Study material for MBA I- Managerial Economics

MBA 102

Managerial Economics

Unit I

1. Define managerial economics. Explain briefly its nature and scope?

Ans. Managerial Economics consists of that part of economic theory which helps the business
manager to take rational decisions. Economic theories help to analyze the practical problems faced by
a business firm. Managerial Economics integrates economic theory with business practice. It is a
special branch of economics that bridges the gap between abstract theory and business practice. It
deals with the use of economic concepts and principles for decision making in a business unit It is
over wise called Business Economics or Economics of the Firm. The terms Managerial Economics
and Business Economics are used interchangably. Managerial Economics is economics applied in
business decision-making. Hence it is also called Applied Economics.

Definition of Business Economics

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

According to Spencer and Siegelman, Business economics is "the integration of economic theory with
business practise for the purpose of facilitating decision-making and forward planning by
management".

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

From the above said definitions, we can safely say that business economics makes in depth study of
the following objectives:

(i) Explanation of nature and form of economic analysis

(ii) Identification of the business areas where economic analysis can be applied

(iii) Spell out the relationship between Managerial Economics and other disciplines
outline the methodology of managerial economics.

Characteristics of business economics

The following characteristics of business economics will indicate its nature:

1. Micro economics: Managerial economics :s micro economic in character. This is so because it

studies the problems of an individual business unit. It does not study the problems of the entire
economy.

2. Normative science: Managerial economics is a normative science. It is concerned with what

management should do under particular circumstances. It determines the goals of the enterprise. Then
it develops the ways to achieve these goals.

3. Pragmatic: Managerial economics is pragmatic. It concentrates on making economic theory more

application oriented. It tries to solve the managerial problems in their day-today functioning.

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

various business problems.

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

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

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

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

9. Art and science.-Managerial economics is both a science and an art. As a science, it establishes
relationship between cause and effect by collecting, classifying and analyzing the facts on the basis of
certain principles. It points out to the objectives and also shows the way to attain the said objectives.

Scope of Business Economics

Managerial economics is a developing science which generates the countless problems to determine
its scope in a clear-cut way. From the following fields, we can examine the scope of business
economics.

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

2. Cost and production analysis. A firm's profitability depends much on its costs of production. A wise
manager would prepare cost estimates of a range of output, identify the factors causing variations in
costs and choose the cost-minimising output level, taking also into consideration the degree of
uncertainty in production and cost calculations.

Production process are under the charge of engineers but the business manager works to carry out the
production function analysis in order to avoid wastages of materials and time. Sound pricing policies
depend much on cost control. The main topics discussed under cost and production analysis are: Cost
concepts, cost-output relationships, Economies and Diseconomies of scale and cost control.

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

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

5. Capital management. Still another most challenging problem for a modern business manager is of
planning capital investment. Investments are made in the plant and machinery and buildings which are
very high. Therefore, capital management requires top- level decisions. It means capital management
i.e., planning and control of capital expenditure. It deals with Cost of capital, Rate of Return and
Selection of projects.

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

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

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

9. Business cycles: Business cycles affect business decisions. They refer to regular fluctuations in
economic activities in the country. The different phases of business cycle are depression, recovery,
prosperity, boom and recession.

Thus, managerial economics comprises both micro and macro-economic theories.

The subject matter of managerial economics consists of all those economic concepts, theories and
tools of analysis which can be used to analyse the business environment and to find out solution to
practical business problems.

Relationship of managerial economics with other sciences

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

Managerial economics and statistics

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

Managerial economics and mathematics

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

Managerial economics and operations research

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

Managerial economics and accounting

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

2. Explain the significance of managerial economics in decision making?

Ans. Managerial economics provides such tools necessary for business decisions. Managerial
economics answers the five fundamental problems of decision making. These problem are : (a) what
should be the product mix (b) which is the least cost production technique and input mix (c) what
should be the level of output and price of the product (d) how to take investment decisions (e) how
much should be the selling cost. In order to solve the problems of decision- making, data are to be
collected and analysed in the lightof business objectives. Business economics supplies such data to the
business economist.

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

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

1. To integrate economic theory with business practice.

2. To apply economic concepts: and principles to solve business problems.

3. To employ the most modern instruments and tools to solve business problems.

4. To allocate the scarce resources in the optimal manner.

5. To make overall development of a firm.

6. To help achieve other objectives of a firm like attaining industry leadership, expansion of the
market share etc.

7. To minimise risk and uncertainty

8. To help in demand and sales forecasting.

9. To help in operation of firm by helping in planning, organising, controlling etc.

10. To help in formulating business policies.

11. To help in profit maximisation.

Business economics is useful because: (i) It provides tools and techniques for managerial decisions,
(ii) It gives answers to the basic problems of business management, (iii) It supplies data for analysis
and forecasting, (iv) It provides tools for demand forecasting and profit planning, (v) It guides the
managerial economist. -

Thus, Business economics offers a number of benefits to business managers. It is also useful to
individuals, society and government.

3. Explain the role and responsibilities of managerial economist in decision making?

Ans. Role of a managerial economist

1. Study of the business environment. Every firm has to take into consideration such external factors
as the growth of national income, volume of trade and the general price trends, for its policy decision.
A firm works within a business environment. The basic element of business environment for a firm
are the trend of growth of national economy and world economy and phase of the business cycle in
which the economy is moving. At what rate and where is population getting concentrated? Where are
the demand prospects for established and new products? Where are the prospective markets? These
questions lead the economists into purposeful studies of the economic environment.

The international economic outlook is a very important environmental factor for exporting firms. The
nature and degree of competition within the industry in which a firm is placed are also a part of the
business environment.

The kind of economic policies pursued by the government constitute a powerful element of the
business environment of a firm. What are the priorities of the new five year plan? In which sectors of
the economy have the outlays been bran increased? What are the budgetary trends? What about
changes in expenditure, tax rates tariffs and import restrictions? For all purposes the economists place
a significant role.

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

3. Study of business operations. The business economist can also help the management in decision
making relating to the internal operations of a firm, i.e., in deciding about price, rate of operations,
investment and growth of the firm for offering this advice ; the economist has specific analytical and
forecasting techniques which yield meaningful conclusions. What will be the reasonable sales and
profit budget for the next year? What are the suitable production schedules and inventory policies?
What changes in wage and price policies are imperative now? What would be the sources of finance?
Thus, he is trained to answer such questions posted by the top management.

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

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

6. Participation in Public Debates. The business economists participate in public debates organised by
different agencies. Both governments and society seek their advice. Their practical experience in
business and industry gives value to their observation. In nut shell a business economist can play a
multi-faceted role. He is not only an analyst of current trends and policies for his employers but also a
bridge between the businessmen in the specific industry and the Govt.

RESPONSIBILITIES OF A BUSINESS ECONOMIST

A business economist is well familiar with his responsibilities. He must keep in the mind the main
objective of making a reasonable profit on the invested capital in his firm. Firms are not always after
profit-maximization, but to continue in business, every firm has to operate for profit. Therefore, a
business economist has the main responsibility of helping the management to make more profits than
before. All his other responsibilities flow from this basic obligation. The responsibilities of a business
economists are summarised below :
1. Making successful Forecasts. Managements have to take decisions concerning the future and it is
uncertain. This uncertainity cannot be eliminated altogether but it can be reduced through scientific
forecasts of the economic environment to his employers. This is required for business planning. If a
business economist can make successful forecasts about business trends, the management will hold
him in great esteem. A wise managerial economist will revise his forecasts from time to time keeping
in view new developments in his business. As soon as he finds a change in his forecasts, he has to
alert the management about it. He assists the management in making the needed adjustments. This
will help him to strengthen his position as a member of the managerial team.

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

3. Earning full Status on the Managerial team. A business economist has to participate in decision-
making and forward- planning. For this he must be able to earn full status on the business team. He
must be prepared to take up assignments on special project also. He should be able to express himself
clearly so that his advice is understood and accepted. Finally, he must be in tune with the industry's
thinking, and not lose the national perspective in giving advice to the management.

Thus, we can conclude from our discussion that managerial economists can earn an important place in
the managerial team only if the understands and undertakes his responsibilities.

4. Elaborate the different principles of managerial economics which are helpful in decision making?

Ans. Fundamental concepts of applied managerial economics

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

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

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

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

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

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

(i) It increases revenue more than costs,

(ii) It decreases some costs more than it increases others,

(iii) It increases some revenue more than it decreases others, and

(iv) It reduces costs more than revenue.

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

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

4. Discounting Principle. Generally people consider a rupee tomorrow to be worth less than a rupee
today. This is also implied by the common saying that a bird in hand is worth than two in the bush.
Anybody will prefer Rs. 1000 today to Rs. 1000 next year. There are two main reasons for this : (1)
the future is uncertain and it is preferable to get Rs. 1000 today rather than a year after ; (2) even if
one is sure to receive the Rs. 1000 next year, one would do well to receive Rs. 1000 now and invest it
for a year and earn a rate of interest on Rs. 100 for one year. What is the present worth (PW) of Rs.
1000 obtainable after one year ? The relevant formula for finding this out is

PW = i Rs .100 where i is the rate of interest.

We find that PW of Rs. 100 = 100 ÷ (1 + 8%)

= 100 ÷ 108 = Rs. 92.59.

The principle of economics used in the calculations given above is called the discounting principle. It
can be explained as "If a decision affects costs and revenues at future dates, it is necessary to discount
those costs and revenues to obtain the present values of both before a valid comparison of alternatives
can be made"present values of both before a comparison of alternatives can be made’’

5. Equi-marginal principle : This is one of the widely used concepts in managerial economics. This
principle is also known the principle of maximum satisfaction. According to this principle, an input
should be allocated in such a manner that the value added by the last unit of input is same in all uses.
In this way, this principle provides a base for maximum exploitation of all the inputs of a firm so as to
maximise the profitability.

The equi-marginal principle can be applied in different areas of management. It is used in budgeting.
The objective is to allocate resources where hey are most productive. It can be used for eliminating
waste in useless activities. It can be applied in any discussion of budgeting. The management can
accept investments with high rates of return so as to ensure optimum allocation of capital resources.
The equi-marginal principle can also be applied in multiple product pricing. A multi product firm will
reach equilibrium when the marginal revenue obtained from a product is equal to that of another
product or products. The equi-marginal principle may also be applied in allocating research
expenditures.

6. Optimisation : This is another important concept used managerial economics. Managerial

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

Unit II

5. What do you mean by demand? Explain the factors affecting/determinants of demand?

Ans. In common usage, demand means a desire or a want but in economics desire, want and demand
are three different concepts. In economics, every desire is not a want and every want is not a demand.
Desire is the wish to have something or to enjoy a service.

Want= Desire + Resources + Willingness

But demand implies more than mere desire. It means that the person is willing and able to pay for the
object he desire. Demand thus means desire backed by willingness and ability to pay. Besides,
demand also signifies a price and a period of time in which demand is to be fulfilled. It is obvious that
a person’s demand for anything varies with the price at which it is offered. He buys more of it at a
lower price, and less of it at a higher price. Similarly, his demand varies with the period of time.

Demand= Want + Relationship of Want with certain price, time and quantity

“By demand we mean the various quantities of a given commodity or service which consumers would
buy in one market in a given period of time at various prices, or at various incomes, or at various
prices of related goods.”— (Bober).

We can represent demand symbolically as a functional relationship as under:

DA=F (Pa, Pc, Pd………………….: I: T)

In this equation DA stands for the households demand for goods A: Pa, Pc, Pd denote the prices of
other goods: I stands for (he income of the household, and the households’ tastes are represented by T.

Kinds of Demand:

Three kinds of demand may be distinguished:

(a) Price demand,

(b) Income demand, and

(c) Cross demand.

Price Demand:

This demand refers to the various quantities of a commodi¬ty or service that a consumer would
purchase at a given time in a market at various hypothetical prices. It is assumed that other things such
as consumers’ income, his tastes and prices of related goods remain unchanged.

The demand of the individual consumer is called Individual Demand and the aggregate demand of all
the consumers combined for the commodity or service is called Industry Demand. The total demand
for the product of an individual firm at various prices is known as firm’s demand or Individual
Seller’s Demand.
Income Demand:

The income demand refers to the various quantities of goods and services which would be purchased
by the consumer at various levels of income. Here we assume that the prices of the commodity or
service as well as the prices of related goods and the tastes and desires of consumers do not change.

The price demand expresses relationship between prices and quantities and the income demand brings
out the relationship between income and quantities demanded. For preparing demand schedule of
income demand, we write incomes in one column and quantities purchased at these incomes in the
second column. Superior goods or high-priced articles command brisk sales when income increases.
On the other hand, inferior goods command large sales when incomes are at a lower level.

Cross Demand:

Cross demand means the quantities of a good or service which will be purchased with reference to
changes in the price not of this good but of other related goods. These goods are either substitutes or
complementary good. A change in price of tea will affect demand for coffee. Similarly, if horses
become sheep, demand for carriages may increase.

Some other kinds of demand

i.Individual and Market Demand:

Refers to the classification of demand of a product based on the number of consumers in the market.
Individual demand can be defined as a quantity demanded by an individual for a product at a
particular price and within the specific period of time. For example, Mr. X demands 200 units of a
product at Rs. 50 per unit in a week.

The individual demand of a product is influenced by the price of a product, income of customers, and
their tastes and preferences. On the other hand, the total quantity demanded for a product by all
individuals at a given price and time is regarded as market demand.

In simple terms, market demand is the aggregate of individual demands of all the consumers of a
product over a period of time at a specific price, while other factors are constant. For example, there
are four consumers of oil (having a certain price). These four consumers consume 30 liters, 40 liters,
50 liters, and 60 liters of oil respectively in a month. Thus, the market demand for oil is 180 liters in a
month.

ii. Organization and Industry Demand:

Refers to the classification of demand on the basis of market. The demand for the products of an
organization at given price over a point of time is known as organization demand. For example, the
demand for Toyota cars is organization demand. The sum total of demand for products of all
organizations in a particular industry is known as industry demand.
For example, the demand for cars of various brands, such as Toyota, Maruti Suzuki, Tata, and
Hyundai, in India constitutes the industry’ demand. The distinction between organization demand and
industry demand is not so useful in a highly competitive market.

This is due to the fact that in a highly competitive market, organizations have insignificant market
share. Therefore, the demand for an organization’s product is of no importance. However, an
organization can forecast the demand for its products only by analyzing the industry demand.

iii. Autonomous and Derived Demand:

Refers to the classification of demand on the basis of dependency on other products. The demand for
a product that is not associated with the demand of other products is known as autonomous or direct
demand. The autonomous demand arises due to the natural desire of an individual to consume the
product.

For example, the demand for food, shelter, clothes, and vehicles is autonomous as it arises due to
biological, physical, and other personal needs of consumers. On the other hand, derived demand refers
to the demand for a product that arises due to the demand for other products.

For example, the demand for petrol, diesel, and other lubricants depends on the demand of vehicles.
Apart from this, the demand for raw materials is also derived demand as it is dependent on the
production of other products. Moreover, the demand for substitutes and complementary goods is also
derived demand.

iv. Demand for Perishable and Durable Goods:

Refers to the classification of demand on the basis of usage of goods. The goods are divided into two
categories, perishable goods and durable goods. Perishable or non-durable goods refer to the goods
that have a single use. For example, cement, coal, fuel, and eatables. On the other hand, durable goods
refer to goods that can be used repeatedly.

For example, clothes, shoes, machines, and buildings. Perishable goods satisfy the present demand of
individuals. However, durable goods satisfy both present as well as future demand of individuals.
Therefore, consumers purchase durable items by considering its durability.

In addition, durable goods need replacement because of their continuous use. The demand for
perishable goods depends on the current price of goods and customers’ income, tastes, and
preferences and changes frequently, while the demand for durable goods changes over a longer period
of time.

v. Short-term and Long-term Demand:

Refers to the classification of demand on the basis of time period. Short-term demand refers to the
demand for products that are used for a shorter duration of time or for current period. This demand
depends on the current tastes and preferences of consumers.

For example, demand for umbrellas, raincoats, sweaters, long boots is short term and seasonal in
nature. On the other hand, long-term demand refers to the demand for products over a longer period of
time.

Generally, durable goods have long-term demand. The long-term demand of a product depends on a
number of factors, such as change in technology, type of competition, promotional activities, and
availability of substitutes. The short-term and long-term concepts of demand are essential for an
organization to design a new product.

Factors Influencing Demand for a Commodity:

They are many factors on which the demand for a commodity depends. They are called determinants
of demand. They are discussed as under:

1. Income of the consumer:

A consumer’s demand is influenced by the size of his income. With increase in the level of income,
there is increase in the demand for goods and services. A rise in income causes a rise in consumption.
As a result, a consumer buys more. For most of the goods, the income effect is positive. But for the
inferior goods, the income effect is negative. That means with a rise in income, demand for inferior
goods may fall.

2. Price of the commodity:

Price is a very important factor, which influences demand for the commodity. Generally, demand for
the commodity expands when its price falls, in the same way if the price increases, demand for the
commodity contracts. It should be noted that it might not happen, if other things do not remain
constant.

3. Changes in the prices of related goods:

Sometimes, the demand for a good might be influenced by prices changes of other goods. There are
two types of related goods. They are substitutes and complements. Tea and Coffee are good
substitutes. A rise in the price of coffee will increase the demand for tea and vice versa. Bread and
butter are complements. A fall in the price of bread will increase the demand for butter and vice versa.
4. Tastes and preferences of the consumers:

Demand depends on people’s tastes, preferences, habits and social customs. A change in any of these
must bring about a change in demand. For example, if people develop a taste for tea in place of coffee,
the demand for tea will increase and that for coffee will decrease.

