Perfect Competition : Under perfect competition, the number of
firms in the industry is very large. Each firm is very small in size. A single firm action does
not affect the market supply. Thus, each firm is a price-taker under perfect competition.
The price is determined in the market and every firm has to accept this price.
MARKET Price (AR) FIRM
Price DM
SM
(Per Unit)
PM EM OP0 AR
Perfectly Elastic
Demand Curve
SM DM
QM
O X X
O Output (Units)
Quantity Demanded/Supplied
In the fig DM DM is the market demand curve and SM SM is the market supply curve,
EM is the point of market equilibrium where market demand and a market supply are
equal to OQM. This gives the equilibrium price in the market (OPM). This price is accepted
by every firm. (OP0) under perfect competition. Thus the demand curve of the firm is
perfectly elastic under perfect competition.
(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. Then buyers and sellers have perfect knowledge of the conditions prevailing
in different parts of the market. All the sellers are selling homogeneous products which are
exactly alike in quality. Moreover, no seller would discriminate between buyers and no buyer

would discriminate between sellers. That is to say, a seller has no reason to refuse to sell to
a particular buyer who is willing to pay the required price. Similarly, no buyer would hesitate to
buy form a particular seller who is charging the same price. Under perfect competition, no
buyer or seller can fix the price of a product, nor can he influence it by his own action. 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.
It is, therefore, worthwhile to explain the working of the price mechanism under perfect
competition.
General Rule Of Price Determination :
Under Perfect Competition, generally, demand and supply play an equally important role in
determining the price. They act and react upon each other and determine the price at the equilibrium
point. This is called Equilibrium Price. Determination of equilibrium price can be explained with the
help of the following demand and supply schedule and demand and supply curves.
Demand for & Supply of Textiles
Price Quantity Demanded Quantity Supplied

(Rs. Per metre) (million metres) (million metres)
250 19 28
240 20 26
230 22 22
220 25 17
210 30 10
The above demand schedule can be shown with the help of the following diagram.
Equilibrium Price
Y
D
S
Price per unit
P E
S
D
X
O M

In the figure quantity demanded and sold is shown on the X- axis and the price is shown on the
Y- axis. DD is the demand curve showing total demand at different prices, and SS is the
supply curve representing the quantity supplied at different prices. The demand curve and the
supply curve balance each other at point E. This point is called on Equilibrium point. Under
perfect competition, the equilibrium price would, therefore, be Rs.230/- per metre and at this
price quantity OM would be sold in the market.
Changes in Equilibrium Price :
The equilibrium price, determined by the interaction of demand and supply need not remain
constant. It can change with every change in the relative positions of demand supply. For
example, if some festival is forthcoming, demand for a product would increase. The supply
being constant, price would rise. Similarly, during a slack season, demand may fall, but
supply being constant, price would fall, Changes in supply would also influence the equilibrium
price. For example, in a particular year, the cotton crop may be affected on account of natural
calamities. Supply of cotton in this case is reduced; but demand being constant, price of
cotton textiles would rise. There is a third possibility; demand and supply may both change
simultaneously. In all the three cases, the equilibrium price would change. It is worthwhile to
see how changes in demand, changes in supply and changes in both, affect the equilibrium
price.
(A) Changes in Demand

Changes in Demand
Y
D1 S
D
Price Per Unit
P1 F
P E
D1
S D
X
O M M1
In figure changes in demand are shown by different demand curves DD and D1D1. The
supply is shown by the supply curve SS. Demand for a product may increase on account
of a festival, growth of population or on account of some other factor. In figure original
equilibrium price is shown at point E i.e. OP. But on account of a higher demand curve

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

Changes in Demand and Supply
Y
D D1 S
S1
Price Per Unit

P1 E1
P E
D1
S
S1 D
O X
M M1
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.'
(e) If demand increases, supply being constant, the price would rise. If demand falls, supply
being constant, price would fall.
(f) If supply is reduced, demand being constant, price would rise and if supply increases,
demand being constant, the price would fall.
(g) 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.

(i) 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 S
D
D1
Price Per Unit
P2
P1 D2
D
D1
X
O S
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.

(ii) 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
D
Price Per Unit
D
S
X
O Q
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 :

Long Run Normal Price
Y
D11
D1
D
Price Per Unit
P S
D11
D D1
X
O
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.
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

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.

Equilibrium of Firm :
There are two methods to study the equilibrium of a firm. Viz.
(a) Total Cost and Total Revenue method, and
(b) 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) It is presumed that a firm is managed as a sole proprietary concern. This would enable
us to study the behaviour of an individual.
(ii) 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) Marginal Revenue should be equal to Marginal Cost i.e. MR = MC

(ii) 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
Y
MC
Cost/Revenue
G AC
Q S
T
E K
R
D AR
H
MR
O X
L M N
Output

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
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.,

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

Short-Run Equilibrium of a Firm
Y
MC AC
Q
P1 L1 (AR) = MR
Price Cost / Revenue

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

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

earn only the normal profit. Similarly, if the price is less than the average cost, losses
would occur and this may drive some of the firms out of the industry. The firm's equilibrium
under perfect competition in the long run is shown in the following diagram.
In the following figure, marginal cost, marginal revenue and price are all equal at point E.
The firm is, therefore, in equilibrium in the long run when its output is OM and price is OP.
Y Long - Run Equilibrium of a Firm

P AR = MR = Price
X
M
Output (units)
Equilibrium of Industry
When all the firms engaged in an industry are in equilibrium, the industry as a whole is
in equilibrium. This means that equilibrium is established by total supply and total demand
in the industry.
If demand is more than the supply, production may be increased, Conversely, if demand
is less than the supply, output may be curtailed. Such changes in the output can not
take place when the industry is in equilibrium. Equilibrium of the industry is determined
by total demand and total supply. The price is also fixed by total demand and total
supply of the industry; and not by any single firm. It is, therefore, necessary that, for
equilibrium of the industry size of production should be stabilized at a certain point.
There should be no tendency for firms to increase or curtail their output. When ideal size
of output is achieved, 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. Thus, when output is
stabilized at the optimum point, marginal cost will be equal to marginal revenue and the
firm would earn only normal profit. All the firms would earn normal profits. If they earn
super-normal profits or incur losses, it would lead to an entry or exit of firms; ultimately,
equilibrium of the industry would be disturbed.

Conclusion
It will be seen form the foregoing discussion that a firm maximizes its profit and achieves an
equilibrium position when its marginal cost, is equal to marginal revenue. When all the firms in
an industry are in equilibrium, the industry as a whole is also in equilibrium. In the long-run
equilibrium of an industry, output is stabilized at an optimum or ideal size and there is no entry
or exit of firms; because in the long run every firm is earning only the normal profit.
(B) Imperfect Competition :
In the real world, perfect competition is seldom realized. What we experience is the imperfect
competition in its several forms. In the 20th century, markets all over the world have become
imperfect on account of several factors. Buyers and sellers do not possess perfect knowledge
and the products sold are no more homogeneous. They are often differentiated as to their
size, design and colour. The number of buyers and sellers is also small. Depending on the
number of sellers operating in the market, 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, is the one where there is absence of any competition.
This is a situation, where there is only one producer, it is called Monopoly.
(a) Pure and Perfect Monopoly

For pure monopoly to exist, the following conditions must be satisfied :
(i) One firm producing in the market,
(ii) The commodity produced should have no substitute.
(b) Impure Monopoly

Impure or simple monopoly exists in the market of a commodity, where there is
only one producer of the commodity; and the commodity has no close substitute.
Since there is only one producer, the distinction between the firm and the industry
does not exist under monopoly.
(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. The producer may be an individual, a partnership firm, the Government
or a Joint-stock Company.
(ii) No Close Substituties : To avoid any possibility of competition in the market,
there should be no close substitutes for the product of the monopolist. This
means that the cross-elasticity of demand for the monopolists product is low.

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

Monopoly differs from perfect competition in the following important respects.
(a) Under perfect competition, there are many buyers and many sellers. No individual
seller or buyer is able to fix or change the market price. The price under perfect
competition is fixed by the interaction of total demand and total supply in the market.
It is beyond the scope of an individual seller to influence the price by his own
action. On the other hand, under monopoly there is only one seller who is free to fix
the price, or change it, whenever he likes.

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

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

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


In the figure, E3 is the point of equilibrium, OQ3 is the equilibrium output, OP3 is the
equilibrium price.
AC = A3Q3
AR = R3Q3, AVC = R3Q3
AR < AC, the firm makes sub-normal profits equal to C3A3R3P3. Even though the firm
makes losses, it continues to produce in the short-run because AVC are covered.
Long - run equilibrium under Monopoly

A firm under monopoly may make normal profits in the long-run; however, it tries to make
super-normal (abnormal) profits in the long-run. The LRAC is flatter than the short-run
average cost curve, but the conditions of equilibrium are the same as in the short-run.
E0 is the point of equilibrium, OQ0 the equilibrium output, OP0 equilibrium price.
AR = R0Q0. AC = C0Q0, AR > AC so the firm makes super - normal profits equal to P0R0C0P.
A Fig showing Long Run Equilibrium under Monopoly

Y
LRMC
Ro
Po
LRAC
P
Co
Eo
AR
MR
MC
O Qo
Output (units)
(f) Price Discrimination Under Monopoly :
INTRODUCTION
By following Trial and Error method, a monopolist fixes the price of his product so as to
maximize his profit. There is a second alternative open to the monopolist. He can discriminate
between buyers and charge different prices to different customers. This is called Price
Discrimination or Discriminating Monopoly. An attempt should, therefore, be made to explain
how price discrimination is practiced by the monopolist.

(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. One market segment may consist of poor, whereas
another market segment may be inhabited by the rich. 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.
Examples of price discrimination are many. A surgeon may charge Rs. 5000/- for operating
a middle class patient, whereas he may charge Rs. 10000/- for the similar operation of a
rich patient. The skill used in both the operations is the same; but the fees charged to
different patients are different. Similarly, different prices are charged by a cinema house
for different classes of viewers. All the viewers see the same movie; but they have to pay
a higher price for occupying a seat in the first class or balcony. Railway companies also
charge different fares to first class, second class and air-conditioned class passengers.
As a matter of fact, the passengers in different compartments reach the destination at
the same time. But they have to pay different fares for traveling by II class, I class or AC
class. Similarly, an electricity company can charge lower rates for domestic consumption
and higher rates for commercial consumption.
Although there is some difference in the comforts provided to different classes of
customers, this difference is negligible. Difference in the prices charged is, however,
substantial. Thus, a monopolist can charge different prices to different segments of
markets so as to maximize his profit.
(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, cooking gas supply
companies are allowed under Law to charge different prices to different classes of
consumers.
(b) Nature of Commodity :
Price discrimination is possible where personal service sold to the customers cannot
be resold. Thus a surgeon may charge a lower fee for operation of a poor patient
than a rich patient for similar operation. Similarly, an advocate may charge very
high fees to a rich client, whereas he may charge a lower fee to a poor client for a
similar court litigation.
(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. In

international trade, markets are separated by raising the protection wall and different
custom duties are charged on the imports from different countries.
(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. Ignorance of consumers thus enables the
monopolist to charge different prices. Sometimes, the consumers may exhibit an
irrational feeling that they are paying a higher price for better quality of goods. It is
likely that the customers may know that a lower price for bertter quality of goods. It
is likely that the customers may know that a lower price is being charged in another
market; but the difference in price being negligible they may not go to the other
market. This may enable the monopolist to charge different prices in different markets.
(3) Conditions of Price Discrimination

The foregoing discussion should explain the situations when price discrimination is possible.
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. i.e. There
should be no contact between buyers in the two markets. If buyers in one market
know that the price charged in another market is lower, they would buy the product
in another market and sell it in their own market. This will lead to equality of price in
both the markets and price discrimination would no more be possible. No possibility
of resale of the product.
(b) The elasticity of demand in different markets should be different. Price discrimination
may not be possible if elasticity of demand is the same in both the markets.
(c) Market must be imperfect.
(4) When is it Profitable?

Having known the conditions of price discrimination, it is worthwhile to know when it is
profitable to the monopolist. In other words, it is necessary to study the position of
equilibrium when the monopolist maximizes his profit. The principles which apply to the
equilibrium of a firm are also applicable in this case. An additional assumption to be
made here is that the monopolist is selling his product in two different markets. This
would make our analysis complicated but it does not affect the basic principle of
equilibrium, viz. a firm is in equilibrium when its marginal cost is equal to marginal
revenue. One more assumption is that the elasticity of demand in two different markets
is different.
(5) Conditions of equilibrium under price-discrimination

(a) MR = MC (B) MRA = MRB where A and B are two markets.

On the basis of these assumptions, let us understand when price discrimination would
be profitable.
Let us presume that the monopolist sells his product in market A and market B. Demand
in market A is inelastic or rigid and demand in market B is very elastic i.e. responsive to
the changes in price. Under such circumstances the monopolist would raise the price in
market A. His sales in this market would not be affected because demand is inelastic.
On the other hand, the demand in market B being elastic, a slight reduction in the price
would increase the sales. The monopolist would, therefore, raise the price in market A
and would reduce it in market B. The volume of sales in market A would remain more or
less the same, but sales in market B will increase, on account of reduction in the price
would increase the sales. The monopolist would, therefore, raise the price in market A and
would reduce it in market B. The volume of sales in market A would remain more or less
the same, but sales in market B will increase, on account of reduction in the price. Naturally,
the monopolist would have to divert the supply form market A to market B. If sales in
market A are slightly reduced on account of higher price, this loss would be compensated
by an increase in sales in market B. 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. The transfer of supply from market A
to market B would be stopped when marginal revenue in both the markets is equal. At this
point, total profit earned by the monopolist is maximum and he is in equilibrium.
(6) Equilibrium under Discriminating Monopoly

Y Y Y
Price /Cost/Revenue
Price /Cost/Revenue
Price /Cost/Revenue
MC
P1 P2
E1 E2 C
E
AR2 MR
AR1
MR 2
MR 1
O Q1 X Q2
X O Q
X
O
Output Output Output
Market A Market B Total A+B (figure 3)
Consider two markets, market A with relatively inelastic demand and market B with
relatively elastic demand.
In figure 3, E is the point of equilibrium where MR = MC, OQ is the total output of the firm.
This is to be sold in the two markets at different prices.
In Market B, 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.

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

(9) Conclusion
Thus a monopolist can practice price discrimination by charging different prices to different
customers. It is also practiced under dumping where different prices are charged in
international and the home market. Such price discrimination,
(a) adds to the power of the monopolist,
(b) adds to the profit of the monopolist, and
(c) adds to the total output than the output under pure monopoly.
2) Monopolistic Competition - 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. There may be 20-25 sellers engaged
in the same line of business. They are producing commodities which are close
substitutes for each other. Every seller has to compete with others to increase his
sales. Since every seller is selling a standardized product for a long time, he acquires
monopoly of that product. When such monopolistic producers are competing
amongst themselves, it is called monopolistic competition. The competition being
very keen, the sellers have to find out different methods to maintain their sales and
profit. Professor Chamberlin has elegantly shown the methods used by such
monopolistic producers. Most of these methods are hazardous and each seller
tries to be rich at the cost of others. This competition is, therefore, called cut-throat
competition and the methods followed are called 'Beggar thy Neighbour tactics'. It
is worthwhile to outline the salient features and the methods of monopolistic
competition.
(ii) Product Differentiation

Under monopolistic competition, every seller tries to distinguish his product from
the products manufactured by others. He claims that his Research and Development
Department has developed a new product after considerable research. As a matter
of fact, the product so introduced in the market is not new. The same old product is
sold under a different trade name, style, design and colour. Thus, by changing the
outward appearance of the product, the general public is made to believe that it is
a new product. Basically, it does not differ in quality and the process of manufacture.
But the people are fooled by stating that it is a product different than the old one.
This is called Product Differentiation. For example, Hindustan Lever Ltd. sells bathing
soaps under different trade marks such as Lux and Rexona. Basic contents and
ingredients in both the soaps are the same. They different. Lux may be used by
one popular actress, whereas Rexona may be used by another popular actress

from the films. Differences thus exist only in outward appearance, not in their contents.
Such a method of product differentiation helps the producers under monopolistic
competition to increase their total sales.
(iii) Selling Costs
Every producer operating under monopolistic competition spends huge amounts

on publicity. He follows all the media of advertising such as press, radio, television,
hoarding, sites, neon signs etc. Every effort is made to keep the product before the
eyes of the consumers, throughout the year. Whether he likes it or not, he has to
spend huge amounts on publicity. This is because when others are spending, he
cannot afford to lag behind in the race. Every producer therefore attempts to spend
more than his rivals.
(iv) Multiplicity of Prices
Due to factor-immobilities, or transport costs or ignorance of market, a single uniform

price cannot be established in the market characterised by monopolistic competition.
On the contrary, similar products which are differentiated by brand names and
advertisements are sold at different prices. Every producer enjoys the freedom to
price his own product; this freedom is within certain limits. Every producer has his
own price-policy. Under perfect competition, this freedom is not available to an
individual firm.
(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. Because, the products
of all firms are not identical, buyers can have preferences. 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. Therefore, under monopolistic competition, the
Average Revenue Curve of a firm is not parallel to the X-axis as it is under perfect
competition. Under monopoly, the Average Revenue Curve of the firm is steep because
there are no close substitutes for the product. Under monopolistic competition, on
the other hand, a firm’s product does have close subsitutes, and therefore, the
Average Revenue Curve cannot be steep. Thus, the AR Curve faced by a firm under
monopolistic competition is shallow indicating a highly elastic demand. Therefore,
if a firm reduces the price of its product while prices of rival products are unchanged,
there would a sizable increase in the sales of the firm.

