V UNIT MBA

Theory of the Firm

What is the 'Theory of the Firm'
The theory of the firm is the microeconomic concept founded in neoclassical
economics that states that firms exist and make decisions to maximize profits. Firms
interact with the market to determine pricing and demand and then allocate resources
according to models that look to maximize net profits.
Expansion on the Theory of the Firm

Modern takes on the theory of the firm sometimes distinguish between long-run
motivations, such as sustainability, and short-run motivations, such as profit
maximization. The theory is always being analyzed and adapted to suit changing
economies and markets. Early economic analysis focused on broad industries, but as
the 19th century progressed, more economists began to look at the firm level to
answer basic questions about why companies produce what they do and what
motivates their choices when allocating capital and labor.
Behavioural Theory of the Firm

Behavioural theories of the firm consider alternatives to profit maximisation as a

business objective. This study note explains.
Business objectives

Behavioural economists believe that large businesses are complex organisations

made up of many different stakeholders.

Stakeholders are groups made up of people who each have a vested interest in the
activity of a business. Examples include:

 Managers employed by a business and other employees

 Shareholders are people who have a stake in a business
 Customers
 The government and its agencies

Each group of stakeholders will have different objectives or goals.

The dominant group at any moment can focus on their own objectives. For
example price and output decisions may be taken at a local level by managers, with
shareholders taking only a distant view of the company's performance and strategy.

Examples of alternatives to profit maximisation

Satisficing behaviour

This happens when businesses aim for minimum acceptable levels of

achievement in terms of revenue and profit.

Sales (output) maximisation

Selling as much as you can without making a loss. At sales maximisation there are
normal profits or no supernormal profits.

Sales (revenue) maximisation

The objective of maximising sales revenue rather than profits was developed by
economist William Baumol whose work focused on the behaviour of manager-
controlled businesses.

 Annual salaries and perks are linked to sales revenue rather than profits
 Companies geared towards maximising revenue are likely to make frequent
use of price discrimination to extract extra revenue and marginal profit from
consumers
 A business might also aim to maximise sales revenue rather than profits
because it wishes to deter the entry of new firms
 If a firm decides to aim to maximise sales revenue rather than profits, one of
the consequences might be a reduction in the price of the firm's shares since
the rate of profit is likely to be lower

MANAGERIAL THEORIES OF THE FIRM

Managerial theories of the firm place emphasis on various incentive mechanisms in

explaining the behaviour of managers and the implications of this conduct for their
companies and the wider economy.

According to traditional theories, the firm is controlled by its owners and thus wishes
to maximise short run profits. The more contemporary managerial theories of the
firm examine the possibility that the firm is controlled not by its owners, but by its
managers, and therefore does not aim to maximise profits. Although profit plays an
important role in these theories as well, it is no longer seen as the sole or dominating
goal of the firm. The other possible aims might be sales revenue maximisation or
growth.

Economics Theories

MANAGERIAL THEORIES OF THE FIRM

 Baumol's Theory of Sales Revenue Maximisation

 Marris Growth Maximization Model:
 Williamson’s Managerial Discretionary Theory
The Concept of Profit in Business:

The concept of profit entails several different meanings. Profit may mean the
compensation received by a firm for its managerial function. It is called normal profit
which is a minimum sum essential to induce the firm to remain in business. Profit
may be looked upon as a reward for true entrepreneurial function. It is the reward
earned by the entrepreneur for bearing the risk. It is termed as supernormal profit
analysis.

Profit may imply monopoly profit. It is earned by a firm through extortion, because
of its monopoly power in the market. It is not related to any useful specific function.
Thus monopoly profit is not a functional reward. Profit may sometimes be in the
nature of a windfall. It is an unexpected reward earned by a firm just by mere chance,
an inflationary boom.

Profit is the earning of entrepreneur. To the economist, the most significant point
about profit is that it is a residual income. However, the term profit has different
connotations.

In short, the following are the distinctive features of profit as a factor reward:
(i) It is not a predetermined contractual payment.

(ii) It is not a fixed remuneration.

(iii) It is a residual surplus.

(iv) It is uncertain.

(v) It may even be negative. Other factor rewards are always positive.
Gross Profit and Net Profit:
In ordinary parlance, profit actually means gross profit.

Gross profit is a term in which the following items are included in addition to
the net profit due to the entrepreneur:
(i) Remuneration for factors of production contributed by entrepreneur himself.

(ii) Depreciation and maintenance charges.

(iii) Extra personal profits.