5. Change in the distribution of income:

If the distribution of income is unequal, there will be many poor people and few rich people in
society. The level of demand in such a society will be low. On the other hand, if there is equitable
distribution of income, the demand for necessaries commonly consumed by the poor will increase and
the demand for luxuries consumed by the rich will decrease. However, the net effect of an equitable
distribution of income is an increase in the level of demand.

6. Price expectations:

Expectations of people regarding the future prices of goods also influence their demand. If people
anticipate a rise in the prices of goods in future due to some reasons, the demand for goods will rise to
avoid more prices in future. Contrarily, if the people expect a fall in price, the demand for the
commodity will fall.

7. State of economic activity:

The state of economic activity is major determinant influencing the demand for a commodity. During
the period of boom, prosperity prevails in the economy. Investment, employment and income
increase. The demand for both capital goods and consumer goods increase. But in period of
depression demand declines due to low investment and low income.

8 . Population:

An increase in population of region will result in an increased demand of various goods. Also, the
composition of population determines the demand of certain goods proportionately. For example, an
increased number of females in the region will generate more demand for sarees, ornaments,
cosmetics etc.

1. Government Policy:
Economic policy adopted by the government also influences the demand for commodities. If the
government imposes taxes on various commodities in the form of sales tax, excise duties, octroi etc.,
the price of these commodities will increase. As a result, the demand of such commodities is very
likely to fall.

2. Advertisement:

In this age of advertisement demand for many fashionable items are created by advertising agents
through T.V., newspapers, radios etc.

3. Weather Conditions:

The demand for various household goods depends upon the changes in weather conditions. For
example, the demand for woolen clothes, coal and electric heaters increases during winter and the
demand for cold drinks, ice creams, room coolers, etc. goes up during hot weather.

The level of demand for a commodity is also influenced by other factors like pattern of saving,
inventions and discoveries and outbreak of war, emergencies, technical progress etc.

6. Explain the law of demand with the help of a demand schedule and demand curve. Also point out
the exception of the law?

Ans. Demand Schedule:

If we write down the different quantities that an individual or a group of individuals would buy at
different prices, we get that individual’s or that group’s demand schedule. Thus, a demand schedule is
a table or a chart which shows the quantities of a commodity demanded at different prices in a given
period of time.

The following is the demand schedule of an imaginary consumer of milk:

Market Schedule:

The above is the demand schedule of a particular individual. But we can also construct a market
schedule showing the total quantity of milk demanded at different prices in a market by the whole
body of consumers. We can divide them into three classes: ‘A’—with u monthly income up to Rs.
500, ‘B’—Rs. 501 to Rs. 1000 and “C”—above Rs. 1000. We can see how much will each class buy
at each price, and then total them up

Difficulties in the Construction of a Demand Schedule:

It is difficult to frame the demand schedule of an individual. It is all hypothetical. An individual

cannot positively say how much he would purchase it the prices were different. Some prices in the
schedule are unreal. The price of milk may never be Rs. 8 or Re 1 per liter. What is the use of asking
an individual how much he would by at these prices? To construct a market schedule is still more
difficult. Market schedule is even more hypothetical.

Practical Utility of a Demand Schedule:

It is not possible to construct a scientifically accurate demand schedule. But it is true that different
quantities are bought at different prices.

The demand schedule is useful as follows:

(i) After all, businessmen do make an intelligent forecast of the quantity they could dispose of at
higher or lower prices. Monopolists sometimes deliberately lower prices to stimulate demand.
Businessmen would like to know the various quantities that are likely to be demanded at different
prices. This would help them to forecast profits and to arrange production.

(ii) In order to find out the effect of different rates of taxes on the sale of a commodity, a Finance
Minister has to get the help of demand schedules. The calculations may be rough, but they are all the
same useful. Imposition of tax is bound to raise prices which would in turn reduce demand. The
Government revenue will depend on how much is actually sold. Demand schedule is helpful in
making these calculations.

Demand Curve:

With the help of the demand schedule of an individual given above, we can draw the curve as shown
on the previous page. The quantities are measured along OX and prices (in rupees) along OY.

When the price is Rs. 7.00 a liter, the consumer purchases only half a liter. We travel half a point on
OX-axis and plot a point against the price of Rs. 7.00; we plot the other points in the same manner,
and by joining these points we get the curve. Like the individual demand curve, we can also have a
market demand curve by plotting the market demand schedule given above.
Why Demand Curves Slope Downwards:

Generally the demand curve slopes downwards. This is in accordance with the law of diminishing
utility. The purchases of most of us are governed by this law. When the price falls, new purchasers
enter the market and old purchasers will probably purchase more. Since this commodity has become
cheaper, it will be purchased by some people in preference to other commodities.

Only in a curve of this slope shall we find shorter price lines cutting longer pieces in the quantity axis.
If the law of diminishing utility is true—and it is generally true—the curve must slope downward, for
only then the phenomenon of increasing demand with falling prices can be represented.

These are the three obvious reasons why people buy more when the price falls:

(i) A unit of money goes farther and one can afford to buy more.

(ii) When a thing becomes cheaper one naturally likes to buy more.

(iii) A commodity tends to be put to more uses when it becomes cheaper. Thus, the old buyers buy
more and some new buyers enter the market. The cumulative effect is an extension of demand when
price falls. But let us go a bit deeper and try to find out why the demand increases when the price
falls, other things being equal. Having a limited amount of money at his disposal, every consumer
wants to get the maximum satisfaction out of it. Knowing his own scale of preferences he will,
according to the law of substitution and equimarginal returns, so arrange his expenditure that he gets
equal marginal utility from the last paisa that he spends in different ways.

He will keep to this arrangement if the prices remain the same. But if the price of a certain commodity
included in his assortment of goods and services falls, then lie must make a corresponding alteration
in his scheme of expenditure. By the fall in price, divergence has been created between the marginal
utility and price and this must be rectified. This can be done by buying more of the cheaper
commodity, thus bringing its marginal utility to the level of the price. That is why people buy more
when the prices fall.

Substitution Effect, Income Effect and Price Effect:

If the price of a commodity rises relatively to other goods, the consumer will buy less of that
commodity and buy more of the other goods in place of this particular good. This is called
Substitution Effect in Economics. Another reason for buying less of goods whose prices have risen is
that raise in prices means a loss of purchasing power. It is as it were that the consumer’s income has
come down. This is called the Income Effect.

This is, the consumer has become relatively poor or wane off since his real income (i.e., income in
terms of goods) has fallen. When the price of a commodity falls, more of it is demanded and
substituted for of the commodities and there is income effect too, for the purchaser feels better o when
the price falls and is able to buy more.
The combination of the substitution effect and income effect is known as the price effect. This is the
case with normal or ordinary goods. But if the goods are considered inferior, the effect will be
opposite, i.e. less will be purchased even if the price falls. But if the substitution effect is greater than
the negating income effect, the law of demand will apply even to inferior goods, i.e. demand will
extend when price falls.

Exceptional Demand Curves:

Sometimes the demand curve, instead of sloping downwards, will rise onwards. In other words,
sometimes people will buy more when the price rises. This can be represented only by a rising curve.
Such occasions are very rare, but we can imagine some.

We can think of the following four cases:

(a) In case a serious shortage is feared, people may be in a panic and buy more even though the price
is rising. They are anxious to avoid the necessity of having to pay a still higher price in future.

(b) When the use of a commodity confers distinction, then the wealthy will buy more when the price
rises, to be included among the few distinguished personages. Conversely, people tend to cut their
purchases, if they believe the commodity to be inferior.

(c) Sometimes people buy more at a higher price in sheer ignorance.

(d) If the price of a necessary of life goes up, the consumer has to readjust his whole expenditure. He
may cut down his expenses on other food articles and, in order to make up, more may have to be spent
on this particular food, more of which will, therefore, be purchased in spite of its high price.

These are a few cases in which demand curve will rise upwards instead of sloping downwards.

7. Explain the concept of elasticity of Demand. What are the various concepts and types of elasticity
of demand?

Ans. The degree of responsiveness of quantity demanded of a commodity to the change in price is
called elasticity of demand. price elasticity of demand is popularly called elasticity of demand. It is
the rate of which quantity demanded changes in response to the change in price. Elasticity of demand
expresses the magnitude of change in quantity of a commodity.

Precisely stated, price elasticity demand is defined as the ratio of percentage change in quantity
demanded to a percentage change in price. Thus elasticity of demand can be expressed in form of the
following as price and quantity demanded move opposite.

Types of Elasticity:

Distinction may be made between Price Elasticity, Income Elasticity and Cross Elasticity. Price
Elasticity is the responsiveness of demand to change in price; income elasticity means a change in
demand in response to a change in the consumer’s income; and cross elasticity means a change in the
demand for a commodity owing to change in the price of another commodity.

Five cases of Elasticity of Demand:

1. Perfectly elastic demand

2. Perfectly inelastic demand

3. Relatively elastic demand

4. Relatively inelastic demand

5. Unitary elastic demand

1. Perfectly Elastic Demand:

When a small change in price of a product causes a major change in its demand, it is said to be
perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand to
zero, while a small fall in price causes increase in demand to infinity. In such a case, the demand is
perfectly elastic or ep = 00.

In perfectly elastic demand, the demand curve is represented as a horizontal straight line, which is
shown in Figure-2:

From Figure-2 it can be interpreted that at price OP, demand is infinite; however, a slight rise in price
would result in fall in demand to zero. It can also be interpreted from Figure-2 that at price P
consumers are ready to buy as much quantity of the product as they want. However, a small rise in
price would resist consumers to buy the product.

Though, perfectly elastic demand is a theoretical concept and cannot be applied in the real situation.
However, it can be applied in cases, such as perfectly competitive market and homogeneity products.
In such cases, the demand for a product of an organization is assumed to be perfectly elastic.

From an organization’s point of view, in a perfectly elastic demand situation, the organization can sell
as much as much as it wants as consumers are ready to purchase a large quantity of product. However,
a slight increase in price would stop the demand.

2. Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change produced in the demand of a product
with change in its price. The numerical value for perfectly inelastic demand is zero (ep=0).
In case of perfectly inelastic demand, demand curve is represented as a straight vertical line, which is
shown in Figure-3:

It can be interpreted from Figure-3 that the movement in price from OP1 to OP2 and OP2 to OP3 does
not show any change in the demand of a product (OQ). The demand remains constant for any value of
price. Perfectly inelastic demand is a theoretical concept and cannot be applied in a practical situation.
However, in case of essential goods, such as salt, the demand does not change with change in price.
Therefore, the demand for essential goods is perfectly inelastic.

3. Relatively Elastic Demand:

Relatively elastic demand refers to the demand when the proportionate change produced in demand is
greater than the proportionate change in price of a product. The numerical value of relatively elastic
demand ranges between one to infinity.

Mathematically, relatively elastic demand is known as more than unit elastic demand (ep>1). For
example, if the price of a product increases by 20% and the demand of the product decreases by 25%,
then the demand would be relatively elastic.

The demand curve of relatively elastic demand is gradually sloping, as shown in Figure-4:

It can be interpreted from Figure-4 that the proportionate change in demand from OQ1 to OQ2 is
relatively larger than the proportionate change in price from OP1 to OP2. Relatively elastic demand
has a practical application as demand for many of products respond in the same manner with respect
to change in their prices.

For example, the price of a particular brand of cold drink increases from Rs. 15 to Rs. 20. In such a
case, consumers may switch to another brand of cold drink. However, some of the consumers still
consume the same brand. Therefore, a small change in price produces a larger change in demand of
the product.

4. Relatively Inelastic Demand:

It can be interpreted from Figure-5 that the proportionate change in demand from OQ1 to OQ2 is
relatively smaller than the proportionate change in price from OP1 to OP2. Relatively inelastic
demand has a practical application as demand for many of products respond in the same manner with
respect to change in their prices.
5. Unitary Elastic Demand:

When the proportionate change in demand produces the same change in the price of the product, the
demand is referred as unitary elastic demand. The numerical value for unitary elastic demand is equal
to one (ep=1).

The demand curve for unitary elastic demand is represented as a rectangular hyperbola, as shown in
Figure-6:

From Figure-6, it can be interpreted that change in price OP1 to OP2 produces the same change in
demand from OQ1 to OQ2. Therefore, the demand is unitary elastic.

The different types of price elasticity of demand are summarized in Table-4:

8. Explain the factors affecting elasticity of demand and also the practical importance of it?

Ans. Various factors which affect the elasticity of demand of a commodity are:

1. Nature of commodity:

Elasticity of demand of a commodity is influenced by its nature. A commodity for a person may be a
necessity, a comfort or a luxury.

i. When a commodity is a necessity like food grains, vegetables, medicines, etc., its demand is
generally inelastic as it is required for human survival and its demand does not fluctuate much with
change in price.

ii. When a commodity is a comfort like fan, refrigerator, etc., its demand is generally elastic as
consumer can postpone its consumption.

iii. When a commodity is a luxury like AC, DVD player, etc., its demand is generally more elastic as
compared to demand for comforts.

iv. The term ‘luxury’ is a relative term as any item (like AC), may be a luxury for a poor person but a
necessity for a rich person.

2. Availability of substitutes:
Demand for a commodity with large number of substitutes will be more elastic. The reason is that
even a small rise in its prices will induce the buyers to go for its substitutes. For example, a rise in the
price of Pepsi encourages buyers to buy Coke and vice-versa.

Thus, availability of close substitutes makes the demand sensitive to change in the prices. On the
other hand, commodities with few or no substitutes like wheat and salt have less price elasticity of
demand.

3. Income Level:

Elasticity of demand for any commodity is generally less for higher income level groups in
comparison to people with low incomes. It happens because rich people are not influenced much by
changes in the price of goods. But, poor people are highly affected by increase or decrease in the price
of goods. As a result, demand for lower income group is highly elastic.

4. Level of price:

Level of price also affects the price elasticity of demand. Costly goods like laptop, Plasma TV, etc.
have highly elastic demand as their demand is very sensitive to changes in their prices. However,
demand for inexpensive goods like needle, match box, etc. is inelastic as change in prices of such
goods do not change their demand by a considerable amount.

5. Postponement of Consumption:

Commodities like biscuits, soft drinks, etc. whose demand is not urgent, have highly elastic demand
as their consumption can be postponed in case of an increase in their prices. However, commodities
with urgent demand like life saving drugs, have inelastic demand because of their immediate
requirement.

6. Number of Uses:

If the commodity under consideration has several uses, then its demand will be elastic. When price of
such a commodity increases, then it is generally put to only more urgent uses and, as a result, its
demand falls. When the prices fall, then it is used for satisfying even less urgent needs and demand
rises.

For example, electricity is a multiple-use commodity. Fall in its price will result in substantial
increase in its demand, particularly in those uses (like AC, Heat convector, etc.), where it was not
employed formerly due to its high price. On the other hand, a commodity with no or few alternative
uses has less elastic demand.

7. Share in Total Expenditure:

Proportion of consumer’s income that is spent on a particular commodity also influences the elasticity
of demand for it. Greater the proportion of income spent on the commodity, more is the elasticity of
demand for it and vice-versa.

Demand for goods like salt, needle, soap, match box, etc. tends to be inelastic as consumers spend a
small proportion of their income on such goods. When prices of such goods change, consumers
continue to purchase almost the same quantity of these goods. However, if the proportion of income
spent on a commodity is large, then demand for such a commodity will be elastic.

8. Time Period:

Price elasticity of demand is always related to a period of time. It can be a day, a week, a month, a
year or a period of several years. Elasticity of demand varies directly with the time period. Demand is
generally inelastic in the short period.

It happens because consumers find it difficult to change their habits, in the short period, in order to
respond to a change in the price of the given commodity. However, demand is more elastic in long
rim as it is comparatively easier to shift to other substitutes, if the price of the given commodity rises.

9. Habits:

Commodities, which have become habitual necessities for the consumers, have less elastic demand. It
happens because such a commodity becomes a necessity for the consumer and he continues to
purchase it even if its price rises. Alcohol, tobacco, cigarettes, etc. are some examples of habit
forming commodities.

Finally it can be concluded that elasticity of demand for a commodity is affected by number of
factors. However, it is difficult to say, which particular factor or combination of factors determines the
elasticity. It all depends upon circumstances of each case.

Price Elasticity of Demand is useful in the following ways:

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

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

3. Helpful to Finance Minister: It helps the Finance Minister to levy tax on goods. After levying taxes
more and more on goods which have inelastic demand, the Government collects more revenue from
the people without causing inconvenience to the people. Moreover, it is also useful for the planning.
4. Fixation of Wages: It guides the producers to fix wages for labourers. They fix high or low wages
according to the elastic or inelastic demand for the labour.

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

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

7. Effect on Employment: The effect of machines on employment opportunities depends on elasticity

of demand for the goods produced by such machines. In the initial stage, use of such machines cause
unemployment and prices will also fall. But when demand for such commodities is more elastic, then
fall in prices will generate more increase in its demand.

As a result, demand will stimulate greater production and hence more employment. If demand for
commodities produced by these machines is inelastic, then even fall in price will not increase demand
as well as employment.

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

9. Incidence of Taxation: Incidence of tax lies on the person who ultimately pays the tax. The
incidence is on the buyer, if demand is perfectly inelastic. He will go on buying as much as before
despite the price rise. Thus, the government has to keep the watch on the ultimate burden of the tax,
which depends on the elasticity of demand of the commodity taxed. If necessaries, which have less
elastic demand are taxed the burden will fall more on the poor sections of society. Therefore, principle
of justice in taxation is based on elasticity of demand.