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

(viii) Unfair Methods
Under cut-throat competition, a number of unfair methods are used to extinguish

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

by product differentiation, selling costs, price war and unfair methods. It is worthwhile
to see how price of a product is determined under monopolistic competition.
Every producer operating under monopolistic competition is selling his product

under a particular brand or trade name. Before, fixing the price he has to take into

account the prices of substitutes. The prices charged by rivals enable him to fix his
price. A producer who has introduced a new product in the market, would necessarily
fix the price which is lower than the price charged by his rivals. The price, fixed in
this manner, may not, however, remain constant. The producer may be required to
reduce his price, if the competitors have reduced their respective prices. Although
an individual producer, under monopolistic competition, is free to fix his price, he
cannot fix it without taking into account the prices charged by rivals. The price
policy under monopolistic competition is thus dependent on the prices charged by
other rival firms. It is, therefore, worthwhile to see how price is fixed and the equilibrium
position is reached under monopolistic competition in the short-run.
Short-run Equilibrium under Monopolistic Competition
Under monopolistic competition, equilibrium of a firm is arrived at in the same manner as

under other forms of competition. A firm's profit is maximum and the firm is in equilibrium
when its marginal cost is equal to marginal revenue. This would be clear form the following
diagram :
Short - Run Equilibrium

Under Monopolistic Competition : Profit
In figure, MR is the marginal revenue curve and AR is the average revenue curve. Similarly,
AC is the average cost curve and MC is the marginal cost curve. Here, the price is OP
and the total profit is TSPP'. The profit is shown by the shaded area. This profit is
supernormal. An existing firm can also incur losses in the short- run. If the position of
demand and cost is unfavorable, the firm may incur losses as shown below :

Losses under Monopolistic Competition
Y
MC
AC
T
P
S
P1
E
AR
MR
X
O
Output
In figure, AC is the average cost curve and it is higher than the average revenue curve AR.
Here the firm would incur a loss of STPP'. Thus, 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.
Long-run Equilibrium under Monopolistic Competition

The supernormal profit earned by a firm may not last long; because new firms may be
attracted to the industry, and the excess profits would be shared between existing and
new firms. The supernormal profits earned in the short-run would, therefore, disappear in
the long-run. Another characteristic of long term equilibrium is that a number of substitutes
are available in the market. The marginal revenue curve is, therefore, elastic. The following
figure would show how the firm would earn normal profits under long-run equilibrium.
Long Run Equilibrium under Monopolistic Competition

Y
MC
AC
Cost/Price/Revenue
T
P
E
AR
MR
X
O M
Output

In figure, AR is the average revenue curve and MR is the marginal revenue curve. Similarly,
MC is marginal cost curve and AC is the average cost curve. The average cost curve
touches the average revenue curve at point T. At point E, MC = MR, OM is the ideal
output and OP is the price. At this price and output the firm's profit is maximum and it is
in equilibrium.
(2) Group Equilibrium under Monopolistic Competition

We have seen how equilibrium of a firm is reached under monopolistic competition.
We have now to see how and when the equilibrium of all the firms is reached. Under
monopolistic competition the number of sellers is large and each seller is selling
his product under a particular Trade name. These products are not homogeneous,
but are differentiated from each other. It is therefore, difficult to analyse the conditions
of group equilibrium where different firms are selling different products. For the sake
of simplicity of analysis, we would, therefore, make the following assumptions :
(a) Competing firms are selling more or less the same product.
(b) The share of every firm in the total sales is equal.
(c) All firms are working with same efficiency.
(d) The number of sellers is large and there is free entry and exit of firms.
Under these assumptions, let us see how group equilibrium is reached. If these
firms are earning supernormal profits in the short-run new firms may be attracted to
the industry. The new firms would charge a lower price so as to secure some
customers. This will compel the old existing firms to reduce their prices. Naturally,
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. Thus, when all the
firms are earning normal profit, the long-run group equilibrium would be reached.
This position is similar to the one prevailing under perfect competition. The only
difference is that under perfect competition, output is very large, whereas under
monopolistic competition output is much less. 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.
(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. However, the price-output situation is different in the two cases.
This is seen clearly in figure.

Y
RMC
Cost/Price/Revenue RAC
E1
Pm Ep
Pp ARp = MRp
Em
ARm
MRm
X
O Qm Qp
Output
The description of the figure showing the comparison between Long run equilibrium under
perfect competition and monopolistic competition is as below.
Perfect Competition Monopolistic Competition

1. ARp = MRp (i.e. average revenue 1. ARm (i.e. average revenue is falling)
equals marginal revenue) MRm (marginal revenue is below the
average revenue.)
2. Ep equilibrium where LRMC = MRp 2. Em equilibrium where LRMC = MRm
3. OQp equilibrium output. (also optimum 3. OQm equilibrium output (less than
output because LRMC is minimum at optimum output OQp)
this output).
4. OQp > OQm Output under perfect 4. OQm < OQp Output under monopolistic
competition is more than output under competition is less than under perfect
monopolistic competition. competition.
5. Full capacity used up because 5. Waste of capacity is equal to Qm Qp
equilibrium output is optimum output. because equilibrium output is less than
optimum output. "Wastes of
competition."
6. Firm is in full - equilibrium 6. Firm not in full equilibrium.
ARp = MRp = LRMC - LRAC
7. OPp equilibrium price is less than price 7. OPm equilibrium price is more than OPp
OPm under monopolistic competition. price under perfect competition.
8. Firm makes normal profits. 8. Firm makes normal profits.
(ARp = AC - Ep Qp) at OQp output. (ARm = AC = E1Qm) at OQm output.

We can the conclude, that, the long - run price is lower and output is higher under perfect
competition as compared to under monopolistic competition.
3) Monopsony
Another type of imperfect competition is called Monopsony. Under Monopsony, there

are many sellers but only one buyer. The buyer is influential and determines the price of
the product. He may exploit the sellers by offering a very low price. An example of
monopsony in India is provided by the Cotton Corporation of India who purchases all
cotton grown by the farmers. Since there is only one buyer the CCI can influence the
prices of cotton. Monopsony is the opposite form of Monopoly.
4) Oligopoly and Duopoly :

Oligopoly is a type of imperfect market. A few firms exist in the industry. An extreme
case of Oligopoly is Duopoly since Duopoly is an extension of an oligopoly market, it is
not necessary to discuss its features separately, where only two firms exist in the market.
The following are the features of Oligopoly :

(i) Small number of Producers : The small number of firm dominates the market of
the commodity. Each firm has a large share of market supply, therefore, all firms
action results in a reaction of other firms in the market. This means that firm under
Oligopoly are mutually dependent on each other. In Duopoly, the number of firms is
two. These firms are also dependent on each other.
(ii) Product may be homogenous or there may be product differentiation :

Duopolistic or Oligopolistic firms producing raw materials or intermediate products,
generally produce homogeneous products, as for example, the production of coal,
copper or any other metal; whereas, firms producing automobiles, computers are
firms which differentiate amongst their products.
(iii) Restrictions to Entry : Under Duopoly and Oligopoly, there are restrictions to the
entry of new firm into the industry. These restrictions are generally financial or
technological in nature. However, entry is not impossible under Oligopoly / Duopoly
but it is difficult.
(iv) Advertisement : If product differentiation exists, it becomes necessary to advertise

the firms product. This is done to convince the buyers about the superiority of the
product over the products of rival firms. However, if the products are homogeneous
advertisement may take the form of informative advertisement.
(v) Price - Control : Firms under oligopoly / duopoly are mutually dependent. Thus all
firms actions results in the reaction by other firms.

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

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

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

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.
Many times the consumers do not know what they need. It is the producers who have
to make the consumers aware of their needs. This is done through selling costs.
Sales promotion includes not only taking 'orders' for their goods but also creating
demand for their goods. Under conditions of perfect - competition, 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. Selling costs is a feature
of an imperfect market condition.
Selling costs include not only cost on advertisement (which forms a large part of
selling costs), but also salaries of sales - managers and sales- representatives,
cost on exhibitions, show - room expenditure, cost on attractive wrappings, gifts,
etc., thus any expenditure which the firm makes, in order to promote its sales, is
selling cost.
(ii) Selling - cost curve is U - shaped :
Y
Selling Cost
O S1 X
Quantity Sold
As the sales of the firm increase, the average selling cost (ASC) first decreases
(upto OS1 sales), and then the ASC increases (after OS1 sales), thus the ASC
curve is a U-shaped curve.
Total Selling Cost

ASC = –––––––––––––––
Quantity Sold
ASC decreases upto OS1 sales because of -
(i) Economies of specialization : As output and sales increase, a large amount is

used for promoting sales and the firm can employ experts to increase its sales or

it can advertise through mass media. These methods of promoting sales are
expensive but the sales increase to an extent that the average selling cost (ASC)
decreases.
(ii) Economies of repetition : As a firm advertising, initially it does not influence the
minds of the consumers. But repeated advertising, slowly has an impact on the
minds of the consumers and the sales increase. And ASC decreases.
ASC increases beyond OS1 sales because of -
(i) Difficulties in trying to influence the buyers' preferences : Once the weak
consumers are influenced, it is difficult to influence the more 'hardened' consumers
(who are already using another brand of the product), and so the expenditure on
sales increases but sales do not increase much. The ASC therefore, increases.
(ii) Counter - advertisement by competitors : Once a producer reaches a high level

of sales, his competitors are affected and they try to defend themselves by advertising
their product. The producer now has to spend more money to increase the sales.
The ASC increases.
(iii) Factors influencing selling costs :
(1) Type of Product : With product differentiation, the sale - expenditure increases.
(2) Introduction of new goods : Firms producing commodities, like clothes,

cosmetics, where the fashion and styles charge, have to bear large selling costs.
(3) Technology changes : Firms producing commodities, like machines, also

have to resort to advertisement, but this is of the informative type.
(4) Other factors : The number of competitors, the psychology of the consumers,
the elasticity of demand and promotional elasticity of a product also affect the
selling costs of a firm.
(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.
(1) The demand curve shifts to the right : Selling costs result in higher quantity
being demanded at every price. So, the original demand curve DD shifts to the
right to D1D1.
(2) The demand curve becomes relatively inelastic (Steeper) : Selling Costs
result in consumer preferences being stronger. If a consumer likes a particular

brand of a product, a charge in the price of the product will not affect the
quantity demanded of the product, by the consumer. The demand becomes
relatively inelastic (Steeper). In the figure the original demand curve DD is less
steeper (less inelastic) than the new demand curve D1D1.
Price per unit Y
Effect of Selling Costs on

X
the Demand Curve of a firm
Quantity Demanded
The average cost curve of the firm, AC, moves upwards to AC1 because of
selling costs as shown in the following figure :
Y
Average Cost
O X
Production
(v) Effect of Selling costs on the Price of the Product :

The selling costs are initially borne by the producers, but ultimately they are passed
- on to the consumers in the form of a higher price of the product. This is possible
because through selling costs, the demand for the firm's product becomes relatively
inelastic, because consumer preferences become stronger.
(b) Non - Price Competition :

We have seen earlier that under monopolist competition the sellers reduce their
prices in order to attract new customers. The reduction in price may go to such an
extent that it may become a price war. Since this type of competition is based on
price reduction, it is called ' price competition'.

Price competition is, however harmful to all the sellers. Instead of competing by
price - reduction they, therefore, use some other methods. When they compete on
grounds other than the price, it is called 'Non-Price Competition'. Non-Price
Competitions is usually practiced through advertising or gift articles.
It is true that spending large amounts on advertising or gift articles amounts to

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

contests for children. An essential condition is that the entry form to be
submitted in the contest, is to be accompanied by a certain number of used
wrappers companies like Nescafe or Cadbury organize such contests. The

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

Thus under imperfect competition, inefficiency is worshipped and efficiency is
dispensed with.
PRICING METHODS OR PRICING PRACTICES
INTRODUCTION
As already discussed, firms pursue a variety of objectives with different weightages to different
objectives. The pricing policy of a firm must therefore conform to the composite objective
accepted by a firm. This can be ensured by following certain guidelines or 'pricing objectives'.
Several such pricing objectives have been suggested; and are actually being pursued by
firms. One such pricing objective is stability. Firms tend to keep-prices stable and short-run
fluctuations in costs, demand etc. are not allowed to influence the price. Maintaining one's
share of the market is another such objective. This is a norm which can be monitored and
hence is accepted as an important one. A decline in the market share can be taken as an
indication of falling popularity of the product. Target Return on Capital is another objective
adopted by firms. A certain target rate of return on capital provides a guarantee of a floor limit.
Pricing policy also, at times, aims at meeting or preventing competition as a goal. This approach
underlines a long-run view of the pricing policy. Finally, when private firms help the government
in carrying out socio-economic programmes like supply of medicines or school books or
nutrition's food etc., they follow the principle of Ethical Pricing, i.e. reasonableness of pricing
that would create a good image of the firm.
The aforesaid principles act as pointers to a proper pricing policy. The method of pricing to be
chosen is a major decision. Basically there are two methods of deciding the selling
price : 1) Full Cost Pricing and 2) Marginal Cost Pricing. In the first one, cost is the
decisive factor; while in the second one, various other consideration are involved.
1) FULL COST OR COST PLUS PRICING

According to this method, the price is set to cover costs; material, labour, overheads and
a certain percentage of profit. Costs to be included in the price are normally actual
costs, expected costs or standard costs. Actual costs are costs actually incurred in the
production period. Expected costs are based on forecasts of production and prices.
Standard costs are based on the forecasts made on the basis of the assumption that the
efficiency, sales, prices, etc., will be normal.
For the profit make-up to be included in costs, various practices are followed. Sometimes
profit is expressed as a percentage of costs.
By simple arithmetic, a formula is usually evolved. For example, let us say, a producer
produces 10 units of product X. He then estimates overhead costs, labour costs and
material cost. Supposing allocable to X and divides it by 10. This gives per unit overhead,

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

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

themselves. For example, let us suppose, the university wants to get some books
printed. 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.
(4) For Public Utility Pricing : When the Government (or a private company) supplies
public utilities like electricity, water, telephone, etc., to the people, cost of service,
is considered as the proper basis. Even when an element of profit this included in
price, the method is cost plus pricing.
Pricing of Multiple Products

The economic theory assumes that a firm produces only one homogeneous commodity.
This is done to simplify the analysis. But, in practice, a firm produces many commodities
and, in Managerial Economics, it is necessary to take cognizance of this fact and examine
the problem of pricing multiple products.
Opportunities to produce Multiple Products : A firm gets an opportunity to produce

multiple products due to the following reasons.
(1) Excess Capacity : The reason for adding a new product to the product-time is
usually to increase profits or to increase competitive strength. To attain this goal, a
firm may use its excess capacity (i.e. unused capacity to produce) if it is there.
A simple example will make this point clear. Suppose, a press printing a daily
newspaper installs new machinery which can print 1 lakh copies. This means half
the capacity of the machine is unused. To utilize this excess capacity, the press
may think of starting a new weekly, fortnightly etc.
In the above example, excess capacity in technical factor is considered. Similar,
excess capacity, may occur in the fields of management, distribution etc. The
existence of such an excess capacity provides an opportunity to add new products
to the line.
(2) Seasonal Variations : Some times the demand is specific to certain seasons, i.e.,
the commodity is in demand in a particular seasons. For instance, the demand for
umbrellas. In other seasons, the machinery and other factors may remain
unemployed. This provides an opportunity to produce some other commodities
during off season.
(3) Cyclical Changes : When demand fluctuates as a result of business cycles, i.e.,
when demand increases and decreases alternatively, the firm suffers. These ups
and downs in business are more accentuated in respect of durable consumers'
goods and luxuries. The producers of such products, therefore, may add some new
products which are not affected (or less affected) by these ups and downs in demand.

(4) Secular Shifts : When there are secular changes in conditions of demand and
supply like changes in the tastes of the consumers, income of the consumers,
availability of raw material, etc., it may be necessary to drop old products and add
new products to the line. For example, in the face of competition of mill cloth, the
handloom industry had to introduce a variety of designs to increase its competitive
strength.
(5) Vertical Integration : Vertical integration of different production processes also

offers an opportunity for increasing the number of products. For example, printing of
books and publication are two processes which can be integration if the publisher
purchases a printing press. Now, after printing all the books he is publishing, if the
press remains idle for some period of the year, this excess capacity may be utilized
by accepting outside jobs like printing of visiting cards, receipt books, hand-bills
etc.
(6) Research : Research creates new methods of production, new techniques, etc.
Old techniques then become outmoded. New products are therefore, discovered
which can be produced with the help of tile machinery, at hand.
Policy of Adding Products
In a dynamic business world, monopoly power does not last long and competition forces
firms to introduce new products. Hence, the policy of adding new products becomes
important, in practice. In selecting new product; the following problems arise.
(1) Standards of Profitability : The products to be selected are to be considered in

order of profitability - the most profitable getting priority. Here, the question is what
concept of profit should be adopted? Should the firm use 'incremental profit' as a
test? That is, should the addition product is made to bear its share of common
costs? If the new product is to be adopted temporarily, the former concept of profit
will be appropriate; but id the new product is to be added permanently, the latter
concept will be suitable.
Once the concept of profit is finalized, the problem of measurement of profit arises.
Contribution of each unit to total profits, percentage return to investment and total
money profits are the each unit to profit is a better measure of profitability. If, no the
other hand, new products are being added on a large scale, percent return to additional
investment is a desirable measure of profitability.
It is not possible to forecast the profit contribution of a product throughout its life.
But such forecasts are usually made for a period of 3 to 5 years and on that basis,
order of preferences is prepared for addition to the product-line.

(2) Product Strategy : Profit is just one consideration in the policy of adding new. But
there are other objectives as well and a strategy of choosing new products has to
be evolved, which keeps in view all these objectives. This 'strategy' has to be evolved
with an eye on the policies of rival firms.
Complementarity is an important part of this strategy. If products in a product-line

are complementary to one another, they create demand for one another. For example,
if an electric supply company starts the production of electrical appliances like
fans, irons etc., the demand for these appliances increases the demand for electricity.
Some times, it is desirable to establish the reputation that the firm supplies all
alternatives. For example, for a company producing paints and varnishes, it is
desirable that it produces all types and shades of paints. This establishes the
company's reputation and the customers rely on the company for all their
requirements
Besides the above considerations, common raw material, common processes of

production, common distribution channels, etc., are additional considerations which
are important in the product strategy.
(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.
They are : (a) Interrelation of demand characteristics : New products and existing
products may have a demand relationship of either complementarity or of alternative
character. 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. Similarly, in case of complementary goods
'we supply the whole range' is a good motto for the firm. If a firm is already producing
household appliances like choppers, mixers, toasters, etc., it is desirable to add
heaters, geysers, cookers, etc., and make the range a s complete as possible. (b)
Distinctive know-how : When a company has some distinctive know-how, it is
desirable to add products that can be based on the same know-how. For example,
a firm producing electronic appliances can add more electronic appliances only. (c)
Common production facilities : We have already seen that new products utilizing
existing production facilities and excess capacity are desirable. (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. For example, a
company producing medicines can add a few cosmetics, but not readymade
garments. (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. A textile mill can start the production of
towels and bed-sheets or raw cotton blankets. (f0 Benefit to present product lint :

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

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

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

be justified if a fall in revenue is less than the fall in costs. As against this, marginal cost refers
to the change in total revenue following a unit change in total revenue following a unit change
in output. Marginal revenue, in the same way, is a charge in total revenue following a unit
change in output. In spite of this technical difference, business discussion usually ignores the
difference and the two terms are used interchangeably. In the context of pricing, marginal cost
would be the proper expression to denote the method.
In this method of pricing, fixed costs are ignored, because marginal cost represents addition
to total cost, which takes place due to variable costs only. When fixed costs are high, full-cost
pricing is likely to make the price uncompetitive. Marginal cost pricing avoids this possibility.
Orders are not turned down because the price offered does not cover average cost. Whatever
excess of price over average variable cost is available can be used for meeting profit
requirements and contribution towards fixed costs. Marginal cost pricing helps the firm to
become more aggressive at the market. The firm can take a full-life perspective and can plan
to cover full costs over a long period. Where full-cost pricing is difficult for reasons noted
earlier, marginal cost pricing is found to be very convenient, though not necessarily satisfactory.
This method has been criticized on the following counts.