(iv) Net profit.

Net profit is the exclusive reward for the entrepreneur for the following
functions performed by him:
(i) Reward for co-ordination

(ii) Reward for risk taking

(iii) Reward for uncertainty bearing, and

(iv) Reward for innovation.

In short,

Gross Profit = Net profit + implicit rent + implicit wages + implicit interest + normal
profit + depreciation and maintenance charges + non-entrepreneurial profit.

Net Profit = Gross profit – (implicit rent + implicit wages + implicit interest + normal
profit + depreciation and maintenance charges + non-entrepreneurial profit)
In fact, Net Profit = economic profit or pure business profit. It is the net profit which
may be positive or negative. A negative profit means a loss.

Accounting Profit and Economic Profit:

An accountant looks at profit as a surplus of revenues over costs, as recorded in the
books of accounts. An accountant is interested in accounting, auditing, planning and
budgeting profit. The accountant does not take care of implicit or opportunity cost.
Accounting profit is also called residual profit.

For the business firm, accounting profit is very important. Accounting profit is
defined as the revenue realised in a given period after providing for expenses
incurred during the production of a commodity. A firm while making accounting
profits may be incurring economic losses. Such a firm would have to withdraw from
business in the long run. In the balance sheet of a firm, accounting profit occupies
an important place.

The economist, however, does not agree with the accountant’s approach to profit.
The accountant would only deduct the explicit or actual costs from the revenues to
determine profit. The economist points out that in addition to the deduction of
explicit cost, imputed cost, i.e., the cost that would have been incurred in the absence
of the employment of self owned factors, should also be deducted.

Their examples are:

(i) Entrepreneur’s wages that he could earn by working for someone else,

(ii) Rental income on self-owned land and building employed in the business, and

(iii) Interest on self owned capital that could have been earned by investing it
elsewhere.
Thus the profit arrived at after deducting both explicit and imputed costs may be
called economic profit. From the managerial point of view, economic profit is very
important because this alone shows the viability of a firm.

Normal Profits and Supernormal Profits:

Normal profits refer to the imputed returns to capital and risk-taking just necessary
to prevent the owners from withdrawing from the industry. The normal profits are
usually defined as the supply price or opportunity cost of entrepreneurship. Such
cost must be covered if the firm is to stay in business in the long run.

When competition among entrepreneurs is perfect, the market price of the product
is equal to average cost which itself includes ‘normal profit’. Normal profit is the
minimum to induce the entrepreneur to remain in the business in the long run.

It is possible that the entrepreneur may not get normal profit in the short run and may
have to sell his product at a loss, but in the long run every entrepreneur must get at
least the normal profits. It is assumed to be part of the price. In the words of Mrs.
Joan Robinson, “Normal profit is that profit which neither attracts a new firm to
enter into the industry nor obligates the existing firm to go out of the industry.”

Supernormal profit is defined as the surplus over the normal profit. It is obtained by
the super marginal firms. The marginal firm gets only the normal profit, but
determines the supernormal profit of the intra marginal firm.

Profit as Functional Reward:

Some economists consider profit as a functional reward. According to them, profit
is a reward for the entrepreneur for his entrepreneurial functions. Some have said
that organising and coordinating other factors of production are the main functions
of the entrepreneur. Some others have said that risk- taking and decision making are
the important functions of the entrepreneur.

They say that since the entrepreneur takes risks in business, he earns profit.
Schumpeter said that the entrepreneur is performing the role of an innovator and
therefore profit is a reward for his innovation. Prof. Knight opined that profit is due
to his risk taking and uncertainty bearing.

Monopoly Profit:
When a firm possesses monopoly power, it can restrict output and obtain a higher
profit than it could under competitive conditions. Profit is the result of continued
scarcity. It can exist only in an imperfect market where output is for various reasons
restricted and the consumers are deprived of the opportunity of alternative sources
of supply.

Sources of such powers are usually found in legal restrictions, sole ownership of raw
materials or access of sale to particular markets. Even some degree of uniqueness in
a firm’s product confers some monopoly power. Summarising, it can be said that
profits may come to exist as a result of monopoly.

Windfall Profit:
Some consider profit as a windfall gain. According to them, profit is not a reward
for any entrepreneurial function or monopoly power. It is merely a windfall gain. It
arises due to changes in the general price level in the market. If the producer or trader
buys his inputs and raw materials when the prices are low and sells the output when
the prices have abruptly gone up due to some unforeseen external factors, we call
the profit as windfall profit. This is also included under net profit.
Earning of Management:
The entrepreneur having good bargaining power, purchases raw materials at
reasonable prices. He makes suitable arrangements to store the raw materials
properly. By proper inventory building, he maintains the supply of raw materials
regularly.