10. Changes in Rate of Exchange: Rate of exchange between two currencies can be changed through
devaluation or overvaluation of one currency in relation to other currencies. A country while deciding
for such a course of action will take into consideration the elasticity of demand for its exports and
imports. If the government devalues the currency without considering the elasticity of demand for its
exports and imports it may not be able to correct unfavorable balance of payments. Under these
circumstances the demand both for its exports and imports turns out to be inelastic.

11. Joint Products: The concept of elasticity of demand plays an important role in determining the
price of joint products. In case of joint products like skin and meat of goat, separate costs are not
known. The producer will be guided mostly by demand and its nature while fixing his price. For
instance, when goat is bought, it is not kept in mind the separate costs of skin and meat.
When the seller sells the skin and meat, the seller keeps in mind the elasticity of demand of skin and
meat. If elasticity of demand for meat is less elastic, in that case the price of meat will be higher. On
the other hand if elasticity of demand for skin is more elastic, in that case the price of the skin will be
low and vice versa.

12. International Trade: The concept of elasticity of demand also plays a significant role in the
international trade or the terms of trade. It is the nature of demand which is helpful in determining the
amount of gain being enjoyed by different countries. The terms of trade would be favourable in case
of those countries, whose exports are of the nature of more elastic demand. On the other hand, the
terms of trade would be un-favourable if the exports of a country are of the nature of less elastic
demand.

13. Market forms: The concept of elasticity of demand is also useful is knowing the different market
forms. If cross elasticity of demand is infinite, in that case there is perfect competition in the market.
If cross elasticity is zero (or Ec = 0) it is a case of absolute or pure monopoly. If cross elasticity of
demand is less than one (or Ec < 1), in that case there is relative monopoly. And if cross elasticity of
demand is greater than one (or Ec >1), in that case, there is monopolistic competition or imperfect
competition.

14. Determination of Price of Public Utilities: This concept is significant in the determination of the
prices of public utility services. Economic welfare of the society largely depends upon the cheap
availability of the essential products like water, electricity, cooking gas, transportation etc. For such
commodities, demand is inelastic and these should be controlled by the government.

The government will distribute these products at fair price. Therefore, Government helps to fix the
prices of necessities of life. Thus, elasticity of demand is a very important tool of analysis and it plays
an important role in economic analysis.

9. What do you mean by demand forecasting? Explain the different types of demand forecasting?

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

anticipating future demand on the basis of past data.

Objectives of Demand Forecasting

A. Short Term Objectives

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

2. To help in ensuring a regular supply of raw materials.

3. To reduce the cost of purchase and avoid unnecessary purchase.

4. To ensure best utilization of machines.

5. To make arrangements for skilled and unskilled workers so that suitable labour

force may be maintained.

6. To help in the determination of a suitable price policy.

7. To determine financial requirements.

8. To determine separate sales targets for all the sales territories.

9. To eliminate the problem of under or over production.

B. Long term Objectives

1. To plan long term production.

2. To plan plant capacity.

3. To estimate the requirements of workers for long period and make arrangements.

4. To determine an appropriate dividend policy.

5. To help the proper capital budgeting.

6. To plan long term financial requirements.

7. To forecast the future problems of material supplies and energy crisis.

Factors Affecting Demand Forecasting

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

1. Prevailing business conditions: While preparing demand forecast it becomes necessary to study the
general economic conditions very carefully. These include the price level changes, change in national
income, percapita income, consumption pattern, savings and investment habits, employment etc.
2. Conditions within the industry: Every business enterprise is only a unit of a particular industry.
Sales of that business enterprise are only a part of the total sales of that industry. Therefore, while
preparing demand forecasts for a particular business enterprise, it becomes necessary to study the
changes in the demand of the whole industry, number of units within the industry, design and quality
of product, price policy, competition within the industry etc.

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

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

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

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

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

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

Process of Demand Forecasting/ Steps in Demand Forecasting

Demand forecasting involves the following steps:

1. Determine the purpose for which forecasts are used.

2. Subdivide the demand forecasting programme into small I parts on the basis of product or sales
territories or markets.

3. Determine the factors affecting the sale of each product and their relative importance.

4. Select the forecasting methods.

5. Study the activities of competitors.

6. Prepare preliminary sales estimates after, collecting necessary data.

7. Analyse advertisement policies, sales promotion plans, personal sales arrangements etc. and
ascertain how far these programmes have been successful in promoting the sales.

8. Evaluate the demand forecasts monthly, quarterly, half yearly or yearly and necessary adjustments
should be done.

9. Prepare the final demand forecast on the basis of preliminary forecasts and the results of evaluation.

M ETHODS OF DEMAND FORECASTING (FOR ESTABLISHED PRODUCTS)

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

(A) Survey methods

Under this method surveys are conducted to collect information about the future purchase plans of
potential consumers. Survey methods help in obtaining information about the desires, likes and
dislikes of consumers through collecting the opinion of experts or by interviewing the consumers.
Survey methods are used for short term forecasting.

Important survey methods are (a) consumers interview method, (b) collective opinion or sales force
opinion methodic) experts opinion method, (d) consumers clinic and (f) end use method.

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

Advantages

1. It is a simple method because it is not based on past record.

2. It suitable for industrial products.

3. The results are likely to be more accurate.

4. This method can be used for forecasting the demand of a new product.

Disadvantages

1. It is expensive and time consuming.

2. Consumers may not give their secrets or buying plans.

3. This method is not suitable for long term forecasting.

4. It is not suitable when the number of consumer is large.

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

Advantages

This method is simple.

1. It is based on the first hand knowledge of Salesmen.

2. This method is particularly useful for estimating demand of new products.

3. It utilises the specialised knowledge of salesmen who are in close touch with the prevailing market
conditions.

Disadvantages

1. The forecasts may not be reliable if the salespeople are not trained.

2. It is not suitable for long period estimation.

3. It is not flexible.

4. Salesmen may give lower estimates that make possible easy achievement of sales quotas fixed for
each salesman.

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

Advantages

1. Forecast can be made quickly and economically

2. This is a reliable method because estimates are made on the basis of knowledge and experience of
sales experts.
3. The firm need not spare its time on preparing estimates of demand.

4. This method is suitable for new products.

Disadvantages

1. This method is expensive.

2. This method sometimes lacks reliability

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

Merits

1. It provides an opportunity to study the behaviour of consumers directly.

2. It provides reliable and realistic picture about future demand.

3. It gives useful information to aid in the decision making process.

Demerits

1. It is a time consuming method.

2. Selecting the participants is very difficult.

3. It is expensive.

4. Consumers may take it as a game. They may not reveal their preferences.

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

Statistical Methods

Statistical methods use the past data as a guide for knowing the level of future demand. Statistical
methods are generally used for long run forecasting. These methods are used for established products.
Statistical methods include: (i) Trend projection method, (ii) Regression and Correlation, (iii)
Extrapolation method, (iv) Simultaneous equation method, and (v) Barometric method.

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

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

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

(iv) Simultaneous equation method.-This involves the development of a complete econometric model
which can explain the behaviour of all the variables which the company can control. This method is
not very popular.

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

Advantages of Statistical Methods

1 The method of estimation is scientific

2 Estimation is based on the theoretical relationship between sales (dependent variable) and price,
advertising, income etc. (independent variables)

3 These are less expensive.

4 Results are relatively more reliable.

Disadvantages of Statistical Methods

1 These methods involve complicated calculations.

2 These do not rely much on personal skill and experience.

3 These methods require considerable technical skill and experience in order to be effective.

Methods of Demand Forecasting for New Products

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

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

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

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

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

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

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

The above methods are not mutually exclusive. It is de desirable to use a combination of two or more
methods in order to get better results.
10. What do you mean by supply? Explain the factors affecting supply?

Ans. In economics, supply during a given period of time means, the quantities of goods which are
offered for sale at particular prices. The supply of a commodity is 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.

Definition of Supply:

According to J. L. Hanson – “By supply is meant that amount that will come into the market over a
range of prices.”

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.

Factors Affecting Supply:

There are a number of factors influencing the supply of a commodity. They are known as the
determinants of supply.

Important factors are as follows:

1. Price of the Commodity:

Price is the most important factor influencing the supply of a commodity. More is supplied at a lower
price and less is supplied at a higher price.

2. Seller’s Expectations about the Future Price:

Seller’s expectations about the future price affect the supply. If a seller expects the price to rise in the
future, he will with¬hold his stock at present and so there will be less supply now. Besides change in
price, change in the supply may be in the form of increase or decrease in supply.

3. Nature of Goods:

The supply of every perishable goods is perfectly inelastic in a market period because the entire stock
of such goods must be disposed of within a very short period, whatsoever may be the price. If not,
they might get rotten. Further, if the stock of goods can be easily stored its supply would be relatively
elastic and vice-versa.

4. 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 the natural conditions will cause a
change in the supply.

5. Transport Conditions:

Difficulties in transport may cause a temporary decrease in supply as goods cannot be brought in time
to the market place. So even at the rising prices, quantity supplied cannot be increased.

6. Cost of Production:

If there is a rise in the cost of production of a commodity, its supply will tend to decrease. Similarly,
with the rise in cost of production the supply curve tends to shift downward. Conversely, a fall in the
cost of production tends to decrease the supply.

7. The State of Technology:

The supply of a commodity depends upon the methods of production. Advance in technology and
science are the most powerful forces influencing productivity of the factors of production. Most of the
inventions and innovations in chemistry, electronics, atomic energy etc. have greatly contributed to
increased supplies of commodities at lower costs.

8. Government’s Policy:

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 the field of
production, so that the supply may increase.

Import restrictions and high customs duties may decrease the supply of imposed goods but it would
encourage the domestic industrial activity, so that the supply of domestic products may increase. A
tax on a commodity or a factor of production raises its cost of production, consequently production is
reduced. A subsidy on the other-hand provides an incentive to production and augments supply.

Question 15. Explain the Law of Supply with the help of a suitable example?

Ans. The law of supply states that, other things remaining the same, the quantity supplied of a
commodity is directly or positively related to its price. In other words, when there is a rise in the price
of a commodity the quantity supplied of it in the market increases and when there is a fall in the price
of a commodity, its quantity supplied decreases, other things remaining the same. Thus, the supply
curve of a commodity slopes upward from left to right.

Assumptions
The term “other things remaining the same” refers to the following assumptions in the law of supply:

1. No change in the state of technology.

2. No change in the price of factors of production.

3. No change in the number of firms in the market.

4. No change in the goals of the firm.

5. No change in the seller’s expectations regarding future prices.

6. No change in the tax and subsidy policy of the products.

7. No change in the price of other goods.

The law of supply can be explained with the help of supply schedule and supply curve as explained
below.

Supply Schedule

Supply Schedule is a tabular presentation of various combinations of price and quantity supplied by
the seller or producer during a period of time. We can show the supply schedule through the following
imaginary table.

The given schedule shows positive relationship between price and quantity supplied of a commodity.
In the beginning, when the price is Rs.10 per kg, quantity supplied by the seller is 1kg. As the price
increases from Rs.10 per kg to Rs.20 per kg and then to Rs.30 per kg, the quantity supplied by the
seller also increases from 1 kg to 2 kg and then to 3 kg respectively. Further rise in price to Rs.40 and
then to Rs.50 per kg results in increase in quantity supplied by the seller to 4kg and then to 5kg. Thus,
the above schedule shows that there is positive relationship in between price and quantity supplied of
a commodity.

Supply curve

The supply curve is a graphical representation of a supply schedule. By plotting various combinations
of price and quantity supplied of the table, we can derive an upward sloping demand curve as shown
in the figure below:
In the given figure, price and quantity supplied are measured along the Y-axis and the X-axis
respectively. By plotting various combinations of price and quantity supplied we derived points A,B,
C, D, E curve and joining these points we find an upward sloping i.e. SS1. The positive slope of the
supply curve SS1 establishes the law of supply and shows the positive relationship in between price
and quantity supplied.

Exceptions and Limitations of the Law of Supply

The law of supply states that quantity supplied increases with increase in price and vice-versa. But
this law doesn’t hold true in case of auction sale. An auction sale takes place at that time when the
seller is in financial crisis and needs money at any cost.

Price expectation of seller

If the seller expects that the price of commodity is going to fall in near future, he will try to sell more
even if the price level is very low. On the other hand, if the seller expects further rise in price of the
commodity he will not sell more even if the price level is high. It is against the law of supply.

Stock clearance sale

When a seller wants to clear its old stock in order to store new goods, he may sell large quantity of
goods at heavily discounted price. It is also against the law of supply.

Fear of being out of fashion

As we know that quantity supplied of a commodity is affected by fashion, taste and preferences of the
consumer, technology and time. If the seller thinks that the goods are going to be outdated in the near
future, he sells more at a lower price which is also against the law of supply.

Perishable goods

Those goods which have very short life-time and they become useless after that are all perishable
goods. Those goods must be made available in the market at its right time whatever be its price. So
the seller becomes ready to sell his goods at any offered price. It is also against the law of supply.

Question 16. Explain the different concepts of elasticity of supply?

Ans. Elasticity of supply: Elasticity of supply is measured as the ratio of proportionate change in the
quantity supplied to the proportionate change in price. It is necessary for a firm to know how quickly,
and effectively, it can respond to changing market conditions, especially to price changes. The
following equation can be used to calculate PES.
While the coefficient for PES is positive in value, it may range from 0, perfectly inelastic, to infinite,
perfectly elastic.

• High elasticity indicates the supply is sensitive to changes in prices, low elasticity indicates little
sensitivity to price changes, and no elasticity means no relationship with price. It is also called price
elasticity of supply.

If supply is elastic (i.e. PES > 1), then producers can increase output without a rise in cost or a time
delay

• When Pes = 0, supply is perfectly inelastic

• When Pes = infinity, supply is perfectly elastic following a change in demand

Unit III

11. What does a production function explain? What are its kinds?

Ans. Meaning of Production

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

Production is the result of co-operation of four factors of production viz., land, labour, capital and
organization. Therefore, the producer combines all the four factors of production in a technical
proportion. The aim of the producer is to maximize his profit. For this sake, he decides to maximize
the production at minimum cost by means of the best combination of factors of production.

The Concept of Production Function

The supply of a product, depends upon its cost of production, which in turn depends upon:

(a) The physical relationship between inputs and output, and

(b) The prices of inputs.

The physical relationship between inputs and output plays an important part in determining the cost of
production. The act of production involves the transformation of inputs into outputs. The word
production in economics is not merely confined to bringing about physical transformation in the
matter it is creation or addition of value.

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

The production function can be expressed in an equation in which the output is the dependent variable
and inputs are the independent variables. The equation is expressed as follows:

Q= f (L, K, T……………n)

Where, Q = output

L = labour

K = capital

T = level of technology

n = other inputs employed in production.

In simple words, production function refers to the functional relationship between the quantity of a
good produced (output) and factors of production (inputs).

The production function of a firm can be studied by holding the quantities of some factors fixed,
while varying the amount of other factors. This is done when the law of variable proportions is
derived. The production function of a firm can also be studied by varying the amounts of all factors.
The behaviour of production when all factors are varied is the subject-matter of the laws of returns to
scale. Thus, in the theory of production, the study of (a) the law of variable proportions and (b) the
laws of returns to scale is included.
Besides this, the theory of production is also concerned with explaining which combination of inputs
(or factors of production) a firm will choose so as to minimise its costs of production for producing a
given level of output or to maximise output for a given level of cost.

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

Assumptions of Production Function

The production function is based on the following assumptions.

1. The level of technology remains constant.

2. The firm uses its inputs at maximum level of efficiency.

3. It relates to a particular unit of time.

4. A change in any of the variable factors produces a corresponding change in the output.

5. The inputs are divisible into most viable units.

Managerial Use of Production Function

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

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

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

3. It enables to plan the production: The production function helps the entrepreneur (or management)
to plan the production.

4. It helps in decision-making :Production function is very useful to the management to take decisions
regarding cost and output. It also helps in cost control and cost reduction. In short, production
function helps both in the short run and long run decision-making process.
Features of Production Function:

Following are the main features of production function:

1. Substitutability:

The factors of production or inputs are substitutes of one another which make it possible to vary the
total output by changing the quantity of one or a few inputs, while the quantities of all other inputs are
held constant. It is the substitutability of the factors of production that gives rise to the laws of
variable proportions.

2. Complementarity:

The factors of production are also complementary to one another, that is, the two or more inputs are to
be used together as nothing will be produced if the quantity of either of the inputs used in the
production process is zero.

The principles of returns to scale is another manifestation of complementarity of inputs as it reveals

that the quantity of all inputs are to be increased simultaneously in order to attain a higher scale of
total output.

3. Specificity:

It reveals that the inputs are specific to the production of a particular product. Machines and
equipment’s, specialized workers and raw materials are a few examples of the specificity of factors of
production. The specificity may not be complete as factors may be used for production of other
commodities too. This reveals that in the production process none of the factors can be ignored and in
some cases ignorance to even slightest extent is not possible if the factors are perfectly specific.

Production involves time; hence, the way the inputs are combined is determined to a large extent by
the time period under consideration. The greater the time period, the greater the freedom the producer
has to vary the quantities of various inputs used in the production process.

In the production function, variation in total output by varying the quantities of all inputs is possible
only in the long run whereas the variation in total output by varying the quantity of single input may
be possible even in the short run

12. What do you mean by returns to scale. How do returns to scale differ from law of variable
proportion?

Ans. Law of Returns to Scale

In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale of
production can be changed by changing the quantity of all factors of production.
Definition:

“The term returns to scale refers to the changes in output as all factors change by the same
proportion.” Koutsoyiannis

“Returns to scale relates to the behaviour of total output as all inputs are varied and is a long run
concept”. Leibhafsky

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Explanation:

In the long run, output can be increased by increasing all factors in the same proportion. Generally,
laws of returns to scale refer to an increase in output due to increase in all factors in the same
proportion. Such an increase is called returns to scale.

