Business Economics II: (C) UPES

UNIT 20: Case Study
BBCE-112D
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BBA (Aviation Operations)
Business Economics II
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Aviation Marketing Management
Course Design
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Advisory Council
Chairman
Dr Parag Diwan
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Members
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Dean Dean CIO
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VP – Academic Affairs Associate Dean VP – Research & Development
SLM Development Team

Wg Cdr P K Gupta
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Author
Vivek Mittal
All rights reserved. No part of this work may be reproduced in any form, by mimeograph or any other means,
without permission in writing from MPower Applied Learning Enterprise.
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Course Code: BBCE-112D
Course Name: Business Economics II
Version: July 2013
© MPower Applied Learning Enterprise

UNIT 20: Case Study
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Contents
Block-I
Unit 1 Business and Economics ................................................................................................ 3
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Unit 2 Forms and Facet of Business Organisation ................................................................ 11
Unit 3 Forms and Fallacies of Economic Analysis ................................................................. 23
Unit 4 Basic Concepts and Precepts ....................................................................................... 35
Unit 5 Case Studies.................................................................................................................. 55
Block-II
Unit 6 Basic Tools and Techniques of Economic Analysis ..................................................... 61
Unit 7 Game Theories in Economic Analysis ....................................................................... 119
Unit 8 Market Analysis.......................................................................................................... 145
Unit 9 Consumption and Demand Analysis ......................................................................... 167

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Unit 10 Case Studies................................................................................................................ 197
Block-III
Unit 11 Production and Supply Analysis................................................................................ 203
Unit 12 Cost Analysis .............................................................................................................. 233
Unit 13 Industry and Market Structure Analysis.................................................................. 255
Unit 14 Theory and Models of Firm and Industry ................................................................. 277
Block-IV
Unit 16 Business Risks and Uncertainty Analysis ................................................................ 295

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Unit 17 Macroeconomic Environment of Business................................................................. 311
Unit 18 Macroeconomic Concepts of Stocks and Flows.......................................................... 323
Unit 19 Macroeconomic Analysis ............................................................................................ 333

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Block-V
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Unit 21 Macroeconomic Problems of Fluctuations and Growth ............................................ 355
Unit 22 Government and Business – Macroeconomic Policy Matters................................... 371
Unit 23 Foundations of Economic Analysis ............................................................................ 387
Unit 24 Business Ethics and Economic Offences ................................................................... 395
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Glossary ..................................................................................................................................... 417

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BLOCK-I
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Detailed Contents
UNIT 1: BUSINESS AND ECONOMICS UNIT 3: FORMS AND FALLACIES OF ECONOMIC

ANALYSIS
 Introduction
 Introduction
 Concept of Business
 Forms of Economic Analysis
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 Concept of Economics
 Fallacies of Economic Analysis
 Concept of Business Economics
 Economics of Business Decisions
UNIT 2: FORMS AND FACET OF BUSINESS
ORGANISATION
UNIT 4: BASIC CONCEPTS AND PRECEPTS
 Introduction
 Introduction
 Business Classifications
 Scarcity – The Source of Economic Problems


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Joint Ventures and Foreign Collaborations
International Business: Forms and Facet
Business Efficiency


Marginalism
Opportunity Costs
 Time Perspective
 Discounting
 Risk and Uncertainty
 Profits
 Externality
 Trade-off
UNIT 5: CASE STUDIES

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UNIT 1: Business and Economics
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Unit 1
Business and Economics
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Objectives
After completion of this unit, the students will be aware of the following
topics:
 Concept of Business
 Concept of Economics

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Concept of Business Economics
Introduction
A business is an economic activity. If we look around the
world of business enterprises, we find that they are
innumerable with great varieties. There are various types
of business – manufacturing, mining, construction,
agriculture, poultry – farming, sericulture, food processing,
banking, insurance, health, education, transportation,
communication, so on and so forth. Each one of these
individual businesses represents activity transforming a set
of inputs into a set of output. Such transformation is the
essence of economic activity. Through the process of
transformation, the value of output generated must exceed
the value of input utilised. Should we say, creation of net
value added is the basic objective of all such activities. In
other words, surplus creation, mobilisation and utilisation
together constitute the core and critical elements of economic
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activity.
Concept of Business
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The purpose of any economic activity such as production,

distribution, exchange, inventory accumulation and final
consumption is to create ‘surplus’ or what is popularly known
as ‘profit’. Some of the Non-Governmental Organisations
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Activity (NGOs) and Non-Business Organisations (NBOs) may not
aim at private profits, they aim at what is called as ‘social
W rite an article on the
comparison of business and benefits’. In an extended sense, all organisations are
economics. organising activities, which are either commercially
profitable or socially desirable. For an economist, all these
organisations represent ‘economic enterprises’ or what we
conventionally call as ‘business enterprises’.
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Decision environment of a business enterprise has to be
understood, taking a very wide and long view. We need to
make reference to social, political, historical, geographical,
physical, ecological and economic aspects of an environment.
Decision making in a business enterprise or by a business
manager is not possible without taking a cognisance of the
decision environment.
UP The point remains, decision making unit today is a complex
organisation and decision making within that complex
organisation is a critical job. Without analysing the pros and
cons of the decision environment, a business unit can neither
survive nor grow. It may be suggested that an analysis of a
business unit and its environment can be attempted through
economics. We can use Macroeconomics to evaluate the
business environment and Micro-economics to evaluate the
performance of a business unit and business manager’s
position therein.
At this stage one must understand what Economics is all
about.
Concept of Economics
Economics is all about a economic problems – their
identification, explanation and possible solutions.
Economics is the study and evaluation of economic problems.

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Each and every economic problem is a problem of choice and

valuation. The question of choice arises as and when means
(resources) are adjusted to ends (wants); the adjustment
itself constitutes an economic activity. The purpose of
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economic activities is to satisfy maximum possible ends by

sacrificing minimum possible resources. The purpose of
economic activities is so defined because of the peculiar
characteristics of both wants and resources.
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Human wants have two fundamental characteristics:
(a) Wants are unlimited. They are numerous in number and

varied in forms. In general, wants are not satiable.
(b) Wants can be graded in order of their intensity. A system

of preference can be worked out so that the less urgent
wants can be placed down the scale.
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Resources like money, materials and time have also got two
fundamental characteristics:
(a) Resources are limited in supply. In general, we face

excess demand for resources and this is the reflection
of their scarcity.
(b) Resources have alternative uses. They can be used for

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more than one purpose. Uses of resources can also be
graded in the order of priority.
It may be noted that the want characteristics and resource

characteristics are very much comparable and contrastable.
Unlimited ends and limited means together present the
problem of choice. Choice has to be exercised in selecting
the ends to be satisfied; choice has to be exercised in selecting
the uses of means to an end. Graded list of preference for
wants and alternative use of resources together reinforce
the question of choice and valuation. Thus, an economic
problem arises because of the fundamental characteristics
of ends and means that have been stated above. The essence
of the problem is ‘scarcity of resources’. Had resources not
been scarce, unlimited wants could have been easily satisfied
by using unlimited resources; resource wastage would not
have been a concern at all. Since resources at our disposal
are limited, we are always concerned about their creation,
mobilisation, allocation and optimum utilisation. Here are
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the various facet of any economic problem. The concern of

Economics is the description and analysis of economic
problems faced by individuals, organisations, nations and the
world. Economics teaches us how to ‘minimise’ the use of
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resources and/or how to ‘maximise’ the level of output,

therefrom. This constitutes optimum solution of an economic
problem.
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Activity Check Your Progress
Prepare a brief report on
business economics. Fill in the blanks:
1. The purpose of an economic activity is to create

surplus, which is popularly known as .................. .
2. .................. is all about economic problems their
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identification explanation and possible solution.
Concept of Business Economics

Based on the preceding sections, we should be in a position
to state logically:
1. Economics as a discipline provides a set of concepts and

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precepts.
The concepts and precepts together furnish us the tools

and techniques of analysis.
3. Economic analysis is used as an aid to understand

business practices and business environment.
4. Such understanding facilitates business decision making

and decision taking. Sometimes, an economic analysis
also helps us to evaluate the rationality and optimality
of business decision already made or taken.
There is a thin line of distinction between Business

Economics and Managerial Economics. Business Economics
normally works as a solid foundation of Managerial
Economics and sometimes the former can be a good substitute
or supplement for the latter.
Business Economics uses:
a. Micro-economic analysis of the business unit; and

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b. Macroeconomic analysis of the business environment.
Business Economics is thus more comprehensive and broad

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based than Managerial Economics which is mostly micro-

economics with high-pitched degree of analytical rigour
through sophisticated tools and techniques of Econometrics
and Operations Research.
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The micro-economic environment deals with the operation
of the firm in (a) an industry; and (b) a market.
The firm, as a corporate unit, is an element of the industry.
The industry is a set of different firms. Each firm has a
position in the industry. It may be a dominant (leader) firm
or a subservient (follower) firm. Sometimes, the single firm
may itself constitute the industry, i.e., monopoly case.
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In the same way, the firm exists in a market. Its position
and operation is affected by demand-supply conditions in
the market, price and cost considerations and the like.
The industry and/or the market which condition the
operation of the firm are in themselves, the elements of an
economy – domestic or national or international. Therefore,
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the macroeconomic analysis of the national and global
environment is called for. In that context, legal, social,
cultural, political, physical aspects along with the economic
aspects of business environment are required to be
examined. As a microscopic element, the firm and its
business managers may not be able to exercise control over
this macro environment and therefore, it is treated ‘external’
to the firm. But, in the same way, the firm may not always
successfully control all those forces and factors which are
‘internal’ to the firm, e.g., the workers, the shareholders, the
promoters, the managers, the subordinate staff and their
expectations.
Check Your Progress

Fill in the blanks:
1. Business is an economic activity ................... .
2. Surplus, creation, mobilization and utilization
together constitute the core and critical elements
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of economic activity. ................... .

3. NBO means non business organizations ...................
4. NGO stands for non government organizations
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................... .
5. Economic is all about a economic problems
................... .
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Summary
The purpose of any economic activity such as production,
distribution, exchange, inventory accumulation and final
consumption is to create ‘surplus’ or what is popularly known
as ‘profit’. Some of the Non-Governmental Organisations
(NGOs) and Non-Business Organizations’ (NBOs) may not
aim at private profits, they aim at what is called as ‘social
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benefits’. In an extended sense, all organisations are
organising activities, which are either commercially
profitable or socially desirable. For an economist, all these
organizations represent ‘economic enterprises’ or what we
conventionally call as ‘business enterprises’.
Economics is all about a economic problems – their

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There is a thin line of distinction between Business

Economics and Managerial Economics. Business Economics
normally works as a solid foundation of Managerial
Economics and sometimes the former can be a good substitute
or supplement for the latter.
Business Economics uses:
1. Micro-economic analysis of the business unit; and
2. Macroeconomic analysis of the business environment.
Lesson End Actvity

Descriptive Type Questions (Business Application Exercises)
1. Make a survey of business in and around you. Following

should be a set of lead questions in your mind:
i. Do you have family business, if yes, what is its

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nature? If no, why is it so?
ii. Have you come across businessmen? Name them

and list their typical traits. Categorise them into
the following three groups:
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iii. What is your idea of a professional?
(a) Businessman (b) Business unit

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iv. Classify the business units into the following three
categories:
Domestic (Local) National International
Keywords
Economics: Economics is all about a economic problems –
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their identification, explanation and possible solutions.
NGO: Non-Governmental Organizations.
NBO: Non-Business Organizations.
HLL: Hindustan Lever Ltd.
SAIL: Steel Authority of India Ltd.
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Questions for Discussion
Find out the striking differences between a typical
national and a multinational corporation, say, Punjab
National Bank vs ANZ Grindlays Bank.
2. Describe exactly the nature of ‘economic activity’ being

undertaken by the following:
(a) Hindustan Lever Ltd.
(b) Steel Authority of India Ltd.
(c) Educational Consultants of India Ltd.
(d) Apollo Hospital
(e) Finance Ministry, Govt. of India
3. Collect some examples of ‘rational’ and ‘irrational’

behaviour on the part of economic agents like a buyer/a
seller/an investor/a contractor.
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Professional Semi-professional Unprofessional
4. Interview one or two professional managers to find out

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how (s) he arrived at a particular decision? In what way

the decision problem is an economic problem?
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Further Readings
Books
Manab Adhikary, Business Economics, Excel Books.
Atmanand, Managerial Economics, Excel Books.
Joseph Nellis, David Parker, Principles of Business
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Economics, 2nd Edition, Excel Books.
Alan Griffiths, Stuart Wall, Economics for Business and

Management, 3rd Edition, Pearson Education.
Robert H. Frank, Ben S. Bernanke, Principles of Economics,

McGraw Hill Education.
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Web Readings
www.businesseconomics.in/
en.wikipedia.org/wiki/Business_economics
economictimes.indiatimes.com/
www.mbe-du.org/
www.basiceconomics.info/
iipm-businesseconomics.com/class-notes.html
tutor2u.net/revision_notes_economics.asp
www.businessandeconomy.org/
mitworld.mit.edu/video/932
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UNIT 2: Forms and Facet of Business Organisation
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Unit 2
Forms and Facet of
Business Organisation
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Objectives
topics:
 Business Classifications
 Joint Ventures and Foreign Collaborations

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Multinational Corporations
Business Efficiency
Introduction
Business concerns are established with the objective of
making profits. They can be established either by one person
or by a group of persons in the private sector by the
government or other public bodies in the public sector. A
business started by only one person is called sole
proprietorship. The business started by a group of persons
can be either a Joint Hindu Family or Partnership or Joint
Stock Company or a Co-operative form of organization.
Almost every country consists of two business sectors, the

private sector and the public sector. Private sector
businesses are operated and run by individuals, while public
sector businesses are operated by the government.
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Business Classifications
Business organisations can be classified by the level of
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activity, by sectors or by legal structure.

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Activity
Classification by Groups of Transactors
Prepare a short report on the Earlier we had stated that business is an economic activity.
various categories of business
classification.
While undertaking such economic activities, people may
organise themselves differently as –
Consumers Demanding goods and services for final

consumption.
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Producers Supplying goods and services by obtaining,
arranging, transforming basic inputs like
men, materials and machines into a flow of
output.
Distributors Facilitating exchange transactions between

consumers and producers; sometimes
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Classification by Level of Activity

 Primary: Firms involved in the first stages of
production. These are extractive industries (e.g.,
quarrying, mining, agriculture).
 Secondary: This second stage of production is

manufacturing. All manufactured goods are included,
e.g., capital or investment goods (plant, buildings,
machine tools), durable consumer goods (e.g., cars,
washing machines) or non-durable goods (e.g., food,
clothing).
 Tertiary: Firms providing services, e.g., police,

education and other services such as banking, insurance
and catering.
Classification by Sector
This is simply grouping businesses into private or public
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areas.
 The private sector includes all firms whose ownership

is by private enterprise (e.g., IBM or the corner shop).
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 The public sector includes businesses which are

controlled by the Government, e.g., Indian Railways,
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SAIL, BHEL, etc. It is worth noting that examples of
the public sector may change with different political
parties in power.
 The joint sector is jointly managed by both private and

public sector.
 The co-operative sector is a voluntary organisation.
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Classification by Legal Structure
The term legal person may refer to any person who can enjoy
certain legal rights and who has certain legal duties. Some
do not enjoy full legal capacity, e.g., children. The term can
also refer to a group of people acting collectively, so the group
becomes a person in its own right and can exist separately
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from the individuals that constitute the group.
Formation of a company is an example of a group of people

becoming a ‘legal person’ enjoying all legal rights that an
individual has, e.g., it can own property. This concept is very
important for business organisations. A company formed in
this way becomes ‘incorporated’ and the people who form it
have rights and responsibilities separate from the firm itself.
Individuals, who enter business as a legal person, in their

own right, have no rights or responsibilities other than those
of an ordinary individual – these associations have no legal
identity and are termed unincorporated associations (e.g.,
sole traders, partnerships).
Unincorporated Associations
 A sole trader/proprietor is the most prevalent and
simplest form of an organisation. The owner has
complete control over the activities of the business and
is alone responsible for any debt incurred. He has
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unlimited liability for the business.
 Partnerships are formed by individuals combining and

each person becomes a partner. The aim may be to bring
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in new capital or expertise. These are usually small

business units, e.g., builders or professional services
such as solicitors.
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The Partnership Act, 1890, defines a partnership as ‘the
relationship which subsists between persons carrying on a
business in common with a view to profit’. Membership is
generally restricted to not more than 20 persons, although,
this restriction does not apply to solicitors, accountants or
members of a recognised Stock Exchange. Any other profit
making association with a greater number must form and be
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registered as a company.
The personal liability of partners is unlimited, just like sole

traders, unless the partnership is registered under the
Limited Partnership Act of 1907. In this case, liability is
limited to the amount of the subscribed capital of partners.
In most cases, though, a partner is liable for the debts and
obligations of the firm which were incurred while he was a
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partner.
A partnership is formed by agreement, which is usually

included in a written statement in the form of a deed called
Articles of Partnership. The rights, powers and duties of
partners are clearly set out in these Articles.
In limited partnerships, there must be one partner with

unlimited liability and those with limited liability are not
allowed to take part in the management of the firm nor
withdraw their financial contribution while the partnership
exists. As this type of firm has no legal identity, the death or
departure of one partner will dissolve the partnership.
Registered Companies
The main distinguishing characteristic between public and
private companies is that a public company can offer shares
and debentures to the public and a private company cannot.
Any company that does not satisfy the requirements of a
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public company is deemed a private company, sometimes

‘closely held’ sometimes ‘widely held’.
The average size of the private company is small because

the maximum number of shareholders is limited. Public
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companies have no limitation.

The sole trader and a partnership forms of organisation are
not suitable for larger enterprises that have large capital
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needs. Shareholders and creditors need assurances that their
money is safe and so the joint-stock company develop from
the partnership to allow shareholders to invest money
without involving themselves in the running of the business,
or having unlimited liability for losses if the business does
not prosper.
The types of company operating today are:
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 Registered companies: These are the most popular and
are registered under the Companies Act;
 Chartered companies: These include charitable bodies
and other institutions that are incorporated by Royal
Charter;
 Statutory companies: These are formed under a
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specific Act of Parliament.
Co-operative societies draw their legal personality from the
Industrial and Provident Societies Act and register with the
Registrar General of Friendly Societies.
Public Sector Organisations

Public organisations trade and supply goods and services at
prices which cover their costs. Non-trading sectors supply
goods and services freely or at subsidised prices. Others are
engaged in purely administrative activities. The government
formulates and proposes policy which is approved by the
Parliament. The agreed policy is implemented by:
 Central government departments, e.g., Department of

Social Welfare;
 Local government authorities, e.g., country councils,

municipalities;
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 Government agencies;
 Nationalised industries;
 National service organisations, e.g., hospitals.

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The public sector, as it exists today, comprises:
 Public utilities like the railways, posts and telegraphs

and irrigation projects;
Activity  Departmental undertakings of the government – Central

and State – such as, the Chittranjan Locomotive Works,
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Make a list of 10 global giants,
i.e. Multinational Corporations. the Integral Coach Factory; and
W rite one informative
paragraph about each.  Other industrial undertakings which derive their
finance almost wholly from the Central Government in
the form of equity capital and loan.
The Joint Sector
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In simple terms, the joint sector is a form of partnership
between the public sector and the private sector – between
the government and the business houses. In recent years,
this sector has grown in importance.
In a memorandum submitted to the Government, JRD Tata
suggested –
UP “A joint sector enterprise is intended to be a form of
partnership between the private sector and the government
in which State participation of capital will be not less than
26 per cent, the day-to-day management will normally be in
the hands of the private sector partner and control and
supervision will be exercised by a board of directors on which
government is adequately represented”.
Check Your Progress

Fill in the blanks:
1. The main distinguishing feature between public and
private company is ................... .
2. A ................... is formed by agreement, which is
usually included in a written statement in the form
of a deed called.
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Joint Ventures and Foreign Collaborations

The Joint Sector enterprises must not be confused with Joint
Venture projects. Various companies operating
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internationally may join hands to take up a project. In the

middle east, for example, the construction projects are being
handled on this principle (such as consortium approach).
Similarly, a domestic company may enter into foreign
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collaboration agreements – either technical or financial or
both. Such foreign collaborations facilitate the inflow of
foreign capital (direct investment), foreign technology,
foreign enterprises, foreign goods, foreign brand names, etc.
All these reflect business interdependence between nations.
Multinational Corporations
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Of late, business is growing global. Business units are,
therefore, expanding beyond their domestic operations and
national boundaries. Thus, Indian business is going abroad
and foreign business is coming to India. For example, Birla,
Kirloskar and SBI are successfully operating abroad. In the
same way, Unilever, Proctor and Gamble, Cadburys, Nestle,
Pepsi and Coca Cola are operating in India. We are living in
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the age of multinational corporations (MNCs). We need to
understand the operation and culture of these MNCs in the
context of international business.

In particular, it is observed that international business
comprises of two types of operational processes:
(a) Economic transactions in the form of exchange of

resources between nations;
(b) Interaction between the multinational firms and the

host society.
The chief players in international business have been

designated by various terms such as: ‘Multinational
Corporations’ (MNC), ‘Multinational Firms’ (MNF),
‘International Corporations’ (IC), ‘Transnational
Corporations’ (TNC), ‘Multinational Enterprises’ (MNE) and
‘Global Companies’ (GC). These terms are often used
)
interchangeably. Nevertheless, various authors have tried

to differentiate between these business units by defining
these terms according to certain specific criteria.
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For example, Fayerweather (1978) uses the term MNC to
distinguish two specific components:
(a) international business in two or more countries; and
(b) the capacity for central control of foreign operations.
Robbinson, quoted earlier, has used the above classification

in the orientation of headquarters of the MNC towards its
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subsidiaries. The corresponding terms used are:
Ethnocentric — International
Polycentric — Multinational
Geocentric — Transnational
Barlett & Ghoshal (1989) used three models on the basis of

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strategic postures and organisational capabilities.
Companies which are sensitive and responsive to different
national environments are called ‘Multinational Companies’.
These companies, driven by the need for global efficiency
and centralised strategic and operational decisions, are often
called ‘Global Companies’.
Business Efficiency
The performance of any business organisation may be
measured in terms of certain parameters. The operational
efficiency of a business unit is often judged in terms of variety
of a measures such as:
i. Turnover — Investment ratio
ii. Investment — Employment ratio
iii. Turnover — Employment ratio
iv. Gross profit — Investment ratio

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v. Net profit — Investment ratio
vi. Assets — Liability ratio

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vii. Debt — Equity ratio
viii. Capital — Output ratio

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ix. After tax or Before tax — Return on investment
x. Net worth — Investment ratio
Economists tend to measure operational efficiency in terms

of productivity concepts like output per labour, output per
capital, output per unit of man-hours or machine-hours,
output per unit of outlay spent, etc. Some of these measures
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relate to physical efficiency, some to cost efficiency. For
example, minimising wastage of materials in a production
process indicates physical efficiency, whereas minimising
outlay spent to produce a given volume of output of a standard
quality indicates cost efficiency.
Check Your Progress

Fill in the blanks:
1.
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Mining, agriculture are primary level of firm
activity ................... .
2. Second stage of production is providing service

................... .
3. Third stage of production is manufacturing

................... .
4. Public companies cannot offer shares ................... .
5. Private companies size is relatively small

................... .
Summary
Earlier we had stated that business is an economic activity.
While undertaking such economic activities, people may
organize themselves differently as –
)
(i) Consumers Demanding goods and services for

finalconsumption.
(ii) Producers Supplying goods and services by

(c
obtaining, arranging, transforming basic

inputs like men, materials and machines
into a flow of output.
S
(iii) Distributors Facilitating exchange transactions
between consumers and producers;
sometimes holding stock and sometimes
releasing it.
The term legal person may refer to any person who can enjoy
certain legal rights and who has certain legal duties. Some
do not enjoy full legal capacity, e.g., children. The term can
E
also refer to a group of people acting collectively, so the group
becomes a person in its own right and can exist separately
from the individuals that constitute the group.
Formation of a company is an example of a group of people

becoming a ‘legal person’ enjoying all legal rights that an
individual has, e.g., it can own property. This concept is very
important for business organisations. A company formed in
UP
this way becomes ‘incorporated’ and the people who form it
have rights and responsibilities separate from the firm itself.
Individuals, who enter business as a legal person, in their

own right, have no rights or responsibilities other than those
of an ordinary individual – these associations have no legal
identity and are termed unincorporated associations (e.g.,
sole traders, partnerships).
Economists tend to measure operational efficiency in terms

of productivity concepts like output per labour, output per
capital, output per unit of man-hours or machine-hours,
output per unit of outlay spent, etc. Some of these measures
relate to physical efficiency, some to cost efficiency. For
example, minimising wastage of materials in a production
process indicates physical efficiency, whereas minimising
outlay spent to produce a given volume of output of a standard
quality indicates cost efficiency.
Lesson End Activity

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Visit and make a list of some business organisations dealing

in:
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(i) Banking
(ii) Insurance
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(iii) Manufacturing
(iv) Consultancy
(v) Communication
(vi) Transportation
Keywords
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Primary Firms: Firms involved in the first stages of
production. These are extractive industries (e.g., quarrying,
mining, agriculture).
Secondary Firms: This second stage of production is

manufacturing. All manufactured goods are included, e.g.,
capital or investment goods (plant, buildings, machine tools),
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durable consumer goods (e.g., cars, washing machines) or
non-durable goods (e.g., food, clothing).
Tertiary Firms: Firms providing services, e.g., police,

education and other services such as banking, insurance and
catering.
Private Sector: The private sector includes all firms whose
ownership is by private enterprise (e.g., IBM or the corner
shop).
Public Sector: The public sector includes businesses which

are controlled by the Government, e.g., Indian Railways,
SAIL, BHEL, etc. The joint sector is jointly managed by both
private and public sector.
Co-operative Sector: The co-operative sector is a voluntary
organisation.
Legal Person: The term legal person may refer to any person
who can enjoy certain legal rights and who has certain legal
duties.
)

1. Explain business classification on the basis of:
(c
(a) Activity (b) Sector (c) Legal structure

2. Explain the concept of join venture and foreign
collaborations.
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3. Describe the concept of multinational corporations.
4. Discuss the forms and facet of international business.
5. What do you understand by business efficiency?
Further Readings
Books
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Web Readings
www.mindtools.com › Strategy Tools
www.explainingthefuture.com/facets.html
www.mbe-du.org/
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UNIT 3: Forms and Fallacies of Economic Analysis
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Unit 3
Forms and Fallacies of
Economic Analysis
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Objectives
topics:
 Forms of Economic Analysis
 Fallacies of Economic Analysis

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Economics of Business Decisions
Introduction
Economic analysis is done to provide this objectivity. In the
name of economic analysis, we may fall back on a variety of
concepts, precepts, tools and techniques. Different types of
economic problems, depending upon the corporate level or
the national level, can be analysed through different sets of
economic analyses.
Forms of Economic Analysis

Accordingly, we may draw a line of contrast between various
types of economic analysis.
1. Micro vs Macroeconomic Analysis: In micro-economic

analysis, we focus on individual units like a consumer,
a producer, a firm, an industry, a single price or a single
commodity. We analyse the behaviour of one market
)
variable at a time – it is a step-by-step analysis. Such an

analysis helps us to understand behaviour of a single
thing, “other things remaining equal”.
(c
In macroeconomic analysis, we study the system as a

whole – not the individuals but the total. We focus on
the form and functioning of the economy as an aggregate
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system. We are interested in the system as a whole, not
in the microscopic minority or a part of the system.
Accordingly, our variables are – national income,
national consumption expenditure, total investment
expenditure, total money supply, general price level,
overall employment and output levels.
2. ‘Partial’ Equilibrium Analysis: ‘Partial’ equilibrium
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analysis in economics means when at a time, one part of
the system is being analysed assuming other parts to be
constant parameters. The assumption of “other things
remaining equal” may be eventually relaxed and then
the interdependence among consumers, among
producers and between consumers and producers is
studied to derive the welfare implications of a situation
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3.
of balance of market forces. This is the system of ‘general’
equilibrium analysis.
Static vs Comparative, Static vs Dynamic Analysis:

In static analysis, the reference is to an adjustment at a
point of time; preferences, techniques and resources are,
therefore, assumed constant. In comparative static
analysis, two or more static states, i.e., shifting
equilibrium situations may be studied so as to identify
the single process of adjustment. In dynamic analysis,
we study adjustment path followed over a period of time
such that successive changes in tastes, techniques and
resources over long run can be taken care of. The
introduction of ‘time-lags’ or ‘period analysis’ is a step
towards dynamising the analysis.
4. Positive vs Normative Economic: Most of the business

policies of an economic unit, like a firm, are based on
micro-economic principles. Most of the national/
international economic policies are based on
)
macroeconomic principles. However, neither the

business sector can overlook the impact of national and
global economic policies of the Government, nor the
economy can overlook the impact of business policies
(c
framed by a particular (individual or group)

management. To the extent economic analysis (positive
economics) and economic policy (normative Economics)
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are inseparable, micro and macro analyses must go Activity
together.
Prepare a short report on the
forms and the fallacies of
5. Short run vs Long run Economic Analysis: If the economic analysis.
constraints are rigidly fixed and pegged, it is the
‘temporary-run analysis’. If some constraints are
variable, while others are fixed, it is a ‘short run analysis’
and if all constraints are variable and adjustable, it is
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‘long run analysis’. For example, a Flexible
Manufacturing System (FMS) is a short run adjustment,
but continuous technological progress is a long run
development.
Fallacies of Economic Analysis

The fallacies of economic analysis are as follows:
1.
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The Fallacy of Composition: To assume what is true
for one part (micro) will necessarily be true for the whole
(macro) is the fallacy of composition. For example,
saving is obviously a virtue for most individual families.
But if every family saves, the level of consumption
expenditure will decrease. Unless someone else spends
more, merchants sales will fall; producers will be forced
to retrench people. Unemployment will surface. The
economy will suffer. Thus, saving, which is a virtue for
an individual turns out to be a vice for the economy as a
whole. This is the famous “paradox of thrift”.
2. Post hoc, Propter hoc: It means: “after that; therefore,

because of that”.
3. The Fallacy in Syllogism: Syllogism is a particular

form of reasoning such as
Major premise : All dogs like bones.

)
Minor premise : Roger likes bones.
Therefore : Roger is a dog.

(c
Note carefully, that the conclusion does not necessarily

follow from the premises; Roger may be a dog, but Roger
may be a man or a woodchuck.
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4. Probabilistic versus Deterministic Inferences: Most
generalisations in economic analysis are based on a set
of assumptions. Some of these assumptions are
sometimes stated explicitly and some implicitly in terms
of phrases like “other things remaining equal”. Some of
these assumptions are factual statements, some are anti-
factual or counter-factual. As such, the inferences which
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are drawn from the set of assumptions can at best be
described as tentative hypotheses, subject to
qualifications. The conclusions from economic analysis
are, therefore, probabilistic rather than deterministic.
5. Black or White or Grey: There is another related
fallacy. If one is not wary, one can go astray by assuming
(explicitly or implicitly) that there is no middle ground
UP between two extremes. On a foggy day, someone asks,
“Is it raining?” You reply, “No”. Then he may retort, “You
mean, it is sunny”, but, of course, it may just be foggy.
6. Wishing It Were So: One of the commonest of human
frailties is to believe the things we want to believe. We
tend to talk to people who agree with us, read the
newspaper that reports things the way we like and run
away from information and conclusions that are painful
to us. We always accept the favourable interpretation
of an event or a course of action. This is one of the most
insidious fallacies that we believe in “pleasure economy”
rather than “pain economy”. The union members believe
that the company could pay higher wages if only it
would. Top management believes that all right thinking
people see that management is right and labour is wrong
in most wage disputes. Just wishing it were so!
Check Your Progress

)
Fill in the blanks:

1. In ................. analysis, we focus on individual units
like customer, a producer, a firm, an industry, a
single price or a single commodity.
(c
2. In ................. analysis, we study the system as a

whole - not the individuals but the total.
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Economics of Business Decisions Activity
A decision problem is often an economic problem because it Write an article for a business
on economics of business
involves a choice from among a set of alternatives. A typical decisions.
problem facing an economy is often stated in the elementary
textbook as: What to produce? Gun or Butter? Military
consumption or civilian consumption item? In today’s world,
the question is: Where to allocate resources – nuclear
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explosion or poverty alleviation? Or, the extended choice
problem may be: Nuclear explosion for what? War or Peace?
In the same way, a typical firm faces the problem: What to
produce? Where to produce? How to produce? When to
produce? For whom to produce? In descriptive economic
terms, we have here reference to various facet of resource
allocation problem involving choice of product or product
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line, choice of location of factories and firms, choice of
technique and technology, choice of timing and scheduling,
choice of target group. Exactly in the same way, every
household may be facing a problem: Where to invest money?
Good education for a girl child or a decent immediate
marriage?
The point remains, each and every economic agent (national/

corporate unit/individual household) faces the problem of
choice while deciding about his rational and optional
economic activities. Thus, decision making is truly economic
in nature.
At this stage, certain distinctions must be spelt out to remove

any element of ambiguity in the minds of the reader or the
learner.
i) Decision vs Action: A decision is not an action. A

decision is just a prelude to an action. Decision making
is a mental process – a process of planning and
)
programming. A decision is not a guarantee for an

action. A decision may just be a prognosis and not a
command. Action is an execution – an implementation
of a decision. The decision taken by the high command
(c
is followed by the operational level action by the field

operators. Many decisions are taken, but are not
followed up by action line or action programmes. Thus,
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“good decisions” may end up as “no-action”. Many a
times, delayed decisions are taken to avoid immediate
action. This is observed at many levels.
“Decisions” are supposed to be followed by actions;

“actions” generate “reactions”. If an action is deemed as
a thesis, then the reaction to it should be deemed as an
antithesis. The decision-maker must make a synthesis
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of thesis and antithesis before taking another decision.
It is an ongoing process.
Decision Actions Reaction New Decisions

s
Figure 3.1
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decision maker is required to revise (rather than repeat)
his decisions and actions.
ii) Decision Making vs Decision Taking: Decisions

originate at various levels of management: top, middle
and lower. Some of these decisions are routine and
repetitive jobs, because these are just based on existing
rules, regulations, guidelines or past practices and
procedures. Such decisions do not involve any analysis
or diagnosis of problems. One does not have to
manufacture a decision—one just takes it with reference
to the rule book or manual. Such decision taking takes
place mostly at lower level. By contrast, at higher level,
policy decisions are made. Decision making involves a
process. All decisions must have reference to some kind
of problems – problems of choice. However, decision
itself should never be accepted as a solution. At best,
any decision is an attempt towards a solution, If the
)
solution works, it is the right decision, if it does not, it

is a wrong decision. A decision maker has to analyse
the problem, then establish its nature locating the root
cause (s), appropriate to which some specific solution
(c
has to be tried to see if it works. In this process, a decision

maker looks at the problem (past), then makes an
attempt towards optimistic decisions-cum-actions
(project) and reads the reactions (future) to repeat or
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revise a decision. Thus, decision making process is
essentially a coordination on the time scale and involves
risk. In contrast, decision taking is mostly risk-free.
iii) Scientific vs Intuitive Decisions: Let us attempt

another interpretation. Decision making is scientific
and decision taking is intuitive. Intuition involves value
judgements based on beliefs and experiences. Many of
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our traditional industrialists and entrepreneurs coming
from big business houses, without going through any
formal management education, had taken business
decisions purely based on their individual business
acumen, experience and wisdom; and today we realise
how perfect they were. By contrast, the second and the
third generation of the same business family, presently
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going through the drill of formal professional
management education like BBA or MBA or DBA, are
now making more scientific decisions than what their
grand or great-grand parents did. Scientific decision
making involves analysis of problems through data,
concepts, precepts and techniques.
iv) General vs Functional Decisions: General

Management decisions mostly pertain to corporate plans
and business policy areas. By contrast, the functional
management decisions relate to a specific functional
area or sub-area such as tax planning, inventory
valuation, production scheduling, staff recruitment and
selection, sales promotion, etc. All general decisions
have functional area implications. For example, a
decision towards corporate restructuring may carry
certain implications. General decisions are to be taken
in view of an integrated approach.
v) Certain vs Risky vs Uncertain Decisions: This

)
contrast has to do more with the nature of decision

environment than with the decision process.
One may wonder why do the managers go for decision

(c
making, while the administrators go for decision taking

in both general and specific functional areas. The answer
lies in the decision environment that a person faces.
Decisions are needed to cope with changes in the decision
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environment. If the changes are known and predictable
accurately or are repetitive in nature, then one can go
for just “decision taking”. But if changes are otherwise,
there is no choice but to make decisions and line up
actions which involve a great deal of risk and
uncertainty.
Let us classify the changes typical of a decision
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environment, in terms of an approach available in
applied economics in the form of a chart.
It is now easy to comprehend that the decision takers would
like to operate under certainty because they are risk-
avoiders. The decision makers, on the other hand, are risk-
takers; some of them may even be risk-lovers. By nature, a
decision maker, even if placed in the world of certainty where
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risk does not exist, imagines risk. In the same way, if he is
placed under uncertainty, a decision maker tries to guess
the element of risk when he cannot estimate it, i.e., he may
even “guesstimate” risk. Thus, the types of decisions or
approaches to decisions indicate the attitude and action of a
decision maker/decision taker.
Check Your Progress

Match the following:
Column A Column B
1. Post hoc, proper hoc a. What is true for one part will
also be true for the whole
2. The fallacy of composition b. Scientific in nature
3. Decisions c. After that; therefore, because
of that
4. Decision making d. Intuitive in nature
5. Decision taking e. Supposed to be followed by
actions
)
Summary
In the name of economic analysis, we may fall back on a
variety of concepts, precepts, tools and techniques. Different
(c
types of economic problems, depending upon the corporate

level or the national level, can be analyzed through different
sets of economic analyses. Here, is a brief description
S
Micro vs Macroeconomic Analysis: In micro-economic
analysis, we focus on individual units like a consumer, a
producer, a firm, an industry, a single price or a single
commodity. We analyse the behaviour of one market variable
at a time – it is a step-by-step analysis. Such an analysis helps
us to understand behaviour of a single thing, “other things
remaining equal”.
E
In macroeconomic analysis, we study the system as a whole
– not the individuals but the total. We focus on the form and
functioning of the economy as an aggregate system. We are
interested in the system as a whole, not in the microscopic
minority or a part of the system. Accordingly, our variables
are – national income, national consumption expenditure,
total investment expenditure, total money supply, general
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price level, overall employment and output levels.
The types of decisions or approaches to decisions indicate

the attitude and action of a decision maker/decision taker.
Lesson End Activity

Identify the nature of economic analysis you would employ
to study:
(i) Inflation problem
(ii) Government’s public works programme
(iii) Textile industry
(iv) Information Technology
(v) Agro-business in India
(vi) Monetary and credit policy of RBI
Keywords
)
Micro-economic Analysis: In micro-economic analysis, we

focus on individual units like a consumer, a producer, a firm,
an industry, a single price or a single commodity.
(c
Macroeconomic Analysis: In macroeconomic analysis, we

study the system as a whole – not the individuals but the
total. We focus on the form and functioning of the economy
as an aggregate system.
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‘Partial’ Equilibrium Analysis: ‘Partial’ equilibrium
analysis in economics means when at a time, one part of the
system is being analysed assuming other parts to be constant
parameters.

1. Explain the “paradox of thrift” stating clearly the
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underlying fallacy.
2. “Wage cut can increase employment”, Is it true or false–

Explain.
3. “The economist‘s concept of equilibrium is too ideal to

be real ... wishing it were so”. Comment with reference
to the real world business.
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4. How is ‘short-run’ analysis different from ‘long-run’
analysis of any economic problem?
5. What is a “risky” environment? When does it become

an “uncertain” environment? Quote examples from
business world.
6. Conceptualise the interrelationship between: (a) Forms

of economic analysis and (b) Fallacies of economic
analysis.
7. Economists are concerned with logical reasoning, while
the businessmen are concerned with practical
operations. How should a business economist resolve
such conflicts?
8. Make a list of types of decisions. Quote one example of
each.
9. Review the various facet of the following decisions:
(a) AT&T and IBM entering a business deal to manage
)
jointly their overseas operations.

(b) New Bank of India is merged with Punjab National
Bank.
(c
(c) ‘Kinetic Honda’ will now be only “Kinetic”.

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(d) Maruti Udyog Ltd has decided to cut the price of
Maruti 800 and Zen model by about ` 35,000 and
` 45,000 respectively, at a time when Tata is
launching Indica model cars.
(e) AKAI TV has a scheme: Bring an old TV set to get a
new TV set — Buyback Scheme!
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Further Readings
Books

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Web Readings
w w w. b p tre n ds . com / d eliv er_ f ile . cf m ?file Ty p e .. . 0 1. . .
SixFallacies
www.infoq.com/articles/seven-fallacies-of-bpm
www.mbe-du.org/
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) UP
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UNIT 4: Basic Concepts and Precepts
Unit 4
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Basic Concepts and Precepts
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Objectives
topics:
 Scarcity – The Source of Economic Problems
 Marginalism, Equi-Marginalism and Opportunity Costs

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Time Perspective, Discounting, Risk and Uncertainty
Profits, X-Efficiency and Externality
 Trade-off
Introduction
Business Economics, as a separate discipline owes its origin
to the growing disenchantment with economic theory in
providing solutions to the problems faced by business. This
should not be taken to mean that business economics
provides ready-made solutions to business problems. What
it provides is a tool-box of analysis and a technique of thinking
which can be helpful in conceptualising the problems faced
by management of a business firm. Management is trained
to take the decisions in a mature manner if exposed to tools
and techniques of economic analysis when applied to the
business environment. Thus, business economics is supposed
)
to enrich the conceptual and technical skills of a manager,

facing business decision problems.
Scarcity – The Source of Economic Problems

(c
This is one of the fundamental concepts of Economics

relevant for Business Economics. This concept lies at the
heart of resource allocation problem of a business enterprise.
The essence of any economic problem, micro or macro, is the
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Activity scarcity of resources. The managers who decide on behalf of
the corporate unit or the national economy always face the
Write an article on marginalism
and equi-marginalism. economic problem of scarcity of one kind or the other. Let us
take a couple of examples to illustrate this. As a production
manager, he may be facing scarcity of good quality of
materials or skilled technicians. As a marketing manager,
he may be encountering scarcity of sales force at his
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command. As a finance manager, he may be facing scarcity
of funds necessary for expansion or renovation programme.
The finance minister of the country, designated as an
important official in the Ministry, his basic problem when
he prepares the budget every year, is to find enough revenue
resources to finance the necessary expenditure on plans and
programmes. Thus, scarcity is a universal phenomenon.
UP Marginalism
The term ‘marginal’ is relevant for all such additional
magnitudes of output or return. For example, we often use
terms like marginal output of labour, marginal output of
machine, marginal return on investment, marginal revenue
of output sold, marginal cost of production, marginal utility
of consumption, marginal profit by producing additional
output and so on. One should be clear about the points given
below before an attempt is made to use such concepts of
marginalism.
(a) The nature of relationship between the variables is to
be clearly stated;
(b) The independent variable is to be changed by just one
unit at a time to work out the impact on the dependent
variable;
(c) The marginalism is not to be confused with the concepts
of average.
)
Equi-Marginalism
While developing the concept and precept of marginalism,
we have noticed that we have assumed a single variable
(c
function, such as:

(a) Revenue depends on output,
(b) Costs depend on output.
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The implicit decision rule in such cases may be stated as:
 If you want to maximise revenue then do not sell output

beyond the point where marginal revenue is zero; or
 If you want to maximise the total product, then do not

employ a factor beyond the point where its marginal
product is zero; or
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 If you want to minimise costs, then produce till your
average costs equal marginal costs provided you have
perfect competitive market.
Such decision rules or “Absolute Activity Level Principles”

imply that at a time, an input has only one use, that of
producing an output – or output has got only one use – either
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generating revenue or involving costs, but not both.
Now suppose output has got both functions, viz., it involves

costs, at the same time, it is capable of generating revenue.
In this case, the manager’s decision about extra volume or
extra batch of production must be based on comparisons of
both marginal revenue and marginal cost. If marginal revenue
exceeds marginal cost, additional production should be
encouraged. If marginal cost exceeds marginal revenue, it is
uneconomic to go in for extra production. Thus, the optimum
level of output should be decided at the point where marginal
revenue just covers the marginal cost. The decision rule is
termed as “Relative Activity Level Principle” (Baumol) and
that is what the economists call “equi-marginalism”.
For managerial use the following rules are very handy.
Nature of Unit Equi-marginal Principle
Multi-market seller MR 1 = MR 2 = MR 3 = MRN

)
Multi-plant monopolist MC 1 = MC 2 = MC 3 = MCn
Multi-factor employer MP1 = MP2 = MP3 = MPn
Multi-product firm Mp 1 = Mp 2 = Mp 3 = Mpn

(c
Multi-commodity MU1 = MU2 = MU3 = MUn

consumer
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The notations used above are:
MRi = Marginal Revenue; i = [1 . . . n markets]
MCi = Marginal Cost; i = [1 . . . n plants]
MPi = Marginal Product; i = [1 . . . n factors]
Mpi = Marginal Profits; i = [1 . . . n products]
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Let us assume the case of a multi-commodity consumer who
is purchasing successive units of X, Y and Z. Each unit costs
the same and the consumer is determined to have a
combination including all the three items. His budget
constraint is such that he cannot buy more than six units in
all. Lastly, but not the least, he is subjected to diminishing
marginal utility, i.e., as he has more of an item, he wants to
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have less of it. His choice menu is illustrated below:
Units Item X Item Y Item Z

st
1 10 9 8
nd
2 9 8 7
rd
3 8 7 6
4th 7 6 5
th
5 6 5 4
th
6 5 4 3
*Each number above represents utils.
We are assuming that marginal utilities are cardinally

measurable, say in terms of rupees and that marginal utility
is a monotonically decreasing function of consumption.
We can work out our utility maximising consumer’s

behaviour when he will end up with purchase of 3X+2Y+1Z
because this combination satisfies equi-marginalism.
)
MUx = MUy = MUz = 8
No other combination would give him so much utilities as he

(c
gets now, namely (10+9+8) + (9+8) + 8 = 52.
We may note that in the real world, it may not be always

possible to have such a neat simple problem. In particular
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we may not have data for each successive units; in that case, Activity
we may have to replace “equi-marginalism” by the concept/
precept of “equi-incrementalism”. But our decision rule or opportunity costs.
optimising principle will remain the same.
Finally, it should be noted that in contrast to Absolute

Activity Level Principle (for single variable function), by way
of equi-marginalism or equi-incrementalism (for multi
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variate function), we have Relative Activity Level Principle.
Check Your Progress

Fill in the blanks:
1. ................. imply that at a time, an input has only

one use, that of producing an output.
2.
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As per ................. principle, the optimum level of
output should be decided at the point where
marginal revenue just covers the marginal cost.
Opportunity Costs
The opportunity costs are the “concepts of sacrificed
alternatives”. Whenever a manager takes or makes a decision,
he chooses one course of action, sacrificing the other
alternative courses. We can, therefore, evaluate the one
which is chosen in terms of the other (next best) alternative
which is sacrificed. This is the method to compute the
opportunity costs of a decision. A few examples will help us
to better appreciate the concept of opportunity cost.
i. A machine can produce either ‘A’ or ‘B’ products. The

opportunity cost of producing a given quantity of ‘A’ is,
therefore, the quantity of ‘B’ which it would have
produced. If that machine can produce 20 units of ‘A’ or
)
10 units of ‘B’, then the opportunity cost of ‘1A’ is ‘B’.
ii. The opportunity cost of holding ` 100 as cash in hand

for one year is 10% interest, which could have been
(c
earned had it been kept in the form of fixed deposit in

the bank.
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Activity iii. Suppose a student has an hour at his disposal which he
can devote either to read a book or to watch cricket
Discuss the various decision
environments faced by a match on the TV. The opportunity cost of watching the
manager. cricket match is the number of pages he could have read
had he not watched the match. So the opportunity cost
of leisure (labour) is the labour (leisure) that one
sacrifices.
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iv. Suppose we have no information about quantities
produced, but have information about their prices. In
this case, the opportunity costs can be computed in
terms of the ratio of their respective prices,
Px/P y
Many more examples can be cited to illustrate the concept
UP of opportunity cost. We should keep in mind the following:
 All decisions which involve choice must involve
calculation of opportunity costs.
 The opportunity costs may be either real or monetary,
either implicit or explicit, either non-quantifiable or
quantifiable.
Time Perspective
Decision making is a task of coordination along the time scale
– past, present and future. Whenever a manager confronts a
decision environment, he must analyse his present problem
with reference to past data of facts, figures and observations
in order to arrive at a decision, contemplating clearly its
future implications in terms of actions and reactions likely
thereupon. Thus, the time dimensions of a managerial
decision are very important.
The economists often consider the time element in terms of

)
concepts like temporary run, short run and long run. The
economists state that in the temporary run, the supply of
output is totally fixed. By contrast, in the short run, the supply
can be changed slightly by altering the factor proportion, a
(c
fixed factor like plant and machinery can be used more

intensively by varying variable factors. In the long run, all
factors are variable and therefore, the output level can be
adjusted freely in tune with the change in demand conditions.
S
A manager can interpret these economic concepts in different Activity
ways. For temporary run or short run, the manager faces a
Write a paragraph highlighting
lot of constraints, but for the long run, there are no the importance of discounting.
constraints; of course, such a long run is too ideal to be real;
“in that long run, we are all dead” (Keynes). For a practising
manager, the short run is the present (immediate) period,
whereas the long run is the distant future (remote) period.
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The manager must calculate the opportunity cost of his
decision if he has to choose between the present and the
future. His decision principle is that he must take care of
both the time periods. A manager cannot afford to have time
perspective that is too short. For example, he may set a high
price for his product today, but then he should be prepared
to face declining sales. Today, the advertisement
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expenditure may inflate the costs, but tomorrow it may
increase the revenue flow. Similarly, at present, the
management may ignore labour welfare to reduce costs, but
in future, this may deteriorate industrial relation climate
with adverse effects on productivity and profitability. Thus,
it is important for the manager to take a short and a long
view of his decisions.
The underlying principle is that the business manager, while
taking a decision, must always take a short and a long view
of the problem. After all, decision making needs coordination
on the time scale – present problem looked in the past to be
resolved for the future.
Check Your Progress

Fill in the blanks:
1. .................... are the concepts of sacrificed
alternatives.
)
2. In temporary run, the supply of output is totally

.................... .
Discounting
(c
This brings us to a very important concept of Managerial

Economics. Discounting is both a concept and a technique,
which is borrowed from Accountancy. For its explanation,
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let us readout the preceding two concepts together –
opportunity costs and time perspective.
Consider the case of a seller. He has to decide between the

immediate cash payment of ` 10,000 by his customer or the
future payment of say ` 11,000 at the end of one year from
now. A human being, as we know, always prefers present to
the future or there is always a time preference in favour of
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the present. For the seller, it is better to get ` 10,000 now
and put the same in the bank at 10% rate of interest per
annum and then realise ` 11,000 thereby. Should we say that
the present value of the future sum of ` 11,000 is ` 10,000?
Let us see how we have arrived at this. We know the

r t
compound interest formula, namely, A = P +(1 ) where
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P is the Principle,
100
r
is Interest rate measured in percentage and
100
t is the Time.
Let us illustrate this formula with the help of an example.

Suppose principal is `. 10,000, interest rate is 10%, time is 1.
If we put these values in the above mentioned formula,
amount will be ` 11,000. This formula can be modified to
explain discounting process. It is as follows:
P A
r t
(1  )
100
Now, using the same figures as given above, if A is ` 11,000,

r is 10% and t = 1, we can find P which will be equal to `
)
10,000.
In the same way, we can work out that at the end of the
second year,
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A2
P
r 2
(1  )
100
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For third year,
A3
P
r 3
(1  )
100
For nth year,

An
P
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r n
(1  )
100
Thus, if an investment of a sum yields a series of return Ai,

through i period; i = 1............n, then in order to calculate its
n
present value, we need to discount A

i 1
i with the help of
i
 r 
1  100 
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n
i
i 1
P i
 r 
1+ 100 
A1 A2 A3 An
 1
 2
 3
 ...  n
 r   r   r   r 
1  100  1  100  1  100  1  100 
We can note that longer the period, larger is the discount

n n 1
 r   r 
factor, 1  exceeds 1  because nth period is
 100   100 
more distant than the (n-1)th period. However, discounting
for the distant period makes sense because future is
uncertain and the distant future involves incalculable risk.
Discounting enables risk-hedging (or risk-covering)
particularly in the context of investment decisions where
)
the return on investment is spread over a number of years

in future. Thus, the present value of future return can be
estimated by discounting it with the opportunity costs of the
safe rate of interest as in the example given above.
(c
Discounting principle has application in areas other than

investment decisions. For example, some economists restate
their marginal principle of wage determination in the labour
market as follows:
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Activity “Wages are equal to discounted value of marginal product of
labour”. This is because the wage rate as a contractual
Make a brief report on risk &
uncertainity in business. payment is fixed at the beginning of the period, but the actual
productivity of the labour who has been employed on that
wage rate is known only at the end of the period. The
employer, therefore, must be discounting the future marginal
productivity of his worker to settle his present wage rate.
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For every decision, past and present, implications must be
compared, if necessary.
Risk and Uncertainty

Changes are not homogeneous. The changes may be known
or unknown. The outcome of known changes may be either
definite or indefinite. The definite outcome associated with
UP known changes define the decision environment of
“certainty”. The indefinite nature of outcome associated with
known changes involves “risk”. Such risks can be estimated
in terms of actual probability of events and accordingly such
risks can be insured. But if the changes are unknown, their
outcome is indefinite and, therefore, the risk element is
incalculable and immeasurable. This is the world of
“uncertainty” which cannot be insured. Thus, a distinction
exists between “risk” and “uncertainty” though these two
terms are often used as synonyms in common parlance. The
distinction has been reproduced earlier as follows:
)
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Figure 4.1: Decision Environment
 is the measure of risk element

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The economists go a step further and suggest that interest
rate is a risk premium, but profit is a reward for uncertainty,
which is non-insurable.
Introduction of risk and uncertainty in the analysis of

decision making is done with the help of statistical concept
of probability.
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The underlying precept is to maximise return and minimise
risk.
Check Your Progress

Fill in the blanks:
1. The definite outcome associated with known
2.
...............
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changes define the decision environment of
The indefinite outcome associated with known

changes involvs .............. .
Profits
Profit of a business enterprise means total revenue minus
total costs. Revenue (TR) depends on physical volume of sales
(Q) and the price at which the output is sold (P). On the other
hand, the total costs (TC) depend on the volume of factors
employed (F) and the average factor cost (C). Thus, Profits
(p) can be stated as
 = TR – TC
= P.Q – C.F
What should be included in costs in order to arrive at profits

is, however, a controversial subject. In this context, a
)
distinction is made between business (accounting) profit and

economic profit.
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The businessman’s concept of profit is shown below:
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Figure 4.2: Businessman’s Concept of Profit
The businessman calculates his return on investment (ROI)

by computing profit as a percentage on investment; he uses
various concepts of profit such as gross profit, net profit,
profit after taxes, etc., depending upon both accounting
convention and accounting convenience.
The concept of economic profit is narrower than that of

accounting profit because the opportunity costs have to be
deducted from accounting profit to get the economic profit.
The costs of employing his “own factors” are the
businessman’s opportunity costs or implicit costs. Suppose
a businessman has employed his “own capital”, “own
)
building” and “own labour” in his own business. The interest,

rent and wages which he could have earned, had he not
employed his “own” factors in his “own business” but in
somebody else’s business, have to be regarded as the
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opportunity costs, which when considered will show that

economic profit is less than accounting profit in his books.
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The managerial economists have developed behavioural Activity
models to give a practical orientation to the concept of profits.
Write an article on X-efficiency
There are now different concepts of profit critical minimum and profits.
(target) profit, actual profit, reported profit and so on.
X-Efficiency
Let us explain the concept of X-efficiency with reference to
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of labour time and the determination of labour output. The
contract to which labour has entered with the management
of the firm, may specify the labour time aspect, that is, the
hours of work that are expected to be kept. However, the
actual activities that an employee carries out, will depend
to some degree on his own choices and those of others with
whom he works. The fact that these choices are highly
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constrained does not deny the related aspect that some
degree of choice or discretion is involved. The intervening
element between labour time and actual output can be
referred to as motivation. Thus, all jobs are presumed to
require interpretation.
Check Your Progress

Fill in the blanks:
1. .................. of a business enterprise means total

revenue minus total costs.
2. Revenue depends on physical volume of sales and

the .................. at which the output is sold.
Externality
The term externality or external economies is employed to
mean services (and dis-services) rendered free (without
)
compensation) by one producer to another. It is agreed that

external economies are a cause for divergence between
private profit and social benefit and thus, for the failure of
perfect competition to lead to an optimum situation.
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External economies exist, according to an economist,

whenever the output (x1) of a firm depends not only on the
factors of production (l1, c1, ....) utilised by this firm but also
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on the output (x2) and factor utilisation (l2, c2, ....) of another
firm or group of firms. In symbols x1 = F (l1, c1, ....; x2, l2, c2,
....) the existence of external economies is indicated by the
presence of the variables to the right of the semicolon. This
has something to do with the peculiarity of how production
is related to various inputs employed by the firm. It is for
this reason it is called, ‘technological external economies’.
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These economies arise because of direct interdependence
among producers. For example, a firm benefits from the
labour market created by the establishment of other firms.
Trade-off
‘Trade-off’ as a concept has its application both at micro as
well as macro levels. If two choice variables are related to
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each other and are conflicting in their operation such that
pursuit of one variable is at the cost of the other, then ‘trade-
off’ is applied. For example, at micro level, if an enterprise
is planning to introduce a new technique which is more
capital intensive in nature, then it may involve employment
of one additional unit of capital at the cost of employment of
less labour by another unit; in that case the enterprise would
face a ‘trade-off’ which is one unit of capital vis-a-vis one
unit of labour. In technical language this can also be referred
to as ‘Marginal Rate of Technical Substitution’.
At macro level we can illustrate the use of ‘trade-off’ with

the help of Philips Curve which was a popular phenomenon
in 1960s. According to Philips Curve, if we show
unemployment per cent on X-axis and inflation rate on Y-
axis, then the Philips Curve is shown sloping downwards
from left to right. The implication of this curve is that if
unemployment percentage is reduced by say, 1 per cent point
this may involve inflation rate going up by say, 2 per cent
)
point. Thus, the ‘trade-off’ worked out is that the economy

must be prepared to face inflation rate of 2 per cent if
unemployment rate is to be reduced by 1 per cent point or if
inflation rate is to be reduced by 2 per cent points, the
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economy should be prepared to face unemployment by 1 per

cent point.
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Check Your Progress
Column A Column B
1. Business economics a. Enrich the conceptual /

technical skills of a manager
2. Essence of economic b. Universal phenomenon
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problem
3. Scarcity c. An input has only one use;

that of producing an output
4. Absolute activity level d. Concepts of sacrificed

principle alternatives
5. Opportunity costs e. Scarcity of resources
Summary
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Management is trained to take the decisions in a mature
manner if exposed to tools and techniques of economic
analysis when applied to the business environment.
The term ‘marginal’ is relevant for all such additional

magnitudes of output or return. For example, we often use
terms like marginal output of labour, marginal output of
machine, marginal return on investment, marginal revenue
of output sold, marginal cost of production, marginal utility
of consumption, marginal profit by producing additional
output and so on.
The opportunity costs are the “concepts of sacrificed

alternatives”. Whenever a manager takes or makes a decision,
he chooses one course of action, sacrificing the other
alternative courses. We can, therefore, evaluate the one
which is chosen in terms of the other (next best) alternative
which is sacrificed. This is the method to compute the
)
opportunity costs of a decision.
Discounting brings us to a very important concept of

Managerial Economics. Discounting is both a concept and a
technique, which is borrowed from Accountancy.
(c
Changes are not homogeneous. The changes may be known

or unknown. The outcome of known changes may be either
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definite or indefinite. The definite outcome associated with
known changes define the decision environment of
“certainty”. The indefinite nature of outcome associated with
known changes involves “risk”. Such risks can be estimated
in terms of actual probability of events and accordingly such
risks can be insured.
The concept of X-efficiency with reference to labour input.
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A distinction must be made between the hiring of labour time
and the determination of labour output.
The fact that these choices are highly constrained does not
deny the related aspect that some degree of choice or
discretion is involved. The intervening element between
labour time and actual output can be referred to as
motivation.
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The term externality or external economies is employed to
mean services (and dis-services) rendered free (without
compensation) by one producer to another. It is agreed that
external economies are a cause for divergence between
private profit and social benefit and thus, for the failure of
perfect competition to lead to an optimum situation.
‘Trade-off’ as a concept has its application both at micro as
well as macro levels. If two choice variables are related to
each other and are conflicting in their operation such that
pursuit of one variable is at the cost of the other, then ‘trade-
off’ is applied.
Lesson End Activity

You have decided to make bulk purchase of stationery items
for your personal use during next six months and you are in
a wholesale market. How would you make the following
decisions of your purchase:
)
(i) What price?

(ii) What quantity?
(iii) Which items?
(c
(iv) Which shop?

State clearly the principle you are working on – Absolute or
Relative Activity Level Principle?
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Keywords
Opportunity Costs: The opportunity costs are the “concepts
of sacrificed alternatives.
Discounting: Discounting brings us to a very important

concept of Managerial Economics. Discounting is both a
concept and a technique, which is borrowed from
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Accountancy.
Definite Outcome: The definite outcome associated with
known changes define the decision environment of
“certainty”.
Indefinite Outcome: The indefinite nature of outcome
associated with known changes involves “risk”. Such risks
can be estimated in terms of actual probability of events and
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accordingly such risks can be insured.
X-efficiency: The concept of X-efficiency with reference to
labour input.
Motivation: The intervening element between labour time
and actual output can be referred to as motivation.
Externality: The term externality or external economies is
employed to mean services (and dis-services) rendered free
(without compensation) by one producer to another.
Trade-off: ‘Trade-off’ as a concept has its application both
at micro as well as macro levels.