He hires labour at normal wages and borrows working capital at reasonable rates of
interest. Thus he manages and controls explicit costs. Ensuring of supply of capital
is the most important function of profit. A certain percentage of net profit is set apart
for better management of business.

2. Profit Policies:

It is generally held that the main motive of a firm is to make profits. The volume of
profit made by it is regarded as a primary measure of its success. Economic theory
advocates profit maximisation as the chief policy of a firm. Modem business
enterprises do not accept this view and relegate the profit maximisation theory to the
back ground. This does not mean that modem firms do not aim at profits. They do
aim at maximum profits but aim at other goals as well. All these constitute the profit
policy.

(i) Industry Leadership:

Industry leadership may involve either the achievement of the maximum sales
volume or the manufacture of the maximum product lines. For the attainment of
leadership in the industry, there has to be a satisfactory level of profit consistent with
capital invested, labour force employed and volume of output produced.

(ii) Restricting the Entry:

If a firm follows a policy of restricting its profit, no competitors are likely to enter
the market. Reasonable profits which guarantee its survival and growth are essential.
According to Joel Dean, “Competitors can invade the market as soon as they
discover its profitability and find ways to shift the patents and make necessary
changes in design, technique, and production plant and market penetration.”

(iii) Political Impact:

High profits are considered to be suicidal for a firm. If the government comes to
know that the firms are earning huge returns, it may resort to high taxation or to
nationalisation. High profits are often considered as an index of monopoly power
and to prevent the government may introduce price control and profit regulation
policies.

(iv) Consumer Goodwill:

Consumer is the foundation of any business. For maintaining consumer goodwill,
firms have to restrict the profit. By maintaining low profit, the firms may seek the
goodwill of the consumers. Consumer goodwill is valued so much these days that
firms often make organised efforts through advertisements.

(v) Wage Consideration:

Higher profits may be taken as an evidence of the ability to pay higher wages. If the
labour associations come to know that the firms are declaring higher dividends to
the shareholders, naturally they demand higher wages, bonus, etc. Under these
circumstances in the interest of harmonious relations with employees, firms keep the
profit margin at a reasonable level.
(vi) Liquidity Preference:
Many concerns give greater importance to capital soundness of a firm and hence
prefer liquidity to profit maximisation. Liquidity preference means the preference to
hold cash to meet the day to day transactions. The first item that attracts one’s
attention in the balance sheet is the ratio of current assets to current liabilities. In
order to give capital soundness, the business concerns keep less profit and maintain
high cash.

(vii) Avoid Risk:

Avoiding risk is another objective of the modem business for which the firms have
to restrict the profit. Risk element is high under profit maximisation. Managerial
decision involving the setting up of a new venture has to face a number of
uncertainties. Very often experienced managements avoid the possibility of such
risks. When there is oligopolistic uncertainty, firms may focus attention at
minimising losses. The guiding principle of business economics is not maximisation
of profit but the avoidance of loss.

a. Alternative Profit Policies:

Economists have suggested different profit policies which business firms may adopt
as an alternative to profit maximisation.

Game theory is a field of mathematics that is used to analyse the strategies

used by decision makers in competitive situations. It can apply to humans,
animals, and computers in various situations but is commonly used in AI
research to study “multi-agent” environments where there is more than one
system, for example several household robots cooperating to clean the
house. Traditionally, the evolutionary dynamics of multi -agent systems have
been analysed using simple, symmetric games, such as the
classic Prisoner’s Dilemma, where each player has access to the same set
of actions. Although these games can provide useful insights into how multi -
agent systems work and tell us how to achieve a desirable outcome for all
players - known as the Nash equilibrium - they cannot model all situations.
Our new technique allows us to quickly and easily identify the strategies
used to find the Nash equilibrium in more complex asymmetric games
- characterised as games where each player has different strategies, goals
and rewards. These games - and the new technique we use to understand
them - can be illustrated using an example from ‘Battle of the Sexes’, a
coordination game commonly used in game theory research.

Here, two players have to coordinate a night out to either the opera or the
movies. One of the players has a slight preference for the opera and one of
them has a slight preference for the movies. The game is asymmetric
because, while both players have access to the same options, the
corresponding rewards for each are different based on the players
preferences. In order to maintain their friendship - or equilibrium - the
players should choose the same activity (hence the zero payoff for separat e
activities).