Suppose, initially production function is as follows:

P = f (L, K)

Now, if both the factors of production i.e., labour and capital are increased in same proportion i.e., x,
product function will be rewritten as.

The above stated table explains the following three stages of returns to scale:

1. Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a situation when all factors of production are
increased, output increases at a higher rate. It means if all inputs are doubled, output will also increase
at the faster rate than double. Hence, it is said to be increasing returns to scale. This increase is due to
many reasons like division external economies of scale. Increasing returns to scale can be illustrated
with the help of a diagram 8.
In figure 8, OX axis represents increase in labour and capital while OY axis shows increase in output.
When labour and capital increases from Q to Q1, output also increases from P to P1 which is higher
than the factors of production i.e. labour and capital.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where if all the factors of
production are increased in a given proportion, output increases in a smaller proportion. It means, if
inputs are doubled, output will be less than doubled. If 20 percent increase in labour and capital is
followed by 10 percent increase in output, then it is an instance of diminishing returns to scale.

The main cause of the operation of diminishing returns to scale is that internal and external economies
are less than internal and external diseconomies. It is clear from diagram 9.

In this diagram 9, diminishing returns to scale has been shown. On OX axis, labour and capital are
given while on OY axis, output. When factors of production increase from Q to Q1 (more quantity)
but as a result increase in output, i.e. P to P1 is less. We see that increase in factors of production is
more and increase in production is comparatively less, thus diminishing returns to scale apply.

3. Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production situation in which output increases
exactly in the same proportion in which factors of production are increased. In simple terms, if factors
of production are doubled output will also be doubled.

In this case internal and external economies are exactly equal to internal and external diseconomies.
This situation arises when after reaching a certain level of production, economies of scale are
balanced by diseconomies of scale. This is known as homogeneous production function. Cobb-
Douglas linear homogenous production function is a good example of this kind. This is shown in
diagram 10. In figure 10, we see that increase in factors of production i.e. labour and capital are equal
to the proportion of output increase. Therefore, the result is constant returns to scale.
13. Explain the different concepts of cost?

Ans. The analysis of cost is important in the study of business operations and decisions because it
provides a basis for two important decisions made by managers:

(a) whether to produce or not and

(b) how much to produce when a decision is taken to produce.

1. Opportunity Cost and Actual Cost: Opportunity cost refers to the loss of earnings due to
opportunities foregone due to scarcity of resources. If resources were unlimited, there would be no
need to forego any income-yielding opportunity and, therefore, there would be no opportunity cost.
Resources are scarce but have alternative uses with different returns. Incomes maximizing resource
owners put their scarce resources to their most productive use and forego the income expected from
the second best use of the resources.

Therefore, the opportunity cost may be defined as the expected returns from the second best use of the
resources foregone due to the scarcity of resources. For example, suppose that a person has a sum of
Rs. 1,00,000 for which he has only two alternative uses. He can buy either a printing machine or,
alternatively, a lathe machine. From printing machine, he expects an annual income of Rs. 20,000 and
from the lathe, Rs. 15,000. If he is a profit maximizing investor, he would invest his money in printing
machine and forego the expected income from the lathe. The opportunity cost of his income from
printing machine is the expected income from the lathe, i.e., Rs. 15,000.

On the other hand, actual costs are those which are actually incurred by the firm in payment for
labour, material, plant, building, machinery, equipment, travelling and transport, advertisement, etc.
The total money expenses, recorded in the books of accounts are, for all practical purposes, the actual
costs.

2. Business Costs and Full Costs: Business costs include all the expenses which are incurred to carry
our business. The concept of business costs is similar to the actual or real costs. Business costs
“include all the payments and contractual obligations made by the firm together with the book cost of
depreciation on plant and equipment”. These cost concepts are used for calculating business profits
and losses and for filling returns for income-tax and also for other legal purposes.

Full costs, on the contrary, include business costs, opportunity cost and normal profit. The opportunity
cost includes the expected earnings from the second best use of the resources, or the market rate of
interest on the total money capital, and also the value of entrepreneur’s own services which are not
charged for in the current business. Normal profit is a necessary minimum earning in addition to the
opportunity cost, which a firm must get to remain in its present occupation.
3. Explicit and Implicit or Imputed Costs: Explicit costs refer to those which fall under actual or
business costs entered in the books of accounts. The payments for wages and salaries, materials,
license fee, insurance premium, depreciation charges are the examples of explicit costs. These costs
involve cash payments and are recorded in normal accounting practices.

In contrast with these costs, there are not certain other costs which do not take the form of cash
outlays, nor do they appear in the accounting system. Such costs are known as implicit or imputed
costs. Implicit costs may be defined as the earning expected from the second best alternative use of
resources. For instance, suppose an entrepreneur does not utilize his services in his own business and
works as a manager in some other firm on a salary basis.

If he starts his own business, he foregoes his salary as manager. This loss of salary is the opportunity
costs of income from his own business. This is an implicit cost of his own business; implicit, because
the entrepreneur suffers the loss, but does not charge it as the explicit cost of his own business. Thus,
implicit wages, rent and interest are the highest wages, rents and interest which owner’s labour,
building and capital can respectively earn from their second best use.

Implicit costs are not taken into account while calculating the loss or gains of the business, but they
form an important consideration in whether or not a factor would remain in its present occupation.
The explicit and implicit costs together make the economic cost.

4. Out-of-Pocket and Book Costs: Out-of-pocket costs means costs that involve current cash payments
to outsiders while book costs such as depreciation do not require current cash payments. In concept,
this distinction is quite different from traceability and also from variability with output. Not all out-of-
pocket costs are variable, e.g., salaries paid to the administrative staff.

Neither are they all direct, e.g., the electric power bill. Book costs are in some cases variable and in
some cases readily traceable, and hence become a part of direct costs. The distinction primarily shows
how cost affects the cash position. Book costs can be converted into out-of-pocket costs by selling the
assets and having them on hire. Rent would then replace depreciation and interest.

B. Some Analytical Cost Concepts:

5. Fixed and Variable Costs: Fixed costs are those costs which are fixed in volume for a certain given
output. Fixed cost does not vary with variation in the output between zero and certain level of output.
The costs that do not vary for a certain level of output are known as fixed cost. Fixed costs are costs
which do not change per unit of output. Even if no crops are grown on a piece of land, the bank will
insist on a mortgage payment from the farmer; even if no output is produced by a corporation, its
bondholders will legally insist on payments of interest. The only way to avoid these payments is to go
out of business; they are accordingly NOT considered in making a short-run operating decision, but
ARE considered in making long-run, entry or exit decisions.

The fixed costs include:

(i) Cost of managerial and administrative staff.

(ii) Depreciation of machinery, building and other Axed assets, and

(iii) Maintenance of land, etc. The concept of fixed cost is associated with short-run.

Variable costs are those which vary with the variation in the total output. They are a function of
output. Variable costs include cost of raw materials, running cost on fixed capital, such as fuel,
repairs, routine maintenance expenditure, direct labour charges associated with the level of output,
and the costs of all other inputs that vary with output. Variable cost is also known as operating cost.

6. Total, Average and Marginal Costs:

Total cost represents the value of the total resource requirement for the production of goods and
services. It refers to the total outlays of money expenditure, both explicit and implicit, on the
resources used to produce a given level of output. It includes both fixed and variable costs. The total
cost for a given output is given by the cost function.

Average cost:

Average cost (AC) is of statistical nature, it is not actual cost. Average cost is total cost per unit of
output, or it is obtained by dividing the total cost (TC) by the total output (Q), i.e. AC = TC/Q

Average cost plays a major role in long-run, entry and exit decisions. The basic decision rules are
parallel to those for marginal cost:

1. If AC < P, the industry is profitable. (Enter)

2. If AC > P, the industry is unprofitable. (Exit)

3. If AC = P, the industry yields zero profit.

Marginal cost:

Marginal, as always in economics, should be read as extra. Here, it is the extra cost of one more item
of output; or the change in total cost divided by change in output. Marginal cost is the addition to the
total cost on account of producing an additional unit of the product. Or, marginal cost is the cost of
marginal unit produced. Given the cost function, it may be defined as MC = TC/ Q. Marginal cost is
the type of cost to consider in short-run output decisions.

The rules to apply are:

1. If MC < P, increase output.

2. If MC > P, decrease output.

3. If MC = P, leave output unchanged. The firm is in short-run equilibrium.

Relation Between Marginal Cost (MC) and Average Cost (AC): The relationship between MC and
AC may be explained as follows:

1. When MC falls, AC also falls but at lower rate than that of MC. So long as MC curve lies below the
AC curve, the AC curve is falling.

2. When MC rises, AC also rises but at lower rate than that of MC. That is, when MC curve lies above
AC curve, the AC curve is rising.

3. MC intersects AC at its minimum. That is, MC = AC at its minimum.

7. Short-Run and Long-Run Costs:

Short-run and long-run cost concepts are related to variable and fixed costs respectively, and often
marked in economic analysis interchangeably. Short-run costs are the costs which vary with the
variation in output, the size of the firm remaining the same. In other words, short-run costs are the
same as variable costs. Long-run costs, on the other hand, are the costs which are incurred on the
fixed assets like plant, building, machinery, etc. Such costs have long-run implication in the sense that
these are not used up in the single batch of production. In the long-run, however, even the fixed costs
become variable costs as the size of the firm or scale of production increases.

8. Incremental Costs and Sunk Costs:

Incremental costs are closely related to the concept of marginal cost but with a relatively wider
connotation. While marginal cost refers to the cost of the marginal unit of output, incremental cost
refers to the total additional cost associated with the marginal batch of output. Incremental costs arise
also owing to the change in product lines, addition or introduction of a new product, replacement of
worn out plant and machinery, replacement of old technique of production with a new one, etc.

The Sunk costs are those which cannot be altered, increased or decreased, by varying the rate of
output. For example, once it is decided to make incremental investment expenditure and the funds are
allocated and spent, all the preceding costs are considered to be the sunk costs since they accord to the
prior commitment and cannot be revised or reversed or recovered when there is change in market
conditions or change in business decisions.

9. Historical and Replacement Costs:

Historical costs are those costs of an asset acquired in the past whereas replacement cost refers to the
outlay which has to be made for replacing an old asset. Historical cost of assets is used for accounting
purposes, in the assessment of net worth of the firm. The replacement cost figures in the business
decision regarding the renovation of the firm.
10. Private and Social Costs:

There are not certain other costs which arise due to functioning of the firm but are not normally
marked in the business decisions. The costs of this category are borne by the society.

Thus, the total cost generated by a firm’s working may be divided into two categories:

(i) Those paid out or provided for by the firms, and

(ii) Those not paid or borne by the firms- it includes use of resource freely available plus the disutility
created in the process of production.

The costs of the former category are known as private costs and of the latter category are known as
external or social costs. The example of social cost are: Mathura Oil Refinery discharging its wastage
in the Yamuna river causes water pollution; Mills and factories located in a city cause air pollution by
emitting smoke.

Similarly, plying cars, buses, trucks, etc., cause both air and noise pollution. Such pollutions cause
tremendous health hazards which involve health cost to the society as a whole. Such costs are termed
external costs from the firm’s point of view and social cost from society’s point of view..

Private costs are those which are actually incurred or provided for by an individual or a firm on the
purchase of goods and services from the market. For a firm, all the actual costs both explicit and
implicit are private costs. Private costs are internalized costs that are incorporated in the firm’s total
cost of production. Social costs on the other hand, refer to the total cost to the society on account of
production of a commodity. Social costs include both private cost and the external cost.

C. Other Costs Concepts:

11. Urgent and Postponable Cost:

Urgent costs are those costs which must be incurred in order to continue operations of the firm. For
example, the costs of materials and labour which must be incurred if production is to take place.

Postponable costs refer to those costs which can be postponed at least for some time e.g., maintenance
relating to building and machinery. Railways usually make use of this distinction. They know that the
maintenance of rolling stock and permanent way can be postponed for some time.

12. Escapable and Unavoidable Costs:

Escapable costs refer to costs which can be reduced due to a contraction in the activities of a business
enterprise. It is the net effect on costs that is important, not just the costs directly avoidable by the
contraction. For Example:
1. Closing apparently unprofitable branch house-storage costs of other branches and transportation
charges would increase.

2. Reducing credit sales-costs estimated may be less than the benefits otherwise available.

Escapable costs are different from controllable and discretionary costs. The latter are like chopping
off the additional fat and are not directly associated with a special curtailment decision.

13. Controllable and Non-Controllable Costs:

The controllability of a cost depends upon the levels of responsibility under consideration. A
controllable cost may refer to one which is reasonably subject to regulation by the executive with
whose responsibility that cost is being identified. Thus a cost which is uncontrollable at one level of
responsibility may be regarded as controllable at some other, usually higher level.

Direct material and direct labour costs are usually controllable. Regarding so for, overhead costs,
some costs are controllable and others are not. Indirect labour, supplies and electricity are usually
controllable. An allocated cost is not controllable. It varies with the formula adopted for allocation
and is independent of the actions of the supervisor.

14. Direct and Indirect Costs (Traceable and Common Costs):

A direct or traceable cost is that which can be identified easily and indisputably with a unit of
operation (costing unit/cost centre). Common or indirect costs are those that are not traceable to any
plant, department or operation, or to any individual final product. To take an example, the salary of a
divisional manager, when division is a costing unit, will be a Direct Cost.

The monthly salary of the general manager, when one of the divisions is a costing unit, would be an
Indirect Cost. The salary of the manager of the other division is neither a direct nor an indirect cost.
Thus, whether a specific cost is direct or indirect depends upon the costing unit under consideration.
The concepts of direct and indirect costs are meaning-less without identification of the relevant
costing unit.

14. Explain the different concepts of revenue?

Ans. Meaning of Revenue:

The amount of money that a producer receives in exchange for the sale proceeds is known as revenue.
For example, if a firm gets Rs. 16,000 from sale of 100 chairs, then the amount of Rs. 16,000 is
known as revenue. Revenue refers to the amount received by a firm from the sale of a given quantity
of a commodity in the market. Revenue is a very important concept in economic analysis. It is directly
influenced by sales level, i.e., as sales increases, revenue also increases. The concept of revenue
consists of three important terms; Total Revenue, Average Revenue and Marginal Revenue.
Total Revenue (TR):

Total Revenue refers to total receipts from the sale of a given quantity of a commodity. It is the total
income of a firm. Total revenue is obtained by multiplying the quantity of the commodity sold with
the price of the commodity.

Average Revenue (AR):

Average revenue refers to revenue per unit of output sold. It is obtained by dividing the total revenue
by the number of units sold. “The average revenue curve shows that the price of the firm’s product is
the same at each level of output.” Stonier and Hague

AR Curve and Demand Curve are the same:

A buyer’s demand curve graphically represents the quantities demanded by a buyer at various prices.
In other words, it shows the various levels of average revenue at which different quantities of the good
are sold by the seller. Therefore, in economics, it is customary to refer AR curve as the Demand
Curve of a firm.

Marginal Revenue (MR):

Marginal revenue is the additional revenue generated from the sale of an additional unit of output. It
is the change in TR from sale of one more unit of a commodity. In algebraic terms, marginal revenue
is the net addition to the total revenue by selling n units of a commodity instead of n – 1.

Therefore,

MR in mathematical terms is the ratio of change in total revenue to change in output

MR = ∆TR/∆q or dR/dq = MR

Total Revenue, Average Revenue and Marginal Revenue:

The relation of total revenue, average revenue and marginal revenue can be explained with the help of
table and fig.
From the table 1 we can draw the idea that as the price falls from Rs. 10 to Re. 1, the output sold
increases from 1 to 10. Total revenue increases from 10 to 30, at 5 units. However, at 6th unit it
becomes constant and ultimately starts falling at next unit i.e. 7th. In the same way, when AR falls,
MR falls more and becomes zero at 6th unit and then negative. Therefore, it is clear that when AR
falls, MR also falls more than that of AR: TR increases initially at a diminishing rate, it reaches
maximum and then starts falling.

In fig. 1 three concepts of revenue have been explained. The units of output have been shown on
horizontal axis while revenue on vertical axis. Here TR, AR, MR are total revenue, average revenue
and marginal revenue curves respectively.

In figure 1 (A), a total revenue curve is sloping upward from the origin to point K. From point K to K’
total revenue is constant. But at point K’ total revenue is maximum and begins to fall. It means even
by selling more units total revenue is falling. In such a situation, marginal revenue becomes negative.
Similarly, in the figure 1 (B) average revenue curves are sloping downward. It means average revenue
falls as more and more units are sold.

In fig. 1 (B) MR is the marginal revenue curve which slopes downward. It signifies the fact that MR
with the sale of every additional unit tends to diminish. Moreover, it is also clear from the fig. that
when both AR and MR are falling, MR is less than AR. MR can be zero, positive or negative but AR
is always positive.

15. Explain the cost-output relations in short run and long run?

Ans. Cost-Output Relations

The cost-output relationship plays an important role in determining the optimum

level of production. Knowledge of the cost-output relation helps the manager in cost

control, profit prediction, pricing, promotion etc. The relation between cost and output is

technically described as the cost function.

TC = (Q)

Where
TC = Total cost

Q = Quantity produced

F = function

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The production function combined with the prices of inputs determines the cost

function of the firm. Considering the period the cost function can be classified as (a)

short-run cost function and (b) long run-cost function.

In economic theory, the short-run is defined as that period during which the

physical capacity of the firm is fixed, and during which output can be increased only by

using the existing capacity more intensively. The long-run is a period during which it is

possible to increase the firm's capacity or to reduce it in size, if trade is very bad.

12.2 Short-run Cost-Output Relation

The cost concepts made use of in the cost behavior are total cost, average cost and

marginal cost. Total cost if the actual money spent to produce a particular quantity of

output. It is the summation of fixed and variable costs.

TC = TFC + TVC

Upto a certain level of production total fixed cost, i.e. the cost of plant, building,

equipment etc. remains fixed. But the total variable costs i.e., the cost of labour, raw

materials etc. vary with the variation in output

AC =

Q
TC

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

(TVC/Q)

Marginal cost is the addition to the total cost due to the production of an

additional unit of product. Or it is the cost of the marginal unit produced. It can be arrived

at by dividing the change in total cost by the change in total output.

MC =

TC

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

total cost implies change in total variable cost only.

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Short-run Cost-Output Relations

Units

of

output

Total

Fixed

cost

TFC

Total
variable

cost

Total

cost

TC

(2+3)

Average

variable

cost

AVC

3/1

Average

fixed

cost

AFC

2/1

Average

cost

(5+6)

AC

Marginal

cost
MC

12345678

60

60

60

60

60

60

60

20

36

48

64

90

132
60

80

96

108

124

150

192

20

18

16

16

18

22

60

30

20

15

12

10

-
80

48

36

31

30

32

20

16

12

16

26

42

Table 1

Table 1 represents the cost-output relation. The table is prepared on the basis of

the Law of Diminishing Marginal Returns. The fixed cost Rs.60 may include rent of

factory building, interest on capital, salaries of permanently employed staff, insurance etc.

These fixed costs are independent of output, whose amount cannot be altered in the shortrun.

But the average fixed cost, i.e. the fixed cost per unit, falls continuously as the out

put increase. The greater the out put, lower the fixed cost per unit. The total variable cost

(TVC) increases but not at the same rate. If more and more units are produced with a

given physical capacity AVC will fall initially. AVC declines upto 3rd unit, it is constant

upto 4th unit and then rises. This is because the efficiency first increases and then
decreases. The variable factors seem to produce somewhat more efficiently near a firm's

optimum capacity output level than at very low levels of output. But once the optimum

capacity is reached, any further increase in output will increase AVC.

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Fig. 1

Fig. 1

The average total cost (AC) declines first and then rises. The rise in AC is felt

only after the AVC starts rising. In the table AVC starts rising from the 5th unit onwards

whereas the AC starts rising from the 6th unit only. AFC continues to fall with increase

in output. But AVC initially declines and then rises. Thus there will be a stage where the

AVC may have started rising, yet AC is still declining because the rise in AVC is less

than the drop in AFC, the net effect being a decline in AC. Thus the table A shows an

increasing returns or diminishing cost in the first instance and eventually diminishing

returns or increasing cost.

The short-run cost-output relationship can be shown graphically also. Fig.1 shows

the relationship between output and total fixed cost, total variable cost and total cost. TFC

curve is a horizontal straight line representing Rs.60, whatever be the output TVC curve

slopes upward starting from zero, first gradually but later at a fast rate. TC = TFC+TVC.

As TFC remains constant, increase in TC means increase in TVC only. As TFC remains

constant the gap between TVC and TC will always be the same. Hence TC curve has the

same pattern of behaviour as TVC curve.

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110

Fig. 2

Fig.2 shows the law of production more clearly. AFC curve continues to fall as

output rises from lower levels to higher levels. This is because the total fixed cost is

spread over more and more units as output increases. TVC increases with the increase in

production since more raw materials, labour, power etc. would be required for increasing

output. But AVC curve (i.e.variable cost per unit) first falls and then rises. This is due to

the operation of the law of variable proportions.

The behaviour of AC curve depends upon the behaviour of AVC curve and AFC

curve. In the initial stage of production both AFC and AVC are declining. Hence AC also

declines. AFC continues to fall with an increase in output while AVC first declines and

then rises. So long as AFC and AVC decline AC will also decline. But after a certain

point AVC starts rising. If the rise in AVC is less than the decline in AFC, AC will still

continue to decline. When the rise in AVC is more than the drop in AFC, AC begins to

rise. In the table we can see that when the production is increased to 5 units AVC

increases but AC still declines. Here the increase in AVC is less than the decline in AFC,

the net effect being a decline in AC. AC curve, thus declines first and then rises.

At first AC is high due to large fixed cost. As output increases the total fixed cost

is shared by more and more units and hence AC falls. After a certain point, owing to the

operation of the law of diminishing marginal returns, the variable cost and, therefore, AC

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111
starts increasing. The lower end of AC curve thus turns up. and gives it a U-shape. That is

why AC curves are U-shaped. The least-cost combination of inputs is indicated by the

lowest point in Ac curve i.e. where where the total average cost is the minimum. It is the

short-run stage of optimum output. It may not be the maximum output level. It is the

point where the per unit cost of production will be at its lowest.

A downward trend in MC curve shows increasing marginal productivity

(i.e.decreasing marginal cost) of the variable input. Similarly, an upward trend in MC

curve shows the rate of increase in TVC, on the one hand and the decreasing marginal

productivity (i.e. increasing marginal cost) of the variable input on the other. MC curve

intersects both AVC and AC curves at their lowest points.

The relationship between AVC, ATC and AFC can be summed up as follows:

1. If both AFC and AVC fall, AC will also fall because AC=AFC+AVC

2. When AFC falls and AVC rises(a) AC will fall where the drop in AFC is more

than the rise in AVC (b) AC remains constant if the drop in AFC=rise in AVC (c) AC

will rise where the drop in AFC is less than the rise in AVC.

12.3 Long-Run Cost-Output Relations

Long-run is a period long enough to make all inputs variable. In the long-run a

firm can increase or decrease its output according to its demand, by having more or less

of all the factors of production. The firms are able to expand the scale of their operation

in the long-run by purchasing larger quantities of all the inputs. Thus in the long-run all

factors become variable. The long-run cost-output relations therefore imply the

relationship between total costs and total output. As the change in production in the longrun
is possible by changing the scale of production, the long-run cost-output relationship

is influenced by the law of returns to scale.

In the long-run a firm has a number of alternatives in regard to the scale of

operations. For each scale of production or plant size, the firm has a separate short-run

average cost curve. Hence the long-run average cost curve is composed of a series of

short-run average cost curves.

A short-run average cost (SAC) curve applies to only one plant whereas the longrun

average cost (LAC) curve takes into consideration many plants. At any one time the

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112

firm has only one size of plant. That plant remains fixed during that period. Any increase

in production in that period is possible only with that plant capacity. That plant has a

corresponding average cost (SAC) curve. But in a long period the firm can move from

one plant size to another. Each plant has its corresponding SAC curve.

Fig. 3

The long-run cost-output relationship is shown graphically by the LAC curve. To

draw an LAC curve we have to start with a number of SAC curves. In the fig. 5.3 we

have assumed that there are only three sizes of plants-small, medium and large, S ACj

refers to the average cost curve for the small plant, S AC, for the medium size plant and

SAC3 for the large size plant. If the firm wants to produce OP units or less, it will choose

the small plant. For an output beyond OQ the firm will opt for medium size plant. Even if

an increased production is possible with small plant production beyond OQ will increase

cost of production per unit. For an output OR the firm will choose the large plant. Thus in
the long-run the firm has a series of SAC curves. The LAC curve drawn will be

tangential to the three SAC curves i.e. the LAC curve touches each SAC curve at one

point. The LAC curve is also known as Envelope Curve as it envelopes all the SAC

curves. No point on any of the LAC curve can ever be below the LAC curve. It is also

known as Planning Curve as it serves as a guide to the entrepreneur

In his planning the size of plant for future expansion. The plant which yields the

lowest average cost of production will be selected. LAC can, therefore, be defined as the

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113

lowest possible average cost of producing any output, when the management has

adequate I time to make all desirable changes and adjustments.

In the long-run the demand curve of the firm depends on the law of returns to

scale. The law of returns to scale states that if a firm increases the quantity of all inputs

simultaneously and proportionately, the total output initially increases more than

proportionately but eventually increases less than proportionately. It implies that when

production increases, per unit cost first’ decreases but ultimately increases. This means

LAC curve falls initially and rises subsequently. Like SAC curve LAC curve also is Ushaped,

but it will be always flatter then SAC curves. The U-shape implies lower and

lower average cost in the beginning until the optimum scale of the firm is reached and

successively higher average cost thereafter. The increasing return is experienced on

account of the economies of scale or advantages of large-scale production Increase in

scale makes possible increased division and _pecialization of labour and more efficient
use of machines. After a certain point increase in production makes management more

difficult and less efficient resulting in less than proportionate increase in output

Long-run Marginal Cost Curve

Fig. 4

Fig. 4

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114

The long-run marginal cost curve represents the cost of an additional unit of

output when all the inputs vary. The long-run marginal cost curve (LMC) is derived from

the short-run marginal cost (SMC) curves. LMC curve intersects LAC curve at its

minimum point C. There is only one plant size whose minimum SAC coincides with the

minimum LAC and LMC.

SAC2 = SMC2 = LAC = LMC

The point C indicates also the optimum scale of production of the firm in the

long-run or optimum output. Optimum output level is the level of production at which the

cost of production per unit, i.e. AC, is the lowest. The optimum level is not the maximum

profit level. The optimum point is where AC=MC. Here C is the optimum point.

16. What is meant by isoquants? What are their main properties?

Ans. Iso-Quant Curve: The term Iso-quant or Iso-product is composed of two words, Iso = equal,
quant = quantity or product = output.

Thus it means equal quantity or equal product. Different factors are needed to produce a good. These
factors may be substituted for one another.

A given quantity of output may be produced with different combinations of factors. Iso-quant curves
are also known as Equal-product or Iso-product or Production Indifference curves. Since it is an
extension of Indifference curve analysis from the theory of consumption to the theory of production.
Thus, an Iso-product or Iso-quant curve is that curve which shows the different combinations of two
factors yielding the same total product. Like, indifference curves, Iso- quant curves also slope
downward from left to right. The slope of an Iso-quant curve expresses the marginal rate of technical
substitution (MRTS).

Definitions:

“The Iso-product curves show the different combinations of two resources with which a firm can
produce equal amount of product.” Bilas

“Iso-product curve shows the different input combinations that will produce a given output.”
Samuelson

“An Iso-quant curve may be defined as a curve showing the possible combinations of two variable
factors that can be used to produce the same total product.” Peterson

“An Iso-quant is a curve showing all possible combinations of inputs physically capable of producing
a given level of output.” Ferguson

Assumptions:

The main assumptions of Iso-quant curves are as follows:

1. Two Factors of Production:

Only two factors are used to produce a commodity.

2. Divisible Factor:

Factors of production can be divided into small parts.

3. Constant Technique:

Technique of production is constant or is known before hand.

4. Possibility of Technical Substitution:

The substitution between the two factors is technically possible. That is, production function is of
‘variable proportion’ type rather than fixed proportion.

5. Efficient Combinations:

Under the given technique, factors of production can be used with maximum efficiency.
Iso-Product Schedule:

Let us suppose that there are two factor inputs—labour and capital. An Iso-product schedule shows
the different combination of these two inputs that yield the same level of output as shown in table 1.

The table 1 shows that the five combinations of labour units and units of capital yield the same level
of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be produced by combining.

(a) 1 units of labour and 15 units of capital

(b) 2 units of labour and 11 units of capital

(c) 3 units of labour and 8 units of capital

(d) 4 units of labour and 6 units of capital

(e) 5 units of labour and 5 units of capital

Iso-Product Curve:

From the above schedule iso-product curve can be drawn with the help of a diagram. An. equal
product curve represents all those combinations of two inputs which are capable of producing the
same level of output. The Fig. 1 shows the various combinations of labour and capital which give the
same amount of output. A, B, C, D and E.

Iso-Product Map or Equal Product Map:

An Iso-product map shows a set of iso-product curves. They are just like contour lines which show
the different levels of output. A higher iso-product curve represents a higher level of output. In Fig. 2
we have family iso-product curves, each representing a particular level of output.

The iso-product map looks like the indifference of consumer behaviour analysis. Each indifference
curve represents particular level of satisfaction which cannot be quantified. A higher indifference
curve represents a higher level of satisfaction but we cannot say by how much the satisfaction is more
or less. Satisfaction or utility cannot be measured.

An iso-product curve, on the other hand, represents a particular level of output. The level of output
being a physical magnitude is measurable. We can therefore know the distance between two equal
product curves. While indifference curves are labeled as IC1, IC2, IC3, etc., the iso-product curves are
labelled by the units of output they represent -100 metres, 200 metres, 300 metres of cloth and so on.

Properties of Iso-Product Curves:

The properties of Iso-product curves are summarized below:

1. Iso-Product Curves Slope Downward from Left to Right:

They slope downward because MTRS of labour for capital diminishes. When we increase labour, we
have to decrease capital to produce a given level of output.

The downward sloping iso-product curve can be explained with the help of the following figure:

The Fig. 3 shows that when the amount of labour is increased from OL to OL1, the amount of capital
has to be decreased from OK to OK1, The iso-product curve (IQ) is falling as shown in the figure.

The possibilities of horizontal, vertical, upward sloping curves can be ruled out with the help of the
following figure 4:

(i) The figure (A) shows that the amounts of both the factors of production are increased- labour from
L to Li and capital from K to K1. When the amounts of both factors increase, the output must
increase. Hence the IQ curve cannot slope upward from left to right.

(ii) The figure (B) shows that the amount of labour is kept constant while the amount of capital is
increased. The amount of capital is increased from K to K1. Then the output must increase. So IQ
curve cannot be a vertical straight line.

(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity of labour increases,
although the quantity of capital remains constant. When the amount of capital is increased, the level
of output must increase. Thus, an IQ curve cannot be a horizontal line.

2. Isoquants are Convex to the Origin:

Like indifference curves, isoquants are convex to the origin. In order to understand this fact, we have
to understand the concept of diminishing marginal rate of technical substitution (MRTS), because
convexity of an isoquant implies that the MRTS diminishes along the isoquant. The marginal rate of
technical substitution between L and K is defined as the quantity of K which can be given up in
exchange for an additional unit of L. It can also be defined as the slope of an isoquant.

It can be expressed as:

MRTSLK = – ∆K/∆L = dK/ dL

Where ∆K is the change in capital and AL is the change in labour.

Equation (1) states that for an increase in the use of labour, fewer units of capital will be used. In other
words, a declining MRTS refers to the falling marginal product of labour in relation to capital. To put
it differently, as more units of labour are used, and as certain units of capital are given up, the
marginal productivity of labour in relation to capital will decline.

This fact can be explained in Fig. 5. As we move from point A to B, from B to C and from C to D
along an isoquant, the marginal rate of technical substitution (MRTS) of capital for labour diminishes.
Everytime labour units are increasing by an equal amount (AL) but the corresponding decrease in the
units of capital (AK) decreases.

Thus it may be observed that due to falling MRTS, the isoquant is always convex to the origin.

3. Two Iso-Product Curves Never Cut Each Other:

As two indifference curves cannot cut each other, two iso-product curves cannot cut each other. In
Fig. 6, two Iso-product curves intersect each other. Both curves IQ1 and IQ2 represent two levels of
output. But they intersect each other at point A. Then combination A = B and combination A= C.
Therefore B must be equal to C. This is absurd. B and C lie on two different iso-product curves.
Therefore two curves which represent two levels of output cannot intersect each other.

4. Higher Iso-Product Curves Represent Higher Level of Output:

A higher iso-product curve represents a higher level of output as shown in the figure 7 given below:

In the Fig. 7, units of labour have been taken on OX axis while on OY, units of capital. IQ1 represents
an output level of 100 units whereas IQ2 represents 200 units of output.

5. Isoquants Need Not be Parallel to Each Other:

It so happens because the rate of substitution in different isoquant schedules need not be necessarily
equal. Usually they are found different and, therefore, isoquants may not be parallel as shown in Fig.
8. We may note that the isoquants Iq1 and Iq2are parallel but the isoquants Iq3 and Iq4 are not
parallel to each other.
6. No Isoquant can Touch Either Axis:

If an isoquant touches X-axis, it would mean that the product is being produced with the help of
labour alone without using capital at all. These logical absurdities for OL units of labour alone are
unable to produce anything. Similarly, OC units of capital alone cannot produce anything without the
use of labour. Therefore as seen in figure 9, IQ and IQ1 cannot be isoquants.

7. Each Isoquant is Oval-Shaped.

It means that at some point it begins to recede from each axis. This shape is a consequence of the fact
that if a producer uses more of capital or more of labour or more of both than is necessary, the total
product will eventually decline. The firm will produce only in those segments of the isoquants which
are convex to the origin and lie between the ridge lines. This is the economic region of production. In
Figure 10, oval shaped isoquants are shown.

Curves OA and OB are the ridge lines and in between them only feasible units of capital and labour
can be employed to produce 100, 200, 300 and 400 units of the product. For example, OT units of
labour and ST units of the capital can produce 100 units of the product, but the same output can be
obtained by using the same quantity of labour T and less quantity of capital VT.

Thus only an unwise entrepreneur will produce in the dotted region of the iso-quant 100. The dotted
segments of an isoquant are the waste- bearing segments. They form the uneconomic regions of
production. In the up dotted portion, more capital and in the lower dotted portion more labour than
necessary is employed. Hence GH, JK, LM, and NP segments of the elliptical curves are the
isoquants.

Isoquant Curve and Returns to a Factor:

Returns to a factor refers to the behavior of output in response to changing application of one factor of
production while other factors remaining constant. As in the case of returns to scale, there are three
different aspects of returns to a factor, viz., increasing returns, constant returns and diminishing
returns.