1. How would you attempt to measure the “Opportunity
Costs” in each of the following cases:
(a) Modern set of equipments facilitating landing of

aircraft under conditions of winter fog are lying idle
)
for last two years.
(b) India has finally gone for nuclear blasts at

Pokharan.
(c
(c) ‘Euro’ as a new currency has been introduced in

Europe on Jan. 1, 1999, by a consortium of eleven
countries which agree to continue with their local
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currencies for the next couple of years till Euro
becomes the single currency from 2001.
(d) You have just left a job to enrol yourself as a full-
time MBA student.
2. List the difficulties you encounter in measuring
opportunity costs in cases such as above. Despite these
difficulties, why is it that every business executive is
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keen to use the concept and measure of ‘opportunity
costs’?
3. (a) Why do you mean by discount? How do you discount?
(b) Why is ` 499 cash-down preferred to ` 510 on credit?

(c) The market rate of interest is 10%. What is the
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4.
present value of ` 1331 and what will it be at the
end of two years from now?
Distinguish between:
(a) Marginal sales (revenue) of advertisement

(expenditure) and marginal advertisement
(expenditure) of sales (revenue).
(b) Marginal absorption (by students) of lecture (by a
teacher) and marginal lecture of absorption.
(c) Marginal costs of production and marginal

production of costs.
(d) Marginal risks of return and marginal return of

risks.
(e) Incremental gain of effort and incremental pain of
effort.
5. One economist remarked, “In the long run we are all

dead”. What is the implication of this statement? If that
)
is so, then why should businessmen consider the long

run at all?
6. Prepare a table showing the number of hours you are
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devoting to a subject in a week. Work out total, average

and marginal workload (in hours) subject wise. Do you
find any rationality behind reallocation of hours? State
clearly and justify.
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7. Would you agree that discounting is a technique of
computing opportunity costs of investment decisions,
keeping the time perspective in consideration?
8. Look around and choose a company of your like and

knowledge. Recall some of the decisions that the
company has taken in the recent past. Review clearly
and categorically the underlying concepts and precepts
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of Business Economics.
Further Readings
Books
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Web Readings
www.studylecturenotes.com/.../economics/62-what-is-
economicsintro...
www.mbe-du.org/
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UNIT 5: Case Studies
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Unit 5
Case Studies
Objectives
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After analyzing these cases, the student will have an appreciation of
the concept of topics studies in this Block.
Case Study 1: Suresh Aggarwal & Co.
Trading and Profit and Loss Account for the Year Ending
UP December 1994
The above statement was given to a business economist for his

)
comments. On enquiry, Sri Suresh Aggarwal supplied the

following additional information:
(a) His drawings during the year amounted to ` 18,000.
(b) Up to the year 1988, he worked as a manager of another
(c
jewellery shop where he was getting a salary of ` 600 per

month. Since then he left the service and started his own
retail shop.
Contd...
(c) The building in which the retail shop is housed, is a two-
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storey air-conditioned building owned by Sri Suresh
Aggarwal himself. The building is located in such a
marketplace that it can readily be let out any time for ` 800
per month.
(d) Sri Aggarwal has invested his own capital of the order of
` 2,00,000. If borrowed, it would have been obtained at a 9
per cent interest per annum.
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The business economist made certain adjustments and thereby a
fresh calculation, which showed that Sri Suresh Aggarwal was
actually running the business at a net loss of ` 5,800 per annum.
On being told so, Sri Aggarwal was surprised and argued:
(a) “Impossible; I am working for profits and not for salary. I
don’t actually draw any salary from the business”.
UP (b)
(c)
“I have got my own building. I do not pay any rent”.
“I have invested my own money. I do not pay any interest.
In fact, I have worked hard to put this business in a position
where there is no need for borrowing money I think, it is
creditable that a businessman here is free from any debt to
banks and moneylenders”.
(d) “If I am saving some money by way of employing my own
labour, own building and own money, how can I incur loss?
Net loss; Unbelievable !”
Questions:
1. What is the problem? Do you agree with Sri Suresh
Aggarwal?
2. In particular, Sri Aggarwal fails to understand the way, the
net loss (of ` 5,800) figures is derived. Prepare a small table
which would help him to understand this derivation. And, if
necessary, explain.
3. Is Sri Aggarwal, an efficient businessman? Should he
)
continue with or close down his business?

Hints: Review your understanding of the concepts of “economic profit” and
“accounting profit”.
(c
Source: Author’s book on Managerial Economics

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Case Study 2: Philips India Ltd.
The Union Government issued a “show cause” notice to Philips

India Ltd., a multinational company, for alleged violation of
Industrial Development and Regulation Act 1951. Notice was
issued against the company for alleged unauthorised manufacture
and sale of cassettes for tape recorders.
The ministry of industry is believed to have made an inquiry into
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the allegation made by some MPs that Philips were engaged in
such activities. The government had assured the Parliament that
the matter would be fully inquired into.
The unauthorised manufacture of cassettes for tape recorders by
the company violates not only the Industrial Development and
Regulation Act but also attracts the Monopolies and Restrictive
Trade Practices Act.
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The small scale industries have been the pioneers in the field of
cassettes for tape recorders. The small scale manufacture of
cassette started as early as 1973. There are also in the market
foreign brand named cassettes which are claimed to be made in
India. Qualified observers say that there was no need for the
country to support foreign brand names in such a simple consumer
item as cassettes.
Viewed in this light, the government action is started to be
significant in extending protection to the small scale sector. Though
no official statistics of production of cassettes for tape recorders are
readily available, it is stated that the demand for the item would
amount to one million. It is also pointed out that the item has large
demand potential at home and in foreign markets. Since it is rather
skill-oriented and highly labour-intensive, the government has been
wanting as a matter of policy to encourage its production in small
scale sector.
Questions
1. Suppose, the Philips India Ltd. fails to “show satisfactory
cause”. What will be the impact on the price and the market
structure of cassettes for tape recorders?
)
2. Suppose, the Philips India Ltd. “shows good cause”. How

will the price out put decision of the small sector be affected?
Source: SPAN, August, 1976.
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BLOCK-II
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Detailed Contents
UNIT 6: BASIC TOOLS AND TECHNIQUES UNIT 8: MARKET ANALYSIS

OF ECONOMIC ANALYSIS
 Introduction
 Introduction
 Market Concepts and Precepts
 Basic Mathematics
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 Tools and Techniques of Market Analysis
 Calculus
 Market Intervention
 Partial Derivatives
 Business View of Forms and Structure of Markets
 Optimisation
 Market Strategies and Tactics
 Input – Output Model
 Linear Programming UNIT 9: CONSUMPTION AND DEMAND

ANALYSIS


Game Theory
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Models and Cases
Statistical Tools and Techniques



Introduction
Concepts of Demand
 Determinants of Demand
UNIT 7: GAME THEORIES IN ECONOMIC
ANALYSIS  Classifications of Products
 Introduction  Concepts of Elasticity
 A Return to Game Theory  The Relationship between Price Elasticity and

Sales Revenue
 Matrices and Their Applications
 Demand Analysis

)
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UNIT 6: Basic Tools and Techniques of Economic Analysis
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Unit 6
Basic Tools and Techniques
of Economic Analysis
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Objectives
topics:
 Basic Mathematics and concept of Calculus in Business Economics
 Optimization: Unconstrained and Constrained Optimization

Technique

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Input-Output Model, Linear Programming and Game Theory
 Matrices and Their Applications
Introduction
Concepts and techniques are not mutually exclusive.
Concepts can be explained better with the help of tools and
techniques like tables, diagrams equations, etc. There are
other more sophisticated techniques, which are drawn from
disciplines like applied mathematics, statistics,
econometrics and operations research. The use of such
methods and measures makes managerial economics or
business economics, a highly technical subject. The use of
techniques is geared towards measurement and optimisation
of economic decision variable.
Basic Mathematics
)
The first concept is that of a set. A set is defined to be a

collection of distinct and well defined objects. In fact, a set
can be defined in two ways — either by enumeration of its
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members or by specifying a criterion for membership. An

example of the first would be the set of numbers 8,9,10
written as (8,9,10); or the set of alphabets, c,d,e written as
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Activity (c,d,e). Sometimes it is difficult to define a set by listing its
members. For instance, the set of all residents of Kolkata or
W rite an article on business
mathematics and its set of all stars in the sky. Hence, we take recourse to the
application in economics. second method by defining a set, i.e., by using some criterion
for membership. For instance the set of all positive integers
between 10 and 50; or the set of all points lying on the line
X+Y+5.
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In business economics, we will be concerned with the choice
executed by a business firm, often the need arises for specifying
the opportunity cost of the decision-maker, i.e., the set of
alternative actions which are feasible. For instance, the
opportunity set of a consumer is the set of all combinations of
goods which the consumer can buy with his given income.
Given the consumer’s money income and prices of all goods,
UP the opportunity set is well defined and we can check whether
a particular combination is feasible for the consumer, i.e.,
whether he can afford to buy that combination of goods.
In business economics, we deal with variables, like

consumption, demand, supply, income, investment, wages,
profits, etc. A variable is a thing which varies, which can
take a set of possible values within a given problem. A
constant is a quantity, which does not change in a given
problem. For instance, in the equation Y= a+b x; a and b are
constants. Their values remain the same within given
problem, e.g., ‘a’ can be 2 and ‘b’ can be ‘3’, the equation then
becomes Y= 2+3x. A constant is also called a parameter. It
may be noted that the constant can assume other values in
different problems, e.g., Y= 5+2x is considered to be a
different equation from Y= 2+3x. In the equations Y= 2+3x
and Y= 5+2x, X and Y are variables. X can assume different
values and this, in turn, will cause Y to assume different
values. X is called the independent variable, while Y is called
)
the dependent variable. X is called exogenous variable, while

Y is called the endogenous variable. The values of X are given
from outside the system, while the values of Y are
determined form within the system (by the given equation).
(c
Let us go to the concept of a function. A function such as

Q=Q(P) expresses a relationship between two variables Q
and P, such that for each value of P there exists one and only
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one value of Q. Functions are the basic building blocks of formal
economic models used in business economics. The function
D=D(P) is called the demand function and its graph on a two-
dimensional diagram with price on one axis and quantity
demanded on other can trace out a demand curve. A function
maps out a relationship between price and quantity – a
mapping of one variable on to another. Here P is the argument
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of the function the independent variable, while D is the
dependent variable. A function indicates the cause – effect
relationship between variables. In the demand function
D=D(P), P is the cause variable while D is the effect variable.
Other examples of functions can be S=S(P) where S is the
amount supplied and P is the price. This is referred to as
supply function. In the production theory, we have
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production function which can be represented as Q=Q(L, K)
where Q is the quantity produced and L and K represent
amount of labour and capital (or inputs) employed.
A function can be represented by means of a table or by means
of a graph. A graph is a geometric representation of the
relationship embodied in the function. Suppose, the specific
form of the demand function is D=10-0.5P where 10 and 0.5
are constants. In a table form, the function can be represented
as follows:
Table 6.1: A Function between Price and Demand
P 1 2 3 4 5
D 9.5 9 8.5 8 7.5

Quantity Demanded (D)
10
)
D =10 – 0.5P
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0 Price (P) 20
Figure 6.1: Graphic Representation of the Function

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A
E
O B
Linear Q = a-bP b = OA/OB a= OA
Figure 6.2: Linear Function Graph
The quantity intercept is 10, while the slope is –0.5 and the
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price intercept is 20. In general terms the above function
can be expressed as D=a-bp where a and b are positive
contents, i.e., they do not vary as the independent variable
P varies. In business economics we normally plot the
independent variable on the vertical axis and the dependent
variable on the horizontal axis, contrary to what is done in
the above diagram.
Graphs of functions can take different forms, depending on

the form of the functions. Functions frequently encountered
in business economics involving a single independent
variable are given below:
A
)
O Quadratic
Q = a-bP-cp2
(c
a = OA, c > O
Figure 6.3: Graph of Function with a Single Independent

Variable
S
Activity
Make a chart for you display
board focussing on some
examples of functions and their
graphs.
A
E
O Cubic
Q = a+bP+cP2+dP3
a =OA
Figure 6.4: Cubic Function Graph

UP
A
O Quadratic
Q = a+bP-cP2
A =OA
Figure 6.5: Quadratic Function Graph
Check Your Progress

Fill in the blanks:
)
1. A ................. is a quantity, which does not change in

a given problem.
2. A ................. is a thing which varies and can take a

(c
set of possible values within a given problem.

Calculus
S
The marginal concept in Economic analysis is easily
amenable to the method of calculus. Suppose Y=Y(X). Then
by way of marginal concept, we try to find out what is the
impact on Y because of an additional change in X. In calculus
y
notation, it reads . Some of the standard rules of
x
E
differentiation in calculus are:
(a) Basic rule : Y = a xn

y
 na x n 1
x
(b) Addition rule : Y = u(x) + v(x)

UP y u v
 
x x x
(c) Product rule : Y = u(x)  v(x)

u v
v u
y x x

x v2
(d) Quotient rule : u x 

Y 
v x 
2
y u v
x
 v x 
x
 u x 
x
v x 
(e) Chain rule : Y = y [u (x)]
y y u
 
x u x
(f) Logarithm rule : Y = loge x

)
y 1

x x
(g) Exponential rule: Y = ex

(c
y
 ex
x
S
y
Let us see the economic interpretation and use of . The
x
y
measures the slope of the curve plotting the function
x
Y = Y(x).
The “slope” in mathematical sense is the concept of
marginalism in economic sense. Thus, if Y= Y(x), then
E
y
stands for change in Y as a result of a unit change in X,
x
i.e., marginal Y of X. Let us give some illustrations.
D
= Marginal demand of price, when D = D(P)
P
S
= Marginal sales of advertisement, when S = S(A)
A
R
A
UP
= Marginal revenue of output, when R = R(Q)
C
= Marginal cost of output, when C = C(Q)
Q
To contrast the marginal with the average we have
D
= Average demand
P
S
= Average sales
A
R
= Average revenue
Q
C
= Average costs
Q
When we divide the marginal with the average, we measure
the elasticity. For example,
)
D P
= Price elasticity of demand
P D
C C
= Output elasticity of cost
(c
Q Q
S A
= Advertisement elasticity of sales revenue.
A S
S
Activity Such ‘elasticities’ measure the proportion of change. For
example, if the percentage change in demand is greater than
W rite an assignment
explaining the concept and D P
calculation of partial the percentage change in price, then > 1  elastic
P D
derivatives.
D P
demand. On the other hand if = 1  unitary elastic
P D
demand and so on.
E
Partial Derivatives
The process of differentiation can be applied to the partial
functions also. The derivative of the partial function is known
as the partial derivative of the original function and is
f
denoted by x or fi(x) or fx (instead of using, ‘uf’ by ‘u x’).
i
UP It may be noted that the partial derivatives are functions of
all variables entering into the original function f(x).
Let us explain the usage of partial derivatives with the help

of a few examples.
(1) If Y = f(x1 ; x2) =
y
Then x = 2 x 1 and
1
y 2 2
 x1 2 x 2  2 x 2 x1
x 2
(2) If Y = x1 x 2  x1 x 2 b g 1
2
1 1
 x1 2 x2 2
½
Y -½ ½ x2
Then X1  ½ x1 x2  ½ ½
x1
)
½
Y  ½ x ½x -½ ½ x 1 
X 2 1 2
x½ 2
If Z = 4x2 + 3xy + 5y2

(c
z z z
Then = 8x+3y and = 3x+10y. On finding we hold Y
x y x
constant and we know that the derivative of a constant is
S
z z
zero, i.e., of 5Y2 is zero. Similarly on finding we hold
x y
z
X constant and of 4x2 is zero. This gives to be 8x+3y and
y
z f f y f
to be 3x+10y. Now x , y , x , x are called first order
x 2
partial derivatives.
E
The second order partial derivatives indicate that the
function has been differentiated partially twice with respect
to a given variable, all other variables being held constant.
These are denoted in the case of the function Z = f(x, y) by
2 f f 2 f f 2 f
or and 2 or . Thus indicates the rate of
x 2 xy y yx x 2
change of the first order partial derivatives fx with respect
UP
to x with y held constant. Similarly
2 f
y 2
is the second order
partial derivative of the function with respect to y with x
held constant.
The partial derivatives fxy or fyx are the second order cross
partial derivatives and measure the rate of change of one of
the first order partial derivatives with respect to the other
variables. The partial derivatives of fx with respect to y is
z
the second order cross partial derivatives fxy or .
x y
Check Your Progress

Fill in the blanks:
1. .................. indicate that the function has been
differentiated partially twice with respect to a given
variable, all other variables being held constant.
)
2. As per the exponential rule, the differentiation of

y = ex is .................. .
Optimisation
(c
The idea of optimisation is present in any quantitative

decision making. For instance, a consumer’s choice of
consumption bundle, a firm’s production decision, a planner’s
S
Activity choice of resource allocation in the economy and so on are
the examples where optimisation decision is involved.
optimisation and its Optimisation means the act of choosing the best alternative
techniques. out of whatever alternatives are available. It helps in making
decisions (i.e., choice among alternatives). All optimisation
problems consist of three elements.
The decision variables: These are variables where optimal
E
values have to be determined.
The objective function: The objective function is a

mathematical relationship between the choice variables and
some variables whose values an economic agent wishes to
maximise or minimise.
The feasible set: An essential part of any optimisation

UP problem is specification of exactly what alternatives are
available to the decision maker. The available set of
alternatives is called the feasible set.
The feasible set: An essential part of any optimisation

problem is specification of exactly what alternatives are
Unconstrained Optimisation Technique

The calculus technique is extensively used in solving
optimisation problems. In the context of decision making
“optimisation” may mean maximisation or minimisation,
either of them may be with constraints or without constraints.
For unconstrained optimisation problem involving single

independent variables, certain ‘conditions’ need to be
satisfied which are shown in table 6.2.
Table 6.2: Unconstrained Optimisation Problem

)
Order Conditions Optimisation (Unconstrained)

First Necessary Maximisation Minimisation
order Conditions y/x = o y/x = o
(c
Second Sufficient 2 2 2 2
 y/x < o  y/x > o
order Conditions
S
We are assuming that y = y(x)
In language of economics, the necessary (first order)

conditions are termed as ‘equilibrium conditions’ whereas
the sufficient (second order) conditions are termed as
‘stability conditions’. ‘Equilibrium’ means the balancing of
two opposite and equal forces. ‘Stability’ means continuance
of that state of equilibrium. There may be equilibrium but it
E
may or may not be stable. In other words, the first order
condition may be satisfied but it is not a guarantee that
second order condition is also satisfied. This can be explained
with the help of economic uses of the conditions.
Constrained Optimisation Technique

So far we have been dealing with unconstrained optimisation
UP
(either maximisations or minimisations). There are, however,
many situations where the objective function has to be
maximised or minimised subject to certain constraints being
present in the problem. For instance, as a producer we may
be maximising sales revenue subject to resource constraint
or cost constraint; as a consumer we may be maximising
utility subject to income constraint. For a producer the
problem can be formally stated in a different form as follows:
Minimise cost subject to the constraint that the firm (the

producer) must purchase sufficient inputs to produce the
specified output given the firm’s production function.
The techniques which are used to analyse such a problem

are based on the techniques used for unconstrained
problems. We convert the constrained problem into an
unconstrained one and solve the latter. This is done with
the help of a technique called Lagrange Multiplier Technique.
In this method we combine the objective function and the
)
constraint in one expression, which is called the Lagrange

expression. In doing so the constrained maximisation or
minimisation problems are reduced to one of unconstrained
maximisation or minimisation problem.
(c
To find whether it is maximum or minimum, we need the

second derivative test. The second order conditions differ
from those of unconstrained optimisation. The second order
S
Activity conditions for constrained optimisation also require the use
of second order direct and cross partial derivatives (as is
Prepare a brief report on linear
programming. the case with unconstrained optimisation). However, it
requires the use of Hessian and bordered Hessian
determinant which we will not develop here.
Check Your Progress
E
Fill in the blanks:
1. ....................... means maximisation or minimisation

of a function may be with constraints or without
constraints.
2. In economics, the necessary conditions are termed

as ....................... whereas the sufficient conditions
UP are termed as ....................... .
Input – Output Model

Input – Output technique is another very popular technique
of economic analysis, though it is not an optimisation one.
This technique is useful in the context of macro level
planning and projection. At the micro level of a corporate
unit, Input-Output model lies at the root of end-use method
of demand forecasting.
Matrix is basic for understanding the rationale and use of

Input-Output models. Such a model essentially states the
nature of technological relationship, which exists between
sectors. In other words, a distinction is made between
endogenous and exogenous variables. Using this model we
can stipulate a change in the exogenous variable and use the
model to determine the system of equations, using
technological relationships, to determine the changes to be
)
made to sustain the new level of autonomous variable.
Linear Programming
(c
Linear Programming may be defined as a method of

determining an optimum programme of interdependent
activities in view of available resources to maximise or
minimise an objective function. A mathematician might be
S
more technical and he may define linear programming as a
method of optimising (maximising or minimising) a linear
objective function subject to certain linear constraints (linear
equations and/or linear inequalities).
In any optimisation problem involving a single inequality

constraint, the Lagrangian method can still be used and is
quite simple.
E
Any linear programming has three constituents:
1. Objective function
2. Constraints
3. Non-negativity constraints.
UP
There are many methods to solve the linear programming
problems but we would employ only one method namely,
graphical method to solve a problem. Again since we can have
maximisation as well as minimisation linear programming
problems we will consider the maximisation case only.
Example: A furniture manufacturing company makes two

types of furniture, chairs and tables. The contribution for
each product as computed by the company’s accounting
department is ` 10 per chair and ` 15 per table. Both these
products are processed on three machines, say A, B and C.
The time required by each product and total time available
(per week) on each machine is as follows:
Table 6.3: Required Time for Machines
Machine Chair Table Available hours per week

A 3 3 36
B 5 2 50
C 2 6 60
)
The problem is to determine the weekly production of chairs

and tables, so that total profit is maximised.
Solution:
(c
Step (1): The first is to present the given information in

mathematical form. This is done as follows.
Maximise Z (Total Profits) = 10x + 15y

S
Subject to:
3x + 3y  36
5x + 2y  50
2x + 6y  60
x  0, y  36
E
Where, x = the number of chairs
y = the number of tables
Step 2: The next step is to graph the constraints. For this

problem, we will chairs on x-axis and tables on y-axis. All
the inequalities of the problem can be drawn on the graph
by finding out their respective intercepts on both the axes
UP
and joining them by a straight line. For the first inequality
this is done as follows:
3x + 3y  36
3x 3 y
 +1
36 36
After finding out the intercepts, a straight line is drawn (as
shown below:
)
(c
Figure 6.6: Constraint Graph

S
Any point on the line will satisfy the equality sign and other
points within the shaded area will satisfy the less than sign.
The same calculation is made for the other two constraints

and all three constraints are plotted in the figure 6.7.
In order to manufacture both the products, all the three

machines must be used. This implies that shaped region in
E
the figure 6.7 is the feasible solution region. In other words,
it contains all possible combinations of products which satisfy
the given constraints simultaneously.
Step 3: Now our objective is to locate a point (X,Y) on the

feasible region which maximises the Profit function. In order
to accomplish this, we are guided by the Profit function. We
assume an arbitrary value for the profit function, say ` 90.
UP
Then we have 10x + 15y = 90.
)
Figure 6.7: ISO-Profit Line Graph
Assume y is zero then x = 90/10 = 9, i.e., by producing 9 chairs

(c
we get total profit of 90 and similarly by assuming x as zero

we get 6 tables. Let us plot this on the above figure 6.7. All
points on ISO-profit line represent feasible solutions, each
S
Activity giving a profit of ` 90. Since the profit per unit of the two
products are fixed, higher profits will result as we move away
Make a draft on the game theory
and models and cases. from the origin and within the feasible region it will give
the maximum profits. When we look for an ISO-profit line
farthest from the origin, two cases may arise. In the first
case, it may coincide with one of the lines of the feasible
region. In this case, all points, which fall on the coincident
E
bounding line are feasible as well as optimum solutions. The
second may be that the ISO-profit line does not coincide with
any of the sides of the feasible region. In this case, the farthest
corner of feasible region will give an optimum solution.
In the problem in question, we observe that point F provides

the maximum profits. At this point, we have,
X=3
UP Y=9
i.e., the solution to the problem is to manufacture 3 chairs

and 9 tables per week for a maximum profit of ` 165 (=3x 10
+ 0 9x 15). Transportation models and Assignment models
are the other special cases of linear programming problem,
for which you should look at any book on linear programming.
Similarly, the simplex method to solve a linear programming
problem is not being introduced here.
Game Theory
There are various types of games – two person zero sum,
two person constant sum. There can also be n-person game,
applicable in oligopoly situation where there are 5 to 7 sellers.
In all such games, the strategy and the tactics are defined.
The strategy may be ‘minimax’ or ‘maximin’ type; based on
this the ‘pay-off matrix’ is stated. In this case, the
interdependence in decision making is evaluated based on
)
available market information collected by the rational and

intelligent players (decision makers) in the game. The
element of risk and uncertainty involved in decision making
can also be taken care of through the game theory approach.
(c
Such techniques are highly mathematical and sophisticated.

Some background knowledge of matrix algebra may be helpful
in using such techniques. We will return to this game theory
S
approach later first let us understand the field where the
game is played. Field may be represented by models and
cases.
Models and Cases

Models
E
The use of models is a very popular technique in economic
analysis. A model is a physical specification—a prototype of
an object like the model of an educational building, the model
of a car, etc. In technical sense, a model is a system or
relations which help us in understanding the reality. Each
relationship can be presented in one or more alternative
forms, table, diagram, flow chart, graphs, mathematical
UP
function and statistical distribution. Irrespective of the form
of representation, a model symbolises the behaviour pattern
of a given variable in relation to other. Thus, a model, though
a theoretical abstraction or just a conceptual construction,
can explain the behaviour that is actually observed and can
predict the behaviour that is likely to be observed. In other
words, a model has both analytical and predictive value.
All models can be classified into three broad categories:
Iconic Models
These are pictorial or visual representations like drawings,
design, prototype, etc., which provide information to
management.
Analogue Models
Such models present a set of properties of the data in a form
which is easily amenable to analysis, e.g., a flow chart, funds
flow statement, statistical distributions such as binomial,
)
Poisson, normal, etc.
Mathematical Models
In these models, relationships are expressed in mathematical
(c
symbols and equations. Such models are extensively used in

economic analysis. These may be further classified as under:
S
Economic Models: Economists often postulate the basic
structural relationship of a market in the form of a “micro
market model” or the structure of an aggregate economy in
the form of a “macro aggregative model”. Sometimes they
focus on the structural relationship between various sectors
like agriculture and industry; these are called “sectorial
models”. Sometimes, they show transactions within an
E
economy between industries dependent on each other. Such
“inter-industry models” are usually put in the form of an
input-output table – a kind of matrix arrangement. For
example, for purposes of forecasting demand such input-
output model is very useful. Similarly for the purposes of
planning and projection for the national economy, both
aggregative and sectorial models are useful.
UP
Econometric Models: Econometrics is a discipline
combining theory, statistical method and mathematical
precision. A model is a statement of relations which can be
stated among variables, endogenous and exogenous and
constant parameters. Relations are stated in the form of
equations. Equations are of two types:
1. Definitional equations which are identities,
definitionally true. All equilibrium conditions are stated
in this form, e.g. Demand = supply or savings =
Investment.
2. Behavioural equations which explain the behaviour of
one variable in terms of other. E.g., Demand depends
on price of a commodity.
In addition, in a model, we may find some:
(a) Autonomous terms which are constraints influencing a
variable;
(b) Exogenous terms determined outside the system of
)
relations postulated and a few others.

(c) Parametric information likes the slope term.
The econometric models may be of two types:
(c
(a) Single equation model as given in the regression

analysis, or
(b) Simultaneous equations models, as illustrated above.
S
Regression analysis is useful in those cases where the factor
influencing the dependent variables are mutually unrelated.
Simultaneous equation models are used where variables are
mutually related.
Quite a few problems of business economics can be
approached through other types of models as well. Some of
these models are listed below:
E
i. Statistical Distribution Models
ii. Allocation and Transportation Models

iii. Scheduling Models
iv. Queuing Models
v. Simulation Models
vi.
Cases
Inventory Models
UP
The case method is a pedagogical technique. In business
economics, the case method is useful to the extent it
stimulates a real world business situation. A case represents
a depiction of the real situation; it describes the actual
environments, experiences, events or incidents or episodes
of the historical past. The factual information comprises
objective data and subjective feeling. A case, when thrown
for discussion and analysis, the participants think about the
problems and come out with probable solutions. Different
orientations and perceptions lead to different points of view.
The idea behind the use of case method is to train the
participants in the exercise of logical thinking.
There is no definite procedure in analysing a case, but

normally the case analyst follows an ordered sequence of
)
the following step:
1. Identify the key issue; keep away the trivial issues.
2. Establish the nature of the issue, the problem of choice

(c
by examining the available data (facts and figures).
3. Examine the information gap and make necessary

assumptions to bridge that gap.
S
Activity 4. Analyse the facts assumed information.
Prepare a presentation on the 5. Work out the range of alternative solutions and the
various statistical tools &
techniques. implied consequences.
6. Recommend a particular solution out of the given set of

alternatives; this is what can be termed as a “decision”.
7. Use the “decision” as a subject for discussion and
E
deliberation by the participants.
The basic idea behind such a method is to raise and resolve

the issue. In the analysis of the issue, sophisticated concepts,
tools and techniques have to be used.
The use of case method requires some degree of maturity,

particularly for our subject some prior knowledge of formal
UP concepts and measurement techniques is necessary. Such a
case method may be appropriate in an advanced course on
business economics. It is very important for a decision maker
to grasp the basic concepts and to learn the use of tools and
techniques, statistics and econometrics such that one is
equipped for case analysis eventually.
Check Your Progress

Fill in the blanks:
1. Economists postulates the structural relationship

of a market in the form of a ................ or the structure
of an aggregate economy in the form of a .................
2. The inter-industry models are usually put in the

form of an input-output table a kind of ................
arrangement.

)
The information collected has to be tabulated in the form of

statistical tables called frequency distributions and then it
has to be analysed by working out various ‘constants’ to make
(c
inferences out of it. If the data is collected by sampling

method, the Statistician has to make inferences about the
characteristics of the universe from the ‘constants’ worked
out of the sample by employing sampling techniques.
S
Similarly, if the data is collected in a time-series form the
Statistician has to use the data to get an estimated value of
a dependent variable given the value of an independent
variable.
Frequency Distributions
We start from an ungrouped data. Suppose we are given the
E
income figures of 50 persons as follows:
(In ` ‘000’ per year)
28, 29, 42, 15, 25, 46, 05, 34, 75, 25
50, 64, 09, 29, 58, 54, 36, 76, 12, 46
62, 68, 64, 38, 46, 75, 46, 62, 80, 16

UP
30, 46, 78, 54, 95, 56, 54, 68, 70, 45
82, 18, 41, 44, 65, 24, 45, 54, 47, 62
This is ungrouped data. This data may be further condensed

by expressing the income in various group. Suppose the
income figures obtained are divided into five groups: 0-20,
20-40, 40-60, 60-80, 80-100. These groups are known as classes,
e.g., the class 40-60 includes all income between 40 and 60
(including 40 and excluding 60). A quantity which varies from
one persons to another is known as a variable or variate,
e.g., income obtained by the persons is a variate (X). The
number of persons against the income is known as frequency
(f) of the variable. In other words frequency (f) means how
often the variate repeats itself, e.g. frequency of 46 income
is 5, which shows that there are 5 persons who have 46
income. The data given above can be put in the form of a
frequency distribution.
Table 6.4: Frequency Distribution

)
Income Mid-value Frequency Cumulative Frequency

00-20 10 06 06
20-40 30 10 16
(c
40-60 50 18 34
60-80 70 13 47
80-100 90 03 50
S
A frequency distribution is usually denoted as xi/fi: i=1,2,
....., n, where x1, x2, ....., x n are the values of the variate x with
frequencies f1, f2, fn respectively. We write f1 + f2 .... fn = fi = N
Some other definitions associated with a frequency

distribution are:
Class Limits: The boundary values of a class are called the
E
class limits. The smaller of the two class limits is known as
the lower limit and the greater value is known as upper limit.
In the class 20-40, 20 the lower limit and 40 is the upper
limit.
Class Interval: The difference of the upper and lower limits

is called the class interval or width of the class.
UP
Cumulative Frequency: It is the total of the observations
(frequencies) up to and including the observations of that
class, e.g., cumulative frequency of the class 40-60 is 34.
Measures of Central Tendency

These are statistical constants which give us an idea about
the concentration of the values in the central part of the
distribution. A central value is the one around which other
values of a distribution revolve.
The various measures of central tendency are:
1. Arithmetic Mean (A.M. or X )
2. Median (Md)
3. Mode (Mo)
4. Geometric Mean (G.M)

5. Harmonic Mean (H.M)
)
Arithmetic Mean (A.M. or X )
Let f1, f2, ....., fn be the frequencies corresponding to the values

of the variate x1, x2, ....., x n. The arithmetic mean X is given
(c
by
n
f1 x1  f2 x 2  .... fn x n 1
X
f1  f2  .... fn

N
fx
i 1
i i
S
n
Where N   fi
i 1
For a ground frequency distribution, we convert X into u

x A
where ui  i ;
h
X1 is general term for the value of the variate X, A is called
E
assumed mean and h is the common width of the class
intervals. We have
xi = A + h ui
and xi = NA = h ui
and xifi = NA + h uifi
 xi fi NA h  ui fi
 
UP
Dividing both the sides of the equations by N we get
N N N
or x  A  u = A + h
Taking an example given in the previous section we find x

as follows:
Table 6.5: Calculation of Mean
Income Mid-values Frequency x  50 uf

u
(x) (f) 20
00-20 10 06 -2 -12
20-40 30 10 -1 -10
40-60 50 18 0 0
60-80 70 13 1 13
80-100 90 03 2 6
fi = 50  ui fi=-3
)
 ui fi
x  Ah
N
 50  1.2
(c
 48.8
S
Weighted Mean (W)
If W1, W2, ....., Wn are the weights attached to the variate

values x1, x2, ....., x n respectively, then their weighted mean
is defined as:
wi xi  w2 x 2  .....wn x n
Wx 
w1  w2  ....  wn
E
Suppose we are given four commodities x1 (Match Box), x2
(Wheat), x3 (Petrol) and x4 (Shirts) and their prices and
quantities are given below:
Table 6.6: Calculation of Weighted Mean
Price in Quantities PW
`P consumed W in `
UP1. 10 per dozen
2. 05 per kg
3. 20 per liter
2 dozens
10 kg
40 litres
20
50
800
4. 150 per shirts 02 shirts 300
P=185 W= 54 PW = 1170
 PW 1170
WX   ` 21.7
 W 54
If we calculate simple x it would be:
  P 185
X  ` 46.25
n 4
Median (Md)
The median of a distribution is the value of the variate which

divides it into two equal parts.
In a frequency distribution we have to first identify the

median class and subsequently the exact value of Median is
)
to be interpolated.
Take the example given earlier.

(c
S
Table 6.7: Calculation of Median
Income Frequency (f) Cumulative

Frequency (cf)
00-20 06 06
20-40 10 6 + 10 = 16
40-60 18 16 +18 = 34
60-80 13 34 + 13 = 47
80-100 03 47 + 03 = 50
E
f =50
We have to find median class for which we divide f = 50 by

f 50
2, i.e., 
2 2
Now 25 lies between 16 and 34, i.e., in 40-60 class which is

the median class and then we calculate median (Md) by the
following formula:
N
– cf
UP
Median (Md) = l + 2 (h)
f
where
l = lower limit of the class in which the median lies
f = frequency of the class in which median lies
cf = cumulative frequency of the class preceding the median
class
h = width of the median class
Applying this formula we get:
25  16
Median (Md) = 40 + (20)
18
180
= 40 +
18
)
= 40 + 10 = ` 50
Mode (Mo)
(c
Mode is that value of the variate which occurs most

frequently in a set of observations. In other words, mode of a
frequency distribution is the value of the variate (X)
corresponding to maximum frequency.
S
First identify the modal class and then interpolate the Model
Value.
In the example given earlier maximum frequency is 18 and
therefore modal Class is 40-60. The mode is interpolated by
the following formula.
f f
m m 1
E
Mode (Mo) = l + ×h
2f  f f
m m-1 m+1
where
l = lower limit of the modal class
f m =frequency of the modal class
fm-1 =frequency of the class preceding the modal class
UP
fm+1 =frequency of the class succeeding the modal class
h =class interval.
Applying this formula we get the mode as follows:
8
Mode (Mo) = 40 + x 20
36 - 10 - 13
8 160
= 40 + × 20 = 40 +
13 13
= 40 + 12.3
= ` 52.3
Geometric Mean (G.M.)
If x1, x2, x3, ...., x n are n values of a variate x, none of them

being zero, their geometric mean (G.M.) is defined as:
G.M. = (x1, x2, x3, ....., x n)1/n
or Log G.M. = log (x1, x2, x3, ....., x n)

)
1
= log [x1, x2 ....., x n]
n
or Log G.M. = [log x1 + log x2 + .... log x n]

(c
For a frequency distribution the geometric mean of n

variables x1, x2, x3, ...., x n of a Variate x with frequency (f1, f2,
f3, ...., fn) respectively is given by:
S
G.M. = x1 f1 , x 2 f2 . . . . x n fn n
or Log G.M. = [f1 log x1 + f2 log x2 + ... fn log xn]

1 n
=  f log xi
n i 1 i
Example: Suppose the sales of a corporation increase by 10%

in the year 1991, 20% in the year 1992 and 30% in the year
E
1993, then the average rate of increase of sales of the
corporation over the three years will be:
G.M. = 3
10  20  40
= 3
8000
= 20%
Harmonic Mean
UP
The Harmonic mean of a number of observations is the
reciprocal of the arithmetic mean of the reciprocals of the
given observations.
If x1, x2 ...., xn are n observations, then their harmonic mean

(H.M.) is given by:
1
H. M. =
1 1 LM1 1 OP
1 N
n x x x
2 n Q
The Harmonic mean of a frequency distribution xi / fi is given
1
H. M.

1
f x1
N i 1
d i N = f i
Example: A cyclist covers his first three kilometres at an

average speed of 8 KMPH, another two kilometres at 3
KMPH and the last one kilometre at 3 KMPH. The average
)
speed for this entire journey is given by:
1 1 3 2 1
  
H. M. 6 8 3 3
(c
1 9 + 16 + 8

6 24
S
1 33 33
 
6 24 24
144 48
H.M.   = 4.4 KMPH
33 11
Measures of Dispersion
E
For a given distribution, it is important to know how the
variates are scattered away from the point of central
tendency. For example, we may have two groups of students
consisting of (i) very bright and very dull students and (ii)
average marks. Thus, the two groups differ in variations from
the mean. Such variation is called dispersion or scatter. The
most popular and sound method to find out the degree of
dispersion is standard deviation represented by s, the
UP
computation of which is explained below:
Consider a frequency distribution
Xi/fi, i = 1, 2, ..., n, fi = N
First we define variance 2 as
2 = u2 = fi (xi – x )2
Now we can define standard deviation () as
 1  f (x  x) 2
i i (1)
N
e f x j
2
2
 fi xi i i
(2)
 
N N
e f x j
2
2
 fi xi i i
h  (3)
)
N N
xi  a
where h is common class width and ui = h and a is arbitrary
chosen value.
(c
Formula (3) is most commonly employed to find out .
Example: Let us take the example to find out measures of

central to explain step involved in the computation of .
S
Table 6.8: Frequency Distribution of Income
Income Mid Frequency x - 50 uf U2f

Values (f)
U=
(x) 20
00-20 10 06 -2 -12 24
20-40 30 10 -1 -10 10
40-60 50 1 0 0 0
E
60-80 70 13 1 13 13
80-100 90 03 2 6 12
f = 50 uf = -3 u2f = 3
20x 59  3 FG IJ 2
 =
50 50 H K
= 20x 1.18  .0036
= 20x 1.1764
UP
= 20 × 1.08 = ` 21.60
Whenever we have to compare dispersion of two distributions
which have different units we compute coefficient of
variation which is defined as follows:

C.V = 100 ×
X
Combined Mean and Standard Deviation
Combined Mean
If we have two distributions with number of observations
equal to n 1 and n 2 and Arithmetic means as x 1 and x 2
respectively then the combined mean of both the
distributions together is given by:
X 1 n1  X 2 n2
)
X=
n1  n2
Combined Standard Deviation

(c
If we have two distributions with number of observations

equal to n1, n2 Arithmetic means as x1, x2 and standard
deviations as 1 and  2 respectively then the combined
standard deviation is computed as
S
=
b g 2
b g
n1  12  n2  22  n1 d1  n2 d2
2
n1  n2
Where d1 = X – X 1
And d2 = X – X 2
E
Measures of Skewness
Measurement of skewness gives us a measure of departure
from symmetry. This departure from symmetry or lack of
symmetry is called skewness.
In a symmetrical distribution the values of mean, median

and mode are alike. In a skewed distribution these values
UP
differ. If the value of mean is greater than the mode, skewness
is said to be positive. On the other hand, if the value of mode
is greater than mean, skewness is said to be negative. The
following diagrams would clarify the meaning of skewness.
Figure 6.8: Skewness Distribution

)
Figure 6.8(a) represents symmetrical distribution,

Figure 6.8(b) shows positively skewed distribution and
Figure 6.8(c) is indicative of negatively skewed distribution.
Skewness can be measured by the formula given below:
(c
b g
Skewness  1 
u32
u23
S
fi ( x i  x) 2
2 
N
LM f u  F f u I OP
2 2
N M GH N JK Q
2 i i i i
= h
and
E
fi ( x i  x) 3
3 
N
LM f u 3
fi ui2 fi ui FG
fi ui IJ OP
3
H K PQ
3 i i
  2
MN N
= h
N 3N 3N
xi  a
where h is common class interval,  i  where a is
h
arbitrary value.
UP
Example: Considering the example earlier taken, let us
compute skewness (1).
Table 6.9: Computing Skewness
3
Income Mid Frequency x - 50 uf u2f Uf
Values (f)
U=
(x) 20
00-20 10 06 -2 -12 24 -48
20-40 30 10 -1 -10 10 -10
40-60 50 1 0 0 0 0
60-80 70 13 1 13 13 13
80-100 90 03 2 6 12 24
2 3
f = N =50 uf = -3 u f = 59 u f = 21
2  59 (–3 2 ) 
2 = 20   
)
 50 50 
= 400 × [1.18 – .0036]
= 400 × 1.1764 = 470.66

(c
 3 = 20 2
L 21  3 x 59 x 3  2x b3g OP
xM
3
MN 50 50 50 50 PQ
= 8000 × [-.42 + 3x1.18x.06 – 2x.000216]
S
= 8000 × [-.42 + .2124 - .000432] = -1664
b1664g 2
Skewness ( ) =1
b470.66g 3
2768896
=
E
104490000
= 0.0265
Hence, this distribution is positively skewed.
Measures of Kurtosis
Kurtosis gives us idea about the flatness or peakedness of a

UP
distribution curve.
The diagram below illustrates the scope of three different

curves:
Leptokurtic
Mesokurtic
Platykurtic
(a) Mesokurtic, (b) Leptokurtic, (c) Platykurtic

)
Figure 6.9: Kurtosis
Kurtosis of a distribution is calculated by the formula given

below:
(c
2 = 2 – 3
4
Where 2 (Kurtosis) =
 22
b g 4
S
4 fi x i  x
 
N
fi u4 4 fi u3 fi ui 6 f i u2  f i u1  fi ui

2
LM OP 4
N Q
4
h x×  , +   3
N N N N N N
2
 
b g
fi x i  x
2
E
N
 h 2×x
LM f u 2
fi ui ) 2 OP
NN Q
i i

N
The terms h and u have already been defined earlier.

For normal distribution 2 = 3, i.e., 2 = 0
leptokuritc distribution 2 > 3, i.e., 2 > 0.

Example: Taking the earlier example, let us compute
UP
In the case of platykurtic distribution 2 < 3, i.e., 2 < 0. For
kurtosis (2). We have already worked out u2 and u3 while

calculating skewness, we need to work out u4 which is shown
below:
Table 6.10: Computing Kurtosis
4
Income Mid Frequency x - 50 Uf
Values
(f) U=
(x) 20
00-20 10 06 –2 96
20-40 30 10 –1 10
40-60 50 1 0 00
60-80 70 13 1 10
80-100 90 03 2 48
4
u f = 164
)
uf = –3
u2f = 164
u3f = –21
(c
L 164 21 3 59 F 3I F 3I O 2 4
= 20 × M 50  4 x 50 x 50  6 x 50 x H 50 K  3 H 50 K P
u f
N Q ×
4 × × ×
= 160000 x [3.28 – 4x – .42x .06 + 6x1.118 × .0036 – 3x

– .000196]
S
= 160000 × [3.28 + .1008 + .025488 + .000588]
= 160000 × 3.406876 = 545100.16
4
 545100.16
2 = 2
  24
 221841
2 = 2.4 – 3 = -.6
E
Since y2 < 0 it is a platykurtic distribution.
There are some other measures also to find out degrees of

skewness and kurtosis of a distribution which we are not
introducing here.
Correlation
UP
Correlation gives us a measure for the simultaneous
variations of two variables x and y which for example may
be advertisement expenditure incurred by a corporation and
its sales over different periods, respectively. Just like 2X
(x - x) 2 (y - y ) 2
(Vx) 2
=  Y (Vy) = gives us a measure of
n n
the variation in x and y respectively, we may get
(x - x)(y - y )
= covariance between x and y [Cov(x,y)]. Based
n
on this, Karl Pearson defined the correlation coefficient xy
as follows:
(x - x) (y - y)
rxy = 2 2
n
x  x  y  y 
n n
xy x y
 
n n n
=
FG IJ FI 2
)
x 2 x 2 y 2 y
n

n H K n

n HK
(c
S
xy
xy
n
=
  2
x
2
 dx i 2 y
2
 ey j
n n
uv u v
 
n n n
=
FG IJ FI 2
E
u 2 u 2 v 2 v
n

n H K n

n HK
xi  A yi  A'
Where ui  h and vi  h'
A = Arbitrary value chosen in x-variable
A’ = Arbitrary value chosen in y-variable
h = Common class interval of x-series

UP
h’ = Common class interval of y-series
[The proof of the above derivations are ignored]
Example: Suppose for the ten years we are given the

advertisement expenditure (x) and sales (y) of a corporation
as follows:
Table 6.11: Advertisement Expenditure
Period (X) (Y)

Advertisement Sales in ` 10 lakhs
Expenditure in ` Lakhs
1 10 5
2 12 6
3 14 7
4 16 8
5 18 9
)
6 20 10
7 22 11
8 24 12
9 26 13
10 28 14
(c
The correlation coefficient is worked out as follows:
S
Table 6.12: Correlation Coefficient
2 2
X Y xi  18 yi  y-9 uv u V
ui  2 vi  1
10 5 -4 -4 16 16 16
12 6 -3 -3 09 09 09
14 7 -2 -2 04 04 04
E
16 8 -1 -1 01 01 01
18 9 0 0 00 00 00
20 10 1 1 01 01 01
22 11 2 2 04 04 04
24 12 3 3 09 09 09
26 13 4 4 16 16 16
28 14 5 5 25 25 25
u = 5 v = 5 uv = 85 2
u = 85 2
v = 85
UP

uv u v
n

n n
2 2
2 u  u  2 v 2  v 
2
   
n  n n  n
85
60 5 5
 x×
 10 10 10
85
60 FG 5 IJ 2
60
85 FG 5 IJ 2
10

H 10 K 10

H 10 K
8.50 – .25 8.25
= 8.50 – .25 8.50 – .25  8.25 8.25
8.25
= 1
8.25
The example we have taken dives us perfect positive
correlation which implies hundred per cent rise in sales is
)
explained by the rise in advertisement expenditure.
Coefficient of Determination
It is defined as r2. For example, if correlation coefficient is
(c
.6, then coefficient of determination is (.6)2 = .36 which implies

36 per cent of rise in dependent variable say y is explained
by rise in independent variable x. Similarly, we can have
coefficient of non-determination which is defined as 1 – r2.
In the example given above this is equal to 1 – .36 = .64 which
implies 64 per cent rise in Y variable is explained by factors
S
other than advertisement expenditure, say quality of
product, price of the product, etc.
Negative sign of correlation coefficient means a change in

independent variable that leads to a change in dependent
variable but in the opposite direction. Correlation coefficient
lies between –1 and or 1 we put it as –1 r  1. Accordingly r2
E
may be 1 or less than 1 or we put it as r2  1.
Regression
Regression gives the best estimate of a variable for any given

value of another variable. For instance, the line of regression
of x on y gives the best estimate of x for any given value of y.
Similarly, the line of regression of y on x gives the best
UP
estimate of y for any given value of x. The former is known
as regression of x on y and the latter as regression of y and x.
A straight line which is the best fit in the least square sense
to a distribution is called the linear regression to the given
distribution. If the straight line is so chosen that the sum of
squares of deviations parallel to the x-axis (y-axis) is
minimum it is called the line of regression of x on y (line or
regression of y on x).
Let us see the equations of the lines of regressions. Let y = a

+ b x be the equation to the line of regression of y on x so that
corresponding to x=xi the expected value of y is yi (=a + b xi).
The sum of the squares of deviations of the observed value
yi from the expected value of yi is
n
given by S =  (i – yi)2
i 1
)
n
=  (yi – a – bxi)2
i 1
According to the principle of least squares, we have to choose

a and b so that S is minimum. The normal equations are
(c
s s
  0,  0
a b
-2 xi (Yi -a-bxi) = 0
 –2 (yi – a – bxi) = 0, –2 xi(i– a – bxi) = 0
S
yi = na + b xi …(1)
xi yi = a xi + b …(2)
Dividing (1) by n, we have
E
yi = a+b xi
n
or y = a + b x
From y = a + bx and y = a + b x , we obtain,
y – y = b(x– x )
UP
The value of b can be derived as equal to where
r = Correlation coefficient
y = Standard deviation of y
x = Standard deviation of x
b = Regression coefficient of y on x.
Similarly, the equation to the line of regression of x on y is
x = a+ by OR
y
x –x = r = (y - y )
x
y
Where b’ isr
 x is called the regression coefficient of y on x
y
and is denoted by b yx. The constant r r
 x is called the
)
regression coefficient of x on y and is denoted by bxy.
y
 b1 = and
x
(c
y
bxy = r
x
S
It can be easily seen that if regression lines of x on y and y on
x are given, we can get coefficient of determination r2 by
multiplying bxy with byx or correlation coefficient will be
2
r r  bxy byx
Example: Let us fit in regressions of y on x and x on y to the

statistical data given for 9 observations
E
X : 1 2 3 4 5 6 7 8 9
Y : 9 8 10 12 11 13 14 16 15
Table 6.13: Regressions of Y on X and X on Y

2 2
X Y X XY Y
1 9 1 19 81
2 8 4 16 64
3
4
5
10
12
11
UP 9
16
25
30
48
55
100
144
121
6 13 36 78 169
7 14 49 98 196
8 16 64 128 256
9 15 81 135 225
2 2
x =45 y=108 x =285 xy = 597 y = 1356
Regression of y on x is
Y = a + bx
The two normal equations are:
y = na + bx
xy = a x + b x2
Putting the values we get
108 = 9a + 45b . . . (1)
597 = 45a + 28b . . . (2)
)
Multiplying equation (1) by 5 and deducting it from equation

(2) we get
540 = 45a + 225b
(c
± 597 = ±45a ± 285b
60
or b = = 1.0526
57
S
Putting the value of b = 1.0526 in equation (1) we get
108 = 9a + 45 x 1.0526
= 9a + 47.368
or 9a = – 47.368 + 108
9a= 60.632
E
60.632
a= = 6.73
9
So y = 6.73 + 1.0526x
Similarly, regression of x on y will x = a + by
Normal equations are

UP
x = na + by
xy = a y + b’ y2.
Putting the values we get
45 =9a + 108b . . . (1)
597 =108a + 1356b . . (2)
Multiplying equation (1) by 12 and subtracting it from

equation (2) we get
540 = 108a + 1296b
 597 =  108a 1356b
– 57 = – 60 b
57
b = = .95
60
Putting the value of b = .95 in equation (1) we get a equal to:
)
45 - 108 x .95 45 - 102.6 -57.6

a 
a     6.4
9 9 9
Regression of x on y is
(c
x = -6.4 + .95y
S
Regression coefficient of y on x is byx = 1.0526
Regression coefficient of x on y is bxy = .95
Coefficient of determination r2
is byx × bxy = 1.0526 x .95
= .999
E
Correlation coefficient r = b xb = 1.0526 x .95 .999 = .9949
yx xy
Probability
A few concepts need to be understood before the theory of

Probability is introduced. Some of the important concepts
are:
1.
UP
Random Experiments and Events: Suppose a coin is
tossed or a dice is thrown or a card is drawn from a
pack of playing cards. There are a number of possible
results or outcomes, which can occur, but there is an
uncertainty as to which one of them will actually occur.
Such experiments are called random experiments. We
can define a random experiment as an experiment which
when repeated under essentially identical conditions
does not give unique results but may result in any one
of the several possible outcomes. These outcomes are
known as events.
For Example:
(a) Getting a head (H) or a tail (T) is an event when we

toss a coin.
(b) Getting any of the six faces (1,2,3,4,5,6) is an event

when a dice is thrown.
)
(c) Getting an ace or a king or a queen is an event when

we draw a card from the pack of well-shuffled cards.
2. Exhaustive Events: The total number of possible

(c
outcomes in a random experiment (or trial) are known

as exhaustive events.
S
For Example:
(a) There are 2 exhaustive events, viz. head (H) and

tail (T) when we toss a coin.
(b) There are 6 exhaustive events when we throw a

dice.
(c) When we throw two dice the exhaustive number of
E
events is 62 = 36.
(d) When we draw two cards from a pack of playing

52
c a r d s t h e e x h C2 since
a u s t i v e n u m b e r o f e v e n t s i n
52
2 cards can be drawn out of 52 cards in C2 ways.
3. Favourable Events: The events which cause the

happening of a particular event A are called the
UP favourable events to the event A. For example:
(a) There are three favourable events for the

occurrence of an even number (or an odd number)
in the throwing of a dice.
(b) When we draw a card from a pack of cards, there

are 4 favourable events for the drawing of a queen;
there are 12 favourable events for the drawing of a
face card (king, queen, jack).
4. Mutually Exclusive Events: Such events, where the

occurrence of one rules out the occurrence of the other
called mutually exclusive events. In other words, events
are mutually exclusive if no two or more of them can
happen simultaneously in the same trial.
For example:
(a) In tossing a coin there are two mutually exclusive

events, for if head comes in a trial, then tail cannot
)
come in the same trial or vice versa.
(b) In throwing a dice there are 6 mutually exclusive

events, for if any of the six faces comes, then the
(c
possibility of other faces in the same trial is ruled

out.
S
5. Equally Likely Events: Two events are said to be
equally likely if none of them is expected to occur in
preference to other.
For Example
(a) In tossing a coin, there are two equally likely events

viz., H&T.
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(b) In tossing a dice, there are 6 equally likely events
viz., 1,2,3,4,5,6.
Definition of Probability
If there are ‘n’ exhaustive, mutually exclusive and equally

likely events out of which ‘m’ are favourable to the happening
of an event A, then the probability of the happening of A,
P (A) =
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denoted by P(A), is defined as
Favourable number of cases


m
Exhaustive number of cases n
The probability that the event A will not happen, denoted

by P(A), is given by
P(A) 
n-m
n
 1
m
n
bg
1 P A
P(A) + P( A )= 1
m
Since 0  m  n, so 0  1
n
Hence, 0  PA  1, for any event A.
If P(A) = 0, then A is called an impossible or null event.
If P(A) = 1 then A is called a certain or sure event.