This game has three equilibria: (i) both players deciding to go to the opera,
(ii) both deciding to go to the movies, and (iii) a final, mixed option, where
each player will opt for their preferred option three fifths of the time. This
last option, which is said to be “unstable”, can be rapidly uncovered using
our method by simplifying - or decomposing - the asymmetric game into its
symmetric counterparts. These counterpart games essentially considers the
reward table of each player as a separate symmetric 2-player game with
equilibrium points that coincide with the original asymmetric game.

In the plot below, the Nash equilibrium is plotted for the two, simple
counterparts allowing us to quickly identify the optimal strategy in the
asymmetrical game (a). The reverse can also be done, using the asymmetrical
game to identify the equilibrium in its symmetrical counterparts.
The red dot represents the Nash equilibrium. For the asymmetric game (a), this can
easily be derived from the plots of the two symmetric counterparts (b) and (c). In all
plots, the x-axis corresponds to the probability with which player 1 chooses opera,
and the y-axis corresponds to the probability with which the 2nd player chooses
opera.
This method can also be applied to other games, including Leduc poker,
which is described in detail in the paper. In all of these situations, the method
proves to be mathematically simple, allowing a rapid and straightforward
analysis of asymmetric games that we hope will also help our un derstanding
of various dynamic systems, including multi-agent environments.

Two-Person Zero-Sum Games: Basic Concepts

Game theory provides a mathematical framework for analyzing the decision-making
processes and strategies of adversaries (or players) in different types of competitive
situations. The simplest type of competitive situations are two-person, zero-sum
games. These games involve only two players; they are called zero-sum games
because one player wins whatever the other player loses.
Example: Odds and Evens
Consider the simple game called odds and evens. Suppose that player 1 takes evens
and player 2 takes odds. Then, each player simultaneously shows either one finger
or two fingers. If the number of fingers matches, then the result is even, and player
1 wins the bet ($2). If the number of fingers does not match, then the result is odd,
and player 2 wins the bet ($2). Each player has two possible strategies: show one
finger or show two fingers. The payoff matrix shown below represents the payoff to
player 1.

Basic Concepts of Two-Person Zero-Sum Games

This game of odds and evens illustrates important concepts of simple games.

 A two-person game is characterized by the strategies of each player and the

payoff matrix.
 The payoff matrix shows the gain (positive or negative) for player 1 that would
result from each combination of strategies for the two players. Note that the
matrix for player 2 is the negative of the matrix for player 1 in a zero-sum game.
 The entries in the payoff matrix can be in any units as long as they represent
the utility (or value) to the player.
 There are two key assumptions about the behavior of the players. The first is that
both players are rational. The second is that both players are greedy meaning
that they choose their strategies in their own interest (to promote their own
wealth).
 MaxiMin Strategy/MiniMax strategy

In game theory, Maximin/Minimax are strategies used when playing games.

The strategy in this case is to maximize the smallest possible payoff that a
player can receive as opposed to trying to maximize your payoff, assuming the
other player will play rationally.

Consider the following game:

If this game was played with both players acting rationally, the optimal
solution is for them both to invest. This is because "Invest" is a dominant
strategy for P2. We can see this by finding P2's best response to P1.

 If P1 uses the strategy "Don't Invest" it is best for P2 to play "Invest" since $15
> $10.
 If P1 uses the strategy "Invest" it is best for P2 to play "Invest" since $20 > $0.

Therefore it always the best strategy for P2 to play "Invest". Now, given that
P2 would know this (using the same logic that we both did), they just need to
compare the options of "Invest" v "Don't Invest" assuming that P2 plays
"Invest". Since $20 > $15, we can conclude the optimal solution is for both
players to use the strategy "Invest" and thus they will both receive a payoff of
$20.

Let's suppose now that P1 decides to use a Maximin strategy but P2 continues
to play rationally. In this case, we play the game as follows:
 If P1 invests, the worst scenario is P2 doesn't invest in which case player 1 gets
a payoff of -$100.
 If P1 doesn't invest, the worst case scenario is that P2 doesn't invest in which
case P1 gets a payoff of $10.

Since $10 > -$100, playing the strategy "Don't Invest" maximizes the minimum
payoff for P1, so P1 plays "Don't invest".

Now since firm B's dominant strategy is to play invest regardless of P1

strategy, they will play the strategy "Invest". The payoff in this situation will
be $15 to P1 and P2. The new equilibrium is P1 playing "Don't invest" and P2
playing "invest". As we can see, from pursuing the strategy of Maximin, this
has cost both players $5.