The returns to a factor can be explained using isoquant techniques. It is assumed that capital is a fixed
input and labour is a variable input.

Different Stages of Returns to a Factor:

The different returns to a factor can be explained as follows:

(i) Increasing Returns to a Factor:

It occurs when additional application of the variable factor i.e., labour increases total output at
increasing rate. Fig. 17 explains the situation of increasing returns to a factor.

In Fig. 17 capital is taken constant at OR units. The line RP shows how larger quantities of labour can
be employed to expand production. It is called output path.

The isoquant curves for 100, 200, 300 and 400 units of output shows that output is increasing by a
constant amount by 100 units. These isoquants intersect the output path RP at point E, F, G and H.

We see here that the distance between successive isoquant curves is decreasing, that is, less and less
labour is needed for every additional 100 units of output. This means an increasing marginal product
of labour. However, the distance EF is greater than FG and FG is greater than GH i.e.

EF = FH = GH

This means that 100 units increase in output can be obtained by employing successively lesser
increments of labour. Let us suppose that EF is 20 units of labour and FG is 10 units of labour. Then
from E to F the additional 100 units of output are obtained by employing additional 20 units of labour.
From F to G additional 100 units of output is obtained by employing only 10 more units of labour. In
short, the marginal product of labour increases when output is expanded along the output path RP.

(ii) Diminishing Returns to a Factor. Diminishing returns to a factor is a situation when increasing
application of the variable factor increases total output only at the diminishing rate.

Fig. 18 illustrates the situation of diminishing rate. When capital is taken constant at OR and
production is expanded by adding more labour, the distance between successive Isoquants becomes
increasingly greater, that is even more and more labour is needed for every additional 100 units of
output. This shows a diminishing marginal product of labour. The distance EF is less than FG and FG
is less than GH.

EF < FG < GH Thus, 100 units increase in output can be obtained only by employing successively
greater increments of labour. Between E to F additional 100 units of output is obtained by applying
additional 10 units of labour. Between F to G additional 100 units of output is obtained by applying
additional 20 units of labour. Therefore, the marginal product of labour diminishes when output is
expanded along the output path RP.
(iii) Constant Returns to a Factor:

A constant return to a factor occurs when increasing application of the variable factor increases total
output only at a constant rate. Fig. 19, we see that when capital is taken constant at OR and production
is increased by adding more labour, the distance between isoquants remains constant, so that same
amount of labour is needed for every additional 100 units of output.

This means a constant marginal product (MP) of labour. In other words, 100 units increase in output
can be obtained by employing equal increment of labour. The distance between different iso-quants
remains equal. It can be written as;

EF = FG = GH

17. What are the internal and external economies of large scale production?

18. Ans. Economies of scale are defined as the cost advantages that an organization can achieve by
expanding its production in the long run. In other words, these are the advantages of large scale
production of the organization. The cost advantages are achieved in the form of lower average costs
per unit. It is a long term concept. Economies of scale are achieved when there is an increase in the
sales of an organization. As a result, the savings of the organization increases, which further enables
the organization to obtain raw materials in bulk. This helps the organization to enjoy discounts. These
benefits are called as economies of scale.

19. The economies of scale are divided into internal economies and external economies discussed as
follows:

20. I]. INTERNAL ECONOMIES: It refers to real economies which arise from the expansion of the
plant size of the organization. These economies arise from the growth of the organization itself.

21. The examples of internal economies of scale are as follows:

22. a. Technical economies of scale:

23. It occurs when organizations invest in the expensive and advanced technology. This helps in
lowering and controlling the costs of production of organizations. These economies are enjoyed
because of the technical efficiency gained by the organizations. The advanced technology enables an
organization to produce a large number of goods in short time. Thus, production costs per unit falls
leading to economies of scale.

24. b. Marketing economies of scale:

25. It occurs when large organizations spread their marketing budget over the large output. The
marketing economies of scale are achieved in case of bulk buying, branding, and advertising. For
instance, large organizations enjoy benefits on advertising costs as they cover larger audience. On the
other hand, small organizations pay equal advertising expenses as large organizations, but do not
enjoy such benefits on advertising costs.

26. c. Financial economies of scale:

27. It takes place when large organizations borrow money at lower rate of interest. These
organizations have good credibility in the market. Generally, banks prefer to grant loans to those
organizations that have strong foothold in the market and have good repaying capacity.

28. d. Managerial economies of scale:

29. It occurs when large organizations employ specialized workers for performing different tasks.
These workers are experts in their fields and use their knowledge and experience to maximize the
profits of the organization. For instance, in an organization, accounts and research department are
created and managed by experienced individuals, SO that all costs and profits of the organization can
be estimated properly.

30. e. Commercial economies:

31. It refers to economies in which organizations enjoy benefits of buying raw materials and selling of
finished goods at lower cost. Large organizations buy raw materials in bulk; therefore, enjoy benefits
in transportation charges, easy credit from banks, and prompt delivery of products to customers.

32.

33. II]. EXTERNAL ECONOMIES:

34. Occur outside the organization. These economies occur within the industries which benefit
organizations. When an industry expands, organizations may benefit from better transportation
network, infrastructure, and other facilities. This helps in decreasing the cost of an organization.

35. Some of the examples of external economies of scale are discussed as follows:

36. a. Economies of Concentration: Refer to economies that arise from the availability of skilled
labour, better credit, and transportation facilities.

37. b. Economies of Information: Imply advantages that are derived from publication related to trade
and business. The central research institutions are the source of information for organizations.

38. c. Economies of Disintegration: Refer to the economies that arise when organizations split their
processes into different processes.
39.

40. Diseconomies of scale occur when the long run average costs of the organization increases. It may
happen when an organization grows excessively large. In other words, the diseconomies of scale
cause larger organizations to produce goods and services at increased costs.

41. There are two types of diseconomies of scale, namely, internal diseconomies and external
diseconomies, discussed as follows:

42. I]. INTERNAL DISECONOMIES OF SCALE:

43. It refers to diseconomies that raise the cost of production of an organization. The main factors that
influence the cost of production of an organization include the lack of decision, supervision, and
technical difficulties.

44. II]. EXTERNAL DISECONOMIES OF SCALE:

45. It refers to diseconomies that limit the expansion of an organization or industry. The factors that
act as restraint to expansion include increased cost of production, scarcity of raw materials, and low
supply of skilled labourer.

Some of the causes which lead to diseconomies of scale are as follows:

i. Poor Communication:

It acts as a major reason for diseconomies of scale. If production goals and objectives of an
organization are not properly communicated to employees within the organization, it may lead to
overproduction or production. This may lead to diseconomies of scale. Apart from this, if the
communication process of the organization is not strong then the employees would not get adequate
feedback. As a result, there would be less face-to-face interaction among employees- thus the
production process would be affected.

ii. Lack of Motivation:

It leads to fall in productivity levels. In case of a large organization, workers may feel isolated and are
less appreciated for their work, thus their motivation diminishes. Due to poor communication
network, it is harder for employers to interact with the employees and build a sense of belongingness.
This leads to fall in the productivity levels of output owing to lack of motivation. This further leads to
increase in costs of the organization.

iii. Loss of Control:

It acts as the main problem of large organizations. Monitoring and controlling the work of every
employee in a large organization becomes impossible and costly. It is harder to make out that all the
employees of an organization are working towards the same goal. It becomes difficult for managers to
supervise the sub-ordinates in large organizations.

iv. Cannibalization:

It implies a situation when an organization faces competition from its own product. A small
organization faces competition from products of other organizations, whereas sometimes large
organizations find that their own products are competing with each other.

46. Explain how price and output is determined under perfect competition?

Ans. Perfect Competition is a market structure where there is a perfect degree of competition and
single price prevails. Under this condition, no individual firm will be in the position to influence the
market price of the product.

According to Bilas, “The perfect competition is characterized by the presence of many firms; they all
sell the same product which is identical. The seller is the price- taker”. In this market a uniform price
prevail during a particular period of time. It is a rare phenomenon which does not exist in reality. Ex.
Street food vendors

Main Features of Perfect Competition

1. Many Sellers: In this market, there are many sellers who form total of market supply. Individually,
seller is a firm and collectively, it is an industry. In perfect competition, price of commodity is
decided by market forces of demand and supply i.e. by buyers and sellers collectively. Here, no
individual seller is in a position to change the price by controlling supply. Because individual seller's
individual supply is a very small part of total supply. So, if the seller alone raises the price, his
product will become costlier than other and automatically, he will be out of market. Hence, that seller
has to accept the price which is decided by market forces of demand and supply. This ensures single
price in the market and in this way, seller becomes price taker and not price maker.

2. Many Buyers: Individual buyer cannot control the price by changing or controlling the demand.
Because individual buyer's individual demand is a very small part of total demand or market demand.
Every buyer has to accept the price decided by market forces of demand and supply. In this way, all
buyers are price takers and not price makers. This also ensures existence of single price in market.

3. Homogenous Product: In this case, all sellers produce homogeneous i.e. perfectly identical
products. All products are perfectly same in terms of size, shape, taste, colour, ingredients, quality,
trade marks etc. This ensures the existence of single price in the market.

4. Zero Advertisement Cost: Since all products are identical in features like quality, taste, design etc.,
there is no scope for product differentiation. So advertisement cost is nil.

5. Free Entry and Exit: There are no restrictions on entry and exit of firms. This feature ensures
existence of normal profit in perfect competition. When profit is more, new firms enter the market and
this leads to competition. Entry of new firms competing with each other results into increase in supply
and fall in price. So, this reduces profit from abnormal to normal level. When profit is low (below
normal level), some firms may exit the market. This leads to fall in supply. So remaining firms raise
their prices and their profits go up. So again this ensures normal level of profit.

6. Perfect Knowledge: On the front of both, buyers and sellers, perfect knowledge regarding market
and pricing conditions is expected. So, no buyer will pay price higher than market price and no seller
will charge lower price than market price.

7. Perfect Mobility of Factors: This feature is essential to keep supply at par with demand. If all
factors are easily mobile (moveable) from one line of production to another, then it becomes easy to
adjust supply as per demand. Whenever demand is more additional factors should be moved into
industry to increase supply and vice versa. In this way, with the help of stable demand and supply, we
can maintain single price in the Market.

8. No Government Intervention: Since market has been controlled by the forces of demand and
supply, there is no government intervention in the form of taxes, subsidies, licensing policy, control
over the supply of raw materials, etc.

9. No Transport Cost: It is assumed that buyers and sellers are close to market, so there is no transport
cost. This ensures existence of single price in market.

10. Determination of price: In a perfect competition market, price is determined by the market force of
demand and supply. Every firm will charge the price determine by the equality of demand and supply
force.

Price determination under perfect competition

Equilibrium of the Industry: An industry in economic terminology consists of a large number of

independent firms, each having a number of factories, farms or mines under its control. Each such unit
in the industry produces a homogeneous product so that there is competition amongst goods produced
by different units called firms. When the total output of the industry is equal to the total demand, we
say that the industry is in equilibrium; the price then prevailing is equilibrium price, whereas a firm is
said to be in equilibrium when it has no incentive to expand or contract production.

As stated above, under competitive conditions, the equilibrium price for a given product is determined
by the interaction of the forces of demand and supply for it as is shown in figure.
 Fig.: Equilibrium of a competitive industry

In Fig., OP is the equilibrium price and OQ is the equilibrium quantity which will be sold at that
price. The equilibrium price is the price at which both demand and supply are equal and therefore, no
buyer who wanted to buy at that price goes dissatisfied and none of the sellers is dissatisfied that they
could not sell their goods at that price. It may be noticed that if the price were to be fixed at any other
level, higher or lower, demand remaining the same, there would not be an equilibrium in the market.
Likewise, if the quantities of goods were greater or smaller than the demand, there would not be an
equilibrium.

Equilibrium of the Firm: The firm is said to be in equilibrium when it maximizes its profit. The output
which gives maximum profit to the firm is called equilibrium output. In the equilibrium state, the firm
has no incentive either to increase or decrease its output. Since it is the maximum profit giving output
which only gives no incentive to the firm to increase or decrease it, so it is in equilibrium when it gets
maximum profit.

Firms in a competitive market are price takers. This is because there are a large number of firms in the
market who are producing identical or homogeneous products. As such these firms cannot influence
the price in their individual capacities. They have to accept the price fixed (through interaction of total
demand and total supply) by the industry as a whole.

PRICE
Industry price OP is fixed through the interaction of total demand and total supply of the industry.
Firms have to accept this price as given and as such they are price-takers rather than price makers.
They cannot increase the price OP individually because of the fear of losing customers to other firms.
They do not try to sell the product below OP because they do not have any incentive for lowering it.
They will try to sell as much as they can at price OP.

As such, P line acts as demand curve for the firm. Thus the demand curve facing an individual firm in
a perfectly competitive market is a horizontal one at the level of market price set by the industry and
firms have to choose that level of output which yields maximum profit.

Table–4: Trends of Revenue for the Firm

Price (`) Quantity Sold Total Revenue Average Revenue Marginal Revenue

2 8 16 2 2

2 10 20 2 2

2 12 24 2 2

2 14 28 2 2

2 16 32 2 2

Firm X’s price, average revenue and marginal revenue are equal to `2. Thus, we see that in a perfectly
competitive market a firm’s AR= MR= price.

Conditions for equilibrium of a firm: As discussed earlier, a firm, in order to attain the equilibrium
position, has to satisfy two conditions:
(i) The marginal revenue should be equal to the marginal cost. i.e. MR= MC. If MR is greater than
MC, there is always an incentive for the firm to expand its production further and gain by sale of
additional units. If MR is less than MC, the firm will have to reduce output since an additional unit
adds more to cost than to revenue. Profits are maximum only at the point where MR= MC.

(ii) The MC curve should cut MR curve from below. In other words, MC should have a positive slope.

In figure, DD and SS are the industry demand and supply curves which equilibrate at E to set the
market price as OP. The firms of perfectly competitive industry adopt OP price as given and considers
P- Line as demand (averagerevenue) curve which is perfectly elastic at P. As all the units are priced at
the same level, MR is a horizontal line equal to AR line. Note that MC curve cuts MR curve at two
places T and R respectively. But at T, the MC curve is cutting MR curve from above. T is not the
point of equilibrium as the second condition is not satisfied. The firm will benefit if it goes beyond T
as the additional cost of producing an additional unit is falling. At R, the MC curve is cutting MR
curve from below. Hence, R is the point of equilibrium and OQ2 is the equilibrium level of output.

Supply curve of the firm in a competitive market: One interesting thing about the MC curve of a firm
in a perfectly competitive industry is that it depicts the firm’s supply curve. This can be shown with
the help of the following example.

Can a competitive firm earn profits? In the short run, a firm will attain equilibrium position and at the
same time, it may earn supernormal profits, normal profits or losses depending upon its cost
conditions.
Supernormal Profits: There is a difference between normal profits and supernormal profits. When the
average revenue of a firm is just equal to its average total cost, it earns normal profits. It is to be noted
that here a normal percentage of profits for the entrepreneur for his managerial services is already
included in the cost of production. When a firm earns supernormal profits, its average revenues are
more than its average total cost. Thus, in addition to normal rate of profit, the firm earns some
additional profits.

PRICE

Fig.: Short run equilibrium: Supernormal profits of a competitive firm

The diagram shows that in order to attain equilibrium, the firm tries to equate marginal revenue with
marginal cost. MR (marginal revenue) curve is a horizontal line and MC (marginal cost) curve is a U-
shaped curve which cuts the MR curve at E. At E, MR=MC. OQ is the equilibrium output for the
firm. The firm’s profit per unit is EB (AR-ATC), AR is EQ and ATC is BQ. Total profits are ABEP.

Normal profits: When a firm just meets its average total cost, it earns normal profits. Here AR=ATC.
The figure shows that MR=MC at E. The equilibrium output is OQ. Since AR=ATC or OP=EQ, the
firm is just earning normal profits.

Losses: The firm can be in an equilibrium position and still makes losses. This is the position when
the firm is minimizing losses. When the firm is able to meet its variable cost and a part of fixed cost it
will try to continue production in the short run. If it recovers a part of the fixed costs, it will be
beneficial for it to continue production because fixed costs (such as costs towards plant and
machinery, building etc.) are already incurred and in such case it will be able to recover a part of
them. But, if a firm is unable to meet its average variable cost, it will be better for it to shut down.

In figure .the equilibrium point and at this point AR= EQ and ATC= BQ since BQ>EQ, the firm is
earning BE per unit loss and the total loss is ABEP.

Long Run Equilibrium of the Firm: In the long run, firms are in equilibrium when they have adjusted
their plant so as to produce at the minimum point of their long run AC curve, which is tangent to the
demand curve defined by the market price. In the long run, the firms will be earning just normal
profits, which are included in the ATC. If they are making supernormal profits in the short run, new
firms will be attracted into the industry; this will lead to a fall in price (a downward shift in the
individual demand curves) and an upward shift of the cost curves due to increase in the prices of
factors as the industry expands. These changes will continue until the ATC is tangent to the demand
curve. If the firms make losses in the short run, they will leave the industry in the long run. This will
raise the price and costs may fall as the industry contracts, until the remaining firms in the industry
cover their total costs inclusive of the normal rate of profit.