)
If A and B are two events, then the probability of the

happening of A or B (i.e., at least one of the two events) is
denoted as P(A+B).
The probability of the simultaneous occurrence of two events

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A and B is denoted as P(A+B).
The probability of the simultaneous occurrence of two events

A and B is denoted by (P(AB).
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At this stage it is also necessary to introduce the concepts of
permutations and combinations.
(i) n! (Known as n factoral) is expanded as n(n–1).......3.2.1

= n! n(n–1) ! = n(n–1), (n–2) 1, etc.
(ii) The number of permutations of n different things taken

r at a time is
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n n!
Pr 
(n - r)!
(iii) The number of combinations of n different things taken

r at a time is
n
Cr
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n
Cr 
n!
r! (n - r)!
For example,
5 5! 5.4
C2    10
2! 3! 2.1
52 52.51.50.49
C4   270725
4.3.2.1
Example 1:
A bag contains 6 white, 5 black and 4 yellow balls. What is

the chance of getting either a white or a black ball in a single
draw?
Solution:
Let A denote the event of getting a white ball and B denote

the event of getting a black ball.
)
Total number of balls = 6 + 5 + 4 = 15
6 5
P(A) = P(B) =
15 15
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6 5 11
Now P(A+B) = P(A) + P(B) =  
15 15 15
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Example 2:
It is 8:5 against a husband who is 55 years old living till he is

75 and 4:3 against his wife who is now 48, living till she is 68.
What is the probability of the couple living 20 years hence?
Solution: Let A and B respectively denote the events of the

husband and wife living 20 years hence. Then
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5 5 3 3
P(A) = = P(B) = 
85 13 4+3 7
Probability that the couple lives for 20 years
5 3 15
= P(AB) = P(A) P(B) = x
× 
13 7 91
Compound Events
UP
The simultaneous occurrence of two or more events is called
a compound event. For example, drawing 5 white balls and
then 3 black balls from an urn containing 10 white balls and
7 black balls is a compound event.
If A and B are two events, then AB denotes the simultaneous

occurrence of A and B and P(AB) denotes the probability of
the simultaneous occurrence of the two events A and B.
Events A and B are said to be independent if the probability
of the happening of one does not depend on the happening
or not happening of the other. For example, consider a bag
containing balls of different colours. Suppose one ball is
drawn from it and it is replaced after the first draw, then
the second draw will be independent of the first draw. Two
such draws are independent events.
The probability of the happening of an event A when the

event B has already happened is called the conditional
)
probability and is denoted by P(A/B). Similarly P(B/A) means

the probability of the happening of an event B when event A
has already happened. For example, in the example given
above if one ball is drawn and is not replaced back and then
(c
second ball is drawn, then the probability of the second ball

drawn is certainly dependent on that of the first ball. The
probability of the second ball is a conditional probability.
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If A and B are two events then
P(AB) = P(A) P (B/A) or the probability of the simultaneous

occurrence of two events is equal to the probability of the
happening of one multiplied by the conditional probability
of the other when the first has already happened.
Example: A bag contains 6 white and 9 black balls. Four balls
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are drawn at a time. What is the probability for the first
draw to give 4 white and the second to give 4 black balls
when the balls are not replaced before the second draw?
Solution: 4 balls can be drawn from a bag containing 6 white

and 9 black in 15C4 ways.
Let A be the event that the first draw gives 4 white balls and
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B be the event that the second draw gives 4 black balls. 4
white balls can be drawn out of 6 white balls in 6C4 ways.
6
c4
P(A) = 15
c4
Since balls are not replaced, the other balls can be drawn in
11C4 ways. The event B that the second draw results in 4
black balls (on the assumption that the first draw has given
4 white balls) has favourable cases.
9C 4
 P(B/A) = 11
C4
Hence p(AB) = P(A) P(B/A)

6C 4 9C 4
= 15 x×
C4
11C 4
3
=
715
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Sampling and tests of significance are very important tools

in business economics. In fact one cannot do any meaningful
marketing research without the requisite knowledge of
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sampling techniques.
Any collection (usually large) of individuals or objects is called

a population or universe.
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A finite subset of a population is called a sample. The number
of individuals in a sample is called the sample size.
The theory of sampling is the study of relationship between

a population and samples drawn from the population. The
main object of sampling is to get as much information as
possible of the population by examining only a part of it. There
are a number of terms which are employed in sampling
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theory. Let us introduce them as follows:
1. Random Sampling: When a sample is taken in such a

way that each member of the population has the same
probability of being selected, the sample so obtained is
called a random sample and the technique is called
random sampling.
2.
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Simple Sampling: It is a special case of random
sampling in which each event has the same probability
of success and the probability of an event is independent
of the success or failure of events in the preceding trails.
Thus, simple sampling is a random sampling in which
the trails are independent and the probability of success
is constant.
3. Large and Small Sample: Samples of size n > 30 are

called large samples and samples of size n  30 are called
small samples.
4. Hypothesis: In order to make certain decisions about a

population on the basis of sample information, some
assumptions are made about the population. Such
assumptions, which are not necessarily true, are called
statistical hypothesis.
5. Null Hypothesis: The hypothesis tested for possible

rejection under the assumption that it is true, is called
)
the null hypothesis.
A hypothesis can be rejected but cannot be proved. The

starting position is to set a null hypothesis, e.g. to test
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whether there is any difference, it is assumed that there

is no difference, to test whether there is any
relationship, it is assumed that there is no relationship,
etc. The rejection of no difference will mean that there
is significant difference between a sample and a given
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population, in terms of given characteristics. Similarly,
the rejection of no relationship implies a significant
relationship.
6. Parameters and Statistics: The statistical constants

of the population viz., mean (m), variance (s2), etc., are
usually referred to as parameters. The statistical
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measures computed from the sample observations above,
e.g., mean ( x ), variance (s2), etc., are called statistics.
7. Level of Significance: We are not introducing

Binomial and Normal distributions in this introductory
book. The following statements may be taken as given:
(i) Normal distribution is the limiting case of the

UP binomial distribution. When n  a (i.e., the number
of trials is indefinitely large) and neither P nor q is
very small.
(ii) The variate Z is defined by
x - np
Z
nPq
Where x is a binomial variate with mean nP and

standard deviation nPq
x-
(iii) If x ~ N (, 2), then Z = is called the standard

normal variate with E(Z)=0 and var (Z) = 1 and is
written as Z ~ N (0,1).
(iv) The probability density function (p.d.f.) of the

standard normal variate z is given by
)
2
1z
1
f(Z) = e 2 - x z 
2
(c
and the corresponding distribution function is given

by Q(z) = P(z  z) = z
z  f ( z ) dz
(v) 
z  f(z) dz  1
z z
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o 

f(z) dz = o
f(z) dz = 0.5
From the above statements it is seen that the

transformation
Z = (X – )/ reduces the distribution N(u, 2) N

N(0,1), which is called the standard normal
distribution. Further,
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P {z1.96} = P {–1.96  z  1.96} = 0.95
P {z 2.58 = P {–2.58  z  2.58} = 0.99
This means the area under the standard normal curve N(0,1)
and bounded by the lines Z = ± 1.96 is 95%. The area beyond
the ordinates z= ± 1.96 in 5%. Similarly, the area under
the standard normal curve N(0,1) and bounded by the lines
Z = ± 2.58 is 1%.
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The 5% area beyond the ordinate Z ± 1.96 is called 5% level
of significance (written as  = 0.05) and 1% area beyond the
ordinates Z = ± 2.58 is called 1% level of significance (written
as  = 0.01).
Almost all z values lie between –3 and +3 because
p {–3  z  3} = 0.9973
and p {z> 3} = 0.0027.
The significance value of z at 5% level of significance is 1.96

and the significance value of z at 1% level of significance is
2.58.
Level of significance is important because given a sample

information, the tests which enable us to decide whether a
hypothesis is to be accepted or rejected are called the tests
of significance. These tests are useful in finding out whether
)
observed sampling results differ significantly or not from

the expected results.
For large sample where n > 30

(c
X  nP
Z= ~ N (0, 1)
nPQ
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(a) If Z < 1.96 we say that the difference is not significant
at 5% level and data is said to be consistent with the
hypothesis and hence the hypothesis may be accepted.
(b) If 1.96 < Z< 2.58, we say that the difference is

significant at 5% level of significance.
(c) If 2.58 < Z< 3, we say that the difference is significant
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at 1% level of significance.
Example: A random sample of 500 apples was taken from a

large consignment and 65 were found to be bad. Work out
that the standard error of the bad ones in a sample of this
size is 0.015 and show that the percentage of bad apples in
the consignment almost certainly lies between 8.5 and 17.5.
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Solution: The number of bad apples in the sample is x = 65
and n = 500. The proportion of bad apples in the sample is
X 65
P   = 0.13
n 500
q = 1 - P = 0.87
Pq
S.E. of Proportion =
n
0.13 x 0.87
=  0.075
500
The limits of the proportion of bad apples in the consignment
Pq
= P± 3
n
= 0.130 ± 3 × 0.015
= 0.130 ± 0.045
)
= .175, .085
Therefore, the percentage of bad apples in the consignment

lies almost certainly between 8.5% and 17.5%.
(c
We are not going into great details but in a summary form

various tests of significance are stated below:
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1. Test of significance for single proportion:
X  nP
The test statistic is Z =
nPQ
2. Test of significance for the difference of

proportions: Under the null hypothesis, there is no
significant difference between the sample proportion,
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the test statistic is
P1  P2
Z
F 1  1I
PQ
Hn n K
1 2
x1  x2
P
n1  n2
3.
Q=1–P
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Test of significance for single mean: Under the null
hypothesis, the sample has been drawn from a
population with mean m and standard deviation  and
the test statistic is
x u
Z

n
4. Test of significance for difference of means: When

there is no significant difference between the sample
means, the test statistic is
x1  x 2
Z
2 2
1 2

n1 n2
If the samples are drawn from the populations with

common standard deviation , then the above test
statistic becomes
)
x1  x2
Z
1 1
 
n1 n2
(c
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5. Test of significance for difference of standard
deviation: Under the null hypothesis, there is no
significant difference between the sample standard
deviations, the test statistic is
s1  s 2
Z
FG  IJ  FG  IJ
2 2
H 2n K H 2n K
1 2
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1 2
How to accept or reject the null hypothesis?
If Z > 3, the difference is highly significant and we

reject the null hypothesis.
If Z < 1.96, the null hypothesis may be accepted at 5%

level of significance.
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6. t-Test
(a) Under the null hypothesis: When there is no

significant difference between the sample mean and
the population mean, the test statistic is
x u
t
s
n
b g
2
2 1 n
S   xi  x
n - 1 i 1
and t has (n-1) degrees of freedom.
(b) Under the null hypothesis: There is no significance

difference between the sample means and the t-
statistic is
x1  x 2
t
)
1 1
s 
n1 n2
1
x1  x 1
n1
(c
1
x2  x 2
n2
S
S 
2
(n1 + n2  2)
1
b
 xi  x1 g   bx  x g
2
i 2
2
and t has (n1 + n2 – 2) degrees of freedom.
How to accept or reject the null hypothesis?
Let t denote the calculated value of t by means of the
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above formula and t0.05 the tabulated value of t for
(n – 1) or (n1 + n2 – 2) degrees of freedom (as the case
may be).
If t calculated > t0.05, the null hypothesis is accepted at

5% level of significance.
If t calculated > t0.05, the null hypothesis is rejected at
7.
5% level of significance.
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F-Test: Under the null hypothesis: If the population
variances are equal, the F-statistic is
2
S x 2 2
F 2
(S x  S y)
S y
b g
2
1 n1
where Sx 2   xi  x
n1 - 1 i1
b g
2
2 1 n2
S y  yi  y
n 2 - 1 j 1
and F has (n1 – 1, n2 – 1) degrees of freedom.
Let F denote the tabulated value 0.05 of F for (n1 – 1, n2 – 1)

degrees of freedom.
If F calculated > F0.05, the null hypothesis is accepted at 5%

)
If F calculated < F0.05, the null hypothesis is rejected at 5%

(c
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Check Your Progress
Fill in the blanks:
1. Samples of size n  ................ are called large

samples and samples of size n  ................ are called
small samples.
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2. The hypothesis tested for possible rejection under
the assumption that it is true is called ................ .
Summary
Concepts can be explained better with the help of tools and
techniques like tables, diagrams equations, etc. There are
other more sophisticated techniques, which are drawn from
UP
disciplines like applied mathematics, statistics,
econometrics and operations research. The use of such
methods and measures makes managerial economics or
business economics, a highly technical subject. The use of
techniques is geared towards measurement and optimisation
of economic decision variable.
In business economics, we deal with variables, like
consumption, demand, supply, income, investment, wages,
profits, etc. A variable is a thing which varies, which can
take a set of possible values within a given problem. A
constant is a quantity, which does not change in a given
problem.
The objective function is a mathematical relationship
between the choice variables and some variables whose
values an economic agent wishes to maximise or minimise.
An essential part of any optimisation problem is specification
of exactly what alternatives are available to the decision
maker. The available set of alternatives is called the feasible
)
set.
Lesson End Activity

(c
“While attempting economic analysis of business decision

problems, we use a host of tools and techniques, but we need
to be cautioned against the misuse and abuse of such
techniques”.
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Explain the statement choosing any specific area e.g.,
Marketing of Finance or Production with which a business
unit may be concerned with.
Keywords
Concept: Concepts can be explained better with the help of
tools and techniques like tables, diagrams equations, etc.
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Variable: A variable is a thing which varies, which can take
a set of possible values within a given problem.
Constant: A constant is a quantity, which does not change

in a given problem.
Partial Derivative: The derivative of the partial function
f
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is known as the partial derivative of the original function
and is denoted by x or fi(x) or fx (instead of using, ‘u’ by

i
‘u x’).
Optimization: Optimization means the act of choosing the

best alternative out of whatever alternatives are available.
It helps in making decisions.
The Decision Variables: These are variables where optimal

values have to be determined.
The Objective Function: The objective function is a

mathematical relationship between the choice variables and
some variables whose values an economic agent wishes to
maximise or minimise.
The Feasible Set: An essential part of any optimisation

problem is specification of exactly what alternatives are
)
Linear Programming: Linear Programming may be defined

as a method of determining an optimum programme of inter-
dependent activities in view of available resources to
maximise or minimise an objective function.
(c
Case: A case represents a depiction of the real situation; it

describes the actual environments, experiences, events or
incidents or episodes of the historical past.
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Case Method: The case method is a pedagogical technique.
In business economics, the case method is useful to the extent
it stimulates a real world business situation.
Regression: Regression gives the best estimate of a variable

for any given value of another variable.
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1. (i) If I invest ` 12,000/ in a fixed deposit with a company
which promises 14% annual rate of return, how
much do I get back at the end of three years?
(ii) If I desire to get just ` 12,000 at the end of three

years, how much should I deposit with the company
now?
UP (iii) Identify and explain the relevant concepts that you
are using.
2. Suggest business applications of the statistical concepts

of
(i) Mean (ii) Median (iii) Mode.
(a) Quote appropriate business examples.
(b) Collect some market data and analyse the same to

illustrate the above concepts.
4. It is given that in a system
Demand, D = 150 – 0.6 P
Supply, S = 60 + 0.3 P
D=S
What kind of model is this. Locate equilibrium price, P

)
and equilibrium quantities. Plot your solution and the

system of equations.
5. It is said that our Population is growing at an

exponential rate at 2%. What do you mean? A
(c
manufacturing firm wanting to introduce a new baby

food is interested in having a computer graphic
presentation of the function. Do the needful.
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6. It is observed that output quantity Q depends on labour
and capital utilised in productive process:
Q = 158 L 0.4 K0.6
Examine the nature of this function and interpret it

fully, while making calculus operations on it.
7. Collect data from Business Magazines to illustrate:-
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(a) Bar diagram (b) Pie chart
(c) Pictogram (d) Histogram
(d) Ogive (Cumulative Frequency) Curve
Further Readings
Books
UP



Web Readings
wiki.answers.com › Wiki Answers › Categories › Business &
Finance
ramton.umd.edu/econ300/econ300-syllabus.pdf
)
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www.mbe-du.org/
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UP
)
(c
UNIT 7: Game Theories in Economic Analysis
Unit 7
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Game Theories in
Economic Analysis
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Objectives
topics:
 A Return to the Game Theory
 Matrices and their Applications

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Elementary Algebra of Matrices
Advantages and Disadvantages of Matrices
Introduction
Game theory is a study of strategic decision making. More
formally, it is "the study of mathematical models of conflict
and cooperation between intelligent rational decision-
makers." An alternative term suggested "as a more
descriptive name for the discipline" is interactive decision
theory. Game theory is mainly used in economics, political
science, and psychology, as well as logic and biology. The
subject first addressed zero-sum games, such that one
person's gains exactly equal net losses of the other
participant(s). Today, however, game theory applies to a wide
range of class relations, and has developed into an umbrella
term for the logical side of science, to include both human
)
and non-humans, like computers. Classic uses include a sense

of balance in numerous games, where each person has found
or developed a tactic that cannot successfully better his
(c
results, given the other approach.
A Return to Game Theory

Competitive games include most of the recreational games
also. For instance, chess, checkers and other games are
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competitive games, each having a clear-cut set of strategies
(moves or alternatives) available to the players or
competitors. Gambling games are not games of strategy
because a person playing such a game is merely betting
against the odds. We confine ourselves to non-gambling
games.
In most of the games, there are elements of chance, skill,
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enjoyment and strategy. Different games vary according to
the amount of these elements present. But, the most
important factor is the strategic behaviour of the individual
player. A strategy indicates what particular move will be
chosen by a player for every situation that can arise within
the play of a game. Emphasis is not merely on the strategy
to be chosen by a player alone, but also on considering his
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action(s) in response to the moves chosen by his competitor(s).
Thus, in every game, the outcome of each player’s action(s)
depends explicitly on the actions of the opponent(s).
The various characteristics of a competitive game are:
(1) The number of players (competitors) is finite,
(2) There is a conflict of interest between the players,
(3) Each player has available to him a finite number of

possible courses of action, referred to as strategies,
(4) Rules governing the choice of actions are known to each

player. Each player chooses one of his courses of action.
These choices are assumed to be made simultaneously,
so that no player knows his opponent’s choice until he
has decided his own course of action,
(5) The outcome of the game is affected by the choices made

by the competitors and
)
(6) All combinations of courses of action chosen by various

players always result in some outcome of the game
denoting gain (or loss) of an individual player. This
outcome can be represented by a single pay off number
(c
that can be Zero (no gain – no loss), positive (gain) or

negative (loss).
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Zero-sum and Non-Zero-sum Games Activity
Competitive games are classified according to the number Write a draft of assignment on
the return to game theory as in
of players involved, i.e., as a two-person game, three-person zero-sum and non-zero sum
game, etc. Another important distinction is between Zero- games.
sum games and Non-zero sum games. If the players make
payments only to each other, i.e., the loss of one is the gain
of other and nothing comes from outside, the competitive
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game is said to be Zero-sum. Mathematically, suppose a n
person game is played by n players, P1, P2 ..... Pn whose
respective pay offs at the end of a play of the game are V1,
V2, ..... Vn then the game will be called Zero-sum if
Vi = 0
at end of each play of the game. A game which is not Zero-

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sum is called a Non-zero-sum game. Most of the competitive
games are Zero-sum games. An example of a Non-zero sum
game is the ‘poker’ game in which a certain part of the pot is
removed from the ‘house’ before the final pay off.
Two-Person Zero-sum Games

We would be confining ourselves only to Two-person Zero-
sum game. By definition, Zero-sum games with only two
players or competitors are called Two-person Zero-sum or
Rectangular games. In this case the loss (gain) of one player
is exactly equal to the gain (loss) of the opponent and each
player knows the outcome for all possible strategies that he
and his opponent may use during a play of the game. The
resulting outcomes, representing gain (or loss) to a
particular player, can be conveniently displayed in the form
of a pay of f matrix. A = (aij) where aij is the pay off to player
I (say), when he employs his ith move player II (the opponent)
employs his jth move.
)
This if player I has m strategies (moves) available to him

and player II has n moves available to him, then the pay
offs for various strategy combinations may be represented
by an m × n pay off matrix (aij). For this reason, the two-
(c
person Zero-sum games are also called matrix games. To

illustrate, suppose a two-person zero-sum-game has two
players, R and C with their respective available strategies
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R1, R2 and C1, C2, C3, respectively. Let the pay offs to the
player R be expressed in terms of gains to him. Let the pay
offs to player R be given by the following 2 × 3 pay off matrix.
Table 7.1: 2 × 3 pay off matrix
R1 C1 C2 C3
 -1 3 0
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R2 2 -4 1
Then the following explanation may be given for the various

pay offs:
Table 7.2: Strategy of R and C
Strategy of R Strategy C
UP R1
C1
R loses 1 unit
C2
R gains 3 unit
C3
R2 R gains 2 unit R gains 3 unit
Since the game is Zero-sum, every gain of player R is an equal

loss of player C and vise versa. Thus, the pay off matrix for
the player C will just be the negative of the pay off matrix of
R, so that the pay off matrix of the two players is ultimately
a null matrix.
For a given pay off matrix, we shall adopt the following:
(a) Row designations are the courses of action available to

player R, who will be called the row player.
(b) Column designations are the courses of action available

to player C who will be called the column player.
(c) The various pay offs are the pay offs to the row player.
)
(d) Though the pay off matrix for the column player can be
obtained just by negating the pay off matrix of the row
player, we hardly need to do so.
(c
The Maximin-Minimax Criterion

Let us try to find a solution of the optimal strategies by the
two players, by employing maximin-minimax criterion.
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Suppose that both the players are conservative, i.e., while Activity
employing his strategy R1, player R believes that his
Make a chart for you display
opponent knows that he is going to employ R1 and similarly board focussing on some
player C believes so about player R while employing his examples of functions and their
graphs.
moves.
To illustrate the maximin-minimax criterion, let us consider

a two-person Zero-Sum game with the following 3 × 3 pay off
E
matrix for player R.
Player C
C1 C2 C3
R1 4 6 4 
Player R R2 3 1 0
UP
R3 4 8 2
The interests of the player R and C are diametrically

opposite; if R wants to win C wants to minimise gains of R
and so on. Thus, if player R adopts a particular strategy,
player C would like to move in such a way that the pay off to
R is the minimum (for that particular strategy). For instance,
if R employs his strategy R1, C’s move would be either C1 or
C3 because either of these will restrict R’s pay offs to 4 units,
minimum possible for his move R1. Similarly if R chooses his
strategy R2, he may gain 3 units or loss 1 unit depending
upon what strategy C chooses. However, whatever be the
move of player C, R is assured to gain at least min. [3, -1, 0] =
-1 units. Likewise if R chooses his strategy R3, the most
advantageous move for C would be to choose C3.
Naturally, the objective of player R would be to select that

strategy for which the minimum assured return is a
maximum. That is, he would identify the maximum of the
minimal pay offs and play the corresponding maximum
)
strategy. For the given pay off matrix, the maximin strategy
for player R is R1, the maximin pay off being 4 units.
Similarly, player C would like to minimise his losses. If he

(c
selects strategy C1, he can suffer a worst possible loss of 4

units, which results when R chooses R1 or R2 in order to
maximise (R’s) own pay offs. If C choose C2 he may gain one
unit depending upon whether R employs R2; but in any case,
S
R cannot harm C more than a loss of 8 units. If C chooses
strategy C3, player R cannot worsen the loss to C more than
4 units, which he does when he plays R1.
The optimal course of action for player C would be to select

that strategy for which his maximum (worst possible) loss
will be minimum. That is, he would identify the minimum of
the maximum losses and play the corresponding minimax
E
strategy. For the given pay off matrix, the minimax strategy
for player C is either C1, or C2, both resulting in the minimax
loss of 4 units.
Thus, we see that the selection of maximin and minimax

strategies of the two players is based upon the maximin-
minimax criterion which guarantees the best of the worst
results. The “maximin pay off” is called the maximin value
UP
and the “minimax loss” is called the minimax value of the
game. In the present example, we observe that maximin
value = 4 = minimax value.
In such cases, where the maximin value is equal to the

minimax value of the game, the corresponding strategies are
called the optimal strategies.
It should be noted that while determining the maximin or

minimax values, we followed the simple procedure.
(a) The minimum assured pay offs to the row player are
given by the minimum element of each row of the pay
off matrix. This gives the row minima vector r = (4, -1,
2).
(b) The maximum possible losses to the column player are

given by the maximum element of each column of the
pay off matrix. This gives the column maxima vector C.
(c) The maximum value is = (4, 8, 4) given by max[r]=4 and

)
the minimax value is given by min[c]=4 when minimax

value = maximum in value = V (say), then V is nothing
but the value of the game.
(c
S
The following are some extensions of the games which can
be considered but it is beyond the scope of this book.
(a) N-person games: These are the games which involve
more than two players each having their own set of
choices for each player of the game.
(b) Non-zero-sum-game: These are the games in which the
sum of the pay offs of both the players, from any play of
E
the game, is not equal to zero. As an example, consider
the case of advertising strategies of two competitors. If
none of them goes in for advertising costs and receive
positive pay offs (representing a non-zero outcome). If
both the competitors spend equal amounts of money on
advertising (assuming equal advertising effects), neither
company’s sales will increase over the other, resulting
UP
in cost of advertising (with no benefits) as the loss to
both the competitors.
(c) Co-operative games: These are the n-person zero-sum
games in which (all or few) competitors cooperate for
some mutual gain(s). These gains may be in violation
(or part) of the company’s policies.
(d) Infinite games: When the players of the game have an
infinite number of pure strategies available to them, the
game is called an ‘infinite’ game. Such types of games
generally occur in situations where the strategy to be
selected can be represented by a continuous decision
variable.
Check Your Progress

Fill in the blanks:
1. .................. games involve each having their own set
of choices for each player of the game.
)
2. A .................. is a rectangular array of numbers,

usually represented by enclosing the array by
brackets.
(c
3. When the players of the game have an infinite

number of pure strategies available to them, the
game is called .................. .
S
Activity Matrices and Their Applications
Make a short report on matrices A matrix is a rectangular array of numbers, usually
and their applications.
represented by enclosing the array by brackets. The numbers
of rows and columns are called the dimensions or order of a
matrix.
2 4 3 
E
6 1 0 is a matrix of dimensions 2 × 3. It has 2 rows and
 
3 columns.
 a11 a12 
a a22 
is a 2 × 2 matrix. It has 2 rows and 2 columns.
 21
 a11 a12 ...... a1n 

UP a 
 21 a22 ..... a2n  is a matrix of order m × n. It has m rows
am1 am2 .... anm 
and n columns. The element in the ith row and jth column is
denoted by aij. Briefly we write A = [aij].
If m = n i.e., if the number of rows equals the number of

columns, we have a square matrix. An n × n matrix is also
called an nth order matrix.
Vectors
A vector is a special type of matrix in which there is only
one row or one column.
A1 xn matrix [a1, a2, ....a n] is called a row vector.
 a1 
a 
 2
Anm x 1 matrix  :  is called a column vector.
 
am 
)
We note that a row vector is an ordered collection of numbers

written in a row. A column vector is an ordered collection of
numbers written in a column. Two row (or column) vectors
(c
are equal if and only if the corresponding elements of the

vectors are equal. If the vectors given are:
a b
u=[a,b], v = [ b ], u1 = [a,b] , v = = [ a ], then u=u1, u1 v = v1
S
The sum of two vectors of the same type is a vector whose
components are the sums of the corresponding elements of
the given vectors:
[u1, u2,...... um] + { v1 v2, ...... v m] = [u1 + v1 u2 + v2, ........ u m + vm]
The product of a vector by a scalar k, i.e., the numerical

multiplication of a vector by a number k, gives a vector whose
E
components are k times the components of the given vector.
k [u1 u2 .... um] = [ku1 ku2 ... kum)
= [u1 u2 .... um]k.
Example: if u = [1,2], v = [3,5], w = [4,7]
u – v = [-2, -3], 2u + 3w = [14 25]

UP
The associative law of addition holds for vectors
[u + v] + w = u + [v + w]
The product of a row vector u = [u1 u2 .... um]
 v1 
v 
 2
and a column vector v =  :  each having the same number
 
vm 
m of components, is defined by
uv = [u1 v1 + u2 v2 + ..... + u m vm]
The row vector u is written first and the column vector v

written after u and the number of components is the same in
each.
Example:
2
)
0
[1 2 3]   = [1(2)+2(0)+3(-1)] = -1
 1
0 
(c
[1 0]   = [1.0 + 0.1] = 0.
1 
S
Activity
Elementary Algebra of Matrices
Prepare a brief report on Equality: Two matrices are equal if and only if they have
optimisation and its
techniques.
the same number of rows and the same number of columns
and the corresponding elements in the two are equal
a b   p q 
 c d    r s  if a = p, b = q
   
E
c=r,d=s
In symbols if A=[aij], B=[bij] then A=B if A, B have the same

dimensions then aij = bij for each (i j).
Addition: The sum of two matrices of the same dimensions

is a matrix with elements which are the sums of the
corresponding elements of the given matrices.
UP a b   p q  a  p b  q 
 c d    r s    c  r d  s
     
If A = [a ij] , B = [b ij] have the same dimensions, then
A + B = [c ij] where C ij = a ij + b ij
If two matrices have different dimensions their addition is

not defined.
Example:
1 2 2 0 5
4 7   3 4 7 is not defined
   
The following laws of addition may be noted:
Associative law A + B = B + A
Commutative law A + (B+C) = (A+B) + C

)
Scalar Multiplication
The product of a matrix by a scalar k is a matrix with elements
k times the elements of the given matrix.
(c
a b  k a k b  a b 
 c d  k c k d    c d k
     
S
kA = k [aij] = Ak
Example:
3 2 6 4 
2   0 2 
0 1   
Multiplication of Matrices
E
Consider the product
 p
 a1 b1 c1     a1 p  b1 p  c1r 
a b q 
 2 2 c2    a p  b q c r 
 2 2 2 
 r 
23 3 1 2 1
UP
Each row of the 2 × 3 matrix, taken as a row vector is
multiplied by the 3 × 1 column vector. This gives us two
numbers which are the elements of a 2 × 1 matrix. The
procedure would be similar for higher dimension matrices.
Example:
 a1 b1   p1 p2 
a b  q q 
 2 2  2 2
 a1 p1  b1q1a1 p2  b1q2 
a p  b2q2 a2 p2  b2q2 
 2 2
Example:
2 1
1 0 2 3  0
2 1 0 3  2
  1 4
3 2 2 0  
2 0
1.2  0.0  2.1  3.2 1.1  0.2  2.4  3.0 

)
  2.2  1.0  0.1  3.2 2.1  1.2  0.4  3.0 

3.2  2.0  2.1  0.2 3.1  2.2  2.4  0.0 
10 9 
 10 0 
(c
 4 1
S
If two matrices A, B are such that the number of columns in
A is the same as the number of rows in B they are conformable
for multiplication.
If A is of order p × q and B is of order q × r then A, B are

conformable for multiplication and A × B is a matrix of order
p × r.
E
This does not mean that we can not find B × A. B, A are not
conformable for multiplication unless the number of columns
in B is the same as the number of rows in A.
The following results may be noted:
Associative law (AB)C = A(BC)
Distributive law A(B+C) = AB+AC, (B+C)A = BA+CA

UP
Scalar product k(AB = (kA) B =A (kB)
In general AB  BA
Sometimes AB exists and BA may not be defined.
Example:
2 1
 3 2 4  
 1 0 1   4 2
  
3 0 
 3  2  2  4  4  3 3( 1)  2( 2)  4  0 
 
 1  2  0  4  1  3 1( 1)  0( 2)  1  0
26 7 
 1 1  This is a 2  2 matrix
 
Some Types of Matrices
Zero or Null Matrix

)
A matrix, with every element zero, is called a null matrix. It

need not be square. In matrix theory it plays the role of zero.
0 0 0 
(c
02  3   is a 2  3 null matrix
0 0 0 
S
Diagonal Matrix
A square matrix all of whose elements are zero except those
in the leading diagonal is called a diagonal matrix.
d1 0 0
D   0 d2 0 
is a 3 × 3 diagonal matrix.
 0 0 d3 
E
Example:
 g1 0 0
0 g2 0 
If G = 
 0 0 g3 
then
d1 g1
 0
DG = GD = 
UP 0
d2 g2
0 
0 
 0 0 d3 g3 
Note that DG is also a diagonal matrix, its diagonal elements

being the products of the corresponding elements of the given
matrices. The multiplication of diagonal matrices is
commutative.
Upper and Lower Triangular Matrices

A square matrix all of whose elements below the main
diagonal are zero is called upper triangular. If all elements
above the main diagonal are zero it is lower triangular.
a11 a12 a13   a11 0 0 

0 a22 a23  and a21
 a22 0 

 0 0 a33   a31 a32 a33 
)
are upper and lower triangular matrices respectively.
The Identity Matrix

If in the diagonal matrix D, each diagonal element = k, it is
(c
called a scalar matrix. An identity matrix has 1 for every

diagonal element and zero elsewhere.
S
1 0 0
I 3 0 1 0
is an identity matrix of order 3. The identity
0 0 1 
matrix plays the role of the number 1.
The Transpose of a Matrix

If we interchange the rows and columns of an m × n matrix
E
A, we get an n × m matrix A’ which is called the transpose of
A.
If Amn = (aij) the A’nm = [a ji]
Example:
 a11 a12 
 a11 a12 a13 
UP
If A a
 21 a22 a23 
then A    a12
a13
a22 
a23 
 x1 
x 
Example: The transpose of a column vector x =  2 
 x 3 
is the row vector x’ = [x1 x2 x3]
Note the following results:
The transpose of the transpose of matrix is the original

matrix. Thus (A’) = A
If k is a scalar (kA) = k A
The transpose of a sum: (A+B) = A+ B
The transpose of a product: (AB) = B A
Symmetric Matrices
)
A square matrix A such that A = A is a symmetric matrix.
A square matrice A such that A = -A is skew symmetric. Its

leading diagonal has all zeros.
(c
r11 r12 r13 

5 a  
a 5  r12 r22 r23 
   are symmetric matrices.
r13 r23 r33 
S
 0 1 2
 1 0 3
  is skew symmetric.
 2 3 0
Note that if A is a square matrix then, (i) A+ A is symmetric

(ii) A- A is skew symmetric, (iii) The square matrix A is the
A  A'
sum of the symmetric matrix 2
and the skew symmetric
E
A  A'
matrix 2
. These results can be easily proved.
If A, B are square and AB=BA then A, B are commutative. If

AB=-BA then A, B are anti-commutative.
If A2 = A then A is called idempotent.
Determinant of a Matrix
UP
A square matrix A has a uniquely defined determinant |A|
associated with the matrix. The determinant of
A a12  a a12 
A   11 is A   11  a11 a22  a12 a21
 a21 a22  a21 a22 
The determinant of the product of two matrices is the product

of their determinants.
|AB| = |A| |B|
Singular and Non-singular Matrices

A square matrix A is (a) singular if |A| = 0
(b) non-singular if |A|  0

Example:
12 3
A  is singular because |A| =60-60=0.
20 5
)
Adjoint Matrix
The adjoint matrix of A is obtained by replacing the elements
of A by their respective co-factors and then transposing.
(c
If A=[a ij] and B=[A ij] where A ij is the co-factor of aij in A

then we have the adjoint matrix of A, written
adj A = [Aij] = [Aji]

S
Example:
 a11 a12 a13   A11 A21 A13 

If A  a21 a22 a23  adj A   A21
 A22 A32 
 a31 a32 a33   A13 A23 A33 
a a23  a a23 
Where A11   22  A12   21 , etc
a32 a33  a31 a33  , etc.
E
Linear Dependence
Let u1, u2, ……, um be m column vectors of the same order.
Let c1, c2, …cm be scalars, not all zero, such that the linear
combination c1u1 + c2u2 +….. cmum = 0, then the vectors u1, u2
…., um are said to be linearly dependent.
UP
u1, u2 ….um are said to be linearly dependent if no such scalars
are available.
Example:
are linearly dependent since 2u1 + u2 – 4u3 = 0.
Note that if u1, u2, ….., um are linearly dependent then either
u1 is linearly dependent on u2, …., um or u2, u3 …. um are
themselves linearly dependent.
In a matrix, the number of linearly independent rows is the

same as the number of linearly independent columns.
The Rank of a Matrix

)
The rank of a matrix is the maximum number of linearly

independent rows (or columns) in the matrix. The rank of a
matrix A is the order of the largest non-zero minor of |A|.
(c
The rank of a matrix is a unique number.

S
Example:
The rank of A =
 0 and this is the minor of the highest order.
E
Example:
The rank of A = is 1 since |A|=0. Each of the
second order minors is zero but every element is not zero.
Inverse of Matrix
UP
If A is a non-singular square matrix, then it has an inverse
denoted by A–1.
The product of a matrix and its inverse gives the identity

matrix.
AA-1 = 1 = A-1 A
A singular matrix does not have an inverse, a rectangular

matrix cannot have an inverse.
If A, B are square matrices of order n such that AB=In=BA,

then A and B are the multiplicative inverses of each other.
There are several procedures for computing the inverse. We

shall find the inverse by using the adjoint matrix. It can be
easily proved that
-1 1 [A ]
)
A = IAI ji
For the 2 × 2 matrix A = the co-factors of a, b, c, d are,

(c
respectively, d, -c, -b, a so that the inverse is given by

S
For the 3 × 3 matrix.
A= [aij] we have the matrix of co-factors.
E
[Aij]=
whose transpose is
UP
[Aji]
-1 1 [A ]
The inverse of A is, therefore, A = IAI ji
Example:
Corresponding to the matrix
A=
=
We have the matrix of co-factors:
[A ij] =
)
Since = |A| = 5 we have

(c
S
Application of Matrices of Linear Systems
A system of equations
a11 x1 + a12 x2 = b1
a21 x1 + a22 x2 = b2
can be expressed in the matrix form
E
or in the condensed form AX = B
where A is the matrix of coefficients

UP
X is the column vector of variable
B is the column vector
We may also write the equation as X ‘A’ = B’
For three equations we may use a similar notation
a11 x1 + a12 x2 + a13 x3 = b1
a21 x1 + a22 x2 + a23 x3 = b2
a31 x1 + a32 x2 + a33 x3 = b3

)
and so on.
Now if AX = B
(c
then A–1 AX = A–1B or X = A–1B since A–1 A=1
i.e., to solve the system of equations we must find A–1 and

then calculate A–1B.
S
The coefficient matrix for the system can be exemplified.
Example:
2x1 + 3x2 = 3x1 + 5x2 = 12 is given by
E
The solution is x1= 9, x2 = -3
Examples: In the system
2x1 – 4x2 + 3x3 = 3

UP
4x1 – 6x2 + 5x3 = 2
–2x1 + x2 – x2 = 1
The solution is x1 = –0.5, x 2 = –4, x 3 = –4
The above problems can also be solved by using the concept

of an augmented matrix. It amounts to reducing the
coefficient matrix to the diagonal form as shown in the
following problem, by performing suitable operations.
x1 + 6x2 – x3 = 10
2x1 + 3x2 + 3x3 = 17

)
3x1 – 3x2 – 2x3 = –9
For this system, the augmented matrix is

(c
E S
The solution is x1 = 1
–9x2 = –18 or x 2 = 2
–32x3 = –32 or x3 = 3
UP
Applications and Advantages of Matrix Algebra
The matrix notation has the merit of being compact and
precise. It is time saving and suitable for systematic
mechanical calculations.
Any accounting system can be conveniently represented in

the form of matrices. Thus, national income accounting is
done in terms of matrix notation. Linear programming also
makes a wide use of matrix methods.
Check Your Progress

Column A Column B
dy
1. Concept of techniques a. y = ax n , =nax n 1
dx
2. Set b. Physical specification

proto type of an objects
)
3. Basic role of calculus c. Used is solving

optimization problems
4. Calculus technique d. Are not mutually

exclusive
(c
5. Model e. Collection of distinct of

well defined objects.
S
Summary
Competitive games are classified according to the number
of players involved, i.e., as a two-person game, three-person
game, etc. Another important distinction is between Zero-
sum games and Non-zero sum games.
A matrix is a rectangular array of numbers, usually
E
matrix.
The matrix notation has the merit of being compact and

precise. It is time saving and suitable for systematic
mechanical calculations.
UP
Any accounting system can be conveniently represented in
the form of matrices. Thus, national income accounting is
done in terms of matrix notation. Linear programming also
makes a wide use of matrix methods.
Lesson End Activity

Make a presentation on the matrices and their application.
Keywords
Population or Universe: Any collection (usually large) of
individuals or objects is called a population or universe.
Sample: A finite subset of a population is called a sample.
Sample Size: The number of individuals in a sample is called

the sample size.
Competitive Games: Competitive games are classified

according to the number of players involved, i.e., as a two-
person game, three-person game, etc.
)
Matrix: A matrix is a rectangular array of numbers, usually

(c
matrix.
S
1. You are required to
Maximise : F = 2x + 3y
Subject to : x + y  8
2x + 3y  16
E
x  0; y  0
Identify the problem and interpret the equality and the
inequalities. Derive solutions. Figure out a business
application of your exercise.
2. Show that if the pay-off matrix for A is…….
B1 B2
A1
A2
2
-2
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Then both A and B will play their strategies with equal

probability and the value of game is Zero.
3. Two players A and B simultaneously place a rupee coin

on a table. If the coins match (i.e., both show heads or
both show tails) then A takes both coins; if they do not
match then player B takes both.
(i) What kind of game is this? Construct the pay-off

matrix for both A and B.
(ii) Calculate the probability of both coin showing heads.
4. A stock market analyst has analysed the price trends of
two stocks X and Y over a period of 30 working days.
He computed the average and the standard deviation
for both stocks as follows:
)
Stock Average Standard deviation

X $85.49 $23.88
Y $112.00 26.22
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Using the coefficient of variation calculation, check if

the dispersion around the mean for stock Y is greater
than similar dispersion for stock X.
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5. As a travelling salesman, John travels to discuss life
insurance with his clients. Since he has claim
compensation for his travel miles covered, he keeps an
accurate record, nearest to one-tenth of a mile. The
following is a sample of 30 daily observations for the
number of miles driven by John.
101.1 125.7 121.9 117.7 098.9 127.3
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105.0 098.6 119.1 120.0 109.1 97.2
127.3 119.1 115.3 099.4 089.6 90.0
130.7 125.5 127.3 095.0 102.0 102.6
119.1 119.7 097.2 120.1 129.6 130.0

UP Construct a frequency table with 6 classes and calculate:
(i) The mean;
(ii) The median;
(iii) The variance and the standard deviation;
(iv) First quartile;
(v) Inter-quartile range.
Further Readings
Books

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Web Readings
wiki.answers.com › Wiki Answers › Categories › Business &
Finance
ramton.umd.edu/econ300/econ300-syllabus.pdf
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www.mbe-du.org/
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) UP
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UNIT 8: Market Analysis
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Unit 8
Market Analysis
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Objectives
topics:
 Market Concepts and Precepts
 Tools and Techniques of Market Analysis
Market Intervention


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Business View of Forms and Structure of Markets
Market Strategies and Tactics
Introduction
A market analysis studies the attractiveness and the
dynamics of a special market within a special industry. It is
part of the industry analysis and this in turn of the global
environmental analysis. Through all of these analyses the
opportunities, strengths, weaknesses and threats of a
company can be identified. Finally, with the help of a SWOT
analysis, adequate business strategies of a company will be
defined. The market analysis is also known as a documented
investigation of a market that is used to inform a firm's
planning activities, particularly around decisions of
inventory, purchase, work force expansion/contraction,
facility expansion, purchases of capital equipment,
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promotional activities, and many other aspects of a company.
Market Concepts and Precepts

Market analysis constitutes the heart of positive micro-
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economics of partial equilibrium approach in a comparative

static framework. While analysing a market in economic
sense, we need to be clear about the nature of market – its
size, structure and systems.
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Activity (i) Market: A market is identified by the nature of
transaction units being traded in that market. In a
W rite an article on market
concepts and precepts. commodity market, consumer goods like bread (single-
use) or car (durable-use) may be bought and sold. Or,
we may think of the market for raw materials or finished
goods including both consumption goods and capital
goods, single-use or durable-use. Or we may think of a
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foreign exchange market where hard or soft currencies
are bought and sold. There are markets for euro-dollar
and petro-dollar, for gold (bullion) and silver. By
contrast, in a factor market, services are traded.
One may even think of the matrimonial market or the

market for MPs/MLAs/MLCs towards forming a
coalition government or the market for human limbs,
UP the market for cattle! All markets work on same
concepts and precepts.
(ii) Market Behaviour: This has reference to the aptitude,

attitude and approach of the market players. In
conventional economic terms ‘behaviour’ has reference
to objectives and constraints of the market players.
(iii) Market Forces: The demand-supply forces works in

opposite directions with equal strength bringing the
transactors to a bargain point wherein both together
strike a deal. In a free market situation, these forces of
demand and supply are left alone such that an
interaction between demand, supply and price takes
place and we call it ‘free market mechanism’. This
mechanism works on the interplay of the following
precepts:
 Dx
(a) Dx = D(Px)  Law of demand:  P  0
x
)
 Sx
(b) Sx = S (Px)  Law of supply:  P  0
x
 Px  Px
(c) Px = P (Dx, Sx)  Law of Market:  (D -S )  0 ;  (Sx -Dx )  0
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x x
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Figure 8.1: Competitive Model
Note: Demand is always at a price, so is supply. Demand

and price are inversely related (at a lower price in the
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market we demand more). Supply and price are directly
related, price works as an incentive for supply (at a
higher price, we supply more). The interplay of
market forces determines as Opx as the price for OQx
quantity — This in an equilibrium combination. To put
more technically, here is a determinate system of three
equations with three unknowns, D x , S x , and P x .
Therefore, the system ends up determining an
‘equilibrium price’ at which an ‘equilibrium quantity’ (at
which Dx = Sx) of X is traded and transacted. This is
illustrated as a “competitive market model” or in the
form of a “free market price mechanism” without any
institutional interference. The transactors who,
individually and/or collectively influence these market
forces are called the ‘market players’/actors whose
behaviour we have referred to earlier.
)
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Figure 8.2: Free –Market Price Mechanism

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(iv) Market Environment: It consists of all those forces and
factors operating in a market which influence the market
behaviour of the market player, but that player
individually cannot exercise any influence on the market
which is a collective institutional entity. In this sense,
the market environment is ‘external’ to the individual
business firm operating in that market. In conventional
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economic analysis, the form and structure of the market
constitutes its own environment the nature of market
environment needs to be examined in terms of number
of players, their size, efficiency and integration of
operations, degree of price discrimination, nature of
product differentiation and product diversification, the
element of free and fair competition (both price and non-
price competition), nature of sales promotion
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control and regulation of the market by the government,
the trade union, the consumers’ forum, the traders’ guild,
the manufacturers’ association, etc., – all those which
together constitute the non-market environment.
(v) Market Failure: The non-market institutions do
interfere with the free markets mechanism and
operations. But why should they do so? The argument is
that the non-market institutions, like the government are
required to interfere when the market fails to ensure
efficiency and equity. When does the market really “fail”
is a normative ethical question, but the economists have
always tried to work out the rationality behind the
intervention by the visible hand of the government, the
apex institution in a society (state). For example, the
government often exercises price control by fixing a
“ceiling price” for products or a “floor price” for services.
Whenever the free market operation has a tendency to
)
hurt either the consumers because of inflated prices or

the workers because of falling wages, the government
does introduce “fair prices” and “minimum wage
legislations”. Sometimes, the government operates on the
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quantity (rather than price) variable say, by fixing ‘quota’

of items to be distributed through the fair price shop
under the Public Distribution System. Similarly, the
government may undertake ‘buffer stock’ operations (by
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procuring grains during bumper crop and releasing the Activity
same during crop failure) to avoid wide fluctuations in
Make a draft of an assignment
market price or in farmers’ income. The idea is to operate on the tools and techniques of
on a buffer to see that the vulnerable sections of the market analysis.
society do not suffer. In the same way, to discourage the
production and consumption of ‘non-merit goods’ like
cigarettes, the government may impose taxes. The
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government may like to encourage the production and
supply of ‘merit goods’ like essential drugs through the
grant of a subsidy. The production of ‘public goods and
services’ like transport, hospital and education is often
subsidised by the government. Thus, taxes and subsidies
are used as fiscal instruments of the government to ensure
allocative efficiency and justice. Left to itself, the free
market fails to do so and that is why the government
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interferes. In fact, free market mechanism is solely
guided by commercial profit motive.
Check Your Progress

Fill in the blanks:
1. A ................ is identified by the nature of transaction
units being traded in that market.
2. ................ consists of all those forces and factors
operating in a market which influence the market
behaviour of the market player.
Tools and Techniques of Market Analysis

Market is the essence of business, it is the be-all and end-all
of all business activities. Market is governed by price or
regulated by the government through instruments like price
controls. Prices, free or controlled, operate simultaneously
with quantity-quality or volume-variety of output. Price-
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output decisions are taken for the product market just as

the price-input decisions are meant for the factor market.
Price is the expression of value of an item in terms of a
monetary unit. Price of a flat in Delhi is expressed in terms
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of Rupees; Price of an air ticket can be expressed in US

dollars and so on. Price tags on any item express the value
in-exchange in the market where exchange transactions take
place.
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As we move from the commodity market to the factor market,
we need to move from product prices to factor piece, e.g.,
rent, wages, interests and profits. Rent is the price one pays
for land or building or a machine on hire. Wage rate per hour
or per price is the price for labour; interest rate is the price
for money and finance capital; profit is accordingly a price
or compensation for entrepreneurial task, responsibility and
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venture. These are examples of factor prices, i.e., prices for
the services rendered by the factors of production.
The impact of a change (some increase) in demand on price

and output in the market can now be shown (Figure 8.3).
Note that in the temporary run, an increase in demand leads

to price increase, without output adjustment. In short run,
the increase in demand raises price and output both. Such a
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‘ f u n c t i o n a l ’ p
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beyond which there
r i c e - r
is inflationary price-rise without any output adjustment

i s
following an increase in demand. In the long run, an increase

e c o n t i n u e s u p t o O P
in demand leads to increased output at reduced price.

)
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Figure 8.3: Shifts in Demand Curves

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Market Intervention Activity
Earlier we have mentioned that governmental intervention W rite an essay on market

intervention.
in the free market operation becomes necessary whenever
there is “market failure”. Market may fail due to a number
of reasons.
First, there may be large scale economies of scale, as a result
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of which the long run firm may enjoy cost advantages internal
to the firm.
Second, the allocative efficiency may also be handicapped

because of presence of externalities. The free market price
mechanism, left to itself, may not ensure perfection because
price often takes care of private costs rather than social costs.
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Third, prices and profits together do not always guarantee
the production of public goods and services like hospitals,
parks, roads and bridges, public transport, etc., because such
production involves huge investment and high overhead
costs; private investors do not venture to undertake such
projects involving high risk and less return.
We may specifically refer to fiscal intervention by way of

(a) imposition of taxes (b) grant of subsidies (transfer).
Business View of Forms and Structure of Markets

When we look around the real world of business situation,
we find, there is a variety of markets.
Pure and Impure Market

Markets are often classified in terms of the nature of
competition and collaboration they facilitate. In economic
analysis, if the element of competition is “pure” then the
market is designated as a pure market. On the other hand,
)
if the element of competition is “impure”, then the market is

designated as “impure market”.
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The purity of competition in a market depends on a number
of cardinal factors, such as the number of transactors in the
market, the nature of items (goods or services) transacted
in the market and the freedom of movement (entry or exit)
enjoyed by the transactor in a market.
Perfect and Imperfect Market
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If the conditions of the pure competition are satisfied along
with some other “perfections” such as availability of perfect
knowledge (i.e., no information cost), perfect mobility of
inputs and outputs facilitating production for sale, perfect
divisibility of items traded and transacted, or any other
related perfection in a layman’s sense are satisfied then the
market under reference is designated as a “perfect market”.
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By contrast, if the elements of impure competition are
enhanced or extended by elements of imperfection, then the
market under reference is designated as “imperfect market”.
There are varieties of imperfect market. Monopoly is an

extreme variety where one seller rules the market. Duopoly
or oligopoly is another variety where two or few sellers,
either in the isolation, ignoring interdependence or in any
combination (joining hands) may rule the market.
The actual nature of the market has to be analysed

empirically. For example, when we look at the range of
products produced by the Hindustan Lever, we may find that
there is an element of competition within the company itself
among different product lines. Each product line may be
competing with the other product line because each is
supposed to work as a “profit centre”.
Depending upon the degree of monopoly or competition, the

firm has to read its own market power – the firm may be a
)
price taker; the firm may be a price maker – price leader or

price follower or price discriminator.
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Figure 8.4: Price Taker or Price Maker
Product Market and Factor Market

Irrespective of the fact whether the market is pure or
impure, perfect or imperfect, there are variety of forces
operating in a market depending upon whether in that
market, goods are being transacted or services are being
transacted. Goods may differ in details such as single use
consumer goods or consumer durables or producer durables
(capital goods single use producer goods e.g., industrial raw
materials or durable use machineries and parts) and so on.
The demand supply forces operate with full force in such
markets, but the relative push and/or pull of these factors
depends on the nature of goods traded and transacted. For
example, if the commodity is perishable, then the supply
compulsions and storage inadequacies may dictate the price.
To liquidate the inventory position and to activate the
production line in their factories, the producers
manufacturing consumer durables may enter into cut-throat
)
competition in the market which may reduce price to the

advantage of the buyers. Sometimes, the buy-back
arrangement is an element of such competition in the market.
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The market for service is primarily demand determined. For

example, if there is demand for technical/financial or
managerial consultancy service then there will be a growing
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market for the consultancy. Higher the demand for quality
service (say, in hospitals or hotels or educational institutes)
higher will be the price charged for making such services
available. There are customers who would like to pay higher
price for a quality service rather than getting a price discount
on a big quantity of service purchased.
Coming to the market for services or what is conventionally
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referred by the economists a “factor market”, the
businessman confront sometimes standardised and
organised markets or sometimes unorganised and
heterogeneous market. Such description is often applied to
labour market or the capital market or the real estate market.
In each of these markets, there are different factors and
forces operating. For example, the real estate market
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normally dictated by the property dealers may crash when
the direct tax authorities conduct raid on unauthorised
construction and assets of conspicuous consumption such as
farm houses. In the same way, the market for unskilled
labour may be dictated by the whims and fancies of the
contract buyer, whereas the market for skilled professionals
such as computer programmer may be dictated by the
suppliers of such services, depending upon the shortage
faced in the market. In the same way, we may look at money
market and capital market – money market dealing in short-
term transaction and capital market dealing in long-term
transaction of funds. The unorganised money lenders may
charge a very high rate of interest from the needy farmers
because these money lenders without being subject to
government controls and regulations, are only answering the
distress call by the firms. The organised money and capital
market including the commercial banks and the non-banking
financial intermediaries may be under control of central bank
or central government so that they may not be in a position
)
to charge indiscriminately high rate of interest.
Buyers Market and Sellers Market

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From the standpoint of market power either the buyer or

the seller or both of them together can exercise control over
the market. In today’s world, every customer is treated as a
king. For some countries, the consumer movement is still in
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its infancy; the customer is only walking towards the throne Activity
and he has not yet assumed the character, power, position
Make a presentation on market
and status of the king. As consumerism is gaining ground, strategies and tactics.
the market has to produce tailor-made goods to the
satisfaction of the customers. In other words, today the
buyer’s market dictates are so commanding that there is a
shift from ‘mass-production’ to ‘customised production’. The
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customer has become very demanding and quality-conscious
and as a result, the customer’s care and satisfaction lies at
the root of any business. If the customers continue to assert
their rights and sometimes they are statutorily protected
through arms of the Consumer Protection Act or through
any other enactments like Monopolies and Restricted Trade
Practices Act, then there is no escape from customer-oriented
production, sale and service.
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Wholesale Market and Retail Market
This distinction is more relevant from the standpoint of
traders. Depending upon the distribution channels and
systems underlying that, this distinction is an operational
arrangement of movement of goods. Normally in the
wholesale market it is a large scale deal but in the retail
market there is small scale deal. We therefore find that the
prices are higher in the retail market than in the wholesale
market.
Home Market and Foreign Market

Sometimes extending the same line of reasoning, one can
classify markets in various segments. From the standpoint
of market segment, we can talk about local, regional, national
and international markets. Sometimes we draw a line of
contrast between Home Market and Foreign Market or
Internal (Domestic) Market and External (Export) Market.
)
Selling foreign goods at a lower price abroad is often referred

as dumping which is essentially the practice of
discriminatory price policy. Depending upon the monopoly
power, the seller can follow a policy of price discrimination
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and keep the market under control by dividing it artificially

and stopping any seepage between the markets.
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Then each domestic and foreign market segments may be
classified or created on the basis of a number of factors such
as the number of buyers, size of their income, their age, sex,
location specific tastes and preferences, etc. Maintaining a
complete customer’s profile is an important task for
promoting business.
Market and Growth
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The size of market determines the growth and diversification
of a firm. Growing demand for variety of products and
services often induces the firm to diversify into new and
newer areas. In fact, growing markets indicate the
profitability of investment. Profits guide investment decision.
Inducement to invest is limited by the size of market. If a
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market is growing then it creates a lot of opportunities for
further investment, inducing and facilitating further
production. Thus, a growing market generates what
economists call “some sort of external economies” so that
simultaneous investment in complimentary projects are
facilitated as one market supports the other market.
Check Your Progress

Fill in the blanks:
1. ............... is the expression of value of an item in

terms of a monetary unit.
2. ............... is a situation where one seller rules the

market of many buyers.
3. ............... is a market where two sellers rule the

market in isolation, ignoring interdependence.
Market Strategies and Tactics

)
The competitive strategy designed by the firm and tactical

operations in view of the design work depends on the nature
of competitive environment. It is very difficult to find a
market where identical products, standardised and
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homogeneous, are produced and sold in such a way that no

firm enjoys any special and specific cost advantage. It is also
difficult to think of a market where transport and distribution
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costs, information costs and other costs of sale remain
identical for all firms such that costs do not distort
competition.
Price-making strategy, typical of a monopoly firm may take

different forms and variety. For example, in an oligopoly
market, the firm may provide different types of price
leadership.
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1. Dominant Price Leadership: A large firm because of
dominant position in the market may act as a price
leader and small firms may act as price followers.
2. Collusive Price Leadership: In an oligopoly market

several firms may feel that strength in unity and
accordingly, may combine together as a cartel and
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collude on price. Such collusion may be explicit and
tacit.
3. Barometric Price Leadership: In some markets, one

‘barometer’ firm (which is not necessarily a dominant
firm) best assesses changes in demand and supply
conditions; other firms may then follow such price
changes. Barometer firm itself may well change over
time.
Price discrimination as a policy may constitute another

strategic design. Because of its monopoly power, a monopoly
firm enjoying absolute and related power may like to price
its homogeneous and standardised product (goods or service)
differently depending upon the nature of market. Economists
often talk about different degrees of price discrimination.
1. First Degree Discrimination: A seller may be in a

position to charge N-prices from N-different buyers such
that not a single buyer is left with any amount of
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consumer’s surplus.
2. Second Degree Discrimination: A seller may be in a

position to charge block rates for different blocks to his
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customers. For example, there may be one rate for

printing 100 invitation cards and another rate for
printing more than 100 invitation cards. The choice is
left to the customer to decide which block he would like
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to belong to. Or, the municipal authorities may charge
two different rates for electricity/power consumption–
residential rate and commercial/industrial rate.
3. Third Degree Discrimination: A seller, because of his

monopoly power, may not allow buyer’s choice and
preference to decide on the block/segment/user’s
category. A seller may dictate the choice on his own. A
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doctor, for example, may quote a very high fee for one
patient by way of his consultancy charges, whereas he
may provide the same service absolutely ‘free’ to another
patient at his own discretion. In this case, different
buyers may enjoy different quantum of consumer surplus
depending upon the seller’s policy and practice of
discretion.
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It has been observed that Fast Moving Consumers Good
(FMCG) are often successfully launched and/or repositioned
in the market during the period of industrial recession. Many
times this is referred as “Boom in the time of Gloom”. It is
interesting to analyse why FMCG companies follow such a
product strategy and tactics to get best out of the market
when the market is depressed because of recessionary
tendencies in the economy. For example, Hindustan Lever
Limited (HLL) have launched, on an average, two products
per month in the FMCG category during 1997 in the Indian
market when the Indian economy was facing recession.
During the same recessionary year in India, Dabur Food
launched as many as 27 products in the FMCG category.
Similar examples can be multiplied. The question may arise
why and how does launching products during a slump make
sense? There can be a variety of reasons:-
1. Stimulating Demand: When sales are sluggish, the

FMCG companies provoke consumers by launching new
)
products and keeping excitement level up.
2. Leveraging Structures: Many FMCG companies have

their distribution system and people in place; so new
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launches and extensions do not require their capital

investment, i.e., economies of scope can be exploited.
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3. Optimising Capacity Used: FMCG companies with
large scale production capacities needs to keep
manufacturing levels high so that fixed costs do not eat
into profitability, i.e., economies of scale are reaped.
4. Continuous Consumption: FMCG sector is a resilient

one. Consumers do not suddenly stop buying soaps and
detergent or personal products or health care products
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or packaged foods.
5. Feel-Good Purchases: In economic slump, consumer

psychology moves in different directions. When things
are bad and depressing consumers often like to give
themselves a treat and get a kick.
6. Blocking Tactics: With some potential entrants

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deciding to wait for the slump to get over the existing
players seize the opportunity to preempt them by
launching fast.
7. More for Less: With advertising down, media budget

gets a better share of ‘voice’ and ads face less clutter.
For many marketers this is a good rational for new
launches.
8. Value for Money Opportunities: A slump is a good

time to launch value for money brands. With money tight
the consumers are receptive to reasonably priced new
products.
The episode of “Boom in time of Gloom” narrated above brings

out one fact clearly and categorically that everyone wants to
make profit; every one–producer, buyer, distributor,
advertiser – one and all wants to get a better deal and a
better pay off. Thus, profit continues to be a strategic
consideration in everybody’s mind.
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Profit Maximisation
Profit maximisation is assumed as a strategy in all through
traditional economic analysis and, in that context pricing,
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product variation or differentiation, advertising, costing,

quality control, discounting facilities, deferred payment
facilities, etc., are all treated as tactical and practical
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operations towards achieving profit maximisation strategies.
As we have observed, profit need not always be a “goal
variable” but it may be a constraining “target variable”.
Satisfying profit as a constraint in the context of mark-up
pricing or full-cost pricing or cost-plus-pricing is now
observed as a universal phenomenon. In reality, profit may
remain as a long run ‘goal variable’ or it may even become an
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‘instrumental variable’ in the short run. For example, a firm
which wants to grow in near future and would not like to
depend on external funds, may like to generate its own
internal resources through reserves and surpluses created
by way of accumulating net retained earning (profit). Profits,
year after year if properly kept as reserves and surpluses
can finance expansion programme of the firm. In other words,
profit is the instrument of generating internal funds.
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According to Porter, there are general strategies for gaining
competitive advantage:
1. Lowest Cost Producer: A firm can aim to be the least

or lowest cost producer, thereby under-pricing the
competition. It is important that the buyers do not read
this low price as ‘cheap and nasty products’. Low price
is a good penetration strategy but it should be coupled
with the tight-belt-of-quality strategy.
2. Product Differentiation: Firm can develop

differentiated products through innovation and
marketing and charge premium prices. Such a policy of
high skimming prices may lead to a ‘focus strategy’ (i.e.,
focusing on particular or broad areas or markets). ‘Niche
Market’ is a concept of focus strategy. A firm which is
neither the lowest cost producer nor the producer of
differentiated products lacks ‘competitive advantage’.
Such firms “stuck in the middle”, do fail in competitive
)
markets.
Porter argues that there are four broad attributes of nations

which determine success. These are illustrated in the
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diagram below which is often referred as Porter’s “Diamond”.

This Diamond shapes the environment faced by the firms
and either promotes or impedes the creation of competitive
advantage. The four attributes are as follows:
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1. The quantity and quality of factors of production, e.g.,
(skilled labour force and infrastructure).
2. The nature of demand for products (specially demand

for high quality goods).
3. The existence of related and supporting industries which

are internationally competitive.
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4. Firm’s strategy, structure and rivalry.
While all four attributes in “Diamond” are important, the

last one is of most interest. Porter believes that tough
domestic rivalry breeds international success. In the days of
globalisation, a firm may produce through global sourcing
and market its product through global network and therefore
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as a matter of strategy a domestic firm may act locally but
think globally.
Source: M. Porter (1990)
Figure 8.5: Porter’s Diamond
Check Your Progress

Column A Column B
1. Price a. Expressive of value in
)
terms of monetary unit

2. Rent b. Land building
machines etc.
3. Basic role of calculus c. Price for money and
finance capital
(c
4. Calculus technique d. Price/compensation for

entrepreneurial task
5. Model e. Price for labour
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Summary
A market is identified by the nature of transaction units being
traded in that market. In a commodity market, consumer
goods like bread (single-use) or car (durable-use) may be
bought and sold. Or, we may think of the market for raw
materials or finished goods including both consumption
goods and capital goods, single-use or durable-use. Or we
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may think of a foreign exchange market where hard or soft
currencies are bought and sold. Market analysis constitutes
the heart of positive micro-economics of partial equilibrium
approach in a comparative static framework.
Market Environment consists of all those forces and factors
operating in a market which influence the market behaviour
of the market player, but that player individually cannot
UP
exercise any influence on the market which is a collective
institutional entity.
Profit maximisation is assumed as a strategy in all through
traditional economic analysis and, in that context pricing,
product variation or differentiation, advertising, costing,
quality control, discounting facilities, deferred payment
facilities, etc., are all treated as tactical and practical
operations towards achieving profit maximisation strategies.
Lesson End Activity

Concentrate on a few items of your daily consumption.
Observe and analyse the market behaviour of those items
during last one month/year with reference to (a) wholesale
and (b) retail markets. Find out why do prices vary between
these two markets? How do you measure such price
variations?
Keywords
)
Dominant Price Leadership: A large firm because of

dominant position in the market may act as a price leader
and small firms may act as price followers.
(c
Collusive Price Leadership: In an oligopoly market several

firms may feel that strength in unity and accordingly, may
combine together as a cartel and collude on price. Such
collusion may be explicit and tacit.
S
Barometric Price Leadership: In some markets, one
‘barometer’ firm (which is not necessarily a dominant firm)
best assesses changes in demand and supply conditions; other
firms may then follow such price changes. Barometer firm
itself may well change over time.
Price Discrimination: Price discrimination as a policy may

constitute another strategic design. Economists often talk
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about different degrees of price discrimination.
First Degree Discrimination: A seller may be in a position

to charge N-prices from N-different buyers such that not a
single buyer is left with any amount of consumer’s surplus.
Second Degree Discrimination: A seller may be in a

position to charge block rates for different blocks to his
customers.
UP
Third Degree Discrimination: A seller, because of his
monopoly power, may not allow buyer’s choice and preference
to decide on the block/segment/user’s category. A seller may
dictate the choice on his own.

1. Think of Matrimonial Markets in India with reference
to various communities and give an economic
interpretation of the term “Dowry”, identifying the
market forces at work.
2. What do you understand by the phrase “Stock Market

Crash”? Quote some examples of such crash. [You may
like to recall Black Monday (Oct. 1987) and Black
Thursday (Oct. 1997)]. Find out what happened and how
it happened?
3. You must have observed the operation of a Co-operative

)
Group Housing Society. What kind of market does such

society confront as (a) buyer and (b) seller? Note that
such societies buy building materials and give different
(c
benefits to its members.