(1) In practice, this method faces many difficulties. Many business do not possess the
knowledge of finding out marginal cost and marginal revenue.
(2) Pricing has to take into account, future costs and prices. Due to uncertainties involved
on both sides, there always arises a discrepancy between planned profits and actual
profits.
(3) It is pointed out that a strict adherence to marginal cost pricing leads to frequent price
changes. Such changes are not liked by the buyers. Moreover, they create problems in
planning, distribution and credit sales and purchases.
(4) A price-cut is usually irreversible and in the absence of a necessary upward revision of
prices, the firm stands to lose.
(5) For a firm producing different products, the cost of operating this method is very high.
This is because the operation involves the creation of a machinery that calculates and
monitors demand elasticity's, sales forecasts etc.
(6) Adherence to marginal cost pricing puts the firm to losses because overhead costs are
not covered by this price.
The criticism is not fully warranted. The points that this method will put the firm to losses is
based on the assumption that MC > AC. We have seen that this holds goods only when c0sts
are diminishing. When costs are rising, MC > AC. Again, full-cost principle may suggest that
one should not produce so long as all the costs are fully covered. This is obviously wrong.
Fixed costs must be incurred even with zero production level. Wisdom, therefore, lies in

producing when incremental costs are covered. This, however, would be a short-term policy.
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.
4) SOME OTHER APPROACHES
Full-cost marginal-cost are the two basic methods we noted so far. In practice, we come
across a very wide, variety of practices in pricing. Let us consider the major approaches, to
pricing which lie at the basis of actual pricing practices. These approaches are not alternatives
but can act as complementary or supplementary to one another.
(A) Intuitive Pricing :

This psychological and subjective approach to pricing is surprisingly very common. Intuitive
pricing, as the term itself suggests, is a response or a reaction to the feel of the market.
The approach can be variously applied. Price based on pure lunch can be taken as a
starting point. At the other end, price based on full cost is taken as a basis. This price-
estimate can then be modified according to the market conditions and the nature of
competition. Thus, though the approach is intuitive, the price cannot be entirely left to
the intuition of the entrepreneur.
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, or at least, the two come very close. This is
hardly possible and requires a great deal of knowledge on the parts of both sellers and
buyers. Some managements can guess correctly the future treads in demand and
competition. Their intuitive prices prove to be successful.
(B) Experimental Pricing :

In search of an optimum price, the firm takes some cognizance of the demand for the
product, and proceeds, to fix a price by a trial- and - error method. This is experimental
pricing. Usually a sample of test markets is selected, and price is varied to see the
reactions. These reactions are observed and then a price that maximizes profits is fixed.
This method is widely used in respect of new products. This method has the potential of
providing a scientific base for pricing policy. However, in oligopolistic structure, where
buyers cannot be separated, this method has got to be applied with caution.
(C) Imitative Pricing

As the name itself suggests, the firm fixes its price equal to, or in some proportion of, the
price of another firm. We have already noted the possible price-leadership situation in
the context of oligopoly. A firm that initiates a change in price in the price-leader. Other
known as price - followers, make adequate change in price. Price-leader usually has a
large share in the market or an established reputation or a sound profit history. Others,
therefore, hope to gain by the leader's experience without risking their own market share.

Imitative pricing perhaps is the easiest method to follow and finds popularly in many
fields. Especially in retail trade or in other manufacturing areas where monopolistic
competition exists, prices are kept imitative so as not to disturb the inter-firm competitive
structure. The firm can then conveniently concentrate on non-price competition. The
disadvantage of this method is that it sacrifices flexibility and leaves no room for
adjustments as per local conditions.
5) SOME GUIDELINES FOR FIXATION
The foregoing discussion concerned some of the approaches to pricing. We shall now try to
provide practical guidelines evolved by people through their business experience. These
guidelines are important in bridging the gap between theoretical prescriptions and practical
applications.
(A) Single Product Pricing

1. Pioneering Price
Every product has a life-cycle : a product is new, it clicks and gets established; but
after some time stagnation and decline phases follow. Once this fact is accepted,
two possible approaches emerge for a pioneering price. 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. For a new product,
the demand initially is not likely to be price-elastic. A firm can decide to skim
the cream of the market by charging a high price. Subsequently price can be
reduced to reach lower income customers.
(b) Penetration Price : Alternatively a firm can begin by charging a very low price
to penetrate the market. In the short-run the firm may make losses; but in the
long-run profits can be earned. This is because, after capturing a large part of
the market, the firm can gradually raise the price. Where large-scale production
is likely to reduce costs considerably, this policy is helpful.
2. Price in Maturity
After the take-off a product reaches maturity stage. During this stage, competition
is keener, substitutes are available and preference for the product becomes weaker.
There aspects of maturity therefore become relevant for reckoning :
(a) technical maturity reflected in increasing standardization with set prototypes
and less product variation;
(b) market saturation with weakened preference and a higher ratio replacement
sales to new sales; and

(c) stability of production methods, market shares and price-structures. During
this stage, therefore, price should be set carefully by taking into account
estimated elasticity of demand, competitive degeneration as well as the
possibilities of non-price competition.
3. Cyclical Price :
In course of its life, a product experiences fluctuations in demand. Firms may
decide to respond to these fluctuations by reducing off-season prices and raising
prices when conditions are brisk. Alternatively, a firm may decide to maintain its
quality- and - price reputation by keeping the price unchanged throughout recession
and prosperity.
4. Backward Cost Pricing

When competition is keen and quality as well as price are consequential to the
buyers, a selling - price is determined first and by working backward, the product
design can be arrived at. A wide variety of products including electrical appliances
automobiles are subjected to this type of pricing; by cause the market is flooded
with competitive products.
5. Refusal Pricing
Many products are such as to serve specific needs of the users. Surgical equipment
is an example of this type. High price and profiteering cannot be followed - in such
cases. Therefore, cost plus limits as floor price are ascertained. No price-reduction
is possible. So, at less than this, he seller just refuses to supply the product.
6. Psychological Consideration
Many times producers resort to tactics which actually exploit the consumers
psychologically. Double-pricing is one such tactic. On the price-tag two prices ate
printed with upper one, which is a higher one, crossed. The consumer get a feeling
that price is lowered by the company and therefore sales get boosted. Prestige
pricing is another tactic. A high price is maintained where buyers attach prestige
considerations to the product. Customary prices are charged in respect of
commodities having kinked demand curves.
These are a few guidelines for single product, i.e. where the firm is producing a
single product. However, when a firm is producing many products-and such firms
are many - a problem of product line pricing arises.
(B) Product Line Pricing

A modern firm produces a wide range of products. Under such circumstances, the problem
of pricing these multiple products in a product line is of vital importance.

1. Alternative Policies of Price Relationship
In pricing products in a line, various alternatives are possible. Important among
them are :
(a) Price that are proportional to full cost : According to this policy common costs
are allocated to individual products. Traceable costs are then added to them
and then by6 adding a profit mark-up the selling price is fixed. This is the cost
plus price we have discussed earlier.
(b) 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 - A, B and C costs are increasing by
Rs.4,000/-, Rs.3,000/- and Rs.1000/- respectively, the expected revenue form
the three products will be distributed over these in the proportion 4:3:1. By
dividing the expected revenue from each by the units of that product, we get
the price. This removes the defect of arbitrariness in the first method. But this
does not recognize the extent of composition in the market or the elasticity of
demand.
(c) Prices with profit margins proportional to conversion costs : Conversion cost
is the cost of converting raw material into final product. This may not be the
same for all the products in the line. E.g. the milk collected by a dairy can be
pasturised and bottled or can be powdered and filled into tins. The conversion
costs of these two are obviously different. If these costs are 4:6 then the profit
also may be divide in the proportion 4:6. With this profit added to costs the
price can be fixed.
(d) 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. Elastic demand has to escape with a low profit margin
while inelastic demand can be burdened with a high profit margin. Firms can
take advantage of the ignorance of customers or a desire for distinction or just
the laziness of customers. These provide opportunities for changing different
prices. The more complicated the process and design of the product the more
are opportunities for such discrimination. E.g. the price differences in the
case of A and B grade sugar cannot be much. But with different cases and
dials, two wrist-watches with the same machines can be sold at a difference
of a hundred rupees. In this method, differences in elasticity are taken maximum
advantage of.
(e) 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

of popularity then lags behind. It is possible that different products in a line are
in different stages. An old product should have a law price. A product that is on
the top of popularity can bear a high price. A new product has to be low-priced.
That is why Mr. E. S. Freeman compares a product line with a family. Young
children have a share in costs. 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. But the total cost of the family is covered by the total family
earnings. This analogy explains the price policy under consideration most
eloquently.
What each product should earn is dependent upon the nature of the competition
in the market and the elasticity of demand for each product.
2. Factors to be considered in pricing

Of the alternative pricing policies suggested above, whichever is chosen, 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. They may be complementary products,
e.g. torches and cells produced by the same company. They may be alternative
products e.g. different models of a radio set produced by the same company.
A new product can be introduced in the market by taking advantages of these
demand relationships. This is how new models of radio-sets are introduced,
or this is why a company producing tooth past introduces it s tooth brush
(complementary) and tooth powder (alternative) as well. 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.
(b) Competitive Differences : All markets where products form one product line
are sold do not have the same degree of competition. 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. The competition
also depends upon the costs of entry, the costs of acquiring new patents.
Capital and technical difficulties in starting a new firm etc. the less the
possibility of emergence of competition, the more, obvious are the opportunities
of increasing profitability by charging high prices.
(c) Cost Estimates : Each set of process will produce a particular product-mix
(i.e. proportions of sales of various products in the line) and a corresponding
total revenue and total cost. This is so because as price changes, demand
changes and so does the total revenue. Similarly, because supply changes,
costs will also change. That set of price is the best which fetches the maximum
profit. The cost estimate to be used here will be dependent on the objectives

of the firm. If for example, profits are subject to letal restriction, full cost should
be included. If using excess capacity is the objective, incremental costs are
relevant and a nominal profit will be considered satisfactory.
3. Some Problems of Product - 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. E.g. in the case of footwear for adults,
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. But if it is decided to vary
prices according to sizes, it is desirable to have a systematic pattern. E.g. if
a shirt of 75 cm is charged at Rs.40 and that of 80 cm is charged at Rs.45,
than that of 85 cm should be charged Rs.50. This has an appearance of
equity.
While pricing alternative sizes, it is advantageous to reduce the price as the

size increases. E.g. the price of a 20ml. bottle of hair oil should be less than
the price of two bottles of 100 ml. taken together. This saves packing costs
and encourages demand.
(2) Pricing Products that Differ in Quality : When there are products of different
quality in a product line, their prices will be determined in accordance with the
objectives of the firm. Sometimes the objective is to bring prestige to the
entire line. Then some high price products are kept deliberately. This increases
the sale of low and medium priced products. If a company prices its quality
neckties at Rs.50 each it can sell cheap ties in large numbers. It is these
cheap ties that really fetch profit.
If price competition is the objective the firm produces low quality products and
charges minimum prices. This enables the firm to project its image as 'a firm
charging reasonable prices'.
(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. This increases sales. This is why
prices like Rs.9.95, Rs.24.95 are charged in place of Rs.10 or Rs.25.
(4) Pricing Special Designs : When a product is custom made or prepared on

special order and specifications, what price should be charge ? As already
seen, if the customer himself is a producer, full cost price is desirable.
Alternatively, what businessmen calla 'parity price' or what economist call
'opportunity cost' should be charged.

(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. To cover such
costs concessional prices can be charged in the off-season. For instance,
fans in winter and blankets in summer can be sold at concessional prices. It
is possible to win new customers by keeping price low at a time when demand
is less. E.g. when matinee shows are screened at lower charges, it is possible
to attract spectators who are not habituals. The same group may later be
habituates and may start visiting regular shows.
(6) Pricing Repair Parts : Many firms producing spare parts earn more than firms
producing the whole machine. Because of the irregularity of demand and the
risk of obsolescence, the price of spare parts are required to be kept high. 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.
(6) Pricing in Public Sector Undertakings (PSU)
The price policy of public enterprises has special significance:

i) The price fixed by a public enterprise should be such as to enable it to raise adequate
resources for re-investment;
ii) The price policy of a public enterprise should be such as to enble it to operate at the
lowest cost possible and maximise efficiency;
iii) 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;
iv) It will have to calculate costs and benefits to the various sections of the community and
v) The price policy in a public enterprise shall have to consider the requirements of foreign
trade, competition from private enterprises, inter-enterprises relationship, etc.
All these factors make the price policy of public enterprises really significant as well as difficult
Responsibility for pricing :

In a Private company, management has the responsibility of fixing prices for the goods the
company produces, though, of course, the broad principles of the price policy are laid down
by the Board of Directors representing the general body of shareholders. In public enterprises
the pricing function is "diffused over the minister, the department and the managers". The
government has the ultimate responsibility to decide about the way a public undertaking will
conduct its affairs. This is particularly so when the quantum of profits which the undertaking
has to earn is to be decided. Even when the government, through the minister concerned,

decides about the general price- profit policy in a PSU, the actual details of the price structure
will have to be worked out by the managers of the undertaking. In general, therefore, 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.
Features of pricing in public enterprises

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

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

b) Public enterprises which produce goods and services in competition with the domestic
producers, the normal market forces of demand and supply will operate and their
productivity will be governed by the prices prevailing in the market; and
c) 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.
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, but also generate a reasonable amount of surplus""
Profit making in public enterprises is considered quite consistent in public purpose.
There may be situations where profitability in the strict sense of the term may be somewhat
of secondary importance. For instance, the prices of infrastructural services and basic
industrial and agricultural inputs, such as transport, coal, steel, petroleum products and
fertilizers, have to be regulated /administered in line with economic costs to prevent a
spiralling effect on prices. In general, 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."
With this policy, the Government took a number of decisions in raising the prices of
steel, coal, petroleum products, fertilizers, aluminium, molasses, alcohol. Similarly the
price of indigeneous crude oil was revised. These price escalations are motivated by the
desire to earn more revenue for the Government. The critics however believe that instead
of absorbing the rise in costs by improving efficiency and productivity, the govt. has been
adopting the rather easy method of raising administered prices. The Government intends
to generate more profit by the use of its monopoly power. The critics further state that
this is in direct conflict with the guidelines on pricing policy laid down by the Government.
(7) Pricing in co-operative societies
In India, the co-operative sector has expanded considerably in the last 50-70 years. However
co-operative management in India, for most of its part, has come under criticism for the lack
of professionalism, absence of marketing skills, lack of productive efficiency and cost-heavy
structures. Of late there are signs of the emergence of a professionally managed co-operative
sector. In the areas of food processing, milk production, transport, production of sugar etc.
several cooperative institutions have made their mark. Pricing of products/services in these
co-operative organizations now needs our attention.
Production in the co-operative sector, in a way, stands between that in the public sector and
the same in the private sector. Like the public sector, the co-operative sector also has to fulfill
certain social objectives and a purely commercial approach is, therefore, ruled out. At the

same time, some co-operative organizations are operating in competition with private sector
organizations and are expected to remain economically viable. As such, the pricing policy of
co-operative societies conforms to the norms of public sector pricing where the situation so
demands. Alternatively, in some cases, they have to face market competition and have to set
competitive prices or leave the prices to the market forces.
1) Cost-based pricing : In many cases, pricing aims at covering the total cost. 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.
Distribution of food grains, lift irrigation services are examples of this type. In some
cases cost-plus pricing method is followed in this case, the price is fixed to equal average
maintenance of certain quality of products/services. In the first case the price is said to
equal the average cost; while in the latter case, some profit is ensured for the organization.
In cases where all the beneficiaries are only the members of the co-operative society,
full-cost pricing (or price equating average cost) is followed. In cases where the number
of users is much larger than the number of members, cost-plus pricing is followed. The
credit and micro-credit societies belong to the former category.
2) Subsidized pricing : Many co-operative societies are following certain social objectives.
Weavers' societies, handicrafts societies or farm-service societies are examples of this
type. Such societies have objectives like providing employment, preserving traditional
skills, supplying cheap inputs or supplying onsumers products ay fair prices. Such
societies are therefore based on 'average cost minus subsidy per unit basis.
Sometimes the subsidy is available in a lumpsum and sometimes it is paid in thus form
of rebate per unit of the product sold, as in case of handloom fabrics.
3) Demand- based Pricing : In many producers 'co-operatives pricing is required to

follow the dicates of demand. In keeping with the law of demand, the price is an
important independent variable and lower the price the greater is going to be the demand.
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. Sometimes, if the society enjoys a certain
amount of monopoly, it can resort to price discrimination. Discrimination can be as
between and the rest of the society or as between different uses or as between different
places. As a case of discriminating prices one can cite the example of dual pricing of
sugar which was followed in India. I this case, the government imposed a certain
percentage of levy on sugar factories most of which are in the co-operative sector. This
levy sugar quantity was purchased by the government at a low price and was distributed
through fair - price shops at remaining sugar produced by the factories, 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

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. 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. For example, co-operatives
like Anand Milk Union Ltd. (amul) can afford to follow such practices.
4) Competitive Pricing : When a society is embarking upon a new venture, 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. When there exists competition among the
local producers, the price has got to be comparable to the range of prices of similar
products produced by other firms, For example, societies producing milk and milk
products, 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. Sometimes,
sealed bids are sell the bagasse in their factories by following this method.
The pricing methods discussed above are subject to regulations and rules framed by the
government, in this regard. CO-operatives are in the jurisdiction of the state government
in India and, in many cases, the prices charged by co-operatives need an approval of the
stat government. This is especially true in respect of prices of commodities like milk,
sugar, cotton and cotton-yarn, etc. 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.

Exercise :
1. How is the price of a product determined under conditions of perfect competition in the
short run and in the long run?
2. Explain how price is determined under monopoly? What is price discrimination? When
is it possible and profitable?
3. How is the price determined under monopolistic competition in both the short and long
run ?
4. Write Short notes on :
(a) Perfect Competition (b) Monopoly (c) Monopsony (d) Selling costs (e) Wasteges of
competition. (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. What guidelines for price fixation can be suggested?