In Fig., we show how firms adjust to their long run equilibrium position. If the price is OP, the firm is
making super-normal profits working with the plant whose cost is denoted by SAC1. It will, therefore,
have an incentive to build new capacity and it will move along its LAC. At the same time, new firms
will be entering the industry attracted by the excess profits. As the quantity supplied in the market
increases, the supply curve in the market will shift to the right and price will fall until it reaches the
level of OP1 at which the firms and the industry are in long run equilibrium.
(a) (b)

Fig.: Long run equilibrium of the firm in a perfectly competitive market

The condition for the long run equilibrium of the firm is that the marginal cost should be equal to the
price and the long run average cost i.e. LMC = LAC = P. The firm adjusts its plant size so as to
produce that level of output at which the LAC is the minimum possible. At equilibrium the short run
marginal cost is equal to the long run marginal cost and the short run average cost is equal to the long
run average cost. Thus, in the long run we have,

SMC=LMC=SAC=LAC=P=MR

This implies that at the minimum point of the LAC, the corresponding (shortrun) plant is worked at its
optimal capacity, so that the minima of the LAC and SAC coincide. On the other hand, the LMC cuts
the LAC at its minimum point and the SMC cuts the SAC at its minimum point. Thus, at the
minimum point of the LAC the above equality is achieved.

Long run equilibrium of the industry: A perfectly competitive industry is in long run equilibrium
when (i) all the firms are earning normal profits only i.e. all the firms are in equilibrium (ii) there is no
further entry or exit from the market.

INDUSTRY

DS
S

Fig.: Long run equilibrium of a competitive industry and its firms

Figure shows that in the long-run AR=MR=LAC=LMC at E1. Since E1 is the minimum point of LAC
curve, the firm produces equilibrium output OM at the minimum (optimum) cost. A firm producing
output at optimum cost is called an optimum firm. All the firms under perfect competition, in long
run, are optimum firms having optimum size and these firms charge minimum possible price which
just covers their marginal cost.

Thus, in the long run, in perfect competition, the market mechanism leads to an optimal allocation of
resources. The optimality is shown by the following conditions associated with the long run
equilibrium of the industry:

a. The output is produced at the minimum feasible cost.

b. Consumers pay the minimum possible price which just covers the marginal cost i.e. MC=AR.

c. Plants are used at full capacity in the long run, so that there is no wastage of resources i.e. MC=AC.

d. Firms earn only normal profits i.e. AC=AR.

e. Firms maximize profits (i.e.MC=MR), but the level of profits will be just normal. In other words, in
the long run, LAR= LMR= P= LMC= LAC and there will be optimum allocation of resources.

But it should be remembered that the perfectly competitive market system is a myth. This is because
the assumptions on which this system is based are never found in the real world market conditions.
47. Explain how price and output is determined under monopoly and monopolistic competition?

Ans. Monopoly is that market form in which a single producer controls the entire supply of a single
commodity which has no close substitutes. There must be only one seller or producer. The commodity
produced by the producer must have no close substitutes. Monopoly can exist only when there are
strong barriers to entry. The barriers which prevent the entry may be economic, institutional or
artificial in nature.

Features

1. There is a single producer or seller of the product.

2. There are no close substitutes for the product. If there is a substitute, then the monopoly power is
lost.

3. No freedom to enter as there exists strong barriers to entry.

4. The monopolist may use his monopolistic power in any manner to get maximum revenue. He may
also adopt price discrimination.

PRICE-OUTPUT DETERMINATION UNDER MONOPOLY

The aim of the monopolist is to maximise profits. Therefore, he will produce that level of output and
charge a price which gives him the maximum profits. He will be in equilibrium at that price and
output at which his profits are maximum. In order words, he will be in equilibrium position at that
level of output at which marginal revenue equals marginal cost. The monopolist, to be in equilibrium
should satisfy two conditions :

1. Marginal cost should be equal to marginal revenue and

2. The marginal cost curve should cut marginal revenue curve from below.

The short run equilibrium of the monopolist is shown in figure below.

AR is the average revenue curve, MR is the marginal revenue curve, AC is the average cost curve and
MC is the marginal cost curve. Upto OQ level of output marginal revenue is greater than marginal
cost but beyond OQ the marginal revenue is less than marginal cost. Therefore, the monopolist will be
in equilibrium where MC = MR. Thus a monopolist is in equilibrium at OQ level of output and at OP
price. He earns abnormal profit equal to PRST.

But it is not always possible for a monopolist to earn super- normal profits. If the demand and cost
situations are not favourable, the monopolist may realise short run losses.

Though the monopolist is a price maker, due to weak demand and high costs, he suffers a loss equal to
PABC.

Long run equilibrium

In the long run the firm has the time to adjust his plant size or to use the existing plant so as to
maximise profits. The long run equilibrium of the monopolist is shown in figure below.

The monopolist is in equilibrium at OL output where LMC cuts MR curve. He will charge OP price
and earn an abnormal profit equal to TPQH.

In order to show the difference between the short run equilibrium and long run equilibrium under
monopoly, both can be shown in a single figure.

The monopolist is in the s h o r t r u n equilibrium at E producing OS level of output. In the long run
he can change the plant and will be in equilibrium at F where MR curve cuts LMC curve. The
monopolist has increased his output from OS to OL and price has fallen from OP to OJ. Profits have
also increased in the long run from TPQR to GHKJ.

Perfect competition and monopoly are rarely found in the real world. Therefore, professor Edward. H.
Chamberlin of Harvard University brought about a synthesis of the two theories and put forth,
"Theory of Monopolistic Competition" in 1933. Monopolistic competition is more realistic than either
pure competition or monopoly. It is a blending of competition and monopoly. "There is competition
which is keen though not perfect, between many firms making very similar products". Thus
monopolistic competition refers to competition among a large number of sellers producing close but
not perfect substitutes.

FEATURES
1. Large number of sellers

In monopolistic competition the number of sellers is large. No one controls a major portion of the
total output. Hence each firm has a very limited control over the price of the product. Each firm
decides its own price-output policy without considering the reactions of rival firms. Thus there is no
interdependence between firms and each seller pursues an independent course of action.

2. Product differentiation

One of the most important features of monopolistic competition is product differentiation. Product
differentiation implies that products are different in some ways from each other. They are
heterogeneous rather than homogeneous. Products are close substitutes but not perfect substitutes.
Product differentiation may be due to differences in the quality of the product. Product may be
differentiated in order to suit the tastes and preferences of the consumers. The products are
differentiated on the basis of materials used, workmanship, durability, size, shape, design, colour,
fragrance, packing etc.

3. Free entry and exit of firms

Another feature of monopolistic competition is the freedom of entry and exit of firms. Firms under
monopolistic competition are small in size and they are capable of producing close substitutes. Hence
they are free to enter or leave the industry in the long run. Product differentiation increases entry of
new firms in the group because each firm produces a different product from the others.

4. Selling cost

It is an important feature of monopolistic competition. As there is keen competition among the firms,
they advertise their products in order to attract the customers and sell more. Thus selling cost has a
bearing on price determination under monopolistic competition.

5. Group equilibrium

Chamberlin introduced the concept of group in the place of industry. Industry refers to a number of
firms producing homogeneous products. But, firms under monopolistic competition produce similar
but not identical products. Therefore, chamberlin uses, the concept of group to include firms
producing goods which are close substitutes.

6. Nature of demand curve

Under monopolistic competition, a single firm can control only a small portion of the total output.
Though there is product differentiation, as products are close substitutes, a reduction in price leads to
increase in sales and vice-versa. But it will have little effect on the price-output conditions of other
firms. Hence each will loose only few customers, due to an increase in price. Similarly a reduction in
price will increase sales. Therefore the demand curve of a firm under monopolistic competition slopes
downwards to the right. It is highly elastic but not perfectly elastic. In other words, under
monopolistic competition, the demand curve faced by the firm is highly elastic. It means that it has
some control over price due to product differentiation and there are price differentials between the
firms.

Price-Output Determination under Monopolistic Competition

Since, under monopolistic competition, different firms produce different varieties of products, prices
will be determined on the basis of demand and cost conditions. The firms aim at profit maximisation
by making adjustments in price and output, product adjustment and adjustment of selling costs.

Equilibrium of a firm under monopolistic competition is based upon the following assumptions:

1. The number of sellers is large and they act independently of each other.

2. The product is differentiated.

3. The firm has a demand curve which is elastic.

4. The supply of factor services is perfectly elastic.

5. The short run cost curves of each firm differ from each other.

6. No new firms enter the industry.

Individual Equilibrium and Price Variation

Based on these assumptions, each firm fixes such price and output which maximises its profit. Product
is held constant. The only variable is price. The equilibrium price and output is determined at a point
where the short run marginal cost equals marginal revenue. The equilibrium of a firm under
monopolistic competition is shown in figure 25. DD is the demand curve of the firm. It is also the
average revenue curve of the firm. MC is the marginal cost of the firm. The firm will maximise profits
by equating marginal cost with marginal revenue. The firm maximises its profit by producing OM
level of output and selling it at Fig. 25 a price of OP. The profit earned by the firm is PQRS. Thus in
the short run, a firm under monopolistic competition earns supernormal profits.
In the short run, the firm may incur losses also. This is shown in figure 26.

The firm is in equilibrium by producing an output of OQ. It fixes the price at OP. As price is less than
cost, it incurs losses equal to pabc. Thus a firm in equilibrium under monopolistic competition may be
making supernormal profits or losses depending upon the position of the demand curve and average
cost curve.

Group Equilibrium and Price Variation

Group equilibrium refers to price-output determination in a number of firms whose products are close
substitutes. The product of each firm has special characteristics. The difference in the quality of the
products of the firms under monopolistic competition results in large variation in elasticity and
position of the demand curves of the various firms. Similarly the shape and position of cost curves too
differ. As a result there exist differences in prices, output and profits of the various firms in the group.
For the sake of simplicity in the analysis of group equilibrium, Chamberlin ignores these differences
by adopting infirmity assumption. He assumes that the cost and demand curves of all the products in
the group are uniform. Chamberlin introduces another assumption known as 'symmetry assumption'. It
means that the number of firms under monopolistic competition is large and hence the action of an
individual firm regarding price and output will have a negligible effect upon his rivals.

Based on these assumptions, short run equilibrium of a firm under monopolistic competition can be
shown in Figure. 27.

Figure (A) represents short run equilibrium and figures (B) the long run equilibrium. In the short run,
the price is OP and average cost is only MR. Hence there is supernormal profit equal to PQRS. But in
the long run, as shown in figure 27 (B), the excess profit is competed away. MC = MR at OM level of
output. LAR is tangent to LAC. Price is equal to average cost and there is no extra profit. Only normal
profit is earned.

48. Explain how price and output is determined under oligopoly?

Ans. Oligopoly is a situation in which few large firms compete against each other and there is an
element of interdependence in the decision making of these firms. A policy change on the part of one
firm will have immediate effects on competitors, who react with their counter policies.

Features

Following are the features of oligopoly which distinguish it from other market structures :

1. Small number of large sellers.

The number of sellers dealing in a homogeneous or differentiated product is small. The policy of one
seller will have a noticeable impact on market, mainly on price and output.

2. Interdependence.

Unlike perfect competition and monopoly, the oligopolist is not independent to take decisions. The
oligopolist has to take into account the actions and reactions of his rivals while deciding his price and
output policies. As the products of the oligopolist are close substitutes, the cross elasticity of demand
is very high.

3. Price rigidity.

Any change in price by one oligopolist invites retaliation and counter- action from others, the
oligopolist normally sticks to one price. If an oligopolist reduces his price, his rivals will also do so
and therefore, it is not advantageous for the oligopolist to reduce the price. On the other hand, if an
oligopolist tries to raise the price, others will not do so. As a result they capture the customers of this
firm. Hence the oligopolist would never try to either reduce or raise the price. This results in price
rigidity.

4. Monopoly element.

As products are differentiated the firms enjoy some monopoly power. Further, when firms collude
with each other, they can work together to raise the price and earn some monopoly income.

5. Advertising.
The only way open to the oligopolists to raise his sales is either by advertising or improving the
quality of the product. Advertisement expenditure is used as an effective tool to shift the demand in
favour of the product. Quality improvement will also shift the demand favorably. Usually, both
advertisements as well as variations in designs and quality are used simultaneously to maintain and
increase the market share of an oligopolist.

6. Group behaviour.

The firms under oligopoly recognise their interdependence and realise the importance of mutual
cooperation. Therefore, there is a tendency among them for collusion. Collusion as well as
competition prevail in the oligopolistic market leading to uncertainty and indeterminateness.

7. Indeterminate demand curve.

It is not possible for an oligopolist to forecast the nature and position of the demand curve with
certainty. The firm cannot estimate the sales when it decides to reduce the price. Hence the demand
curve under oligopoly is indeterminate.

TYPES OF OLIGOPOLY

Oligopoly may be classified in the following ways:

a. Perfect and imperfect oligopoly.

On the basis of the nature of product, oligopoly may be classified into perfect (pure) and imperfect
(differentiated) oligopoly. If the products are homogeneous, then oligopoly is called as perfect or pure
oligopoly. If the products are differentiated and are close substitutes, then it is called as imperfect or
differentiated oligopoly.

b. Open or closed oligopoly.

On the basis of possibility of entry of new firms, oligopoly may be classified into open or closed
oligopoly. When new firms are free to enter, it is open oligopoly. When few firms dominate the
market and new firms do not have a free entry into the industry, it is called closed oligopoly.

c. Partial and full oligopoly.

Partial oligopoly refers to a situation where one firm acts as the leader and others follow it. On the
other hand, full oligopoly exists where no firm is dominating as the price leader.

d. Collusive and non- collusive oligopoly.

Instead of competition with each other, if the firms follow a common price policy, it is called
collusive oligopoly. If the collusion is in the form of an agreement, it is called open collusion. If it is
an understanding between the firms, then it is a secret collusion. On the other hand, if there is no
agreement or understanding between oligopoly firms, it is known as non-collusive oligopoly.

e. Syndicated and organised oligopoly.

Syndicated oligopoly is one in which the firms sell their products through a centralised syndicate.
Organised oligopoly refers to the situation where the firms organise themselves into a central
association for fixing prices, output, quota etc.

P. Sweezy introduced the kinked demand curve to explain the determination of equilibrium in'
oligopolistic market. The demand curve facing an oligopolist has a kink at the prevailing price. This is
because each oligopolist believes that if he lowers the price below the prevailing level increases his
price above the prevailing level his competitors will not follow his increase in price. Due to this
behavioural pattern of the oligopolists, the upper segment of the demand curve is relatively elastic and
the lower portion is relatively inelastic.

If the oligopolist reduces its price below the prevailing price level MP, the competitors will fear that
their customers would go away from them. Therefore, they will also reduce the price. Since all the
competitors are reducing their price, the oligopolist will gain only very little sales. Hence the demand
curve which lies below the prevailing price is inelastic. If the oligopolist raises his price above the
prevailing price level his sales Fig. 38 will be reduced. As a result of a rise in price, his customers will
go to his competitors.

Thus an increase in price will lead to a large reduction in sales. This shows that the demand curve
which lies above the current price level is elastic. Since the oligopolist will not gain a larger share of
the market by reducing his price below the prevailing level and will loose a large share of the market
by increasing his price he will not change the price.

For determining profit maximising price-output, combination, marginal revenue curve has to be
drawn. The marginal revenue curve corresponding to the kinked demand curve has a gap or
discontinuity between G and H. This gap in MR curve occurs due to the kink in the demand curve and
lies right below the kink. The length of the gap depends on the relative elasticities of the two portions
of the demand curve. The greater the difference in the two elasticities the greater the length of the
discontinuity. If the marginal of the oligopolist passes through the discontinuous portion of the MR
curve the oligopolist will be maximising his profit at the prevailing price level OP. As he is
maximising profits at the prevailing price level he will have no incentive to change the price.

Even if cost conditions change the price will remain stable.

When the marginal cost curve shifts upward from MC to MC1 , the price remains unchanged as MC1
passes through the gap GH.

Similarly, the price will remain stable even when the demand conditions change. When the demand
for the oligopolist increases from D to D1, the given marginal cost curve MC cuts the new marginal
revenue curve MR within the gap. This means that the same price continues to prevail in the market.

The major drawback of the kinked demand curve is that it does not explain the determination of price.
It explains only price rigidity. Further it is not applicable to price leadership and cartels. Kinked
demand curve is also not applicable to oligopoly with product differentiation. Due to these
deficiencies, a general theory of pricing is impossible under oligopoly.

Unit IV

49. Define macro economics. Also explain its nature and importance?

Ans. Macroeconomics (Greek makro = ‘big’) describes and explains economic processes that concern
aggregates. Macro Economics is the study of aggregates or averages covering the entire economy,
such as total employment, national income, national output, total investment, total consumption, total
savings, aggregate supply, aggregate demand and general price level, wage level and cost structure.
Otherwise, it is aggregative economics which examines the interrelations among the various
aggregates, their determination and causes of fluctuations in them.

Prof. Ackley defines Macro Economics as “Macro Economics deals with economic affairs ‘in the
large, it concerns the overall dimensions of economic life. It looks at the total size and shape and
functioning of the elephant of economic experience, rather than working of articulation or dimensions
of the individual parts. It studies the character of the forest, independently of the tress which compose
it.”

Macroeconomics is the study of what is happening to the economy as a whole, the economy-in-the-
large, the macroeconomy. Macroeconomists' principal tasks: to try to figure out why overall economic
activity rises and falls: the value of production, total incomes, unemployment, inflation. Intermetdiate
variables like interest rates, stock market values, and exchange rates--that play a major role in
determining the overall levels of production, income, employment, and prices.

Example: The decision of a firm to purchase a new office chair from company X is not a
macroeconomic problem. The reaction of Austrian households to an increased rate of capital taxation
is a macroeconomic problem.

Scope of Macro Economics

Macro Economics is of much theoretical and practical importance. Let us see what are the importance
and the scope where macro economics are being used.

1. To Understand the working of the Economy

The study of macro economics variables is requisite for considerate the operation of the financial
system. Our main economic complexities are associated with the performance of total income,
irredundant and the normal price scale in the fiscal. These variables are geometrically measurable in
this manner facilitating the probabilities of analysing the effects on the functioning of the economy.

2. In Economic Policies

Macro Economics is extremely useful from the view point of the fiscal policy. Modern Governments,
particularly, the underdeveloped economies are confronted with innumerable national problems. They
are the problems of over population, inflation, balance of payments, general under production etc. The
main conscientiousness of these governments rests in the regulation and control of over population,
general prices, general volume of commerce, general productivity etc.

I. In General Unemployment

Redundancy is caused by deficiency of effectual demand. In order eradicate it, effective demand
should be raised by increasing total investment, total productivity, total income and consumption.
Thus, macro economics has special significance in studying the causes, effects and antidotes of
general redundancy.

II. In National Income

The study of macro economics is very significant for evaluating the overall performance of the
economy in terms of national income. This led to the construction of the data on national income.
National income data help in anticipating the level of fiscal activity and to comprehend the
distribution of income among different groups of people in the economy.

III. In Economic Growth

The economics of growth is also a study in macro economics. It is on the basis of macro economics
that the resources and capabilities of an economy are evaluated. Plans for the overall increase in
national income, productivity, employment are framed and executed so as to raise the level of fiscal
development of the economy as a whole.

IV. In Monetary Problems

It is in terms of macro economics that monetary problems can be analysed and understood properly.
Frequent changes in the value of money, inflation or deflation, affect the economy adversely. They
can be counteracted by adopting monetary, fiscal and direct control measures for the economy as a
whole.

V. In Business Cycle

Moreover, macro economics as an approach to fiscal problems started after the great Depression, thus
its significance falls in analysing the grounds of fiscal variations and in providing remedies.

3. For Understanding the Behaviour of Individual Units

For understanding the performance of individual units, the study of macro economics is imperative.
Demand for individual products depends upon aggregate demand in the economy. Unless the causes
of deficiency in aggregate demand are analysed it is not feasible to understand fully the grounds for a
fall in the demand of individual products. The reasons for increase in costs of a specific firm or
industry cannot be analysed without knowing the average cost conditions of the whole economy.
Thus, the study of individual units is not possible without macro economics.

50. Define business cycles? Explain the characteristics and phases of business cycles. Also suggest
the measures to control them?

Ans. While the topic of economic growth is concerned with changes in GDP over very long periods of
time, it is an economic fact of life that GDP changes occur over much shorter time-horizons as well.
The periodic ups and downs of economic activity are termed the “business cycle.” It is the recurrent
ups and downs in economic activity observed in market economies.

1. Business cycles occur periodically- Though they do not show same regularity, they have some
distinct phases such as expansion, peak, contraction or depression and trough. Further the duration of
cycles varies a good deal from minimum of two years to a maximum of ten to twelve years.

2. Secondly, business cycles are Synchronic- That is, they do not cause changes in any single industry
or sector but are of all embracing character. For example, depression or contraction occurs
simultaneously in all industries or sectors of the economy. Re¬cession passes from one industry to
another and chain reaction continues till the whole economy is in the grip of recession. Similar
process is at work in the expansion phase, prosperity spreads through various linkages of input-output
relations or demand relations between various industries, and sectors.

3. Thirdly, it has been observed that fluctuations occur not only in level of production but also
simultaneously in other variables such as employment, investment, consump¬tion, rate of interest and
price level.

4. Another important feature of business cycles is that investment and consumption of durable
consumer goods such as cars, houses, refrigerators are affected most by the cyclical fluctuations. As
stressed by J.M. Keynes, investment is greatly volatile and unstable as it depends on profit
expectations of private entrepreneurs. These expec¬tations of entrepreneurs change quite often
making investment quite unstable. Since consumption of durable consumer goods can be deferred, it
also fluctuates greatly during the course of business cycles.

5. An important feature of business cycles is that consumption of non-durable goods and services does
not vary much during different phases of business cycles. Past data of business cycles reveal that
households maintain a great stability in consumption of non-durable goods.

6. The immediate impact of depression and expansion is on the inventories of goods. When
depression sets in, the inventories start accumulating beyond the desired level. This leads to cut in
production of goods. On the contrary, when recovery starts, the inventories go below the desired level.
This encourages businessmen to place more orders for goods whose production picks up and
stimulates investment in capital goods.

7. Another important feature of business cycles is profits fluctuate more than any other type of
income. The occurrence of business cycles causes a lot of uncertainty for businessmen and makes it
difficult to forecast the economic conditions. During the depression period profits may even become
negative and many businesses go bankrupt. In a free market economy profits are justified on the
ground that they are necessary payments if the entrepreneurs are to be induced to bear uncertainty.

8. Lastly, business cycles are international in character- That is, once started in one country they
spread to other countries through trade relations between them. For ex¬ample, if there is a recession
in the USA, which is a large importer of goods from other countries, will cause a fall in demand for
imports from other countries whose exports would be adversely affected causing recession in them
too. Depression of 1930s in USA and Great Britain engulfed the entire capital world.

A typical business cycle has two phases ex¬pansion phase or upswing or peak and con¬traction phase
or downswing or trough. The upswing or expansion phase exhibits a more rapid growth of GNP than
the long run trend growth rate. At some point, GNP reaches its upper turning point and the
downswing of the cycle begins. In the contraction phase, GNP declines.

At some time, GNP reaches its lower turning point and expansion begins. Starting from a lower
turning point, a cycle experiences the phase of recovery and after some time it reaches the upper
turning point the peak. But, continuous prosperity can never occur and the process of downhill starts.
In this con¬traction phase, a cycle exhibits first a reces¬sion and then finally reaches the bottom—the
depression.

Thus, a trade cycle has four phases:

(i) depression,

(ii) revival,

(iii) boom, and

(iv) recession.

These phases of a trade cy¬cle are illustrated below. In this figure, the secular growth path or trend
growth rate of GNP has been labelled as EG. Now we briefly describe the essential characteristics of
these phases of an idealised cycle.

1. Depression or Trough:

The depression or trough is the bottom of a cycle where eco¬nomic activity remains at a highly low
level. Income, employment, output, price level, etc. go down. A depression is generally
character¬ised by high unemployment of labour and capital and a low level of consumer demand in
relation to the economy’s capacity to pro¬duce. This deficiency in demand forces firms to cut back
production and lay-off workers.

Thus, there develops a substantial amount of unused productive capacity in the economy. Even by
lowering down the interest rates, fi¬nancial institutions do not find enough bor¬rowers. Profits may
even become negative. Firms become hesitant in making fresh invest¬ments. Thus, an air of
pessimism engulfs the entire economy and the economy lands into the phase of depression. However,
the seeds of recovery of the economy lie dormant in this phase.

2. Recovery:

Since trough is not a permanent phenomenon, a capitalistic economy experiences expansion and,
therefore, the process of recovery starts.

During depression some machines wear out completely and ultimately become useless. For their
survival, businessmen replace old and worn-out machinery. Thus, spending spree starts, of course,
hesitantly. This gives an optimistic signal to the economy. Industries begin to rise and expectations
tend to become more favourable. Pessimism that once prevailed in the economy now makes room for
optimism. Investment becomes no longer risky. Additional and fresh investment leads to a rise in
production.

Increased production leads to an increase in demand for inputs. Employment of more labour and
capital causes GNP to rise. Further, low interest rates charged by banks in the early years of recovery
phase act as an incentive to producers to borrow money. Thus, investment rises. Now plants get
utilised in a better way. General price level starts rising. The recovery phase, however, gets gradually
cumulative and income, employment, profit, price, etc., start increasing.

3. Prosperity:

Once the forces of revival get strengthened the level of economic activity tends to reach the highest
point—the peak. A peak is the top .of a cycle. The peak is characterised by an allround optimism in
the economy—income, employment, output, and price level tend to rise. Meanwhile, a rise in
aggregate demand and cost leads to a rise in both investment and price level. But once the economy
reaches the level of full employment, additional investment will not cause GNP to rise.

On the other hand, demand, price level, and cost of production will rise. During prosperity, existing
capacity of plants is overutilised. Labour and raw material shortages develop. Scarcity of resources
leads to rising cost. Aggregate demand now outstrips aggregate supply. Businessmen now come to
learn that they have overstepped the limit. High optimism now gives birth to pessimism. This
ultimately slows down the economic expansion and paves the way for contraction.

4. Recession:

Like depression, prosperity or pea, can never be long-lasting. Actually speaking, the bubble of
prosperity gradually dies down. A recession begins when the economy reaches a peak of activity and
ends when the economy reaches its trough or depression. Between trough and peak, the economy
grows or expands. A recession is a significant decline in economic activity spread across the economy
lasting more then a few months, normally visible in production, employment, real income and other
indications.

During this phase, the demand of firms and households for goods and services start to fall. No new
industries are set up. Sometimes, existing industries are wound up. Unsold goods pile up because of
low household demand. Profits of business firms dwindle. Output and employment levels are reduced.
Eventually, this contracting economy hits the slump again. A recession that is deep and long-lasting is
called a depression and, thus, the whole process restarts.

The four-phased trade cycle has the following attributes:

(i) Depression lasts longer than prosperity,

(ii) The process of revival starts gradually,

(iii) Prosperity phase is characterised by extreme activity in the business world,

(iv) The phase of prosperity comes to an end abruptly.

The period of a cycle, i.e., the length of time required for the completion of one complete cycle, is
measured from peak to peak (P to P’) and from trough to trough (from D to D’). The shortest of the
cycle is called ‘seasonal cycle’.

51. What do you mean by inflation? Explain its types and different measures taken by government to
control them?

Ans. Some of the most important measures that must be followed to control inflation are: 1. Fiscal
Policy: Reducing Fiscal Deficit 2. Monetary Policy: Tightening Credit 3. Supply Management
through Imports 4. Incomes Policy: Freezing Wages.

We discuss below the efficacy of the various policy measures to check demand-pull inflation which is
caused by excess aggregate demand.

1. Fiscal Policy: Reducing Fiscal Deficit:

The budget deals with how a Government raises its revenue and spends it. If the total revenue raised
by the Government through taxation, fees, surpluses from public undertakings is less than the
expenditure it incurs on buying goods and services to meet its requirements of defence, civil
admin¬istration and various welfare and developmental activities, there emerges a fiscal deficit in its
budget.

It may be noted here that the budget of the government has two parts:

(1) Revenue Budget,

(2) Capital Budget.

In the revenue budget on the receipts side revenue raised through taxes, interests, fees, surpluses from
public undertakings are given and on the expenditure side consumption expenditure by the
government on goods and services required to meet the needs of defence, civil administration,
education and health services, subsidies on food, fertilizers and exports, and interest payments on the
loans taken by it in the previous years are important items.

In the capital budget, the main items of receipts are market borrowings by the government from the
Banks and other financial institutions, foreign aid, small savings (i.e., Provident Fund, National
Savings Schemes etc.). The important items of expenditure in the capital budget are defence, loans to
public enterprises for developmental purposes, and loans to states and union territories.
The deficit may occur either in the revenue budget or capital budget or both taken together. When
there is overall fiscal deficit of the Government, it can be financed by borrowing from the Reserve
Bank of India which is the nationalised central bank of the country and has the power to create new
money, that is, to issue new notes.

Thus, to finance its fiscal deficit, the Government borrows from Reserve Bank of India against its
own securities. This is only a technical way of creating new money because the Government has to
pay neither the rate of interest nor the original amount when it borrows from Reserve Bank of India
against its own securities.

It is thus clear that budget deficit implies that Government incurs more expenditure on goods and
services than its normal receipts from revenue and capital budgets. This excess expenditure by the
Government financed by newly created money leads to the rise in incomes of the people. This causes
the aggregate demand of the community to rise to a greater extent than the amount of newly created
money through the operation of what Keynes called income multiplier.

However, when there is too much resort to monetisation of fiscal deficit, it will create excess of
aggregate demand over aggregate supply. There is no wonder that this has contributed a good deal to
the general rise in prices in the past and has been an important factor responsible for present inflation
in the Indian economy.

To reduce fiscal deficits and keep deficit financing (which is now called monetization of fiscal deficit)
within a safe limit, the Government can mobilise more resources through raising:

(a) Taxes, both direct and indirect,

(b) Market borrowings, and

(c) Raising small savings such as receipts from Provident Funds.

National Saving Schemes (NSC and NSS) by offering suitable incentives. The Government borrows
from the market through sales of its bonds which are generally purchased by banks insurance
companies, mutual funds and corporate firms.

Therefore, to check inflation the Government should try to reduce fiscal deficit. It can reduce fiscal
deficit by curtailing its wasteful and inessential expenditure. In India, it is often argued that there is a
large scope for pruning down non-plan expenditure on defence, police and General Administration
and on subsidies being provided on food, fertilizers and exports.

Thus, both by greater resource mobilisation on the one hand and pruning down of wasteful and
inessential Government expenditure on the other, the fiscal deficit and consequently inflation can be
checked.

2. Monetary Policy: Tightening Credit:

Monetary policy refers to the adoption of suitable policy regarding interest rate and the avail-ability of
credit. Monetary policy is another important measure for reducing aggregate demand to control
inflation. As an instrument of demand management, monetary policy can work in two ways.

First, it can affect the cost of credit and second, it can influence the credit availability for private
business firms. Let us first consider the cost of credit. The higher the rate of interest, the greater the
cost of borrowing from the banks by the business firms. As anti-inflationary measure, the rate of
interest has to be kept high to discourage businessmen to borrow more and also to provide incen¬tives
for saving more.

It is noteworthy that a recent monetary theory emphasizes that it is the changes in the credit
availability rather than cost of credit (i.e., rate of interest) that is a more effective instrument of
regulating aggregate demand. There are several methods by which credit availability can be reduced.

Firstly, it is through open market operations that the central bank of a country can reduce the
availability of credit in the economy. Under open market operations, the Reserve Bank sells
Govern¬ment securities. Those, especially banks, who buy these securities, will make payment for
them in terms of cash reserves. With their reduced cash reserves, their capacity to lend money to the
busi¬ness firms will be curtailed. This will tend to reduce the supply of credit or loanable funds which
in turn would tend to reduce investment demand by the business firms.

The Cash Reserve Ratio (CRR) can also be raised to curb inflation. By law banks have to keep a
certain proportion of cash money as reserves against their deposits. This is called cash reserve ratio.
To contract credit availability Reserve Bank can raise this ratio. In recent years to squeeze credit for
checking inflation, cash reserve ratio in India has been raised from time to time.

Another instrument for affecting credit availability is the Statutory Liquidity Ratio (SLR). According
to statutory liquidity ratio, in addition to CRR, banks have to keep a certain minimum proportion of
their deposits in the form of specified liquid assets.

And the most important specified liquid asset for this purpose is the Government securities. To mop
up extra liquid assets with banks which may lead to undue expansion in credit availability for the
business class, the Reserve Bank has often raised statutory liquidity ratio.

Selective Credit Controls:

By far the most important anti-inflationary measure in India is the use of selective credit control. The
methods of credit control described above are known as quantitative or general methods as they are
meant to control the availability of credit in general. On the other hand, selective credit controls are
meant to regulate the flow of credit for particular or specific purposes.

Whereas the general credit controls seek to regulate the total available quantity of credit (through
changes in the high powered money) and the cost of credit, the selective credit control seeks to change
the distribution or allocation of credit between its various uses. These selective credit controls are also
known as Qualitative Credit Controls. The selective credit controls have both the positive and
negative aspect.

In its positive aspect, measures are taken to stimulate the greater flow of credit to some particular
sectors considered as important:

(1) Changes in the minimum margin for lending by banks against the stocks of specific goods kept or
against other types of securities.

(2) The fixation of maximum limit or ceiling on advances to individual borrowers against stock of
particular sensitive commodities.

(3) The fixation of minimum discriminatory rates of interest chargeable on credit for particular
purposes.

3. Supply Management through Imports:

To correct excess demand relative to aggregate supply, the latter can also be raised by importing
goods in short supply. In India, to check the rise in prices of food-grains, edible oils, sugar etc., the
Government has often taken steps to increase imports of goods in short supply to enlarge their
available supplies.

When inflation is of the type of supply-side inflation, imports are increased to augment the domestic
supplies of goods. To increase imports of goods in short supply the Govern¬ment reduces customs
duties on them so that their imports become cheaper and help in containing inflation. For example in
2008-09 the Indian Government removed customs duties on imports of wheat and rice and reduced
them on oilseeds, steel etc. to increase their supplies in India.

1. Incomes Policy: Freezing Wages:

Another anti-inflationary measure which has often been suggested is the avoidance of wage increases
which are unrelated to improvements in productivity. This requires exercising control over wage-
income. It is through wage-price spiral that inflation gets momentum.

When cost of living rises due to the initial rise in prices, workers demand higher wages to compensate
for the rise in cost of living. When their wage demands are conceded to, it gives rise to cost-push
inflation. And this generates inflationary expectations which add fuel to the fire.

To check this vicious circle of wages-chasing prices, an important measure will be to exercise control
over wages. However, if wages are raised equal to the increase in the productivity of labour, then it
will have no inflationary effect. Therefore, the proposal has been to freeze wages in the short run and
wages should be linked with the changes in the level of productivity over a long period of time.
According to this, wage increases should be allowed to the extent of rise in labour productivity only.
This will check the net growth in aggregate demand relative to aggregate supply of output.

However, freezing wages and linking it with productivity only irrespective of what happens to the
cost of living has been strongly opposed by trade unions. It has been validly pointed out why freeze
wages only, to ensure social justice the other kinds of income such as rent, interest and profits should
also be freeze similarly. Indeed, effective way to control inflation will be to adopt a broad- based
incomes policy which should cover not only wages but also profits, interest and rental incomes.

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