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4. Make a list of:
(i) Public goods
(ii) Private goods
(iii) Merit goods
(iv) Non-merit goods
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(v) White goods
(vi) Public utilities
(vii) Essential services
In the light of the items you have listed, distinguish

between (a) ‘Good Marketing’ and ‘Services Marketing’
UP (b) Free and Regulated Markets. You may note that
Market may refer to a transaction in a place, but in
marketing, you have to consider several Ps: Price
Product, Package Promotion, People, etc.
5. Consider agro-based industrial raw materials (e.g., raw

cotton for cotton textile industry). Identify the range of
market and non-market forces which affect their price.
6. Recall your understanding of the following, quoting real

world business examples: Spot Market, Forward
Market, Bond Market, Money Market, Capital Market,
Market for the MBAs. Have you ever observed/
experienced the physical operation of such markets?
7. What do you understand by the expression, “Price of a

Rupee”? Where and how is this price determined?
Collect time series data on this price of Indian Rupee.
Mention the source of your data. Plot it in a diagram.
Analyse the trend.
)
8. Quote some business examples/ experiences of ‘Market

Failure’. In each case, critically review the action/
inaction of the Government or any other regulatory
authority.
(c
Arrange a debate on the subject:
“Market Failure vs Government Failure” in India Today

S
9. Let us take a macro view of market. It is observed that
many countries are increasingly becoming market
economies. How would you account for this emerging
trend? Does this reflect a tendency towards business
upswing?
It is also observed that some of the market economies,

characterised by accelerated economic growth, have met
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with sudden collapse (Boom Burst!). How would you
account for this?
10. In layman’s language, the terms “price” and “cost” are

often used interchangeably. Are these terms
synonymous? Or, is there any difference? Think about
the ‘rent’ for building or ‘rental’ for machines on hire;
do they represent price or costs or none or both?
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Explain, with reference to their market implications.
11. Attempt a brief summary of Porter’s model. Do you know

that Porter himself was hired by Indian Industry
Association to examine the applicability of his model to
India and his finding have been criticised by many
others? Find out the details of this, contacting library
materials available anywhere.
Frame your opinion on the issue:
Competitive Advantage – from Market to Nations.
12. Write a critical essay on:
(i) Government Monopoly in India
(ii) The case of Public Enterprises
Further Readings
)
Books

(c

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Web Readings
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www.mbe-du.org/
UP
)
(c
UNIT 9: Consumption and Demand Analysis
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Unit 9
Consumption and Demand
Analysis
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Objectives
topics:
 Concepts and Determinants of Demand
 Classifications of Products

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Concepts of Elasticity and Demand Forecasting
Introduction
The market for a firm’s product cannot be analysed without
reference to the demand conditions. For a firm or an industry
consisting of several firms, the extent of demand determines
the size of market. Successful business firms, therefore, spend
considerable time, energy and effort in analysing the demand
for their products. Without a clear understanding of
consumers’ behaviour and a clear knowledge of the market
demand conditions, the firm is handicapped in its attempt
towards profit planning or any other business strategy
planning. For example, estimating present demand and
forecasting future demand constitutes the first step towards
measuring and determining the flow of sales revenue and
profits which generate internal resources to finance
business. The stability and growth of business is linked to
size and structure of demand.
)
Concepts of Demand
Economists use the term ‘demand’ to connote
(c
(a) desire to have possession, and
(b) willingness to pay for that possession

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Activity Demand is thus reflected in terms of the amount the
consumers are willing to buy at a given price over a given
concept and determinants of period of time. Demand, in the economist’s sense, does not
demand. mean the wants, desire or need of people since these may
not be backed up by the ability to pay.
At any given time and for any goods or services, it is possible

to perceive a consumer’s demand curve which relates the
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amount a consumer is willing to buy to each conceivable price
for the product.
An aggregate of individual demand curves yield a market


demand curve. To derive the market demand curve  Di
i1
we sum up individual demand curves, d1 …dn of consumers
UP horizontally, as illustrated below, where i = 1 & 2. The
negative slope of these normal demand curves suggests an
inverse relationship between price and quantity demanded.
Note: OQA + QQE = OQ(A&E)
Figure 9.1: Adam and Eve’s Demand
Determinants of Demand
)
Demand as defined by the economists depends on a number

of factors like price, income, market environment, etc. These
factors which determine or induce demand are referred as
(c
explanatory variables.
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The most crucial determinant of demand for an item is its
own price. Demand for x is determined by the price of x, [Px]
other factors being given (ceteris paribus). A household
consumer, with given income and tastes, buys more at a lower
price and less at a higher price. This relationship constitutes
the core of Law of Demand.
dDx
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Dx = D(Px)  dPy < 0
Given other factors, the demand for x may be influenced by

the price of y[Py] which happens to be the substitute for x.
As y becomes relatively cheaper, more will be the demand
for y and hence less will be the demand for x.
dDx
Dx = D(Py)  dPy > 0
UP
In the same way, the demand for x is affected by the price of
its complementary item like z [Pz]. Here x and z are jointly
demanded. Thus, at lower price of z, more z (and x) may be
demanded, ceteris paribus.
dDx
Dx = D(Pz)  dPz < 0
Income, particularly disposable income (after tax) is another

crucial determinant of demand. Income is the purchasing
power of the buyer as it indicates the budget position [B]
very often. Income constitutes the constraining factor. If
income is flexible and variable, then at higher income, the
buyers demand more and at lower income, the buyer demands
less. This is true for all ‘normal goods’. Sometimes, this may
not hold true for exceptional cases. Thus, after things
remaining equal,
dD 
Dx = D(B)  dBx  0
)
Another factor which influence a buyer’s behaviour and

consumer’s demand is advertising expenditure [A]
undertaken as a sales promotion activity by the firms.
(c
Advertisement may be a positive impact on sales up to a

S
point, but not beyond. One firm’s advertisement may kill
another firm’s demand. Thus, given other factor,
dD 
Dx = D(A)  dAx  0
Sometimes, price/income expectation [E] also affect demand.

A price-rise may be taken as a prelude to a further rise in
prices and therefore, some buyers may decide to purchase
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more (rather than less) at a higher price. In the same way,
the expectation that pay is going to be hiked following pay
commission’s report and recommendation, may induce some
buyers to buy some consumer durables. Of course, the role
of expectation factor itself depends a lot on the psychology
of the buyer, which is always not accurately predictable.
Thus,
UP
D = D (E)  dD
dE

 0
Additionally, there are other factors like cost and availability

of credit [C], size of population [P n ], family needs (F);
neighbours demonstration/community compulsions (N),
tastes and preferences (T) etc., that also affect demand
significantly. Some of these factors are “exogenous” –
environmental factors; some of them work as “stochastic
variables” subject to erratic behaviour. Nevertheless, these
are important to take note of.
Thus, we can now state a generalised demand function:
Dx = D (Px, Py, Pz, B, A, E, F, C, P n, N, T)
If we relate Dx to Px, we get the conventional demand curve

stating own-price effect on demand, other things remaining
equal. A demand curve is thus a single variable demand
function. The own price effect is shown in terms of ‘movement
)
along the demand curve’, i.e., either “extension” due to a fall

in price OR “contraction” due to a rise in price. When we
consider the multivariate function and allow for a change in
factors other than own price, there will be a shift in the
(c
demand curve (either to the left showing a “decrease” in

demand or to the right showing an “increase” in demand).
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Check Your Progress Activity
Make a slide show on the
Fill in the blanks: classification of products.
1. Factors like price, income, market environment

etc, which determine or induce demand are
referred as .............. .
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2. .............. is the purchasing power of the buyer as it
indicates the budget position very often.
Classifications of Products
The term product includes goods and services.
(i) Normal Products: Goods and services may be classified

as ‘normal products’ if the quantity demanded rises as
UP
incomes rise and falls as incomes fall.
(ii) Inferior Products: Certain products are classified as

‘inferior’ because the demand for them falls as incomes
rise (and vice versa).
(iii) Giffen Products: A special case of the inferior product

arises when as price rises, more of the good in question
is bought – resulting in an upward sloping demand
curve, contrary to the normal law of demand. Such
products are classified as Giffen products, named after
a nineteenth-century English economist who studied the
response to changes in the price of potatoes in Ireland.
(iv) Veblen Products: It has also been suggested that

‘luxury type’ products also display perverse price
demand relationship, though for different reasons to
that of the Giffen products case. These are sometimes
referred to as Veblen products, after the American
economist, Thorstein Veblen (1857-1929), who explored
)
the phenomenon.
(v) Basic Necessities (Products): By contrast to the

Veblen products, there are products which enter the
(c
consumption basket of all income class, high or low.

Theses products which are provided at subsidised rate
to the people below poverty line, as a part of minimum
need programme of a welfare state, may not be very
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Activity responsive to price –income factors in a free market. It
is observed by the traditional Engel’s Law of
concepts of elasticity. Consumption that as income goes up, the percentage of
total expenditure on food may go down, though absolute
expenditure may continue to increase.
(vi) Miscellaneous Products: Public goods and services

including public utilities like electricity, drinking water,
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education, security, health and hygiene related useful
goods, public transport and parks are often provided
for “mass-consumption” at a subsidised rate by the
Welfare Government. In case, the same goods and
services are provided as “private goods” e.g., private
security arrangement, the price-income factors become
active determinant of “class-consumption”, even other
UP effects may work very strong.
Concepts of Elasticity
Demand is affected by many factors, we can calculate
elasticity (i.e., responsiveness of quantity demanded) with
respect to a wide range of variables other than price, notably
the price of other goods and income. Thus, we can define the
following.
(i) Price elasticity of demand: This measures the

responsiveness of quantity demanded of a product to
changes in its ‘own price’. For example, if the price of
alcohol increases, what happens to the quantity of
alcohol demanded?
(ii) Cross-price elasticity of demand: This measures the

responsiveness of quantity demanded to changes in the
prices of other goods (both complements and
substitutes).
)
For example, if the price one brand of coffee rises, what

happens to the demand for another coffee brand? Or, if
the price of petrol falls, what happens to the demand
for cars?
(c
(iii) Income elasticity of demand: This measures the

responsiveness of demand to a change in the real income
S
of consumers. For example, if real incomes are rising,
on average, by ` 500 per month, what will happen to the
demand for housing?
In general terms, a coefficient of elasticity can be calculated

for each of the above categories using the following general
formula:
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Percentage change in quantity demanded
Coefficient of elasticity 
Percentage change in the relevant var iable
We will now examine each of the these three elasticity

concepts in more detail, followed by a few other relevant for
operational business decision.
Price Elasticity of Demand

UP
Based on the general formula, the (own) price elasticity of
demand for a product may be defined as:
Percentage change in quantity demanded %Dx

Ed 
Percentage change in the price of the product
%Px
Cross Price Elasticity of Demand

Cross price elasticity of demand (sometimes simply referred
to as ‘cross-elasticity’) indicates the responsiveness of the
demand for one product to changes in the prices of other
goods or services. The concept has most relevance whether
there are obvious substitutes or complementary commodities
and it is, therefore, of key important of businesses which
face major competition or whose sales vary directly with the
sales of other goods, e.g., mortgages and mortgage protection
insurance.
If A is the goods or service we are interested in and B is the

other product whose price is altering, we can calculate the
)
value of the cross-price elasticity of demand for A with

respect to B as:
Percentage change in the quantity of A demanded %Dx

(c
Cross Price Ed  Percentage change in the price of B 

%Py
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Income Elasticity of Demand
As noted earlier, demand is also likely to be responsiveness
to factors other than ‘own price’ or the price of complements
and substitutes. One important factor is real income (i.e.,
nominal income adjusted for inflation). Empirical studies
usually define nominal income in terms of either household
disposable income (i.e., household income after income tax
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and other direct taxes, plus welfare state payments have been
incorporated) or gross national income. Income elasticity of
demand is defined as:
Percentage change in quantity demanded %Dx

Income Ed  
Percentage change in real income
%B
Elasticity of Price Expectation

UP
The change in observed present price may induce a change
in expected future price. This responsiveness is measured
as,
Percentage change in expected price in future %Pt1
Epe  
Percentage change in observed price at present
%P
This concept and measure is very useful in analysing the

share market behaviour.
Promotional Elasticity
Advertisement expenditure promotes sales, because it
creates new demand. This responsiveness of sales to
advertisement is measured as
Percentage change in sales revenue %Rx

EA  
Percentage change in advertisement expenditure
% x
Check Your Progress

)
Fill in the Blanks:

1. ................ indicates the responsiveness of the
demand for one product to changes in the prices of
(c
other goods or services.

2. ................ measures the responsiveness of demand
to a change in the real income of consumers.
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The Relationship between Price Elasticity and Activity
Sales Revenue Write a summarised report on
the relationship between price
In addition to income elasticity, a firm’s fortunes will also elasticity and sales revenue.
be affected by price elasticity as demand and hence the firm’s
revenue changes as a result of price changes. The total
receipts or total revenue (TR) earned by a business from sales
is calculated by multiplying the total output sold (Q) by the
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average unit price (P), i.e., TR = P × Q. The resulting value
of total revenue is illustrated by the shaded area in
figure 9.2 with price at P1 and quantity demanded equal to
Q1. Where there is unit elasticity of demand, as the price is
varied the total revenue earned from sales remains
unchanged. For example, a 1% fall in price will bring about a
1% rise in sales, leaving total revenue unaltered. However,
UP
as we indicated earlier, unit elasticity is an extreme case
and unlikely to be found over more than modest stretches of
a demand curve. It will usually be the case that the value of
elasticity will vary along the demand curve, as shown earlier.
As price changes by a certain proportion, the quantity
demanded usually changes by a greater or lesser proportion.
In general, we can derive the following rules:
(i) With a price inelastic demand:
(a) an increase in price causes a reduction in quantity

demanded, but total revenue increases;
(b) a fall in price causes an increase in quantity

demanded, but total revenue earned declines.
(ii) With a price elastic demand:
(a) an increase in price causes such a large fall in sales

that total revenue falls;
)
(b) a reduction in price causes such a large increase in

the quantity demanded that the total revenue rises.
Hence, it is clear that accurate estimates of price elasticity

(c
are vital to business decision making. Putting this another

way, ignorance of the market response to price changes is
likely to be a recipe for disaster!
S
The link between total revenue and price elasticity results
from the fact that, faced with a downward sloping demand
curve for a product, management must lower price if they
want to sell more (other factors held constant). But if extra
sales compensate for the lower unit price then total revenue
will not decline. Similarly, management might raise the price
of a product to raise revenues, but the resulting collapse of
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demand may actually cause total revenue to contract. In
other words, the precise responsiveness of demand to a price
change determines the effect of a price change on revenue
received.
UP
)
Figure 9.2: Degrees of Elasticity of Demand
At this stage, let us recount a few revenue concepts:

(c
(i) Total Revenue
TR = P.Q
S
Total volume of production and sales, Q at a given
market price, P, determines the flow of sales revenue.
(ii) Average Revenue
P.Q
AR  TR P
Q Q
P is the revenue per unit of output Q. Similarly, Q may
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be treated as sales revenue per unit of price, i.e.
P.Q
AR  TR
P P P
(iii) Marginal Revenue
R
MR  TR
Q or where R  RQ 
Q
UP
MR is the incremental revenue of an output change by
single unit. MR is defined as the change in total revenue
as a firm sells more or one less unit of its output.
Figure 9.2 shows the relationship between elasticity, total

revenue, marginal revenue (MR) and the demand curve (D).
The demand curve is also the average revenue (AR) curve
because it shows the price at which each unit is sold. Provided
that when units are sold and they are all sold at the same
price, price and average revenue must be identical.
The key points to note are as follows:
 The marginal revenue curve declines at twice the rate

of the demand (average revenue) curve. Hence, the
marginal revenue curve cuts the horizontal axis at a
point midway between the origin and point e in the
figure 9.2. A proof of this mathematical relationship is
given at the end of the unit.
)
 When total revenue is increasing, marginal revenue is

positive. This results from the fact that demand is elastic
between points A and B on the demand curve DD in
figure 9.2.
(c
 When total revenue is falling, marginal revenue is

negative. A negative marginal revenue value means that
demand is inelastic between point B and e in figure 9.3.
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Marginal revenue is concerned with changes in total revenue
resulting from small changes in sales. Since many business
decisions hang on whether to increase or reduce sales, the
concept of marginal revenue is central to such business
decision making.
Let us restate the relationship between, TR, P(=AR), MR

and Ed.
E
TR  P. Q
d (P.Q) DP
MR   [P  Q ]
dQ dQ
Q
 P [1  P dP ]
dQ
LM 1 OP
MN dQdP QP PQ
 AR 1 
UP
Because the demand curve has a negative slope and price
elasticity of demand is the inverse of quantity elasticity of
price. It follows that
LM dQ P OP
Ed 
N dP Q Q
LM OP
MR  AR 1  1
N EQ d
MR  L1  1 O
AR MN E PQ d
1  1  MR  AR  MR
Ed AR AR
Ed  AR
AR  MR
Note that for a sales maximising firm, MR = 0 and therefore

Ed = |1|, but for a profit-maximising monopoly firm, AR >
)
MR and therefore Ed > 0. For perfectly competitive firms,

AR = MR and therefore, Ed = .
On a linear demand shown earlier, Ed =  at the intercept

(c
of Y-axis, Ed = 0 at the intercept of X-axis and Ed = 1 at the

middle. The reader may verify this by applying the
definitional measure of price elasticity of demand.
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Another mathematical operation is in order. Take a linear Activity
demand curve:
W rite an essay on demand
analysis. Also cover the
P = a–bQ where a>0 approaches of demand
analysis.
TR = aQ – bQ 2 b<0
d(TR)
MR = dQ = a - 2bQ
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P = AR = a – bQ
Thus the AR and MR curves have same intercept

(autonomous demand), but the MR has (negative) slope, twice
that of AR curve. Also note that slope is not the elasticity.
dQ P
Ed = dP Q  Price elasticity of demand
Where
dQ
dP
UP P
is a marginal term and Q is an average term.
Thus,
Marginal demand
Elasticity, Ed  Average demand
dQ
Slope, = Marginal demand.
dP
Demand Analysis
Economists have developed several techniques of analysing
demand. Econometricians have tested some of the
propositions underlying the economic theory of demand as
developed by the economists. Of late, in the name of
psychological economics, the behavioural scientists have
attempted explanation as well as psychometric measure of
consumer’s behaviour. In this section, taking care of all these
developments, we intend to refer briefly to:
)
i. Marginal Utility Approach
ii. Indifference Curve Analysis

(c
iii. Revealed Preference Approach
iv. Recent Developments.

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Marginal Utility Approach
It is a traditional approach used by Marshall and Jevons to
explain the consumer behaviour. Consumers demand items
of goods/services, because they feel utility for them. The utils
(utility-content) indicate ‘value-in-use’ and they command
price in the market; the price paid indicates the ‘value-in-
exchange’. Sometimes we observe that products with
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tremendous ‘value-in-use’ do not command any ‘value-in-
exchange’ i.e., those are “free goods” like air, water available
in plenty at ‘no price’ because there is no scarcity. Utility
(value-in-use) along with scarcity determines price. Diamond
is not that useful, but being rare it is very valuable; therefore,
such “economic goods” command a high price.
Economists assume that the utils (i.e., the utility-content of

UP
products) are cardinally measurable and comparable in terms
of a measuring unit of money, provided the utility of that
money is held constant. A consumer, while purchasing a
commodity often compares his sacrifice (in terms of price
paid), i.e., value-in-exchange with his satisfaction (in terms
of utility derived, i.e., value-in-use). If price exceeds marginal
utility, he reduces his purchase. If marginal utility exceeds
price, he reduces his purchase. If marginal utility exceeds
price, he enhances his purchase. Ultimately when price
equals marginal utility, he is in an equilibrium state of his
purchase decisions.
M arg inal utility of Pr oduct

M arg inal utility of money spent 
Pr ice of the product
MU
MU m  P x  Px  du  Mu x
x dx
Indifference Curve Analysis

)
This approach has been developed by the economists like

Hicks and Allen to overcome some of the above limitations.
Assuming ordinal measurement of utility and relatedness
of goods and relaxing the assumption of constant marginal
(c
utility of money, the technique of indifference analysis has

been developed.
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We start with a multi-commodity consumer rather than a
single commodity consumer, typical of traditional utility
approach. Thus, the utility function is stated as: U = U (X, U)
where x and y stand for two products.
The consumer wants to purchase of combination of x (say,

cereals) and y (say, vegetables). With given resources and
given need, whenever he buys more of x he has to be satisfied
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with less of y. Thus, a trade-off between x and y has to be
read along the indifference curve in terms of an additional x
(x) being possessed when an additional y (y) is sacrificed
such that the buyer remains indifferent to the bundle of
choice. The rate at which this substitution takes place is
termed as the marginal rate of substitution, MRSxy which
measures the slope of the Indifference curve
UP Y
MRSxy   X OR dY
dX
Figure 9.3: Slope of Indifference Curve

)
Even if the consumer moves from combination A to B there

is no change in his satisfaction level, because the utility-
content of the bundle as a whole is intact; more of x may
reduce the utility of x, but less of y may have increased the
(c
utility of y. This follows from the law of diminishing utility.

Each Indifference curve can, therefore, be treated as an iso-
utility curve.
S
A set of Indifference curves is referred as an Indifference
Map. It may be noted that each curve represents a given level
of utility (satisfaction); a higher curve represents a higher
level of satisfaction. Rationality on the part of a consumer is
reflected in terms of his objective to maximise utility, i.e.,
getting onto the highest curve, if feasible.
E
UP
Figure 9.4: A Set of Indifference Curve
The feasibility of a particular scale of preference depicted

by an indifference curve is determined by the buyer’s
purchasing capacity. The most desirable bundle of
consumption may not be within the reach of the buyer
because of his budget constraint. The budget line GF
indicates that constraint. If by spending his entire budget,
the consumer of (X+Y) get maximum either OG of x or OF of
y then the area OEF defines his feasibility area.
By superimposing the indifference map on the budget line,

we find that C is the most desirable but not feasible; D is
feasible but not desirable. In fact E is both desirable and
)
feasible; E turns out to be the consumer’s equilibrium bundle

of purchase.
(c
E S
Figure 9.5: Buyer’s Purchasing Capacity
Using the indifference curve technique, we may now restate

various effects on demand.
UP
The price effect on demand is illustrated by the Price-
Consumption Curve PCC which shows the effect of a change
in our price of x on the purchase of x given the income and
the price of y. As the price of x falls more of x can be purchased
at a given income. Thus, the budget line shifts and, therefore,
the equilibrium point shifts from e to e1 to e2.
Figure 9.6: Price-Consumption Curve
The income effect on demand is shown by the Income-

consumption Curve, IC given the price of x and y remaining
)
uncharged: the price-ratio, i.e., the slope of budget line

remains same even when income changes and as a result the
budget line changes its position. With an increase in income,
the x-purchaser buys more of x when x is normal or less of x
(c
when x is inferior. Had x been inferior or y been inferior or

both been inferior, the situation would have been as
illustrated by the diagram.
E S
Figure 9.7: Income Consumption Curve
Finally, when the relative price structure changes either

because of a change in the price of x or the price of y or both,
then the substitution effect comes to play as depicted in the
diagram.
UP
Figure 9.8: Price of X
)
(c
Figure 9.9: Price of Y

E S
Figure 9.10: Substitution Effect of Price
When x is relatively cheaper, additional x-x1 is purchased

because of substitution favour of x.
Combining all these effects, the reader may read that the
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price effect (x0-x1) is the aggregate of both income effect (x0-
x1) and substitution effect (x-x1).
Applications
The Indifference Curve Analysis has got a lot of business
applications. Take, for example, risk return trade-off in
business decisions. An investor can calculate the opportunity
costs of “risks” in terms of the return he gets from an
investment. In the same way, the opportunity costs of
“returns” can be estimated in term of risks taken. Depending
upon the attitude of the investor, we may think of different
types of Indifference curves showing risk-return trade-off.
In this diagram Mr A is risk-indifferent, i.e., change in actual
risk taken is proportional to change in expected return. Mr
B, by contrast is risk-lover and Mr C is a risk-avoider.
Beyond r*, Mr B is prepared to take more and more risks
even if there is no expected additional return. Similarly,
beyond R*, even if there is additional return, Mr C does not
want to take any additional risks. The reader may read as
)
MRSRr (Marginal Rate of Substitution between return R and

risk r). Here is an Indifference map which is a good reference
for an investor’s decisions. An investor needs to satisfy the
equilibrium condition.
(c
LMMRSR  PRP OP
N r rQ Where
PR/Pr ratio can be interpreted as the opportunity cost ratio.

E S
UP Figure 9.11: Opportunity Cost of Risk and Return
Let us take another application of indifference curve

technique in market situation with two market players, 1
and 2; on e is the rival of other; one reacts to the decision of
other such that price charged by 1 is followed by the price
revision by 2.
P2 = P (P1) 1 is the leader and 2 is the follower.

)
Figure 9.12: Market Situation

(c
The player 1 is interested to maximise his profit subject to

reaction of 2 which should be minimised. The solution
(equilibrium) is at E where the slope of profit curve of 1 is
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equal to the slope of 2’s reaction curve. And you may note
that profit of 1 depends on different combinations of price
charged by 1 and 2, each reacting to the other.
1 =  (P1, P2) and
N2 = N (P1, P2)
Thus at E, there is a price-trade off, typical of a duopoly
E
market, to the satisfaction of both price leader and price-
follower.
Revealed Preference Approach

Indifference curve analysis is a powerful tool, but beyond a
point it cannot be stretched. Today, the businessmen have
to understand the buyer’s behaviour from the standpoint of
UP
more of psychology than of economics. The economists
themselves have realised this limitation. Towards
overcoming this limitation, there is an attempt towards new
theorisation towards understanding the concept and
measurement of choice.
A consumer buys a combination of x and y; his choice takes

care of his “preferences” as well as his “constraints”. What
is desirable may not always be available and feasible.
Therefore while choosing, he balanced the two. Does this
choice reveal his preference? Yes it does, provided the
following axioms are satisfied:
1. Choice set is complete. Before the buyer exercises his

choice, he takes into account all available choices. The
choice set is bounded and not open-ended.
2. Choice is rational. Rationality on the part of the chooser

implies that he is never satisfied (non-satisfied) and that
he wants to get the best satisfaction out of his least
)
scarifies.
3. Choice is optimal. Optimality means that either he

maximises his satisfaction (utility derived) or he
(c
minimises his sacrifice (price-paid), if there is no

constraint. Otherwise, he goes for either constrained
maximisation or constrained minimisation.
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4. Choice is strongly ordered. When we say, in the context
of indifference curve analysis that X is equally preferred
to Y (X³³ Y), it is “Weak Ordering”. If X is definitely
preferred to Y (X>Y), it is “strong ordering”. The
strongest of the strong ordering is called “Lexico
Graphic Ordering”.
5. Choice is transitive. This means that if X is preferred
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to Y and Y is preferred to Z, it follows that X is preferred
to Z.
X > Y, Y > Z  X > Z
6. Choice is consistent. It does not mean that the same is

chosen time and again; it only means the same
preference. For example, X was chosen because X>Y.
UP Then the stock of X exhausted. So in the next situation,
the buyer chooses Y out of (Y and Z) being available,
because Y>Z. Thus, the choice of X earlier and the choice
of Z later are consistent choices, i.e., choice without
altering the scale of preference.
If the above axioms are satisfied, then only Choice reveals

preference. It should now be clear that the demand analyst
cannot use terms like demand, need, preference, ordering,
choice, etc., interchangeably.
Some Recent Developments

In recent years, there is an attempt to make demand analysis
more pragmatic. Without questioning the fundamental
precept of demand, the economists have formulated demand
functions directly on the basis of market data. There are
difficulties in econometric estimation of demand functions.
Once these difficulties are taken care of by economic theory
and statistical methodology, the interpretation of those
)
demand functions become a handy reference for business

decisions.
Taking an overview of these recent developments, we may

(c
suggest categorically:
1. Empirical studies indicate that there is a need to

distinguish between “demand as seen by the buyer” and
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“demand as seen by the seller”; also between “demand
for goods” and “demand for services”; between “retailers’
demand”, “wholesalers’ demand” and “manufacturers’
demand” for products. The determinants of final
consumer’s demand may not be same as those of demand
for inventory of finished (and semi-finished) goods (and
raw materials) held by the stockists.
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2. Statistical studies like opinion poll, consumer’s survey,
market research and experimental simulated exercises
do generate plethora of empirical data. The analysis of
such data generates observations and findings specific
to product specific to market and specific to business
environment prevailing at a particular period. Such
observations cannot be always built into generalisations
3.
or theorisation.
UP
In some econometric estimation of demand function,
some economists have used distributed lag models. This
is an attempt towards a dynamic analysis of demand.
For example,
Qt = d {(Pt, Pt-1, Pt+1) ; (Yt, Yt-1, Yt+1); (Qt-1, Qt, Qt+1)}
The determinants of quantity of an item demanded in

period are listed above as:
Pt = Actual present price of that item
Pt-1 = Observed past price of that item
Pt+1 = Expected future price of that item
Yt = Current income
Yt-1 = Past income (generating savings)
Yt+1 = Future income (expected capacity to pay back)

)
Qt-1 = Quantity of the item purchased earlier in t-1
Qt-2 = Quantity of the item purchased earlier in t-2

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[Note : If t = 2000, t-1 = 1999 and t-2 = 1998]
If the item under consideration is a consumer durable

item (like a music set) then Qt-1 and Qt-2 may be
S
interpreted as past purchases towards building up
‘Stock’ adjustment. If the item is a consumer non-durable
item (like cigarettes) Qt-1 and Qt-2 are to be interpreted
as past purchases towards “Habit” formation. Either
way, the current purchase Qt is influenced by past
purchases.
4. In some recent work, the budget constraint has been
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reinterpreted as a Linear expenditure system.
B = P x X + Py Y Y
Px .X = The expenditure on purchase of X
Py .Y = The expenditure on purchase of Y.
[B-x .Py] = Surplus to be spent on Y out of a given income

UP (budget)
[B-y .Py] = Surplus to be spend on X out of a given

income (budget)
Sometimes X is taken as substance items and Y is taken as

supernumerary item; the former is a basic necessity, the later
is comforts or luxuries or accessories. Thus, total income B
has two parts – subsistence income and supernumerary
income. The buyer’s purchase pattern depends on the
proportion of these income components in total budget.
These recent development are significant from the

standpoint of business analysis of demand estimation,
forecasting and interpretation – as a prelude to strategic
sales management.
Check Your Progress

Fill in the blanks:
)
1. The stability and growth of business is linked to

................ of structure of demand.
2. Demand means ................ to have possession.

(c
3. The most crucial determinant of demand for an item

is its own ................ .
Contd...
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4. Certain products are called as ................ because
the demand for them falls as income rise /vice versa
5. Veblen products includes ................ products.
6. Price elasticity measure ................ of quantity

demanded of a product to change in its own price.
7. ................ responsiveness of quality demanded to
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change in the price of other goods.
% change in quantiity demand
8. Coefficient of elasticity =
?
9. Income Eid = ?
10. When total revenue is increasing, managerial

revenue is ................ .
Summary
UP
Demand as defined by the economists depends on a number
of factors like price, income, market environment, etc. These
factors which determine or induce demand are referred as
Economists use the term ‘demand’ to connote
(a) desire to have possession, and
(b) willingness to pay for that possession
Demand is thus reflected in terms of the amount the

consumers are willing to buy at a given price over a given
period of time. Demand, in the economist’s sense, does not
mean the wants, desire or need of people since these may
not be backed up by the ability to pay.
Demand is affected by many factors, we can calculate

)
elasticity (i.e., responsiveness of quantity demanded) with

respect to a wide range of variables other than price, notably
the price of other goods and income.
(c
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Lesson End Activities
1. Make a survey of a retail market and a wholesale market
for any standard item of your choice. Prepare demand
schedules for the total market as well as market
segments. [Do not use imaginary data. Use actual data
collected through survey]. Plot the schedules on graph
paper.
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2. Use the same data to distinguish between slope and
elasticity of demand.
Keywords
Demand: Demand as defined by the economists depends on
a number of factors like price, income, market environment,
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etc
Normal Products: Goods and services may be classified as

‘normal products’ if the quantity demanded rises as incomes
rise and falls as incomes fall.
Inferior Products: Certain products are classified as

‘inferior’ because the demand for them falls as incomes rise
(and vice versa).
Giffen Products: A special case of the inferior product arises

when as price rises, more of the good in question is bought –
resulting in an upward sloping demand curve, contrary to
the normal law of demand. Such products are classified as
Giffen products
Veblen Products: It has also been suggested that ‘luxury

type’ products also display perverse price demand
relationship, though for different reasons to that of the Giffen
products case. These are sometimes referred to as Veblen
products
)
Basic Necessities (Products): Products which are provided

at subsidised rate to the people below poverty line, as a part
of minimum need programme of a welfare state are termed
(c
as basic necessities.
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Price E lasticity of Demand: This measures the
responsiveness of quantity demanded of a product to changes
in its ‘own price’.
Cross-price Elasticity of Demand: This measures the

responsiveness of quantity demanded to changes in the prices
of other goods (both complements and substitutes).
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Income E lasticity of Demand: This measures the
responsiveness of demand to a change in the real income of
consumers.

1. A consultancy firm has been floated by a few experienced
MBA graduates with engineering background, as a co-
UP
operative venture. The firm, while setting up its
business, is interested to recruit fresh MBA graduates,
MBA(F). Determine a demand function for MBA (F).
Define and explain each term.
2. A housewife is to choose between buying a new air-

conditioner or repairing the old air-conditioner, because
the summer is forthcoming. When she puts up the
proposal before her husband who is a small factory
owner, he reports that he is facing the same problem of
choice for his office room inside the factory.
Use all relevant concepts of demand to compare and

contrast the home front with the factory front.
3. Review all concepts of choice, ordering and preference,

quoting real world business examples.
4. Take an example for an industrial raw-material and

refer to its end-uses.
)
(a) Distinguish between its direct and derived demand.
(b) Explain the end-use method of forecasting its

demand.
(c
(c) Specify the limitations of your forecasting method.

S
5. In the past, it was observed that higher the executive
position of a person in the hierarchy, more was the
richness of data/information reaching him. Today in the
present, the information revolution has changed all
these. Because of internet wherefrom the data can be
downloaded, everybody has access to every bit of
information. In fact, The PA has more and earlier
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information compared to what the boss has.
(a) Consider the ‘hierarchy of position’ and ‘hyperarchy

of information’ as your X-axis and Y-axis in a
diagram. Attempt to draw on indifference curve
each for past and present, showing the trade-off
between your items on X-axis and Y-axis.
(b) What will be your considerations corresponding to

UP Budget Line? Draw a line keeping in mind (i)
Linear Expenditure System and (ii) Opportunity
Cost concepts.
(c) Illustrate and interpret the position of

“equilibrium” in this context.
[You may try to locate a reference article in Harvard

Business Review (1997 issue) as you reference].
6. Use Indifference Curve Technique to illustrate and

explain, with logic, the trade-off between:
(a) Leisure and Labour
(b) Risk and Return
(c) Spending and Saving (Money)
(d) Company Shares and Government Bonds
Consider (b) and (d) together to explain the portfolio

)
choice of an investor.
7. Pick up any company’s balance sheet to collect at least

two consecutive year’s data on sales revenue and
(c
advertising expenditure. Calculate:
(a) Sales elasticity of ad.
(b) Ad. elasticity of sales.

S
How are (a) and (b) related? Why are the coefficients
different? What will be the business use of such
estimated coefficients?
8. As an employee of the business development

department of a corporate unit, you are required to
identify the determinants of the firm’s demand
requirement for
E
(a) Fixed Capital
(b) Working Capital
You are also required to guess the likely “effects” of your

Do your job to satisfy your boss.
9.
UP
Economists often talk about:
(i) Demand as seen by the seller
(ii) Demand as seen by the buyer
Is there any difference when you look at it from the

standpoint of different viewers?
Further Readings
Books


)

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Web Readings
www.fao.org/docrep/W4388E/w4388e0u.htm
ww w.g ree nan dwhite. net /~chrisch an/ ce/n ote s/m icro/
DS_I.doc
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www.mbe-du.org/
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Unit 10
Case Studies
Objectives
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Case Study 1: The XYZ Firm
The XYZ Firm located in Okhla Industrial Estate manufactures

UP
an item Q with the help of two resources a and b. The production
process of the firm is characterised by the following function.
Q = 50.00 a0.20 b0.80
This is what was statistically estimated a year ago by a consultant
employed by the firm. In the current year, the firm is facing a
problem of allocating resources ‘a’ and ‘b’ in a combination such
that the greatest amount of product will be produced for a given
cost outlay. The prices of ‘a’ and ‘b’ are respectively ` 2 per unit
and ` 1 per unit and the given cost outlay for the firm is ` 19. The
production department of the firm has developed the following
marginal product (MP) table.
Questions:
1. Is the finding of the production department consistent with
)
the estimate of the consultant? Give reasons.

2. Assuming the table is correct, what combination of a and b
would give maximum output, given prices and cost
(c
constraints?
Hints: Use concepts like input-elasticity, function-coefficient, returns to
factors/scale, equi-marginalism, etc.
S
Case Study 2: Slimming the Bretton Woods Duo
When a report sponsored by America’s Congress and embraced

by senior Republicans, argues that the IMF and the World Bank
should be radically scaled back, but that foreign aid to the poorest
countries should be dramatically increased, it is hard not to be
cynical. America is one of the world’s stingiest donors of foreign
aid. It spends a measly 0.1% of GDP on development aid a year,
E
by far the lowest of any industrialised country. In countless budget
battles, Republicans have masked their parochialism with rhetoric
about international bureaucracies and contempt for corrupt foreign
countries.
Put aside that cynicism. Does this report (known as the Meltzer
report, after the committee’s Allan Meltzer of Carnegie-Mellon
University and signed by Jeffrey Sachs, a well-known development
economist at Harvard) offer sensible principles for reforming
UP international financial institutions and for rebuilding consensus
for foreign aid in America?
The report argues that the IMF should concentrate on one big
market failure: financial panics in which solvent economies cannot
borrow. It should stop having detailed loan agreements with
economic strings attached. To be eligible for IMF support, countries
should pass four preconditions, including adequately capitalised
banks and a yet-to-be-determined criterion for fiscal prudence.
The money should be lent short-term and at penal rates. Only in
systemic crises should non-eligible countries receive fund bailouts.
And it should not lend at subsidised rates to the poorest countries.
This vision of the IMF providing liquidity to healthy countries as
a central bank might provide it to healthy banks is not new; a
small library to academic papers is devoted to the subject. It is,
nonetheless, appealing. How much better to have a clearly focused
IMF than today’s grubby combination of geopolitical slush fund
and emerging-economy schoolmaster. Unfortunately, the appealing
principle does not translate easily into practice.
It is, first of all, impossible to devise preconditions ensuring that
)
basically sound but strapped-for-cash countries get IMF money.

Make eligibility conditions too stringent and too few countries
would qualify; but bailouts of big countries would be justified
because of “systemic risk”. Make them too loose and moral hazard
would increase because investors would expect bailouts of too many
(c
countries. But the Meltzer report is, nonetheless, a sensible

direction for IMF reform. Countries with better banking systems
and more prudent economic policies should have easier access to
Contd...
S
money at lower interest rates than those that do not. The IMF
should provide incentives for countries to aspire to better financial
standards.
Developing Principles
Underlying the report’s vision for the development banks such as
the World Bank is a similarly attractive principle. In a world
where private capital flows to poor countries dwarf official
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assistance, development banks should do what markets cannot
or will not do. They should provide international public goods (such
as research into the treatment of tropical diseases) and should
transfer resources to alleviate poverty in the very poorest countries,
and those that do not have access to private capital.
That hardly seems today’s practice. According to the report, some
70% of the Bank’s non-concessional lending over the past seven
years has gone to 11 countries (including China, Argentina, Mexico
UP
and Brazil) that had access to capital markets. And, it says, almost
half of the Bank’s lending to countries with access to capital
markets in the 1990s went to activities from which the private
sector can profit.
Given that poverty alleviation is the Bank’s ostensible goal, this
is odd. It is true that the Bank’s lending has become more focused
on social sectors recently and it is also true that the majority of
the world’s poor people live in countries such as China or Brazil,
which do have access to capital markets. But, as the report points
out, the fact that there are poor people in a country with such
access does not self-evidently justify lending by the Bank.
Often, such countries’ failure to spend on the poor is down to bad
budgeting. That is why the report recommends phasing out all
development-bank lending to countries with investment-grade
ratings or an income per head of over $ 4,000. Instead, resources
should focus on the poorest: countries with income per head of
less than $ 2,500. Those in between and those with erratic access
to capital markets, would get limited aid. Again, however, the
attractive principle faces a murky reality. Countries’ access to
private capital is more limited than aggregate figures would
)
suggest.
On occasion, the Bank can be a catalyst for private sector money.
In the aftermath of Asia’s crisis, Bank guarantees helped to speed
up countries’ return to the capital markets. And with the advice
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and conditions it attaches to its loans, World Bank lending arguably

fosters good economic policy better than the private sector. But
Contd...
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even these qualifications do not undermine the basic direction of
sensible reform: not to concentrate resources on countries with
access to capital markets.
The real risks of refocusing the Bank more explicitly on the poorest
countries are political. The Bank itself is a mechanism to raise
resources for the poorest. Roughly a third of the Bank’s
shareholders would use this as an excuse to cut their own foreign-
aid budgets still more. Then you would lose the Bank’s benefits
E
for middle-income countries and also have less money for the
poorest. To expect such an outcome would, of course, be much too
cynical.
Questions:
1. Do you agree with the recommendations of the report under
reference? Argue it from the standpoint of both developed
and developing economies.
UP 2. Recall your understanding of
(a)
(b)
Bretton Woods Duo,
Asia crisis
(c) International Public goods
(d) Development Banks
(e) Systemic Risk
Source: The Economist, March 18, 2000
)
(c
E S
UP
BLOCK-III
)
(c
S
Detailed Contents
UNIT 11: PRODUCTION AND SUPPLY UNIT 13: INDUSTRY AND MARKET STRUCTURE
ANALYSIS ANALYSIS
 Introduction  Introduction
 Analogy: Concepts, Precepts and Techniques  Industry and Market Structure Analysis
E
 Technique and Technology  Forms and Structure of Market
 Stages of Production  Perfect Competition
 Production Strategy  Monopoly
 Production Perspective and Returns  Monopolistic Competition
 Production Functions  Duopoly and Oligopoly

UP
Effects and Elasticities
From Production to Supply Function
Generalised Supply Function

UNIT 14: THEORY AND MODELS OF FIRM AND
INDUSTRY
 Introduction
 Production Decisions  The Determinants of Firm Structure
UNIT 12: COST ANALYSIS  Theory vs Models
 Introduction  Some Contrasts
 Cost Concepts
 Economies and Diseconomies
 Theoretical Cost Functions
 Empirical Costs Situation
 Applications of Cost Analysis
 Efficiency
)
(c
UNIT 11: Production and Supply Analysis
S
Unit 11
Production and Supply Analysis
E
Objectives
topics:
 Analogy: Concepts, Precepts and Techniques
 Technique and Technology
 Stages of Production and Production Strategy

UP
Production Perspective and Returns
Production Functions
 Effects and Elasticities
 From Production to Supply Function
 Generalised Supply Function
 Production Decisions
Introduction
Consumption and Production are analogous economic
activities such that the two can be compared and contrasted.
Production is the process of creating the ‘utils’. Both present

similar problems. In production, for example, the problems
are : What to produce? How to produce? When to produce?
Where to produce? In the same way, in consumption, the
problems are: What to consume? When to consume? How to
)
consume? Where to consume? Thus the choice of a basket of

consumption units, say at the morning breakfast table, is
similar to the choice of inputs of men, materials and machines
at the shop floor of a factory.
(c
S
Activity Analogy: Concepts, Precepts and Techniques
Make a presentation on the The various concepts are as follows:
concepts, precepts and
techniques of production
analysis. Production and Productivity
Production technology is analogous to the consumption
technology. Thus, the production function, Q = Q (L, K) is
E
analogous to the utility function, U = U (X, Y), where X and
Y are usable goods; and L and K are usable inputs. Just as X
and Y can be combined in different proportion in consumption
process, L and K can also be combined in different proportion
in a productive process. As such the concepts of total average
and marginal productivity stand in one to one, vector
relationship to total, average and marginal utility.
UP Q
L

U
X
 Averages
Q U
  Marginals
L X
Q U
  Marginals
K Y
Q Q U U
;   Incrementals
L K X Y
At this stage, one must note that production has reference

to physical volume or money value of output, whereas
productivity has reference to output per unit of input.
Productivity is a ratio; average productivity is a ratio of total
output to total input; the marginal productivity is a ratio of
incremental output to incremental input.
Isocost Line
)
In the same way, we may state the analogy with reference to

the Budget or Cost Constraint.
[ = X. Px + Y. Py]  [ = L.P1 – K. P k]
(c
LMX = B  P Y OP  LML = C  P K OP
N P P Q N P P Q
Y K
x X L L
LMY = B  P X OP  LK = C  P LO
S
N P P Q MN P P PQ
x L
y y K K
As stands for consumer’s budget constraint, stands for

producers’ cost constraint, Px, Py, PL, Pk are either commodity
prices or factor prices like wage rate and interest rate or
rental rate. Thus, in production front, we have the Isocost
E
Line just as we have the budget line on the consumption front.
These straight lines’ slope indicate price ratio, whereas there
can be shifts in these lines to indicate the impact of a change
in (a) income or cost (b) a change in price of goods or factors.
UP
Figure 11.1: Isoclines in different situations
The Isocost Line or Isocline as it is called sometimes, may

shift from Ko-Lo to Ko-L2 because of a fall in wage rate, other
factors remaining same; from Ko-Lo to K1-L1 because of larger
size of cost budget other factors remaining same; from K1 –
L1 to K1 – L2 because of a change in relative factor prices.
Isoquants
)
In view of the scale of preference of the producer, we may

think of constructing a producer’s indifference map,
analogous to that of consumer. Then an isoquant curve stands
(c
neck to neck to an iso-utility curve. The slope of the isoquant

L dL
or represents Marginal Rate of Technical Substitution
K dK
between factors K and L (MRTSKL).
E S
Figure 11.2: Isoquants
Just as different combinations of X and Y produce same

satisfaction (ISO-utility) level, different combination of inputs
of labour and capital produce same quantity of a given output
(ISO-quant).
UP
Optimum Decision Rule
Just as a consumer maximises utility subject to the budget
constraint or minimises the use of his income subject to the
utility constraint, the producer may also maximise
production subject to the cost constraint or minimise costs
subject to the output constraint. Either way, constrained
maximisation or constrained minimisation the maximum
physical production or least costs production (i.e., input
choice), the production optimisation is achieved when:
LMMRS OP  LMRTS OP
Q MN
MU x Px MPL PL
N xy
 
MU y Py LK

MPK PK Q
LM U OP LM Q OP
MMMRS PP  MMMRTS PP
P L  PL
xy  X  x LK
U Py Q PK
N Y Q N K Q
MU x
Note that is marginal utility of income spent on X.
Px
)
MPL
In the same way, is the marginal utility of expenditure
PL
allocated to L.
PL may be reinterpreted on the wage rate, W 1 a sacrifice

(c
made by the employer to give satisfaction to the employee.

Thus,
[W > MPL)  employer’s loss

S
[W < MPL)  employee’s loss
[W = MPL)  Both employer and employee satisfied
In the same way,
The rate of interest or rental [r = MPK] = Both lender and

borrower satisfied.
E
But in a multifactor production situation loss on one count
may be made by the gain on the other count. Thus,
W  MPL
r  MPK
F MP  W I
Yet H MP r K
L
K
UP
Note that the ratio of marginal productivity of factors is
termed as Marginal Rate of Technical Substitution between
factors – MRTSLK is analogous to MRSxy concept.
And the proportionality rule, a restatement of equi-marginal

principle or relative activity level principle is renamed as
‘optimum (production) decision rule’ here.
)
(c
Figure 11.3: Optimum (production) Decision Rule

S
Activity In all these diagrams, E denotes the equilibrium point
satisfying optimum decision rule suggesting optimum input
Prepare a short report on
technique and technology in combination OL* + OK* to produce Q1.
product.
Check Your Progress
Fill in the blanks:
1. The ratio of marginal productivity of factors is
E
termed as .............. .
2. A restatement of equi-marginal principle is

renamed as .............. .
Let us now move from economic theory to business practice.
Technique and Technology

UP The terms ‘technique’ and ‘technology’ are often used
interchangeably; but technically they are different. For
example, the choice of production technique is a tactical
operation (say, on the shop floor), whereas the choice of
production technology is a strategic policy decision (arrived
at the Board Room).
In the context of production decision, the technique has

reference to ‘factor-proportion’ or what may be called
‘intensity of factor utilisation’. We may think of:
L
(i) Labour-intensive technique: The ratio goes up as
K
we produce more Q.
K
(ii) Capital-intensive technique: The ratio goes up as
L
we produce more output.
)
(iii) Neutral technique: The input ratio, the man-machine

ratio, remains unchanged irrespective of any change in
Q.
In today’s world, the entire range of consumer electronics is

(c
technology intensive and technology sensitive. The

conversion of sand into microchips by the Videocon company
S
is a great achievement in India. With regard to the choice of
technology, a country like India can choose from among:
1. Imitation: Blindly copying the product or the process

and the pattern. In India, we have plethora of ‘Deshi’ vs
‘Genniva’ product.
2. Innovation: New ideas, new techniques, new product
E
coming through extended use or modified version of an
existing item.
3. Innovision: Going beyond the obvious. In Punjab,

washing machines were used for preparing Lassi!
The choice of technique and technology depends on the
sufficiency and efficiency of inputs and the nature of output
which is to be produced through transformation of inputs
UP
some of which are ‘fixed’, some are ‘variable’. For example,
for agricultural production, we need seeds, fertilizers and
water on a given plot of land. For producing consultancy
services, we need professionals, knowledgable workers,
sophisticated equipments and library of reference materials.
In general, we need men, materials, machines and money to
produce anything, something, everything and sometimes
nothing. All inputs may go to waste; sometimes we may
produce recyclable products and so on.
Planning any production activity the producer must take note
of the life cycles:
1. Product Life Cycle : The product goes through stages:
Introduction  Growth  Maturity  Saturation
 Decline
2. Process Life Cycle: The production process has its
stages:
)
Hand (isation)  Mechanisation  Automation

 Computerisation  Robotisation
3. Project Life Cycle:
(c
Planning  Construction  Commission  Operation

 Maintenance
S
Activity Stages of Production
W rite an article on the The marketing concept of ‘product life cycle’ should not be
production strategies.
confused with the economic concept of stages of production
illustrated in the following diagram.
We have a set of product curves
TPL = Total product of labour, when Q = (L)
E
Q
APL = Average product of labour,
L
dQ
MOL = Marginal product of labour,
dL
All are measured in physical volume. Had those been

UP measured in money value of revenue earned, we would have
renamed these curves as Total, Average and Marginal
Revenue product curves.
Figure 11.4: Relationship between TP, AP and MP
Stage I: TPL, APL and MPL – all are rising. This implies that
as more and more input (labour) is used in the production
process, the output due to labour in a given situation
)
increases. This continues till APL, reaching maximum, is

equal to MPL.
Stage II: This stage II begins where stage I ends and

continues up until stage III begins. In this stage, TPL is rising
(c
but at a falling rate, such that both AP L are MPL are declining
till MP L becomes zero corresponding to TP L reaching
maximum.
S
Stage III: It shows that both TP L and APL are declining, so
does MPL at a faster rate such that it is negative (both in
terms of absolute level of output and relative rate of change).
The objective of the production unit would help decide the
firm how many labourers should it employ.
Check Your Progress
E
Fill in the blanks:
1. In relation to production, the technique has
reference to ‘factor-proportion’ and it may be called
.............. .
2. Blindly copying the product or the process and the
pattern is called .............. .
Production Strategy
UP
The choice of technique and technology does not constitute
the only element of strategic management of production.
There are other facet and aspects.
Objectives
In the preceding analysis we have considered the objective
of either maximising production or maximising productivity.
Sometimes the choice is between average and marginal
productivity maximisation. In same way, the production
objective may not be only ‘quantity’ consideration; it may be
‘quality’ considerations as well. Sometimes quality may suffer
when quantity (volume or variety) is emphasised. Some firms
therefore may enforce strict quality control measures like
ISO certification. Similarly some firms may aim at TQM (Total
Quality Management) or QWL (Quality of Work Life). The
people-centered organisations in contrast to production-
)
centered organisations are more concerned about

parameters of QWL and TQM. Such quality considerations
build up the corporate image and culture of the organisation.
(c
Another objective in running a productive process may be to

minimise wastage of resources indirectly, this means
promoting both ‘physical efficiency’ and ‘cost efficiency’ in
running a production unit. Sometimes the large volume of
S
waste materials can be put to profitable use. And thus the
main product (Q1) and the by-product (Q2) may be produced
jointly from the same set of factors. This is known as joint-
product strategy.
Constraints
The attainment of objectives is often constrained. In formal
E
theory, we have talked about either cost-constraint or
technology-constraint. In reality, there are many more
constraints. For chemical plants, the location itself is a
constraint.
The nature of constraints differ depending upon the nature

of production unit which may be classified as:
UP
1. Single factor, single product firm
Q = Q (L)
2. Multifactor, single product firm
Q = Q (L, K, T)
3. Single factor, joint product firm
F = F (Q1, Q2)
4. Multifactor, multiproduct firm
n
LM OP
m
i 1 N Q
 Qi  f  Fj
j 1
5. Single period, single product firm
Qt = Q (Lt) or Qt = Q (Lt, Kt)
6. Single product, multiperiod firm
Qt+1 = Q(Ft-1, Ft, Qt Qt-1)

)
7. Multifactor, multiproduct, multiperiod firm
t+n
LM OP
t+m
N Q
 Qi  Q  Fj
(c
i t j t
S
Production Perspective and Returns
One of the basic concepts underlying any economic analysis
preceding any business decision is Time prospective; and
this is not defined in terms of duration of time and clockwise
precision; it is defined in terms of the nature of constraints.
If the constraints are so compelling that those are
unsurmountable, then it is ‘temporary run’. If some of the
E
constraints can be overcome, then it is ‘short run’. If all the
constraints can be overcome, then it is ‘long run’ may be in
the long-run, “we are all dead!” (Keynes).
In operational terms,
 Temporary Run: The level of output, the nature of

inputs, the scale of plant, the size of firm, the production
UP
unit, the structure of industry – all are rigidly fixed and
pegged. The supply of output is perfectly inelastic.
 Short Run: Some inputs are fixed, others variable; thus

variable inputs can be varied – extended or reduced –
on a given fixed inputs which are operated intensively
to yield some increase in output, without allowing for a
change in the scale of firm and the structure of industry.
The supply of output is relatively inelastic – eventually
totally inelastic.
 Long Run: All factors (including labour, material,

building and technology) are variable; as a result, level
of output, scale of plant, size of firms, structure of
industry – all are adjustable.
Thus, the production constraints, through proper planning,

should ease slowly and gradually to yield complete flexibility,
perfect segmentation and infinite indivisibilities in the long
run.
)
Against the production (time) perspective, we would like to

draw a distinction between two useful concepts of ‘returns
to a factor’ and ‘returns to scale’.
(c
 Returns indicate the productivity of factor(s), depending

upon the sufficiency and efficiency of inputs utilised in
the productive process; it is some sort of production pay
S
off measurable in either physical or money terms input
effect on output.
 Returns to a factor is a short run concept. Given the

fixed, factor say, land, building, machinery, etc., as more
and more variable factors like labour and/or raw
materials are used successively the average and
marginal output may decline. This is called diminishing
E
returns to a variable factor. There may be increasing
returns to a factor. If the rate of change of inputs is
proportional to that of output, it is constant returns; if
output changes are proportionately more (or less) the
input-change, it is increasing (or diminishing) returns.
If the input change is proportional to the output change,
it is constant returns to an input, other inputs remaining
UP

fixed or constant.
Returns to scale is a long run concept. As a result of

simultaneous changes in all inputs by same proportions
the long run output changes may be subject to increasing
or constant or diminishing returns to scale, depending
upon the proportion of change in inputs vis-a-via output.
Economic Zone of Production

When we move from single factor production models to the
)
two factor production models, we find that beyond ridge lines

OA and OB, it is not advisable to produce because either
marginal productivity of labour or capital tends to be zero.
(c
Thus, the production must be undertaken within the zone

countered by the ridge lines.
S
Activity
Collect information and
diagrams of production
functions and make a collage
from it.
E
Figure 11.5: Economic Zone
Check Your Progress

Fill in the blanks:
1.
UP
If the constraints are so compelling that those are
unsurmountable, then it is ................. .
2. If some constraints can be overcome, it is ..................
3. It all the constraints can be overcome, it is

................. .
Production Functions
The degree or extent of substitutability between or among
inputs utilised decide the form of production function. There
are various forms:
1. Cobb-Douglas type: Q = Q(L,K)
Q = AL K1- where ‘A’ is a constant (index of

efficiency),  and 1 -  indicate returns to factors labour
)
and capital. These power terms added together are

called ‘function coefficient’ ( + 1 - ) = 1 ‘constant
returns to scale in production economics’.
Mathematically, it reveals a homogenous function of
(c
degree one. Most of the manufacturing processes reveal

this type of production function, such that diminishing
returns to factors become perfectly compatible with
constant returns to scale.
F K LI
S
2. Leontief type: Q = minimum H a bK where ‘a’ and ‘b’
are constants. In this case of fixed proportion production
function, there is no scope (technological feasibility
lacking) for substitution between factors.
3. Linear type: At the other extreme, there may be cases

where there is no limit to the substitutability between
E
factors, such that a multivariate production function
works out to be a single-variable linear production
function, Q = aL or bK where ‘a’ or ‘b’ represent factor
proportionality.
4. CES type: The Cobb-Douglas type stated earlier, with

function coefficient equal to 1 is a special case of
UP Constant Elasticity of Substitution (CES) type. In other
CES type, constant may take any other value (other than
one). Q = B[gL-h+ (1-g)K-h]-1/h is a CES types production
function, with B,G and h as constants; h>-1.
5. VES type: If the function coefficient does not remains

constant, but varies in the productive process, pay over
shifts, then it is Variable Elasticity of Substitution
(VES).
Effects and Elasticities

In consumption, we have talked about the price effect, income
effect and substitution effect of a commodity-price change
on demand. Analogous to that, we may talk about the effect
of a change in factor-price on the demand for inputs in
production.
 Own Price Effect: As the price of a factor, say labour

(i.e., wage rate) changes, the utilisation of that factor
labour in the productive process may also change.
)
L L
or 
 0. In normal cases, the wage effect on labour
w w
is negative. In exceptional cases, it may be different. In
(c
K K
the same way, or  0. (where r is the rental rate
r r 
or interest rate).
S
 Cross Effect: This tells us about either substitutability
or complementarity or unrelatedness between factors
of production.
L L
or < 0  L & K are complements
r r
K K
or > 0  L & K are substitutes
E
w w
K K
or = 0  L& K are not related
w w
 Substitution Effect: As the relative factor price

structure changes, the input utilisation may change.
L L

F I F w I  0
w
H K HrK
r
or
UP
 Expenditure Effect: Analogous to income effect on
demand for consumption items, we have the
L L
expenditure effect or 0 where C is the total cost
C C
budget spent on the purchase of inputs. For normal
factor, the expenditure effect will be positive, but for
an inferior factor, the expenditure effect will be
negative. As more expenditure is sanctioned by
managements it is possible that the manufacturer may
move from hand to machines, as a result the demand
for labour comes down when the size of C (Cost budget
allocation) is increased. Sometimes, the ‘expenditure
effect’ is renamed as ‘output effect’ which traces the
movement along the expansion-path.
Corresponding to the effects which can be shown in

)
Isoquant – Isocost line diagram, we have the follow-up

concepts of elasticity, (are or point) in production.
 Input Price Elasticity:
(c
Coefficient values
L % L L w 0
ew  or .
% w w L 0
S
K % K K r 0
er  or .
%r r K 
 Cross (input) price elasticity
l % L L r 0
er  or .
% r r L 0
E
K % K K w 0
ew  or .
%w w K 
 Cross (input) quantity elasticity
l % L L K 0
ek  or .
% K K L 0
UP or its inverse
0

 Expenditure elasticity
l % L L C 0
ec  or .
% C C L 0
0

We may also rename it as ‘cost elasticity of input’.
In analysing production, we have another important concept

of elasticity:
 Elasticity of factor substitution
% K d i % K d i e j
 K
L
f
es 
L

L
F I
e j GH Q /  K JK
, or   Q /  L
)
% (MRTS LK ) % MP L
MPK
It may be noted that e sf  0 for Leontief Function; but

(c
f f
e s  1 for Cobb-Douglas Function, e s   for a Linear
Function; e sf  constant for CES function, whereas e sf is
a variable for VES type of production function.
S
 Input elasticities of output
In Cobb-Douglas type functions, Q = AL K1-
Q L %Q
   Labour elasticity of output,
L Q %L
Q K %Q
(1   )  ,   Capital elasticity of output,
E
K Q %K
If we add up these input elasticity, we get the
 Function coefficient, F
F = e lq + e kq    1    1
It may be noted that there is an organic relationship

UP
between concepts and measures of factor intensity (say
MPL MPK
K/L) factor productivities (say AP AP ) elasticity of
L K
factor substitution () and marginal rate of technical

substitution between factors (MRTSLK).
Multi-factor Case
Let us take the Cobb-Douglas Function to demonstrate this
relationship underlying the case.
Q = (L, K) = AL K1-
Q  1 1-   AL K 1-  Q
MPL    AL K     . APL
L L L
F KI 1-
or,  A
H LK
Q  1-  -1    AL K 1- Q
MPK   (1   ) AL K   (1    (1  APK
)
K K K
F LI 
or,    A
H KK
(c
S
MPL
Q
L LM  . K OP
MPK
 MRTSLK 
Q
K

N1   L Q
Also note,
Q
MPL
  L 
q
E
 el
Q APL
L
Q
K MPK q
      ek
Q APK
K
Thus, factor productivity ratio, marginal to average,

UP
determines factor-elasticities of output, the components of
function coefficient. The ratio of factor elasticities and factor
intensity – their product determines the marginal rate of
technical substitution between factors of production.
Joint Product Case

Carrying this further to the joint product case where two
products Q1 and Q 2 are jointly produced to be sold in the
market at P1 and P2 prices respectively, we can think of
maximising P1Q1 + P2Q2 subject to the constraint, F = F(Q1Q2)
or minimising resource F (Q 1Q 2) subject to the revenue
constraint R = P1Q2 + P2Q2. The optimising decision rule
arrived in this case would be
LM dF OP
MM dQdF  MRPT
1
q1q2
 P
P1
PP
MN dQ
2
PQ
2
)
This reads that the Marginal Rate of Product Transformation

(MRPTq1q2) which is the ratio of marginal resource cost of
production should be proportional to the product price ratio.
(c
In terms of diagrams, we have equilibrium at e……..e 1.