It is also worth noting that even if P2 used a Maximin strategy they would still
choose to invest since that is a dominant strategy, which means it maximizes
their payoff regardless of the other players actions. Clearly this also maximizes
their minimum payoff.

This strategy is typically only used when one player believes that another
player will not play rationally. The fear for P1 would be that if they play the
strategy "Invest" and the other plays irrationally and chooses "Don't Invest",
P1 would lose $100.

he theory of zero-sum games is vastly different from that of non-zero-sum games

because an optimal solution can always be found. However, this hardly represents
the conflicts faced in the everyday world. Problems in the real world do not usually
have straightforward results. The branch of Game Theory that better represents the
dynamics of the world we live in is called the theory of non-zero-sum games. Non-
zero-sum games differ from zero-sum games in that there is no universally accepted
solution. That is, there is no single optimal strategy that is preferable to all others,
nor is there a predictable outcome. Non-zero-sum games are also non-strictly
competitive, as opposed to the completely competitive zero-sum games, because
such games generally have both competitive and cooperative elements. Players
engaged in a non-zero sum conflict have some complementary interests and some
interests that are completely opposed.
A Typical Example

The Battle of the Sexes is a simple example of a typical non-zero-sum game. In this
example a man and his wife want to go out for the evening. They have decided to go
either to a ballet or to a boxing match. Both prefer to go together rather than going
alone. While the man prefers to go to the boxing match, he would prefer to go with
his wife to the ballet rather than go to the fight alone. Similarly, the wife would
prefer to go to the ballet, but she too would rather go to the fight with her husband
than go to the ballet alone. The matrix representing the game is given below:

Husband

Boxing Match Ballet

Wife Boxing Match 2, 3 1, 1
Ballet 1, 1 3, 2

The wife's payoff matrix is represented by the first element of the ordered pair while
the husband's payoff matrix is represented by the second of the ordered pair.

From the matrix above, it can be seen that the situation represents a non-zero-sum,
non-strictly competitive conflict. The common interest between the husband and
wife is that they would both prefer to be together than to go to the events separately.
However, the opposing interests is that the wife prefers to go to the ballet while her
husband prefers to go to the boxing match.

Analyzing a Non-Zero-Sum Game

 Communication

It is conventional belief that the ability to communicate could never work to

a player's disadvantage since a player can always refuse to exercise his right
to communicate. However, refusing to communicate is different from an
inability to communicate. The inability to communicate may work to a
player's advantage in many cases.

An experiment performed by Luce and Raiffa compares what happends when

player can communicate and when players cannot communicate. Luce and
Raiffa devised the following game:
 a b
A 1, 2 3, 1
B 0, -200 2, -300

If Susan and Bob cannot communicate, then there is no possiblity of threats

being made. So, Susan can do no better than to play strategy A and Bob can
do no better than to play strategy a. Susan, therefore gains 1 and Bob gains 2.
However, when communication is allowed, the situation is complicated.
Susan can threaten Bob by saying that she will play strategy B unless Bob
commits himself to playing strategy b. If Bob submits, Susan will gain 2 and
Bob will lose 1 (as opposed to Susan gaining 1 and Bob gaining 2 when
communication is not allowed).

 Restricting Alternatives

The Battle of the Sexes example given above seems to be an unsolvable

dilemma. However, this problem can be solved it either the husband or the
wife resticts the others' alternatives. For example, if the wife buys two tickets
for the ballet, indicating that she is definitely not going to the boxing match,
the husband would have to go to the ballet along with his wife in order to
maximize his self-interest. Because the wife bought the two tickets, the
husbands optimal payoff, now, would be to go along with his wife. If he were
to go to the boxing match alone, he would not be maximizing his self-interest.

 The Number of Times the Game is "Played"

If the game is played only once, players do not have to fear retaliation from
their opponents, so they may play differently than they would in a game
played repeatedly.
Examples of Typical Non-Zero-Sum Games:

The Prisoner's Dilemma game was first proposed by Merrill Flood in 1951. It was
formalized and defined by Albert W. Tucker. The name refers to the following
hypothetical situation:

Two criminals are captured by the police. The police

suspect that they are responsible for a murder, but do
not have enough evidence to prove it in court, though
they are able to convict them of a lesser charge
(carrying a concealed weapon, for example). The
prisoners are put in separate cells with no way to
communicate with one another and each is offered to confess.