NOTES

NOTES

NOTES

Chapter 7
COST BENEFIT ANALYSIS
Preview
Introduction, Private versus Public Goods, Government Investment, Overall Resource Allocation
-Steps in Cost-Benefit Analysis-Justification for the use of Cost-Benefit Analysis.
INTRODUCTION
The cost-benefit analysis, in a very narrow sense, would just be limited to finding out the
benefit cost ratio which happens to be a measure inter alia, to analyse various investment
opportunities and to find out the worth of each of them. However, in its broader sense, 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. In this sense, 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). It should be obvious that anybody contemplating
investment must try to judge its cost benefits. But whatever has been said here, regarding the
'broader' sense has a reference to a micro level decision, whether by a private or by a public
sector undertaking. However, in the broadest sense, the cost-benefits can be adopted on a
macro level either at the level of the economy as whole, as a part of a five year plan, 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.
1. 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. A good may be priced in the market and only those may be allowed the use of it who
pay its stipulated price. To put it differently, such a good may be priced and the principle of
exclusion may be applied to its use. Those who do not agree to pay its market price, or those
who cannot pay for it, are excluded from its use. In this way, the good becomes divisible so far
as its use is concerned. Thus, the ability to price a good, its divisibility of a good and the
Cost Benefit Analysis 257

exclusion principle, all go together. The indivisibility characteristic is also stated to mean that
each individual has an access to the entire amount of public good. His use of it does not
reduce its availability to others. Tuning in of a radio or TV programme by one does not deprive
anyone else from enjoying the same programme. On the other hand, it may be that in the
case of a certain good, some members of the society cannot be prevented from its consumption,
provided some other members have the access to its use. A typical example would be the
defence service. Once the country is protected against foreign aggression, every citizen is
more or less equally protected and benefited. A section of the society cannot be excluded
from enjoying the benefit of this protection. The defence service, in other words, is indivisible.
It cannot be priced in the market in order to deprive some members of the society from its use
or its benefits. In some cases a consumer cannot surrender the use of a service even if he
wants to. An individual cannot ask to be left undefended by the defence arrangement of the
state, or refuse the benefit of a reduction in air pollution or that of street lighting etc.
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. If, for
example, an individual does not voluntarily agree to pay the market price for the milk, the
market would refuse to supply him the required quantity. But we have seen that this exclusion
principle can not be applied to the indivisible goods. And this creates a problem of raising the
necessary finances in their case. For example, in the case of defence service, every individual
would argue that even if he does not pay for it, the supply of the service will still be there. So
he would rather avoid the payment and let others contribute for providing the defence service.
Under the influence of this argument, very few would pay voluntarily, hoping that through the
contributions and efforts of others the service will be there. This is referred to as the problems
of free riders - 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. As a result the provision of such a good or service has to be made through compulsory
contributions by the members of the society - such as through taxation.
In the case of a good which cannot be priced, the buyers would decide, through their demand,
preferences, whether or not it is to be supplied at all; and in case it is to be supplied, then they
will also decide about the quantity of its supply. But in the case of an indivisible good, such
decisions cannot be taken through market mechanism. The society has to decide the way in
which these decisions will be taken and financed and these decisions need not be unanimous.
As seen above, since very few individuals beneficiaries will be ready to pay for it voluntarily,
there is to be some form of compulsion in providing the necessary finance. The decisions
regarding these goods are, therefore, left to the government agencies.
The indivisible goods, whose benefits cannot be priced, and therefore, to which the principle of
exclusion does not apply, are called pure public goods. Pure private goods, are completely

divisible and to them the principle of exclusion applies in full measure. In the market, any one
who disagrees to pay (or cannot pay) the requisite price would be excluded from their
consumption.
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. People living near the political
boundaries of a country may, for obvious reasons, be relatively less protected. People living
near public parks are actually more benefited even when the parks are accessible to all the
members of the society. Thus, 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. The financing of the concerned
activity has to be through public expenditure and not through market pricing. This conclusion
implies that the pure public goods must be in the hands of public sector only. It, however, does
not prove as to which sector (Public or Private) should provide the pure private goods. In order
to get an answer to this question we have to consider the following additional factors:
i. 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;
ii. The political and social considerations such as the philosophy that the economy should
not be dominated by private monopolies.
iii. Additional characteristics of pure public and pure private goods.
Externalities
Another important characteristic of pure pubic goods is the existence of externalities. The
term externalities refers to the economic effects which flow from the production or use of the
good to other parties or economic units. Such economic effects may also be called spill-over
effects, neighbourhood effects or third party effects. 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 is in contrast with a technological externality in which the consumption/
production levels of an economic unit affects those of others in the economy.) This affects the
prices in the economy which in turn transmit their effects on to production and consumption
decisions of other economic units. This causes a divergence between the "internal" (or "private")
and "social" marginal costs (or benefits) of the goods in question. Thus, for example, a
powerhouse using coal would cause a lot of ash-throwing in the neighbourhood through its
chimneys. Similarly, 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. This is a cost to society but not to the individual undertakings like the power
house or the railways. Similarly, driving the smoke-emitting buses and trucks in the cities add
to the social cost of these transport facilities. An example of the externalities in the form of an

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

remembered that mostly this principle applies in reality, only to a limited extent. One cannot
say that we can keep on adding to the number of vehicles that may use the same bridge; we
cannot have the same defence budget if our population keeps on increasing, and so on. 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. Similarly, the provision of
the public goods may be increased or decreased for budgetary reasons or due to extraneous
factors. Pure public goods which possess this characteristic have a strong case for inclusion in
the public sector since public goods are indivisible also. In the case of private goods, on the
other hand, the argument is basically in the favour of large-scale production - for which either the
society should agree to monopolistic type of private enterprise or should go in for public sector.
Decreasing Average cost

Another likely characteristic of pure public goods is that it would be subject to the law of
decreasing costs. Being lumpy, it would be subject to the economies of scale. If the public
good is provided in small units, then the average cost is likely to be much more. For example,
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. When it comes to the choice between public and
private sectors for the provision of goods possessing this characteristic, considerations similar
to the ones mentioned above in the case of 'Marginal cost' characteristic apply.
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, it is highly difficult to come across pure
private goods. In general most goods possess elements of both 'publicness' and 'privateness'.
The difference between goods is mostly of degree and not of kind. 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). If the elements of 'publicness' are predominant in
the mixture of characteristics of a good, then it may be termed a public good; and in the
opposite case, a private good.
2. 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. Investment analysis is very important but very difficult due to
the elements of uncertainty, changing value of money etc., as discussed above. besides,
there are capital constraints and social costs and benefits involved. steps above. Besides
there are capital constraints and social costs and benefits involved. Steps involved in the cost-
benefit analysis are, in fact, the steps involved in capital budgeting and then in analysing
various projects from the point of view of an individual investor. The cost -benefit analysis as
a method for investment analysis can proceed along the following steps:

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. In doing so, he
has to keep in mind the size of the investments he has contemplated and his own
expertise and interest. For this purpose, the investor can get the necessary information
from development organizations who are engaged in developing project profiles. He can
also borrow ideas from the established and reputed investors within and outside the
country. It is possible that he has some new project ideas. Whatever the case, 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.
2) Formulation of the Project : Once a list of projects chosen for scrutiny is ready, with
a blue print and all details of requirements in terms of land, building, plant and machinery,
raw materials fuel, and power, labour and technocrats etc. with prices of each, one can
proceed further. 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. After
the alternatives are formulated, each of them has to be examined in terms of its feasibility.
Feasibility of implementation includes technical feasibility, i.e., the availability of land,
plant and machinery, raw materials, and technical know-how; financial feasibility, i.e.,
availability of finance in time and at reasonable rates and for desired time periods; economic
feasibility ,i.e., prospects of employment generation, development of backward areas/
social groups etc.; and management feasibility ,i.e., availability of management personnel
for implementing and running the project smoothly and professionaly. 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.
3) Appraisal and Selection of the Project : Appraisal of feasible projects refers to their
assessment in terms of economic viability. This can be done with the help of projected
cash outflows and inflows from each project and then comparing them out on merit. For
this purpose various measures used for evaluating the investment worth, including cost-
benefit analysis, can be adopted. Through this step of screening, those of the selected
projects which are viable as well as within the investment limit contemplated by the
investor are selected.
4) 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). If and where critical values are involved, each measure
would produce several outcomes. This would enable the investor to compare the rates of
return along with the risks involved. 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

acceptance of risk. One may select a project promising high returns with high uncertainty
or low profitability with low risk level.
5) Selection and Implementation: Keeping in view the funds available for investment one
or more of the projects can be selected for implementation. The selected projects will
then be implemented in accordance with the blue prints already prepared. While
implementing the project after it being commissioned, it is necessary to monitor the
project on a regular basis. This includes ensuring the projected time period involved is
observed in practice, after ascertaining the quality and quantity are as per norms assumed
and the marketing of the product industrial relations, repayment of loans and payments
of dividend follow the norms anticipated while formulating the project.
6) Mid-term Project Evaluation: A post- compilation audit of the project is the last step.
But in respect of long term projects, amid-term appraisal is always desirable. 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. 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. Such an appraisal provides
opportunity for rectifying any mistakes and improving upon the performance.
3. JUSTIFICATION FOR THE USE OF COST-BENEFIT ANALYSIS :
We have discussed above various techniques of measuring the worth of investment. However,
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. It can also incorporate other consideration besides the
monetory returns, for assessing the worth of an investment. In justification of the cost-benefits
analysis, therefore, we can enumerate the following arguments:
1) Social Costs and Benefits : As discussed in a subsequent section, the government has
to intervene, regulate and even control; the business activities even in a market-driven
economy, as and when necessary. We have also noted the distinction between private
and social costs and benefits. At the macro level it is necessary to minimize the divergence
between public and private costs and benefits. 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. However, 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. This is possible by resorting to a modified
version to reconcile the conflicting interests. This is possible by resorting to a discussed
in detail.

2) Intangible Factors : many times certain intangible factors enter into the consideration
of project appraisal and such factors are not unimportant. The prestige of the business
firm, the reputation or the image of the firm in the market, the moral of the employees,
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. Under such
circumstances, the pecuniary (ie monetary)considerations may not be proper guides for
acceptance or rejection of a project. It is true that these ultra-financial criteria are difficult
to quantify. But this cannot be an excuse for discarding them. There are ways like
shadow/pricing which can be adopted for computing costs or benefits of such intangible
factors. This is possible only with the broad-based or a comprehensive cost-benefit
analysis.
3) 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. In such a case, a
proposal with a smaller rate of return but a larger size of investment would get rejected.
Such a decision would lead some of the funds unutilized. In fact the overall profitability,
i.e., 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. Such a criterion
can be evolved with the help of cost-benefit analysis.
4) Certain Uncertainty Vs. Uncertain Certainty : uncertainty is an important element in

case of any business in the modern dynamic competitive world. But the investor would
always endeavour to minimize uncertainty. 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. As against this,
some projects would involve uncertainty which can be incorporated in the measure
adopted, as disused earlier. This (latter) then becomes a case of certain uncertainty. The
investor therefore is faced with a choice between certain uncertainty and uncertain certainty.
When guided by the cost-benefits analysis rather than by a leap in the dark(i.e. purely
subjective valuations), the investor would prefer an uncertainty which is certain i.e.,
estimable.
5) 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. Such a neglect would accentuate the gap between the organized sector and
the unorganized sector in a dualistic developing economy. 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 can act as
limping partner and thwart the pace of development. 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. 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.

6) National Industrial Policy : Every country has its own set of economic policies including
the industrial policy. 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. Besides
the industrial policy, there are other policies like the import-export policy, the MRTPA &
policies under the act, the monetory policy, the fiscal policy etc. which have a bearing on
an industry's performance. 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. Further in view of the fact that there is a divergence between
private and social costs and benefits, the policies formulated by the government contain
correctives for narrowing down the gaps between the private and the social costs/benefits.
in fact such policies are viewed as instruments of performing these tasks, inter alia. This
fact about the State policy as it effects the performance of industries justifies the cost
benefits analysis.
7) Future Disposable value : The cost- 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.
Such a regularity of analyzing costs and benefits not only helps to review the performance
but also provides basis for acquisitions and mergers etc. which have become a familiar
event in the present context of liberalization. With intense global competition and highly
dynamic changes taking place in the business world, no firm can rule out the possibility
of handing over or taking over or purchasing a share in investment of some other firm.
Under such circumstances, a scrupulously carried out cost benefit analysis on a
continuing basis has become as important prerequisite.
8) Unforeseen Circumstances : in spite of all the efforts at a systematic planning of future

steps and the incorporation of uncertainty in the investment analysis, contingencies and
eventualities may occur which were unforeseen at the time of the launching of the project.
Natural calamities, wars, mass riots etc., are such examples. Such calamities not only
demand urgent steps and expenses to make good the losses but also a quick quantification
of such losses. For this purpose cost-benefit analysis can be of great help.
4. COST-BENEFIT ANALYSIS: PRIVATE AND SOCIAL :
We have noted earlier that economics and accounting concepts of costs are different. We
also saw that the economic concept of opportunity cost is more relevant than the accounting
concept of total cost or individual resource cost. This is why, when we come to the distinction
f\between private and social cost-benefit analysis, the latter is recognized as economic cost-
benefit analysis to be contra-distinguished from financial cost-benefits analysis which his
analogous to private cost- benefit analysis.

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

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

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

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

As some exmples of the negative externalities. i.e. social costs, Prof. Samulson mentions
the air and water pollution, risks from unsafe factories or nuclear power plsnts,danger
from drunken drivers or gargantuan trucks etc. these he calls negative economies. As
positive externalities, he cities the examples of radical inventions, 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, polio,typhoid, plague etc.
All these externalities are suggestive of a market failure or an inefficiency on the part of
free markets."……… the general remedy for externalities", observes Prof. SAmulson,' is
that the externality must be somehow internalized". Interms of the diagram of divergence
between private andsocial costs/benefits, we saw that when pollution standards are
imposed, the MPD corresponds to the MSD because of the incentive to improve (or a
disincentive to degenenrate).
Private Action providing Correctives: In most of the developing countries, an action on

that part of the government would be necessary in such cases. However, in advanced
countries, where the legal and judiciary systems are transparent, private approaches
may also succeed.
i) Negotiation: One such remedy is negotiation .If a factory is polluting the water or
air of a locality, the local residents can use the company and place a claim fo
compensation. 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. This corrective ,however, has three limitations: i) the negitiatied
compensation would be less than warranted by the damage; ii) the loss o damage
must be indentifiable ; and iii) the number of firms as well as that of the affected
people must be limited.
ii) Liability Rules: where tha law clearly lays down reules regarding liability of the
person/s causing damage, the affected people can always take resourse to judicial
intervention and demand compensation. The court may order a compensation which
would fully (or partly) bridge the gap between MPD and MSD.
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. Such action may be in terms of a direct control or financial
penalties.
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. in
cases of firms or persons causing damage, the government orders to keep the
damage under specified limits which are judged to be safe. Such safe limits are

publicized and those who exceed these limits are penalized. The pollution under
control (PUC) certificate to be kept ready for examination by environment. in the
diagram we have already seen how such a standard -setting works. 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.
These limitations are: i) for choosing a minimum standard, the government has to
perform a cost-benefit analysis for which it must have full data regarding damage
and abatement costs. Such a situation is almost impossibleto obtain. ii)strictly
speaking the standard willl have to be zero, in which case the factory will ah veto be
cloe\sed down unless it invents and adopts a new pollution-free-technology. iii) The
enforcement of control is not effective enough. In fact, unless the penalty imposed
exceeds the cost of removing the short-comings, the private firms/persons will
never reach the required standards. They may opt to pay the firm and continue
doing he damage because this is a cheaper option. iv) The enforcing officials
themselves must be above suspicion, or else they could be bribed to ignore the
default, v) finally, the law fails to distinguish between large firms and small firms,
more hazardous and less harmful pollutants, and so on. Such a road roller application
of standards cannot work. Moreover, under such a system of rules, the big defaulters
escape and the small ones penalty.
ii) Externality taxes : Another way suggested by economists is the imposition of an

emission tax or an externality tax, in general. The rate of taxation will have to be
high enough to induce the firm to adhere to the standards rather then pay the tax.
This measure also suffers from certain limitation: i) though economists have
advocated these taxes, in practice, very few governments have given them atrial,
may be because they think it difficult to impose and collect them. For one thing,
the legislative bodies should have the political will to follow this course of action.ii)
secondly, the taxmeasure should be economical, I,e, 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. But
these considerations are unattractive to the politicians on whose initiative rests the
tax-measure legislation. iii) finally, there is basic conflict of objectives whichstrenthens
the inaction referred to in the preceding limitation. The success of this tax measure
lies in damage -control but this means the tax would notyield any revenue; and if it
does, it would confirm its failure to control the dmage caused by the externality
concerned.

6. COST BENEFITS ANALYSIS AND OVERALL RESOURCE ALLOCATION :
We saw that in a market economy where consumers and producers are enjoying maximum
economic freedom, the role of the government as a producer gets limited. However, the
government is not supposed to simly watch what is happening in the economy as a whole.
Infact, in a modern economy, 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. Therefore, after carefully outlining the objectives of such a
policy, the government has to plan macro-economic policy. 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, 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.
for adjusting the economy to such shocks and abrrations, awell thought-out policy has
got to be formulated.
ii) Speeding up the pace of the Economy: Every government has a set of well- 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. A macro-economic policy and
a governmental intervention is needed to give a stimulus to forces declared objectives.
Such an action/policy instrument becomes necessary when the economy is either going
to slow or it is going in the wrong direction.
iii) Weeding out Economic Evils: Unemployment, inflation, business fluctuations etc. are
the economic evils which need to be eradicated by adopting the right types of macro-
economic policy instruments. These instruments would serve to stimulate the right types
of forces and to discourage or suppose the undesirable trends in the economy. In a
dynamic global modern economy, such situations are likely to occur from time to time
and they need to be corrected in time.
iv) Structural Changes in the Economy: The very dynamism of the economy makes it
necessary to adopt structural changes in the economy. However, there are several
obstacles and frictions in switching over to the new order. But the system demands that
these changes must be brought about promptly and properly. The State is, therefore,
called upon to intervene and take necessary legislative and regulatory measures for
assisting the smooth change-over.
v) Fine Tuning of the Economy: The functioning of the economy, at any given time, could
be going through deviations from the normal and competent course. Under such
circumstances many of the economic operations might need a fine-tuning. This task can
be performed by macro-economic policy instruments.

[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. This
approach has been found to be useful in handling the problems related to the welfare
objectives. However, welfare consideration follows the net wealth consideration. This is
because thecost-benefit analysis is basically devised to maximize the net wealth i.e. to
maximize the difference between benefits and costs. 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.
With a view to understand the working of the cost-benefit principles, let us start by
assuming that economic welfare as part of total community welfare can be maximized
by maximizing net wealth. A little elaboration, at this juncture, is perhaps necessary.
Welfare is the resultant of a state contenment and fulfillment which itself is the result of
the feeling of satisfaction. Since satisfaction is a state of mind,there is no way of quantifying
it. Moreever, satisfaction can result from many non-economic activities. Therefore total
welfare of an individual or of the society comprises of various human activities which lead
to welfare. Here, we are concerned with economic welfare whch is assumed to be
maximized by satisfying as many of human wants as possible. For satisfying wants we
need the production and/ or acquisition of economic goods and services. There are,
however, various qualification to assumptions that maximization of net wealth maximizes
social benefit. In the first plcace, the satisfaction of wants as a pre- condition for well-
being can be applied and accepted in respect of necessaries of life and of efficiency. But
when it comes to comforts and luxurious, the same can not be said .Secondly many
economic activities generate wealth but do not lead towelfare. Production and trading of
several commodities can be cited as an exmple of this type. Production of cigarettes,
liquor or drug-trafficking are examples of this type. Thirdly, on the macro-level, a summation
of maximum individual welfare does not automatically lead to maximum social welfare.
This is because one man's food, as the saying goes, is another man's poison. Finally,
dividing welfare parameters involve value judgements which may vary from society to
society and from one set of objectives to another .
For acheiveing the maximization of net wealth, full utilization of all the resources is
necessary. 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. 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, given the amount of
available resources.See the following figure as an illustrsation. In this diagram, the curve

AB is the frontier which is known as the production possibility curve or the production
possibility frontier. With the resources being given and limited, the limit AB can be
rached only by using the resources fullu. In this diagram, 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); or a combination of both X and Y. By using all the resources,
the economy can produce OB amount of commodity X or OA amount of commodity Y.
A E
C
Commodity Y
D
M
O X
N B
Commodity X
Figure showing Production Possibility Curve
Alternatively, 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. For example, point D indicates the
possible combination as OM amount of commodity Y plus ON amount of Commodity X.
In the same way, any other point on the AB curve, like thepoint E, would show the
maximum possible amount of output with varying resources. As against this, point C in
the diagram indicates under utilization of resources. As against this, point C in the
diagram indicates under utilization of resources, since the production has been stabilized
at point C when it is possible to move forward to any other point like D and E. It should
therefore be clear what we mean by full utilization of resources. 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.
For maximization of output, 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. 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. If we want to produce more
than what the production possibility curve demands, we shall have to reach a point which

would lie on another and outer production possibility curve which would lie beyond AB
and away from the point of origin O. This would be possible only by raising the productive
capacity of the economy, either by finding out or mobilizing additional resources or by
increasing the productive efficiency of the existing resources. Such a shift in the production
possibility curve indicates economic growth. For achieving economic growth we shall
have to maximize the output in the existing conditions of resource-availability. The cost-
benefit analysis, under the assumption noted above, can serve as a guide for macro -
economic policy.
(B) ADVANTAGES OF COST - 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, in turn, can increase social welfare.
ii) In following this principle, the problem of infinite target value does not arise. This is
because, 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.
iii) By using this analysis we can show the measures necessary for attaining maximum
net wealth and optimal policy aiming at this goal.
iv) Even when a target is partially attained, 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.
v) The measurement of a trade - off between different targets is always a difficult
problem. 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. This enables us to measure objectively the trade-off.
vi) In this approach, the cost of a policy measure can be explicitly identified and can
be incorporated in the total cost of the project.
vii) By adopting a suitable discounting method, the costs and benefits as arising in
different periods of time in future can be estimated. The problem of assigning costs
and benefits to various targets does not arise in this analysis.

(C) LIMITATIONS OF COST - BENEFIT ANALYSIS :
The cost - benefit analysis as discussed above obviously suffers form certain limitations.
i) Critics have pointed out that this analysis is applicable in a partial equilibrium
framework. However economists like A. C. Harberger have shown that it can be
applied to the general equilibrium analysis as well.
ii) 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. We have already seen that this is not so.
iii) The cost benefit analysis is applied on another assumption that the existing pattern
of distribution of income, distribution is given and has to be kept as it is. In fact, a
change in income distribution does lead to a change in net wealth and further in
social welfare.
iv) 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.
v) By assuming the positive correlation between wealth and welfare, the analysis
assumes away all difficulties involved in the calculation of present and future cost
as well as private and social cost.
vi) Whatever applies to costs also applies to benefits i.e., calculation of present and
future benefits as well as private and social benefits involves similar difficulties.
7. 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. 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'. Increasing
division of labour or specialization has been taking place in both developing and developed
countries. This means everyone is at present producing goods and services (including labour
of various types) for the market. Everyone at present carries thousands of exchanges which
alone enable him to live comfortably. Market has become the pivotal point in modern capitalist
and mixed economies. All prices have become closely interrelated and influence all other
prices. It is when market becomes the pivotal or central folcrum of the economy and influences
allocation of resources and distribution of income and wealth, we say that there has emerged
''Market System' or 'Market Economy'.

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.
Consumers, who are free to spend their income as they please, express their preferences
through prices. Thus if consumers begine to prefer TV sets than radio sets, prices of TV sets
will go on rising more relatively to prices of radio sets. Under market mechanism, since
producers are free to use their resources as they like, and as they are motivated to make
maximum profit, they will divert their resources from production of radio sets to the production
of TV sets. Thus more TV sets and relatively less radio sets will be produced for the market.
People express their preferences through prices. Changes in free fluctuating prices act as
signal to producers. They switch their resources, on the basis of price changes, to the production
of goods according to the changing preferences of consumers. This gives consumers what
they prefer more. Naturally this results in maximization of welfare of the community everyone
getting what he wants. This also means that market mechanism brings about most efficient
use of the community's 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, to a level where
profits in both TV manufacturing and radio manufacturing industries become equal.
Market (or price) mechanism is explained above with a simple model of only two commodities.
Market or price mechanism operates along the same principle even when there are many
commodities and services. Thus market or price mechanism is supposed to help solve the
basic economic problem - how to make the most efficient use of community's resources and
how to derive the maximum satisfaction from the community's resources.
Assumption of Market (or Price) Mechanism
There are certain assumptions on which operation of the market (or price) mechanism is
based. The important assumptions are as follows:
i. Each consumer knows what is in his best interest and acts rationally to secure maximum
satisfaction.
ii. There is perfect competition in the market - competition among consumers and among
producers, each consumer and producer knowing fully well what is taking place in the
market and hoe prices are moving.

iii. 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.
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. This is because the above assumptions are not always and
fully valid and do not obtain in real world. Thus consumers do not always know what is in their
best interest and do not always act rationally. The competition among consumers and producers
assumed in the above model is often absent. There is also not full knowledge among consumers
and producers about market conditions and happenings. 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. There is never perfect mobility of factors of production,
especially in the case of labour. Some factors of production are specific and can produce only
certain goods and not other goods though the prices of the latter may rise. 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.
8. 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. Individual, the best judge of self-interest :

In the market system or capitalist economy, it is assumed that every individual is the
best judge of his personal interest. Every individual knows what is in his interest and no
one does that well than himself. 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.
ii. Consumer's Sovereignty :

The above assumption implies that in a market system of economy, 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. This means the
market system of economy is characterized by consumer's sovereignty.
iii. Freely Fluctuating Price Mechanism :

The sovereign consumers express their demands and preferences through freely operating
prices or through price mechanism. Freely operating price mechanism thus acts as a
signaling system indicating to various producers ,consumers' preferences - that they
prefer TV sets to radio and radio sets to gramophone and so on - and influencing and

bringing about allocation of limited resources of the community in accordance with
consumers' preferences.
iv. Private Enterprise :

In the market system in economy, most of the goods and services are produced by
individual producers or groups of individual producers. That is why the market system is
also known as private enterprise economy. 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.
v. 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. The chief or major foundation of the market system
or private enterprise economic system is that among all motives to human activities, private
profit motive (i.e self-interest) is the most powerful motive which will bring out the best effort
by every individual. And therefore under this system all production is carried on by individual
producers with a view to maximize their personal profit.
vi. Institution of Private Property :

Another major foundation of the market system of economy is the institution of private
property (i.e. exclusive right to own and enjoy one's property in land, buildings, factories,
precious metals like gold and silver, share and other financial assets and such other
tangible and intangible goods).
vii. 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. In this system consumers compete among
themselves for goods and services in the market by offering competitive prices to get
them, and producers compete among themselves for getting factors of production to
produce goods and services to be sold to consumers at competitive prices.
viii. 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, it
follows that when all individuals attain maximum satisfaction of their own, community
made up of those individuals would automatically attend the maximum satisfaction or
welfare. There is thus no clash between interest of an individual and that of community.

ix. 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, not only of himself but also that of the
community, and if there is no clash between interest of an individual and welfare of the
community, and no clash of interest between welfare of consumers and that of 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.
People should free to carry on their economic activities as consumers and as producers.
The above are the foundations (that means the assumptions) on which the 'Market System'
(also known as Market Economy or Capitalism) stands or functions.

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

NOTES

NOTES

NOTES

Chapter 8
MACRO ECONOMIC ANALYSIS
Preview
Macro Economics - The Keynesian Macro Economic Theory - Income determination,

Consumption and Investment Function; Business Fluctuations, Inflation - Macro Polices of
Full Employment, Economic Stabilization.
MICRO ECONOMICS
INTRODUCTION
Macro-economics is the study of the aggregate behaviour of the economy as a whole. It is

concerned with the macro-economic problems such as the growth of output and employment,
national income, the rates of inflation, the balance of payments, exchange rates, trade cycles,
etc.
According to Prof. Ackley: "Macro economics deals with economic affairs 'in the
large'; it concerns the overall dimensions of economic life."
In short, macro-economics deals with the major economic issues, problems and policies of
the present times.
Macro-economics deals with the major economic issues, problems and policies of the present
times.
National income, money, total investment, savings, unemployment, inflation, balance of

payments, exchange rates, etc. Are the crucial economic aggregates.
In macro-economic analysis the behaviour of economic agents such as firms, house-holds

and government is seen in total, disregarding details at the particular level - i.e., micro level.
An individual consumer, particular market for a given commodity, operation of a firm, etc are
the subject matter of Micro economics. Macro-economics deals with the market for all goods
as a whole. It is considered as the product or commodity market in general. Similarly, labour
Macro Economic Analysis 285

market is taken as a whole for the entire labour force in the economy. Likewise, financial
market is taken as a whole which covers money market, capital market and all banking and
non-banking institutions taken together.
Prior to Keynesian revolution in economic thinking in the 1930s, the classical economists had
concentrated more on micro-economic approach and macro behaviour was also described as
mere summation of individual observations. Prof. J. M. Keynes in 1936 published The General
Theory of Employment, Interest and Money which revolutionized the whole economic
thinking. He suggested that macro economic behaviour should be studied separately. Behaviour
in total is quite different then what we may try to infer by summation of individual behaviour. He
said that, for instance, saving is a private virtue but it is a public vice in a matured economy
cause deficiency of demand leading to depression.
Keynes prescribed macro-economics as a policy - oriented science to deal with the problems
like unemployment, inflation etc.
Economics of Keynes serves as the foundation centre for the modern economics.
It follows that the scope of macro-economics is confined with the behaviour of the economy in
total. It does not examine individual behaviour. It relates to the economy-wide total or aggregates
and problems of general nature. Its policies are general.
The subject matter of macro-economics includes the theory of income and employment,
theory of money and banking, theory of trade cycles and economic growth.
IMPORTANCE OF MACRO - ECONOMIC STUDIES
Macro - economic studies have unique theoretical and practice significance.

1) Macro - economics provides an exploration to the Functioning of an Economy in
general: Using macro - economic tools and technique of economic analysis one can
understand the working of the economic system in a better way.
2) Empirical Evidences : Macro - studies are based on empirical evidences of the theoretical
issues. Macro - economics is more realistic.
3) Policy - orientation : Macro - economics is a policy - oriented science. It suggests a
best of policy measures, such as fiscal policy, monetary policy, income policy, etc. to
deal with complex economic problem like unemployment, poverty, inequality, inflation,
etc. faced by the country in modern times.
4) National Income : Macro - economics teaches the computation, use and application of
national income data. 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.

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

Keynes realistically adopts the short-term variables. He believed in the short-run philosophy
of life. To him, 'in the long run, we are all dead'. Thus, Keynes presumed an economic model
as a short-period model in his analysis.
Since it deals primarily with short-term phenomena in economic life, many of the strategic
variables in the Keynesian theory, like consumption function, interest rates etc. are assumed
to be constant, as they would change very little in the short period.

Again, on account of his short-period analysis of the problem, Keynes treated national income
as Gross National Product (GNP), rather than Net National Product (NNP). Because he felt
that in the short period, repairs, replacement etc. have no significant relevance; so depreciation
allowances, etc. are to be considered only in the long-run analysis. So, GNP is appropriately
used for measuring the community's total income during the short run.
Generality of Approach:
Keynes' theory is general. Its approach and analysis are general. It is general in the sense
that it is not time - bound. Keynesian tools of analysis are applicable at any point of time, in
any economy.
Again, Keynesian, analysis being macro-economic, it contains generality in approach. It takes

a general view of the economic system as a whole.
Keynes argued that the postulates of the classical theory are applicable to a special case of
full employment only and not to general cases. He criticized classical economists for their
unrealistic assumption of full employment equilibrium condition in their economic models. He
observed that there is always less than full employment in the economy; full employment is
only a rare phenomenon. He claimed his theory to be general in the sense that it deals with all
levels of employment and in all cases. It applied equally well to economies with less than full
employment, under - employment or full employment. Thus, its generality implies its universal
applicability.
The Principle of Effective Demand :
The gist of Keynesian analysis of income determination lies in the principle of effective demand.
Keynes pointed out that the level of income and output in an economy is determined by the
level of employment (i.e. the employment of workers along with the exploitation of other given
resources such as land, capital, etc.) Which, in turn, is determined by the level of effective
demand.
In a money economy, effective demand is revealed by the total expenditure incurred by the
people on real goods and services, meant for consumption as well as investment. The flow of
expenditure, in turn, determines the flow of income, as one man's expenditure becomes
another man's income in the economic system. It thus follows that Total Expenditure = Total
Income.
As the flow of expenditure varies, the level of income also varies accordingly. That is to say, if
the total expenditure flow in an economy increases, the flow of income will also increase in
the same proportion. And, if the aggregate expenditure flow decreases, income flow also
decreases likewise.

In real terms, the expenditure flow in the community consists of consumption expenditure and
investment expenditure, expressing the total demand for consumption goods and capital goods.
Effective demand, thus, represents the total expenditure on the total output produced, at any
equilibrium level of employment. It thus denotes the value of total output of the community,
which is described as national income. Obviously, national income equals national expenditure.
And, as total output comprises consumption goods and capital or investment goods, so the
national expenditure consists of expenditure on consumption goods plus investment goods.
In short, there are two basic determinants of effective demand in an economy. These are
consumption and investment. The level of effective demand determines the level of employment
which, in turn, determines the level of output and income in the economy. It follows, thus, that
the level of employment is fundamentally determined by consumption and investment.
Since Keynes sought to explain the point of effective demand in a capitalist economy, free
from government intervention, he considered consumption and investment expenditure of the
community relating to private individuals and enterprises only. But, in modern times, a capitalist
economy is actually a mixed economy due to that, government expenditure is also a significant
determinant of effective demand in a modern economy.
Modern economists, therefore, define effective demand as:

Effective demand = C + I + G,
Where,
C = Consumption expenditure of the households.
I = Investment expenditure of private firms.
G = Government's expenditure on consumption and investment goods.
It must, however, be noted that government expenditure is autonomous. Thus, it is the outcome
of government's value judgment and policies, based on political and social considerations
rather than economic forces.
Following Keynes, we shall, however, restrict our analysis to the consumption and investment,
elements of effective demand relating to the private sector only. If must be borne in mind that
the investment and employment activities in the private sector are induced and not autonomous,
as in the case of public sector.
Again, from the Keynesian dictum that the level of employment and income depends on the
level of effective demand in an economy, it also follows that the lack of effective demand
implies unemployment and corresponding poverty, or low level of income. As such, to ease
the unemployment problem, and to raise the level of income and economic prosperity, the
level of effective demand has to be raised. Income and employment, thus, increase only when
the total demand either from consumption side or from the investment side increases.

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, using technical
terminology, Keynes stated that effective demand is determined by the interaction of the
aggregate supply function and the aggregate demand function. That is to say, 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. Price
here means the amount of money received from the sale of output, i.e. sales proceeds.
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. Hence, the supply schedule of
that commodity shows the varying level of quantities of the commodity the seller offers for sale
at alternative prices. Similarly, 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.
Keynes measured the whole of output of the economy in terms of the amount of laboour
employed with a given marginal productivity. He, thus, said that the level of output varies with
the level of employment, obviously, each level of employment results in a certain level of
output of commodities, i.e. real income along with the money income generated in the process
of investment expenditure.
Each level of employment (of labour) necessitates certain quantities of the other factors of
production like land, capital, raw materials, etc., to assist the labour employed. All these
factors of production are to be paid according to the prevailing factor prices, which are known
as cost of production. Thus, each level of employment would involve certain money costs
(including profits). Every prudent entrepreneur must at least seek to recover the total cost of
production, including normal profit. Thus, the entrepreneur must get some minimum amount
of sales revenue to cover the total costs incurred at a given level of employment. Only if the
sales proceeds are high enough to cover the total costs of production at a given level of
employment and output, the entrepreneur will be induced to provide that particular level of
employment.
This minimum price of revenue proceeds that the entrepreneurs must get from the
sale of output, associated with different levels of employment, is defined as, "aggregate
supply price schedule" or "aggregate supply function". Thus, 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.
According to Keynes, 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. We may illustrate
the Keynesian aggregate supply function hypothetically as in following Table :

The Aggregate Supply Function
Level of employment Money wages Aggregate Supply Price (ASF)

(in lakhs of workers) (per annum in 1,000) (in crores of Rs.)
(N) (W) (N x W)
1 10 100
2 10 200
3 10 300
4 10 400
5 10 500
6 10 600
In the table it is assumed that money wages, on an average to be paid per year, is. Rs.10,000.
Thus, 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. It
can be seen that to employ one lakh workers during the year, entrepreneurs should expect to
get a minimum of Rs.100 crores from the economy by selling the resulting output. Similarly,
for two lakh workers to be employed, the minimum expectation of sales proceeds is Rs.200
crores, and so on.
Graphical Presentation : The numerical schedule of aggregate supply price of employment

may be plotted graphically and the cruve so derived is called ASF curve. Following figure
illustrates the ASF curve drawn by the graphical representation of data contained in previous
table.
Rs. ASF
crores
Y
Minimum Receipts/Income
Employment (N) (In lakhs of workers)

In the figure, the X - axis represents the level of employment and the Y - axis measures the
expected minimum sales proceeds. The curve ASF represents the aggregate supply function.
It is linear, because we have assumed a constant wage rate. But, if the wage rate is changing
(increasing) or costs of employment are rising with an increase in employment, the ASF curve
will be non-linear and upward sloping. Indeed the aggregate supply price is correlative with the
employment level, in any case. However, the aggregate supply function - ASF curve - will
become perfectly inelastic at a point where the economy is at a full employment level. Thus,
at the full employment level, the aggregate supply function will be a vertical straight line.
Suppose, in our illustration, the economy reaches full employment when all its 6 lakh workers
are employed, then the ASF curve will become vertical at point Z as shown in the figure. That
means, the level of employment cannot exceed Q level (i.e.600 in our example), whatever the
expectations of minimum sales proceeds. 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.
The Shape of ASF Curve :

As has been seen in previous figure, the ASF curve is an upward sloping curve, but it is not
very easy to conclude about its shape. To determine the shape of the curve ASF, the relationship
between employment (N) and marginal productivity should be traced. 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). In a technical sense, thus, ASF is
obtained by aggregating the expected total revenue functions of all the firms. The actual
shape of the ASF curve, however, will be determined by the aggregate production functions of
all firms in the economy and money wages.
Apparently, the linear ASF curve, assumed in previous figure, is a much simplified case. It is
based on the assumption that : (i) the money price of all outputs and inputs is constant, 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, change in the
same proportion. This means that if the total money expenditure is doubled, employment and
income will also double and vice versa. In reality, however, such proportionate relationship is
rarely found. Thus, the actual ASF curve which relates to changes in prices of all outputs and
inputs, cannot be linear. The linear ASF curve was assumed by Keynes for the sake of
simplicity in analysis. Again, the steepness of the ASF curve depends on the technical
production conditions. It depends on the productivity of labour, capital and other resources
employed by the economy.
Aggregate Demand Function (ADF) :

In the Keynesian terminology, 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, resulting at

various levels of employment. Thus, the quantum of maximum sales revenue expected
from the output produced is described as the demand price of a particular level of
employment. There is a positive correlation between the level of employment and
the demand price, i.e. expected sales receipts.
Thus, with an increase in the level of employment, the aggregate demand price tends to rise,
and vice versa. The aggregate demand price - the maximum sales proceeds expected for a
given level of output - depends upon the total expenditure flow of the economy, which is
determined by the spending decisions of the community as a whole. In a free capitalist economy,
households and firms are the two major economic sectors which spend on consumption and
investment. Now, what these sectors are expected to spend in the next period is viewed as
the aggregate demand price, the expectation of sales revenue, for the given level of output and
employment by the entrepreneurs.
A much simplified presentation of aggregate demand function may be illustrated through the
following hypothetical table.
The Aggregate Demand Function (Schedule)
Level of Employment Expected minimum sales proceeds

(N) (expected Total Expenditure ADF)
(in lakhs of workers) (in crores of Rs.)
1 175
2 250
3 325
4 400
5 475
6 550
The aggregate demand schedule links real income or output (which Keynes measured in
terms of the quantity of employment) and spending decisions, thus, the expenditure flow in
the economy as a whole. Evidently, the aggregate demand schedule shows the aggregate
demand price for each possible level of employment.
The aggregate demand function may be represented graphically as in following figure.
In following figure, the curve ADF represents the aggregate demand schedule. It shows that
the aggregate demand price is the direct or increasing function of the volume of employment.

ADF = f (N)
(Anticipated Total Expenditure)

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

The Equilibrium Level of Employment
Employment Aggregate Aggregate Comparison Direction of

(in lakhs of Supply Function Demand Function change in
workers) (in crores of Rs.) (in crores of Rs.) employment
(N) (ADF) (ADF) (DN)
1 100 175 ADF > ASF Increase

4 400 400 AD = AS Equilibrium
5 500 475 ADF < ASF Decrease
6 600 550 ADF < ASF Decrease
So long as the aggregate demand price (ADF is greater than the aggregate supply price
(ASF), the level of employment tends to increase. The economy reaches equilibrium level of
employment when the aggregate demand function becomes equal to the aggregate supply
function. At this point, 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. In the given
schedule above, it is Rs.400 crores which is the entrepreneur's expected minimum as well as
maximum sales proceeds, so that 4 lakh workers' employment is the equilibrium amount.
This is the point of effective demand.
In graphical terms, the point of effective demand and equilibrium of the economy can be
represented in the following figure.
Following figure has two panels. Panel (A) depicts linear AD and AS curve. Panel (B shows
non-linear AD and AS curves. We have preferred linear curves for the sake of simplicity of
analysis, though non-linear curves are more realistic.
Y ASF Y
(A) (B)
ASF
Z
ADF
E E
R ADF
a
ADF ADF
b
& &
ASF ASF
O N1 N Nf
X
O
X
N
Volume of Employment (N) Volume of Employment
Effective Demand

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

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

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

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

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

run. Thus, the marginal efficiency of capital with a given rate of interest, is the most significant
factor determining the inducement to invest. In fact, as Keynes believed, fluctuations in the
marginal efficiency of capital are the fundamental cause of trade cycles and income fluctuations
in a capital economy.
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, and does not take government expenditures into account. But, modern economists give
due recognition to government expenditure as an important factor of effective demand. In
today’s world, government expenditure is day be day increasing, and it cannot be ignored in
estimating the effective demand in a community.
Thus, to be more realistic, we may formulate effective demand thus :
Effective demand = C + I + G,
where,
C = Consumption outlay for the households,
I = Investment outlay in the private sector, and
G = Government's spending for consumption as well as investment.
It should be noted, however, that government expenditure is autonomous, as it depends on

the policies of the existing government which are largely influenced by political and social
rather than economic factors.
BUSINESS FLUCTUATIONS
INTRODUCTION
Business fluctuations, booms and slumps, in the economic activities form essentially the
economic environment of a country. They influence business decisions tremendously and set
the trend of future business. The period of prosperity opens up new and larger opportunities for
investment, employment and production, and thereby promotes business. On the contrary,
the period of depression reduces the business opportunities. A profit maximizing entrepreneur
must therefore analyse the economic environment of the period relevant for his important
business decisions, particularly those pertaining to forward planning.
This part of the chapter is in fact devoted to a brief discussion of, main phases of business
cycles and their causes.

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

3. Recession
4. Trough
5. Recovery and expansion.
The five phases of a business cycle have been presented in the figure. The steady growth line
shows the growth of the economy when there are no economic fluctuations. The various
phases of business cycles are shown by the line of cycle which moves up and down 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. the phase of expansion is characterized
by increase in output, employment, investment, aggregate demand, sales, profits, bank credits,
wholesale and retail prices, per capita output and a rise in standard of living. The growth rate
eventually slows down and reaches the peak. The phase of peak is generally characterized
by slacking in the expansion rate, the highest level of prosperity, and downward slide in the
economic activities from the peak.
Business Fluctuations. A figure showing phases of Business Cycle

The phase of recession begins when the downward slide in the growth rate becomes rapid and
steady. Output, employment, prices, etc. register a rapid decline, though the realized growth
rate may still remain above the steady growth line. So long as growth rate exceeds or equals
the expected steady growth rate, the economy enjoys the period of prosperity - high and low.
When the growth rate goes below the steady growth rate, it makes the beginning of depression
in the economy.
In a stagnated economy, depression begins when growth rate is less than zero, i.e. the total
output, employment, prices, bank advances, etc., decline during the subsequent periods. The
span of depression spreads over the period growth rate stays below the secular growth rate or
zero growth rate in a stagnated economy. Trough is the phase during which the down - trend
in the economy slows down and eventually stops, and the economic activities once again

register an upward movement. Trough is the period of most severe strain on the economy.
When the economy registers a continuous and repaid upward trend in output, employment,
etc., it enters the phase of recovery though the growth rate may still remain below the steady
growth rate. And, when it exceeds this rate, the economy once again enters the phase of
expansion and prosperity. If economic fluctuations are not controlled by the government, the
business cycles continue to recur as stated above.
Let us now describe in some detail the important features of the various phases of business
cycle, and also the causes of turning points.
Prosperity : Expansion and Peak

The prosperity phase is characterized by rise in the national output, rise in consumer and
capital expenditure rise in the level of employment. Inventories of both input and output increase.
Debtors find it more and more convenient to pay off their debts. Bank advances grow rapidly
even thought bank rate increases. There is general expansion of credit. Idle funds find their
way to productive investment since stock prices increase due to increase in profitability and
dividend. Purchasing power continues to flow in and out of all kinds of economic activities. So
long as the conditions permit, the expansion continues, following the multiplier process.
In the later stages of prosperity, however, inputs start falling short of their demand. Additional
workers are hard to find. Hence additional workers can be obtained by bidding a wage rate
higher than the prevailing rates. Labour market becomes seller's market. A similar situation
appears also in other input markets. Consequently, input prices increase rapidly leading to
increase in cost of production. As a result, prices increase and overtake the increase in
output and employment. Cost of living increases at a rate relatively higher than the increase in
household income. Hence consumers, particularly the wage earners and fixed income class,
review their consumption. Consumer's resistance gets momentum. Actual demand stagnates
or even decreases. The first and most pronounced impact falls on the demand for new houses,
flats and apartments. Following this, demand for cement, iron and steel, construction-labour
tends to halt. This trend subsequently appears in other durable goods industries like automobiles,
refrigerators, furniture, etc. This marks reaching the Peak.
Turning - Point and Recession

Once the economy reaches the peak, increase in demand is halted. It even starts decreasing
in some sectors, for the reason stated above. Producers, on the other hand, unaware of this
fact continue to maintain their existing levels of production and investment. As a result, a
discrepancy between output supply and demand arises. The growth of discrepancy, between
supply and demand is so slow that it goes unnoticed for some time. But producers suddenly
realize that their inventories are piling up. This situation might appear in a few industries at the
first instance, but later it spreads to other industries also. Initially, it might be taken as a
problem arisen out of minor mal-adjustment. But, the persistence of the problem makes the

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

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

In the words of Prof. Samuelson, "Inflation occurs when the general level of prices and
costs is rising - rising prices for bread, gasoline, cars; rising wages, land prices, rentals

on capital goods". Thus, inflation marks rising commodity prices as well as factor prices.
Factor prices when rise, cause an increase in costs. According to Milton Friedman, inflation
is "process of a steady and sustained rise in the prices". Many more definitions of
inflation can be given. Instead of going into all these definitions, let us outline the
characteristics of inflation as they emerge form the above - mentioned (and other similar)
definitions of inflation :
(i) Inflation is a phenomenon of rising prices. However, every price - rise is not inflationary,
though every period of inflation indicates price - rise. In other words, temporary price -
rise in some sectors may occur due to some causes but they may not necessarily be
indicative of inflation.
(ii) Inflation is a sustained and appreciable rise in prices. Once started, inflation goes on
feeding itself and it is not self-limiting. It is a continuous process.
(iii) Inflation is a general and a dynamic phenomenon. It is not limited to one or two sectors
or geographical localities of a country. Rather, it takes within its stride the entire country
and all the sectors of the economy. It is dynamic in the sense that its severity, nature
etc. go on changing (and causing changes) over a period of time. Inflation occurs over a
period of time.
(iv) True inflation or pure inflation starts only after reaching the full employment level.
(v) It cannot be anticipated, in the sense that one cannot be sure regarding the timing and
intensity of inflation.
(vi) Inflation is characterized by an excess of demand or an increase in costs or usually

both.
The Causes of Inflation
The causes of inflation can be studied from two sides, i.e. from the demand side and from the
supply side.
1. 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. This increase in
government expenditure means an increase in the total demand, which leads to
rise in prices. This demand is in addition to the normal demand, which leads to a
price rise.
(ii) Increase in Private Expenditure : When optimism prevails in the business world,
businessmen are eager to spend more money on capital goods. This increases the

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

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

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

follows:

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

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

There are several political and social effects. 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. Those who toil and moil continue to become poorer, and those who hold important
positions, go on amassing wealth. This puts an end to harmony and understanding in
society. Morality and business ethics are violated and people do not hesitate to do

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

In the technical language of macro - economic analysis, 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, though, of course, in many of these markets, there is
the likelihood of an excess of demand over supply, or of supply over demand, 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." He, therefore, suggested that an economic policy aiming at achieving full
employment, should be designed to uplift the effective demand appropriately.
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. It
also implies preventing over and under - employment. Stabilisation does not mean rigidities,
it should permit a reasonable degree of flexibility for 'self - adjusting forces of the economy.'
The major objective of stabilization policies are :
(i) preventing excessive economic fluctuations,
(ii) efficient utilization of labour and other productive resources as far as possible;
(iii) encouraging free competitive enterprise with minimum interference with the
functioning of the market economy.
The two most important and widely used economic policies to achieve economic stability
are (i) fiscal policy; 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. Taxation
is a measure of transferring funds from the private purses to the public coffers; it amounts
to withdrawal of funds from the private use. Public expenditure, on the other hand,
increases the flow of funds into the private economy. Thus, taxation reduces private
disposable income and thereby the private expenditure, and public expenditure increases
private incomes and thereby the private expenditure. Since tax-revenue and public
expenditure form the two sides of the government budget, the taxation and public
expenditure policies are also jointly called as 'budgetary policy.'
Fiscal or budgetary policy is regarded as a powerful instrument of economic stabilization.

The importance of fiscal policy as an instrument of economic stabilization rests on the
fact that government activities in modern economies are greatly enlarged, and government

tax-revenue and expenditure account for a considerable proportion of GNP, ranging from
10 - 25 per cent. Therefore, the government may affect the private economic activities to
the same extent through variations in taxation and public expenditure. Besides, 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. If fiscal policy of the
government is so formulated that it during the period of expansion, it is known as 'counter
- cyclical fiscal policy'.
b) Monetary Policy :
Monetary policy refers to the programme of the Central Bank's variations, in the total
supply of money and cost of money to achieve certain predetermined objectives. One of
the primary objectives of monetary policy is to achieve economic stability. The traditional
instruments through which Central Bank carries out the monetary policies are :
Quantitative Credit Control Measures such as open market operations, changes in
the Bank Rate (or discount rate), and changes in the statutory reserve ratios. Briefly
speaking, open market operation by the Central Bank is the sale and purchase of
government bonds, treasure bills, securities, etc., to and form the public. Bank rate is
the rate at which Central Bank discounts the commercial banks' bills of exchange or first
class bill. 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 - vault. 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.
In addition these instruments, Central Banks use also various selective credit control
measures and moral suasion. The selective credit controls are intented to control the
credit flows to particular sectors without affecting the total credit, and also to change the
composition of credit from undesirable to desirable pattern. 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.
The fiscal and monetary policies may be alternatively used to control business cycles in
the economy, though monetary policy is considered to be more effective to control inflation
than to control depression. It is however, always desirable to adopt a proper mix of fiscal
and monetary policies to check the business cycles.

Exercise :
1. Define Macro Economics.
2. Explain the nature and scope of Macro economics.
3. Explain J. M. Keynes' analysis of income determination in the context of the principle of

Effective Demand.
4. Write Short notes on :
a) Factors determining Effective Demand b) Consumption Function c) Investment Function

d) Fiscal Policy e) Monetary Policy.
5. Explain with an illustration, various phases of Business Cycle.
6. Define Inflation. Explain the Causes of Inflation.
7. What are the consequences of Inflation?
8. Explain Macro Economic Polices with special emphasis on a) Full Employment and b)
Economic Stabilization.

NOTES

NOTES

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

If yes, 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.
1) NEED FOR GOVT. 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; (ii) that all those who are employed get
their living in accordance with their contribution to the total output, (i.e., their productivity); (iii)
that factors of production are optimally allocated between the various industries; and (iv)
production and distribution pattern of national product is such that all get sufficient income to
meet their basic needs - food, clothing, shelter, education, medical care, etc. The world has
however experienced that the free enterprise system has failed to orgainse the economy
which would satisfy the above requirements. The failure of the free market economy is attributed
to its following shortcomings.
Shortcomings of Market System/ Limitations or Defects of Market System :
Following are the important limitations of the market mechanism (i.e. 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. In a free competitive economic system, those with
productive resources or intellectual abilities find it easy to obtain rising income and
wealth, whereas those who have no productive resources or mental abilities do not get
much share in annual national income and wealth. And the number of such people in any
society is generally so great that they constitute the majority. Thus, market mechanism
results in unequal distribution of income and wealth and their concentration in the hands
of a few people in society. The rich go on becoming richer, while the poor who constitute
majority continue to remain poor. These economic inequalities give rise to social and
political unrest disturbing social and political peace in the country.
(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, the efficient
ones who are always few because of uneven distribution of organizational abilities among
people, will begin to absorb the inefficient ones. The final result is that only one (absolute

monopoly), two (duopoly) or a few (oligopoly) units in the industry remain. These units
naturally begin to enjoy monopolistic power exploiting both consumers and workers.
Also, 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.
(iii) Failure to Provide Full Employment :

It was assumed that under competitive conditions, market mechanism or price mechanism
would automatically bring about and establish equilibrium at the level of full employment.
J. M. Keynes however showed that due to several rigidities (especially wage rigidities
due to emergence of trade unions in the labour market), it so happens that the economy
may get established at the level of less than full employment. Thus market mechanism
does not ensure full employment of labour force. Thus the labour force which could have
produced much needed wealth lies unemployed and is wasted.
(iv) Instability :
Market economy or private enterprise economy is a planless economy. In such an
economy where millions of consumers and millions of producers are taking their own
independent decisions, it is rarely that some sort of balance would be achieved between
demand for thousands of commodities and their supply. This imbalance gives rise to
frictional disturbances and cyclical booms and depressions. It is inconceivable that the
modern complex economy involving millions of commodities and millions of consumers
and producers would always work smoothly. Market economy is bound to be characterized
by great instability.
(v) Wastages of Market Economy :

As we have seen, market system or market economy suffers from time to time from
economic depressions. During period of depression various factors of production lie
unutilized. These factors could have been used to produce much needed wealth for the
poorer sections of the society.
Secondly, we have seen that competition often gives rise to monopolies. 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, if such a step gives maximum
profit. Thus under monopoly there is tremendous wastages of productive resources.
In those lines of production where competition exists, there appear what may be called
wastages of competition. Thousands of units in the same industry take independent
decisions regarding production. Often there is over-production in some industries and
there is under-production in certain other industries.

Also, in a competitive regime, there are wastages of advertisement. Hundreds of producers
of a similar commodity spend vast amounts on advertisement. Since rivals are advertising,
it is possible that the final effect of advertisement by rival parties is neutralized. This
would mean that great amount of labour and other resources employed for advertisement
are wasted. While some advertisements are truly informative most are misleading and
therefore, 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.
On the contrary capitalism abounds in wastages due to unemployment, over and under-
production and vast expenditure on advertisements necessitated by cut-throat competition
among rival firms.
(vi) Indifference to and Sacrifice of Social Welfare :

In a market economy or free enterprise economy, production of goods and services is all
guided by the aim of securing maximum private profit. Goods are produced for which
there is greater demand. That is how in capitalism luxury and semi-luxury goods, which
richer sections of the community can afford to buy because they have the necessary
purchasing power, get preference over production of mass consumption goods needed
by poorer sections of the community. Their production is neglected in preference to
production of luxury and semi-luxury goods for richer sections of society. This means
that very little attention is paid to the welfare of the society.
(vii) Poverty in the midst of Plenty :

In a market economy, inspired by private profit motive, tremendous technological progress
has taken place. This has tremendously increased productive powers of the economy
and production of various goods and services. But due to the institution of private property
and law of inheritance and succession (which are basic features of free enterprise system
of economy), rich become richer who continue to exploit the vast poor masses. 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.
In a free enterprise economy, there is thus observed the existence of contradictory position
of poverty in the midst of plenty.
(viii) Undesirable Psychological and Social Effects :

Capitalism with emphasis on private profit motive and money making has great adverse
social, cultural and psychological effects. In capitalism, money becomes the yardstick
of measuring success in every field - art, music, literature and so on. Art, music and
literature all come to be judged by their financial success and not on the basis of their
inherent quality or merit.

Emphasis on private profit motive and on money-making arouses in capitalist regime
instincts of acquisitiveness, unscrupulousness, combativeness and immorality
suppressing good human instincts like kindness, love, cooperation and consideration for
the welfare of others.
(ix) Exploitation of Backward Countries and World Rivalry :

The developed capitalist countries, with a view to make higher and higher profits, 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, India versus Pakistan, etc.) just because the defence
industries owned by rich capitalists in Western countries should make rising profits.
Developed capitalist countries are putting restrictions on exports from developing or

backward counties thus hampering their rapid economic development.
Giant multi national corporations try to subvert national governments opposed to their
interests by sabotage and various other methods.
All this has led to international rivalry, disturbances and violence which go against economic
development of poor and backward countries in Asia. Africa and Latin America.
Concluding Remarks:
It would thus be seen that while free enterprise economy or market system has some
solid achievements to its credit, it also suffers from very serious limitations or evils,
affecting both its own working and that of other countries.
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 - precisely
from the start of the Second World War - partly through ever-mounting demand on the one
side and inadequately rising supply on the other. The expanding demand is due to the rapid
growth of our population, rising money income, expansion in money supply and liquidity in the
country, rising volume of black money and continuous rise in demand for goods and services
due to periodic wars, rapid economic development, etc. Supply of goods and services too has
been rising but the rise in supply has not been proportionate and matching the rise in demand;
this is due to monsoon, use of backward technology, bottlenecks in transport and power and
shortages of various inputs. At any given time, therefore, there is demand and supply imbalance.
Let us emphasize some of the causes behind the inflationary rise in prices in India in
recent years.

A. DEMAND PULL FACTORS
(i) Mounting Government Expenditure - Government expenditure has been steadily
increasing over the years. The total expenditure of both Central and State
Governments including Union Territories had risen from nearly Rs.740 crores in
1950-51 to Rs.37000 crores in 1980-81; and nearly Rs.5, 69,400 crores in 1999-
2000 an more than Rs. 11,000 crores in 2003 approximately. In a predominantly
agricultural economy like India, big programmes of economic development involving
huge investments have been undertaken. Mounting government expenditure implies
a growing demand for goods and services and thus, is an important factor for the
rise in price. Beside, 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.
(ii) Deficit Financing and increase in money supply - the Government of India is
responsible for adopting deficit financing as a method of financing economic
development.
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.
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, reckless expenditures
and unauthorized over-drafts.
(iii) Role of Black Money - It is well-known that there is a large accumulation of

unaccounted money in the hands of income-tax evaders, smugglers, builders and
corrupt politicians and government servants estimated at Rs.6,00,000 crores in
1997-98. There is considerable slush money with politicians and Government
servants, especially those dealing with licensing, registration, collection of taxes,
etc. A large part of the unaccounted money is used in buying and selling of real
estate in urban areas, extensive hoarding and black marketing in many essential
and inflation - sensitive goods, such as sugar, edible oils, etc. 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.
(iv) Uncontrolled growth of population - It is the continually rising population in India

which is responsible for the persistent gap between demand and supply, in almost
all consumer goods and services, thus exerting continuous pressure on prices.

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

gulf-surcharge which raised the prices of petroleum products to an unprecedented
level in one single jump is major cause for rise in price during 1990-91.
C. 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. We can cite specific cases. In 1973, the Government
nationalized the wholesale trade in wheat along with a threat to introduce a similar
measure for rice. This measure completely upset the normal trade and the price of open
market wheat shot up. At the same time, the government did not fail to procure adequate
amount of food grains for the public distribution system, nor was it able to import the
necessary quantity from foreign countries.
The Government of India has generally followed a highly vacillating and anti-peasant
policy in fixing procurement prices. This is equally true in fixing and controlling prices of
such essential goods as sugar, vanaspati, soap, cloth, etc. Nor are the controls properly
enforced thus giving great scope for rampant black-marketing to exist, for the benefit of
the traders.
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. The immediate cause for the pressure on prices since, 1990, as
mentioned earlier, was the Gulf War and the consequent shortages and increase in the
prices of administered items such as coal, petroleum products, fertilizers, electricity,
etc. According to the Government, the buildup of inflationary pressure during the Nineties
was mainly attributable to:
(a) Higher fiscal deficit - 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.
(b) 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; this
was the basis of the rise in money supply and liquid resources with the general
public at that time;
(c) Supply-demand imbalances - sensitive commodities like pulses, edible oils, and
even onions and potatoes due to shortfalls in domestic production; and
(d) A sharp increase in procurement prices of cereals and consequent rise in the issue price;
(e) The 9/11 attack on W.T.C. (U.S.A.); U.S. and allied forces invading Afghanisthan,
Iraq and take-over of the Iraq by U.S. and allied forces global recession etc.

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. Since the price
situation is the outcome of shortages in basic goods and services and a rapid growth in
money supply and bank credit, various types of measures relating to money supply, pricing
and distribution of commodities are pressed into service.
Demand Management
(i) Fiscal measures - The Government of India has generally insisted on controlling its own
expenditure and keeping in check both its revenue deficit and fiscal deficit - this has
been a major instrument of inflation - control. In July 1974, for example, 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. Again in January 1984, the Government of India announced a
package of programmes to curtail public expenditure, to postpone fresh recruitments to
Government job etc.
It was only since 1990-91 that the Government of India has appreciated the importance
of reducing fiscal deficit. 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.
These measures, along with monetary measures helped to contain the volume of monetary
measures helped to contain the inflationary pressure on price since 1995-96.
(ii) Monetary measures - The monetary policy of RBI consists of extensive use of general
and selective credit control measures. The main thrust has been to restrict bank-credit
against inflation sensitive goods and to influence the cost and availability of commercial
bank credit. The RBI relies heavily on selective credit controls on bank loans against
food grains, cotton, oil-seeds and oils, sugar and textiles so as to discourage speculative
hoarding.
During the Eighties and Nineties, 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.
The cash reserve ratio (CRR) was raised from 6 to the statutory maximum of 15 per cent
gradually. These steps resulted in a large measure, 'in mopping up excess liquidity in
the economy, moderating monetary and credit expansion and consequently helped in
bringing down the rate of inflation.

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

(e) Public Distributions System (PDS) and consumer protection - An important aspect
of the Government's policy was strengthening of the PDS. The Government has set up a
network of fair price shops numbering nearly 4,00,000 which cover a population of over 5-
million and which distribute wheat, rice, sugar, imported edible oils (palm oil), kerosene,
soft coke and controlled cloth. The public distribution system serves two purposes.
Firstly it helps to hold down prices. Secondly, it provides essential commodities to low
income groups at relatively low prices. But whenever the PDS is hard pressed due to
inadequate supply, prices of essential goods tend to rise. PDS has been strengthened
and extended to rural areas.
(f) Control over Private Trade in Food grains - To check prices and to eliminate hoarding
and speculative activity in food grains trade, wholesale dealers in food grains were licensed
in many States. Limits were also fixed beyond which traders and producers could not
hold stock without declaration. 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.
g) Other relevant measures by Government of India to control inflation.
i) Adoption of OGL (Open General License) import policy for importing sugar, pulses etc.
ii) Adjustment in trade and tariff policies in the Central Government Budgets to ensure
their domestic prices of Industrial products remain competitive.
iii) Great reduction in excise duties on a numbers of items expected to accelerate the
speed of industrial revival and raise industrial growth.
(1) Administered Prices :
The Government of India follows administered price policy in respect of commodities

which are either vital industrial raw materials, produced wholly or largely in the
public sector such as steel, fertilizer, coal and petroleum products. The Government
also fixes the rates and charges of public utilities like railways and state electricity
boards. 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. Administered prices are normally set on the basis of cost
plus a stipulated margin of profit. There are two basic objectives of
administered prices. :
(i) to fix and maintain the prices of essential raw materials so to avoid
cost and price escalation; this has special significance during a period
of shortages and rising prices; and
(ii) to ensure economic prices to uneconomic units so that the latter too
can earn profits.

Whenever there is a change in cost, the administered price is also changed. As the
Government is generally slow and sluggish in its actions, the change in administered
prices may not be proportionate to change in cost and, besides, the change in
price may come much later than change in cost. In fact, this has been a major
criticism against administered prices in India. As the administered prices are often
inadequate to meet cost escalation, basis industries like fertilizers and cement
were unable to generate sufficient financial resources for modernization and
expansion. 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.
(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. This does not mean that the benefit of
subsidy and low price should go even to those who do not require it. 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. Such a policy is (a) in the
interest of the vulnerable sections, and (b) it does not discourage the producers
from expanding production and investment in the particular sector.
Originally started with the price of steel, dual pricing was extended to many other
essential goods such as major food grains, sugar, edible oils, and cheaper varieties
of cotton cloth. 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,
even though it was meant to benefit the weaker sections.
(3) SUPPORT / PROCUREMENT PRICES :
A proper price policy will have to include measures directed towards cereals, pulses
and oil-seeds viz. their production, purchase, movement, sale and distribution. The
level at which agricultural prices should be stabilized is important from the point of
view of production and consumption. In fixing food grain prices, 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. This is particularly
important as the volume of production has increased considerably under the
influence of the "green revolution".
(b) 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

and speculation. Food zones are abolished and inter-state movement of the
food grains is the monopoly of the Food Corporation of India.
(c) Holding the price line covers not only to cereals, but to all basic consumption
goods as for instance pulses, sugar, oil and vanaspati, cloth, kerosene, etc.
The Government of India announces support prices on the recommendations of the

Agricultural Prices Commission, redesignated as Commission for Agricultural Costs
and Prices. The Commission is guided in recent years by the three-fold objectives of
(a) raising productivity through assured remunerative prices to farmers ;
(b) procuring sufficient quantities of rice and wheat for running the public distribution
system; and
(c) promoting a desirable inter-crop balance.
While making recommendations to the Government regarding revision of minimum

procurement and support prices, the Commission takes into account, among other
things, the changes in production costs, the inter-crop balance and the terms of
trade between agriculture and other sectors of the economy.
The basic framework for determining support prices for major cereals has been
relatively fair. The interests of both farmers and general consumers have been well
protected. But there are a number of distortions: One is the announcement of
higher minimum prices by state Government to satisfy local interests. Another is
that support prices for coarse grains, pulses and oilseeds are of a notional nature
and are not backed by an organized system of official procurement. In these case
also, 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.
(4) Public Distribution System :

Rationale of PDS : The distribution of essential commodities through fair
price shops at government - controlled prices has come to be known as
public distribution system.
There are various reasons for the setting up of the public distribution system
in India.
1) In order to maintain stable price conditions, an efficient management of the
supplies of essential consumer goods is necessary. Moreover, as most of these
commodities are agriculture-based, their prices are subject to large seasonal
variation. Public distribution system will, therefore, have to play a major role in
ensuring supplies of essential consumer goods of mass consumption to people
at reasonable prices, particularly to the weaker sections of the community.

State trading and buffer stock operation on the one side and public distribution
on the other are essential in the case of agricultural products.
2) A large proportion of agricultural products - both food grains and raw

materials - come to the market soon after the harvest when prices are
depressed. It is necessary to devise a scheme to buy such commodities
at prices which ensure a certain minimum profit to the farmers. 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;
they also help in stabilizing agricultural process. At the same time, these
goods would be supplied through public channels to consumers especially
the weaker sections of the community - this would mean that in critical times,
they would receive supplies of essential commodities at reasonable prices.
3) The PDS has become a stable and permanent feature of India's strategy to
control prices, reduce fluctuations in prices and achieve an equitable distribution
of essential consumer goods among the people.
Goods to be included in the public distribution system. Since distribution is a

highly complex matter, only the most essential goods of mass consumption should
be brought under the public distribution system, e.g. cereals, sugar, edible oils and
vanaspati, kerosene, soft coke, controlled cloth, tea, toilet soap and washing soap,
match boxes, exercise books for children, etc.
Supplies to the public distribution system. Both Central and state Governments
have made arrangements to procure essential commodities and supply them through
the public distribution outlets. In the case of food grains, FCI undertakes the
necessary operations. In regard to sugar, FCI undertakes these operations. The
State Trading Corporation (STC) has been entrusted with the responsibility of
importing and distributing edible oils. Kerosene is being handled by the public
sector corporations like Indian Oil Corporation (IOC), Hindustan Petroleum, Bharat
Petroleum, etc. 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).
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. The tug-of-war between
monopoly producers and scattered consumers obviously works to the advantage of the
producers. This is why Prof. J.K.Galbraith favoured the organization of the advantage of the
producers. This he termed countervailing power. A consumer's interest has several facets and

its protection amounts to empowering the consumer. Such an empowerment can be achieved
by the consumers themselves by organizing together and further by creating consumer's co-
operatives. Such an option is difficult to achieve, especially where the consumers are spread
over a vast area and where they lack in awareness, education and organizational ethics. It is
under these conditions that the government is called upon to step in, in order to protect the
consumer's interest.
One way of protecting the interest of the consumers is the formation of their co-operatives.
But due to various limitations it is lengthy and tedious process. Therefore, the government, at
best, can announce a set of concessions and facilities for their development. 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. The consumer Protection Act, 1986,
in India is such an effort. The act provides for the settings up of quasi-judicial bodies at the
district, state and central levels for the redressal of consumer protection act which provides for
reliefs and compensation to the consumers wherever deemed appropriate.
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.
ii) Right to Information: A consumer has a right to the information regarding the quality,
quantity, potency, purity, standard and the price of goods and services as the case may
be, so that he can protect himself against unfair trade practices like being misguided
and cheated.
iii) Right to a competitive Price: Wherever possible, the consumer must be assured of an
access to a variety of goods and services at a competitive price. This right, on the one
hand accepts the freedom of retailers from the exploitative conditions imposed by the
producers and on the other hand, contains the monopoly powers of the producers.
iv) Right to be Heard: The establishment of appropriate forums at various levels aims at
hearing the grievances of the consumers.
v) 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. It is therefore, necessary to educate the consumers in this protection
given to them. It is therefore, necessary to educate the consumers in this regard.
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 well-
being. Such practices include; a) False representation of the quality, quantity, grade,

composition, style, etc. of the product; b) False claims regarding the quality, grade or
effectiveness of a service; c) False representation regarding re-built, removed, reconditioned
or old goods as new goods; d) False claims regarding sponsorship, approval, performance
uses or benefits which the goods really do not possess; e) false representation regarding
affiliation or authorized dealership; f) misleading representation concerning the need for or the
usefulness of goods/services; and g) giving as untested or unrealistic guarantee regarding the
quality /performance of the goods /services.
Protection of a consumer’s freedom to buy the goods and services of his choice is necessary,
and goods which are found defective must be treated as an infringement of his freedom of
choice. Therefore, action is required to be taken against the producers/ sellers of substandard
goods and services. For this purpose action based upon certain standards should be laid
down, like AGMARK or ISI seal, can be taken by the government. Similarly, protection against
deficiency in the product or service implying a fault, imperfection, shortcoming or inadequacy
in the quality, nature or performance has got to be accorded.
It is necessary to remember that in respect of the protection of consumer's interests, the

Consumer Protection Act is not only act concerned. In fact, the Indian ContractAct, the
Sale of Goods Act, the Negotaible Instrument Act, the Banking Regulation Act, the
Compines Act etc.,also contain provisions regarding protection accorded to the consumers
in cases relevant under the Act concerned. Because the Consumer Protection Act is specially
intended and framed for this purpose, we have discussed some of the provisions/ considerations
of this Act.
Under the various Acts, in accordance with the provisions in this regard, the consumer has to
be provided with an access to the machinery evolved for or already existing to the redressal of
his grievances. As such as aggrived parties, the consumers can take resourse to filing suits
in the relevant course. Obviously, 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.
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. As such, it involves various
steps by way of creating machinery,monitoring the performance and penalizing the defaulters.
This in turn, created the need for maintaining inspection/ supervision personnel, procedures
for enforcing the laws and actions for penalizing the defaulters andcompensating the sufferers.
Needless to say that this is a major and pervasive intervention in the system of marketing and
pricing. In this context, it is essential to implement fhe suggestions and recommendations
given by a committee headed by Anna Hazare, a great Social Reformer.

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

(VCRs, Colour TVs, C.D. Players, Tape Recorders). 18. White goods (Domestic
Refrigerators, Domestic Dish Washing Machines, Programmable Domestic Washing
Machines, Microwave ovens, Air conditioners).
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.
(B) Areas where security and strategic concerns predominate, will continue to be reserved
for the public sector.
List of Industries to be reserved for the Public Sector
1. Arms and ammunition and allied items of defense equipments, Defense aircraft and
warships. 2. Atomic Energy. 3. Coal and lignite. 4. Mineral oils. 5. Mining of iron ore,
manganese ore, chrome ore, gypsum, sulphur, gold and diamond. 6. Mining of copper,
lead, zinc, tin, molybdenum and wolfram. 7. Minerals specified in the Schedule to the
Atomic Energy (Control of production and use) Order, 1953. 8. Railway transport.
(C) In projects where imported capital goods are required, automatic clearance will be given
in cases where foreign exchange availability is ensured through foreign equity; or if the
CIF value of imported capital goods required is less than 25% of total value (net of taxes)
of plant and equipment, up to a maximum value of Rs.2 crore.
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) In locations other than cities of more than 1 million population, there will be no requirement
of obtaining industrial approvals from the Central Government except for industries subject
to compulsory licensing. In respect of cities with population greater than 1 million,
industries other than those of a non-polluting nature such as electronics, computer software
and printing will be located outside 25 kms of the periphery, except in prior designated
industrial areas.
Foreign Investment
In order to invite foreign investment in high priority industries, requiring large investment and
advanced technology, it has been decided to provide approval for direct foreign investment
upto 51 per cent foreign equity in such industries.
Foreign Technology
With a view to injecting the desired level of technological dynamism in Indian industry, government
would provide automatic approval for technology agreements related to high priority industries

within specified parameters. No permission will be necessary for hiring of foreign technicians,
foreign testing of indigenously developed technologies.
Public Sector Policy
Public enterprises have shown a very low rate of return of the capital invested. 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.
The 1991 Industrial Policy has adopted a new approach to public enterprises. The priority
areas for growth of public enterprises in the future will be the following :
(a) Essential infrastructure goods and services.
(b) Exploration and exploitation of oil and mineral resources.
(c) 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.
(d) Manufacture of products where strategic considerations predominate such as defence

equipment.
Government will strengthen those public enterprises which fall in the reserved areas or are
generating goods or reasonable profits. Such enterprises will be provided a much greater
degree of management autonomy through the system of memoranda of understanding.
Competition will also be induced in these areas by inviting private sector participation. In the
case of selected enterprises, 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.
There are a large number of chronically sick public enterprises incurring heavy losses, operating
in a competitive market and serving little or no public purpose. The following measures are
being adopted.
(i) BIFR - Public enterprises which are chronically sick and which are unlikely to be turned
around would, 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.
(ii) Disinvestment - In order to raise resources and encourage wider public participation, a
part of the government's shareholding in the public sector would be offered to mutual
funds, financial institutions, the general public and workers.

(iii) Boards of public sector companies would be made more professional and given greater
powers.
(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.
MRTP ACT.
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
interference of the Government through the MRTP Act has to be restricted. Towards this end.
(i) The pre-entry scrutiny of investment decisions by so-called MRTP companies will no
longer be require. Instead, emphasis will be on controlling and regulating monopolistic,
restrictive and unfair trade practices rather than making it necessary for the monopoly
houses to obtain prior approval of Central Government for expansion, establishment of
new undertakings, merger, amalgamation and takeover and appointment of certain
directors.
(ii) The thrust of policy will be more on controlling unfair or restrictive business practices.
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. These three items were : motor cars, white
goods (which include refrigerators, washing machines, air conditioners, etc.) and raw
hides and skins and patent leather. The basic purpose fo dereservation of these items
was to increase the flow of investment in these industries. With the growth of a large
middle class, ranging between 100 to 120 milions, the demand for the white goods like
washing machine, refrigerators, air conditioners is growing and these items are no longer
viewed as luxury goods. Similary the demand for motor cars by the upper middle class
and the affluent sections is also growing, more especially when the government is providing
loans to businee executives and other senior officials to buy cars. To provide a boost to
th motor car and white goods industries, the government has decided to de-reserve
these items so that their production improves as response to the market, instead of
remaining shackled by the bureaucratic process of liscenceing.
Regardsing raw hides and skins and patent leather, the Government wants to push up
their exports. 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.
In pursuance of the liberalization policy towards foreign investment, the Government

decided in December 1996 to include 16 categories of industries in respect of which

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

For achieving these long-term objectives, the government undertook to instill internal and
external confidence in to the economy by adopting stabilization measures, the major ones
beings as follows:
i) Fiscal Policy Reforms aimed at reducing the overall public sector defict from 12.5% to
4% of GDP by mid-nineties. This involved raising the income level through both tax and
non-tax revenues and controlling public expenditure. This required a greater tax-effort, a
more realistic administered price structure, a reduction in subsidies and a better fiscal
discipline.
ii) Financial Sector Reforms based on stricter monitory policy first and then a reversal to a
liberal policy, embraced a wide range of industrial areas including the Reserve Bank,
Sheduled Banks, CO-operative Banks ,Foreign Banks, Mutual Funds Insurance
Companies, Housing Finance Companies, and Stock exchanges. 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, norms of
capital adequacy, insistence of credit rating and scaling down of interest rates and more
autonomy to the financial institutions. All these aimed at strengthening the financial
sector and making it more competitive
iii) Social Sector Policy was guided by the needs of human development. It aimed at revitalized
efforts at poverty alleviation, spread of education through formal and nonformal streams,
employment guarantee initiatives, supply of safe drinking water,revamping of housing
programmes, immunization and other health measures and special attention to the welfare
of woman, children and the privileged sections of the society.
iv) 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 was
sought to be achieved by following a phased programme of de-regulation. Expecting the
industries of strategic: importance in the areas of defence, defence production and internal
energy and such other industries related to protection of environment and internal security,
industrial licensing was abolished. 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. Areas of
industrial activity reserved for the public sector were opened to the private sector, thereby
narrowing down the scope of the public sector.
v) The policy regarding Foreign Capital was recast so as to attract foreign capital, increase
foreign exchange earnings, avail of marketing techniques. For this purpose, several reforms
and changes were made in the policy. Diract Foreign Investment, up to 51%, was permitted
in export=oriented industrial units, trading companies too could have 51% foreigners
held equity if they were primarily engaged in export trade. For foreign collaborations,

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. 1 crore.
vi) Trade Policy was modified, in phases, 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, all
quantitative restrictions on imports were removed and a system of price-based system
of duties, wherever necessary, was substituted.
vii) Public Sector Policy underwent an overhaul. The new involved a more realistic review of
earlier policy, greater autonomy to units which needed to continue in the public sector, a
progressive reduction in the budgetary support to public sector, 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, the measures taken included a) reduction in the number of
industries reserved for the public sector from 17to 8, b) rehabilitation of sick units through
BIFR (Board for Industrial and Financial Reconstruction), c) a close monitoring to ensure
profitability, and d) a policy of disinvestment. Besides, several steps for protecting the
interests of the employees were taken which included VRS packages, retaining
programmes etc.
A preview of the deals of liberalisation is not very encouraging from certain angles. It has
opened up new avenues for enterprise and has attained some success in terms of global
linkages of the Indian economy. However, the rates of industrial growth have fallen,
agriculture remains neglected, regional as well as personal income disparities have
widened and poverty, unemployment and development have attained higher magnitude,
as if to mock reforms!
8) THE PROCESS OF DISINVESTMENT: NEED AND METHODS
With economic liberalization, the private sector was given more freedom and greater scope in
the interest of improving the overall performance of the economy as a whole. Greater scope for
the private sector may mean incremental disinvestment which connotes the expansion of
PSUs can be left to some private company. It may also mean denationalization of the public
sector units taking private sector as a partner. In other words, disinvestment is a part of the
process of privatization.
a) Need for Disinvestment
Over a period of four decades beginnings with the 1950s, the scope of public sector was
continuously expanding, due to various reasons like lack of public sector's funds, non-

interest on the part of private sector in undertaking long-term investment projects and so
on. With the onset of the New Economic Policy oriented towards providing an upper
hand to the private sector, a reversal of the erstwhile policy of public-sector-dominance
was set in motion. As a part of this, the process of disinvestment which meant selling of
the shares of a PSU to private corporates and individuals started. By selling stocks the
public sector could encash part of its investment and hence, the term disinvestment.
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. This is done through disinvestment.
ii) Professionalism: Ina highly dynamic modern world, efficiency and competitive
strength requires the association of professional and management experts with the
PSUs (public sector undertakings). But the cream of such expertise is always
attracted by the private sector by offering them lucrative, flexible and potentially
progressive working conditions. If this expertise is to be available to the public
sector, the public sector must offer a share in ownership to the private sector. The
public sector in India has continuously been under criticism ofr its lack of a
professional approach, mainly due to the fact that most of these units are headed
by administrative experts rather than management experts.
iii) Reducing deficit: As noted earliar, the Government of India was keen on reducing
the overall deficit of the public sector to 4% of GDP. For this purpose it needed
funds which would help bridge the gap. Disinvestment provided an opportunity of
selling stocks and raising funds.
iv) Re-allocation of Resources: Conceptually, the process of disinvestment amounts

to reallocation of resources between the private and the public sectors. This step,
in the new business environment, was expected to improve the productive efficiency
of the PSUs, thereby paving the way for improving the performance of the economy
as a whole.
v) Capital Support to Plans: Non-Plan expenditure has been continuously increasing

due to a number of reasons like higher rates of D.A. for the employees, a rise in the
salary bill due to the Fifth Pay Commission's recommendations, rising prices of
goods purchased plan projects which needed capital support were therefore, starved
of investible funds. Desinvestment accruals are a part of the capital receipts and
can be diverted to the capital needs of the plan projets.
vi) Substitute for Taxation: If we take into account the ground-level need in the midst
of present difficulties faced by the Government of India, the disinvestment programme

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

2) Total Denationalization: The second method involves a complete sellout of a
PSU to a private corporate organization- it may be domestic or foreign or a
collaboration concern. Such a step can be taken under a number of possible
situations. Firstly, it is possible that the unit which earlier existed in the private
sector was nationalized, with a specific objective. Once the objective is fulfilled, the
same unit can be denationalized. Secondly, it is possible (though conceptually
only!) that the unit was sick and was taken over by the state. After its complete
recovery and rehabilitation, the same can be handed back to the private sector.
Finally, a PSU is incurring losses due to mismanagement in the public sector. If a
private body corporate comes forward with confidence to set things right, it can buy
the entire unit with all assets and liabilities.
3) Liquidation: By going through the procedure laid down by the constitution/MOU of

the PSU, the government may announce its decision of going into liquidation in
case of the unit concerned. 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
4) Management buy-out: As a special case of de-nationalization, a PSU can be
sold to the employees of the project. All the assets could be sold to the employees
organization which could be formed as a worker's cooperative, or they can form a
joint companies act. Provision of bank finance for enabling the workers to buy the
assets can be made. The employees would continue getting wages as before plus
a divided from the companies pool of distributed profits.
5) 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. The buyers of
stocks, in such cases, can be the Life Insurance Corporation of India, the General
Insurance Corporation of India, the Industrial Development Bank of India, and the
Unit Trust of India and so on.
c) Methods of Implementation:
Once the decision is taken regarding the option of disinvestment to be choose a method of
disinvestment, i.e. actual implementation of the decision to part with ownership either partially
or wholly, either in favour of the employees or in favour of other public sector institutions etc.
There are various methods of implementation for achieving this end.
1) Sale of Stocks and Allotment: Like any other company a PSU can announce -
not a new issue but existing shares - an issue with a premium and a policy of
allotment intending buyers may apply and will be allotted shares. In keeping with
the goals to be predetermined, the PSU concerned can decide upon a premium
over and above the face value and can also decide the mode of allotment. /it would

include the proportion to be allotted to individuals, the same to be sold to institutions
and so on.
2) Negotiating joint ownership: when a part of equity is to be made over to a

prospective buyer, such a buyer has got to be identified and then the terms and
conditions of partial transfer of ownership are to be negotiated. When an agreement
is reached and is duly signed, the process of disinvestment is carried out in
accordance with the agreement, i.e. 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, etc. This method can be adopted
where specialized products are involved are a few reputed accountability, the whole
deal must be transparent and a fairly reasonable price must be negotiated.
3) Open auction: Another method is the auction method. Under this method, the
government may announce its intention to sell a given amount of shares to a particular
class of buyers (e.g. individuals, resident or non-resident, institutional: domestic
or/ and foreign etc.) and may invite bids or offers. The highest bid may be accepted.
However, this can be qualified with other conditions like technical know- how,
managerial track-record, market reputation and so on. It is possible that a prospective
buyer offers a second best price but has a very good track- record and a reputation
in the market. Such an offer may be accepted.
4) Informal Approach: Informally, the government department concerned or the PSU

itself may probe into the world-wide corporate sector for finding a prospective partner.
Such a buyer may then be contacted and the terms and conditions may be finalized.
These terms and conditions would include the payment in foreign or domestic
currency, its mode; powers etc. and such a deal would be subject to the approval of
the public authorities concerned like the disinvestment committee and parliament.
5) Pre-planned Transfer: In cases of types (4) and (5) discussed above, a systematic
plan can be prepared and worked out. When the company is to be handed over to
the employees, all details like price per share amount of down payments, the mode
of allotment ,loan- arrangements phased transfer of management, policy regarding
managerial/supervisory staff, the form of oraganisation to be adopted etc. are to be
well planned and then the whole plan has got to be implemented.
Where the ownership is to be partially transferred to other public sector institutions,

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.Generally, stocks are dispensed with in lots and then the promoters or

the business house concerned would elect/select a board of directors and take
over the responsibility. 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. Repercussions on demand are also expected through
a change in the expectations of the consumers.
7) Liquidation: Incase of liquidation, the procedure is analogous to any private

company going into liquidation. Asset values are low, share-prices are to be valued
through assessors and share holder being the government, it receives payment in
installments and on the basis of the price decided by the assessor/expert committee
appointed for this task.
d) Disinvestment of Public sector share holding- Indian experience:
Considering the performance and shortcomings of the Public Sector Undertakings, the
government has gone in for a programme of disinvestment of public sector enterprises.
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. In the 1991-92 budget, the government announced the intention of
partial disinvestment in selected PSUs in order to raise resources, encourage wider
public participation and promote greater accountability. Upto 20% of the government
equity in 31 selected enterprises was offered to Mutual Funds, Financial / Investment
Institutions, workers and general public. It is likely that such a measure may provide
resources to the tune of Rs.2,500 crores to the Government to reduce its deficit.
Disinvestment of PSU Shares :
In pursuance of Industrial policy Statement of 1991, the Government has carried out
various rounds of disinvestment of equity shareholding, realizing a total amount of
Rs.20,320 crores form PSUs till March 2000.
The Government of India set up the Disinvestment Commission in August 1996 to advise
it on the extent, strategy, methodology and hiring for investment in each PSU. Till March
1998, the Government referred 50 PSUs to the Commission for its advice. So far the
Commission has given its recommendations on 41 PSUs - these recommendations
include trade sale (6 units), strategic sale (18 units) and offer of shares (5 units). In other
12 cases, the Commission has recommended : no disinvestment, disinvestment deferred,
and closure and sale of assets (for 4 units)
As against a total budgeted estimate of Rs.38,307 crores during 1991-92 and 2000-01,
the Government realized only Rs.20,320 crores i.e. 38.4 per cent of the budgeted amount.
Obviously, Government failed to raise the budgeted disinvestment in the capital market.
Many reasons may by ascribed for this failure, but the most important is the non-

acceptability of the shares of PSUs in the capital market. The token privatization to the
extent of 8 - 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.
Year wise Receipts from Disinvestment of PSUs
Rs. Crores
Year Disinvestment Budgeted estimate Receipts Actual
1991-91 2,500 3,038

1992-93 2,500 1,913
1993-94 3,500 Nil
1994-95 4,000 4,843
1995-96 7,000 168
1996-97 5,000 380
1997-98 4,800 910
1998-99 9,006 5,371
1999-2000 10,000 1,829
2000-2001 10,000 1,869
Total 58,306 20,320
Source : RBI, Report on Currency and Finance (1998-99) and Economic Survey (2002-2002.)
The Cabinet Committee on Disinvestment in its meeting held on June 23, 2000 gave a
clearance for disinvestment to 11 PSUs including IBP. MMTC, STC and SCI. BESIDES
THE 11 PSUs cleared, 19 other PSUs had been given clearance earlier. All this is being
done to fulfill the objective of raising Rs.10,000 crores form disinvestment during the
year. The Government hopes to complete the disinvestment process in Indian Airlines,
Air India, ITDC, BALCO and IPCL within the financial Year 2000-01.

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

NOTES

NOTES

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

NOTES

NOTES
Reference Books 353

NOTES

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MANAGERIAL

Prof. Pradeep Datar

© Symbiosis Center for Distance Learning (SCDL)

This book on Managerial Economics is written to present a simple text to the

Prof. Pradeep Datar

The author of this book is a Lecturer in the Department of Economics at

Mrs. Swati Chaudhari

Chapter TITLE Page

1 Introduction to Managerial Economics 1

2 Types of business Organizations 17

5 Production and Costs 141

6 Pricing and output determination in different markets 185

7 Cost- Benefit Analysis 257

8 Macro Economic Analysis 285

9 Government and Private Business 319

Reference Book 351

Introduction, Definition of Managerial Economics, Nature and Scope of Managerial Economics,

1. Definitions of Managerial Economics

1. Prof. Spencer Sigelman : Managerial Economics deals with integration of economic

2. Prof. Hague : Managerial Economics is concerned with using logic of economics,

Introduction to Managerial Economics 1

The definitions given above highlight the following points :

2. Nature of Managerial Economics :

1. It is true that managerial economics aims at providing help in decision-making by firms.

4. Managerial Economics is prescriptive in nature and character. It recommends that a

Introduction to Managerial Economics 3

3. Scope of Managerial Economics :

1. Demand analysis and forecasting :

Introduction to Managerial Economics 5

It is obvious form the foregoing discussion that managerial economics is applied

Some other areas covered by Managerial Economics are :

THE SOURCE OF ECONOMIC PROBLEMS

Introduction to Managerial Economics 7

6. Meaning of Economic Problem :

Economic Problem at the Family Level

Economic Problem at the Universal Level Or Economic Problem – A Universal Problem

Introduction to Managerial Economics 9

Basic Economic Problems

7. Seven Questions faced by all economies :

Introduction to Managerial Economics 11

Why do market society’s experiences such periods of involuntary unemployment which

6) Is the purchasing power of money and savings constant, or is it being eroded

Introduction to Managerial Economics 13

1. Define Managerial Economics.

2. Explain the Nature and Scope of Managerial Economics.

3. What is the Significance of Marginal Economics?

4. What is an economics problem?

5. “There is something Universal about and economic problem” Discuss.

Introduction to Managerial Economics 15

Introduction, A firm, plant, Industry, Types of Business organizations - Proprietary Firms,

Organisation of production requires bringing together various factors of production and

1. Definition of a firm as a producing unit.

1. Hansn : The firm may be defined as an independently administered business unit.

Types of Business Organisations 17

The firm may be a proprietorship firm or a partnership firm or a Multi-National Corporation.

2. The firm and the industry

Types of Business Organisations 19

3. The firm and the plant

4. Types of Business Organisations

l Types of Business Organization :

Types of Business Organisations 21

The following chart indicates various forms of business organization:

Types of Business Organization