E S
UP
Figure 11.6: Marginal Rate of Product Transformation
On examining this set of diagrams, we can talk about several

other effects and elasticities.
 Elasticity of Product Transformation
LM OP
F Q I %FG Q IJ MM  FG Q IJ F  F PP
% G J
H Q K  H Q K  MM H Q K  Q Q PP
2 2 2
p
F MF I M LM F OP Q P
1 1 1 1 2
e 
t %MRPT
% G
H MF JK MM  M Q P Q PP
q1q2 q1 2
MM MMN QF PPQ

1 1
PP
q2
N 2 Q
p
)
Note e that is analogous to the concept and measure

t
f
of e .
s
(c
S
 Output elasticity of factor (Input)
F %F(L, K)
eq   This will tell us if any additional
%Q(Q1Q2 )
output combination is to be produced,
what will be the factor requirements.
This is reverse of input elasticity of output.
E
 Output elasticity of revenue
r %R1 R1 Q1
e q11  or . . . . where R1=P1Q1
%Q1 Q1 R1
r %R2 R 2 Q2
e q22  or . . . . where R2=P2Q2
%Q2 Q2 R 2
UP
 Cross elasticities in production
q Q1 P2 q Q2 P1
e p21  ; e p12  . . . . cross price elasticities
P2 Q1 P1 Q2
q Q1 Q2 q Q2 Q1
e q21  ; e q12  . . . . cross quantity
Q2 Q1 Q1 Q2
elasticities
Such elasticities are significant for product line decision

and product-mix decisions.
The reader may note that all these ‘elasticities’ are

merely extension of ‘effect’, which are measured by
marginal magnitudes. For example,
r R1 R1 MR1
e q11   
 Q1 Q1 AR1
Elasticities are essentially ratios of marginal to average

)
magnitudes. Marginal term (slope) alone does not

measures elasticity.
Also note that analogous to various ‘effects’ we have

(c
talked about earlier, we may also refer to:

S
 Output (product) effect on factor (input)
F1 F1 F2 F2

or ; or
Q1 Q1 Q2 Q2
 Revenue effect on product line
Q1 Q1 Q2 Q2

or ; or
E
R1 R1 R2 R2
 Transformation effect (analogous to substitution

effect)
Q 1 Q1
F I F P I
P
or
H K HP K
 1
P2
1
2
UP
A change in relative product price structure may induce
a change in product transformation or, what is
sometimes called product mix. Sand is transformed into
microchips, but these chips have to be properly mixed
for manufacturing the Videocon TV set for sale.
 Revenue effect on factor requirement
Q F F F
 or
R Q R R
As sales revenue increases, the output which gets

revenue needs to be produced and for that there will be
more input requirement.
 Product Price effect on Product line
Q1 Q1 Q2 Q2

or ; or
P1 P1 P2 P2
)
From Production to Supply Function

Ordinarily the terms production and supply are used
interchangeably. Technically, this is wrong.
(c
Production Function is an input-output relation. Q = Q(L) is

the simplest form. In contrast, the Supply Function is a price-
output relation, S=S(P). If it is supply of X, then Sx=S(Px). If
S
it is supply of q quantity out of Q produced then Sq = S(Pq).
Supply is price-responsive and production-determined,
supply is meant for the market, whereas production is
factory/firm centered.
S = Q – D r – In
The market supply S along with market demand D
E
determines the market price, P:
P = P(D, S); D = d(P); S = s(P)
D S
The reader may recall :  0 , but 0
P P
This brings us to the supply curve, with a positive slope, in

contrast to the demand curve with a negative slope.
UP
The slope and shape of the supply curve depends on
production conditions and laws of returns.
 Upward Sloping Curve: This is a normal supply curve

LM S OP  0 . It reflects
with positive price effect on supply
N P Q
diminishing returns and rising costs conditions.
 Constant remaining supply curve: This reflects

LM P OP   or LMP OP  0 .
constant returns to scale, with
N S Q N S Q
 Downward falling supply curve: This reflects
increasing returns and diminishing costs conditions,
LM S OP  0 . Increasing returns result from economies
with
N P Q
of scale. As more and more is produced less becomes
the unit cost of production and therefore price becomes
low. Thus, at lower price, more is supplied.
)
The reader may also recall that the shape and slope of the
supply curves depends on the production time perspective.
In the temporary run, the supply is totally price-inelastic;
(c
in the short run, it is relatively price-elastic up to a point

but not beyond; in the long run, the supply is relatively price-
elastic and non-price factors like technology, etc., effects
supply favourably.
S
Generalised Supply Function
Analogous to a generalised demand function, we can state a
generalised supply function as:
Sq = S (Pq, Pw, Pv, C, T, I n, Dr, e)
Thus, the supply of Q to the market depends on
E
Pq = Own price of Q
Pw = Price of W, a substitute of Q (say, its wastes)
Pv = Price of V, a complementary item of Q (like in a joint

product case)
C = Cost budget, taking care of input prices (like wage

rate, rental rate, interest rate)
T =
UP
Technology, flexible or fixed
In = Inventory demand
Dr = Reservation demand
e = Stochastic variable, erratic in nature.
We may accordingly talk about relevant ‘effects’ and

‘elasticities’ with reference to the above function which is
amenable to econometric estimation.
Lag Model
In the same way, analogous to a distributed lag model in
demand analysis, we may think of a supply function in terms
of lagged variables.
LMe j ; bC , C ge jOPQ
N
Sq  S Pq Pq
t t 1
, Pq
t 1
t t1
, C t1 ; Sq
t1
, Sq
t 1
)
This is only an illustrative function; we may introduce other

variables with or without lag. It is indeed meaningful to think
that supply of item q today in the market is determined by
the previous stock position and desirable stock building,
(c
previous and expected future price of the item, the other

item related to it, cost allocation yesterday and tomorrow.
The point is, current price and non-price variables are not
the sole determinants of supply.
S
Also note, among other concepts and measures, in this
context analogous to demand analysis, we can think of
Elasticity of supply expectations:
%Sq Sq Sq
e t t t-1
es   .
%Sq Sq Sq
t-1 t-1 t
E
%Sq Sq Sq
e t+1 t+1 t
es   .
%Sq Sq Sq
t t t+1
This coefficient will be very useful for decision to place

purchase order, decision to display in the market, decision
to build stock and create artificial scarcity and the like. The
speculative supply activity is as real as the speculative
UP
demand activity.
Production Decisions
Production decisions have many facet. It should be clear from
the foregoing analysis that the decision to produce is linked
with several other decisions like the decision to supply to
the market, the decision to build or liquidate inventory, the
decision to enhance the plant capacity or to go for intensive
capacity utilisation, the decision concerning location of the
unit, variability of inputs, choice of technique and technology,
product line decisions, product mix decisions, multiplant
operations and logistic management and so on. It is an endless
list.
There are operational problems in measuring productivity

of various inputs, various shift operations and various
production schedules or batch or lot size. Economists have
spent a lot of time and energy in resolving some of these
)
measurement problems, yet the problems continue. For

example, when a new machine is installed and a few hands
are replaced, it will read that labour productivity (output
per labour) has gone up. Similarly, output per acre of land
(c
may go up, despite no increase in labour productivity, because

of good seeds, fertilisers and irrigated water supply.
Production decision cannot be resolved through
S
considerations of only ‘physical efficiency’ but also ‘cost
efficiency’. In fact, production maximising decisions are
invariably cost minimising decisions. The best output to be
produced is the least cost output. Thus, efficiency can be
measured in terms of not only volume and variety, but also
quality and costs. Thus, we need to move from production to
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costs analysis. And then we may revisit some of the optimum
production decisions in view of costs considerations.
Check Your Progress

Fill in the blanks:
1. Production technology is ................ to the
2.
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consumption technology.
Production is the process of creating the ................
3. In ................ technique the input ratio, the man-

machine ratio remains unchanged irrespective of
any change in Q.
4. In product life cycle: Introduction  Growth 

Maturity  ...............  ................ .
5. Production decision have many ................ .
Summary
Production is the process of creating the ‘utils’. Both present
similar problems. In production, for example, the problems
are : What to produce? How to produce? When to produce?
Where to produce? In the same way, in consumption, the
problems are: What to consume? When to consume? How to
)
consume? Where to consume? Thus the choice of a basket of

consumption units, say at the morning breakfast table, is
similar to the choice of inputs of men, materials and machines
at the shop floor of a factory.
(c
Production technology is analogous to the consumption

technology. Thus, the production function, Q = Q (L, K) is
analogous to the utility function, U = U (X, Y), where X and
Y are usable goods; and L and K are usable inputs.
S
The terms ‘technique’ and ‘technology’ are often used
interchangeably; but technically they are different. For
example, the choice of production technique is a tactical
operation (say, on the shop floor), whereas the choice of
production technology is a strategic policy decision (arrived
at the Board Room).
The production constraints, through proper planning, should
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ease slowly and gradually to yield complete flexibility, perfect
segmentation and infinite indivisibilities in the long run.
Production decisions have many facet. It should be clear from

the foregoing analysis that the decision to produce is linked
with several other decisions like the decision to supply to
the market, the decision to build or liquidate inventory, the
decision to enhance the plant capacity or to go for intensive
UP
capacity utilisation, the decision concerning location of the
unit, variability of inputs, choice of technique and technology,
product line decisions, product mix decisions, multiplant
operations and logistic management and so on. It is an endless
list.
Lesson End Activity

Visit (a) one small firm (b) one large firm. On what criteria
did you distinguish between the two? List separately a list
of ten production decision problems pertaining to each.
Keywords
Production: Production is the process of creating the ‘utils’.
Production Technology: Production technology is

analogous to the consumption technology. the production
function, Q = Q (L, K) is analogous to the utility function, U
= U (X, Y), where X and Y are usable goods; and L and K are
)
usable inputs.
‘Technique’ and ‘technology’: The terms ‘technique’ and

‘technology’ are often used interchangeably; but technically
(c
they are different.

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Imitation: Blindly copying the product or the process and
the pattern.
Innovation: New ideas, new techniques, new product coming

through extended use or modified version of an existing item.
Innovision: Going beyond the obvious.
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1. Assume that there is technological progress which is
capital intensive, but labour saving. How would you
measure the productivity of manpower employed on the
shop-floor of an automated plant?
2. Distinguish between ‘production’ and ‘productivity’.

UP
Construct hypothetical examples (tables) to accept or
reject the hypothesis.
Labour productivity can never increase when total

production is falling (in a period say, night shift
operation in a printing press).
3. Distinguish between:
(a) Returns to a factor and Returns to scale.
(b) Input elasticities and Function coefficient.
(c) Elasticity of factor substitution and Elasticity of

product transformation.
(d) Inferior goods and Inferior factors.
(e) Income elasticity and Expenditure elasticity.
4. Under what conditions, would you get
(a) Positive own-price effect (say wage effect on labour

)
utilisation).
(b) Negative cross (price) effect on factor utilisation.
(c) Supply curve with a negative slope.

(c
(d) L-shape isoquants.
(e) Shift in Production Possibility curves.

S
5. What is disguised unemployment? How would you
measure it? Would you agree that there may be
underemployment of not only labour but also capital
(machine)?
6. Write lucid notes on:
(a) Second stage of short-run production
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(b) Economic zone of production.
Collect some cases from real work situations to illustrate

the relevance of these economic concepts.
7. For each of the following production functions,

determine whether returns to scale are decreasing, or
increasing or constant?
UP (i) Q =K/L
(ii) Q = 100 + 3K + 2L
(iii) Q = 5KaLb where a = 0.6 and b = 0.4
(iv) Q = 20 K0.8 L0.5
(v) Q = 2K + 3L + KL
8. The marginal product of labour in a production process

is statistically estimated as
MPL = 10 (K/L)0.5
Currently the process is using 100 units of K and

121 units of L. Given the very specialised nature of
capital equipment K, it takes about a year to increase
K; but the rate of labour input, L, can be varied daily. If
the wage rate is $ 10 per unit and the price of output is
$2 per unit, is the firm operating efficiently in the short
)
run? If not, explain why. Also determine the optimal

rate of labour input. On what factors does the labour-
efficiency depend?
(c
9. Prepare a table with hypothetical business data to

illustrate exactly the three-stage-production-diagram.
S
10. How would you explain
(a) Under-utilised capacity in a plant or building.

(b) Underemployment of labour in a factory or
Government office.
(c) Over capacity utilisation in BHEL or NTPC.

(d) Emergence of idle capacity in an automobile
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factory.
Give real world business examples of each. Collect data.
11. What do you mean by the statement:
“Firms operate in the short run and plan for the long
run.”
Further Readings
Books
UP



Web Readings
)
www.mbe-du.org/
(c
(c
) UP
E S
UNIT 12: Cost Analysis
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Unit 12
Cost Analysis
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Objectives
topics:
 Cost Concepts
 Economies and Diseconomies

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Theoretical Cost Functions
Empirical Costs Situation
Applications of Cost Analysis
Introduction
Cost analysis (also called economic evaluation, cost
allocation, efficiency assessment, cost-benefit analysis, or
cost-effectiveness analysis by different authors) is currently
a somewhat controversial set of methods in program
evaluation. One reason for the controversy is that these
terms cover a wide range of methods, but are often used
interchangeably.
Cost Concepts
A businessman needs to look at costs from various points of
view. At least, he needs to take care of three sets of costs,
knowing fully well that they may overlap each other–
)
 Economic Costs
 Accounting Costs
(c
 Engineering Costs
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Economic Costs
In formal economic theory, costs are taken as a function of
output. Output is produced by combining the use of fixed
factors and variable factors. In the long run when all factors
are variable, all costs are variable costs; but in the short run,
the economists make a distinction between fixed costs and
variable costs.
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Short Run Costs
The total cost of any output is the value of all the inputs
used in its production. Costs, therefore, will rise or fall as
the ratio of outputs to inputs changes. Such changes may
come about as a result of changes in the efficiency of the
conversion process or changes in the prices of the inputs.
UP
Average cost is the cost per unit of output needed to prevent
the use of input in alternative uses. This ‘resistance’ is
sometimes measured by the price of the factor used. When
we are deciding upon proper allocation of more than one
input, the resistance is generally measured in terms of the
usefulness or marginal productivity of the resource in each
use.
Average cost is a function of (a) the organic composition of

the firm and (b) the level of output, prices of inputs being
given. The organic composition of the firm refers to the
distribution of resources among varying kinds of assets
having different degrees of liquidity, or time-spans over
which they yield services. The cost function will differ
depending on differences in the organic composition of the
capital or asset structure.
In the short run, just as the total costs are the aggregate of
total fixed and variable costs, the average costs are also the
)
aggregate of average fixed costs and average variable costs.
Marginal costs refer to change in costs, obviously in variable

part of the costs. As the total variable costs vary with the
(c
level of output produced, the marginal costs change. The

marginal costs represent the costs of producing an additional
level of output.
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We may now represent these short run costs through a set Activity
of diagrams.
Make a slideshow on the
concept and various sets of
Long run Costs costs.
In the long run, the firm has time to adapt fully its plan
implying that all inputs are variable. The long run average
cost (LAC) curve is the cost curve showing the average cost
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of production at different levels of output, turned out by
different sized plants. This is shown in the following diagram
under the assumption that the number of possible short run
is infinitely large, i.e., plant of virtually any size can be built.
UP
Figure 12.1: Long-run Average Cost Curve
The long run total costs (LTC) is also an envelope curve

containing several short run total cost curves as illustrated
in the Figure 12.2.
)
(c
E S
UP Figure 12.2: Long-run Total Cost Curve
The long run marginal cost (LMC) curve is obtained by taking

the first derivative of the long run total cost function with
respect to output.
d(LTC)
LMC 
dQ
The LMC is not the envelope of the short run marginal cost
(SMC) curves. The SMC is the rate of change of total costs
with respect to output with some costs variable and other
fixed. The LMC is the rate of change of total costs with all
cost variables. The short and the long run marginal cost
curves may cross; the short and long run average cost curves
touch but never cross. The long run marginal cost curve is
the focus of those points on the short run marginal cost curves
which correspond to the optimum plant size for each output.
The relation between the long run average costs and long
run marginal costs, when stated in terms of a ratio, works
)
out to be the inverse of ‘output elasticity of costs’.
LAC LTC/Q LTC Q LTC Q

LMC  LTC/ Q  Q  LTC  LTC  Q
1 1
(c
 
LTC Q LTC Q
 
LTC Q LTC Q
LM LTC  Q OP  dC  Q
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Note that
N LTC Q Q dQ C = output elasticity of costs
The shapes of the long run average and marginal cost curves
are contrastable to those of short run curves. Both LAC and
SAC are U-shaped, though the LAC is flatter than the SAC.
As the SMC passes through the minimum point of the SAC,
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the LMC also passes through the minimum point of the LAC.
The long run average cost first falls, remains constant and
then rises. The movement along the LAC and the shifts in
the LAC can be explained in terms of the economic concepts
of economies and diseconomies of scale.
Other Economic Costs

UP
In addition to the short run and long run costs, the
economists make reference to other costs such as:
 Production Costs vs Selling Costs
 Real Costs vs Money Costs
 Pecuniary Costs vs Opportunity Costs
 Private Costs vs Social Costs
 Zero vs Positive Information Costs
Accounting Costs
From the standpoint of financial control and management
(incorporating activities like accounting, auditing, costing,
budgeting and tax planning), there are several cost concepts.
These are all explicit (outlay) costs to be recorded in books
of accounts. Some of these costs are:
 Capital costs: Costs of land, building, machinery, plant

)
and equipment, head office (administrative) expenses
 Overhead costs or fixed overheads (indirect costs)
Labour and material costs (direct costs)

(c

S
 Depreciation and replacement, interest on borrowed
capital, taxes, etc. (period costs).
These costs are often reclassified as:
1. Fixed vs variable vs semi-variable costs, depending upon

the degree of variation of these costs with respect to
output.
E
2. Out-of-pocket vs book costs, depending upon the
immediacy of expenditure. Book costs can be converted
into out-of-pocket costs by selling assets and leasing
them back from the buyer.
3. Traceable vs common costs, depending upon the degree

of traceability of costs to product, or process (operation)
UP
4.
or pattern (technique) or department.
Floating vs sunk costs, depending upon activity-related

costs or activity-independent costs. For example,
amortisation of past expenses; depreciation is a sunk
cost, but additional cost consequent upon additional
activity is a floating cost.
5. Incremental vs marginal costs; both are additional costs

of operations or activity, but the latter is narrower than
the former. Costs resulting from unit change in product,
process or pattern or any activity is marginal, but
additional costs from chunk changes in product, etc., is
incremental.
6. Historical vs replacement costs, depending upon the

timing of asset valuation, past or present. Costs reported
by conventional financial accounts are based on
historical (original outlay) valuation.
7. Controllable vs non-controllable costs, depending on the

)
degree of controllability of costs. Sometimes

discretionary control can be exercised by the business
executives.
(c
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8. Escapable vs unavoidable costs, depending upon the
possibility of avoiding some costs, almost on the same
lines as above in (7) or (4).
9. Present vs future costs, a distinction depending upon

actual and planned nature of costs.
Engineering Costs
E
From the standpoint of project management, the engineers
often refer to costs pertaining to:
1. Pre-investment phase: Planning costs.
2. Investment phase: Execution costs including drawing

and designing, procurement and construction, erection
and commissioning, etc.
3.
UP
Post investment (operation) phase: Running/Operation
costs, preventive or breakdown maintenance costs,
depreciation and replacement costs, etc.
These engineering costs can be reclassified into either

accounting or economic costs.
Check Your Progress

Fill in the blanks:
1. .................. is the rate of change of total costs with

respect to output with some costs variable and
other fixed.
2. .................. is the focus of those points on the

short-run marginal cost curves which corresponds
to the optimum plant size for each output.
)
(c
Economies and Diseconomies
S
Activity
Prepare a brief report on the Figure 12.3 presents a total view of these economies and
theoretical cost functions.
diseconomies.
E
UP
Figure 12.3: A View of Economies and Diseconomies
Theoretical Cost Functions

The determinants of cost vary so much from firm to firm and
from problem to problem that no general set is applicable to
all. Nevertheless, there are a few determinants which are
important enough in modern manufacturing enterprises so
as to deserve special mention. They are:
1. Rate of output (i.e., utilisation of fixed plant)

)
2. Size of plant
3. Prices of input factors (materials and labour)
4. Technology
(c
5. Size of lot
6. Stability of output
7. Efficiency (of management as well as labour)

S
The word ‘cost’ that we are using has different meanings in
different settings. The kind of cost concepts to be used in a
particular situation depends upon the business decision to
be made. Hence, an understanding of the meaning of various
concepts is essential for clear business thinking.
The economists normally use output as the determinant of

costs such that
E
C = C (Q)
when Q = Q (L, K, T, M)
Thus, C = C [Q (L, K, T, M,…..)]
where,
L is labour
K
T
Capital
Technology, and
UP
M Management
We would continue our analysis with the wide variable cost
function C = C(Q).
It may be noted that cost function and production function
are related.
Then we can write,

TC = TFC + TVC
AC = AFC + AVC
 TFC  TVC
Q Q
MC = TVC  AVC for a linear short run cost function.

Q
)
We can rewrite total variable costs as,
TVC = PV.V
AVC = TVC  PV. V

(c
Q Q
 PV. 1
Q/V
S
Activity Where Q/V is the expression for average product of the
variable factor. This means that the average variable costs
W rite an article on empirical
costs situation. of labour is the ratio of wage rate to average product of
labour. Similarly,
MC = PV. V because MC  TVC

Q
E
 PV. 1
Q / V
Where Q/V is the expression for marginal product of the

variable factor.
This means that the marginal costs of labour is the ratio of
wage rate to the marginal product of labour.
UP It is clear that given the information about factor-price and
production function, we can compute AVC and MC.
We may consider several forms of cost functions:
The four forms of the total cost function which can be
estimated by econometric method are (1) Linear,
(2) Quadratic, (3) Cubic and (4) Double-log forms.
Empirical Costs Situation

The empirical studies of costs are of two broad types:
statistical analysis and cost estimates. Cost estimates are
less frequently cited in the literature, but those are probably
more important from the viewpoint of managerial decision
making. It is in the field of cost estimates and cost projections
that the special knowledge and skill of the cost accountants
are of vital importance.
A number of statistical cost studies present cost-output

relations in the short run. Certain conditions should be
)
satisfied so that the statistical cost functions may be of some

value for business decision making. These conditions are:
(i) The basic time period for series of paired observations

(c
on costs and output should be one in which the observed

output was attained by a uniform rate of production
during the period. If a week is the time period taken,
the daily production should be reasonably constant.
S
(ii) Cost figures should be directly paired with the
corresponding output figures. We do not get any
meaningful results if we associate costs recorded in
period t0 with the output figure in period t1, unless there
is one period lag between costs and output flow.
(iii) There should be a wide spread of output observations

so that cost behaviour can be observed at widely
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different outputs.
(iv) The experimental data should not be contaminated by

factors extraneous to the cost functions, such as changes
in factor prices, etc.
Check Your Progress

Fill in the blanks:
1.
UP
Marginal costs of labour is the ratio of wage rate to
the .................. .
2. The empirical studies of costs are of two broad

types: .................. and .................. .
Applications of Cost Analysis

Cost concepts and analysis have a lot of business applications.
Some of these applications are discussed below:
1. Optimum Output Decisions: The production manager

and his team members are required to guide their work
force by stating the production target, production
schedules, product mix and so on. Critical to all these is
the optimum output decision.
The concept of ‘optimum scale of output’ or ‘optimum

size of plant’ is founded on the discussion of the
)
theoretical cost functions. The scale of output/the size

of plant is economically optimum when average costs
equal marginal costs; and this happens at the minimum
point on the average cost curve, assuming U-shaped
(c
average cost curve.
This definition holds true for both short run and long
run. Since there are no fixed costs in the long run, at
S
the point of optimum, the average variable costs are
equal to marginal costs.
2. Optimum Inventory Level or Economic Order

Quantity: The optimal inventory level is that level of
stock, i.e., goods in the pipe line – goods which have
been produced, but have not yet reached the final
consumer – which can be held at minimum costs. The
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inventory is held by the wholesaler as well as the
retailer. Let us confine our analysis simply to a retailer
who may be getting his stock either from a wholesaler
or from a manufacturer. To determine the optimum
inventory level, the costs of holding inventory must be
identified first.
There are two types of costs involved: Carrying costs

UP and Reorder costs. The inventory carrying costs include
storage costs and interest costs on the cash used to buy
the inventory. There are reorder costs involved in
placing and delivering an order; a part of the reorder
costs (such as book keeping and long-distance
telephoning for orders) is fixed and the other part (which
changes with the size of the order) is variable.
Determination of the optimal inventory level involves
a systematic balancing of the savings in inventory
carrying costs (which result from cutting the size of the
inventory held) against the increased reorder costs
(which reduced inventory will require). Here optimality
calculation involves unconstrained cost minimisation.
3. Optimal Length of Queues: Related to the inventory

question is the problem of the optimal length of queues
in the production process. As an example, consider a
manufacturing facility in which workers obtain certain
tools from a specific location. The tools are handed out
)
by clerks as workers request them. They are returned

to the clerks when they are no longer needed.
If there was a clerk for every production worker, there

(c
would never be any delays in getting tools. A clerk would

always be available to provide assistance. But there is a
cost involved in having more clerks. Hence, managers
have an incentive to reduce costs by cutting back on
S
clerks. However, fewer clerks mean more time spent
waiting for tools. Even with a small number of clerks,
workers may sometimes be able to obtain a tool without
waiting. But, at other times there may be a considerable
delay while other workers are being served. In general,
the average waiting time for service is inversely related
to the number of clerks. Clearly, there is a cost involved
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in having production workers waiting for tools. During
the waiting time, nothing will be produced. The longer
the wait, the greater the loss of production.
4. Break Even Decisions: In the initial phase of market
oriented production, the business manager wants to
‘break even’, i.e., to cover his total costs by the total
revenue he earns. Thus, at break even point
TR =
UP
P.Q =
TC
TFC + TVC
PQ = TFC + AVC.Q
 Q = TFC/(P-AVC)  QB
Note, QB denotes break even volume of output, i.e., that

output level which enables the firm to spread its total
fixed costs, TFC, over the average contribution margin,
(P-AVC).
P × QB = QV  Break even value or sales revenue
LM QQ . 100OP  Break even percentage

B
A l s o n o t e
N Q
C
QB %, i.e., Break even volume as a ratio of capacity

output QC. Let us take an example to illustrate.
Given TR = 108Q
)
TC = 6200 + 46Q
Plant capacity, QC = 200 units
6200 = 100 units
We get QB = – 108-46
(c
Q V = 100 × 108 = 10800 ( `)
QB %= 50%
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It may be noted that other things remaining the same,
 Any increase in price will reduce QB.
 Any increase in fixed costs will increase QB.
Any imposition of tax (say, fixed lump sum) will

increase QB but a grant of subsidy (say, fixed lump
sum) will reduce QB.
E
 Any increase in variable costs will increase QB.
Some of these results may be verified even through the

UP diagram–the Break Even Chart.
Figure 12.4: The Break Even Chart

)
5. Produce or Shut-Down Decision: In the short run,

all fixed costs may not always be covered. In the short
run, therefore, the revenue earned must cover at least
(c
the total variable costs. In other words, the price per

unit of output sold in the market should be sufficient to
cover the average variable costs, i.e. costs of labour and
S
material per unit of output. Thus, [PAVC] defines the
shutdown possibility. If the price [P<AVC], then the
production process should be stopped. If P>AVC then
there is some contribution margin to cover at least a
part of fixed costs or losses thereupon. If [P = AVC], i.e.,
Zero contribution margin, it is a critical indication of
marginal operation or Shutdown point s and the
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corresponding shutdown level of output.
For a given price OP, the minimum AVC coincides with

MC; thus
PVC = AVC = MC
For example, if the minimum wage rate is ` 96/- and the

raw material cost is ` 108/- for providing one unit of
UP
output, then the price, ` 204 = (` 108 + ` 96) is the
shutdown price, OP; and the shutdown output is OQS.
Figure 12.5: Shutdown Level of Output
6. Cost Reduction and Control: This is an important area

of business decision with respect to product or process
)
or pattern or the like including promotion of its sale. In

some organisations, there are regular programmes to
make employees cost conscious such that everybody does
his bit to reduce and control costs, keeping in view the
(c
norms of cost-efficiency and effectiveness.
In this context, the accountant’s classification of

avoidable vs unavoidable or controllable vs
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uncontrollable costs serves as a useful manual. It may
however, be noted that there may be absolute and
relative costs reduction and reduction is not always an
element of optimum control. To control telephone bills,
the easiest and surest method may be to cut the
telephone connection, but that is absurd; the feasible
proposition is not to reduce the bill to zero, but to
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attempt a relative reduction by monitoring telephone
calls. Sometimes ABC analysis or value engineering is
an attempt towards costs control, so are DERT and CPM
techniques to find out optimal cost activity path.
Efficiency
In the context of production and costs analysis, ‘efficiency’ is
UP
a major consideration. Earlier we have made reference to
the concepts of ‘efficiency’. Let us recall them for operational
purpose.
There are two concepts of efficiency:
 Physical efficiency
 Cost efficiency
Physical Efficiency
It is reflected in either total or partial factor productivity.
Suppose, we have a single variable production function, Q =
Q (L). In this case, either Q/L or DQ/DL can be used as a
measure of physical efficiency. If more Q can be produced by
same L as before or same Q can be produced by less L, then
output per labour goes up. This productivity enhancement
indicates an improvement in labour efficiency.
Cost Efficiency
)
It is measured not in terms of physical productivity but in

terms of money returns, i.e., value rather than volume
considerations. A buyer of a product, for example, would like
to realise ‘value for money’ he has spent on acquiring the
(c
product he intends to use. Similarly, a producer-seller is

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equally entitled to receive ‘money for value’ (mutilise) he
has produced for sale in the market. Reducing and
controlling, i.e., saving costs is an element of cost efficiency.
Durability of the product is an element of physical efficiency.
There is an intimate relation between the two. Costly
products should be physically better products and vice versa.
Similarly, cheap (less costly) products may be useless
E
(physically) products.
Cost Efficiency and Cost Effectiveness

These two concepts must be distinguished from each other.
In many government projects we often emphasise ‘outlay
spent’ and not ‘output derived’. In earthquake relief work, a
lot of money may be spent, but it may not reach the needy
UP
person, this means it is not ‘cost effective’. Reducing costs is
‘cost efficiency’ but rising costs being allowed to reach a
particular result is ‘cost effectiveness’.
X–Efficiency
It is a relatively new concept used by the economists to refer
to the ability of the production unit (monitored and
controlled by production manager) to reduce the wastage of
resources. More wastage means more costs.
Optimal Scale and X–Inefficiency

Companies may not always be able to identify exactly their
short run or long run technical optimum, as this requires
considerable knowledge of the nature of production costs as
output rises. Companies’ unit costs may be higher than is
technically feasible – a ‘production-cost’ gap – for the
following two broad reasons:
1. The firm is not producing at its optimal scale of

)
production.
2. The firm wastes resources and its costs are higher than
necessary at its existing scale of production (so-called
(c
‘x-efficiency’ because it can exist to any degree).

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Check Your Progress
Fill in the blanks:
1. ............... cost of any output is the value of all the in

its production inputs used in its production.
2. The ............... cost represent the cost of producing
E
an additional level of output.
3. Cost of land, head office expenses comes under

............... costs.
4. ............... efficiency is the ability of producer unit

to reduce wastage.
5. Two types of efficiencies are ............... and ...............

UP
Summary
efficiencies
A businessman needs to look at costs from various points of

view. At least, he needs to take care of three sets of costs,
knowing fully well that they may overlap each other–
1. Economic Costs
2. Accounting Costs
3. Engineering Costs
Average cost is the cost per unit of output needed to prevent

the use of input in alternative uses. This ‘resistance’ is
sometimes measured by the price of the factor used. When
we are deciding upon proper allocation of more than one
input, the resistance is generally measured in terms of the
usefulness or marginal productivity of the resource in each
use.
)
Average cost is a function of (a) the organic composition of

the firm and (b) the level of output, prices of inputs being
given. The organic composition of the firm refers to the
(c
distribution of resources among varying kinds of assets

having different degrees of liquidity, or time-spans over
which they yield services. The cost function will differ
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depending on differences in the organic composition of the
capital or asset structure.
In the short run, just as the total costs are the aggregate of
total fixed and variable costs, the average costs are also the
aggregate of average fixed costs and average variable costs.
Marginal costs refer to change in costs, obviously in variable
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part of the costs. As the total variable costs vary with the
level of output produced, the marginal costs change. The
marginal costs represent the costs of producing an additional
level of output.
Lesson End Activity

Visit a nearby (a) factory, (b) hospital, (c) corporate office
UP
and (d) educational institute.
For each of the above, collect information or data concerning

their costs. Reclassify all those with appropriate name, into
two separate categories: Economic Costs and Accounting
Costs.
Keywords
Cost: costs are taken as a function of output.
Output: Output is produced by combining the use of fixed

factors and variable factors
Total Cost: The total cost of any output is the value of all
the inputs used in its production.
Average Cost: Average cost is the cost per unit of output

needed to prevent the use of input in alternative uses
Marginal Costs: Marginal costs refer to change in costs,

obviously in variable part of the costs.
)
Long Run Cost: In the long run, the firm has time to adapt
fully its plan implying that all inputs are variable.
(c
LAC: The long run average cost (LAC) curve is the cost curve
showing the average cost of production at different levels of
output, turned out by different sized plants.
S
1. Visit a construction site. Meet the team of architect,
engineer, labour contractor or supervisor and the labour
leader. Prepare a detailed list of construction project
costs. Reclassify them as Economic Costs.
2. (a) How is the concept of ‘cost effect on production’
E
different from that of ‘cost elasticity of production’?
Suppose, your reference is to a Stage Production of
a three-act musical play by a Music Theatre Group.
(b) Distinguish between concepts of ‘costs efficiency’

and ‘costs effectiveness’ with reference to organising
(i) An event (like exhibition/marriage/cultural

UP programme)
(ii) Relief operation (in say, flood-affected area/

earthquake-hit area/railway accident).
(c) With reference to the variety of examples cited

above, draw a line of distinction between ‘private
costs’ and ‘social costs’.
3. (a) Would you agree with the view that a marketing-

cum-production unit often tries to explore the
‘economies of scope’ as and when it exhausts
exploiting the ‘economies of scale’? Give real world
examples quoting companies and cases.
(b) Can you think of some ‘diseconomies of scope’

parallel to ‘diseconomies of scale’? Give examples.
4. The Government of India has a scheme called Broad

Banding which allows the manufacturer to diversify into
related areas of production without seeking a fresh
)
licence. Explain the cost implications of the scheme,

identifying the relevant concept of ‘economies’.
5. (a) Suppose a firm can produce a produce mix from the

use of same input (e.g. wool and mutton, while
(c
rearing the same sheep or crude oil and associated

gas, while drilling well). How should the firm
decide about the optimum product mix? How will
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you restate the optimum decision rule in this case
in terms of cost concepts? Do you anticipate any
measurement problems while applying your rule?
(b) How would you apply the economic concepts of ‘X-

efficiency’ or ‘X-inefficiency’ in the above case?
6. Review you understanding of the implications of
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(i) Zero information costs
(ii) Zero opportunity costs
(iii) Zero selling costs
(iv) Zero inventory costs

The Japanese managers often recommend ‘Just-in-time
UP
production’ and that suggests zero inventory costs, i.e.,
(iv) above. Can you think of similar recommendations
or practices which suggest (i) through (iii) above?
7. Attempt an explanation of each of the following
situation, supported by suitable examples:
(i) Many firms tend to produce in excess of their

(licensed) capacity output.
(ii) Some firms do not, even if they can, expand their

scale of operations beyond a critical limit.
(iii) For many firms, despite their best intentions and

efforts, capacity often remains under-utilised.
8. Attempt a comprehensive note on ‘Slope and Shifts’ in

the cost curve from the standpoint of both (a) theory
and (b) practice. How would you integrate the two?
9. If the ‘economies of scale’ are so important, how would
you explain the coexistence, (rather survival) of small
)
firms alongside large firms in the same industry?

10. The estimated total cost function of firms is:
TC = Q0 + 2Q1 + 3Q2 + 4Q3 + 43210

(c
If the firms decides to produce 50 units of Q, what will

be the estimated total, average and marginal costs of
production? Show all the components of economic costs.
S
11. What do you mean by Economic Order Quantity (EOQ)?
What are the determinants of EOQ? Why is it that the
Variable (Reorder) Costs do not influence the EOQ
decision?
Further Readings
Books
E


UP

Web Readings
www.businessdictionary.com/definition/cost-analysis.html
www.ask.com/Cost+Analysis
www.mbe-du.org/
)
(c
UNIT 13: Industry and Market Structure Analysis
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Unit 13
Industry and Market
Structure Analysis
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Objectives
topics:
 Structure - Conduct - Performance Paradigm
 Forms and Structure of Market

UP
Competitive Strategy
Introduction
Economic theory lays the foundation for the analysis of public
policy, business behaviour and market performance, but it
is in business economics that these questions occupy centre
stage.
Industry and Market Structure Analysis

Much of this approach in Business Economics has been based
on Structure-Conduct-Performance paradigm. The linear
relationship is illustrated below:
)
Figure 13.1: Structure - Conduct - Performance Paradigm
In this basic view, market structure determines the

behaviour of the firms in the market and the behaviour of
(c
firms determines the various aspects of market performance.

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Activity
Structure
Make a presentation on industry The major elements of market structure describe ways in
and market structure analysis.
which markets depart from the conditions that describe
perfect competition.
Number and Size Distribution of Sellers

A classroom competitive market consists of many small
E
buyers and sellers, no one of whom is able to influence the
price. Among other things, a competitive industry will, in
the long run, supply a product at a price equal to its
opportunity cost – the value of the resources needed to
produce it.
In contrast, a monopolised market is supplied by but a single

UP seller, who is able to restrict output and hold the price above
the opportunity cost of production. Some consumers who
would be willing to pay the cost of producing the product
are unable to obtain it. It is this output restriction that is
central to economists’ belief that monopoly is an inefficient
way to organise production.
Concern with the number of sellers reflects the intuitive

notion that fewer the number of sellers in a market, the more
likely is the market to perform as a monopoly. Concern with
the size distribution of sellers reflects the belief that a
market with one very large firm and several small ones is
more likely to perform as a monopoly than a market with a
few firms of roughly equal size.
Product Differentiation
The overall implications of product differentiation are
complex. There is a trade-off between market power – the
power to control price – and variety. Society will usually be
)
willing to put up with some market power in order to get

some product variety.
Entry Conditions
(c
The economic analysis of entry conditions focuses on the

various factors that influence the decision of a firm to enter
a market. How large must a firm be to produce efficiently.
S
How large an investment must a firm make to begin
operations? If a firm enters a market and fails, how much of
its investment can be recovered by selling off assets and how
much will be sunk in the market? What sorts of sales efforts,
if any, will be needed for a successful operation? How will
established firms react to the prospect of new competition?
On a basic level, entry conditions help explain the number
E
and size of distribution of firms that operate in a market.
Because entry conditions determine the nature of potential
competition between established firms and firms that can
enter a market, entry conditions affect market performance
in their own right, as well as through their effect on market
structure.
Conduct
UP
Firm conduct is a subject that becomes interesting only when
competition is imperfect. Under competition, a firm can sell
all it wishes at the market price, but only at the market price.
In such circumstances, a firm has no incentive to advertise,
to react to what rivals do, or to attempt to discourage entry.
Firms in a competitive market with free and easy entry have
an incentive to collude, but any such attempt is doomed to
fail. Even if all of the many small firms in a competitive
industry could coordinate a cartel, new firms would come
into the market. This situation is different when competition
is imperfect.
Performance
In a competitive market (and in long run equilibrium), the
quantity demanded equals the quantity supplied at a price
equal to the marginal cost of production. Production is
efficient if all firms have access to the same technology and
)
firms unable to use the available technology effectively lose

money in the short run and disappear in the long run. The
issue of technological progress does not fit comfortably in
the model of perfect competition, which assumes complete
(c
and perfect knowledge of the available technology. This

situation, too, is different when competition is imperfect.
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Interactions
The linear Structure-Conduct-Performance model depicted
in Figure 13.1 presumes very simple causal relationships.
Structure determines conduct, conduct determines
performance. But it is evident from our brief discussion of
the Structure-Conduct-Performance model that industrial
relationships are not so simple. The linear Structure-
E
Conduct-Performance model has been augmented to reflect
the interactions among structure, conduct and performance
that occur in real-world markets (Figure below).
UP
Figure 13.2: The Interactive Structure - Conduct -
Performance Framework
The relationships among structure, conduct and performance

are complex and interactive. Structure and conduct are both
determined, in part, by underlying demand conditions and
technology. Structure affects conduct, as shown in earlier
figure, but conduct – strategic behaviour – also affects
structure. Structure and conduct interact to determine
performance. Sales efforts, an element of conduct, also feed
back and affect demand.
Forms and Structure of Market

)
The business environment of a firm is conditioned by the

forms and structure of the market wherefrom it purchases
its inputs and wherein it sells its output. The behaviour and
performance of a firm depends on the competitive market
(c
environment in which it operates. The cardinal elements of

competition in the market have been referred to earlier by
way of identifying the structure of the market. In what follows
we would now like to state and explain the forms of market
S
structure based on those cardinal elements of competition.
Economists distinguish between the following broad forms
depicted in Figure 13.3.
E
UP
Figure 13.3: Types of Market
Check Your Progress

Fill in the blanks:
1. Structure and Conduct interact to determine

...............
2. In a competitive market, the quantity demanded

equals the quantity supplied at a price equal to
the ............... .
Perfect Competition
A perfectly competitive market reveals the following cardinal
features.
)
 Large number of transactors, i.e., buyers and sellers so

that individually no one can influence the price sought
by the free play of forces of demand and supply.
(c
 Homogeneous (identical and standardised) products.
 Freedom of movement, i.e., entry into and exit from the

industry.
S
Activity  No transport and distribution costs to distort
competition.
Write an article describing the
features of a monopoly.
 No information costs to handicap the free flow of
information about market data.
 No firm enjoys any special cost advantage, i.e., all firms

having identical cost conditions and access to external
E
economies.
In perfectly competitive markets, because the product is

homogeneous, the competition can centre only on price. The
demand curve faced by a producer is therefore, horizontal
or perfectly price elastic. The way in which a perfectly
competitive market operates can be best described with the
aid of diagrams.
UP While analysing each form of market structure the
economists take profit maximisation as the motivational
assumption behind the activity of each firm and the industry
which the firms constitute. Accordingly, we can refer to
double conditions of equilibrium:
dR dC
1. Firm Level : MR = MC or dQ  dQ
TR TC
2. Industry Level : AR = AC or Q  Q
While analysing the market structure, we have to examine

how these conditions are satisfied and what are their business
implications. Also, we need to note what is the time
perspective of the firm and the industry under consideration.
This is because it gives us an insight into the ‘constraints’
alongside the ‘objectives’ of the firm and the industry – the
factors which exercise their impact on the “conduct”, given
the “structure”.
)
Monopoly
Monopoly is the polar opposite of perfect competition.
Economists define a monopolist as the sole supplier to a
(c
particular market. This should not be confused with the

everyday use of the term to describe a supplier with a
relatively large share of the market. Nor should it be
S
confused with monopoly as defined in government legislation
– in the United Kingdom a supplier with more than 25% of
the market. Like the perfect competition model, the
monopoly model is designed to be an extreme case and it is
rarely found in practice. Commonly, state industries are
described as monopolies, but though they often dominate an
industry, they are rarely monopolies of a market. In other
E
words, it is possible to find examples of monopolistic
industries, but rarely of monopolistic markets.
In the lack of competition, monopoly is associated with the

following:
The monopolist always makes a profit: We may rework

the monopoly situation by splitting the different phases of
the cost curves separately as follows:
UP
In each case, corresponding to the monopoly equilibrium at
E, there is price exceeding marginal costs. The constructing
elements are:
Case I : P = AR > MR = MC >AC  P > MC > AC
Case II : P = AR > MR = MC = AC  P > MC = AC
Case III : P = AR > MR = MC < AC  P > MC < AC
The monopolists make higher profit under Case I than under

Case II than under Case III. That is the reason, the monopolist
loves to produce under increasing costs (diminishing return)
conditions.
Profit Rates
In a competitive market profit rates should be lowered.
Hence, the level of profitability might be an indicator of the
degree of monopolisation of the market. In practice,
)
however, a snapshot of current profit rates tells us nothing

about how profit rates are changing over time in the face of
competition. The use of profit rates is therefore, a very crude
indicator of monopoly power. An alternative is to use what
(c
is called the Lerner index.

S
Concentration Ratios
These ratios represent the extent of the market supplied by
a given number of firms. For example, a four-firm
concentration ratio shows the percentage of the market
supplied by the four largest producers. Therefore, if the four-
firm concentration ratio is 60%, this means that 60% of the
market is supplied by the four largest companies. Where the
E
four-firm concentration ratio is 100%, this means that four
(or fewer) firms produce all the output and hence the industry
is highly concentrated. In addition to four-firm concentration
ratios, five-firm and sometimes eight-firm ratios are used
by economists.
Market Share
UP
Although frequently used to assess the degree of competition
in a market, the concentration ratio does not tell us the
different market shares of the largest producers. For
example, there may be two industries with four-firm
concentration ratios of 60%, but in one industry each of the
four firms might have 15% of the market, while in the other
industry three of the firms might have 5% each and a
dominant firm might have 45% of the market. The amount of
competition may be very different in the two markets. We
might expect to see more monopolistic behaviour in the
latter market where the dominant firm may be more able to
affect the market price. An alternative approach to assessing
competition is therefore, to look at the market share of the
largest firms.
Herfindahl Index (HI)

Now commonly used by government bodies when measuring
the degree of competition in a market, this index takes into
)
account the size distribution of firms. It is measured as:

n
Herfindahl Index (HI) =  S 2i

i 1
(c
where Si represents the market shares of each of the i firms

in the market. Hence, the index depends on the number of
firms in the industry and their relative market shares. A
value closer to 1 indicates increased monopolisation because
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it suggests a small number of firms and/or very unequal
market shares.
In the same context, we may suggest two alternative

measures of Degree of Monopoly.
Kalecki’s Measure
The degree of monopoly is measured by the deviation
E
between price and MC. Under monopoly,
P = AR
AR > MR
MR = MC
P > MC
can be measured as
P  MC P  MC
UP
Accordingly, the degree of monopoly power mp of the firm
mp = MC
or P
Lerner Index
Alternatively,
1 AR-MR
mp = ep  AR
Higher the demand inelasticity, greater is the degree of

monopoly for the firm selling that product. It may be noted
that the above two measures are related starting with
Kalecki,
mp = P-MC
P
We may rewrite the same as
mp = AR-MC
AR
)
and at equilibrium MC = MR. Thus, we get Lerner’s Index
1
mp = AR-MR
AR = ep where ep is the price elasticity of demand.
(c
S
Cross-Elasticity Measures
The reader may recall these concepts from demand analysis.
Cross Price elasticity of demand, for jth product in response

to the price of the ith product, may be stated as
 Q j dQ j Pi
eij   
 Pi dPi Q j
E
if eij = 0, it implies that the i and j are not substitutable; thus
either i or j seller enjoys the monopoly power. By contrast,
eij   suggests there is perfect competition.
Cross Quantity Elasticities

UP e qiqj 
% Q j
%Qi

Q j Qi
.
Qi Q j
Cross Price Elasticities
 Pj Pj Pi
e pipj   
 Pi Pi Pj
qj Pj
Zero e qi or e Pi suggests that there is no market
interdependence such that we need not talk of price-reaction
or output-reaction among the market players. By contrast,
infinite cross quantity or cross price elasticities suggests a
high degree of market dependence among rival players.
Check Your Progress

Fill in the blanks:
1. ................... represents the extent of the market

supplied by a given number of firms.
)
2. Herfindahl Index = ................... .
Monopolistic Competition
(c
Monopolistic competition refers to markets in which there

are a large number of firms competing, supplying products
which consumers believe are close but not complete
S
substitutes. Therefore, it is a market in which firms compete Activity
through slight product differentiation and management has
discretion in pricing, trading-off price against quantity sold. duopoly and oligopoly.
The demand curve faced by each firm will be more price
elastic because of the existence of considerable competition.
It is assumed that there is relatively free entry into and exit
from the industry and that entry and exit are regulated by
E
the level of profit earned.
Monopolistic competition (the large group case) is analogous

to perfect competition except for the element of ‘product
differentiation’. It is this feature which induces the firm to
spend on selling costs like ad expenditure to promote the
sale of its product characterised by ‘distinctiveness’. It is this
feature which enables the firm to price is product differently
UP
for different market segments. It is this feature which makes
the demand for its product relatively price-elastic, elasticity
being in the range of greater than unity but less than infinity.
Duopoly and Oligopoly

Oligopoly is the term used to describe such markets. Where
there are only two suppliers the term duopoly is used.
Oligopolists may supply a relatively homogeneous product,
such as oil, or they may compete through differentiated
products, for example, as in the motor car industry. The
greater the product differentiation, the greater the scope to
be a price-maker rather than a price-taker.
The oligopolistic interdependence in decision making has

far reaching consequences for the industry, market and
consumers. Since moves and countermoves are closely
related, since decisive strategies and tactics of one firm affect
rivals’ decisions and actions, since anticipated reaction of
the rival is the basis for working out the optimal decision
)
path of one firm, the oligopolist has developed an armoury

of aggressive and defensive marketing weapons. For
example, advertising can become a life-and-death matter
where a firm which fails to keep up with the advertising
(c
budget of its competitors may find its customers drifting off

to rival products. There is constant struggle, rival against
rival, a sort of true competition. Under these circumstances,
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a very wide variety of behaviour patterns becomes possible.
One possibility is collusion which is referred to in the
preceding paragraph. The other possibility is cutthroat
competition, till the relatively weaker firm are competed
out of existence. For analytical convenience, different models
and their underlying approaches can be as follows:
(i) Ignoring interdependence
E
(ii) Predicting rival’s countermoves
(iii) Preparing against optimal moves by rivals
Monopsony, Duopsony & Oligopsony

Monopsony is the buyer’s monopoly. For example, the
contractor on the construction site buys the services of the
UP
construction workers. Under duopsony, two buyers obtain
factors independently or jointly if collusion or carte is
formed. IOL and ONGC can jointly plan oil drilling and
refining; IA and AI may jointly plan fleet utilisation, pilots
deployment and technology upgradation. Under oligopsony
a few buyers may get together to form a cooperative. For
example, the Group Housing Societies run on oligopsony
principle while undertaking all activities from construction
to maintenance of the building complex. In operational
terms, in each one of these buyer-market-forms, the strategy
planning and tactics execution may be on similar, if not same,
pattern as in the seller market.
Notwithstanding this similarity, the contrasting analogy

should be drawn between the seller market and the buyer
market. And for that, certain key concepts have to be defined,
with reference to a factor market, say labour market.
TRPl = Total Revenue Product of labour

)
MRPl = Marginal Revenue Product of labour
VMPl = Value of the Marginal Product of labour
TFCl = Total Factor Costs of employing labour

(c
MFCl = Marginal Factor Costs of employing labour

S
AFCl = Average Factor Costs of employing labour
L = Labour Employed
Q = Output Produced
P = Price of the output sold
The reader may recall the concepts of total, average, marginal
E
(physical) product of labour, when we have Q = Q (L).
Similarly, given P = P(Q), the concepts of total, average and

marginal revenue may be recalled such that
Q dQ
VMPl = [AR.MPl] = P.  P.
L dL
LM R . Q OP  LM dR . dQ OP  dR
MRPl = MVPl = [MR.MPl] =
UP N Q L Q N dQ dL Q dL
LM C . Q OP  LM dC . dQ OP  dC
MFCl = [MCl.MPl] =
N Q L Q N dQ dL Q dL
TFCl WL
AFCl =  = W, the wage rate
L L
In the seller market, the equilibrium condition reads MR =

MC.
In the buyer market, the corresponding equilibrium

condition reads
MRPl = MFCl
It is still the equimarginal principle.
Monopsony, Duopsony or Oligopsony are different forms of

imperfect factor market (labour market) where labour is not
organised and, therefore, gets exploited. We will have more
)
to say on exploitation of factors later.
Presently, while talking of analogy between the buyer market

and the seller market, we would like to refer to Reaction
(c
Functions:
P1 = P (P2) or Q1 = Q (Q2)
S
Corresponding to the ‘price reaction’ and ‘output reaction’
typical of duopoly-oligopoly situation, we may now talk of
‘input reaction functions’. Let us suppose that the contractor
is procuring his construction worker from two sources: male
labour and female labour. And because of his monopsony
power, he may discriminate among two grades of labour, by
offering them two different wage rates corresponding to the
E
seller market practice of a monopolist practising ‘price
discrimination’ (depending upon elasticities of demand for
his product); in the buyer market, a monopsonist may practise
‘wage discrimination’ depending upon the elasticity of supply
of the input (labour) required in the productive process.
Thus, corresponding to the price relation function,
P1 = P(P2), of a discriminating monopolist, there may be the
wage relation function of a discriminating monopsonist W1
UP
= W (W2). In the same way, we may talk about input reaction
function, L1 = L (L2) or L2 = L (L1) where 1 and 2 are different
grades of the same input, labour.
It may be noted that the VMPL curve indicates the demand

for factor (labour), where the AFCL curve indicates the
supply of labour. Had the factor market been perfectly
competitive, the wage rate would have been decided by the
free play of these factor market forces; that would have been
the competitive solution. Otherwise, much would depend on
the relative strength of the buyer and the seller.
Product Market & Factor Market

Let us now view the product market and the factor market
together. We may consider four possible cases:
Perfect Product Market and Perfect Factor Market

If the product market is perfect, then given price, P, AR=MR,
)
and therefore, VMPL = MRPL. Assuming diminishing

returns to labour, we have a downward falling demand for
labour curve. If the factor market is also perfect, then wage
rate, W, being given, AFCL = MFCL. Thus, in the factor
(c
market, OW wage rate prevails and OL labour is employed

because at that MRPL = MFCL. There is no profit no loss for
either the employer or the employee.
E S
Figure 13.4: Equilibrium of Perfect and Factor Market
Imperfect Product Market and Perfect Factor Market

UP
In this case, in the product market the seller is a price maker
such that AR > MR and therefore, VMPL > MRP L (with
diminishing returns assumptions). Whereas in the factor
market, because of perfection, AFC1 = MFC1, again, the
equilibrium condition, i.e., equi-marginalism.
(MRP L = MFC L) is satisfied at E, corresponding OL is

employed at OW wage rate and the employer makes WERS
as profit which is the measure of exploitation of labour; it is
monopolistic exploitation because it originates in product
market imperfection (i.e., monopoly).
)
(c
Figure 13.5: Imperfect Product and Perfect Factor Market

S
Because of perfection in the product market, VMPL = MRPL.
However, because of imperfection in the factor market
(i.e., monopsony) under rising costs conditions, AFCL will
be rising and therefore, MFCL > AFCL. The equilibrium
point E suggests that OL will be employed at OW wage rate.
As a result, TRPL = TFCL by WCER which is the employer’s
profit, but employer’s loss, i.e., exploitation of labour. This
E
is monopsonistic exploitation because it originates with
imperfection in the factor market (i.e., monopsony).
UP
Figure 13.6: Perfect Product Market and Imperfect
Factor Market
Imperfect Product Market & Imperfect Factor Market

When both the markets are imperfect because of presence
of monopoly and monopsony elements, we have both
monopolistic and monopsonistic exploitation of labour. This
is the real world situation. If minimum wages are fixed, say
at OT, the monopsonistic exploitation WCET can be removed
because the gap between AFC1 and MFC1 will be squeezed
till AFCL = MFCL = TEGH. In order to remove monopolistic
exploitation, the commodity price control has to be
)
introduced. If product price is fixed and administered, then

only VMPL = MRPL and, as a result, the area TERS can be
wiped off.
(c
E S
Figure 13.7: Imperfect Product and Factor Market
The message is clear: Minimum wage legislation and

UP
enforcement cannot remove all forms of exploitation. Also
note that we have considered labour market situation here.
It is a representative case of any factor market. Any factor
can be exploited. In fact, in today’s world, it is not labour but
management that is exploited through prolonged labour
strikes, go-slow, pen-down, bandh, etc.
Check Your Progress

Fill in the blanks:
1. Economic theory lays the foundations for the

analysis of private policy. ...................
2. Market structure describe ways is which market

depart from the conditions that describe perfect
competition. ...................
3. In imperfect competition situation conduct is non

essential. ...................
)
4. Performance depends on competitive market

environment in which it operates. ...................
5. Homogeneous product means identical and

(c
standardized products. ...................

S
Summary
Economic theory lays the foundation for the analysis of public
policy, business behaviour and market performance.
The major elements of market structure describe ways in
which markets depart from the conditions that describe
perfect competition.
E
Firm conduct is a subject that becomes interesting only when
competition is imperfect. Under competition, a firm can sell
all it wishes at the market price, but only at the market price.
In such circumstances, a firm has no incentive to advertise,
to react to what rivals do, or to attempt to discourage entry.
Monopoly is the polar opposite of perfect competition.

Economists define a monopolist as the sole supplier to a
UP
particular market. This should not be confused with the
everyday use of the term to describe a supplier with a
relatively large share of the market. Nor should it be
confused with monopoly as defined in government legislation
– in the United Kingdom a supplier with more than 25% of
the market.
Monopolistic competition refers to markets in which there

are a large number of firms competing, supplying products
which consumers believe are close but not complete
substitutes. Therefore, it is a market in which firms compete
through slight product differentiation and management has
discretion in pricing, trading-off price against quantity sold.
Oligopoly is the term used to describe such markets. Where

Oligopolists may supply a relatively homogeneous product,
such as oil, or they may compete through differentiated
products, for example, as in the motor car industry.
)
Lesson End Activity

Attempt a market survey of the following items, and establish
the farm-and-structure of the market they belong to.
(c
(a) Legal Profession
(b) Privates Hospitals

S
(c) Bofors Guns
(d) Sports Shoes
(e) Bank Union & Bank Management – negotiated average

settlement
(f) Text Books of Management
E
Keywords
Economic Theory: Economic theory lays the foundation for
the analysis of public policy, business behaviour and market
performance.
Firm Conduct: Firm conduct is a subject that becomes
interesting only when competition is imperfect.
UP
Monopoly: Monopoly is the polar opposite of perfect
competition. Economists define a monopolist as the sole
supplier to a particular market. This should not be confused
with the everyday use of the term to describe a supplier with
a relatively large share of the market.
Monopolistic Competition: Monopolistic competition
refers to markets in which there are a large number of firms
competing, supplying products which consumers believe are
close but not complete substitutes.
Oligopoly: Oligopoly is the term used to describe such
markets. Where there are only two suppliers the term
duopoly is used.

1. (a) Classify selected industries by entry barriers
following the format below.
)
(c
(b) Would you agree: Greater the degree of ‘entry

barriers’ higher is the degree of monopoly.
S
(c) How do entry barriers affect the long-run pricing
strategy of a firm?
2. (a) What is the use of cross-elasticity measures for a

marketing manager?
(b) Do cross price elasticities and cross quantity

elasticities generate same type of market
E
information for managerial use?
3. (a) Suggest a measure of ‘degree of monopsony’,

parallel to Kalecki’s measure of ‘degree of monopoly’
(b) Illustrate ‘dead weight loss’ under (i) monopoly and

(ii) monopsony in two separate diagrams.
4. Market shares for the firm’s in two industries are as

UP follows.
Both industries have same number of constituent firms.