If neither prisoner confesses, both will be convicted of the lesser offense and
sentenced to a year in prison. If both confess to murder, both will be sentenced to 5
years. If, however, one prisoner confesses while the other does not, then the prisoner
who confessed will be granted immunity while the prisoner who did not confess will
go to jail for 20 years

Schumpeter’s Theory of Innovation

Definition: Schumpeter’s Theory of Innovation is in line with the other
investment theories of the business cycle, which asserts that the change in
investment accompanied by monetary expansion are the major factors behind the
business fluctuations, but however, Schumpeter’s Theory posits that innovation in
business is the major reason for increased investments and business fluctuations.

According to Schumpeter, the cyclical process is almost exclusively the result of

innovation in the organization, both industrial and commercial. By innovation he
means, the changes in the methods of production and transportation, production of a
new product, change in the industrial organization, opening up of a new market, etc.
The innovation does not mean invention rather it refers to the commercial
applications of new technology, new material, new methods and new sources of
energy.

Schumpeter has developed a model in two stages, i.e. first approximation, and
second approximation, in order to further explain his business cycle theory of
innovation. The first approximation lays emphasis on the primary impact of
innovatory ideas while the secondary approximation deals with the subsequent
responses obtained from the application of the innovations. Let’s study these stages
in detail:

 First Approximation: This stage begins with the economic system in

equilibrium in which there is no involuntary unemployment, firm’s mc =
mr (marginal cost is equal to marginal revenue) and price = Average Cost (AC).
In the situation of complete equilibrium in the economy, if the firm decides to
undertake a new technique of production, then the same needs to be financed
through bank credit. Since the economy is in equilibrium, there are no surplus
funds to finance the new venture.
With the additional funds from the banking system, the firm keeps on bidding
higher prices for the inputs with a view to withdrawing them from the other less
important uses. With an increased expenditure in the economy, the price begins
to rise. This process further expands, when other firms try to imitate the
innovation and raise additional funds from the banking system. As the innovation
gets widely adapted the output begins to flow in the market. This marks the
beginning of prosperity and expansion.

But after a certain level, with an increase in the level of output the price and
profitability decreases. This is because the further innovation does not come by
quickly and thus, there will be no additional demand for the funds. Instead, the
firms which borrowed the funds from the bank start paying it back. This results
in the contraction in money supply and hence the prices fall further. The process
of recession begins and remains until the equilibrium in the economy is restored.

 Second Approximation: The second approximation deals with the waves

generated by the first approximation. The speculation is the main element of
second approximation. As the primary wave of expansion begins, the investor,
particularly in capital goods industries, expects this upswing to remain permanent
and hence borrows heavily.
Even the consumers expecting the prices to increase in future go into debt to
acquire durable consumer goods. This heavy indebtedness turns out to be havoc
when prices begin to fall. Both the investors and consumers find it difficult to
meet their obligations, and this situation leads to a panic and then depression.
The Schumpeter’s theory of innovation suffers from the following criticisms:

 It is not only difficult but also unavailing to perform the objective evaluation of
Schumpeter’s theory of the business cycle because its arguments are more based
on the sociological factors rather than the economic factors.
 Schumpeter’s theory is not basically different from the over-investment theory; it
differs only in the respect of the cause of variation in investment when the
economy is in stable equilibrium.
 Like other theories of the business cycle, this theory also leaves out other factors
that cause fluctuations in the economic activities. Innovation is not the sole factor,
rather is only one of the factors that cause fluctuations in the economy.
In spite of these shortcomings Schumpeter’s theory of innovation is widely
acceptable in the modern economy and is used to determine the economic
fluctuations.

The Harrod Domar Model suggests that economic growth rates depend on two
things:

1- Level of Savings (higher savings enable higher investment)

2- Capital-Output Ratio. A lower capital-output ratio means investment is more

efficient and the growth rate will be higher.

A simplified model of Harrod-Domar:

Harrod-Domar in more detail:

1- Level of savings (s) = Average propensity to save (APS) – which is the ratio of
national savings to national income.

2- The capital-output ratio = 1/marginal product of capital.

3- The capital-output ratio is the amount of capital needed to increase output.

4- A high capital output ratio means investment is inefficient.
5- The capital-output ratio also needs to take into account the depreciation of
existing capital

Main factors affecting economic growth:

• Level of savings. Higher savings enable greater investment in capital stock

• The marginal efficiency of capital. This refers to the productivity of investment,

e.g. if machines costing £30 million increase output by £10 million. The capital-
output ratio is 3
• Depreciation – old capital wearing out.