(a) compute the Herfindahl Index for each industry.
(b) Locate the dominant firm in industry B.
(c) What will happen in industry A if all small firms

combine together? What will be the likely form of
market?
(d) Can you attempt to measure some sort of
‘concentration ratio’ in these two industries?
5. The market for television sets is given by
P = 1000 –10Q
)
The industry consists of one large firm which acts as a

price leader, and two smaller firms having aggregated
marginal costs as follows:
MCF = 2.5 Q F
(c
The large firm’s marginal costs is
MCL = 1.0 Q L
S
The objective of all firms (in the industry) is to maximise
profit. (a) what price will the dominant firm charge?
(b) What price will the two smaller firms charge?
(c) What will be the market share of the large firm?
6. Explain the consider under which you may get the

following market demand curve?
E
Explain price-costs relationship under each of the above
cases.
7.
UP
In a duopoly market, the market demand is estimated
as Q = 66–P. Derive the price-reaction functions
assuming P1 as the price of the leader and P2 as the price
of the follower. Can there be a stable solution (i.e., no
price war)?
8. The equilibrium price in a perfectly competitive market
is ` 10. The marginal cost function is given by MC = 4 +
0.2Q. The firm is presently producing 40 units of output,
to maximise output, should the output rate be increased
or decreased? Explain.
9. A firm is facing the market demand and cost as
Q – 20-P
TC = 2+8Q+Q 2
Estimate the
(a) Profit maximising output
(b) Revenue maximising output
)
(c) Sales maximising output subject to a minimum

profit of 8.
Illustrate the case in a diagram.
(c
10. Compare the market environment of monopolistic

competition with that of perfect competition, quoting
real world business examples.
S
11. Distinguish between:
(a) Buyer’s Market & Sellers Market
(b) Product Strategy & Promotion Strategy
(c) Competitive Advantage of Firms & Nations
(d) Monopolistic & Monopsonistic Exploitation of
Labour.
E
(e) Collusive & Non-collusive Oilgopoly.
12. Examine the relationship between market structure,
market behaviour and market performance of firms
selling differentiated products.
Further Readings
UP
Books



Web Readings
en.wikipedia.org/wiki/Industrial_organization
www.westga.edu/~bquest/1997/ecnmkt.html
)
www.mbe-du.org/
(c
UNIT 14: Theory and Models of Firm and Industry
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Unit 14
Theory and Models of Firm
and Industry
E
Objectives
topics:
 The Determinants of Firm Structure
 Economist's Theory of Firm

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A Critique of the Economists' Theory
Introduction
The theory of the firm consists of a number of economic
theories that describe, explain, and predict the nature of the
firm, company, or corporation, including its existence,
behavior, structure, and relationship to the market.
The Determinants of Firm Structure

In the models of elementary micro-economics, the firm is
essentially a ‘black box’ that houses a production function.
Factors of production flow into the box and goods and services
flow out. These flows occur in such a way so as to maximise
the firm’s profit. The production function summarises the
technological relationships between inflow and outflow. Any
differences in performance are due to the environment
surrounding the black box – to the structure of its market –
)
not to anything that goes on within the black box.
Internal Structure
The internal organisation of firms raises (at least) three
(c
interesting questions. First, why are certain collections of

production functions assembled under a single corporate
umbrella? Why, for example, does production in some
S
Activity industries typically involve vertical integration, while in
other parts of the economy vertically related markets are
W rite an article on the
determinants of the firm occupied by independent firms?
structure.
Second, how do firms organise the relationships among the
productive activities of which they are comprised? What, in
other words, is the internal structure of the firm? Are some
forms of internal organisation more efficient than others?
E
Third, how do all of these factors affect performance in the
markets in which the firm operates? Is efficiency enhanced
in any market if firms that operate in unrelated markets
combine to form a conglomerate? Is market power at any
level enhanced vertically?
Firms may expand horizontally, vertically or into unrelated

UP markets. This is attained through ‘integration’ or what we
often call ‘merger’.
Mergers
A merger is an integration of two or more firms under a single
ownership. Mergers play an important role in a free
enterprise economy, in that less efficient firms are
swallowed by the more efficient. Thus, mergers often result
in redeployment of productive assets and facilitate the
efficient flow of investment capital. But it is also possible
for mergers to have an adverse effect on competition by:
1. Reducing the number of firms capable of entering

concentrated markets.
2. Reducing the number of firms with the capability and

incentive for competitive innovation.
3. Increasing the barriers to entry in concentrated

markets.
)
4. Diminishing the vigour of competition by increasing

actual and potential customer – supplier relationships
among leading firms in concentrated markets.
(c
Mergers may be classified as horizontal, vertical or

conglomerate.
S
Horizontal Mergers: A horizontal merger is one in which
different plants producing similar products are brought
under a single ownership. Three reasons are often advanced
for such expansion.
1. To meet the demands of a growing market.
2. To take advantage of economies of scale in production
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and distribution.
3. To increase market share and market power.
Vertical Mergers: A vertical merger is one in which firms

engaged in different stages of the chain of production and
distributions are united under one ownership. For example,
a manufacturing firm might integrate backwards to obtain
UP
control of a source of raw material or forward to obtain
control of sales outlets for its products. Two major reasons
for vertical mergers exist:
1. To reduce costs: For example, substantial cost

reductions were obtained in the steel industry when the
furnaces were integrated with the rolling mills, thus
eliminating costly reheating steps in the production
process.
2. To gain control of the economic environment: For

example, Freestone has complete vertical integration
from rubber plantations to manufacturing facilities to
retail outlets. Their supply of raw materials is secure,
as is their access to the ultimate consumer of their tyres
and other rubber products.
Conglomerate Mergers: A conglomerate merger is one in

which different companies producing different products are
)
brought under a single ownership. Such diversification

enables the acquiring company to spread risk, find good use
for idle capital, add a line of products to its marketing
capacity or simply gain in economic power.
(c
In every case, mergers have mixed effects: some to improve

performance, some to increase market power and worsen
S
performance. The net effect of mergers will have to be judged
on a case-by-case basis.
Check Your Progress

Fill in the blanks:
1. ................ merger is one in which different plants
E
producing similar products are brought under a
single ownership.
2. ................ merger is one in which different

companies producing different prodcuts are
brought under a single ownership.
Theory vs Models
UP
In view of the determinants of firm structure and industry
size we would like to take stock of some standard theories
and models of firm’s economic behaviour. In this context, we
should note that:
In this background, we may consider:
1. Economist‘s Theory of Firm
2. Behavioural Models of Firm
Economist’s Theory of Firm

Without attempting elaborate refinements and sophisticated
developments, the economists’ theory of the firm may be
summarised in a set of propositions.
1. The firm is a transformation unit. It transforms factors

into products. In this process of transformation, it aims
at creating ‘surplus values’ – the value of products higher
)
than the value of factors which enter the products. This

involves (a) knowledge of production function and (b)
knowledge of least cost factor combination.
(c
2. The firm tries to create as much ‘surplus values’ as

possible. It is this surplus which constitutes the profits
for the firm. The firm aims at maximising profit either
by maximising revenue which it earns by sale of its
S
product in the commodity market or by minimising costs
of production by cutting down the expenditure on the
factors which it purchases in the factor market or by
both.
3. The firm attains its objective of profit maximisation in

a rational manner. The economic rationality on the part
of the behaviour of the firm implies (a) that the firm
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regards profit maximisation as the state of equilibrium,
(b) that the firm takes those decisions and follow up
actions which ultimately lead to the state of equilibrium
and (c) that the firm tries to return to its equilibrium
path even if it is momentarily displaced from it.
4. The firm maximises profit (and thus attains the state of

equilibrium) by equating marginal revenue (MR) with
UP
marginal costs (MC). The firm decides to produce that
level of output, Q, at which the addition made to the
total revenue, R, just covers the addition made to total
costs, C. In terms of our notations, the necessary
condition of the firm’s equilibrium reads:
dR dC
dQ = dQ
dR dC
or dQ = dQ = 0
In addition to this necessary condition MR=MC, the firm

must satisfy the condition that at the point of
equilibrium, the MC must be rising: here is the
sufficiency condition which makes the equilibrium
stable.
5. The market environment in which the firm operates is

given. The nature of competition in the market is
defined in terms of (a) number of firms, (b) nature of the
)
firm’s product, homogeneous or differentiated and (c)

movements, entry or exit of firms.
Depending on whether the market is perfect or

(c
imperfect, the quantum of maximum profit is

determined, though the MR=MC condition for maximum
profit remains unchanged.
S
6. The given time perspective before the firm is defined in
terms of the economic concepts of ‘short run’ and ‘long
run’. The profit maximising condition does not change
with reference to the time perspective. The introduction
of time element, however, helps the analysis of
adjustments with respect to the structure of industry,
the size of firm, the scale of plant and the scale of output;
E
these factors affect the magnitude of profit. The firms
tend to maximise long run profit.
7. The decision variables, which the firm can affect, are:

prices, quantities and qualities of inputs and outputs.
Most of the behavioural theories of the firm overlook
the quality variable presumably because it is not easily
reducible to economic measurement. It is implicitly
UP assumed that the firm has perfect knowledge of all
relevant variables when making decisions; there is no
information cost involved in acquiring this knowledge.
Fundamentally, the economists’ theory of the firm

centres on the assumption of profit maximisation and
the assumption that the firm acts rationally in pursuit
of this objective subject to the constraints imposed by
market environment, factor endowment, production
technology, etc.
Behavioural Models of Firm

Following the criticism of the economists’ theory of firm, some
authors have taken an approach to underplay the ‘economic’
content and to highlight the ‘behaviour’ content to explain
firms’ conduct and performance. Among such constructs, we
have already referred to some as:
1. Baumol’s Sale-maximising Firm

)
2. Stackleberg’s Reaction-oriented Firm
In addition, we would like to refer to a radically different

behavioural approach as propounded in
(c
3. Cyert and March Behavioural Model
R M Cyert and J G March have propounded some critical

ideas underlying the behaviouralist model:
S
(i) The firm is a coalition of various vested interest
groups; different departments, different levels of
management, different groups of workers, suppliers
and consumers, shareholders, etc.
(ii) A complex process of bargaining must take place

between these various groups within the firm to
determine their collective goals. Some of the goals
E
could be related to the following:
 Production: A goal that output must lie within

a certain satisfactory range.
 Sales: A goal that there must be a satisfactory

level of sales.

UP
Market share: A goal indicating a satisfactory
size of market share as a measure of
comparative success as well as growth.
 Profit: Still an important goal, but one amongst

many rather than necessarily of overriding
importance.
Consequently, there is no single objective of the

firm; instead, there are multiple goals which
emerge from the potential for conflict amongst
interest groups within the firm.
(iii) These goals may also change over time as

environment changes. The firm is an ‘adoptive
rational system’, adopting itself and its operation
to environment pull and push factors.
(iv) In view of firm’s ‘adoptive rational system’ when

environment changes, the goals may conflict with
each other.
)
(v) Such conflicts are to be resolved by emphasising a

‘satisfying’ rather than ‘maximising’ behaviour on
the part of one firm.
(c
(vi) If the different agents (vested interested groups)

are not ‘satisfied’, than they may generate,
individually or collectively, ‘shocks’ for the firm.
S
(vii) The only way to avoid such environmental ‘shocks’
is to allow for some ‘slacks’, i.e., some sort of ‘side
payments’ in the nature of economic rent for these
agents.
Some Contrasts
Certain other differences between these two models may be
E
noted. First, the profit maximising firm always reports the
entire amount of actual profits, while in Williamson’s model
the fraction of actual profits reported is generally less then
unity and this fraction changes in response to parameter
changes.
Second, the responses of firms to tax changes under the two

models are stirringly different. The output behaviour of a
UP
profit maximising firm is independent of changes in either
the corporate profits tax rate or a lump sum tax. This is to
be expected, once the firm, which is maximising profits, must
necessarily also, be maximising any fraction of these profits
(such as profits remaining after taxes). But in Williamson’s
model, all the decision variables of the firm are affected by
changes in either tax rates of lump sum taxes.
Check Your Progress

True or False:
1. The firm is a ‘black-box’ that house a production

function.
2. Factors of production flows out and goods to

services flows in.
3. A merger is an integration of two/more firms under

a single ownership.
)
4. Mergers are of only two types -horizontal and

vertical mergers.
5. Economist theory of firm can be criticized because

(c
of its profit maximization assumption.

S
Summary
Firms may expand horizontally, vertically or into unrelated
markets. This is attained through ‘integration’ or what we
A merger is an integration of two or more firms under a single

ownership. Mergers play an important role in a free
E
enterprise economy, in that less efficient firms are
swallowed by the more efficient.
Mergers may be classified as horizontal, vertical or

conglomerate.

UP
under a single ownership.

distributions are united under one ownership. For example,
a manufacturing firm might integrate backwards to obtain
control of a source of raw material or forward to obtain
control of sales outlets for its products.

brought under a single ownership. Such diversification
enables the acquiring company to spread risk, find good use
for idle capital, add a line of products to its marketing
capacity or simply gain in economic power.
Lesson End Activity

Visit some markets. Collect the names of firms which supply
their goods and/or services to these markets. Identify the
nature of the firms and the industry they belong to.
)
Keywords
Firm Expansion: Firms may expand horizontally, vertically
(c
or into unrelated markets. This is attained through

‘integration’ or what we often call ‘merger’.
S
Merger: A merger is an integration of two or more firms
under a single ownership. Mergers play an important role
in a free enterprise economy, in that less efficient firms are
swallowed by the more efficient.

under a single ownership.
E
distributions are united under one ownership

brought under a single ownership.
UP
1. Collect annual report and/or corporate plan document
of at least ten companies. Prepare company profile of
each.
2. Concentrate on information that you have gathered by

way of exercise (1) and (2) above. Prepare a table
incorporating those information as precisely as possible
in the following format.
)
* In case of multiple objectives, prioritise them as the 1,

2, 3 etc...
** In case of multiple constraints, indicate critically unit

(c
1, 2, 3 etc...
3. Distinguish between
S
(a) ‘Managerial Enterprise’ and ‘Managerial
Discretion’;
(b) Environment ‘Shocks’ and Organisation ‘Slacks’;

and
(c) Organisational shocks and Management slacks.
E
Give illustrative examples of each.
4. Explain, with reference to context, your understanding

about the firm as a/an;
(a) Transformation unit
(b) Black box
(c)
UP
Adaptive rational system
(d) Coalition
5. Compare and draw a line of contrast between:
(a) Sweezy model and Stackleberg model
(b) Baumol’s Static and Dynamic models
What do you observe and conclude about their empirical

validity?
6. “Economic theory often assumes ‘perfect competition’

and ‘profit maximisation’. Business practice negates
both”. Comment.
7. “Firms may not always maximise profit, but they do

satisfy profit constraint and they do have a profit
policy”. Discuss.
)
Further Readings
Books
(c

S

Web Readings
wiki.answers.com › ... › Science › Social Sciences › Economics
E
en.wikipedia.org/wiki/Oligopoly
UP
www.mbe-du.org/
)
(c
S
Unit 15
Case Studies
Objectives
E
Case Study 1: Coke Bottles Losses in India with a $400

million Asset Write Down
UP
That Coke was taking a hit in India was known, but to what
extent wasn’t. Now it is and it’s stunning. Coca-Cola Co’s chief
financial officer, Gary Fayard told analysts in New York on
Tuesday that the company was writing off $ 400 million of its
assets in India in the first quarter of 2000. In other words, virtually
half the investment made by the beverages giant in India has
turned to ashes.
This huge dent in its Indian assets, the company clarified, didn’t
in any way alter Coca-Cola’s commitment to India. “We remain
just as committed,” said a company spokesman here, while
declining to comment any further. He wouldn’t be drawn into a
discussion on the implications of the write off on Coke’s future
plans here or on whether this would lead to changes in the
management structure.
The cat was out of the bag on January 26. When Coke filed its
1999 fourth quarter results with the US Securities & Exchange
Commission on that day, it had admitted to a 21 per cent dent in
its bottom line and a $ 45 million loss in that quarter.
It had admitted to more: “The reason for this is the company’s
)
investments in Japan and India.” It had also said that it would

carry out a comprehensive re-evaluation of its assets in India.
The job, therefore, was cut out for its new worldwide boss. Douglas
Daft and his new Indian lieutenant Alex von Behr. And it was
(c
obvious that it wouldn’t be a pleasant one. The magnitude of the

writing down of its assets makes it appear that the Coke brass
has chosen to make a clean breast of the Indian mess and restart
it with a clean slate.
Contd...
S
But why had the mess piled up in the first place. While Coke
India itself is not communicative about it, piecing together
available information makes it appear that the large losses were
mainly due to three reasons – the huge expenses Coke incurred
in buying out bottlers, its lavish market discounting schemes
and its expensive advertising campaigns.
Coke is estimated to have paid off its bottlers about ` 1,500 crores
for a smooth acquisition process, which apart from giving the
E
company an integrating bottling network, hasn’t really given
commensurate returns. On top of that, there have been high
discounting scheme expenses as well as the expenses to acquire
key accounts (restaurants, five-star hotels, movie theatres) as
well as costly ad campaigns (it’s said that it has signed on current
Bollywood sensation Hrithik Roshan for more than ` 5 crore).
The runaway expenses in India is said to have been worrying
UP Atlanta for a while.
Coke’s former boss, Doug Ivestor, had come to India in August
1999 to see things for himself. Prior to that, an audit team from
the headquarters had visited the local HQ in Gurgaon and said to
have found the expenses high indeed. Thereafter, there has been
a change in local management structure and cost control measures
were initiated.
Now, the impact of the write off could be two fold. One: Coca-Cola
India now gets to start afresh. And two: the big brother in Atalanta
is likely to keep a close eye on future expenses which might reduce
the operating freedom of the local management.
Questions:
1. Analyse the case. Comment on the nature of ‘economic
problem’ and ‘choice of strategy’.
2. Analyse the market environment of Coca-Cola in India today.
Comment on the observation, “AD war is a mad war; it is
just a zero-sum game at the end.”
Source: The Economic Times, April 5, 2000
)
(c
S
Case Study 2: Microsoft Held Guilty of Breaking Antitrust
Laws
A Federal judge has ruled in a landmark decision that Microsoft

Corporation seriously violated US antitrust laws, exposing the
software giant to harsh penalties that could even result in its
break-up.
District Judge Thomas Penfield Jackson yesterday found that the
E
Redmond, Washington based firm broke the law by abusing its
monopoly power in personal computer operating systems, doing
“violence to the competitive process.”
Microsoft promised to appeal once the trial ends months from
now and was confident it would ultimately prevail. The company’s
stock, down the entire day, improved slightly after verdict but
was still off $ 15-3/8 at $ 90-7/8 in after-hours trading.
UP
Judge Jackson’s most serious conclusion was that Microsoft violated
Section 2 of the Sherman Antitrust Act by using its might against
other companies, especially Netscape Communications, its rival
in the 1990s for control of the internet browser market.
Netscape’s market share withered under Microsoft’s attack and
it sold out to America Online during the early part of the trial.
“Microsoft maintained its monopoly power by anti-competitive
means and attempted to monopolise the web browser market,”
wrote Judge Jackson in his 43-page ruling.
While it is legal to gain a monopoly through skill or lucks, it is
illegal to use that power to perpetuate a monopoly by preventing
competitors from springing up.
Representatives of the justice department and the 19 States that
brought the case, left open the possibility that they would seek
the strongest remedy available for such a serious violation – a
break-up of the company. Alternatively, they could seek changes
in the company’s business practices.
` 60,000 Crore Gone as Markets Crash
The panic on the country’s stock markets over the last few days
)
today took a dramatic turn for the worse with investors losing a
massive ` 60,000 crore in the largest meltdown in the country’s
stock market history since the Harshad Mehta bubble burst in
the early ’90s. The Bombay Stock Exchange’s Sensex fell 361 points
(c
or lost over 7.2 per cent of its total value today, with 55 top stocks
in the ‘A’ group falling by 8 per cent before they hit the lower
‘circuit filter’ which stopped all trading in them.
Contd...
S
In continuing with the trend of the past few days, technology
firms like Infosys and Satyam were the worst hit – tech stocks
have been falling on the US Nasdaq as well with investors of the
view that these stocks have been hyped too much. Technology
shares like Infosys, Satyam and Wipro, pharma shares like
Ranbaxy, L&T, MTNL, Reliance, HFCL, VSNL and SBI plunged
on sustained unloading of shares by panicky investors.
Today’s bloodbath, initially triggered off by the collapse of the
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American Nasdaq after the US court ruled that Microsoft had
indeed violated antitrust legislation, was worsened by rumours
spread by interested stock market operators in the Indian markets.
One of the country’s pink financial dailies carried a report this
morning (April 4) that the income tax authorities were demanding
taxes from Foreign Institutional Investors (FIIs) which had routed
their investment through the Mauritius tax-haven, to claim tax
advantages. While the report was denied by the Finance Ministry
UP in New Delhi early enough in the morning – the income tax claims
were a mere ` 9 crores from just 7 of the total of over 600 FIs who
operate in India – operators used this to wreak havoc.
Rumours were spread that this was just the beginning of a
massive income tax swoop on FIIs.
Questions:
1. State the case for and against Microsoft as a company.
2. What are the macro implications of such a ruling on a micro
unit?
Source: The Economic Times, April 4, 2000

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UP
BLOCK-IV
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Detailed Contents
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UNIT 16: BUSINESS RISKS AND UNIT 18: MACROECONOMIC CONCEPTS OF
UNCERTAINTY ANALYSIS STOCKS AND FLOWS
 Concept and Measure of Risk  Relations between Stocks and Flows
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 Decision Making under Risk  Stocks and Flows of Money – Revisited
 Risk and The Investment Decisions  Flows of Income, Employment and Output
 Decision Tree – A Technique  Measurement of National Income
 Decision Making under Uncertainty

UNIT 19: MACROECONOMIC ANALYSIS
 The Hurwicz Alpha Decision Criterion
 Introduction

UP
Risk Exposure Calculator
UNIT 17: MACROECONOMIC ENVIRONMENT

OF BUSINESS


Say’s Law of Market
Fisher’s Quantity Theory
 Introduction  Walras’ General Equilibrium
 Business Environment  The Economics of Keynes
 Economic and Non-Economic Environment  Post Keynes Developments

Interaction  Some Issue-based Principles
 Circular Flow of Money: A Schematic Model
of Business Environment and Business UNIT 20: CASE STUDIES
Transactions
 Economic Environment and Business

Management
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UNIT 16: Business Risks and Uncertainty Analysis
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Unit 16
Business Risks and
Uncertainty Analysis
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Objectives
topics:
 Concept and Measure of Risk
 Risk and the Investment Decisions
 Decision Tree - A Technique: Sequential Decision Analysis under

Risks
UP
Introduction
The analysis of market behaviour of firms and industry bring
out clearly the significance of business risks and uncertainty.
There are both market risks and non-market risks; the
former works through demand, supply, product price, costs,
rivals’ existence and operation; whereas the latter operates
through institutional forces like the Government, trade
unions, traders’ association, management club, legal bodies,
voluntary organisations and so on. Traditional economic
theory assumes the world of certainty, i.e., the risk free world.
In reality, risks always exist. Even if risks do not exist, the
market players imagine risks. Business world in general and
the market in particular are always full of risks. And these
‘risks’ are not homogenous – some of them are calculable
probabilities, some are incalculable and infinite; such
countless infinite risks are called ‘uncertainty’.
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Concept and Measure of Risk

Risk is defined as a state of knowledge in which each
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alternative leads to one of a set of specific outcomes with

objectively determined probabilities. Risk can be determined
a priori (i.e., by deduction) or a posteriori (i.e., by statistical
analysis of data obtained by experimentation or sampling).
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Activity Intuitively, we sense that the degree of risk is indicated by
the degree to which the actual outcome or pay off of a strategy
Write an article on the concept
and measure of risk and or project deviates from its expected (mean) value. This is
decision making under risk. indicated by the spread or variation in the probability
distribution of possible outcomes for each proposal.
One way of measuring variation is to calculate the range,

which is the difference between the most extreme pay off
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values. A common and accurate measurement of variation
in the statistics is called the standard deviation, s (sigma).
Decision Making Under Risk

The mean, standard deviation and coefficient of variation
have direct application in assessing the expected return and
risks associated with managerial decision and are referred
UP to as ‘evaluation statistics’.
Suppose that two investments, a and b, are being considered.

Both investments require an initial cash outlay of ` 100 and
have a life of five years. The dollar returns on each depend
on the rate of inflation over the five-year period. Of course,
the inflation rate is not known with certainty, but suppose
that the collective judgement of economists is that the
probability of no inflation is 0.20, the probability of moderate
inflation is 0.50 and the probability of rapid inflation is 0.30.
The returns are defined as the present value of net profits
for the next five years. These returns for each state of nature
(i.e., rate of inflation) for each investment are shown in the
table 16.1.
Table 16.1: Probability Distributions for

Two Investment Alternatives
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Analysis of these investments can be made by calculating
and comparing the three evaluation statistics for each
alternative. The expected value () is an estimate of the
expected dollar return for the investment. Because risk has
been defined in terms of the variability in outcomes, the
standard deviation () is a measure of risk associated with
the investment. The larger is the , the greater is the risk.
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Risk per dollar of expected return is measured by the
coefficient of variation (v).
The evaluation statistics for each investment alternative are

computed as follows:
n
 a =  PX
i i
=0.2(100) + 0.5(200) + 0.3(400) = 240
t=1
n
UP 2 2
 a =  Pi (xi ui ) 2 = 0.2(100 - 240) 2 + 0.5(200 - 240) + 0.3(400 - 240) = 111.36
i 1
a
a =  111.36 = 0.46
a 240
Investment – b
 b = 0.2(150) + 0.5(200) + 0.3(250) = 205
2 2
 b = 0.2(150 - 205) 2 + 0.5(200 - 205)  0.3(250 - 205) = 35.00
 b = 35.00 = 0.17
205
The expected return for investment a of ` 240 is higher than

for b (` 205), but a riskier investment because a= 111.36 is
greater than b= 35. Also, risk per dollar of expected returns
for a (=0.46) is higher than that for b(=0.17). Which is the
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better investment? The choice is not clear. It depends on

the investor’s attitude about taking risks. An entrepreneur
may well prefer ‘a’ whereas a person investing a few dollars
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in a retirement account where risk ought to be minimised

might prefer ‘b’. The entrepreneur is in a better position to
absorb a loss if it occurs and is probably accustomed to
investing in risky ventures.
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Unfortunately, higher returns are usually associated with
higher risks. Indeed, the essence of economics is making
choices where there is a trade-off. Virtually all investment
choices require giving up expected returns for lower risk or
accepting higher risk for a greater expected return. Clearly,
attitudes about risk will play an important role in making
managerial decisions. The next section describes how
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individual attitudes about risk affect decision making.
Check Your Progress

Fill in the blanks:
1. ............... is defined as a state of knowledge in which

each alternative leads to one of a set of specific
outcomes with objectively determined probabilities.
UP 2. The mean, standard deviation and coefficient of
variation have direct application in assessing the
expected return and risks associated with
managerial decision and are referred to as ................
Risk and The Investment Decisions

Investment decisions involve a good deal of risk and
uncertainty. Lack of authentic information, dependable data
and imperfect foresight of the investor creates problems.
Different approaches have been proposed for dealing with
the consequences of imperfect ability to predict events and
the investors’ risks involved therein. Some of these
approaches are briefly sketched.
Finite Horizon Method

Here the decision procedure involves laying down a terminal
date beyond which any prospective development out of an
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investment activity today is simply ruled out.
This method forces us to ignore totally what little we can

forecast about the distant future with some degree of
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confidence.
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Risk Discounting Method
A method more attractive than the finite horizon method is
the use of a risk discount factor. A risk factor d is added to
the rate of interest, r, which is employed in discounting
calculations. Suppose, the actual rate of interest is 5 per cent.
The rate used in discounting might then be increased to
7 per cent, 2 per cent being the ‘risk factor’. Such a risk
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discount reduces the value of the discount rate, d, because,
d= 1 , and
1+r+
d< 1
1+ r
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This means that higher the risk, the more we lower our
evaluation of a given expected return.
The Shackle Approach

Prof George Shackle argues that most investors characterise
the risk inherent in investment decisions with the aid of two
representative outcomes – potential gain and potential loss,
which are called respectively, the ‘focal gain’ and the ‘focal
loss’. Instead of a risk discount, Shackle proposes a concept
of ‘potential surprise’ which asserts that investors think in
terms of measure, which indicates how surprised they would
be if, say, outcome V transpired rather than outcome U. If
there is a fifty-fifty chance of U or V, neither outcome may
really surprise us if it transpires, i.e., zero potential surprise.
Thus, even though on an actual risk calculation each outcome
should be discounted substantially, under the potential
surprise hypothesis, neither of them would be discounted at
all. Using these concepts and an appropriate indifference
map, Shackle determines what he calls ‘certainty equivalent’
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of any risky investment proposition.
The Probability Theory Approach

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This approach points out that no expected return figure can

adequately represent the full range of possible alternative
outcomes of a risky investment activity. Rather, a large
number of alternative pay offs must be considered for each
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pertinent future data and each such possibility must be
assigned some statistical probability. If the return at period
t is represented by Rt and if Rt is assumed to have a finite
value, then we can deal with a probability function.
P = p(Rt)
Sensitivity Analysis
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Here is another method of considering the risk element in
investment decisions. First step is to decide the most crucial
and most uncertain variables in calculations and then to test
how sensitive the computed present value figure is to likely
change in the value of that strategic variable. Suppose that
a company is considering an investment proposal of
launching a new product and its plans are based on the
UP
assumption that the company will be in a position to capture
10 per cent share of the market within the next year. From
this and other information, the company can estimate:
(a) the anticipated present value of the investment if the

expectation comes true;
(b) the effect of alternative possible market share figures

on the calculated present value of investment and
particularly;
(c) the market share figure at which the net present value
of the investment is zero, i.e., the ‘breakdown’ market
share.
The Decision Theory and the Von Neumann-Morgenstern

Utility Index
Here are the most sophisticated and the most recent methods
of considering risk and uncertainty. The decision theory,
which is an extension of the game theory, starts with knight’s
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distinction between risk and uncertainty. Risk refers to

situations in which the outcome is not certain but where the
probabilities of the alternative outcome is not certain but at
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least be estimated. Uncertainty is present where the

unknown outcomes cannot even be predicted in probabilistic
terms. Available information may enable one to locate either
risk or uncertainty in given investment proposals and then
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a number of ‘decision rules‘ (such as the maximin criterion, Activity
the minimax criterion, the Hurwich criterion, the minimax
Prepare a short report on
regret criterion, etc.) may be applied to select the optimum decision tree under risks.
investment decision under risk and uncertainty.
Decision Tree – A Technique

Sequential Decision Analysis Under Risks
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A decision tree is a graphic device that shows a sequence of
strategic decisions and the expected consequences under
each possible set of circumstances. The construction and
analysis of a decision tree is appropriate whenever a
sequential series of conditional decisions must be made
under conditions of risk. By conditional decision, we mean a
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decision that depends upon circumstances or options that
will occur at a later time.
Construction of the decision tree begins with the earliest

decision and proceeds forward in time through a series of
subsequent events and decisions. At each decision or event
the tree branches out to depict each possible course of action,
until finally all logical consequences and the resulting pay
offs are depicted.
Check Your Progress

Fill in the blanks:
1. Most investor characterise the risk inherent in

investment decisions with two outcomes potential
gain and potential loss which are called respectively
the .................. and .................. .
2. .................. approach points out that no expected

return figure can adequately represent the full
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range of possible attequative outcomes of a risky

investment actively.
Decision Making Under Uncertainty

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Uncertainty is defined as the state in which one or more

alternatives result in a set of possible specific outcomes
whose probabilities are either unknown or meaningless. This
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Activity means that decision-making under uncertainty is always
subjective. However, if the decision maker can identify the
on the Hurwicz Alpha Decision possible states of nature and estimate the resulting pay offs
Criterion. for each available strategy, then the two basic approaches
are available.
1. The decision maker uses the best available information
and his own personal judgement and experience to
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assign subjective probabilities to the possible states of
nature.
2. The decision maker may either disregard probabilities
or treat them as equal, which amounts to the same thing.
When this approach is taken, four decision criteria are
available for evaluation of proposed strategies:
(a) The Wald decision criterion, also called maximin.
UP (b) The Hurwicz alpha decision criterion.
(c) The Savage decision criterion, also called minimax
regret.
(d) The Laplace decision criterion, also called the Bayes
decision criterion.
The Wald Decision Criterion

The Wald, or maximum decision criterion is described by
various authors as the criterion of pessimism, the criterion
of extreme conservatism and an attempt to maximise the
security level. It envisions nature as perverse and malevolent
with Murphy’s law full operational . Therefore, the criterion
say: determine the worst possible outcome of each strategy
and then pick yielding the best of the worst results.
The Hurwicz Alpha Decision Criterion

The Hurwicz alpha decision criterion proposes to create a
)
decision index (d) for each strategy, which is a weighted

average of its extreme pay offs. The weighting factors are a
coefficient of optimism (), which is applied to the maximum
pay off (M) and its complement (1 t ), which is applied to
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the minimum pay off (M). The value of each strategy is thus:
i = Mi + (1 – )Mi
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The strategy with the highest value for di is chosen as
optimal.
The coefficient of optimism ranges from 0 to 1, enabling the

decision maker to express his attitude toward risk taking as
a subjective degree of optimism. If the decision maker is
completely pessimistic, he may decide that  = 0. The result
is the Wald or maximin criterion. If the decision maker is an
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incurable optimist, he may decide that  = 1. The result would
be the maximax criterion.
The Savage Decision Criterion

The Savage criterion, sometimes called the minimax regret
criterion, examines “regrets”, which are the opportunity
costs of incorrect decisions. Regret is measured as the
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absolute difference between the payoff for a given strategy
and the payoff for the most effective strategy within the same
state of nature.
The rationale for measurement of regret is quite simple. If

any particular state of nature occurs in the future and if we
have chosen the strategy that yields the maximum payoff
for the state of nature, then we have no regret. But if we
choose any other strategy, regret is the difference between
what actually occurs and what we could have earned had we
made the optimal decision. After determining the maximum
regret for each strategy, the strategy with the smallest
maximum regret is chosen.
A regret matrix is needed and it is constructed by modifying

the payoff matrix. Within each column (state of nature) the
largest payoff is subtracted from each payoff number in the
column. The absolute difference between them is the
measurement of regret.
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The Laplace Decision Criterion

The Laplace criterion is a criterion of rationality, completely
insensitive to the decision maker’s attitude. It is extremely
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sensitive, however, to the decision maker’s definition of the

states of nature. For example, suppose the states of nature
are hot, warm and cool weather. In the absence of weather
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Activity forecast, the Bayesian probability of cool weather would be
one third. But suppose the states of nature are warm and
Make a chart for your display
board on risk exposure cool. Now the probability of cool weather has changed to one
calculator. half. In reality, of course, equiprobability of all states of
nature is unlikely, particularly in the short run. Thus, the
Laplace criterion is more suitable to long run forecasts by
larger firms.
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To conclude, the process of decision making under
uncertainty is essentially one of choosing a criterion and then
performing the calculations necessary to establish a choice
within that criterion. We have also seen that the four decision
criteria discussed, when applied to the same decision matrix,
can lead to four different strategy selections.
UP Risk Exposure Calculator
Of late interesting techniques are being developed for (a)
country risk analysis and (b) company risk analysis. With
regard to (b), Tax exposure calculator is an innovation.
The calculator shows the pressure points present in every

organisation that lead to increased risk, such as the speed
of operational expansion and the level of internal
competition. Depending on a company’s circumstances and
management style, the amount of pressure on each point can
be low or high. A uniformly low score on these pressure
points, it should be noted again, isn’t necessarily a virtue.
Remember that nothing ventured is nothing gained. But too
high a score on too many pressure points can be a strong
signal that a company is exposed to dangerous levels of risk.
Remedial action may be necessary and fast.
The risk exposure calculator is not a precise tool like an

electronic spreadsheet or a discounted cash flow analysis;
)
its results are directional. It allows executives to determine

if a company’s risk level is in the safety, caution, or danger
zone. Once executives calibrate and understand a company’s
risk level, they can align it with the organisation’s strategy.
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The risk exposure calculator also gives executives the

opportunity to conduct two illuminating exercises. First,
managers can ask people at different levels and in different
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functions within a company to use the calculator and then
compare scores. In my experience, that process shows that
people at the very top of the company are less aware of risk
exposure than those closer to the ground. Similarly, the
exercise often reveals that people in one division or business
unit rate the company’s exposure to risk much higher than
the rest of the organisation. In such cases, it is time for senior
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executives to find out what one business unit knows that no
one else does.
Second, managers can calculate their company’s current risk

exposure and then calculate what it would have been 24
months ago. Comparing those scores reveals an
organisation’s internal risk-exposure trajectory. One
executive who did so found that her organisation had
UP
somehow managed to soar from the safety to the danger zone.
She acted swiftly to alert her senior team and steps were
taken to bring risk back under control.
In dynamic markets, taking risks is an integral part of any

successful strategy. But understanding the conditions that
create unhealthy levels of risk can go a long way toward
preventing failure. It is critical, then, for senior executives
to keep track of each pressure point.
Scores and Result Interpretation
9 to 20: The Safety Zone

Companies that carry this low level of risk are probably safe
from unexpected errors or events that could threaten the
health of the business. However, managers of such companies
should question whether their risk exposure score is too low.
Innovative, successful companies invariably create risk
pressure. If your business scores in the safety zone, perhaps
it’s time to take some calculated gambles.
)
21 to 34: The Caution Zone

Most companies will find that they fall in this middle zone.
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But even here, managers should be alert for high scores in

any two of the three risk dimensions. For example, if your
business scores high on both growth and culture, but the total
score falls below 35, there is still reason for concern.
35 to 45: The Danger Zone
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If you find that your total score is 35 or above, alarm bells
should be ringing and fast action should follow. Use the levers
of control: belief systems, boundary systems, diagnostic
control systems and interactive control systems – coupled
with traditional internal controls – to protect your business
from disaster.
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Now that we’ve identified all the pressure points that
contribute to risk exposure, let’s take a look at what managers
can do after they’ve calculated their score.
The Levers of Control

To control the internal risk that accompanies strategy,
UP
managers have levers of control at their disposal. Ask yourself
the following questions to see if those levers are being pulled
in your organisation. The question at the very bottom relates
to what are commonly known as internal controls – the
checks and balances that safeguard assets and ensure
reliable information. Internal controls do not vary with
strategy; they are, however, an essential foundation for
controlling risk in all organisations.
1. Belief Systems: Have senior managers communicated

the core values of the business in a way that people
understand and embrace?
2. Boundary Systems: Have managers in your

organisation clearly identified the specific actions and
behaviours that are off-limits?
3. Diagnostic Control Systems: Are diagnostic control

systems adequate at monitoring critical performance
)
variables?
4. Interactive Control Systems: Are your control systems

interactive and designed to stimulate learning?
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Check Your Progress
Match columns
Column A Column B
1. Priori a. Difference between most

experience pay off values.
2. Posteriori b. Deduction
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3. Range c. Rationality
4. Standard deviation d. Statistical analysis of data
5. Laplace criterion e. s (sigma)
Summary
The analysis of market behaviour of firms and industry bring
UP
out clearly the significance of business risks and uncertainty.
There are both market risks and non-market risks; the
former works through demand, supply, product price, costs,
rivals’ existence and operation; whereas the latter operates
through institutional forces like the Government, trade
unions, traders’ association, management club, legal bodies,
voluntary organisations and so on.
Risk is defined as a state of knowledge in which each
Investment decisions involve a good deal of risk and
uncertainty. Lack of authentic information, dependable data
Different approaches have been proposed for dealing with
the consequences of imperfect ability to predict events and
the investors’ risks involved therein.
)
Lesson End Activity

Construct a 3 x 3 Payoff Matrix for player # A in a duopoly
(c
market where the player # B exists as a rival. Get B’s Regret

Matrix from A’s Payoff Matrix. Take imaginary data, but do
not forget to define and describe the ‘strategy’ and
‘environment’.
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Keywords
Analysis of Market Behaviour: The analysis of market
behaviour of firms and industry bring out clearly the
significance of business risks and uncertainty.
Risk: Risk is defined as a state of knowledge in which each

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Investment Decisions: Investment decisions involve a good

deal of risk and uncertainty. Lack of authentic information,
dependable data and imperfect foresight of the investor
creates problems.
UP
Decision Tree: A decision tree is a graphic device that shows
a sequence of strategic decisions and the expected
consequences under each possible set of circumstances
Laplace Criterion: The Laplace criterion is a criterion of

rationality, completely insensitive to the decision maker’s
attitude. It is extremely sensitive, however, to the decision
maker’s definition of the states of nature.

1. (a) Distinguish between ‘risk’ and ‘uncertainty’. Give
some business examples to illustrate the
distinction.
(b) Observe the real world of business around you and
find how do the following economic agents hedge
risk? (Consult the dictionary of economic terms to
know what is ‘hedging’.)
)
(i) An individual
(ii) A company
(iii) A Government
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2. Comment on the business uses and abuses of Evaluation

Statistics which attempts to measure risks.
3. A marketing consultant, while servicing his clients has
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come up with five alternative brand names, four package
design of a product and three advertising campaigns to
be released through two media.
(i) How many strategies must management consider?
(ii) What states of nature might affect management’s
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choice? Give examples.
(iii) How can management take into account the rival’s
reaction?
4. Would you agree that a Payoff Matrix can be constructed
into a Decision Tree and vice versa? Take hypothetical
examples to justify your answer.
5.
UP
A company has an opportunity to invest in two different
projects. Using the matrix below, find the expected
values of both investment and their standard deviations.
You may also use the coefficient of variation to indicate
which investment is risky. Explain your finding.
6. The XYZ Co. is contemplating introducing a new product

in either of the three designs. The cost estimates are
reproduced below:
`
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Three probable levels of sales are estimated to be 2000

pieces, 4000 pieces and 6000 pieces, with probabilities
0.30, 0.45 and 0.25 respectively. The sale price of the
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product will be ` 400/- per piece.
(a) Construct a decision tree to locate the optimal

choice of the design through an analysis of the tree.
(b) Construct a payoff matrix to locate the same optimal

choice of a design.
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(c) Suppose that the estimated probabilities are net
dependable. Which design would you choose under
the Bayes criterion?
(d) Construct a Regret Matrix and indicate the choice

under Savage Criterion.
(e) Compare and contrast the decision tree approach
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with decision theory approach.
Further Readings
Books

UP


Web Readings
en.wikipedia.org/wiki/Risk
ww.sfrpc.com/Climate%20Change/2.pd
www.mbe-du.org/
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UNIT 17: Macroeconomic Environment of Business
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Unit 17
Macroeconomic Environment
of Business
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Objectives
topics:
 Business Environment
 Economic and Non-Economic Environment of Business

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Economic Environment and Business Management
Introduction
The firm is a micro level decision making unit. Earlier we
have described it variously as either a ‘transformation unit’
or a ‘black box’ or a ‘coalition’ or an ‘adaptive rational system’.
The fact remains that the firm does not exist in vacuum; it
exists in an environment, which conditions its survival and
growth or decay. The firm has to adapt itself to a business
environment keeping in mind its own strategic focus. In that
sense, it is an ‘adaptive system’. Also while adjusting its own
tactical operations to achieve its strategy, the firm has to
balance its own interests with those of others who are critical
players in its business environment.
By ‘environment’ we have reference to a set of external forces

and factors which affect the business unit, but the business
unit in itself cannot influence the environment. Of course,
)
one may talk about the internal environment of the business

unit in terms of reference to the workplace, work culture,
collegial relations, office dynamics, etc. By and large, the
business environment is external. In this sense, the external
(c
environment is characterised by the existence and operation

of various vested interested groups, associations and units.
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Activity Business Environment
W rite a report on business Business environment may be classified on different criteria,
environment and the economic
environment of business. such as time, space, forces and factors. Based on ‘time’ we
may talk of past, present and future environment of business.
Based on ‘space’ we may think of local, regional, national
and international environment of business. Based on ‘forces’
of market such as supply, price, etc., or non-market
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institutions like government, we may distinguish between
market and non-market environment of business. Finally,
based on the relevance of economic or non-economic ‘factors’,
we may specify economic and non-economic environment of
business. Such classification of environmental variables is
mainly for reasons of analytical convenience to understand
their pull and/or push. In real world situation, the
UP environmental variables interact with each other. Such
interaction can be conceptualised through the formal
presentation of Interaction Matrix. Because of the involved
nature of these interactions, the environment often appears
very complex, dynamic and sometimes beyond any theoretical
comprehension. But for an efficient operation of the firm,
there is no alternative to identification, description and
explanation of its business environment, immediate and
remote.
Economic Environment of Business

The critical elements of macroeconomic environment are:
 Economic system
 Nature of the economy
 Anatomy of the economy
 Functioning of the economy

)
 Economic planning and programmes
 Economic policy statements and proposals

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 Economic controls and regulations
 Economic legislations
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 Economic trends and structure
 Economic problems and prospects.
The critical elements are not always mutually exclusive. But

we may treat them separately for analytical purpose.
Non-Economic Environment of Business
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The environment is so complex and so dynamic that it is
difficult to identify, describe and analyse it. For meaningful
identification, description and explanation of the
environment, it may be wise to scan the environmental
factors and limit our focus to a specific few. Let us take an
overview of the factors, typical of the non-economic
environment.
Sociological
UP
First, we can talk about the sociological factors which give
content and form to the system of values and culture. Among
these factors, we can list (i) View towards management –
social attitude towards business and managers; business –
moral or immoral thing/Managers-Marx’s bourgeoise or
barefoot creatures? (ii) View towards authority,
responsibility, delegation – authority respectable or
condemnable? Worker’s participation – myth or reality? (iii)
View towards achievement and work – achievement
recognised or not? Good work leading to promotion or a
transfer? View towards wealth and income – earn like-a-
king-and-live-like-a-sage or earn-money-to-spend-and-spend-
money-to-earn? Live poor to die rich or vice versa? (iv) View
towards change and risk-taking-businessmen, risk-takers or
risk-averters? Resistance-to-change operate or not? Customs,
traditions and conventions – rigid or flexible? (v) View
towards scientific method – people believe in religion or
)
reason through science? (vi) Class structure and labour

mobility – caste system, joint family system, etc. (vii) Inter-
organisational and individual cooperation or conflict – extent
to which private business enterprise, government, labour
(c
unions, consumers’ cooperative, etc., live in harmony and

enrich each other or counteract each other?
S
Educational-Cultural
In this category, we may list (i) Attitude towards education
and acquisition of knowledge (ii) Types of education – formal
or informal? Liberal arts or technical? Quantity and Quality
of higher education. (iii) Literacy level – correlation between
formal literacy and the level of culture. (iv) Educational
match with the skill requirements of industry and manpower
E
utilisation – specialised, vocational and technical training –
role of business schools and (management) executive
development programmes: education vs training . These and
other similar factors which constitute the educational-cum-
cultural environment exercise a strong influence on business
activities and management skill.
UP
Political
There are various laws relating to business and industry.
Some of these laws are clearly economic in content and
intent, but most of them are non-economic in content and
economic in intent. The political-legal environment of
business depends on (i) Legal rules of the game of business –
its formulation and implementation, its efficiency and
effectiveness. (ii) Defence and military policy – impact of
defence policy on industrial enterprises in terms of trading
with potential enemies, purchasing policies, strategic
industrial development, etc. (iii) Political stability – impact
of factors like civil war, the declaration of President’s rule
and emergency, changes in the form and structure of
government administration. (iv) Political organisation –
ideology of the ruling government, philosophy of the political
parties, degree and extent of bureaucratic delays, red tape,
the influence of premier groups, the question of donation of
business houses to the political parties. (v) Flexibility and
adaptability of law – constitutional amendments, their
)
urgency and frequency, ‘velocity’ of public policies. (vi)

Foreign policy–alignment or non-alignment, tariffs, customs,
unions, etc. – image of the country and its leaders.
(c
Historical
The historical heritage of the country also influences the
current environment of business. The role of historical
S
factors in the context of non-economic environment may not, Activity
therefore, be minimised. Here we have to look at the
Make a report on economic and
sociological, cultural, educational and related factors which non-economic environment
influence business in their historical perspective. interaction.
History is not to be treated as ‘dead past’; historical events

and ideologies leave a strong impact on the current state of
business. In fact, ‘history’ is often the explanatory factor
E
behind the prevalent business situation. Historical
environment (perspective) produces the current
environment.
Physical
Lastly, though not the least important one, reference must
be made to the physical environment, i.e., the role of physical
UP
and geographical factors in the realm of non-economic
environment. The application of modern technology in
industry, it is now argued, leads to rapid economic growth
at a huge social cost – deterioration of the physical
environment around us, i.e., air pollution, noise pollution,
so on and so forth. The nature of such costs is being assessed
by biologists, ecologists, sociologists, consumers and
conservationists (some of them in a manner as if it is all a
new discovery). In the light of this, much talk is there about
the social responsibilities of business. Business now has to
calculate the social net profitability (social benefit-social cost)
of its ventures. In this calculation business must consider
the physical environment factors such as the quantity and
quality of existing forest wealth, possibility of artificial rain,
the exploitation of sea products like fish, the health hazards
arising out of pollution, social costs of rapid urbanisation
and industrialisation, etc.
Check Your Progress

)
Fill in the blanks:
1. ............... factors give context and form to the system

of values and culture.
(c
2. ............... is not to be treated as dead-past.

S
Economic and Non-Economic Environment
Interaction
In the literature, there is a concept of ‘Interaction Matrix’
which suggests that in the context of environment, the
economic and the non-economic factors act and interact with
each other and this is what indicates the difficulty and
complexity of any environmental scanning and analysis. We
E
may take a couple of examples to illustrate this element of
interaction, concentrating on the critical elements of both
economic and non-economic environment.
The economic system at work is often influenced by the

political ideology of the party in power under democracy.
The leftist in power often promote the cause of socialism;
UP
the rightist, on the other hand, promote capitalism. The
mixed economic system at work indicates co-existence of
private (capitalist) sector and public (socialist state sector).
The prevailing political instability may create business
uncertainty. As Government changed hands in Maharastra,
the Enron project was in trouble. This is a classic case to
illustrate political economy of business.
Finally at the international level also, the economic and non-

economic environmental factors interact with each other.
Thus, Pokhran explosions in India and economic sanctions
by the USA, or Kargil intrusion by Pakistan and IMF Loans
or European integration by way of EU and introduction of
EURO currency all these go together. National economic
management cannot be separated from the dynamics of
international politics and sociology. The cases of MNCs in
India and those of Indian companies like Ranbaxy, Infosys,
SBI, etc., going global illustrate this interaction.
Circular Flow of Money: A Schematic Model of

)
Business Environment and Business Transactions

In a modern complex economy, individuals often consume
things which they do not produce or often produce things
(c
S
which they do not consume. As a result, exchange has
assumed crucial significance as an economic activity which
brings the consumers and the producers group together and
solve their problems of mutual dependence. Money serves
as the medium of exchange transactions. Money takes the
form of income and expenditure and flows among different
transactors. Different transactors may be identified by way
E
of their belonging to different sectors of an economy:
Household, Business, Government, Capital market and
Abroad.
The household sector includes those transactors who demand

goods for consumption and supply services for production.
The business sector includes those transactors which demand
factor services but supply finished goods. There are national
UP
and multinational business, private business and public
business, big business and small business, agricultural
business and non-agricultural business, so on and so forth.
The government sector represents the apex institution of
the State. It includes transactors concerned with political
activities – legislation, executive and judiciary. The capital
market sector represents another essential constituent of a
modern complex economy. It consists of all those banking
financial intermediaries which deal in short-term and long-
term and non-banking cash and/or credit transactions.
Primarily these transactions take the form of saving deposits
and investment loans. Finally, the picture of the national
economy remains incomplete unless reference is made to the
abroad sector which is represented by the rest of the world.
Since the modern economics are open to trade, exports from
and imports into the economy play significant role in
influencing the functioning of an economy. Foreign trade
provides the scope for international transmission-cum-
diffusion effect of business activities.
)
(c
E S
UP Figure 17.1: Circular Flow of Money
Economic Environment and Business Management

Existing business environment may act as either a stimulant
or a constraint for business management. If the prevailing
environment is favourable for business growth and prosperity
then management feels happy and responds positively. Small
business owners, for example, are often encouraged to
produce more when the government pays them subsidy. On
the other hand, when the prevailing environment is
unfavourable, it yields a disincentive effect. For example,
when the government tries to impose a high tax rate on
corporate profits, many business concerns try to evade tax
by under-reporting their profits. Interestingly, the same
environment may act as both stimulant or constraint,
simulating for some and constraining for others. Reconsider
the tax example. A high tax rate increases the propensity to
evade taxes; it induces corporate tax-payer to restrict his
)
output, sales or profits. At the same time, that very high

tax-rate situation provides an opportunity for thriving
business by the tax consultants.
(c
Environmental scanning thus becomes an important step

towards corporate planning and business policy decisions.
S
Corporate managers analyse the Strength (S), Weakness (W),
Opportunity (O) and Threat (T) that exist for their
organisation in the context of its environment. Opportunity
(O) and Threat (T) are external to the firm whose internal
Strength (S) and Weakness (W) are decisive factors whether
or not the environment can be properly managed. With
strength, a firm can seize the opportunity and capitalise on
E
it and because of its weakness, it becomes the victim of threat
in the environment. The SWOT analysis precedes the
formulation of strategic planning and tactical decisions by
management.
Environment and management thus influence each other.

The existing environment exercises its influence on corporate
level planning, business strategy and business tactics; it
UP
affects the size, structure, location, integration and growth
of business. While adjusting to such environmental effects,
favourable or adverse, managerial success or failure is
realised. The nature of such realisation, its frequency and
duration, induces the corporate managers to cultivate some
standards of business philosophy, business ethics and
business practice. Simultaneously, the government managers,
the labour managers and the like also start adjusting to the
changing organisation culture. This yield a new business
environment. And so the process continues. It is a never-
ending process of interactions: Environment  Management
 Environment . As if, it is a biological organism which
keeps both environment and management responsive to each
other.
Check Your Progress

Column A Column B
1. Environment a. Local, regional, national,
)
international
2. Space b. Goods for consumption and
supply for production
3. Household sector c. Set of external forces/factors
(c
4. Sociological factor d. content and form to the

system
5. Types of education e. Formal /informal
S
Summary
By ‘environment’ we have reference to a set of external forces
and factors which affect the business unit, but the business
unit in itself cannot influence the environment. Of course,
one may talk about the internal environment of the business
unit in terms of reference to the workplace, work culture,
colleagueal relations, office dynamics, etc. By and large, the
E
business environment is external. In this sense, the external
environment is characterised by the existence and operation
of various vested interested groups, associations and units.
Business environment may be classified on different criteria,
such as time, space, forces and factors. Based on ‘time’ we
may talk of past, present and future environment of business.
Based on ‘space’ we may think of local, regional, national
UP
and international environment of business. Based on ‘forces’
of market such as supply, price, etc., or non-market
institutions like government, we may distinguish between
market and non-market environment of business. Finally,
based on the relevance of economic or non-economic ‘factors’,
we may specify economic and non-economic environment of
business. Such classification of environmental variables is
mainly for reasons of analytical convenience to understand
their pull and/or push. In real world situation, the
environmental variables interact with each other. Such
interaction can be conceptualised through the formal
presentation of Interaction Matrix. Because of the involved
nature of these interactions, the environment often appears
very complex, dynamic and sometimes beyond any
theoretical comprehension. But for an efficient operation of
the firm, there is no alternative to identification, description
and explanation of its business environment, immediate and
remote.
)
Lesson End Activity

List the exact documents from the following sources to have
a view of data and system environment of Indian economy,
(c
business and industry.

(i) Government
(ii) FICCI
(iii) RBI
S
(iv) CII
(v) NCAER
Keywords
Environment: By ‘environment’ we have reference to a set
E
of external forces and factors which affect the business unit,
but the business unit in itself cannot influence the
environment..
Business Environment: Business environment may be

classified on different criteria, such as time, space, forces
and factors. Based on ‘time’ we may talk of past, present and
UP
future environment of business. Based on ‘space’ we may
think of local, regional, national and international
environment of business. Based on ‘forces’ of market such as
supply, price, etc., or non-market institutions like
government
LIC: Life Insurance Corporation

1. It is said that all non-economic environmental factors
have economic implications. Do you agree? Quote
specific examples to establish your arguments.
2. Analyse the impact of each on Indian business operation:
(a) Joint family system breakdown
(b) Child marriage
(c) Caretaker government at the Centre

)
(d) Growing pollution in the cities
3. What do you mean by ‘Economism’? What factors would

(c
you consider to study the economic environment of the

country abroad where you want to promote your own
business?
S
4. Write briefly about industry-environment of the
following corporate units:
(a) State Bank of India
(b) Reliance Industries Ltd
(c) Life Insurance Corporation (LIC)
(d) Videocon
E
(e) SAIL
5. Explain with examples, how corporate level business
management gets affected by the national level economic
environment.
Further Readings
UP
Books
Web Readings
wps.pearsoned.co.uk/ema_uk_he_sloman...3/18/.../index.html
essaywritingnotes.com/.../macroeconomic-environment-
business-essa...
)
www.mbe-du.org/
(c
UNIT 18: Macroeconomic Concepts of Stocks and Flows
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Unit 18
Macroeconomic Concepts of
Stocks and Flows
E
Objectives
topics:
 Relations between 'Stocks' and 'Flows'
 Flows of Income, Employment and Output

UP
Measurement of National Income
Introduction
By ‘stock’, we make reference to something which exists at a
point of time; whereas by ‘flow’ we refer to something which
circulates over a period of time. Thus, for the country as a
whole, we talk about stock of health, stock of capital, stock
of forest, stock of mineral resources, stock of crude oil, stock
of human capital (population size and distribution in a given
census year) and so on.
Relations between Stocks and Flows

At operational level, the concepts of stock and flows are very
organically and meaningfully related. In a very simple way,
this relationship is depicted Figure 18.1.
)
(c
Figure 18.1: Conceptual Relation between Stocks and Flows

S
Activity The reader may note that this chart itself is a flow diagram;
the arrows indicate the direction of the flow.
W rite an article on relations
between stocks and flows.
The macroeconomic analysis of business environment can
run in terms of identifying these stocks and flows and then
establishing a relationship between them.
In the background of the above, we may refer to several ratios
E
to throw further light on Stock-Flow relationship:
(i) I  Flow  Investment rate

Y Flow
S  Flow  Saving rate

(ii) Y Flow
(iii) Q
K  Stock  Capital-output ratio
Flow
UP K dK
(iv) Q or dQ  Incremental or marginal capital output
ratio
(v) Y
M  Flow  Income velocity of money
Stock
M  Stock 
(vi) W Stock Money-wealth ratio; Portfolio
composition
Stocks and Flows of Money – Revisited

Money has got dual personality; it exists as both ‘stocks’ and
‘flows’. Let us examine this personality trait factor in a little
more detail.
The Reserve Bank of India, by the virtue of its own authority,

brings some stocks of money into circulation, such that we
talk about currency and coins with the public – in India, this
)
category is known as M-1. In addition to this liquidity, if we

take care of post office saving deposits, then we have M-2. In
the same way, when time deposits are added to M-2, we have
M-3. Finally, we include ‘near money’ or ‘money substitutes’
(c
to have M-4; of late, the ‘credit cards’ or ‘plastic money’

components are increasing as ‘near money’. In addition to
cash and credit supplied by the bank, i.e., ‘Bank Money’, we
S
have also ‘Government Money’ as legal tender money, e.g.,
one rupee printed or coin minted by our Government. Thus,
in India, there is dual authority, the Central Bank, RBI and
the Central Government, to decide on the stocks of money.
Sometimes this ‘dual authority’ works out to be a ‘divided
responsibility’ such that control and management of the stock
of money really becomes difficult. Also, sometimes, bonds
E
and government securities work so close as near money that
their existence and circulation defeat the purpose of
restricting the normal M stock which is treated as exogenous,
i.e., M = M .
The stock of money (M) multiplied with its velocity of

circulation (V) determines the flow of money (Ms) supplied
to the system
UP Ms = M.V
In case M has two components, cash and credit, then Ms = M1

V1 + M2 V2. For our analysis here, we may ignore these
components.
In addition to money supplied to the system, we need to take

care of money demanded, because it is only through
adjustments of demand and supply that any exchange
transaction takes place in a market.
The demand for money (Md) is determined by the prevailing

price (P) and the volume of transactions (T) undertaken.
Thus,
Md = P. T
Taking care of both the demand and the supply side, we have
Md = Ms  Equation of Exchange
P.T. = M.V
)
Assuming V and T as constants at a given point of time, we

have P = V
T M = C.M. Where C is a constant factor
FG V IJ . It follows
(c
proportionality HTK
P = P(M)
S
Activity This implies that through controlling M, the level of P may
be controlled. The Quantity Theory of Money asserted that
Prepare a brief report on flows
of income, employment and P and M are unidirectional and uniproportional. A 10% rise
output. in M will yield exactly 10% rise in prices and vice versa.
Thus, the control of M is an instrument to control inflation
(price rise) or deflation (price fall).
In subsequent observations and analysis, the economists have
E
viewed the supply of and demand for money differently
compared to what is stated above.
Check Your Progress

Fill in the blanks:
1. ............... is something which exists at a point of time

UP 2.
and ............... is something that circulates over a
period of time.
Stocks of money in India is known as ............... .
Flows of Income, Employment and Output

National Income is the money value of output produced in
an economy at a given point of time. In an economy, there
are several productive sectors – Primary, Secondary and
Tertiary. The primary sector produces cultivation related
agro based items; the secondary sector produces industrial
goods; and the tertiary sector produces services. These are
all examples of real or physical flows, which can be measured
in specific units. For example, we have bales of cotton, tons
of foodgrains, number of cars, number of doctors, etc. To
produce these goods and services in the economy as a whole,
we need inputs, specific to the sectors of use. For example,
we need seeds, fertilisers and water for agriculture;
industrial raw materials for the secondary sector and
)
infrastructural support for the services sector. It is not

possible to aggregate these physical flows of either outputs
or inputs. However, we can always look at the prevailing
(c
market price of these items and compute the money value of

output net of money value of inputs. This is called ‘net value
S
added’ by each sector of production. An aggregate of these
net values added is called Gross Domestic Product at market
prices (GDP at m.p).
To this GDP, we may add the net flow of money from the
abroad sector which is measured by the export of visible and
invisible items of trade and other payments like loans and
capital outflows net of imports of trade and other payments
E
by way of investment flows from abroad and loans inflows.
This adjusted figure at the prevailing market price (rate of
exchange) is often termed as Net Foreign Investment (NFI).
Thus, GDP added to NFI, gives the Gross National Product
(GNP) at market price.
From GNP, we may take out depreciation costs to calculate

the Net National Product at market prices (NNP at m.p.),
UP
because earlier while calculating net value added by each
sector of production, we have accounted for explicit cost of
inputs, but not depreciation.
At the next stage, we adjust the NNP figures with reference

to the net flow of money from the government sector; this is
transfer minus taxes, i.e., Net Transfer (N.Tr). By adding
net transfer to NNP at market price, we get NNP at factor
costs because this aggregate value is the one out of which all
factor costs are met. These factor costs include rent (R),
wages and salaries (W), interest income (r) and undistributed
profits (p). The aggregate of these factor costs also total up
to Net National Product at factor costs (NNP at f.c.) and this
is what is usually referred to as National Income (Y). It is
this income that a nation spends to employ factors towards
producing the output of goods and services. Thus,
employment generates output whose money value is income
to finance expenditure at national level. Thus, the basic
principle of national income accounting or what is called
)
social accounting is that:
National output = National Income = National Expenditure

(c
E S
Figure 18.2: Principal of National Income Accounting
UP
The Y, National Income, when estimated at current prices,
is called nominal national income. On the other hand, the Y
when estimated at constant prices measures real national
income. Also, we take the ratio of Y to population (Pu) to
estimate the per capita nominal or real income if. The real
income per capita (per head) is now being replaced by the
purchasing power parity index as a better indicator of
comparative socio-economic development of countries.
It may be observed that
Y W  Y
Y P
n Pn W where W = workers
Thus, income per capita is the product of labour force

participation rate (W/Pn) and labour productivity, i.e., output
(=income) per worker. Thus, productivity is the determinant
of per capita. It should be clear that physical and monetary
measures are related.
Measurement of National Income

)
National income is the money value of output produced in

an economy. This can be estimated as a flow on a given date
of time. There are three methods of estimation:
(c
Production Method: We need to start by identifying the

sectors of production of goods and services and aggregate
the ‘net value added by each sector’.
S
Income Method: The value of output produced exhausts in
terms of payments made to all input entering the productive
process. Thus, if all factor payments (which accrue an income
to factors) are added, we get national income.
Expenditure Method: National income and national
expenditure equate, because spending on consumption and/
or saving is financed out of income earned. Thus, Y = C + S
E
And Y = C + I
I=S
In a closed economy, savings investment equality early
follows. In an open economy, net foreign investment
supplements domestic savings towards financing national
investment.
UP
Aggregating physical flows in production method is difficult
because goods and services produced are not homogeneous
and therefore, their monetary evaluation is needed to bring
them down to a common denominator.
Check Your Progress

Column A Column B
1. Stock a. Service
2. Flow b. Something which exist at a
point of time
3. Dual personality c. It exist as both stock and flows
of money
4. Primary sector d. Something which circulate
over a period of time
5. Tertiary sector e. Agro based items
Summary
)
By ‘stock’, we make reference to something which exists at a

point of time; whereas by ‘flow’ we refer to something which
circulates over a period of time. Thus, for the country as a
whole, we talk about stock of health, stock of capital, stock
(c
of forest, stock of mineral resources, stock of crude oil, stock

of human capital (population size and distribution in a given
census year) and so on.
Money has got dual personality; it exists as both ‘stocks’ and
S
‘flows’.
National Income is the money value of output produced in

an economy at a given point of time. In an economy, there
are several productive sectors – Primary, Secondary and
Tertiary. The primary sector produces cultivation related
agro based items; the secondary sector produces industrial
E
goods; and the tertiary sector produces services. These are
all examples of real or physical flows, which can be measured
in specific units.
Lesson End Activity

Collect Indian data on the above items.
UP
(a) Net addition to capital stock
(b) Income velocity of money
(c) Stock of wealth of a nation
(d) Gross capital formation
(e) Net National Product factor costs
(f) Gross National Product at market prices
Source: CSO/Government of India/RBI
Keywords
Stock: By ‘stock’, we make reference to something which
exists at a point of time; whereas by ‘flow’ we refer to
something which circulates over a period of time.
Money: Money has got dual personality; it exists as both

)
‘stocks’ and ‘flows’.
National Income: National Income is the money value of

output produced in an economy at a given point of time
(c
Primary Sector: The primary sector produces cultivation

related agro based items.
Secondary Sector: Secondary sector produces industrial

goods.
S
Tertiary Sector: Tertiary sector produces services.
Production Method: We need to start by identifying the

sectors of production of goods and services and aggregate
the ‘net value added by each sector’.
Income Method: The value of output produced exhausts in

terms of payments made to all input entering the productive
E
process.
Expenditure Method: National income and national

expenditure equate, because spending on consumption and/
or saving is financed out of income earned.