Warranted Growth Rate:

Roy Harrod introduced a concept known as the warranted growth rate.

• This is the growth rate at which all saving is absorbed into investment. (e.g. £80bn
of saving = £80bn of investment.
• Let us assume, the saving rate is 10%. the Capital output ratio is 4. In other words,
£10bn of investment increases output by £2.5bn
• In this case, the economy’s warranted growth rate is 2.5 percent (ten divided by
four).

• This is the growth rate at which the ratio of capital to output would stay constant
at four.

The Natural Growth Rate:

• The natural growth rate is the rate of economic growth required to maintain full
employment.
• If the labour force grows at 3 percent per year, then to maintain full employment,
the economy’s annual growth rate must be 3 percent.

• This assumes no change in labour productivity which is unrealistic.

Importance of Harrod-Domar:

It is argued that in developing countries low rates of economic growth and

development are linked to low saving rates.

This creates a vicious cycle of low investment, low output and low savings. To boost
economic growth rates, it is necessary to increase savings either domestically or
from abroad. Higher savings create a virtuous circle of self-sustaining economic
growth.

Impact of increasing capital:

The transfer of capital to developing economies should enable higher growth, which
in turn will lead to higher savings and growth will become more self-sustaining.

Criticisms of Harrod Domar Model:

• Developing countries find it difficult to increase saving. Increasing savings ratios
may be inappropriate when you are struggling to get enough food to eat.

• Harrod based his model on looking at industrialised countries post-depression

years. He later came to repudiate his model because he felt it did not provide a model
for long-term growth rates.

• The model ignores factors such as labour productivity, technological innovation

and levels of corruption. The Harrod Domar is at best an oversimplification of
complex factors which go into economic growth.
• There are examples of countries who have experienced rapid growth rates despite
a lack of savings, such as Thailand.

• It assumes the existences of a reliable finance and transport system. Often the
problem for developing countries is a lack of investment in these areas.

• Increasing capital stock can lead to diminishing returns. Domar was writing during
the aftermath of the Great Depression where he could assume there would always
be surplus labour willing to use the machines, but, in practice, this is not the case.
• The Model explains boom and bust cycles through the importance of capital, (see
accelerator theory) However, in practice businesses are influenced by many things
other than capital such as expectations.

• Harrod assumed there was no reason for the actual growth to equal natural growth
and that an economy had no tendency to full employment. However, this was based
on the assumption of wages being fixed.
• The difficulty of influencing saving levels. In developing economies it can be
difficult to increase savings ratios – because of widespread poverty.

• The effectiveness of foreign capital flows can vary. In the 1970s and 80s many
developing economies borrowed from abroad, this led to an inflow of foreign capital
however, there was a lack of skilled labour to make effective use of capital. This led
to very high capital-output ratios (poor productivity) and growth rates didn’t increase
significantly. However, developing economies were left with high debt repayments
and when interest rates rose, a large proportion of national savings was diverted to
paying debt repayments.

• Economic development implies much more than just economic growth. For
example, who benefits from growth? does higher national income filter through to
improved health care and education. It depends on how the capital is used.

What is a 'Break-Even Analysis'

Break-even analysis entails the calculation and examination of the margin of

safety for an entity based on the revenues collected and associated costs. Analyzing
different price levels relating to various levels of demand, an entity uses break-even
analysis to determine what level of sales are needed to cover total fixed costs. A
demand-side analysis would give a seller greater insight regarding selling
capabilities.
 Elaborate Break – Even Analysis.

The Break-Even Point

The break-even point (BEP) in economics, business—and specifically cost
accounting—is the point at which total cost and total revenue are equal, i.e. "even".
There is no net loss or gain, and one has "broken even", though opportunity
costs have been paid and capital has received the risk-adjusted, expected return. In
short, all costs that must be paid are paid, and there is neither profit nor loss.[1][2]

The break-even point (BEP) or break-even level represents the sales amount—in
either unit (quantity) or revenue (sales) terms—that is required to cover total costs,
consisting of both fixed and variable costs to the company. Total profit at the break-
even point is zero. It is only possible for a firm to pass the break-even point if the
dollar value of sales is higher than the variable cost per unit. This means that the
selling price of the good must be higher than what the company paid for the good or
its components for them to cover the initial price they paid (variable costs). Once
they surpass the break-even price, the company can start making a profit.
The break-even point is one of the most commonly used concepts of financial
analysis, and is not only limited to economic use, but can also be used by
entrepreneurs, accountants, financial planners, managers and even marketers. Break-
even points can be useful to all avenues of a
Either option can reduce the break-even point so the business need not sell as many
tables as before, and could still pay fixed costs.