1. (a) What are the various concepts of national income
UP
you are familiar with?
(b) Why does estimation of national income in an
underdeveloped economy pose difficulties?
2. It is suggested that compared to national income index,

the Purchase Power Parity (PPP) index is a better
measure of economic growth and development. Do you
agree? Explain. [Consult a dictionary on economic terms
for PPP. Alternatively, you may consult World
Development Report.]
3. How would you measure the stock of (a) Human capital,

(b) Non-human capital in an economy? Justify
investment expenditure in both forms of capital.
4. Review money both as a stock and as a flow. Collect
information about the components of M1, M2, M3 and M4
in Indian context.
Further Readings
)
Books
(c

S

Web Readings
en.wikipedia.org/wiki/Stock_and_flow
E
spm.sph. sc.edu/courses/Econ/. ../Stocksa ndflows/
Stocksandflows.h
UP
www.mbe-du.org/
)
(c
UNIT 19: Macroeconomic Analysis
S
Unit 19
Macroeconomic Analysis
E
Objectives
topics:
 Says’s Law of Market
 Fisher’s Quantity Theory

UP
Walras’ General Equilibrium
The Economics of Keynes
Post Keynes Developments
Introduction
The classical economists took a simple view of macroeconomic
environment of an economy to champion the cause of ‘Laissez
Faire’ capitalism guided by free market price mechanism,
private property rights and commercial profit motive. There
are three pillars of classical macroeconomics.
1. JB Say’s Law of Market
2. I Fisher’s Quantity Theory of Money
3. Walras’ General Equilibrium Model
Let us discuss each one of them and see their relevance today.
)
Say’s Law of Market

According to Say’s law, there is a functional relationship
between the market forces at work such that supply
(c
determines demand and the free market price mechanism

helps this process. Suppose in a market for X, the supply of
X exceeds the demand for X, then excess supply will bring
about the tendency of price of X to fall. As the price of X
S
Activity falls, the demand for X may be extended and as a result, the
equilibrium condition (Demand-Supply) may be satisfied. In
on Say’s Law, Fisher’s Theory the same way, in the labour market, excess supply of labour
and Walras’ Model. (i.e., unemployment) may exercise a downward pressure on
the wage rate such that the employer may employ more
labour and the labour market equilibrium is restored.
Fisher’s Quantity Theory
E
If free market price mechanism has to play its role and
responsibility, then price must come to exist so as to reflect
the relative position of either scarcity or abundance in the
market. Price itself is measured in terms of money. In fact,
price is the value of something expressed in a monetary unit.
Thus, we may have rupee price or dollar price or yen price,
UP which was stated by Fisher. Starting from his ‘equation of
exchange’, we worked out earlier that the money is an
instrumental variable to control prices. A reduction of money
by 10% may bring about deflation, i.e., price reduction by
exactly 10%. Otherwise, when money increases in the system,
more money chases few goods, people’s propensity to spend
money goes up and this is reflected in a price rise, called
inflation.
Thus, Fisher’s quantity theory of money works as a

supplement to Say’s law of market. One is not complete
without the other.
Walras’ General Equilibrium

Hitherto we have been building up our arguments in the
context of a market. The economy is the aggregate of several
markets and therefore, we need to take care of multi-market
adjustment. That is what Walras does. Walras develops a
system of simultaneous equations and solves the system to
)
locate general equilibrium. If there are n-markets with n-

equations of exchange and if (n-1) markets are in
disequilibrium reflecting some sort of maladjustments
between specific demand and specific supply, then the n-th
(c
market must also be in disequilibrium such that at the end

of interaction among markets, we reach
S
n n
 Di   Si
i 1 i 1
where [i = 1y, .........., n] represents several markets.
The Economics of Keynes

The economics of Keynes can be summarised in terms of a
number of propositions from Keynes’ General Theory (1936):
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1. The economy must be treated as an aggregate system –
a macro approach.
2. One of the important macro-concepts is national income,

the money value of net national output of goods and
services produced in the economy over a given period
of time. The level of output is functionally related to
3.
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the employment of labour, its number and productivity.
The flow of employment, income and output is

determined by the level of effective demand. Effective
demand is that level of aggregate demand (reflected in
terms of the volume of total expenditure) which
effectuates the aggregate supply (reflected in terms of
aggregate of consumption and saving). If effective
demand increases, the level of income-employment
output will increase and vice versa.
4. In the short run, aggregate supply (consumption +

savings) being given, effective demand is simply that
level of aggregate demand (consumption + investment)
which matches the aggregate supply. Aggregate demand
consists of ‘Consumption Demand’ and ‘Investment
Demand’; this follows definitionally.
5. The level of consumption demand (expenditure on

consumer goods) is determined by a set of subjective
)
factors as well as an objective factor, the income. Larger

the income, larger will be the consumption expenditure
and vice versa. As income changes, consumption must
change in the same direction; but by something less than
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the proportional change in income. Here is the

‘Functional Psychological Law’ of Keynes’ Consumption
Function. The ratio of consumption to income is the
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‘average propensity to consume’ (APC = C/Y) and the
ratio of a change in consumption income is the ‘marginal
propensity to consume’ (MPC = C/Y).
6. The Investment Function states that the level of

investment demand (expenditure on capital goods) is
determined by (a) the rate of interest – the cost of
investment and (b) the marginal efficiency of capital –
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the expected return on investment. Investment is
inversely related to the rate of interest and directly
related to the expected rate of return. Investment is
stimulated if there is any net benefit, i.e., expected
returns exceed the actual rate of interest.
7. The rate of interest is the price of money. Like any other

price, the interest rate is determined by the forces of
UP demand for money and supply of money. The supply of
money is exogenously determined. Given the supply of
money by the monetary authority, the demand for money
determines the interest rate. The demand for money
may be for either transaction purpose or precautionary
purpose or speculative purpose. The demand for money
for transaction and precaution, i.e., the demand for
‘active money’ is income elastic, but the speculative
demand or what is called the demand for ‘inactive
money’ is interest elastic. Higher the rate of interest,
lower will be the desire to hold inactive money in hand
in the form of liquid cash and vice versa. This gives a
downward falling liquidity preference curve.
8. In the short run, consumption demand being ‘stable’ and

the long-term rate of interest being ‘sticky’ the marginal
efficiency of capital becomes the most crucial
determinant of private investment. Marginal efficiency
of capital (d) is that imputed internal rate of return which
)
when applied to the aggregate of expected series of yield

from investment (R1, R2, ......... Rn), leaves the
discounted sum equal to the supply price of capital (C).
(c
R1 R2 Rn n
b g b1  d g
C = 1 d
 2
 .... 
b1  d g n
  Ri (1  d) i
i 1
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Gloomy expectation means low marginal efficiency of capital, Activity
low investment demand, low effective demand, business
Prepare a short report on post
depression (i.e., fall in income, employment and output). keynes development.
Similarly, a high marginal efficiency of capital brings about
business prosperity.
These propositions can be presented in the form of a

schematic model:
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UP
Figure 19.1: The Economics of Keynes
Check Your Progress

Fill in the blanks:
1. ................ is that level of aggregate demand which

effectivates the aggregate supply.
2. The ratio of consumption to income is the ................
Post Keynes Developments

)
The entire economics of Keynes can be summarised in terms

of three basic functions:
 Consumption Function
(c
 Liquidity Function
 Investment Function
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With regard to each one of these functions, a lot of post
Keynes developments are reported in the literature of
macroeconomic analysis. Let us take stock of these
developments.
Consumption Function
Keynes observes, among other things,
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1. C = C(Y). Real consumption expenditure depends on
absolute level of real national income. This is known as
‘absolute income hypothesis’.
C C
2.  . The average propensity to consume equates
Y Y
marginal propensity to consume because consumption
UP function is stable.
C
3. 1 > > 0. The mpc remains constant between zero
Y
and one. This is Fundamental Psychological Law who
lies at the root of a flat consumption function, suggesting
that as income rises, consumption rises, but by less than
the proportionate increase in income. This Law is
‘fundamental’ because without this the multiplier
1
k
coefficient C becomes indeterminate.
1
Y
4. The tendency towards under consumption is observed

in the long run.
Taking care of all these hypotheses, one can sum up that
W
)
C = C (y, r, ).
P
where Y is income; r is the rate of interest; W is stock of

nominal wealth and P is price level. It is formal that on
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consumption the income-effect is positive, interest effect is

negative and the real balance effect is positive.
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C
> 0  As income changes, consumption changes in the
Y
same direction, though in lesser proportion.
C
< 0  As interest rate rises, people may like to save
r
more and therefore, consume less.
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C
FW I

H PK > 0  measures real value of wealth or what is called
‘real balances’. Say, P remains constant, but W rises, then

goes up; as a result, people spend more on consumption
expenditure.
Liquidity Function
Keynes observes that
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1. L = L 1 + L2
The desire to hold money in hand, called Liquidity

Preference, has two components: Active demand for
money (L1) for purposes of transaction and precaution
and inactive demand for money (L2) for speculative
motive.
L
1
2. L2 = l1 (y); y  O
The active demand for money is income responsive.

Higher the income, more is the demand for active money.
L2
3. L2 = l2 (r); O
r
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The inactive demand for money is interest related. Rate

of interest offered by banks is the opportunity cost of
holding money idle in hand. Therefore, at higher
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interest, the demand for L2 is less and vice versa.

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4. r = r (L2, M ).
The rate of interest being a price of money is determined

in the money market through the interaction of
speculative demand for money and exogenous money
supply.
5. If r comes down to an institutional minimum level at
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which the speculative demand for money becomes
perfectly elastic, then the economy is caught in ‘Liquidity
Trap’ and in that case, any increase or decrease in money
supply does not affect interest rate at all. Monetary
policy then fails to be effective.
Investment Function
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Investment lies at the heart of macroeconomic analysis.
Keynes observes that
1. I = I (r, )
Investment depends on the actual rate of interest, r and

the expected rate of return on investment, .
I
2. <0
r
The demand for capital, I, is inversely related to the

cost of capital, r.
I
3. >0

The demand of capital to be invested is directly related

to expected rate of return on investment. In fact,
investment depends on net return ( - r).
4. Investment may be autonomous and/or exogenous. It is

)
this investment which works through the multiplier

mechanism to generate income.
1
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Y = k. I = 1  C I
Y
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One act of investment generates a series of income such
that the additional income generated is the multiple of
initial additional investment expenditure.
5. If private investment is not forthcoming, then the

Government should invest. Such expenditure by
Government (G), even if exogenously determined can
compensate the fall in private – I and activate multiplier
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effect. Such public spending is sometimes known as
‘pump-priming’. The Government may propose a ‘deficit
budget’ (i.e., Public Expenditure, Public Revenue) and
may finance these deficits through money creation, i.e.,
printing money; the Government needs to activate the
economy, if caught in downswing of recession or
depression.
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The policy implications of Keynes’ principles were
reinforced by the post Keynes’ work. In particular, the
relation between investment and income has been
reworked in terms of a new principle called
‘Acceleration’ and ‘Capital Stock Adjustment’. Let us take
a total view of investment.
1. It = K = [Kt+1 – Kt]
Investment is net addition to capital stock. This is
just a definition.
2. It = T = [Yt+1 – Yt]
K
where  =  Incremental capital/output ratio
Y
3. It = aYt – bKt
where a>0 and b>0 are positive constants.
Some Issue-based Principles

)
A review of classical and Keynesian economics brings into

limelight several issue based principles of management. Let
us make reference to some such issues, which carry profound
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policy implications.
The Supply side economics rests on a number of principles

listed below.
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1. Supply creates its own demand for goods, but not for
bads. Goods are bundle of utilities. If there is value-in
use of the goods produced, then the goods would
certainly be consumed value-in-exchange in the market.
By contrast, if bads are produced, i.e., bad scheduling,
bad packaging, bad quality, bad customer’s services ...
all these reflect that market cannot rather will not,
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absorb them. Then there is bound to be a ‘market glut’.
2. Productivity is more important than production. Quality
is more important than the quantity considerations.
Output per head is more important than outlay spent
per head to realise output.
3. Goods are purchased with ‘cash’ but produced with
‘effect’. Cash reflects only the size and segment of
UP demand effort, on the other hand, reflects involvement,
dedication and commitment to work.
4. Lower the tax rate, larger will be the tax base because
of better tax compliance by people and hence larger will
be the flow of tax revenue. Additional taxes have
disincentive effect on production and income
generation; by the same logic, tax cuts release the
incentive effect.
5. Taxes work as instruments of ‘forced savings’. High tax

rate forces people to look for tax shelter, as per the
advice of tax consultants and then the people are forced
in ‘save’ in the name of tax planning.
6. Government should reduce revenue earning through

taxes and simultaneously should spend also. This will
bring down the size of their ‘budget deficits’ and that
would be good for the economy based on functional
finance principles.
)
7. To reduce unproductive expenditure, the government

needs to reduce transfer such as subsidies, old age
pensions, unemployment dole, etc. Such expenditures
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induce inactivity rather than productivity.
8. The best policy mix to revive a sagging economy is to

have “fiscal ease with tight money”. Fiscal ease can
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encourage production, whereas dear money policy can
discourage consumption. Thus, demand pull inflation
can be controlled at a time when growth impetus has to
be provided for enhancing supply.
Check Your Progress

Fill in the blanks:
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1. Say’s law states that there is a functional
relationship between market ...................... .
2. ...................... is measured in terms of money.
3. Fisher’s quantity theory of money work as

...................... to say’s law of market.
4. Keynes general theory was given in year
5.
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......................
Goods are purchased with ................. but produced

with ................... .
Summary
The classical economists took a simple view of macroeconomic
environment of an economy to champion the cause of ‘laissez
faire’ capitalism guided by free market price mechanism,
private property rights and commercial profit motive. There
are three pillars of classical macroeconomics.
1. JB Say’s Law of Market
2. I Fisher’s Quantity Theory of Money
3. Walras’ General Equilibrium Model
The entire economics of Keynes can be summarised in terms

of three basic functions:
)
1. Consumption Function
2. Liquidity Function
(c
3. Investment Function
A review of classical and Keynesian economics brings into

limelight several issue based principles of management.
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Lesson End Activity
Collect data on India’s inflation rate and unemployment rate.
Plot the data. Do you observe any trade off between the two
in the (a) short run, (b) long run.
Keywords
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Say’s Law: According to Say’s law, there is a functional
relationship between the market forces at work such that
supply determines demand and the free market price
mechanism helps this process.
Fisher’s Quantity Theory: If free market price mechanism
has to play its role and responsibility, then price must come
to exist so as to reflect the relative position of either scarcity
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or abundancy in the market. Price itself is measured in terms
of money.
Walras’ General Equilibrium: Walras develops a system
of simultaneous equations and solves the system to locate
general equilibrium. If there are n-markets with n-equations
of exchange and if (n-1) markets are in disequilibrium
reflecting some sort of maladjustments between specific
demand and specific supply, then the n-th market must also
be in disequilibrium such that at the end of interaction among
markets, we reach
n n
 Di   Si
i1 i 1
where [i = 1y , .........., n] represents several markets.

Economics of Keynes: The economics of Keynes can be
summarised in terms of a number of propositions from
Keynes’ General Theory (1936):

)
1. Examine the following propositions, suggesting their

empirical relevance. Quote suitable illustration from the
world of Business around you:
(c
(a) Supply creates its own demand.

(b) Effective demand determines income-employment-
output.
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2. Review your understanding of the terms:
(a) Multiplier
(b) Propensity to consume
(c) Marginal Efficiency of capital
(d) Real balance effect
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(e) Liquidity trap
(f) Pump printing
3. Collect data on tax rate and tax revenue flow in Indian

economy since Independence. Plot the data. What kind
of Laffer curve do you get. Do you find any justification
4.
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for ‘Kinked Laffer Curve’?
How would you explain recession in (a) Steel, (b)

Automobiles, (c) Electronics (white goods)? Where from
what data would you collect to establish the symptoms
of business recession?
5. The miracle economies are now subject to a melt down

process (Economist, 1997). What do you mean by this?
How would you explain the process?
6. “The South East Asian crisis can be compared to the

earlier Mexican crisis, it is on the grounds of principles
of Monetarian vs Keynenanism”. Comment.
7. Is the capital stock adjustment principle of any use for

explaining business fluctuations in an industrial
economy?
Further Readings
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Books
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Web Readings
planningcommission.nic.in/plans/stateplan/upsdr/vol.../01-
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esvol-1.pd..
books.google.com › ... › Economics › Macroeconomics
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www.mbe-du.org/
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Unit 20
Case Studies
Objectives
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Case Study 1: Eco-Friendly Business
The financial dealings of a company may be private concern but

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its environment record is a matter of public concern. Civic society
has every right to know and pressurise private companies and
industries to adopt a more environment friendly approach to
business.
This view prompted the Centre for Science and Environment to
rate Indian companies on the basis of how environmental friendly
they are, and inform and create an image in the public about
their environment concerns – their social obligation towards the
public.
The rating, first of its kind in India, has been supported by the
United Nation Development Programme and the Ministry of
Environment and Forests. One of the first industries to be rated
by the centre are the paper and pulp industries which are
considered highly polluting. The next most highly polluting
industries are the automobile industries.
J K Paper Mills has been rated as the most environment friendly
among the 28 industries with a minimum production capacity of
more than 100 tonnes a day. The next best was Andhra Pradesh
Paper Mills Limited. Though Sinar Mas Pulp and Paper (India)
)
Limited is also green thinking, it could not be given a rating as it

was not in operation for the entire period of three years in which
the performance of the mills were reviewed.
Sadly, even the J K Paper Mills failed to score 50 per cent of the
(c
marks on the evaluation scale and could manage only 42.75 per
cent. The companies were rated on a scale of 100 and the
parameters included corporate environment policy and
Contd...
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management systems, plant-level environmental performance and
the public perceptions of the mill’s environmental responsibility,
including that of local community.
Industrialisation is always accompanied by the problems of
pollution. The whole world has gone through this phase. Industrial
revolution in England barely left the Thames of London a river.
People in Tokyo (Japan) would carry Oxygen cylinder with them
on roads.
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“Economic development is a must for tackling the mass poverty
but at the same time it must be sustainable, especially for the
masses who are living on the edge,” said Dr Manmohan Singh,
former Union minister formally releasing the ratings. Manmohan
Singh, also the head of the project advisory panel of the green
rating project added that initiative for effective environment
management however must invariably come from the industries
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themselves. “We need capitalist to be concerned about masses
and pollution. Self regulation is the best regulation,” he added.
“Government and various pollution controlling bodies are there
to lay norms for industries to check pollution, but this is not
enough. The CSE director, Mr Anil Agarwal said, “No amount of
governmental regulation will suffice. The government can only
set the minimum guidelines to be followed, failure of which will
make it illegal. But it is for the industries to take initiative and
move further.”
Mr H P Singhania, deputy managing director of J K Corps said
that the industrialists are as concerned as the environmentalist
but there are too many problems. “We in India use all kinds of
raw material from bamboo to bagasse to grass. But things are
changing. We now talk of forests as sustainable forest and
renewable forest. The industry needs an agenda to change
concerning all factors like availability, cost factors and feasibility.
I believe this rating will help in providing the same.”
According to a CSE report, the industry is plagued by resource
use inefficiency, improper sourcing of raw material, outdated
technology and a highly wasteful and polluting production process.
)
The CSE was highly critical about the use of chlorine as the
bleaching agent and the amount of water used and wasted by the
Indian Industries. “Many mills in India use 250 to 300 tonne of
water as opposed to 25 tonnes in the industrialised countries.
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Cheap availability of water is the main reason for such trend.

Water should be made available at a costlier rate, while the
Contd...
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industries too should look for alternatives like harvesting rain
water and recycling effluents,” said Agarwal.
Questions:
1. What do you mean by ‘Eco-friendly Business’?
2. Explain the economics of such Business.
3. Relate your discussion to “Social and Moral Responsibilities
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of Business” in India today.
) UP
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Case Study 2: Colour Chips Plans Hollywood Animation
Unit
Colour Chips (India) Ltd., India’s largest animation house, is

planning a pre-production facility in Hollywood. “It could be as a
joint venture or outright purchase of one of the animation studios
there. We are talking to one of Hollywood’s top 10 companies,”
Colour Chips chairman and managing director Uttam Kumar
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told Business Standard on Monday. Kumar spent over a decade
in Hollywood’s top animation studios before setting up his company
here.
The proposed tie up, Kumar said, was in line with the company’s
plan to corporatise animation and emerge as a leader in animation
and cartoons feature syndication.
Colour Chips recently acquired UBC Feature World, India’s
UPlargest cartoon and graphics based syndication company. It has
tied up with the Chandamama group of publications to provide
creative and technical services for digital publishing and revised
editions of Chandamama, the most popular magazine for children
in India with 12 language editions.
Initially, the company will concentrate on producing 2D and 3D
animation for the electronic media, special effects for feature films
and features, cartoons, puzzles and games for the print media.
The company has acquired state-of-the-art equipment in a 25,000
sq ft area in Jubilee Hills here and production will start on April
14. Uttam Kumar said for 3D animation, he was negotiating for
interactive games, CDs and game engines with some of India’s
top companies, not only for production but also strategic
partnership and joint ventures.
He strongly feels that it is time India also builds an Indian
character just as in the West, where stories revolve around known
characters like Mickey Mouse and Donald. “We don’t have a single
such character,” he said.
According to Uttam Kumar, Colour Chips provides facilities in
)
advanced systems with SGI workstations and leading software

for digital content creation, SFX and processing, full-fledged set
up for animators, BG and lay-out artistes and editors.
Other facilities include motion capture set up, sound editing and
(c
post-production suite, library of print and digital references besides

research materials, leased lines for ISDN communication and
data transfer besides web hosting facility at Singapore. He has
invested ` 10 crores in the venture. Contd...
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Though it is the presence of IT companies that drew Uttam Kumar
to Hyderabad, he maintains that animation is “neither IT nor
movie”. He adds: “It is an artistic driven technology. I hire artistes
and not programmers. To create, say a cloud, the artiste can
imagine better than a programmer.”
He said that required manpower was not readily available in India.
“Parents want their children to go for professional courses like
engineering and medicine and now for IT, but not for creative
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work as artistes. This mindset has to change,” he said.
In Korea and Taiwan, which have made great strides in animation
industry, a single studio employs several thousand artistes. Color
Chips now has 400 employees which will treble in a year’s time.
“But we are handicapped by the lack of women artistes. Women
are not coming into this field,” says Uttam Kumar.
Questions:
1.
UP
State clearly the objectives and constraints of Colour Chips
(India) Ltd.
2. Explain the nature of the “company” and its “product”. Figure
out its “strategy”.
3. Identify the production function, supply function and demand
function for the company’s product line.
Source: Business Standard, April 6, 2000
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UP
BLOCK-V
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Detailed Contents
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UNIT 21: MACROECONOMIC PROBLEMS OF UNIT 23: FOUNDATIONS OF ECONOMIC
FLUCTUATIONS AND GROWTH ANALYSIS
 Recession  Micro Foundations of Macroeconomics
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 Inflation  Macro Foundations of Microeconomics
 Mixed (Demand-Cost) Inflation  An Integrated View
 Unemployment
UNIT 24: BUSINESS ETHICS AND ECONOMIC
 Underdevelopment OFFENCES
UNIT 22: GOVERNMENT AND BUSINESS:  Introduction

Introduction
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MACROECONOMIC POLICY MATTERS
Government – Business Relationship:



Ethics and Economics
Moral Responsibilities of Business
Philosophy, Principles and Policies  Social Responsibilities of Business
 Grounds for Government Intervention  Corporate Governance and Business Ethics
 Does Money Policy Matter?  Economic Offences
 Does Income Policy Matter?  Managerial Challenges

)
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UNIT 21: Macroeconomic Problems of Fluctuations and Growth
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Unit 21
Macroeconomic Problems of
Fluctuations and Growth
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Objectives
topics:
 Recession
 Inflation

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A Note on Business Cycles
Introduction
Economic policies and planning make sense only in the
context of economic problems. It is the nature of economic
problem which provides a meaningful direction to the
objectives, instruments and mechanism of various economic
plans and policies. The purpose of this unit is, therefore, to
describe and analyse the nature of some economic problems
as an environmental variable.
Economic environment is given form and shape in terms of

the order and intensity of economic problems. Economic
problems are two fold: some relate to short run cyclical
fluctuations in business conditions; others relate to long run
economic growth.
Recession
)
For the last couple of years, we are hearing of worldwide

recession. Both the developed and the developing countries
of the world, except the oil exporting ones, have been
complaining of deepening business recession and sluggish
(c
economic growth associated with it.
Though present recession is likely to assume a long run

chronic character, we often understand it as “typical short
S
Activity run cyclical problem.” For a clear understanding of the
problem of business recession, we may categorically discuss
Make a presentation on
recession and the effects of its four aspects – the symptoms, the causes, the consequences
recent recession phase in and the remedial measures.
India.
Symptoms
Recession is a phase in the downswing of business cycles. It
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is a state in which there is a general deceleration of economic
activities, resulting in cuts in production and employment,
piling up of unsold stocks and sometimes, though not
necessary, fall in prices. Thus, growing unemployment,
falling sales, accumulating inventories, decreasing waiting
lists, etc., are often read as danger signals of emerging
recessionary conditions. Such business recessions may be
UP caused by the interplay of structural, monetary and fiscal
factors. Some of these causes may be explained separately.
Causes
A structural factor which has a typical economic rather than
psychological tone is the changing terms of trade between
agriculture and industry. It is particularly observed during
periods of inflation that the industrial prices rise faster than
the agricultural prices and in the process when the industrial
goods become costlier, some shift in the pattern of
consumption is very likely. People have to spend so much on
essential/primary goods to maintain the basic minimum
consumption level, that they are left with less and less
purchasing power for non-essential/industrial goods. This
is how the consumer durable often faces demand recession
in course of galloping inflation. In other words, inflation
becomes the cause of recession.
Experiences
)
Sometimes the mounting balance-of-trade deficit, which

means a transfer of purchasing power from domestic to
international economy also generates recessionary
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pressures. If an open economy follows a liberal import policy,

then cheaper goods from abroad may get dumped in the
domestic economy. Such dumping often causes demand
recession for domestic goods which are made to compete with
S
foreign goods. In this way, recession from one country may
get transmitted to another country.
It has become conventional to talk of only demand recession.

But demand recession itself may be a reflection of over-
production, i.e., excess supply. Such situations result from
inaccurate forecasting, lack of sufficient planning, inadequate
control and inappropriate management of production. The
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point remains that recession may result from
mismanagement of not only demand but also supply.
Consequences
The economic consequences of recession are quite dangerous.
For example, as the demand for consumption goods
decreases, unnecessary inventories of finished consumer
UP
goods pile up with the stockist. The manufacturers,
therefore, face declining orders for their finished goods.
Eventually, the manufactures are forced to cut down the rate
of production. This results in underutilised capacity with
plant and equipment. Machines, remaining idle for long,
increase the maintenance costs. Men also cannot be kept idle
for long, that increases labour costs. Sooner or later, labourers
are retrenched. Unemployment level as well as rate start
increasing. The manufacturer’s order for raw materials also
falls. In other words, the demand for men, materials and
machines, all of them being ‘derived demand’, suffers during
recession when the ‘direct demand’ for output declines. In
this process, recession from one sector spreads to another
sector. The spread effect depends on the inter-sectoral
linkages, forward, backward or sideward.
If such deterioration continues in the international economic

order, then there will be no escape from deepening crisis.
Recession will then degenerate into depression. Many
)
countries in the world today stand critically in that

transitional stage between mild recession and severe
depression.
(c
Revival Measures
To avoid this situation, many countries plan timely remedial
measures to overcome recession. It is easier to overcome
S
Activity sectoral recession than general depression. Various anti-
cyclical policies, both monetary and non-monetary, including
Write an article for a business
magazine on Inflation. fiscal and physical measures, can be adopted.
Some physical controls and regulations may also be called

for to fight recession. Special measures will have to be taken
to resolve peculiar problems confronted by some industries.
For example, an anti-dumping law may be necessary to
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restrict the inflow of cheap imports and thereby to protect
the domestic market for indigenous products. Similarly,
excess production of some industries have to be diverted to
export markets, wherever possible and feasible. The idea is
to overcome limitations in the domestic demand for domestic
goods. Such diversions do not cause major distortions
provided the Government properly plans the growth of
UP export-oriented industries.
Check Your Progress

Fill in the blanks:
1. ................ is a phase of downsizing of business cycles.
2. Its is easier to overcome sectoral recession than

................ .
Inflation
Inflation is a dynamic disequilibrium process. It means a
steady increase in the general price level over time due to
demand-pull and cost-push influences. The traditional
explanation of inflation runs in terms of changes in the
amount of money in circulation and changes in the stock of
gold. This quantity theory explanation of inflation has got
replaced by the Keynesian income-expenditure approach.
According to this approach, an increase in quantity of money
)
will not induce a rise in the general price level if the effective
demand generated by the increased money supply leads to
an increase in the level of output and employment by putting
(c
the hitherto unemployed resources into use. If the effective

demand continues to rise even after full employment has
been realised, the general price level will rise and that is
inflation. Inflation is a post-full employment phenomenon.
Each and every rise in price is not a symptom of inflation.
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There are two types of price rise: (a) functional price rise;
(b) inflationary price rise. In case of (a) an increase in demand
is followed by rise in price as well as output, i.e., price rise
indicates the line of output adjustment. In the later case,
increase in demand is followed by rise in price because output
becomes inelastic at full-employment. In the diagram P – P’
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reflects functional rise in price but P’ – P” reflects an
inflationary rise in price, output remaining static at full
employment (Y f).
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Figure 21.1: Inflation
Types of Inflation
Prof. Machlup describes two basic model sequences of
consumer-price inflation as follows:
(a) Demand-pull Inflation: Automatic expansions of

demand (government spending, consumer spending) are
followed by responsive (competitive) price and wage
)
increases.
(b) Cost-push Inflation: Aggressive increases of wage rates

and/or material prices are followed by induced and/or
(c
supportive (compensatory) demand expansions.
Cost-push models are relatively simple as long as they

contain only a single impulse – either wage or price
increases – with all sequential changes in the nature of
adjustments.
(b-1) ‘Pure’ Wage-push Inflation: Aggressive increases
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Activity
of wage rate are followed by induced and/or supportive
Make a brief report on demand
cost inflation and demand expansions and by responsive increases of
unemployment. material prices and other wage rates.
(b-2) ‘Pure’ Price-push Inflation: Aggressive increases

of material prices are followed by induced and/or
supportive demand expansions and by responsive
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increases of other material prices and wage rate.
Mixed (Demand-Cost) Inflation

Inflation may get generated from either demand side or
supply side or both. On the demand side, it is an increased
availability of money income (expenditure) for a given volume
UP of output, which causes inflationary rise in prices. On the
supply side, there are three sources – wage-push, profit-push
and supply shocks. We have discussed the first two using
Machlup’s framework. The third one is of recent (post-
Machlup) origin. The sudden increase in crude oil prices by
the OPEC in 1973-74 and 1978-79 sent shock waves
throughout the world economy; and the ultimate result was
oil induced ‘shock inflation’ in almost all the oil importing
countries of the world. Lastly, the demand and supply factors
get so much mixed up, it becomes difficult to distinguish
between the origin and the end, between the cause and the
effect of inflation. This is where price expectations also
contribute to inflation. The rate of mixed hyper inflation
depends on the elasticity of price expectations. Higher the
elasticity, larger is the marginal rate of inflation.
)
(c
Figure 21.2: Mixed Inflation

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Unemployment
Unemployment is perhaps the most vexing problem of the
present-day world. Leaving aside a few socialist countries,
almost every country in the world today faces the economic
problem of unemployment. It is a problem which is both short
run and long run in character, a problem which threatens
the economic environment of both developed and
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underdeveloped countries. In order to understand the nature
and dimension of this problem, one may consider the various
types of unemployment.
Voluntary Unemployment
Unemployment may not necessarily result from lack of jobs;
it may result as well from the lack of willingness to accept
the available jobs.
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Some people may prefer idleness (inactivity) to work
(activity) and so they may not work. They may voluntarily
create a parasitic class. Pigou thought that such
unemployment occurs because the workers do not accept a
cut in their wage rate. Viewed objectively, voluntary
(Pigovian) unemployment is more of a psychological problem
than an economic problem. Economists do not have a
readymade solution for such problems.
Involuntary Unemployment
People may be unemployed not because of lack of will to work
but because of lack of jobs. Normally, such a situation develops
during the period of business depression which is a regularly
repetitive phase of trade cycle. As such, involuntary
unemployment is known as depressionary or cyclical
unemployment. It is also known as Keynesian
unemployment, because Keynes attempted an explanation
)
of such unemployment in terms of his General Theory.

According to the economics of Keynes, demand deficiency
resulting from low marginal efficiency of capital is the cause
(c
of involuntary unemployment.
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Structural Unemployment
Involuntary unemployment itself may be of various kinds:
cyclical, seasonal, frictional and structural. The major cause
of unemployment in an underdeveloped economy is the
deficiency of the stock of capital in relation to the needs of
growing labour force. If the working force grows faster than
the stock of capital, the entire addition of labour force cannot
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be absorbed in productive employment – because not enough
instruments of production are there to employ them. Capital
formation lags behind skill formation. The resulting
unemployment is known as structural, long-term or Marxian
unemployment. It reflects the structural weakness of an
underdeveloped economy and this structural disequilibrium
is a long run phenomenon.
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Seasonal Unemployment
This type of unemployment arises because of the seasonal
character of a particular productive activity so that people
become unemployed during the slack season. Indian
agriculture is a seasonal operation so that the farmers do
not have sufficient work during the slack season. Other
examples are the ice factories, the rice mills, etc. The solution
is to be found in rearranging the process of production and
where this is not possible, complementary jobs have to be
created for the people suffering from seasonal
unemployment.
Frictional Unemployment
frictional unemployment exists when there is unsatisfied
demand for labour but the unemployed workers are either
not fit for the jobs in question or are not in the right place to
meet this demand. In other words, such unemployment
)
results from the lack of synchronisation between ‘specific

demand and specific supply’. Such a situation is so temporary
in character that frictional unemployment is often described
as unemployment between jobs.
(c
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Disguised Unemployment or Underemployment Activity
Disguised unemployment constitutes the basic problem Make a draft of an assignment

on under development.
of an overpopulated underdeveloped economy.
Underemployment goes together with underdevelopment.
The growing labour force in an underdeveloped economy gets
easily absorbed in agriculture, because it is in agriculture
that labour-absorption capacity is high, that capital-output
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ratio is low and that skill requirement is low. People get
‘occupied’ in agriculture, but not ‘fully-employed’. Most of
them are apparently employed, through actually unemployed
(hidden). It is a common knowledge that with minor changes
in organisation and with existing techniques, agriculture can
be managed by a smaller number of persons, than are actually
engaged in it. Since employment opportunities in the non-
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agricultural sector are not growing rapidly, the new entrants
to the work force are compelled to remain in agriculture and
perpetuate the phenomenon of disguised unemployment
which means that people are engaged in occupations, where
their marginal productivity is very low (if not zero or
negative) and that a shift to alternative occupations will
improve their marginal productivity and add to national
income of the country. It is said that “disguised
unemployment contains a disguised saving potential.” If the
disguisedly unemployed nephews are taken away from their
productively employed uncles’ firms, then (a) the uncles are
left with some surplus of income over their consumption
(with which they were supporting the nephews earlier) and
(b) nephews can be employed in public works programmes
such as irrigation and road building and thus they can
directly assist national capital formation.
Underdevelopment
)
Underdevelopment is a transitional stage in a country, which

is undergoing a process of socio-economic change – a change
in economic trends and structures, a change in the system of
social values and ethics and finally a change in ideas and
(c
institutions. Here is a set of fundamental changes which must

be substantial over a long period such that a society changes
permanently from a low level equilibrium. The transformation
of an undeveloped economy into a fully developed economy is
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characterised by a change from a low level of per capita income
to a high level of per capita income and such a change in
income level is generally associated with changes in the
structure of output, occupation, capital formation,
consumption and foreign trade. The direction and proportion
of these economic changes become conducive to a change in
the system of social preferences and ethical values.
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Underdevelopment – Nature and Problems
Underdevelopment represents a series of complex problems.
Basically underdevelopment is reflected in terms of a low
level of income. Low income may result from a low rate of
growth of income despite a high initial level of income or
from both low initial level and low rate of growth. Low
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income, characteristic of an underdeveloped country, causes
low capacity to save and low inducement to invest. Lack of
saving capacities and investment incentives bring low rate
of capital formation. Lack of capital (material as well as
human) results in inadequacy of material resources and
managerial skills. Resources and management both are vital
for efficient production. Production may suffer because of
lack of resources or lack of management or both. Good
management may overcome the shortage of resources
through an appropriate use of resources; bad management
may aggravate the shortage of resources through an
inappropriate use (misuse) of resources. Thus, lack of
investment which adversely affects the rate of material
capital formation and the rate of managerial skill formation,
ultimately, gets reflected in terms of low-productivity of the
country. Low production in physical terms turns out to be
low income in money terms. Underdevelopment, therefore,
starts with low income and ends with low income. This is
the so-called ‘vicious circle of poverty’, a constellation of
)
forces which perpetuate underdevelopment (in which

traditionally the role of management was not emphasised).
Underdeveloped economies are, by and large, agricultural.

(c
There is a very high concentration of employment and output

in agriculture because the speed of industrialisation is slow
and the spread of industrialisation is limited. This sectoral
disequilibrium manifests itself through concentrated
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production structure – production is less diversified.
However, the consumption pattern is widely ranged
presumably because of ‘international demonstration effect’.
To balance consumption requirements and production
possibilities, the dependence on imports becomes inevitable.
Very often growing imports of food, metals and machinery
cannot be financed through export surplus which is
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generated. Thus, balance of payments difficulties, i.e., foreign
exchange crisis, becomes inevitable.
Check Your Progress

Fill in the blanks:
1. Recession is a phase in the ............. of business

cycles.
2.
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Economics environment is given form and shapes
in terms of ............. and intensity of economic
problems.
3. Balance-of-trade deficit means transfer of

purchasing power from ............. to international.
4. Demand for men, material and M/Cs are .............

demand.
5. ............. means steady increase in the general price

level over time.
Summary
Economic environment is given form and shape in terms of
the order and intensity of economic problems. Economic
problems are two fold: some relate to short run cyclical
fluctuations in business conditions; others relate to long run
)
economic growth.
Recession is a phase in the downswing of business cycles. It

is a state in which there is a general deceleration of economic
activities, resulting in cuts in production and employment,
(c
piling up of unsold stocks and sometimes, though not

necessary, fall in prices.
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A structural factor which has a typical economic rather than
psychological tone is the changing terms of trade between
agriculture and industry. It is particularly observed during
periods of inflation that the industrial prices rise faster than
the agricultural prices and in the process when the industrial
goods become costlier, some shift in the pattern of
consumption is very likely.
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Inflation is a dynamic disequilibrium process. It means a
steady increase in the general price level over time due to
demand-pull and cost-push influences.
Lesson End Activity

Suppose the economy is caught up in business recession.
Suggest recession marketing strategy and tactics that a firm
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producing and selling consumer durables can take up. Quote
illustrative examples.
Keywords
Economic Environment: Economic environment is given
form and shape in terms of the order and intensity of
economic problems.
Economic Problems: Economic problems are two fold: some
relate to short run cyclical fluctuations in business
conditions; others relate to long run economic growth.
Recession: Recession is a phase in the downswing of business
cycles. It is a state in which there is a general deceleration
of economic activities, resulting in cuts in production and
employment, piling up of unsold stocks and sometimes,
though not necessary, fall in prices.
Inflation: Inflation is a dynamic disequilibrium process. It
means a steady increase in the general price level over time
)
due to demand-pull and cost-push influences.

Demand-pull Inflation: Automatic expansions of demand
(government spending, consumer spending) are followed by
responsive (competitive) price and wage increases.
(c
Cost-push Inflation: Aggressive increases of wage rates and/

or material prices are followed by induced and/or supportive
(compensatory) demand expansions.
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Cost-push Models: Cost-push models are relatively simple
as long as they contain only a single impulse – either wage
or price increases – with all sequential changes in the nature
of adjustments.
‘Pure’ Wage-push Inflation: Aggressive increases of wage
rate are followed by induced and/or supportive demand
expansions and by responsive increases of material prices
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and other wage rates.
‘Pure’ Price-push Inflation: Aggressive increases of
material prices are followed by induced and/or supportive
demand expansions and by responsive increases of other
material prices and wage rate.
Underdevelopment: Underdevelopment is a transitional

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stage in a country, which is undergoing a process of socio-
economic change – a change in economic trends and
structures, a change in the system of social values and ethics
and finally a change in ideas and institutions.

1. Run down couple of business magazines to find out the
current state of our industrial economy. Be sure to
collect data on a few selected –
(a) Industries
(b) Firms and also the
(c) National economy.

2. (a) The government of India in August 1999 announced,
“Our inflation rate has come down to an all time
low 1.66% in last 17 years”. What do you mean by
this claim?
)
The housewives visiting markets claimed that they

were still paying higher prices (for necessities)
compared to last year. How can that be?
(b) Inflation as indexed by Wholesale Price Index and

(c
by Consumer Price Index often differs. How would

you explain this observation?
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3. How does inflation affect the following groups?
(a) Creditor
(b) Debtor
(c) Stockist
(d) Consumer
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State and explain categorically.
4. (a) Comment on the nature of unemployment problem
found in underdeveloped countries.
(b) Why is the category of unemployed youth often
referred as ‘Industrial Reserve Army’?
(c) Visit a nearby Employment Exchange. Analyse the
UP data (and its use) available in this Exchange.
(d) Suggest some measures to tackle both rural and
urban underemployment.
(e) Visit a nearby Career Counselling Unit. Describe
its activity and comment on it.
5. What is ‘Stagflation’? Would you agree that there is a
trade-off (Social Choice) between the problem of
inflation and unemployment?
6. “Economies in the third world countries are
underdeveloped because these are undermanaged”.
Examine this statement quoting adequate and
appropriate examples from the World Development
Report.
7. In view of social responsibilities of business, in what
ways can a business unit contribute to national economic
development? Give examples from the Indian context.
Further Readings
)
Books
(c

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Web Readings
www.nber.org/programs/efg/efg.html
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www.wellesley.edu/Economics/weerapana/.../lecture%20202-
01.pdf
www.mbe-du.org/
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)
(c
(c
) UP
E S
UNIT 22: Government and Business: Macroeconomic Policy Matters
Unit 22
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Government and Business –
Macroeconomic Policy Matters
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Objectives
topics:
 Government–Business Relationship: Philosophy, Principles and

Policies
Physical Policies


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Some Major Policy Issues
Introduction
The relationship between government and business is
complex, with both positive and negative aspects in terms of
what can be called the "public good." To make things even
more complex, notions of the public goods change depending
on a person's ideology.
Currently, most developed countries use a variation of

Keynes's policies, allowing a large degree of private business
while maintaining strict regulation of certain aspects of the
economy through the government. Today's relationship
between government and business is thus neither lassez faire
nor socialist, but rather a combination of both, essentially
what is called a "mixed economy."
)
Government–Business Relationship: Philosophy,

Principles and Policies
(c
The government-business relationship is often explained on

the basis of philosophy, principles and policies.
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Activity
Philosophy
Prepare a draft of an Some economists believe in the philosophy of laissez faire,
assignment on government
business relationships.
i.e., ‘let alone’. According to this philosophy, the best
government is the one that interferes the least in business
sector. By contrast, some believing in socialist philosophy
feel that the best government is one which governs the most,
including business, law and order, welfare schemes, etc.
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Experiences have shown that both are extreme cases. We
need to talk about a workable (functional) business-
government relationship.
In today’s world, the government exists as an apex

institution to maintain law and order, provide infrastructure
and so on such that a business unit or an industrial complex
can develop without bottlenecks. Depending upon the social
UP needs, benefits and costs, the government may:
(a) Promote business, e.g., subsidy to small-scale enterprises.
(b) Control and regulate business, e.g., enforcing MRTP,

FERA, etc.
(c) Own and run business, e.g., Public enterprises.
Thus, the government can be a planner or entrepreneur or

promoter or owner or shareholder or controller and
regulator of business. Of late, there is a talk that the
government need not govern business.
Principles
This brings us to the question of principles which together
go in the name of economic rationality and optimality. We
need to take it up for a detailed discussion later. For the
time being it should suffice to note that government’s
intervention in business is normally based on the principle
)
of Maximum Social Advantage, i.e., maximum good for the

maximum number. The economists have developed an
elaborate principle known as Social Benefit Costs Analysis.
If social benefits exceed social costs, i.e., if net externalities
(c
are generated, then only government intervention in business

and economic activity is justified.
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Policies Activity
From principles, we move to policy considerations which Write an article on grounds for
government intervention.
when applied in practice, should justify the instruments
employed to achieve the goal of social welfare and justice.
Macroeconomic policies may originate at various levels:
1. Monetary and Credit Policies from the Central Bank
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2. Fiscal and Budgetary Policies from the Central
Government (Finance Ministry)
3. Physical Policies of Central and Regulation from the
Government (Non-finance Ministry).
Several macroeconomic policies may originate at state
government and local self-government levels. In view of
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these macro level national economic policies, plans,
programmes and procedures, the micro corporate level plans
and policies are often designed.
At the macro level, economic policies may be analysed with

reference to their
(a) Objectives ... (Goal Variable)
(b) Instruments ... (Instrumental Variable)
(c) Mechanism... (Operational Process)

(d) Evaluation ... (Effectiveness: Success or Failure)
Grounds for Government Intervention

Economic Externalities
An externality is a market imperfection that arises when
persons not directly involved in an economic transaction
nevertheless receive benefits or bear costs as a result of that
transaction. Since externalities are not reflected in the
)
market price of goods or services, the result is a misallocation

of resources. Without some sort of intervention in the
marketplace, too little will be produced of goods with
(c
beneficial (positive) externalities and too much of goods with

harmful (negative) externalities. Externalities may arise
from either production or consumption, as discussed in the
following sections.
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Production Externalities
An external economy of production arises when an increase
in the firm’s production results in some benefit to society
(persons outside the firm) for which the firm is not
compensated in the prices of its products. Social benefits
from expanded production may arise in at least two different
ways:
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1. By direct service to others: For example, if a firm
expands production by building a new plant in a small
town, merchants in the town will profit when the new
plant’s employees spend their wages.
2. By indirect cost reduction to other firms: For

example, when Henry Ford introduced the automobile
UP assembly line, the increased production of automobiles
greatly increased the demand for steel. Since large
economies of scale were possible in the steel industry,
all users of steel benefited from Ford‘s innovation.
An external diseconomy of production arises when expansion

of the firm’s production results in adverse effects (social
costs) that are not paid for by the firm and are, therefore,
not reflected in the prices of its products. For example,
increased output of a manufacturing plant may put strains
on the local transportation system that increases costs for
all users.
But there can also be negative externalities associated with

a production process whether or not it expands. The example
that is most often cited, perhaps because it is the most
serious, is the industrial pollution of air or water. If a firm
dumps noxious or toxic wastes into a river, municipalities
downstream must spend large sums on purification. If a firm
spews wastes into the air, both health and property of
)
downwind residents may be adversely affected.
Consumption Externalities
(c
An external economy of consumption arises when the

purchase and consumption of a good or service results in
utility for people who do not pay for the good or service. For
example, suppose that the owner of an old house in a run-
S
down condition pays a contractor for a thorough remodelling
and renovation. The house increases in value and that is what
the owner paid for. But if (as often happens) the improvement
in that house causes the whole neighbourhood to look better,
then values of all homes will rise. The neighbours get a ‘free
ride’, or positive externality.
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An external diseconomy of consumption arises when the
purchase and consumption of a good or service results in
disutility for people not involved in the transaction. Again,
taking house remodelling as an example, suppose that all
the neighbours except one renovate and remodel their homes.
By comparison with the others, the lone exception will look
even worse than before and will suffer a loss in value.
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The Economic Impact of Externalities
Consumption patterns are also conditioned by consumption
externalities. The fortunes of the garment industry, for
example, turn upon their ability to induce the purchase of
new styles before old garments are worn out. Those who are
unable or unwilling to buy the new styles may suffer a
diseconomy – they may feel dowdy or behind the times even
when well dressed in yesterday’s styles.
Managers of both private and public enterprises need to be

aware of the economic and social effects of externalities that
stem from their operations. The private firm’s management
should analyse the firm’s operations to determine what
positive or negative externalities may be generated in the
normal course of business. If positive benefits are identified,
they should be emphasised in the firm’s public relations
activities. It negative externalities are recognised, the firm
should seek to remedy them by internal action, if possible. If
)
not, the firm should prepare for and attempt to influence

the remedies that may be imposed by the government.
Misallocation of Resources
(c
The most serious consequence of either positive or negative

externalities, regardless of whether the enterprise is private
or public, is the misallocation of resources. In case of positive
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externalities, the result is underutilisation; that is, society
is not using enough resources in the production of a
particular good or service.
Incentives for Beneficial Externalities

When beneficial externalities exist, some people pay while
others get a ‘free ride’. There are two basic ways of solving
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the free ride problem: (1) prevent those who do not pay from
receiving any benefits or (2) ensure that everyone who
receives benefits pays.
The first technique is often employed by private enterprises.

For example, suppose that a developer plans to renovate all
the houses in a blighted city neighbourhood. If he buys and
remodels them one at a time, the surrounding property
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owners get a free ride as the values of their properties
increase, too. The solution is that the builder should buy all
the old houses at the same time. Then the increase in value
of surrounding properties will be internalised as each one is
renovated.
The second technique is more suitable to government action

and may result in the provision of public goods paid for by
taxation.
Check Your Progress

Fill in the blanks:
1. An external economy of production arises when an

............... in the firm’s production result in some
benefit to the society.
2. An external economy of consumption arises when

the purchase and consumption of a good or service
results in ............... .
)
Does Money Policy Matter?

The basic question in designing macroeconomic policy
(c
package relates to the role and responsibilities of

Government and other institutions like the Central Bank.
Money is the lifeblood of business. It is obvious that money
S
matters in business, industry and economy. Even then the
economists have raised the question: Does Money Matter?
There are three theoretical answers to this question:
1. Money does not matter at all: Money is just a medium

of exchange transactions which facilitates business.
Anything can perform the ‘veil’ role of money.
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2. Money matters least: Money is only a means to measure
income and expenditure flows in the economy; and those
policies working through income expenditure flows only
matter.
3. Money matters most: Money is the be-all and end-all

of business. Therefore, money alone matters.
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The first answer is ‘classical’; the second answer is
‘Keynesian’; and the third answer is “monetarist” answer.
Such debates may continue on theory, but in practice, both
monetary and non-monetary policies matter.
Mechanism of Monetary Policy

There is no unanimous view about the way monetary policy
operates. This is perhaps because of the fact that there is no
unanimous opinion about the role of money.
According to the traditional quantity theory of money, the

monetary policy affects the price levels because of constancy
in (a) the volume of transactions and (b) the velocity of
circulation of money. Fisher’s equation of exchange
postulates an identity between the demand for and of supply
of money. The supply of money is determined by the product
of stock of money, M, with its velocity of circulation, V. The
demand for money, on the other hand, is the product of
volume of transactions, T, to be undertaken and the general
)
price level, P. Thus, the equations of exchange in its simplest

form appears as
PT = MV
(c
V and T are assumed as constants because at a point of time,

given the size and composition of population, tastes,
techniques, resources, purchase habits of the people, etc.,
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the volume of trade transacted, T and the velocity of
circulation of money, V, do not change.
Thus:
P = V V
T M, where T = some constant, c
P = cM
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dP/dM = c
and dP/dM × M/P = 1
This reads that the money elasticity of price level is unitary.

That is, a given change in the quantity of money, M, through
any instrument of monetary policy, will induce a same
directional and same proportional change in the general level
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of prices. An increase in money supply will raise the price
level and it will thus be inflationary whereas a dear money
policy will be deflationary. Monetary policy operates thus
because of constancy in V and T. If, for one reason or the
other, the so called constancy assumption does not hold, the
entire mechanism of money policy breaks down.
)
(c
Figure 22.1: Monetary Policy Mechanisms

S
According to the Keynesian school of thought, money policy
does not affect the price level, rather it affects the level of
real income and that too ‘indirectly’.
If there is an exogenous increase in money supply from M1

to M 2 , then, given the demand for money (liquidity
preference), the rate of interest is reduced. With a reduction
in the rate of interest, from r1 to r2, the investment demand
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is stimulated. As investment increases, from I1 to I2, the level
of real income increases from Y1 to Y2 through the multiplier
effect. Exactly in the same way, a decrease in money supply
is followed by a rise in the rate of interest—a fall in
investment expenditure and therefore, a fall in real income.
In order that this mechanism works, we need to assume (a)
the absence of ‘liquidity trap’, (b) the interest elasticity of
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investment and (c) the operation of ‘multiplier effect’. If the
economy is caught in the ‘liquidity trap’ (i.e., a perfectly
elastic liquidity preference over a range), a given change in
money supply cannot just induce any change in the rate of
interest; the interest rate gets so rigidly pegged to an
institutional minimum that it does not change. As if, a horse
is taken to the water (money supply is changed), but he does
not drink water (it has no influence on the rate of interest in
the money market). Interest rate may be insensitive to
monetary policy also because of a simultaneous shift in the
liquidity preference curve when there is a change in the
quantity of money exogenously determined. Even if interest
rate is responsive to money supply, there is no guarantee
that the level of investment (demand for capital) will be
interest elastic. If interest charges do not account for a major
part of the total costs of investment or if investment activity
is determined by factors other than costs (factors such as
the size of market, location, government patronage, expected
returns, etc.), then it is possible that investment becomes
)
interest inelastic. In fact, empirical observation suggests such

interest inelasticity of investment. Finally, even if interest
is money sensitive and investment is interest elastic,
monetary policy may not generate income changes because
(c
the so-called investment multiplier may not operate. For

example, if the economy is characterised by full employment
and absence of excess capacity or if the marginal propensity
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Activity to consume is very high, multiplier mechanism may not work;
in that case, a rise in investment may increase only prices
Make a presentation the money
policy and income policy of an but not real income. Excess investment may generate
economy. demand-pull inflation and to that extent the expansion in
real income (following cheap money policy) may suffer.
Does Income Policy Matter?
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Incomes-expenditure policies originate with the
government. These policies go by the name of Fiscal and
Budgetary Policies. Any policy instrument which affects
consumption, saving and investment in the economy is a part
of fiscal policy operation. For example, the government may
like to raise public revenue through taxes and/or non-tax
sources. The government may undertake public expenditure
through subsidies and transfer payments. Also, the
UP government may like to float Public loans, internally by
floating bonds or externally through borrowings from IMF
and World Bank. All these are instruments of fiscal policy
and budgetary operations by the government, central, state
and local self-government level.
It is the multiplier mechanism, through which such policies

work. Similarly, foreign direct investment or export and
imports may work through foreign trade or payments
multiplier.
An overview of all policies is in the chart on the next page.
Instruments of Fiscal Policy

Fiscal policy instruments are operated by the government
at various levels – Central, State and Local. Broadly these
instruments are listed below:
Public Revenue
)
The government normally raises revenue through taxation:

Direct and Indirect. Direct taxes are imposed on income,
wealth and property of the individual or the corporate unit.
By contrast, the indirect taxes are imposed on commodities.
(c
Excise, customs, octroi and sales tax are all examples of

indirect tax.
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Direct taxes like income tax and wealth tax are geared to
ensure distributive justice. This is the reason we have
‘progressive’ income tax whereby the rate of tax increases,
as income increases. In case of ‘proportional‘ income tax, the
tax and income move together in the same proportion and
same direction; and thus it has no redistributive effect. In
case of ‘regressive’ taxation, the tax rate comes down as the
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income increases. It is clear that regressive taxes may induce
propensity to serve and invest, but the egalitarian principle
of justice is violated.
Indirect taxes are normally used for revenue raising purpose.

If a very thin burden of taxes is spread widely over a large
number of commodities, a huge amount of revenue can be
easily raised; this is the reason a Minimum Alternative Tax
UP
(MAT) was introduced in our country.
Administrating a tax system and structure is a managerial

problem. If the cost of administering a tax is larger than the
revenue it raises, then it is uneconomic. Similarly, the norms
of ‘simplicity’ and ‘convenience’ must be satisfied along with
‘economy’ as ‘Cannons’ of a good tax system. Sometimes, it is
argued that indirect taxes are inflationary in nature, because
those taxes immediately raise the cost of supply and may
discourage production. Of course, if such taxes are imposed
on ‘non-merit goods’, then social benefits outweigh social
costs; the production loss and supply rigidity in those cases
do stand justified. In fact, indirect taxes are often used to
ensure allocative efficiency in the process of utilisation of
scarce resources, keeping public good in mind.
If taxes do not suffice to raise sufficient revenue for the

government, then non-tax revenue may be raised through
sources like profits of public enterprises, disinvestment of
shares of public sector undertakings or even borrowing from
)
the public internally or raising loans externally.
Public Expenditure
(c
Revenues are raised towards financing public expenditure.