Purposes (Uses)

The main purpose of break-even analysis is to determine the minimum output that
must be exceeded for a business to profit. It also is a rough indicator of the earnings
impact of a marketing activity. A firm can analyze ideal output levels to be
knowledgeable on the amount of sales and revenue that would meet and surpass the
break-even point. If a business doesn't meet this level, it often becomes difficult to
continue operation.
The break-even point is one of the simplest, yet least-used analytical tools.
Identifying a break-even point helps provide a dynamic view of the relationships
between sales, costs, and profits. For example, expressing break-even sales as a
percentage of actual sales can help managers understand when to expect to break
even (by linking the percent to when in the week or month this percent of sales might
occur).
The break-even point is a special case of Target Income Sales, where Target Income
is 0 (breaking even). This is very important for financial analysis. Any sales made
past the breakeven point can be considered profit (after all initial costs have been
paid)
Break-even analysis can also provide data that can be useful to the marketing
department of a business as well, as it provides financial goals that the business can
pass on to marketers so they can try to increase sales.
Break-even analysis can also help businesses see where they could re-structure or
cut costs for optimum results. This may help the business become more effective
and achieve higher returns. In many cases, if an entrepreneurial venture is seeking
to get off of the ground and enter into a market it is advised that they formulate a
break-even analysis to suggest to potential financial backers that the business has the
potential to be viable and at what points.
In the linear Cost-Volume-Profit Analysis model (where marginal costs and
marginal revenues are constant, among other assumptions), the break-even point
(BEP) (in terms of Unit Sales (X)) can be directly computed in terms of Total
Revenue (TR) and Total Costs (TC) as:

where:

 TFC is Total Fixed Costs,

 P is Unit Sale Price, and
 V is Unit Variable Cost.
The Break-Even Point can alternatively be computed as the point
where Contribution equals Fixed Costs.

The quantity, , is of interest in its own right, and is called the Unit
Contribution Margin (C): it is the marginal profit per unit, or alternatively the
portion of each sale that contributes to Fixed Costs. Thus the break-even point
can be more simply computed as the point where Total Contribution = Total
Fixed Cost:

To calculate the break-even point in terms of revenue (a.k.a. currency units,

a.k.a. sales proceeds) instead of Unit Sales (X), the above calculation can be
multiplied by Price, or, equivalently, the Contribution Margin Ratio (Unit
Contribution Margin over Price) can be calculated:

R=C,
Where R is revenue generated, C is cost incurred i.e. Fixed costs +
Variable Costs or

or, Break Even Analysis

Q = TFC/c/s ratio = Break Even
Limitations( Assumptions)

The Break-even analysis is only a supply-side (i.e., costs only) analysis, as it tells
you nothing about what sales are actually likely to be for the product at these various
prices.

It assumes that fixed costs (FC) are constant. Although this is true in the short run,
an increase in the scale of production is likely to cause fixed costs to rise.

It assumes average variable costs are constant per unit of output, at least in the range
of likely quantities of sales. (i.e., linearity).

It assumes that the quantity of goods produced is equal to the quantity of goods sold
(i.e., there is no change in the quantity of goods held in inventory at the beginning
of the period and the quantity of goods held in inventory at the end of the period).

In multi-product companies, it assumes that the relative proportions of each product

sold and produced are constant (i.e., the sales mix is cons

Uses of Break-Even Analysis:

(i) It helps in the determination of selling price which will give the desired profits.

(ii) It helps in the fixation of sales volume to cover a given return on capital
employed.

(iii) It helps in forecasting costs and profit as a result of change in volume.

(iv) It gives suggestions for shift in sales mix.

(v) It helps in making inter-firm comparison of profitability.

(vi) It helps in determination of costs and revenue at various levels of output.

(vii) It is an aid in management decision-making (e.g., make or buy, introducing a

product etc.), forecasting, long-term planning and maintaining profitability.
(viii) It reveals business strength and profit earning capacity of a concern without
much difficulty and effort.

It assumes that the quantity of goods produced is equal to the quantity of goods sold
(i.e., there is no change in the quantity of goods held in inventory at the beginning
of the period and the quantity of goods held in inventory at the end of the period).

In multi-product companies, it assumes that the relative proportions of each product

sold and produced are constant (i.e., the sales mix is cons