This is called ‘functional finance’. In present days, the
government has to spend money on defence and
development. Maintaining internal law and order and
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country’s sovereignty involves huge expenditure. Some
economists feel that these are unproductive consumption
expenditure, but there is no escape. Sometimes war like
situation may force the government to divert resources from
development to non-development expenditure, from planned
to non-planned expenditure. Development expenditures are
supposed to be productive in the long run. In the short run,
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such investment oriented public expenditures may release
inflationary forces, because income generated may not be by
immediate supply of output.
Public investment expenditure usually have a long gestation

period and it yields low and slow rate of return; but such
expenditures are unavoidable because such expenditures are
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necessary for growth and development of the economy.
Non-plan expenditure of central government in a country

like ours has the following components: defence, interest
payments on loans, administrative expenditure and subsidies
(on items like food, fertiliser, export and education).
Government’s administrative expenditures on wages,
salaries, pensions and other consumption items like
stationeries, maintenance, etc., are sometimes beyond
control.
Public expenditure shows a tendency to grow over time. It

is very difficult to cut any expenditure, which has once been
committed by the government.
Public Debt
If public expenditure exceeds public revenue flow, then we
have ‘deficits’ in the budget. ‘Budgetary deficits’ have two
components – Revenue Deficits (= Current Revenue –
)
Current Expenditure) and Capital Deficits (Income –

Expenditure on capital account transactions). Such deficits
may be partly met by:
(a) Borrowing, internally or externally or both.

(c
(b) Money creation (e.g., printing of notes) which is known

as ‘deficit financing’. The extent of deficit financing
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indicates the size of ‘monetised deficits’. Similarly, the
budgetary deficits when adjusted to borrowing (loans
on interest), we get the idea of ‘fiscal deficits’.
Check Your Progress

Fill in the blanks:
1. According to laissez faire philosophy — the best
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government is the one that ............... the least is
business sector.
2. Money does not matter at all relate to ...............

theory.
3. Money matter least relates to ............... theory.
4.
5.
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Money matter most relates to ............... theory.
............... controls are imposed in view of import

requirements of the economy.
Summary
The government-business relationship is often explained on
the basis of philosophy, principles and policies.
In today’s world, the government exists as an apex

institution to maintain law and order, provide infrastructure
and so on such that a business unit or an industrial complex
can develop without bottlenecks. Depending upon the social
needs, benefits and costs, the government may:
(a) Promote business, e.g., subsidy to small-scale

enterprises.
(b) Control and regulate business, e.g., enforcing MRTP,

FERA, etc.
)
(c) Own and run business, e.g., Public enterprises.
Principles brings us to the question of principles which

together go in the name of economic rationality and
(c
optimality.
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Import controls are imposed in view of import requirements
of the economy. Such controls mostly take the form of
prohibition of import of certain non-essential items and
liberalisation of import of certain essential raw materials
and goods.
Export controls depend upon internal supply position,

domestic consumption requirements, international market
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conditions, etc. The principal objectives of such controls are
(a) earning foreign exchange, (b) conserving stocks of raw
materials and final products for internal consumption, (c)
enforcing standards of quality and grading, (d) fulfilling
export commitment in accordance with trade agreements.
As economic growth takes place, there are a series of

structural changes, typical of economic development. Some
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of these changes relate to changes in output structure,
occupation structure, productivity structure, consumption
pattern, foreign trade structure, income distribution
structure and so on.
Lesson End Activity

Make a list of macroeconomic policies, plans and programmes.
Indicate the institutional origin or source of all these in a
country like India.
Keywords
Government-business Relationship: The government-
business relationship is often explained on the basis of
philosophy, principles and policies.
Foreign Trade: The difference between domestic

consumption and domestic production is bridged by foreign
trade.
)
Import Controls: Import controls are imposed in view of

import requirements of the economy. Such controls mostly
take the form of prohibition of import of certain non-essential
(c
items and liberalisation of import of certain essential raw

materials and goods.
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Export controls: Export controls depend upon internal
supply position, domestic consumption requirements,
international market conditions, etc.

1. It is said that business strategy, structure and system
are affected by government’s economic policies. Do you
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agree? Give suitable examples in support of your answer,
quoting experiences from across the world of business.
2. Distinguish between the instruments of quantitative and

qualitative credit control. Which would you recommend
for tackling sectoral inflation and sectoral recession?
3. What is the rationale behind replacing Physical Control

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by Financial Controls of business operations like
investment, production, export and distribution?
4. Examine each of the following statements in the context

of Indian economy, business and industry:
(a) Higher the tax rate, narrower becomes the tax base.
The government can increase tax revenue by
lowering the tax rate.
(b) Financing the deficits in the budget may be

inflationary.
5. What are the items of non-plan expenditure of our

government? Collect data to analyse the trends in this
expenditure. What measures would you suggest to
reverse the trend?
6. Ensuring ‘economic growth with social justice’ requires

a balanced mixture of several policies, monetary as well
as non-monetary. Explain.
)
7. Explain the mechanism through which the following

policy instruments may work towards (short-term)
macroeconomic stability and (long term) structural
(c
adjustments:
(a) Borrowing from the IMF and World Bank;
(b) Government spending on Public Work Programme;

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(c) Foreign direct investment;
(d) Pay hike announced and effected by government;
(e) Consumer credit (such as House Building Loans).
8. “It is said that corporate policy often follows the

formulation and execution of national economic
policies”. Establish this statement supported by real
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world business examples.
9. Justify government’s interference with free market

mechanism.
Further Readings
Books
UP



Web Readings
www.growthcommission.org/storage/cgdev/.../
gcwp048web.pdf
en.wikipedia.org/wiki/Keynesian_economics
)
www.mbe-du.org/
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UNIT 23: Foundations of Economic Analysis
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Unit 23
Foundations of Economic
Analysis
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Objectives
topics:
 Micro Foundations of Macroeconomics
 Macro Foundations of Microeconomics

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An Integrated View
Introduction
In course of presenting the economic analysis for business
use, it is conventional to draw a line of distinction between
micro and macro economic analysis. For a beginner on the
course of business economics, this distinction is relevant and
convenient. The decision making process and its variables
for a corporate business unit can be analysed within the
framework of micro-economics. In the same way, the business
environment facing the firm, industry and economy can be
analysed within the framework of macroeconomics.
Micro Foundations of Macroeconomics

In micro-economic analysis of demand, we talk about price
effect, income effect and substitution effect of a change in
consumative factors on demand. Thus the reader may recall:
)
(c
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Activity Sometimes we also talk about expectation effects, e.g., Price
expectations or Sales expectations such that
Make a comparitive report on
micro and macro foundations
of micro economics.
We are using standard symbols: P x = own price of x,

Py = related price of y, B = income, S = sales, P = price
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t = actual today, td = expected tomorrow.
Macro Foundations of Microeconomics

Of late, the economists have conceded that the behaviour of
a firm cannot be analysed without full understanding of the
market environment where the firm operates. Some of the
UP latest behavioural theories and managerial models anlaysing
the firms’s market behaviour take an explicit note of this
fact. For example, the payment of ‘economic rent’ on what is
called ‘Slacks’ is necessitated towards avoiding potential
‘Shock’ which may be generated by the (market) environment.
In fact, choice of strategy and tactics by the firm depends on
the nature and structure of the industry the firm belongs to,
which in turn depends on the macro environment of the
business and economy.
Business environment induces the choice of strategy by the

firm. For example, when the economy is characterised by
cost inflation, the firms mostly follow ‘costs plus pricing
strategy’ to satisfy the target profit. Alternative to mark-up
pricing the firms may follow price minus costing strategy
keeping the target profit. Similarly, a lot of firms follow
specially designed recession marketing strategy such as
repositioning old products, try back schemes to liquidate
inventory, relaunching economy brands of costly products,
price discounts, etc.
)
Another area of micro analysis where macro foundations are

strong is the area of explaining the demand function for
consumer durables and/or non-durables through the use of
(c
distributed lag models as proposed by Houthaker-Taylor and

Nerlove. In fact, their stock adjustment principle of demand
analysis is directly rooted in the macroeconomic principle
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of capital stock adjustment. The gap between the desired
level of output and the actual present level, specific to
existing stock of capital is bridged by fresh investment.
It = [aYt – b Kt], where a > 0 ; b > 0; in the same way, the

current purchase expenditure on consumer durables may be
an attempt to build up a desired level (stock) of consumer
durables. Sometimes acquisitive lust keeps on changing the
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desired level of stock possession.
The intensity and periodicity of business cycles have a direct

influence on business strategic planning and execution by
firms. The entire set of macro theories and/or models
explaining business fluctuations—cyclical, seasonal, and
random is thus relevant for analysing micro-economic
behaviour pattern of individual economic agents like
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producer, marketer, investor, speculator, buyer, supplier, etc.
Check Your Progress

Fill in the blanks
1. Behavior of firm can be analyzed without

understanding market structure where the firms
operates ................ .
2. Choice of strategy depends on nature & structure

of industry, the firm belongs to ................ .
An Integrated View
The preceding sections are only illustrative and not
exhaustive towards establishing relationship between
‘foundations’ and ‘analysis’. Foundations constitute basics
and analysis follows there upon. In this section, we attempt
to take a few policy instruments and then make positive
)
analysis of the same with reference to both micro and macro

implications.
Let us take direct taxes imposed by the central government

(c
on income, wealth and property. Such taxes affect

individuals, firms as well as industries within an economy.
Thus the ultimate analysis of economic effects to such taxes
must move from micro towards macro level. We may talk
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about tax-rate elasticity of direct tax revenue. If this elasticity
is zero that means that taxes are in control. In normal cases,
we observe that this elasticity is negative—higher the tax
rate, lower may be the tax revenue flow because of the
tendency of the tax players to ‘dodge’ or ‘avoid’ or ‘evade’ or
‘plan’ taxes. In the same way, a lumpsum tax, if it is too heavy,
may not raise enough revenue. In the case of indirect taxes
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also, it is better to spread the burden of the tax thinly over a
wide range of products because the revenue-effect will be
substantial.
Apart from the revenue effect, we need to consider the

incidence of taxes, i.e., distribution of the tax burden, say
between the buyers and the sellers. It is observed that more
inelastic the demand, more will be the burden on the buyers;
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whereas more inelastic supply position, more will be burden
on the sellers.
Let us take the case of open door policy followed by countries

in the days of globalisation, liberalisation and privatisation.
Such a policy implies flooding of domestic economy with
foreign technology foreign companies, foreign goods, foreign
brands, foreign media and so on. It is suggested such entry
of foreign elements provides a benchmark and ensures
competition and operational efficiency. Of course, the
Swadeshi School of Thought always argues against such influx
of Videshi elements. According to this line of reasoning, such
unrestricted and unconditional entry and operation may pose
a threat to the survival of domestic enterprises who are not
positioned on the level playing field. Such macro arguments
and counter arguments are well known. For our purpose, it
is important to note whatever is argued from the standpoint
of a nation has ultimate bearing on the adjustment process
at the level of individual firms and industries. As a result,
)
taking advantage of open door (entry and exit) policy, some

of our best engineers, doctors, computer programmer,
technologists, scientists and managers may leave the country
for their individual good; and that may involve a huge social
(c
costs underlying the ‘brain drain.

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Check Your Progress
Fill in the blanks:
1. Business environment induces the choice of
strategy by the firm ................ .
2. The intensity and periodicity of business cycle has
indirect influence on business strategic planning.
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................ .
3. Foundation contributes basics and analysis follow
these upon. ................ .
Summary
The decision making process and its variables for a corporate
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business unit can be analysed within the framework of micro-
economics. In the same way, the business environment facing
the firm, industry and economy can be analysed within the
framework of macroeconomics.
Business environment induces the choice of strategy by the
firm. For example, when the economy is characterised by
cost inflation, the firms mostly follow ‘costs plus pricing
strategy’ to satisfy the target profit. Alternative to mark-up
pricing the firms may follow price minus costing strategy
keeping the target profit. Similarly, a lot of firms follow
specially designed recession marketing strategy such as
repositioning old products, try back schemes to liquidate
inventory, relaunching economy brands of costly products,
price discounts, etc.
Apart from the revenue effect, we need to consider the
incidence of taxes, i.e., distribution of the tax burden, say
between the buyers and the sellers. It is observed that more
)
inelastic the demand, more will be the burden on the buyers;

whereas more inelastic supply position, more will be burden
on the sellers.
(c
Lesson End Activity

Policies cannot stand for long, if they are not based on principles.
Principles are generalised ideologies or philosophies based on
long drawn practice of policy prescriptions
Reconcile the viewpoints expressed above.
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Keywords
Decision-making Process: The decision making process and
its variables for a corporate business unit can be analysed
within the framework of micro-economics.
Business Environment: Business environment induces the

choice of strategy by the firm. For example, when the economy
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is characterised by cost inflation, the firms mostly follow
‘costs plus pricing strategy’ to satisfy the target profit.

1. Beyond a point, there is no need to distinguish between
ether, micro and macro analyses or positive and
normative analyses in Economics.
UP Do you agree with the above observation. Quote
illustrative examples to support your arguments?
2. The concept of ‘trade-off’ measuring some sort of

opportunity costs is basic to both micro and
macroeconomic tools and techniques of analysis.
Discuss.
3. Explain, in the context of micro and macroeconomic

analysis, your understanding of:
(a) price effect, (b) income effect, (c) cross effect,

(d) substitution effect on demand (or consumption).
4. Recall different concepts of “elasticities’s” in whole of

economic analysis. How useful are these concepts in the
context of decision making by (a) Business Unit and
(b) Government Department.
5. Examine both micro and macro effects of each of the

)
following:
(a) An increase in corporate tax rate.
(b) A reduction in food subsidy.

(c
(c) Devaluation of a domestic currency.
(d) Exchange rate fluctuations.

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(e) A sudden crop failure.
(f) Central Bank printing more currency notes.
(g) Introduction of silver coin.
(h) Sale of gold by Bank of England.
(i) Introduction of new currency, EURO.
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(j) A company, declared ‘sick’.
6. State clearly economic reasoning behind:-
(a) Dumping
(b) Wage discrimination.
(c) Minimum Wage Act.
Further Readings
UP
Books



Web Readings
en.wikipedia.org/wiki/Foundations_of_Economic_Analysis
)
www.thefreelibrary.com › ... › Reason › December 1, 1993

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www.mbe-du.org/
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UP
)
(c
UNIT 24: Business Ethics and Economic Offences
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Unit 24
Business Ethics and
Economic Offences
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Objectives
topics:
 Ethics and Economics
 Corporate Governance and Business Ethics
 Economic Offences
UP
Introduction
Ethics is a branch of Philosophy. It analyses both moral and
immoral behaviour of individuals and organisations to make
value judgements towards making prescriptions about
proper conduct. In this sense, ethics is a normative enquiry
rather than being a positive analysis; it is prescriptive rather
than being descriptive. Some descriptions are unavoidable,
but such descriptions only provide material for a well-
founded ethical judgement.
Ethics and Economics

It follows that ethics has a twofold objective: (a) It evaluates
individual and organisational practices by calling upon moral
standards; and (b) it gives prescriptive advice on how to act
morally in a specific kind of situation. Thus, analysis and
)
prescriptions go together. In this sense, the positive and

normative economic analyses of the conduct of business and
businessmen go hand in hand.
(c
Business Ethics
Robert C Soloman and Kristine Hanson in their book, “It’s
Good Business” write,
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Activity “To err is human, perhaps, but to be caught lying, cheating,
stealing, or reneging on contracts is not easily forgotten or
Make a report on business
ethics and economics. forgiven in the business world. And for good reason: such
actions undermine the ethical foundation on which the
business world thrives. Almost everyone can have compassion
for someone caught in ethical dilemma. No one can excuse
immorality.”
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The theme underlying the above paragraph is that good ethics
is also good business. Unless there is strong ethical
foundation of business practitioner, business itself cannot
survive and grow. This is the reason why business must be
self-regulated on the basis of moral standards. If not, the
unethical conduct of business will be regulated or restricted
by others – government, trade unions, consumer forum, social
UP activists, courts, etc.
Many people do not agree with the viewpoint propounded

above. Their arguments, if stated clearly and classified
properly, will surface and suffice as challenges to the notion
of Business Ethics.
The Right Wing Challenges

The proponents of ‘laissez faire’ philosophy feel that the term
‘Business Ethics’ is as inconsistent oxymoron as other terms
such as ‘Luxury Budget Hotel’ or ‘Deluxe Bus Service’. Adam
Smith, the eighteenth century economic philosopher argued,
business runs on profit motive and in a free market, the forces
of demand and supply act as a sort of ‘invisible hand’ to guide
business and therefore, we do not need government to control
and regulate business or the marketplace where business is
transacted. Milton Friedman, a contemporary economist
advocating free market almost on the same lines as Adam
Smith, puts it more clearly, “The business of business is
)
business,……. business cannot have any social

responsibility”, because “business runs on profit motive”. In
making and maximising profit, economic rationality
overrides ethical judgements. The economists, concerned
(c
with positive principles, need not bother above normative

judgements and prescriptions. For a business firm, profit is
the goal variable, there may be a number of instrumental
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variables to attain the goal. The end must justify the means,
however unethical the means may be. Thus, business
practices should be independent of ethical considerations.
In view of this, ‘Business Ethics’ is a contradiction in term.
Business and businessmen know their self interest better
than anybody else; so they should be left alone to design and
execute their own business practices; the questions of ethics,
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morality and value-judgements have no place in the business
world.
The Left Wing Challenges

The critics of business activity on the left of political
spectrum often see business as inherently unethical; it is a
practice based on immoral and illegal transactions. It is in
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this view that Business Ethics is an oxymoron. Karl Marx
propounded his theory of ‘surplus value’ taking the view that
business is essentially exploitative in nature. Marx begins
his analysis by observing that every society by way of some
kind of ‘economic substructure’ (i.e., business arrangement
of productive factors such as land, labour and capital)
produces goods and services. From the economic substructure
follows the ‘social superstructure’ characterised by social
hierarchy of social classes – the haves and have nots on the
bourgeoisie and proletariat or simply the capitalists and
workers (replacing the land owners and serfs of feudal
society). In such a society “labour produces more than what
is needed to maintain labour on productive process’’. Thus,
the workers produce and the capitalists pocket the ‘surplus
value’. Growing volume of business profit is indicative of
growing exploitation of labour by way of long hours of work,
pathetic working conditions, low wages, etc. Profit earned
by the capitalists is invested and reinvested and thus their
income begets further income and in the process, the society
)
gets characterised by growing income inequalities and

increasing poverty. In this perspective, the businessman
capitalist or the industrialist is looked down upon as the
‘blood-sucking vampire bats’, exploiting the workers. The
(c
profit motive may induce the businessmen to exploit others

also, say, the customers, the suppliers of materials and so
on. In such a society, class conflict is inevitable.
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Activity Since Marxist times, the class conflict continues; relations
between labour-unions and owner-management are
W rite an article on the moral
responsibilities of business. sometimes warlike. Some businesses may have the interests
of their employees high on the list of corporate priorities; in
today’s world, there are people-centered rather than
production-centered organisations. In general, even today,
motivated solely and regularly by profit considerations, some
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business organisations thrive on their position by exploiting
people, illegally restricting trade, engaging in unfair trade
practices, cheating the customers by misrepresenting their
products, subjecting workforce (sometimes child labour) to
hazardous tasks, polluting the environment and so on. When
one observes the world of business around, one may feel that
business has no social responsibility, no moral commitment
and no ethical considerations. Therefore, the critics of free
UP and liberated business, loudly and clearly call for government
intervention in business to curb the menace of economic
offences.
It is now clear that there are compelling moral grounds for

the ethical conduct of business at all times. We will
concentrate on the practical business reasons for doing so.
Check Your Progress

Fill in the blanks:
1. ............... analyses both moral and immoral

behaviour of individuals and organisations to make
value judgements of proper conduct.
2. To make profits, some organisation behave ...............
Moral Responsibilities of Business

One of the basic principles of business management reads
)
that authority and responsibility must commensurate with

each other. Authority denotes power, position and status,
whereas responsibility indicates a sense of duty and
obligation. Authority may be imposed or superimposed,
(c
similarly responsibility may be delegated, but the sense of

responsibility must come from within.
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The idea of moral responsibility follows from the concept of
moral standard and ethical judgement. Every corporate unit
has some moral responsibility. At a minimum level, the
corporate unit commits itself to four such corporate
responsibilities:
1. Corporate governance
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2. Customer care
3. Care for minimum working conditions
4. Environmental care
Corporate Governance is a serious concern today. A

corporation has to be governed by its own Board of Directors.
Each member of the Board is responsible individually and
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collectively for running the organisation without violating
the principles of business ethics and moral code of conduct.
For example, the business unit must command the trust and
confidence of the shareholders who have put in their money
in the shares of the company. Also, the financial institutions
have a stake in the company. In this case, it becomes the
moral responsibility of the nominee director to see that the
corporate funds are properly used. Increasingly, many firms
are getting into financial scams and scandals because of moral
irresponsibility on the part of corporate governors.
Customer Care and comfort is another area of concern. It is

the moral responsibility of the corporation and its operating
staff to serve and satisfy the customers. Today’s philosophy
is that the customer is the king and therefore, should be
given a royal treatment. This means that the customers’
grievances must be immediately attended to; his suggestions
must be heard and executed, if possible; good public relations
must be maintained. All these are essentially required to
)
protect business, promote sales and earn goodwill. In the

short run, customer care measures may add to costs; but in
the long run these measures do pay off. It may be noted that
the customer buys a product which is a bundle of goods and
(c
services which must be provided with concern for safety,

quality, packaging, courtesy and so on. It is the collective
responsibility of all concerned – from the manufacturer to
the distributor to the retailer – to ensure that the customer
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is satisfied at the end of any business transaction. This
requires moral commitment on the part of one and all
handling the product.
Care for Working Conditions: Ensuring a good quality of

work life (QWL) is the moral responsibility of the corporate
units like a factory or a firm or an office. Among other things,
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QWL hinges on the nature of work environment, e.g., hours
of work, safety and security at hazardous work, quantum of
wages, health and hygiene factors including cleanliness, first
aid, etc. If the workers do not have proper working
conditions, their efficiency suffers and the organisation loses
productivity. Similarly, regular preventive and breakdown
maintenance of machines and labour are equally important.
UP
Some of these working conditions can be ensured only
through ‘kind’ and not ‘cash’ given directly to the employee.
Therefore, it is suggested that the organisation should spend
on providing quality work environment such that the
employees are motivated to work hard and long and some of
them may not even object to put in a little extra effort, i.e.,
‘labour of love’. The point is, if the organisation takes up
moral responsibility to ensure comfort and care for the
employees, then the employees will also reciprocate; and will
work towards the advantage of the organisation.
Care for Environment: The preceding paragraph was

devoted to care for internal environment of office, factory,
firm or any other workplace of an organisation. We would
now like to concentrate on environment as something
external to the organisation. Environment, in this sense, has
reference to geo-physical factors. It has been observed that
in the course of industrialisation and urbanisation
)
accompanying it, material progress and environmental

pollution go together. Some argue that pollution is the price
(or social costs) one has to pay for progress. Thus, NTPC
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produces power (social benefit) but adds to air pollution. New

models of car, indicating material prosperity, when dumped
on the roads along with old depleted fleet of buses and cars
add to vehicular air pollution, noise pollution and so on. IDPL
producing life saving essential drugs (social benefit) adds to
water pollution (social cost) when the pollutants are dumped
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in the river water. Similarly, an airport located in the heart
of a city is a risk for the civilians. Allowing unauthorised
construction of jhuggi alongside the railway tracks without
any facilities for sanitation, health and hygiene, drinking
water and other basic necessities is a health hazard for
others. Allowing the aged chemical plants to continue may
bring disasters like Bhopal Gas Tragedy. Such examples can
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be multiplied to throw light on cases of irresponsibility on
the part of government and business. Both government and
corporate units should feel morally responsible to prevent
such cases and take proactive measures to reverse the trend.
That is why we find some organisations take up constructive
measures like adoption of villages, literacy mission, drive to
ban the use of plastic products, tree plantation, maintaining
public parks or gardens at/near zebra crossings on the roads,
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organising socially gainful activities like cleanliness drive,
monitoring traffic and garbage clearing. All actions spring
out of a sense of moral responsibility on the part of individuals
and institutions. The concern for environment in today’s
world is also necessary for maintaining ecological balance.
Sometimes the tourism industry takes up eco-tourism as a
mission which reflects a corporate moral responsibility.
The issues are so formidable that no single business or

industry can attack them alone. The Rio Summit on the
environment, held in 1992, attempted to deal with such
questions. Technically known as the United Nations
Conference on Environment and Development, the
Conference tried to produce consensus – unsuccessfully, it
turned out – on steps to be taken worldwide to reduce the
harmful effects on the environment produced by modern
industrialised civilisation. As the Rio conference showed,
rational solutions to the problems of living with
environmental fragility are beyond the capabilities of a single
)
industry, or even a single country and requires concerted

worldwide action.
Social Responsibilities of Business

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It is often argued that business is overwhelmingly concerned

with commercial profitability rather than social welfare.
According to this line of thought, private profit motive makes
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Activity business socially irresponsible. This is not a very correct
view. We need to examine (a) Business-Government
Make a presentation on
corporate governance and Relationship (b) Business-Society Relationship, wherein
business ethics. government is a part of society.
In today’s world, we often insist on the social responsiveness

of management which means the ability and willingness of
management to relate the plans and policies to the social
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environment in such ways that are mutually beneficial to
the organisation and to the society. The social responsiveness
implies actions and the ‘how’ of the responses of the
management. The current trend is in company’s involvement
in social actions. The mission of a corporation expresses such
involvement in social actions to improve the quality of life.
Any enterprise must interact with and live in, as a
UP responsible citizen in the society. In an age of fast changing
and turbulent environment, proaction on the part of
management is demanded to meet the challenges faced by
the society.
Corporate Governance and Business Ethics

Corporate Governance and Business Ethics is a subject of a
raging debate. The global debate now is converging
increasingly in favour of ethics in all aspects of society –
politics, administration, judiciary, business, not forgetting
family and personal life. There has to be less hype and more
strategic thinking.
Good corporate governance is a way of life and not a set of

rules. Good governance implies that the organisation is run
for the optimal benefit of the stakeholders in it.
The mind-set brought about by the licence raj has to change.

The commitment to move towards an ethical non-
)
compromising organisation needs to be explicitly stated and

worked out. Ethics, according to a dynamic interpretation
is a concern that clarifies what constitutes human welfare
and the kind of conduct necessary to promote it. Ethics is
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about living a “Good Life”, not an easy life.
Instead of waiting for the entire system to be cleansed, it is

individual efforts that will make the difference. This means
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that if each individual works with a sense of moral and social
responsibility, then corporate governance will enhance in
quality because of organisation level dedication and
commitment to the cause of ethics and morality.
Economic Offences
Violation of ‘business ethics’ may be summarily termed as
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‘economic offence.’ If any individual and/or organisation
violates the norms of moral code of conduct in business
dealings and operations, then some kinds of economic
offences are being committed. Many individuals and
organisations may feel that the so-called ‘economic offences’
originate in their attempt to overcome ‘economic problems’.
The argument runs that a cash starved company may
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innovate illegal and immoral methods of raising money and
finance. In the same way, an individual officer enforcing law
and order in the need of paying capitation fees to get his son
admitted in an engineering institute, may accept some bribe
money to condone a criminal offence. A judge may explore
and exploit some underworld connections to recover his
dues, legitimate or otherwise. Two top railway officials may
misuse their authority by arranging a special train to travel
as per their whims which may cost Indian Railways a neat
` 1 lakh when their special carriages could have been
attached to regular trains. Such examples can be multiplied.
At this stage, we must take a broader view of the core terms

like “economic problems” and “economic offences”. The reader
may recall, all problems of choice are termed as ‘economic
problems’ scarcity of resources being at the root of such
problems. In the same way, the act of violating the principles
of business ethics is termed as “economic offences”, presence
of acquisitive lust is the symptom of such offences. Just as
)
all economic problems need not be just financial problems,

in the same way, all economic offences may not be just pinned
down to matters of money and finance. The problems and
offences may exist beyond money matters.
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In what follows, we would like to make classified analysis of
economic offences at the level of –
a) Individual.
b) Organisation.
c) Nation.
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Managerial Challenges
This brings us to the issue of managerial challenges towards
discharging corporate tasks and responsibilities in the
forthcoming millennium.
In the emerging environment, challenges are posed by the

tendencies like globalisation, privatisation, liberalisation,
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corporatisation and marketisation. It is being argued that
liberalisation has liberated the forces of corruption. There
is a growing number of frauds, forgery, cheating, financial
irregularities, unfair trade practices and therefore, court
cases waiting for adjudication. It is becoming increasingly
difficult for a professional corporate manager to function in
this environment where economic offences, both individual
and organisational, are multiplying.
When the cases of corporate corruption is on the increase,

the managers have to be extra careful and critical about
procedures they follow and personalities they serve. At any
stage, a manager may be taken for a ride as a ‘scapegoat’ by
any extra-smart fellow. On the one hand, technological
revolutions are taking place to create comfort at work place;
on the other hand, executive stress and tension is growing
because of illegal and immoral approaches taken by the
human factor stationed at the work place. Human
intelligence has conquered the world in every sphere but at
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the same time, has misused system. The manager today is

required to keep his cool and calm, and yet steer through
the cyclonic effects of corporate-level competitive challenges.
The managers, will have to demonstrate the traits of
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character and confidence to cope with these challenges and

commitments.
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Check Your Progress
Fill in the blanks:
1. Philosophy is a branch of ethic ................ .
2. Ethic analyse both moral/immoral behaviour of
individuals and organization. ................ .
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3. Analysis and prescription go separately ................ .
4. Business always run on profit motive ................ .
5. Customer care is the moral responsibility of the
cooperation and its operating staff to serve and
satisfy the customers ................ .
Summary
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Ethics is a branch of Philosophy. It analyses both moral and
immoral behaviour of individuals and organizations to make
value judgements towards making prescriptions about
proper conduct. In this sense, ethics is a normative enquiry
rather than being a positive analysis; it is prescriptive rather
than being descriptive. Some descriptions are unavoidable,
but such descriptions only provide material for a well-
founded ethical judgement.
Many people do not agree with the viewpoint propounded
above. Their arguments, if stated clearly and classified
properly, will surface and suffice as challenges to the notion
of Business Ethics.
Milton Friedman, a contemporary economist advocating free
market almost on the same lines as Adam Smith, puts it more
clearly, “The business of business is business,……. business
cannot have any social responsibility”, because “business
runs on profit motive”. In making and maximising profit,
economic rationality overrides ethical judgements.
)
One of the basic principles of business management reads

that authority and responsibility must commensurate with
each other. Authority denotes power, position and status,
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whereas responsibility indicates a sense of duty and

obligation. Authority may be imposed or superimposed,
similarly responsibility may be delegated, but the sense of
responsibility must come from within.
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Lesson End Activity
Collect a case of corporate corruption in India and write it
down in a narrative (story telling) form. Add a paragraph on
the lessons derived from the story.
[Hint: ITC tax evasion case, Security scam involving Harshad

Mehta, Bihar Fodder scam, Bofors Gun deal and the like].
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Keywords
Ethics: Ethics is a branch of Philosophy. It analyses both
moral and immoral behaviour of individuals and
organizations to make value judgements towards making
prescriptions about proper conduct.
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Business Ethics: Many people do not agree with the
viewpoint propounded above. Their arguments, if stated
clearly and classified properly, will surface and suffice as
challenges to the notion of Business Ethics.
Moral Responsibility: The idea of moral responsibility

follows from the concept of moral standard and ethical
judgement. Every corporate unit has some moral
responsibility.
Good Corporate Governance: Good corporate governance

is a way of life and not a set of rules. Good governance implies
that the organisation is run for the optimal benefit of the
stakeholders in it.
Economic Offences: the act of violating the principles of

business ethics is termed as “economic offences”, presence
of acquisitive lust is the symptom of such offences.

)
1. Establish the relationship between:
(a) Economics and Ethics.
(b) Business and Morality.

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2. What do you understand by the term, “Economic
Offences”? Make an illustrative list of such offences
committed by an:
(a) Individual.
(b) Organisation.
[Collect your data from business magazines and
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Business/Economy pages of daily newspapers].
3. Argue for and against each statement, supported by facts

and figures:
(a) There is corruption more in government sector than

in non-government (private) sector.
4.
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(b) There is more corruption in India compared to any
other countries of the world.
Attempt a clear distinction between:
(a) Business practices and economic offences.
(b) Social and moral responsibilities of an individual.
(c) Social responsibilities and responsiveness of

business.
Quote examples to illustrate your understanding.
5. The parallel economy of India thrives on black money,

black income, black expenditure and black assets.
(a) Do you agree? Can you give examples of each of

these black items? Is there any other form in which
the parallel economy manifests itself?
(b) Analyse the factors behind the growth of parallel

economy of India since Independence.
)
(c) Recount the measures our Government has taken

to control this economy.
(c
(d) Organise a brainstorming session among your

friends on the subject and come up with practical
suggestions to reduce the forces of parallel economy
in India today.
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Further Readings
Books
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Web Readings
www.anebooks.com/addtocart.asp?from=detail&id=1255..
www.excelbooks.com/detail.aspx?iid=360
www.mbe-du.org/
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Unit 25
Case Studies
Objectives
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Case Study 1: One Truth Many Paths
Tata Tea’s $ 370 million (` 1,590 crore) takeover of Tetly reflects

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the growing globalisation of Indian business. It is also a boost for
Ratan Tata himself, a man of the greatest integrity, decency and
modesty who has been under siege facing numerous challenges in
various Tata businesses.
Indian companies are adopting different approaches to
globalisation. The first is the Reliance approach. Here the Indian
company attains global parameters of production but its market
focus is mainly domestic. Other examples: Bajaj Auto, Hero Cycles,
Maruti Udyog and BHEL. Second is the Sundaram Fasteners
route where an Indian company emerges as a global sub-
contractor. The Chennai-based Sundaram Fasteners is now a
major supplier of radiator caps to General Motors but without
any equity participation by GM. Such niche players can multiply
in light manufacturing.
The third route to globalising is simply to build on India’s
comparative advantage and push up exports. This has been done
brilliantly in the software industry by companies like Tata
Consultancy Services (TCS), Infosys, Wipro, NIIT and others. But
in other areas like leather and textiles such companies have not
emerged because of India’s policy of small scale reservation. If
)
policy is unshackled, Indian textile giants could well emerge. As

for TCS, a bonanza awaits it if and when Tata decides to make it
go public, something that should have already been done.
The fourth approach is the one epitomised by the Tata Tea–Tetly
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deal itself. Aditya Birla was one of the pioneers with his
petrochemical investments in East Asia. Hotels managed by Indian
groups like Tatas, Oberoi and ITC are present in different countries.
Contd...
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Ranbaxy is another company that has invested close to $ 85 million
abroad. Since April 1994, the total approvals for Indian
investments in joint ventures and wholly owned subsidiaries
overseas (equity, loans, guarantees and share swaps) amount to
about $ 2.8 billion. In the next 18 months, Indian software
companies will invest close to $ 10 billion in the US largely through
stock swaps. Biotechnology and oil are other areas where overseas
acquisitions are crucial.
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Fifth, Indian affiliates of MNCs like GE could emerge as major
suppliers to their parent companies. Increasingly, this route will
gain importance since already over one-third of international trade
in many industries is intra-company sales. Daewoo is making
India a major production platform for car engines and Peugeot is
doing so for two-wheelers. Other MNCs that could make India
their major centres includes Motorola and Ford. However, we are
at a severe disadvantage as a manufacturing base is in competition
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with China. This has to do with poor infrastructure and our neglect
of time as a key factor.
Sixth, new opportunities are opening up in services as well. GE
capital, for instance, has a call centre in Gurgaon where, taking
advantage of time zone differences, an advantage that we have
yet to fully understand and exploit, Indian girls mimic American
accent and call up credit card and other customers in the US.
Companies like British Airways, American Express and Swissair
have already relocated a part of their back office processing
operations to India. New start-ups in medical transcription are
coming up. Another area is R&D. Unilever’s food research centre
is in Bangalore, while Dupont and GE have a number of R&D
joint ventures with the Pune based NCL. The big bang would be
when we entice a Bell Labs, for which we will need world class
patent laws and telecom services.
Seventh, professional Indians emerging as CEOs and on boards
of major corporations is another dimension of globalisation. Keki
Dadiseth and Victor Menezes are in the top echelons of Unilever
and Citibank respectively and not a day passes without an Indian
being inducted into top management of noted firms. Indians have
)
proliferated in investment banks. Rajat Gupta runs McKinsey,

Rana Talwar is CEO of Standard Chartered, Rakesh Gangwal of
US Air, Rono Datta of United Airways, Arun Netrawali of Bell
Labs, Sanjay Kumar of Computer Associates, Jim Wadia of Arthur
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Anderson, Shailesh Mehta of Providian and M Farooq of Ethan

Allan.
Contd...
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Finally, overseas based Indian entrepreneurs are emerging as
global players. The London based L N Mittal owns over 20 million
tonnes of steel capacity in different countries. An increasing
proportion of hi-tech start-ups in Silicon Valley is by Indian techies,
the most glitzy of them all being Sycamore of Gururaj Deshpande.
Thus, globalisation has many avatars, each of which is giving
Indian enterprise opportunity to flourish. No surprise really for
the heirs to a civilisation that first propounded Vasudhaiva
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Kutumbakam.
Questions:
1. What do you understand by globalisation?
2. List the eight categories/factors mentioned here. Look for
more examples (similar to the one cited here) under each
category.
3.
4.
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Argue for an against “Indian Business going global.”
Discuss what is your view on “Foreign Business Coming to
India.”
Source: The views expressed here are by Jairam Ramesh in India Today,
March 13, 2000.
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Case Study 2: Miracle Economy
Whoever said the 21st century belongs to India knew a thing or

two about demography. Or at least he should have if he didn’t
want to be called just another hopeless optimist. Because there is
this interesting theory on population and its effect on economic
growth, which, if it proves accurate, says India will become the
economic superpower in the next couple of decades. It’s big ‘if’.
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But wait. The theory has already done quite well for itself,
explaining the origins of the East Asian boom for one. In fact,
economist Paul Krugman, who became famous for predicting the
Asian crisis before everyone else, identified the population structure
of the East Asian countries as one of the two biggest reasons for
their dramatic growth rates in the seventies and eighties (The
other factor, he said, was their high rate of capital accumulation).
In the last 30 years, the region has sustained an economic boom
UP which no other region has at any time in history (For all the
credit they get, the baby boomers pushed the growth of the
American economy only a notch higher, to about 3% from a steady
state 2% growth rate. They never took it to the stratospheric 8%
levels East Asia enjoyed). Now it is India’s turn to go after the big
numbers, says this theory. The sceptics may cringe at this, so
let’s quickly run through the theory’s arguments and then look
at the possibilities for India.
In a nutshell, this is what the theory says: when the share of the
working population in the total population of a country rises
rapidly and grows at a faster rate than the total population, it’s
time for a big boom economy.
The reason is actually quite simple. If there are a large number
of young, working people in an economy, that is, the proportion of
dependents is less, then greater output is generated. Not only
that, these working young save more than the old, which means
there is a lot of money for investment. This speeds up growth
even more.
This is precisely what happened in the miracle economies of East
)
Asia which witnessed one of the most dramatic and fastest

demographic transitions in recent history (and that’s why these
economies have sustained such a high growth rate). In South
Korea, Singapore, Hong Kong, Malaysia, Taiwan and Thailand,
the percentage of working people started rising from the early
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seventies (which coincides with the first surge in output of these

economies. Between 1965 and 1990, their working age population
Contd...
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grew at the rate of 2.39% annually, which was much faster than
the 1.58% rate that the population as a whole was experiencing.
As the ranks of workers swelled, their contribution to production,
defined as labour input per capita, increased by 1.1% every year.
These virtuous people saved more as well, causing the saving
rate to increase by an enormous 13.6 percentage points in just
two decades.
Obviously then, its impact on output was substantial. The per
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capita Gross Domestic Product (GDP) of these economies has grown
at an average rate of 6.11% for the last 30 years. According to a
study by Harvard professors David E Bloom and Jeffrey G
Williamson, the population dynamics can claim credit for at least
a third of the GDP growth in the region. And, if one were to look
at its contribution to growth in excess of the 2% growth that’s
standard for mature economies, the numbers are even more
impressive. Then, the population factor is nearly half the story
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behind the miraculously high growth levels.
Now comes the twist in the tale. After the crisis of 1997-98, these
economies are bouncing back. Employment is rising again, people
are working harder, production is picking up and so on. However,
the good run is about to come to an end. Their demographic growth
engine is losing steam. The working age population share in East
Asian countries will peak in 2010 and then start declining rapidly.
That’s roughly when India should take over. The labour force is
growing faster than ever before, at a time when overall population
growth is slowing down. According to Ninth Plan projections made
by the Planning Commission, in another two years, our labour
force will be growing at a higher rate of 2.48% against the overall
population growth of 1.57% and the gap between the two will widen
by 0.91 percentage points as against only 0.29 percentage points
in 1994. For the East Asian countries, the last 30 years’ average
differential works out to exactly the same figure: 0.91 percentage
points.
This will happen because of two events in our population cycle.
First, in the late 70s and early 80s, the birth rate was very high.
)
In the coming years, the surge in the workforce, especially in the

25-40 years age group, can be attributed to this phenomenon.
Second, between 1991 and 1995, for the first time, the birth rate
fell more than the death rate. So from now on, there will fewer
young dependents to feed. The dependency ratio for the young is
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set to drop from 0.66 in 1997 to 0.45 in 2012.
Contd...
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This shift is going to have a dramatic impact on the number of
economically active people in the country. In the late seventies,
for every productive person in the country, there was one dependent
to take care of. Within the next decade, there will be two active
people for every dependent, the magic figure that the East Asian
economies reached in 1990.
Is China closer to this than India? The good news is that as far as
population driven growth is concerned, China is not going to be
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much of a force. Its share of the working age population is also set
to decline along with the East Asian countries. So there it is.
India will have demographics on its side and others won’t.
But this does not mean that these economies are necessarily on
the slide. Because demography was not the only thing they got
right. Tapping export markets in a big way, actively seeking
foreign technology, shifting labour from the low-skilled, low-
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productivity sectors by investing in training and education – all
of this has played a big role in their growth. And they continue to
enjoy these advantages.
India’s real potential depends a lot on how it stacks up against
these other parameters. With the opening up of the domestic
economy, the first two conditions will probably be taken care of.
The worrying feature is the characteristics of our workforce.
Almost two out of three workers in the country are still employed
in the agriculture sector. Despite massive industrialisation of the
economy, not many of these workers have been able to migrate to
better paying, higher skilled jobs in the manufacturing sector. In
fact, compared to the previous decade, industry is producing more
with fewer workers while the productivity in agriculture has
declined. Between 1977 and 1994, agriculture’s share in GDP
dropped by 10 percentage points, but its share in the workforce of
the country dropped by only 8 percentage points.
Moreover, casual employment is rising, up from 28% in 1997 to
33% in 1994. This is itself may not appear to be cause for concern,
especially when official statistics tell us that the rate of
unemployment is just 3%, but the real story is actually quite
)
dismal. The fact that the number of poor in the country is many,
many times more than those without jobs suggests that a lot of
these jobs pay virtually nothing.
And though there are more jobs on offer, this increase has not
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kept pace with the growth of the economy. Between 1977 and
1994, our labour force grew at less than the 5% growth in GDP.
The employment scenario for the future: the Planning Commission
Contd...
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projects that even if our GDP grows at a healthy 6.5% for the
next 12 years, unemployment rate will get worse. Unless GDP
grows by 7.4%, in which case the number of unemployed will
start falling, again a first for the economy.
But will higher growth result in more jobs for more people? That’s
the wrong question. Let’s turn it on its head (which is the whole
point of this exercise). Will there be higher growth if there are
more hands and minds on call? Recent Asian history suggests
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that the answer is a definite ‘yes’.
The focus then should be on what must be done to make it happen.
Because any population driven boost will only be for a short while
– a cycle which plays itself out over 30-40 years. It does not offer
any permanent advantage but is only a launchpad to move into a
high-growth trajectory.
What is more, our rising workforce is not a problem? Trained and
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educated, it will be the biggest catalyst in making India an
economic powerhouse. If only the government understood that its
biggest and highest priority today is to educate its people.
Everything else will take care of itself. Really.
Questions:
1. Discuss categorically both macro and micro level
implications of the underlying economic theory.
2. Compare and contrast the present theory with ‘the theory of
demographic transition’ as propounded by Coale and Hoover
(Refer the book by the author).
3. Work out corresponding features of a Debacle Economy.
Collect data to verify.
Source: Business World, January 10, 2000.
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Glossary
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Glossary
Analysis of Market Behaviour: The analysis of market behaviour of

firms and industry bring out clearly the significance of business risks
and uncertainty.
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Average Cost: Average cost is the cost per unit of output needed to
prevent the use of input in alternative uses
Barometric Price Leadership: In some markets, one ‘barometer’

firm (which is not necessarily a dominant firm) best assesses changes
in demand and supply conditions; other firms may then follow such
price changes. Barometer firm itself may well change over time.
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Basic Necessities (Products): Products which are provided at
subsidised rate to the people below poverty line, as a part of minimum
need programme of a welfare state are termed as basic necessities.
Business Environment: Business environment may be classified on

different criteria, such as time, space, forces and factors. Based on
‘time’ we may talk of past, present and future environment of business.
Based on ‘space’ we may think of local, regional, national and
international environment of business. Based on ‘forces’ of market such
as supply, price, etc., or non-market institutions like government
Business Ethics: Many people do not agree with the viewpoint

propounded above. Their arguments, if stated clearly and classified
properly, will surface and suffice as challenges to the notion of Business
Ethics.
Case Method: The case method is a pedagogical technique. In business

economics, the case method is useful to the extent it stimulates a real
world business situation. Regression: Regression gives the best
estimate of a variable for any given value of another variable.
)
Case: A case represents a depiction of the real situation; it describes

the actual environments, experiences, events or incidents or episodes
of the historical past.
(c
Collusive Price Leadership: In an oligopoly market several firms

may feel that strength in unity and accordingly, may combine together
as a cartel and collude on price. Such collusion may be explicit and
tacit.
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Competitive Games: Competitive games are classified according to
the number of players involved, i.e., as a two-person game, three-person
game, etc.
Concept: Concepts can be explained better with the help of tools and
techniques like tables, diagrams equations, etc.
Conglomerate Mergers: A conglomerate merger is one in which
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different companies producing different products are brought under a
single ownership.
Constant: A constant is a quantity, which does not change in a given

problem.
Co-operative Sector: The co-operative sector is a voluntary

organisation.
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Cost: costs are taken as a function of output.
Cost-push Inflation: Aggressive increases of wage rates and/or

material prices are followed by induced and/or supportive (compensatory)
demand expansions.
Cost-push Models: Cost-push models are relatively simple as long as

they contain only a single impulse – either wage or price increases –
with all sequential changes in the nature of adjustments.
Cross-price Elasticity of Demand: This measures the responsiveness

of quantity demanded to changes in the prices of other goods (both
complements and substitutes).
Decision-making Process: The decision making process and its

variables for a corporate business unit can be analysed within the
framework of micro-economics.
Decision Tree: A decision tree is a graphic device that shows a sequence

of strategic decisions and the expected consequences under each possible
set of circumstances
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Definite Outcome: The definite outcome associated with known

changes define the decision environment of “certainty”.
Demand: Demand as defined by the economists depends on a number

(c
of factors like price, income, market environment, etc

Glossary
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Demand-pull Inflation: Automatic expansions of demand
(government spending, consumer spending) are followed by responsive
(competitive) price and wage increases.
Discounting: Discounting brings us to a very important concept of

Managerial Economics. Discounting is both a concept and a technique,
which is borrowed from Accountancy.
E
Dominant Price Leadership: A large firm because of dominant
position in the market may act as a price leader and small firms may
act as price followers.
Economic Environment: Economic environment is given form and

shape in terms of the order and intensity of economic problems.
Economic Offences: the act of violating the principles of business

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ethics is termed as “economic offences”, presence of acquisitive lust is
the symptom of such offences.
Economic Problems: Economic problems are two fold: some relate to

short run cyclical fluctuations in business conditions; others relate to
long run economic growth.
Economic Theory: Economic theory lays the foundation for the analysis
of public policy, business behaviour and market performance.
Economics of Keynes: The economics of Keynes can be summarised

in terms of a number of propositions from Keynes’ General Theory
(1936).
Economics: Economics is all about a economic problems – their

Environment: By ‘environment’ we have reference to a set of external

forces and factors which affect the business unit, but the business unit
in itself cannot influence the environment..
Ethics: Ethics is a branch of Philosophy. It analyses both moral and

)
immoral behaviour of individuals and organizations to make value

judgements towards making prescriptions about proper conduct.
Expenditure Method: National income and national expenditure

(c
equate, because spending on consumption and/or saving is financed

out of income earned.
S
Export controls: Export controls depend upon internal supply position,
domestic consumption requirements, international market conditions,
etc.
Externality: The term externality or external economies is employed

to mean services (and dis-services) rendered free (without compensation)
by one producer to another.
E
Firm Conduct: Firm conduct is a subject that becomes interesting
only when competition is imperfect.
Firm Expansion: Firms may expand horizontally, vertically or into

unrelated markets. This is attained through ‘integration’ or what we
First Degree Discrimination: A seller may be in a position to charge

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N-prices from N-different buyers such that not a single buyer is left
with any amount of consumer’s surplus.
Fisher’s Quantity Theory: If free market price mechanism has to

play its role and responsibility, then price must come to exist so as to
reflect the relative position of either scarcity or abundancy in the market.
Price itself is measured in terms of money.
Foreign Trade: The difference between domestic consumption and

domestic production is bridged by foreign trade.
Giffen Products: A special case of the inferior product arises when as

price rises, more of the good in question is bought – resulting in an
upward sloping demand curve, contrary to the normal law of demand.
Such products are classified as Giffen products
Good Corporate Governance: Good corporate governance is a way

of life and not a set of rules. Good governance implies that the
organisation is run for the optimal benefit of the stakeholders in it.
Government-business Relationship: The government-business

)
relationship is often explained on the basis of philosophy, principles

and policies.
HLL: Hindustan Lever Ltd.

(c
Horizontal Mergers: A horizontal merger is one in which different

plants producing similar products are brought under a single ownership.
Glossary
S
Imitation: Blindly copying the product or the process and the pattern.
Import controls: Import controls are imposed in view of import

requirements of the economy. Such controls mostly take the form of
prohibition of import of certain non-essential items and liberalisation
of import of certain essential raw materials and goods.
Income Elasticity of Demand: This measures the responsiveness of
E
demand to a change in the real income of consumers.
Income Method: The value of output produced exhausts in terms of

payments made to all input entering the productive process.
Indefinite Outcome: The indefinite nature of outcome associated with

known changes involves “risk”. Such risks can be estimated in terms
of actual probability of events and accordingly such risks can be insured.
UP
Inferior Products: Certain products are classified as ‘inferior’ because
the demand for them falls as incomes rise (and vice versa).
Inflation: Inflation is a dynamic disequilibrium process. It means a

steady increase in the general price level over time due to demand-pull
and cost-push influences.
Innovation: New ideas, new techniques, new product coming through

extended use or modified version of an existing item.
Innovision: Going beyond the obvious.
Investment Decisions: Investment decisions involve a good deal of

risk and uncertainty. Lack of authentic information, dependable data
LAC: The long run average cost (LAC) curve is the cost curve showing
the average cost of production at different levels of output, turned out
by different sized plants.
Laplace Criterion: The Laplace criterion is a criterion of rationality,

)
completely insensitive to the decision maker’s attitude. It is extremely

sensitive, however, to the decision maker’s definition of the states of
nature.
Legal Person: The term legal person may refer to any person who can
(c
enjoy certain legal rights and who has certain legal duties.
LIC: Life Insurance Corporation

S
Linear Programming: Linear Programming may be defined as a
method of determining an optimum programme of inter-dependent
activities in view of available resources to maximise or minimise an
objective function.
Long Run Cost: In the long run, the firm has time to adapt fully its
plan implying that all inputs are variable.
E
Macroeconomic Analysis: In macroeconomic analysis, we study the
system as a whole – not the individuals but the total. We focus on the
form and functioning of the economy as an aggregate system.
Marginal Costs: Marginal costs refer to change in costs, obviously in

variable part of the costs.
Matrix: A matrix is a rectangular array of numbers, usually

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represented by enclosing the array by brackets. The numbers of rows
and columns are called the dimensions or order of a matrix.
Merger: A merger is an integration of two or more firms under a

single ownership. Mergers play an important role in a free enterprise
economy, in that less efficient firms are swallowed by the more efficient.
Micro-economic Analysis: In micro-economic analysis, we focus on

individual units like a consumer, a producer, a firm, an industry, a
single price or a single commodity.
Money: Money has got dual personality; it exists as both ‘stocks’ and
‘flows’.
Monopolistic Competition: Monopolistic competition refers to markets

in which there are a large number of firms competing, supplying
products which consumers believe are close but not complete substitutes.
Monopoly: Monopoly is the polar opposite of perfect competition.

Economists define a monopolist as the sole supplier to a particular
market. This should not be confused with the everyday use of the term
)
to describe a supplier with a relatively large share of the market.
Moral Responsibility: The idea of moral responsibility follows from

the concept of moral standard and ethical judgement. Every corporate
unit has some moral responsibility.
(c
Motivation: The intervening element between labour time and actual

output can be referred to as motivation.
Glossary
S
National Income: National Income is the money value of output
produced in an economy at a given point of time
NBO: Non-Business Organizations.
NGO: Non-Governmental Organizations.
Normal Products: Goods and services may be classified as ‘normal

products’ if the quantity demanded rises as incomes rise and falls as
E
incomes fall.
Oligopoly: Oligopoly is the term used to describe such markets. Where

Opportunity Costs: The opportunity costs are the “concepts of sacrificed

alternatives.
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Optimization: Optimization means the act of choosing the best
alternative out of whatever alternatives are available. It helps in making
decisions.
Output: Output is produced by combining the use of fixed factors and

variable factors.
‘Partial’ Equilibrium Analysis: ‘Partial’ equilibrium analysis in

economics means when at a time, one part of the system is being
analysed assuming other parts to be constant parameters.
Partial Derivative: The derivative of the partial function is known

f
as the partial derivative of the original function and is denoted by
x i
or fi(x) or fx (instead of using, ‘u’ by ‘u x’).
Population or Universe: Any collection (usually large) of individuals

or objects is called a population or universe.
Price Discrimination: Price discrimination as a policy may constitute

another strategic design. Economists often talk about different degrees
)
of price discrimination.
Price Elasticity of Demand: This measures the responsiveness of

quantity demanded of a product to changes in its ‘own price’.
(c
Primary Firms: Firms involved in the first stages of production. These

are extractive industries (e.g., quarrying, mining, agriculture).
S
Primary Sector: The primary sector produces cultivation related agro
based items.
Private Sector: The private sector includes all firms whose ownership
is by private enterprise (e.g., IBM or the corner shop).
Production Method: We need to start by identifying the sectors of

production of goods and services and aggregate the ‘net value added by
E
each sector’.
Production Technology: Production technology is analogous to the

consumption technology. the production function, Q = Q (L, K) is
analogous to the utility function, U = U (X, Y), where X and Y are
usable goods; and L and K are usable inputs.
Production: Production is the process of creating the ‘utils’.

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Public Sector: The public sector includes businesses which are
controlled by the Government, e.g., Indian Railways, SAIL, BHEL,
etc. The joint sector is jointly managed by both private and public
sector.
‘Pure’ Price-push Inflation: Aggressive increases of material prices

are followed by induced and/or supportive demand expansions and by
responsive increases of other material prices and wage rate.
‘Pure’ Wage-push Inflation: Aggressive increases of wage rate are

followed by induced and/or supportive demand expansions and by
responsive increases of material prices and other wage rates.
Recession: Recession is a phase in the downswing of business cycles.

It is a state in which there is a general deceleration of economic activities,
resulting in cuts in production and employment, piling up of unsold
stocks and sometimes, though not necessary, fall in prices.
Risk: Risk is defined as a state of knowledge in which each alternative

leads to one of a set of specific outcomes with objectively determined
)
probabilities. Risk can be determined a priori (i.e., by deduction) or a

posteriori (i.e., by statistical analysis of data obtained by
experimentation or sampling).
Regression: Regression gives the best estimate of a variable for any

(c
given value of another variable.
SAIL: Steel Authority of India Ltd.

Glossary
S
Sample Size: The number of individuals in a sample is called the
sample size.
Sample: A finite subset of a population is called a sample.
Say’s Law: According to Say’s law, there is a functional relationship

between the market forces at work such that supply determines demand
and the free market price mechanism helps this process.
E
Second Degree Discrimination: A seller may be in a position to
charge block rates for different blocks to his customers.
Secondary Firms: This second stage of production is manufacturing.

All manufactured goods are included, e.g., capital or investment goods
(plant, buildings, machine tools), durable consumer goods (e.g., cars,
washing machines) or non-durable goods (e.g., food, clothing).
UP
Secondary Sector: Secondary sector produces industrial goods.
Stock: By ‘stock’, we make reference to something which exists at a

point of time; whereas by ‘flow’ we refer to something which circulates
over a period of time.
‘Technique’ and ‘Technology’: The terms ‘technique’ and ‘technology’

are often used interchangeably; but technically they are different.
Tertiary Firms: Firms providing services, e.g., police, education and

other services such as banking, insurance and catering.
Tertiary Sector: Tertiary sector produces services.
The Decision Variables: These are variables where optimal values

have to be determined.
The Feasible Set: An essential part of any optimisation problem is

specification of exactly what alternatives are available to the decision
maker. The available set of alternatives is called the feasible set.
The Objective Function: The objective function is a mathematical

)
relationship between the choice variables and some variables whose

values an economic agent wishes to maximise or minimise.
Third Degree Discrimination: A seller, because of his monopoly

(c
power, may not allow buyer’s choice and preference to decide on the
block/segment/user’s category. A seller may dictate the choice on his
own.
S
Total Cost: The total cost of any output is the value of all the inputs
used in its production.
Trade-off: ‘Trade-off’ as a concept has its application both at micro as

well as macro levels.
Underdevelopment: Underdevelopment is a transitional stage in a

country, which is undergoing a process of socio-economic change – a
E
change in economic trends and structures, a change in the system of
social values and ethics and finally a change in ideas and institutions.
Variable: A variable is a thing which varies, which can take a set of

possible values within a given problem.
Veblen Products: It has also been suggested that ‘luxury type’ products
also display perverse price demand relationship, though for different
UP
reasons to that of the Giffen products case. These are sometimes referred
to as Veblen products
Vertical Mergers: A vertical merger is one in which firms engaged in

different stages of the chain of production and distributions are united
under one ownership
Walras’ General Equilibrium: Walras develops a system of

simultaneous equations and solves the system to locate general
equilibrium. If there are n-markets with n-equations of exchange and
if (n-1) markets are in disequilibrium reflecting some sort of
maladjustments between specific demand and specific supply, then the
n-th market must also be in disequilibrium such that at the end of
interaction among markets, we reach
n n
 Di   Si
i 1 i 1
where [i = 1y , .........., n] represents several markets.
X-efficiency: The concept of X-efficiency with reference to labour input.

)
(c

Business Economics II: (C) UPES

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UNIT 20: Case Study

Dr S R Das Dr S P S Narang Dr Sanket Goyal

SLM Development Team

Mr Kapil Mehra Mr A N Sinha

Course Code: BBCE-112D

Course Name: Business Economics II

Version: July 2013

© MPower Applied Learning Enterprise

Unit 1 Business and Economics ................................................................................................ 3

Unit 3 Forms and Fallacies of Economic Analysis ................................................................. 23

Unit 4 Basic Concepts and Precepts ....................................................................................... 35

Unit 5 Case Studies.................................................................................................................. 55

Unit 6 Basic Tools and Techniques of Economic Analysis ..................................................... 61

Unit 7 Game Theories in Economic Analysis ....................................................................... 119

Unit 8 Market Analysis.......................................................................................................... 145

Unit 9 Consumption and Demand Analysis ......................................................................... 167

Unit 11 Production and Supply Analysis................................................................................ 203

Unit 12 Cost Analysis .............................................................................................................. 233

Unit 13 Industry and Market Structure Analysis.................................................................. 255

Unit 14 Theory and Models of Firm and Industry ................................................................. 277

Unit 15 Case Studies................................................................................................................ 289

Unit 16 Business Risks and Uncertainty Analysis ................................................................ 295

Unit 17 Macroeconomic Environment of Business................................................................. 311

Unit 18 Macroeconomic Concepts of Stocks and Flows.......................................................... 323

Unit 19 Macroeconomic Analysis ............................................................................................ 333

Unit 20 Case Studies................................................................................................................ 347

Unit 22 Government and Business – Macroeconomic Policy Matters................................... 371

Unit 23 Foundations of Economic Analysis ............................................................................ 387

Unit 24 Business Ethics and Economic Offences ................................................................... 395

Glossary ..................................................................................................................................... 417

UNIT 1: BUSINESS AND ECONOMICS UNIT 3: FORMS AND FALLACIES OF ECONOMIC

International Business: Forms and Facet

 Risk and Uncertainty

UNIT 5: CASE STUDIES

The purpose of any economic activity such as production,

Economics is the study and evaluation of economic problems.

Each and every economic problem is a problem of choice and

economic activities is to satisfy maximum possible ends by

(a) Wants are unlimited. They are numerous in number and

(b) Wants can be graded in order of their intensity. A system

(a) Resources are limited in supply. In general, we face

(b) Resources have alternative uses. They can be used for

It may be noted that the want characteristics and resource

the various facet of any economic problem. The concern of

resources and/or how to ‘maximise’ the level of output,

1. The purpose of an economic activity is to create

2. .................. is all about economic problems their

Concept of Business Economics

1. Economics as a discipline provides a set of concepts and

The concepts and precepts together furnish us the tools

3. Economic analysis is used as an aid to understand

4. Such understanding facilitates business decision making

There is a thin line of distinction between Business

Business Economics uses:

a. Micro-economic analysis of the business unit; and

b. Macroeconomic analysis of the business environment.

Business Economics is thus more comprehensive and broad

based than Managerial Economics which is mostly micro-

Check Your Progress

of economic activity. ................... .

Economics is all about a economic problems – their

There is a thin line of distinction between Business

Business Economics uses: