MBA

PAPER 1.3
MANAGERIAL ECONOMICS

SYLLABUS
Unit 1 Managerial economics: Meaning, nature and scope;
Economic theory and managerial economic; Managerial
economics and business decision making; Role of
managerial economics.
Unit 2 Demand Analysis: Meaning, types and determinants of
demand.
Unit 3 Cost Concepts: Cost function and cost output
relationship; Economics and diseconomies of scale;
Cost control and cost reduction.
Unit 4 Production Functions: Pricing and output decisions
under competitive conditions; Government control over
pricing; Price discrimination; Price discount and
differentials.
Unit 5 Profit: Measurement of profit; Profit planning and
forecasting; Profit maximization; Cost volume profit
analysis; Investment analysis.
Unit 6 National Income: Business cycle; Inflation and deflation;
Balance of payment; Their implications in managerial
decision.

REFERENCE BOOKS:

1. Gupta G S, Managrial Economics, Tata McGraw-Hill

2. Varshney and Maheswari, Managerial Economics, Sultan Chand
and Sons.
3. Mehta P L, Managerial Economics, Sultan Chand and Sons.
4. Joel Dean, Managerial Economics, Prentice-Hall.
5. Rangarajan, Principles of Macro Economics, Tata McGraw-Hill.

CONTENTS
0. SYLLABUS MgrEco-1300.doc
1. NATURE & SCOPE OF MANAGERIAL MgrEco-1301.doc

ECONOMICS
2. DEMAND ANALYSIS MgrEco-1302.doc
3. COST CONCEPTS MgrEco-1303.doc
4. PRODUCTION FUNCTION MgrEco-1304.doc
5. PROFIT MgrEco-1305.doc
6. NATIONAL INCOME MgrEco-1306.doc
 LESSON – 1

NATURE & SCOPE OF MANAGERIAL ECONOMICS

The terms Managerial Economics and Business Economics are often

used interchangeably. However, the terms Managerial Economics has
become more popular and seems to displace Business Economics.

DECISION-MAKING AND FORWARD PLANNING

The chief function of a management executive in a business firm is
decision-making and forward planning. Decision-making refers to the
process of selecting one action from two or more alternative courses
of action. Forward planning on the other hand is arranging plans for
the future. In the functioning of a firm the question of choice arises
because the available resources such as capital, land, labour and
management, are limited and can be employed in alternative uses.
The decision-making function thus involves making choices or
decisions that will provide the most efficient means of attaining an
organisational objectives, for example profit maximization. Once a
decision is made about the particular goal to be achieved, plans for
the future regarding production, pricing, capital, raw materials and
labour are prepared. Forward planning thus goes hand in hand with
decision-making. The conditions in which firms work and take
decisions, is characterised with uncertainty. And this uncertainty not
only makes the function of decision-making and forward planning
complicated but also adds a different dimension to it. If the
knowledge of the future were perfect, plans could be formulated
without error and hence without any need for subsequent revision. In
the real world, however, the business manager rarely has complete
information about the future sales, costs, profits, capital conditions.
etc. Hence, decisions are made and plans are formulated on the basis
of past data, current information and the estimates about future that
are predicted as accurately as possible. While the plans are
implemented over time, more facts come into the knowledge of the
businessman. In accordance with these facts the plans may have to
be revised, and a different course of action needs to be adopted.
Managers are thus engaged n a continuous process of decision-
making through an uncertain future and the overall problem that they
deal with is adjusting to uncertainty.
To execute the function of ‘decision-making in an uncertain
frame-work’, economic theory can be applied with considerable
advantage. Economic theory deals with a number of concepts and
principles relating to profit, demand, cost, pricing, production,
competition, business cycles and national income, which are aided by
allied disciplines like accounting. Statistics and Mathematics also can
be used to solve or at least throw some light upon the problems of
business management. The way economic analysis can be used
towards solving business problems constitutes the subject matter of
Managerial Economics.

DEFINITION
According to McNair the Merriam, Managerial Economics consists of
the use of economic modes of thought to analyse business situations.
Spencer and Siegelman have defined Managerial Economics as
“the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by
management.”
The above definitions suggest that Managerial economics is the
discipline, which deals with the application of economic theory to
business management. Managerial Economics thus lies on the margin
between economics and business management and serves as the
bridge between the two disciplines. The following Figure 1.1 shows
the relationship between economics, business management and
managerial economics.
APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT
The application of economics to business management or the
integration of economic theory with business practice, as Spencer
and Siegelman have put it, has the following aspects :
• Reconciling traditional theoretical concepts of
economics in relation to the actual business behavior
and conditions: In economic theory, the technique of analysis
is that of model building. This involves making some
assumptions and, drawing conclusions on the basis of the
assumptions about the behavior of the firms. The assumptions,
however, make the theory of the firm unrealistic since it fails to
provide a satisfactory explanation of what the firms actually do.
Hence, there is need to reconcile the theoretical principles
based on simplified assumptions with actual business practice
and develop appropriate extensions and reformulation of
economic theory. For example, it is usually assumed that firms
aim at maximising profits. Based on this, the theory of the firm
suggests how much the firm will produce and at what price it
would sell. In practice, however, firms do not always aim at
maximum profits (as they may think of diversifying or
introducing new product etc.) To that extent, the theory of the
firm fails to provide a satisfactory explanation of the firm’s
 actual behavior. Moreover, in actual business language, certain
terms like profits and costs have accounting concepts as
distinguished from economic concepts. In managerial
economics, an attempt is made to merge the accounting
concepts with the economics, an attempt is made to merge the
accounting concepts with the economic concepts. This helps in
a more effective use of financial data related to profits and
costs to suit the needs of decision-making and forward
planning.
• Estimating economic relationships: This involves the
measurement of various types of elasticities of demand such as
price elasticity, income elasticity, cross-elasticity, promotional
elasticity and cost-output relationships. The estimates of these
economic relationships are to be used for the purpose of
forecasting.
• Predicting relevant economic quantities: Economic
quantities such as profit, demand, production, costs, pricing
and capital are predicated in numerical terms together with
their probabilities. As the business manager has to work in an
environment of uncertainty, the future needs to be foreseen so
that in the light of the predicted estimates, decision-making
and forward planning may be possible.
• Using economic quantities in decision-making and
forward planning: This involves formulating business policies
for establishing future business plans. This nature of economic
forecasting indicates the degree of probability of various
possible outcomes, i.e., losses or gains that will occur as a
result of following each one of the available strategies. Thus, a
quantified picture gets set up, that indicates the number of
courses open, their possible outcomes and the quantified
probability of each outcome. Keeping this picture in view, the
business manager is able to decide about which strategy
should be chosen.
 • Understanding significant external forces: Applying
economic theory to business management also involves
understanding the important external forces that constitute the
business environment and with which a business must adjust.
Business cycles, fluctuations in national income and
government policies pertaining to taxation, foreign trade,
labour relations, antimonopoly measures, industrial licensing
and price controls are typical examples. The business manager
has to appraise the relevance and impact of these external
forces in relation to the particular business unit and its business
policies.

CHARACTERISTICS OF MANAGERIAL ECONOMICS

There are certain chief characteristics of managerial economics,
which can help to understand the nature of the subject matter and
help in a clear understanding of the following terms:
• Managerial economics is micro-economic in character. This is
because the unit of study is a firm and its problems. Managerial
economics does not deal with the entire economy as a unit of
study.
• Managerial economics largely uses that body of economic
concepts and principles, which is known as Theory of the Firm
or Economics of the Firm. In addition, it also seeks to apply
profit theory, which forms part of distribution theories in
economics.
• Managerial economics is concrete and realistic. I avoids difficult
abstract issues of economic theory. But it also involves
complications ignored in economic theory in order to face the
overall situation in which decisions are made. Economic theory
ignores the variety of backgrounds and training found in
 individual firms. Conversely, managerial economics is
concerned more with the particular environment that influences
decision-making.
• Managerial economics belongs to normative economics rather
than positive economics. Normative economy is the branch of
economics in which judgments about the desirability of various
policies are made. Positive economics describes how the
economy behaves and predicts how it might change. In other
words, managerial economics is prescriptive rather than
descriptive. It remains confined to descriptive hypothesis.
• Managerial economics also simplifies the relations among
different variables without judging what is desirable or
undesirable. For instance, the law of demand states that as
price increases, demand goes down or vice-versa but this
statement does not imply if the result is desirable or not.
Managerial economics, however, is concerned with what
decisions ought to be made and hence involves value
judgments. This further has two aspects: first, it tells what aims
and objectives a firm should pursue; and secondly, how best to
achieve these aims in particular situations. Managerial
economics, therefore, has been described as normative
microeconomics of the firm.
• Macroeconomics is also useful to managerial economics since it
provides an intelligent understanding of the business
environment. This understanding enables a business executive
to adjust with the external forces that are beyond the
management’s control but which play a crucial role in the well
being of the firm. The important forces are: business cycles,
national income accounting, and economic policies of the
government like those relating to taxation foreign trade, anti-
monopoly measures and labour relations.
DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND
ECONOMICS
The difference between managerial economics and economics can be
understood with the help of the following points:
• Managerial economics involves application of economic
principles to the problems of a business firm whereas;
economics deals with the study of these principles only.
Economics ignores the application of economic principles to the
problems of a business firm.
• Managerial economics is micro-economic in character, however,
Economics is both macro-economic and micro-economic.
• Managerial economics, though micro in character, deals only
with a firm and has nothing to do with an individual’s economic
problems. But microeconomics as a branch of economics deals
with both economics of the individual as well as economics of a
firm.
• Under microeconomics, the distribution theories, viz., wages,
interest and profit, are also dealt with. Managerial economics
on the contrary is mainly concerned with profit theory and does
not consider other distribution theories. Thus, the scope of
economics is wider than that of managerial economics.
• Economic theory assumes economic relationships and builds
economic models. Managerial economics adopts, modifies and
reformulates the economic models to suit the specific
conditions and serves the specific problem solving process.
Thus, economics gives the simplified model, whereas
managerial economics modifies and enlarges it.
• Economics involves the study of certain assumptions like in the
law of proportion where it is assumed that “The variable input
as applied, unit by unit is homogeneous or identical in amount
and quality”. Managerial economics on the other hand,
introduces certain feedbacks. These feedbacks are in the form
of objectives of the firm, multi-product nature of manufacture,
 behavioral constraints, environmental aspects, legal
constraints, constraints on resource availability, etc. Thus
managerial economics, attempts to solve the complexities in
real life, which are assumed in economics. this is done with the
help of mathematics, statistics, econometrics, accounting,
operations research, etc.

OTHER TERMS FOR MANAGERIAL ECONOMICS

Certain other expressions like economic analysis for business
decisions and economics of business management have also been
used instead of managerial economics but they are not so popular.
Sometimes expressions like ‘Economics of the Enterprise’, ‘Theory of
the Firm’ or ‘Economics of the Firm’ have also been used for
managerial economics. It is, however, not appropriate t use theses
terms because managerial economics, though primarily related to the
economics of the firm, differs from it in the following respects:
• First, ‘Economics of the Firm’ deals with the theory of the firm,
which is a body of economic principles relating to the firm
alone. Managerial economics on the other hand deals with the,
application of the same principles to business.
• Secondly, the term ‘Economics of the firm’ is too simple in its
assumptions whereas managerial economics has to reckon with
actual business behaviour, which is much more complex.

SCOPE OF MANAGERIAL ECONOMICS

As regards the scope of managerial economics, there is no general
uniform pattern. However, the following aspects may be said to be
inclusive under managerial economics:
• Demand analysis and forecasting.
• Cost and production analysis.
• Pricing decisions, policies and practices.
• Profit management.
• Capital management.
 These aspects may also be defined as the ‘Subject-Matter of
Managerial Economics’. In recent years, there is a trend towards
integrations of managerial economics and operations research.
Hence, techniques such as linear programming, inventory models and
theory of games have also been regarded as a part of managerial
economics.

Demand Analysis and Forecasting

A business firm is an economic Organisation, which transforms
productive resources into goods that are to be sold in a market. A
major part of managerial decision-making depends on accurate
estimates of demand. This is because before production schedules
can be prepared and resources are employed, a forecast of future
sales is essential. This forecast can also guide the management in
maintaining or strengthening the market position and enlarging
profits. The demand analysis helps to identify the various factors
influencing demand for a firm’s product and thus provides guidelines
to manipulate demand. Demand analysis and forecasting, thus, is
essential for business planning and occupies a strategic place in
managerial economics. It comprises of discovering the forces
determining sales and their measurement. The chief topics covered in
this are:
• Demand determinants
• Demand distinctions
• Demand forecasting.

Cost and Production Analysis

A study of economic costs, combined with the data drawn from the
firm’s accounting records, can yield significant cost estimates. These
estimates are useful for management decisions. The factors causing
variations in costs must be recognised and thereby should be used
for taking management decisions. This facilitates the management to
arrive at cost estimates, which are significant for planning purposes.
An element of cost uncertainty exists in this because all the factors
determining costs are not always known or controllable. Therefore, it
is essential to discover economic costs and measure them for
effective profit planning, cost control and sound pricing practices.
Production analysis is narrower in scope than cost analysis. The chief
topics covered under cost and production analysis are:
• Cost concepts and classifications
• Cost-output relationships
• Economics of scale
• Production functions
• Cost control.
Pricing Decisions, Policies and Practices
Pricing is a very important area of managerial economics. In fact
price is the origin of the revenue of a firm. As such the success of a
usiness firm largely depends on the accuracy of price decisions of
that firm. The important aspects dealt under area, are as follows:
• Price determination in various market forms
• Pricing methods
• Differential pricing product-line pricing and price forecasting.
Profit Management
Business firms are generally organised with the purpose of making
profits. In the long run, profits provide the chief measure of success.
In this connection, an important point worth considering is the
element of uncertainty existing about profits. This uncertainty occurs
because of variations in costs and revenues. These are caused by
factors such as internal and external. If knowledge about the future
were perfect, profit analysis would have been a very easy task.
However, in a world of uncertainty, expectations are not always
realised. Thus profit planning and measurement make up the difficult
area of managerial economics. The important aspects covered under
this area are:
• Nature and measurement of profit.
 • Profit policies and techniques of profit planning.
Capital Management
Among the various types and classes of business problems, the most
complex and troublesome for the business manager are those
relating to the firm’s capital investments. Capital management
implies planning and control and capital expenditure. In this
procedure, relatively large sums are involved and the problems are
so complex that their disposal not only requires considerable time
and labour but also top-level decisions. The main elements dealt with
cost management are:
• Cost of capital
• Rate of return and selection of projects.
The various aspects outlined above represent the major
uncertainties, which a business firm has to consider viz., demand
uncertainty, cost uncertainty, price uncertainty, profit uncertainty and
capital uncertainty. We can, therefore, conclude that managerial
economics is mainly concerned with applying economic principles and
concepts to adjust with the various uncertainties faced by a business
firm.
MANAGERIAL ECONOMICS AND OTHER SUBJECTS
Yet another useful method of explaining the nature and scope of
managerial economics is to examine its relationship with other
subjects. The following discussion helps to understand relationship
between managerial economics and economics, statistics,
mathematics, accounting and operations research.

Managerial Economics and Economics

Managerial economics is defined as a subdivision of economics that
deals with decision-making. It may be viewed as a special branch of
economics bridging the gulf between pure economic theory and
managerial practice. Economics has two main divisions-
microeconomics and Macroeconomics. Microeconomics has been
defined as that branch where the unit of study is an individual or a
firm. It is also called “price theory” (or Marshallian economics) and is
the main source of concepts and analytical tools for managerial
economics. To illustrate, various micro-economic concepts such as
elasticity of demand, marginal cost, the short and the long runs,
various market forms, etc., are all of great significance to managerial
economics.
Macroeconomics, on the other hand, is aggregative in character
and has the entire economy as a unit of study. The chief contribution
of macroeconomics to managerial economics is in the area of
forecasting. The modern theory of income and employment has direct
implications for forecasting general business conditions. As the
prospects of an individual firm often depend greatly on general
business conditions, individual firm forecasts rely on general business
forecasts.
A survey in the U.K. has shown that business economists have
found the following economic concepts quite useful and of frequent
application:
• Price elasticity of demand
• Income elasticity of demand
• Opportunity cost
• Multiplier
• Propensity to consume
• Marginal revenue product
• Speculative motive
• Production function
• Liquidity preference
• Business economists have also found the following main areas
of economics as useful in their work. Demand theory
• Theory of firms – price, output and investment decisions
• Business financing
• Public finance and fiscal policy
• Money and banking
 • National income and social accounting
• Theory of international trade
• Economies of developing countries.
Thus, it is obvious that Managerial Economics is very closely
related to Economics.

Managerial Economics and Statistics

Statistics is important to managerial economics in several ways.
Managerial economics calls for the organising quantitative data and
deriving a useful measure of appropriate functional relationships
involved in decision-making. For instance, in order to base its pricing
decisions on demand and cost considerations, a firm should have
statistically derived or calculated demand and cost functions.
Managerial economics also employs statistical methods for
experimental testing of economic generalisations. The generalisations
can be accepted in practice only when they are checked against the
data from the world of reality and are found valid. Managers do not
have exact information about the variables affecting decisions and
have to deal with the uncertainty of future events. The theory of
probability, upon which statistics is based, provides logic for dealing
with such uncertainties.

Managerial Economics and Mathematics

Mathematics is yet another important subject closely related to
managerial economics. This is because managerial economics is
mathematical in character, as it involves estimating various economic
relationships, predicting relevant economic quantities and using them
in decision-making and forward planning. Knowledge of geometry,
trigonometry ad algebra is not only essential but also certain
mathematical tools and concepts such as logarithms and exponential,
vectors, determinants, matrix, algebra, calculus, differential as well
as integral, are the most commonly used devices. Further, operations
research, which is closely related to managerial economics, is
mathematical in character. It provides and analyses data ad develops
models, benefiting from the experiences of experts drawn from
different disciplines, viz., psychology, sociology, statistics and
engineering.

MANAGERIAL ECONOMICS AND ACCOUNTING

Managerial economics is also closely related to accounting, which is
concerned with recording the financial operations of a business firm.
In fact, a managerial economist depends chiefly on the accounting
information as an important source of data required for his decision-
making purpose. for instance, the profit and loss statement of a firm
shows how well the firm has done and whether the information it
contains can be used by managerial economist to throw significant
light on the future course of action that is whether the firm should
improve its productivity or close down. Therefore, accounting data
require careful interpretation, reconstruction and adjustments before
they can be used safely and effectively. It is in this context that the
link between management accounting and managerial economics
deserves special mention. The main task of management accounting
is to provide the sort of data, which managers need if they are to
apply the ideas of managerial economics to solve business problems
correctly. The accounting data should be provided in such a form that
they fit easily into the concepts and analysis of managerial
economics.

Managerial Economics and Operations Research

Operations research is a subject field that emerged during the
Second World War and the years thereafter. A good deal of
interdisciplinary research was done in the USA. as well as other
western countries to solve the complex operational problems of
planning and resource allocation in defence and basic industries.
Several experts like mathematicians, statisticians, engineers and
others teamed up together and developed models and analytical
tools leading to the emergence of this specialised subject. Much of
the development of techniques and concepts, such as linear
programming, inventory models, game theory, etc., emerged from
the working of the operation researchers. Several problems of
managerial economics are solved by the operation research
techniques. These highlight the significant relationship between
managerial economics and operations research. The problems solved
by operation research are as follows:
• Allocation problems: An allocation problem confronts with
the issue that men, machines and other resources are scarce,
related to the number sand size of the jobs that need to be
completed. The examples are production programming and
transportation problems.
• Competitive problems: competitive problems deal with
situations where managerial decision-making is to be made in
the face of competitive action. That is, one of the factors to be
considered is: “What will competitors do if certain steps are
taken?” Price reduction, for example, will not lead to increased
market share if rivals follow suit.
• Waiting line problems : Waiting line problems arise when a
firm wants to know how many machines it should install in
order to ensure that the amount of ‘work-in-progress’ waiting to
be machined is neither too small nor too large. Such situations
arise when for example, a post office, or a bank wants to know
how many cash desks or counter clerks it should employ in
order to balance the business lost through long guesses against
the cost of installing more equipment or hiring more labour.
• Inventory problems: Inventory problems deal with the
principal question: “What is the optimum level of stocks of raw-
materials, components or finished goods for the firm to hold?”
The above discussion explains that the managerial economics is
closely related to certain subjects such as economics, statistics,
mathematics and accounting. A trained managerial economist
combines concepts and methods from all these subjects by bringing
them together to solve business problems. In particular, operations
research and management accounting are getting very close to
managerial economics.

USES OF MANAGERIAL ECONOMICS

Managerial economics achieves several objectives. The principal
objectives are as follows:
• It presents those aspects of traditional economics, which are
relevant for business decision-making in real life. For this
purpose, it picks from economic theory those concepts,
principles and techniques of analysis, which are concerned with
the decision-making process. These are adapted or modified in
such a way that it enables the manager to take better
decisions. Thus, managerial economics attains the objective of
building a suitable tool kit from traditional economics.
• Managerial economics also incorporates useful ideas from other
disciplines such as psychology, sociology, etc. If they are found
relevant for decision-making. In fact, managerial economics
takes the aid of other academic disciplines that are concerned
with the business decisions of a manager in view of the various
explicit and implicit constraints subject to which resource
allocation is to be optimised.
• It helps in reaching a variety of business decisions even in a
complicated environment. Certain examples of such decisions
are those decisions concerned with:
o The products and services to be produced
o The inputs and production techniques to be used
o The quantity of output to be produced and the selling
prices to be subscribed
o The best sizes and locations of new plants
o Time of replacing the equipment
o Allocation of the available capital
 • Managerial economics helps a manager to become a more
competent model builder. Thus, he can pick out the essential
relationships, which characterise a situation and leave out the
other unwanted details and minor relationships.
• At the level of the firm, functional specialists or functional
departments exist, e.g., finance, marketing, personnel,
production etc. For these various functional areas, managerial
economics serves as an integrating agent by co-ordinating the
different areas. It then applies the decisions of each
department or specialist, those implications, which are
pertaining to other functional areas. Thus managerial
economics enables business decision-making to operate not
with an inflexible and rigid but with an integrated perspective.
This integration is important because the functional
departments or specialists often enjoy considerable autonomy
and achieve conflicting goals.Managerial economics keeps in
mind the interaction between the firm and society and
accomplishes the key role of business as an agent in attaining
social economic welfare. There is a growing awareness that
besides its obligations to shareholders, business enterprise has
certain social obligations as well. Managerial economics focuses
on these social obligations while taking business decisions. By
doing so, it serves as an instrument of furthering the economic
welfare of the society through socially oriented business
decisions.
Thus, it is evident that the applicability and usefulness of
managerial economics is obtained by performing the following
activates:
• Borrowing and adopting the tool-kit from economic theory.
• Incorporating relevant ideas from other disciplines to achieve
better business decisions.
• Serving as a catalytic agent in the course of decision-making by
different functional departments/specialists at the firm’s level.
 • Accomplishing a social purpose by adjusting business decisions
to social obligations.

ECONOMIC THEORY AND MANAGERIAL ECONOMICS

Economic theory offers a variety of concepts and analytical tools that
can assist the manager in the decision-making practices. Problem
solving in business has, however, found that there exists a wide
disparity between the economic theory of a firm and actual observed
practice, thus necessitating the use of many skills and be quite useful
to examine two aspects in this regard:
• The basic tools of managerial economics which it has borrowed
from economics, and
• The nature and extent of gap between the economic theory of
the firm and the managerial theory of the firm.
Basic Economic Tools in Managerial Economics
The most significant contribution of economics to managerial
economics lies in certain principles, which are basic to the entire
range of managerial economics. The basic principles may be
identified as follows:

1. Opportunity Cost Principle

The opportunity cost of a decision means the sacrifice of alternatives
required by that decision. This can be best understood with the help
of a few illustrations, which are as follows:
• The opportunity cost of the funds employed in one’s own
business is equal to the interest that could be earned on those
funds if they were employed in other ventures.
• The opportunity cost of the time as an entrepreneur devotes
to his own business is equal to the salary he could earn by
seeking employment.
• The opportunity cost of using a machine to produce one
product is equal to the earnings forgone which would have
been possible from other products.
 • The opportunity cost of using a machine that is useless for
any other purpose is zero since its use requires no sacrifice of
other opportunities.
• If a machine can produce either X or Y, the opportunity cost
of producing a given quantity of X is equal to the quantity of Y,
which it would have produced. If that machine can produce 10
units of X or 20 units of Y, the opportunity cost of 1 X is equal to
2 Y.
• If no information is provided about quantities produced,
except about their prices then the opportunity cost can be
computed in terms of the ratio of their respective prices, say
Px/Py.
• The opportunity cost of holding Rs. 500 as cash in hand for
one year is equal to the 10% rate of interest, which would have
been earned had the money been kept as fixed deposit in a
bank. Thus, it is clear that opportunity costs require the
ascertaining of sacrifices. If a decision involves no sacrifice, its
opportunity cost is nil.
For decision-making, opportunity costs are the only relevant
costs. The opportunity cost principle may be stated as under:
“The cost involved in any decision consists of the sacrifices of
alternatives required by that decision. If there are no sacrifices, there
is no cost.”
Thus in macro sense, the opportunity cost of more guns in an
economy is less butter. That is the expenditure to national fund for
buying armour has cost the nation of losing an opportunity of buying
more butter. Similarly, a continued diversion of funds towards
defence spending, amounts to a heavy tax on alternative spending
required for growth and development.
2. Incremental Principle
The incremental concept is closely related to the marginal costs and
marginal revenues of economic theory. Incremental concept involves
two important activities which are as follows:
 • Estimating the impact of decision alternatives on costs and
revenues.
• Emphasising the changes in total cost and total cost and total
revenue resulting from changes in prices, products, procedures,
investments or whatever may be at stake in the decision.
The two basic components of incremental reasoning are as
follows:
• Incremental cost: Incremental cost may be defined as the
change in total cost resulting from a particular decision.
• Incremental revenue: Incremental revenue means the change
in total revenue resulting from a particular decision.
The incremental principle may be stated as under:
A decision is obviously a profitable one if:
o It increases revenue more than costs
o It decreases some costs to a greater extent than it
increases other costs
o It increases some revenues more than it decreases other
revenues
o It reduces costs more that revenues.
Some businessmen hold the view that to make an overall profit,
they must make a profit on every job. Consequently, they refuse
orders that do not cover full cost (labour, materials and overhead)
plus a provision for profit. Incremental reasoning indicates that this
rule may be inconsistent with profit maximisation in the short run. A
refusal to accept business below full cost may mean rejection of a
possibility of adding more to revenue than cost. The relevant cost is
not the full cost but rather the incremental cost. A simple problem will
illustrate this point.
IIIustration
Suppose a new order is estimated to bring in additional revenue of
Rs. 5,000. The costs are estimated as under:
Labour Rs. 1,500
Material Rs. 2,000
 Overhead (Allocated at 120% of labour cost) Rs. 1,800
Selling administrative expenses
(Allocated at 20% of labour and material Rs. 700
cost)
Total Cost Rs. 6,000

The order at first appears to be unprofitable. However,

suppose, if there is idle capacity, which can be, utilised to execute
this order then the order can be accepted. If the order adds only Rs.
500 of overhead (that is, the added use of heat, power and light, the
added wear and tear on machinery, the added costs of supervision,
and so on), Rs. 1,000 by way of labour cost because some of the idle
workers already on the payroll will be deployed without added pay
and no extra selling and administrative cost then the incremental
cost of accepting the order will be as follows.
Labour Rs. 1,500
Material Rs. 2,000
Overhead Rs. 500
Total Incremental Cost Rs. 3,500

While it appeared in the first instance that the order will result
in a loss of Rs. 1,000, it now appears that it will lead to an addition of
Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does
not mean that the firm should accept all orders at prices, which cover
merely their incremental costs. The acceptance of the Rs. 5,000 order
depends upon the existence of idle capacity and labour that would go
unutilised in the absence of more profitable opportunities. Earley’s
study of “excellently managed” large firms suggests that progressive
corporations do make formal use of incremental analysis. It is,
however, impossible to generalise on the use of incremental principle,
since the observed behaviour is variable.

3. Principle of Time Perspective

The economic concepts of the long run and the short run have
become part of everyday language. Managerial economists are also
concerned with the short-run and long-run effects of decisions on
revenues as well as on costs. The actual problem in decision-making
is to maintain the right balance between the long-run and short-run
considerations. A decision may be made on the basis of short-run
considerations, but may in the course of time offer long-run
repercussions, which make it more or less profitable than it appeared
at first. An illustration will make this point clear.

IIIustration
Suppose there is a firm with temporary idle capacity. An order for
5,000 units comes to management’s attention. The customer is
willing to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not
more. The short-run incremental cost (ignoring the fixed cost) is only
Rs. 3.00. Therefore, the contribution to overhead and profit is Re.
1.00 per unit (Rs. 5,000 for the lot. However, the long-run
repercussions of the order ought to be taken into account are as
follows:
• If the management commits itself with too much of business at
lower prices or with a small contribution, it may not have
sufficient capacity to take up business with higher
contributions when the opportunity arises. The management
may be compelled to consider the question of expansion of
capacity and in such cases; even the so-called fixed costs may
become variable.
• If any particular set of customers come to know about this low
price, they may demand a similar low price. Such customers
may complain of being treated unfairly and feel discriminated.
In response, they may opt to patronise manufacturers with
more decent views on pricing. The reduction or prices under
conditions of excess capacity may adversely affect the image
of the company in the minds of its clientele, which will in turn
affect its sales.
It is, therefore, important to give due consideration to the time
perspective. The principle of time perspective may be stated as
under: ‘A decision should take into account both the short-run and
long-run effects on revenues and costs and maintain the right
balance between the long-run and short-run perspectives.”
Haynes, Mote and Paul have cited the case of a printing
company. This company pursued the policy of never quoting prices
below full cost though it often experienced idle capacity and the
management was fully aware that the incremental cost was far below
full cost. This was because the management realised that the long-
run repercussions of pricing below full cost would make up for any
short-run gain. The management felt that the reduction in rates for
some customers might have an undesirable effect on customer
goodwill particularly among regular customers not benefiting from
price reductions. It wanted to avoid crating such an “image” of the
firm that it exploited the market when demand was favorable but
which was willing to negotiate prices downward when demand was
unfavorable.
4. Discounting Principle
One of the fundamental ideas in economics is that a rupee tomorrow
is worth less than a rupee today. This seems similar to the saying that
a bird in hand is worth two in the bush. A simple example would make
this point clear. Suppose a person is offered a choice to make
between a gift of Rs. 100 today or Rs. 100 next year. Naturally he will
choose the Rs. 100 today.
This is true for two reasons. First, the future is uncertain and
there may be uncertainty in getting Rs. 100 if the present opportunity
is not availed of. Secondly, even if he is sure to receive the gift in
future, today’s Rs. 100 can be invested so as to earn interest, say, at
8 percent so that. one year after the Rs. 100 of today will become Rs.
108 whereas if he does not accept Rs. 100 today, he will get Rs. 100
only in the next year. Naturally, he would prefer the first alternative
because he is likely to gain by Rs. 8 in future. Another way of saying
the same thing is that the value of Rs. 100 after one year is not equal
to the value of Rs. 100 of today but less than that. To find out how
much money today is equal to Rs. 100 would earn if one decides to
invest the money. Suppose the rate of interest is 8 percent. Then we
shall have to discount Rs. 100 at 8 per cent in order to ascertain how
much money today will become Rs. 100 one year after. The formula
is:
Rs. 100
1+i
V=
where,
V = present value
i = rate of interest.
Now, applying the formula, we get
Rs. 100
1+i
V=
100
1.08
=

If we multiply Rs. 92.59 by 1.08, we shall get the amount of money,

which will accumulate at 8 per cent after one year.
92.59 x 1.08 = 99.0072
= 1.00
The same reasoning applies to longer periods. A sum of Rs. 100
two years from now is worth:
Rs. 100 Rs. 100 Rs. 100
(1+i)2 (1.08)2 1.1664
V= = =

Similarly, we can also check by computing how much the

cumulative interest will be after two years. The principle involved in
the above discussion is called the discounting principle and is stated
as follows: “If a decision affects costs and revenues at future dates, it
is necessary to discount those costs and revenues to present values
before a valid comparison of alternatives is possible.”

5. Equi-marginal Principle
This principle deals with the allocation of the available resource
among the alternative activities. According to this principle, an input
should be allocated in such a way that the value added by the last
unit is the same in all cases. This generalisation is called the equi-
marginal principle.
Suppose a firm has 100 units of labour at its disposal. The firm
is engaged in four activities, which need labour services, viz., A, B, C
and D. It can enhance any one of these activities by adding more
labour but sacrificing in return the cost of other activities. If the value
of the marginal product is higher in one activity than another, then it
should be assumed that an optimum allocation has not been attained.
Hence it would, be profitable to shift labour from low marginal value
activity to high marginal value activity, thus increasing the total value
of all products taken together. For example, if the values of certain
two activities are as follows:
Value of Marginal Product of labour
Activity A = Rs. 20
Activity B = Rs. 30
In this case it will be profitable to shift labour from A to activity
B thereby expanding activity B and reducing activity A. The optimum
will be reach when the value of the marginal product is equal in all
the four activities or, when in symbolic terms:
VMPLA = VMPLB = VMPLC = VMPLD
Where the subscripts indicate labour in respective activities.
Certain aspects of the equi-marginal principle need
clarifications, which are as follows:
• First, the values of marginal products are net of incremental
costs. In activity B, we may add one unit of labour with an
increase in physical output of 100 units. Each unit is worth 50
paise so that the 100 units will sell for Rs. 50. But the increased
output consumes raw materials, fuel and other inputs so that
variable costs in activity B (not counting the labour cost) are
higher. Let us say that the incremental costs are Rs. 30 leaving
 a net addition of Rs. 20. The value of the marginal product
relevant for our purpose is thus Rs. 20.
• Secondly, if the revenues resulting from the addition of labour
are to occur in future, these revenues should be discounted
before comparisons in the alternative activities are possible.
Activity A may produce revenue immediately but activities B, C
and D may take 2, 3 and 5 years respectively. Here the
discounting of these revenues will make them equivalent.
• Thirdly, the measurement of value of the marginal product may
have to be corrected if the expansion of an activity requires an
alternative reduction in the prices of the output. If activity B
represents the production of radios and it is not possible to sell
more radios without a reduction in price, it is necessary to
make adjustment for the fall in price.
• Fourthly, the equi-marginal principle may break under
sociological pressures. For instance, du to inertia, activities are
continued simply because they exist. Similarly, due to their
empire building ambitions, managers may keep on expanding
activities to fulfil their desire for power. Department, which are
already over-budgeted often, use some of their excess
resources to build up propaganda machines (public relations
offices) to win additional support. Governmental agencies are
more prone to bureaucratic self-perpetuation and inertia.

Gaps between Theory of the Firm and managerial Economics

The theory of the firm is a body of theory, which contains certain
assumptions, theorems and conclusions. These theorems deal with
the way in which businessmen make decisions about pricing, and
production under prescribed market conditions. It is concerned with
the study of the optimisation process.
For optimality to exist profit must be maximised and this can
occur only when marginal cost equals marginal revenue. Thus, the
optimum position of the firm is that which maximises net revenue.
Managerial economics, on the other hand, aims at developing a
managerial theory of the firm and for the purpose it takes the help of
economic theory of the firm. However, there are certain difficulties in
using economic theory as an aid to the study of decision-making at
the level of the firm. This is because for the purposes of business
decision-making it fails to provide sufficient analytical tools that are
useful to managers. Some of the reasons are as follows:
• Underlying all economic theory is the assumption that the
decision-maker is omniscient and rational or simply that he is
an economic man. Thus being omniscient means that he knows
the alternatives that are available to him as well as the
outcome of any action he chooses. The model of “economic
man” however as an omniscient person who is confronted with
a compete set of known or probabilistic outcomes is a distorted
representation of reality. The typical business decision-maker
usually has limited information at his disposal, limited
computing ability and a limited number of feasible alternatives
involving varying degrees of risk. Further, the net revenue
function, which he is expected to maximise, and the marginal
cost and marginal revenue functions, which he is expected to
equate, require excessive knowledge of information, which is
not known and cannot be obtained even by the most careful
analysis. Hence, it is absurd to expect a manager to maximise
and equalise certain critical functional relationships, which he
does not know and cannot find out.
• In micro-economic theory, the most profitable output is where
marginal cost (MC) and marginal revenue (MR) are equal. In
Figure 1.2, the most profitable output will be at ON where
MR=MC. This is the point at which the slope of the profit
function or marginal profit is zero. This is highlighted in Figure
1.3 where the most profitable output will be again at ON. In
economic theory, the decision-maker has to identify this unique
output level, which maximises profit.
 In real world, however, a complexity often arises, viz., certain
resource limitations exist. As a result, it is not possible to attain the
maximum output level (ON). In practical terms the maximum output
possible as a result of resource limitations is, say, OM. Now the
problem before the decision-maker is to find out whether the output,
which maximises profit, is OM or some other level of output to the left
of OM. It is obvious that economic theory is of no help for ON level of
output because it is not relevant in view of the resource limitations. A
managerial economist here has to take the aid of linear
programming, which enables the manager to optimise or search for
the best values within the limits set by inequality conditions.
• Another central assumption in the economic theory of the
firm is that the entrepreneur strives to maximise his residual
share, or profit. Several criticisms of this assumption have
been made:
o The theory is ambiguous, as it doesn’t clarify. Whether
it is short or long run profit that is to be maximised.
For example, in the short run, profits could be
maximised by firing all research and development
personnel and thereby eliminating considerable
immediate expenses. This decision would, however,
have a substantial impact on long-run profitability.
o Certain questions create some confusion around the
concept of profit maximisation. Should the firm seek
to maximise the amount of profit or the rate of profit?
What is the rate of profit? Is it profit in relation to total
capital or profit in relation to shareholders’ equity?
o There is no allowance for the existence of “psychic
income” (Income other than monetary, power,
prestige, or fame), which the entrepreneur might
obtain from the firm, quite apart from his monetary
income.
o The theory does not recognise that under modern
conditions, owners and managers are separate and
distinct groups of people and the latter may not be
motivated to maximise profits.
o Under imperfect competition, maximisation is an
ambiguous goal, because actions that are optimal for
one will depend on the actions of the other firms.
 o The entrepreneur may not care to receive maximum
profits but may simply want to earn “satisfactory
profits”. This last point is particularly relevant from the
behavioural science standpoint because it introduces
a concept of satiation. The notion of satiation plays no
role in classical economic theory. To explain business
behaviour in terms of this theory, it is necessary to
assume that the firm’s goals are not concerned with
maximising profit, but with attaining a certain level or
rate of profit, holding a certain share of the market or
a certain level of sales. Firms would try to satisfy
rather than maximise. But according to Simon the
satisfying model damages all the conclusions that can
be derived concerning resource allocation under
perfect competition. It focuses on the fact that the
classical theory of the firm is empirically incorrect as a
description of the decision-making process. Based on
this notion of satiation, it appears that one of the main
strengths of classical economic theory has been
seriously weakened.
• Most corporate undertakings involve the investment of
funds, which are expect to produce revenues over a number
of years. The profit maximisation criterion provides no basis
for comparing alternatives that can promise varying flows of
revenue and expenditure over time.
• The practical application of profit maximisation concept also
has another limitation. It provides no explicit way of
considering the risk associated with alternative decisions.
Two projects generating similar expected revenues in the
future and requiring similar outlays might differ vastly as
regarding the degree of uncertainty with which the benefits
to be generated. The greater the uncertainty associated with
the benefits, the greater the risk associated with the project.
• Baumol on the other hand is of the view that firms do not
devote all their energies to maximising profit. Rather a
company will seek to maximise its sales revenue as long as
a satisfactory level of profit is maintained. Thus Baumol has
substituted “Total sales revenue” for profits. Also, two
decision criteria or objectives have been advanced viz., a
satisfactory level of profit and the highest sales possible. In
other words, the firm is no longer viewed as working towards
one objective alone. Instead, it is portrayed as aiming at
balancing two competing and non-consistent goals.
Baumol’s model is based on the view that managers’
salaries, their status and other rewards often appear as
closely related to the companies’ size in which they work
and is measured by sales revenue rather than their
profitability. As such, managers may be more concerned to
increased size than profits. And the firm’s objective thus
becomes sales maximisation rather than profits
maximisation.
• Empirical studies of pricing behaviour also give results that
differ from those of the economic theory of firm as can be
seen from the following examples:
o Several studies of the pricing practices of business
firms have indicated that managers tend to set
prices by applying some sort of a standard mark-up
on costs. They do not attempt to estimate marginal
costs, marginal revenues or demand elasticities,
even if these could be accurately measured.
o For many firms, prices are more often set to attain, a
particular target return on investment, say, 10 per
cent, than to maximise short or long-run profits.
o There is some evidence that firms experiencing
declining market shares in their industry strive more
vigorously to increase their sales than do competing
 firms, which are experiencing steady or increasing
market shares.
• An alternative model to profit maximisation is the concept of
wealth maximisation, which assumes that firms seek to
maximise the present value of expected net revenues over
all periods within the forecasted future.
• As pointed out by Haynes and Henry, a study of the
behaviour of actual firms shows that their decisions are not
completely determined by the market. These firms have
some freedom to develop decisions, strategies or rules,
which become part of the decision-making system within the
firm. This gap in economic theory has led to what has come
to be known as ‘Behavioural Theory of the Firm’. This theory,
however, does not replace the former but rather powerfully
supplements it. The behavioural theory represents the firm
as an adoptive institution. It learns from experience and has
a memory. Organisational behaviour, is embodies into
decision rules and standard operating procedures. These
may be altered over long run as the firm reacts to
“feedback” from experience. However, in the short run,
decisions of the organisation are dominated by its rules of
thumb and standard methods.

CONCLUSION
The various gaps between the economic theory of the firm and the
actual decision-making process at the firm level are many in number.
They do, however, stress that economic theory seriously needs major
fixing up and substantial changes are in progress for creating better
and different models. Thus the classical economic concepts like those
of rational man is undergoing important changes; the notion of
satisfying is pushing aside the aim of maximisation and newer lines
and patterns of thoughts are being developed for finding improved
applications to managerial decision-making. A strong emphasis is laid
on quantitative model building, experimentation and empirical
investigation and newer techniques and concepts, such as linear
programming, game theory, statistical decision-making, etc., are
being applied to revolutionise the approaches to problem solving in
business and economics.

MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIES

A managerial economist can play a very important role by assisting
the management in using the increasingly specialised skills and
sophisticated techniques, required to solve the difficult problems of
successful decision-making and forward planning. In business
concerns, the importance of the managerial economist is therefore
recognised a lot today. In advanced countries like the USA, large
companies employ one or more economists. In our country too, big
industrial houses have understood the need for managerial
economists. Such business firms like the Tatas, DCM and Hindustan
Lever employ economists. A managerial economist can contribute to
decision-making in business in specific terms. In this connection, two
important questions need be considered:
1. What role does he play in business, that is, what particular
management problems lend themselves to solution through
economic analysis?
2. How can the managerial economist best serve management,
that is, what are the responsibilities of a successful managerial
economist?

Role of a Managerial Economist

One of the principal objectives of any management in its decision-
making process is to determine the key factors, which will influence
the business over the period ahead. In general, these factors can be
divided into two categories:
• External
• Internal
 The external factors lie outside the control of management
because they are external to the firm and are said to constitute
business environment. The internal factors lie within the scope and
operations of a firm and hence within the control of management,
and they are known as business operations. To illustrate, a business
firm is free to take decisions about what to invest, where to invest,
how much labour to employ and what to pay for it, how to price its
products, and so on. But all these decisions are taken within the
framework of a particular business environment, and the firm’s
degree of freedom depends on such factors as the government’s
economic policy, the actions of its competitors and the like.

Environmental Studies of a Business Firm

An analysis and forecast of external factors constituting general
business conditions, for example, prices, national income and output,
volume of trade, etc., are of great significance since they affect every
business firm. Certain important relevant factors to be considered in
this connection are as follows:
• The outlook for the national economy, the most important local,
regional or worldwide economic trends, the nature of phase of
the business cycle that lies immediately ahead.
• Population shifts and the resultant ups and downs in regional
purchasing power.
• The demand prospects in new as well as established markets.
Impact of changes in social behaviour and fashions, i.e.,
whether they will tend to expand or limit the sales of a
company’s products, or possibly make the products obsolete?
• The areas in which the market and customer opportunities are
likely to expand or contract most rapidly.
• Whether overseas markets expand or contract and the affect of
new foreign government legislations on the operation of the
overseas plants?
 • Whether the availability and cost of credit tend to increase or
decrease buying, and whether money or credit conditions
ahead are likely to easy or tight?
• The prices of raw materials and finished products.
• Whether the competition will increase or decrease.
• The main components of the five-year plan, the areas where
outlays have been increased and the segments, which have
suffered a cut in their outlays.
• The outlook to government’s economic policies and regulations
and changes in defence expenditure, tax rates tariffs and
import restrictions.
• Whether the Reserve Bank’s decisions will stimulate or depress
industrial production and consumer spending and how will
these decisions affect the company’s cost, credit, sales and
profits.
Reasonably accurate data regarding these factors can enable the
management to chalk out the scope and direction of their own
business plans effectively. It will also help them to determine the
timing of their specific actions. And it is these factors, which present
some of the areas where a managerial economist can make effective
contribution. The managerial economist has not only to study the
economic trends at the micro-level but also must interpret their
relevance to the particular industry or firm where he works. He has to
digest the ever-growing economic literature and advise top
management by means of short, business-like practical notes. In
mixed economy like that of India, the managerial economist
pragmatically interprets the intentions of controls and evaluates their
impact. He acts as a bridge between the government and the
industry, translating the government’s intentions and transmitting the
reactions of the industry. In fact, the government policies emerge out
of the performance of industry, the expectations of the people and
political expediency.
Business Operations
A managerial economist can also be helpful to the management in
making decisions relating to the internal operations of a firm in
respect of such problems as price, rate of operations, investment,
expansion or contraction. Certain relevant questions in this
context would be as follows:
• What will be a reasonable sales and profit budget for the
next year?
• What will be the most appropriate production schedules and
inventory policies for the next six months?
• What changes in wage and price policies should be made
now?
• How much cash will be available next month and how should
it be invested?

Specific Functions
The managerial economists can play a further role, which can cover
the following specific functions as revealed by a survey pertaining to
Brittain conducted by K.J.W. Alexander and Alexander G. Kemp:
• Sales forecasting.
• Industrial market research.
• Economic analysis of competing companies.
• Pricing problems of industry.
• Capital projects.
• Production programmes.
• Security / Investment analysis and forecasts.
• Advice on trade and public relations.
• Advice on primary commodities.
• Advice on foreign exchange.
• Economic analysis of agriculture.
• Analysis of underdeveloped economics.
• Environmental forecasting.
 The managerial economist has to gather economic data, analyse
all relevant information about the business environment and prepare
position papers on issues facing the firm and the industry. In the case
of industries prone to rapid theological advances, the manager may
have to make continuous assessment of tl1e impact of changing
technology. The manager' may need to evaluate the capital budget in
the light of short and long-range financial, profit and market
potentialities. Very often, he also needs to prepare speeches for the
corporate executives. It is thus clear that in practice, managerial
economists perform many and various functions. However, of all
these, the marketing functions, i.e., sales force listing an industrial
market research, are the most important.
For this purpose, the managers may collect statistical records of
the sales performance of their own business and those rehiring to
their rivals, carry out analysis of these records and report on trends
in demand, their market shares, and the relative efficiency of their
retail outlets. Thus, while carrying out heir functions, the managers
may have to undertake detailed statistical analysis. There are, of
course, differences in the relative importance of· the various
functions performed from firm to firm and in the degree of
sophistication of the methods used in performing these functions. But
there is no doubt that the job of a managerial economist requires
alertness and the ability to work uriderpressure.

Economic Intelligence
Besides these functions involving sophisticated analysis, managerial
economist may also provide general intelligence service. Thus the
economist may supply the management with economic information of
general interest such as competitors
prices and products, tax rates, tariff rates, etc.

Participating in Public Debates

Many well-known business economists participate in public debates.
The government and society alike are seeking their advice and views.
Their practical experience in business and industry adds prestige to
their views. Their public recognition enhances their protégé in the
.firm itself.

Indian Context
In the Indian context, a managerial economist is expected to perform
the following functions:
• Macro-forecasting for
demand and supply.
• Production planning at macro and micro levels.

• Capacity planning and product-mix determination.

• Economics of various production lines.
• Economic feasibility of new production lines / processes and
projects.
• Assistance in preparation of overall development plans.

• Preparation of periodical economic reports bearing on various

matters such as the company's product-lines, future growth
opportunities, market pricing situation, general business,. and
various national/international factors affecting industry and
business.
• Preparing briefs; speeches, articles and papers for top
management for various chambers, Committees, Seminars,
Conferences, etc
Keeping management informed of various national and
International Developments on economic/industrial matters.
With the adoption of the new economic policy, the macro-
economic environment is changing fast and these changes have
tremendous implications for business. The managerial economists
have to playa much more significant role. They ha'1e to constantly
measure the possibilities of translating the rapidly changing economic
scenario into workable business opportunities. As India marches
towards globalisation, the managerial economists will have to
interpret the global economic events and find out how the firm can
avail itself of the various export opportunities or of establishing plants
abroad either wholly owned or in association with local partners.

Responsibilities of a Managerial Economist

Besides considering the opportunities that lie before a managerial
economist it is necessary to take into account the services that are
expected by the management. For this, it is necessary for a
managerial economist to thoroughly recognise the responsibilities
and obligations. A managerial economist can serve the management
best by recognising that the main objective of the business, is to
make a profit on its invested capital. Academic training and the
critical comments from people outside the business may lead a
managerial economist to adopt an apologetic or defensive attitude
towards profits. There should be a strong personal conviction on part
of the managerial economist that profits are essential and it is
necessary to help enhance the ability of the firm to make profits.
Otherwise it is difficult to succeed in serving management.
Most management decisions necessarily concern the future,
which is rather uncertain. It is, therefore, absolutely essential that a
managerial economist recognises his responsibility to make
successful forecast. By making the best possible forecasts and
through constant efforts to improve, a managerial' ng, the risks
involved in uncertainties. This enables the management to· follow a
more orderly course of business planning. At times, it is required for
the managerial economist to reassure the management that an
important trend will continue. In other cases, it is necessary to point
out the probabilities of a turning point in some activity of importance
to management. In any case, managerial economist must be willing
to make fairly positive statements about impending economic
developments. These can be based upon the best possible
information and analysis. The management's confidence in a
managerial economist increases more quickly and thoroughly with
a record of successful forecasts, well documented in advance and
modestly evaluated when the actual results become available.
A few consequences to the above proposition need also be
emphasised here.

• First, a managerial economist has a major responsibility to alert

managelI1ent at the earliest possible moment in' case there is
an err6r' in his forecast. This will assist the mallagement in
making appropriate adjustment in policies and programmes and
strengthen his oWn position as a member of the management
team by keeplrighis fingers on the economic pulse of the
business.

• Secondly, a managerial economist must establish and maintain

many contacts with individuals and data sources: which would
not be immediately available to the other members of the
management. Extensive familiarity with reference sources and
material is essential. It is still more important that the known
individuals who are specialists in particular fields have a bearing
on tpe managerial economist's work. For this purpose, it is
required that managerial economist joins professional
associations and tak~ active part in them. In fact, one of the
best means of determining the quality of a managerial
economist is to evaluate his ability to obtain information quickly
by personal contacts rather than by lengthy research from
either readily available or obscure reference sources. Within any
business, there' may be a wealth of knowledge and experience
but the managerial economist would be really useful ifit is
possible pn his part to supplement the existing know-how with
additional information and in the quickest possible manner.

Again, if a managerial economist is to be really helpful to the

management in successful decision-making and forward planning, it
is necessary'" to able to earn full status on the business team.
Readiness to take up special assignments, be that in study teams,
committees or special projects is another important requirement. This
is because it is necessary for the managerial economist to win
continuing support for himself and his professional ideas. Clarity of
expression and attempting to minimise the use of technical
terminology while communJcating his ideas to management
executives is also an essential role so as to win approval.
To conclude, a managerial economist has a very important role to
play by helping management in successful decision-making and
forward planning. But to discharge his role successfully, it is
necessary to recognise the 'relevant responsibilities and obligations.
To some business executives, however, a managerial economist is
still a luxury or perhaps even a necessary evil. It is not surprising,
therefore, to find that while tneir status is improving and their
impor;ance is gradually rising, managerial economists in certain firms
still 'feel quite insecure. Nevertheless, there is a definite and growing
realisation that they can contribute significantly to the profitable
growth of firms and effective solution oftMir problems, and this'
promises them a positive future.

REVIEW QUESTIONS
1. What is managerial economics? How does it differ from
traditional economics?
2. Discuss the nature and scopeofmanagerial economics.
3. Show the significance of economic analysis in business
decisions.
4. Managerial Economics is perspective rather than descriptive in
character? Examine this statement.
5. Assess the contribution and limitations of economic analysis to
business decision-making.
6. Briefly explain the five principles, which are basic to the entire
gamut of managerial economics.
7. Explain the role of marginal analysis in determining optimal
 solution if managerial economics. How does it compare with
break-even analysis?
8.Discuss some of the important economic concepts and
techniques that help busirless management.
9. Explain the various functions of a managerial economist. How
can he best serve the management?
 LESSON – 2
DEMAND ANALYSIS

Demand is one of the crucial requirements for the existence of

any business firm. Firms are interested in their profit and sales,
both of which depend partially upon the demand for the product.
The decisions, which management makes with respect to
production, advertising, cost allocation, pricing, inventory
holdings, etc. call for an analysis of demand. While how much a
firm can produce depends upon its capacity and demand for its
products. If there is no demand for a product, its production is
unworthy. If demand falls short of production, one way to balance
the two is to create new demand through more and better
advertisements. The more the future demand for a product, the
more inventories the firm would hold. The larger the demand for a
firm's product, the higher is the price it can charge.
Demand analysis seeks to identify and measure the forces
that determine sales. Once this is done the alternative ways of
manipulating or managing demand can easily be inferred.
Although, demand for a finri's product reflects what the
consumers buy, this can be influenced through manipulating the
factors on which consumers base their demands. Demand
analysis attempts to estiinate the demand for a product in future,
which further helps to plan production based on the estimated
demand.

MEANING OF DEMAND

Demand for a good implies the desire of an individual to acquire the

product. It also includes willingness and ability of ail individual to
pay for the product. For example, a miser's desire for and his ability
to pay for a car is not demand, for he does not have the necessary
will to pay for the car. Similarly, a poor person's desire for· and his
willingness to pay for a car is not demand because he lacks the
necessary purchasing power. One can also imagine an individual,
who possesses both the will and the purchasing power to pay for a
good. But this purchasing power is not the demand for that good,
this is because he does not have the desire to buy that product.
Therefore, demand is successful when there are all the three
factors: desire, willingness and ability. It should also be noted that
demand for any goods or services has no meaning unless it is
stated with reference to time, price, competing product, consumer's
incomes, tastes and preferences. This is because demand varies
with fluctuations in these factors. For example, the demand for an
Ambassador car in India is 40,000 is meaningless unless it is stated
that this was the demand ·in 1976 when an Ambassador car's price
was around thirty thousand rupees. The price of the competing
cars’ prices were around the same, a Bajaj scooter's price was
around five thousand rupees and petrol price was around three and
a half rupees per litre. In 1977, the demand for Ambassador cars
could be different if any of the above factors happened to be
different. Furthermore, it should be noted that a product is defined
with reference to its particular quality. If its quality changes it can
be deemed as another product. Thus, the demand for any product
is the desire, wi1lihigness and ability to buy the product with
reference to a partkular time and given values of variables on which
it depends.

TYPES OF DEMAND
The demand for various kinds of goods is generally classified on
the basis of kinds of consumers, suppliers of goods, nature of
goods, duration of consumption goods, interdependence of
demand, period of demand and nature of use of goods
(intermediate or final), The major classifications of demand are as
follows:
• Individual and market demand
 • Demand for firm's prodtictand industry's products
• Autonomous and derived demand
• Demand for durable and non-durable goods
• Short-term and long-term demand

Individual and Market Demand

The quantity of a product, which an individual is willing to buy at a
particular price during a specific time period, given his money
income, his taste, and prices of other commodities (particularly
substitutes and complements), is called 'individual's demand for a
product'. The total quantity, which all comsumers are willing to buy
at a given price per time unit, given their money income, taste,
and prices of other commodities is known as 'market demand for
the good'. In other words, the market demand for a good is the
sum of the individual demands of all the c6-nsumers of a product,
over a time period at given prices.

Demand for Firm's Product and Industry's Products

The quantity of a firm's yield, that can be disposed of at a given
price over a period refers to the demand for firm's product. The
aggregate demand for the product of all firms of an industry is
known as the market-demand or demand for industry's product. This
distinction between the two kinds of demand is not of much use in a
highly competitive market since it merely signifies the distinction
between a sum and its parts. However, where market structure is
oligopolistic, a distinction between the demand for firm's product
and industry's product is useful from managerial point of view. The
product of each firm is so differentiated from the products of the
rival firms that consumers treat each product different from the
other. This gives firms an opportunity to plan the price of a product,
advertise it in order to capture a larger market share thereby to
enhance profits. For instance, market of cars, radios, TV sets,
refrigerators, scooters, toilet soaps and toothpaste, all belong to this
category of markets.
In case of monopoly and perfect competition, the distinction
between demand for a firm's product and industry's product is not
of much use from managerial point of view. In case of monopoly,
industry is one-firmindustiy andthe demand for firm's product is the
same as that of the industry. In case of perfect competition,
products of all firms .of the industry are homogeneous and price for
each firm is determined by industry. Firms have little opportunity to
plan the prices permissible under local conditions and
advertisement by a firm becomes effective for the whole industry.
Therefore, conceptual distinction between demand for film's
product and industry's product is not much use in business
decisions making.

Autonomous and Derived Demand

An Autonomous demand for a product is one that arises

independently of the demand for any other good whereas a derived
demand is one, which is derived from demand of some other good.
To look more closely at the distinction between the two kinds of
demand, consider the demand for commodities, which arise directly
from the biological or physical needs of the human beings, such as
demand for food, clothes and shelter. The demand for these goods is
autonomous demand. Autotnomous demand also arises as a' result
of demonstration effect, rise in income, and increase in population
and advertisement of new produCts. On the other hand, the demand
for a good that arises because of the demand for some other good is
called derived demand. For instance, demand for land, fertiliser and
agricultural tools and implements are derived demand, since the
demand of goods, depends on the demand of food. Similarly,
demand for steel, bricks, cement etc., is a derived demand because
it is derived from the demand for houses and other kind of buildings.
[n general, the demand for, producer goods or industrial inputs is a
derived one. Besides, demand for complementary goods (which
complement the use of other goods) or for supplementary goods
(which supplement or provide additional utility from the use of other
goods) is a derived demand. For instance petrol is a complementary
goods for automobiles and a chair is a complement to a table.
Consider some examples of supplement goods. Butter is supplement
to bread, mattress is supplement to cot and sugar is supplement to
tea. Therefore, demand for petrol, chair, and sugar would be
considered as derived demand. The conceptual distinction between
autonomous demand and derived demand would be useful according
to the point of view of a bllsinessman to the extent the former can
serve as an indicator of the latter.

Demand for Durable and Non-durable Goods

Demand is often classified under demand for durable and non-durable
goods. Durable goods are those goods whose total utility is not
exhausted in single or short-run use. Such goods can be used
continuously over a period of time. Durable goods may be consumer
goods as well as producer goods. Durable consumer goods include
clothes, shoes, house furniture, refrigerators, scooters, and cars. The
durable producer goods include mainly the items under fixed assets,
such as building, plant and machinery, office furniture and fixture.
The durable goods, both consumer and producer goods, may be
further classified as semi-durable goods such as, clothes and furniture
and durable goods such as residential and factory buildings and cars.
On the other harid, non-durable goods are those goods, which can be
used only once such as food items and their total utility is exhausted
in a single use. This category of goods can also be grouped under
non-durable consumer and producer goods. All food items such as
drinks, soap, cooking fuel, gas, kerosene, coal and cosmetics fall in
the former category whereas, goods such as raw materials', fuel and
power, finishing materials and packing items come in the latter
category.
The demand for non-durable goods depends largely on their
current prices, consumers' income and fashion whereas the expected
price, income and change in technology influence the demand for the
durable good. The demand for durable goods changes over a
relatively longer period. There is another point of distinction between
demands for durable and non-durable goods. Durable goods create
demand for replacement or substitution of the goods whereas non-
durable goods do not. Also the demand for non-durable goods
increases or decreases with a fixed or constant rate whereas the
demand for durable goods increases or decreases exponentially, i.e.,
it may depend· upon some factors such as obsolescence of
machinery, etg. For example, let us suppose that the annual demand
for cigarettes in a city is 10 million packets and it increases at the
rate of half-a-million packets per annum on account of increase in
population when other factors remain constant. Thus, the total
demand for cigarettes in the next year will be 10.5 million packets
and 11 million packets in the next to next year and so on. This is a
linear increase in the demand for a non-durable good like cigarette.
Now consider the demand for a durable good, e.g., automobiles. Let
us suppose: (i1 the existing number of automobiles in a city, in a year
is 10,000, (ii) the annual replacement demand equals 10 per cent of
the total demand, and (iii) the annual autonomous increase ·in
demand is 1000 automobiles. As such, the total annual clemand for
automobiles in four subsequent years is calculated and presented in
Table 2.1.

Table 2.1: Annual Demand for Automobiles

Beginning Total no. of Replacement Annual Total Annual
of the year automobiles demand autonomous demand increase
(Stock) demand in
, demand
1st year 10,000 - - 10,000 -
2nd year 10,000 1000 1000 _12,000 2000
-3id year 12,000 1200 1000 14,200 2200
4th year 14,200 1420 1000 16,620 2420
Stock + Replacement + Autonomous demand = TotalDemand
 It may be seen from the Table 2.1 that the total demand for
automobiles is increasing at an increasing rate due to acceleration
in the replacement demand. Another factor, which might
accelerate the demand for automobiles and such durable goods, is
the rate of obsolescence of this category of goods.

Short-term and Long-term Demand

Short-term demand refers to the demand for goods that are

demanoed over a short period. In this category fall mostly the fashion
consumer goods, goods of seasonal use and inferior substitutes
during the scarcity period of superior goods. For instance, the
demand for fashion wears is short-term demand though the demand
for the generic goods such as trousers, shoes and ties continues to
remain a longterm demand. Similarly, demand for umbrella,
raincoats, gumboots, cold drinks and ice creams is of seasonal
nature; 'The demand for such goods lasts till the season lasts. Some
goods of this category are demanded for a very short period, i.e., 1-2
week, for example, new greeting cards, candles and crackers on
occasion of diwali.
Although some goods are used only seasonally but are durable in
pature, e.g., electric fans, woollen garments, etc. The demand for
such goods is of also durable in nature but it is subject to seasonal
fluctuations. Sometimes, demand for certain gools suddenly
increases because of scarcity of their superior substitutes. For
examp1e, when supply of cooking gas suddenly decreases, demand
for kerosene, cooking coal and charcoal increases. In such cases,
additional demand is of shGrtterm nature. The long-term demand, on
the hand, refers to the demand, which exists over a long-period. The
change in long-term demand is visible only after a long period. Most
generic goods have long-term demand. For example, demand for
consumer and producer goods, durable and non-durable goods, is
long-term demand, though their different varieties or brands may
have only short-term demand. Short-term demand depends, by and
large, on the price of commodities, price of their substitutes, current
disposable income of the consumer, their ability to adjust their
consumption pattern and their susceptibility to advertisement of a
new product. The long-term demand depends on the long-term
income trends, availability of better substitutes, sales promotion, and
consumer credit facility. The short-term and lcmg-term concepts of
demand are useful in designing new products for established
producers, choice of products for the new entrepreneurs, in pricing
policy and in determining advertisement expenditure.

DETERMIN!\NTS OF MARKET DEMAND

The knowledge of the determinants of market demand for a product
and the nature of relationship between the demand and its
determinants proves very helpful in analysing and estimating
demand for the product. It may be noted at the very outset that a
host of factors determines the demand for a product. In general,
following factors determine market demand for a good:
• Price of the good- .
• Price of the related goods-substitutes, complements and
supplements
• Level of consumers' income
• Consumers' taste and preference

Advertisement of the product

• Consumers' expectations about future price and supply
position
• Demonstration effect and 'bend-wagon effect’
• Consumer-credit facility
• Population of the country
• Distribution pattern of national income.
These factors also include factors such as off-season discounts
and gifts on purchase of a good, level of taxation and general social
and political environment of the country. However, all these factors
are not equally important. Besides, some of them are not
quantifiable. For example, consumer's preferences, utility,
demonstration effect and expectations, are difficult to measure.
However, both quantifiable and non-quantifiable determinants of
demand for a product will be discussed.

1. Price of the Product

The price of a product is one of the most important determinants of
demand in the long run and the only determinant in the short run.
The price and quantity demanded are inversely related to each
other. The law of demand states that the quantity demanded of a
good or a product, which its consumers would like to buy per unit of
time, increases when its price falls, and decreases when its price
increases, provided the other factors remain' same. The assumption
'other factors remaining same' implies that income of the consumers,
prices of the substitutes and complementary goods, consumer's
taste and preference and number of consumers remain unchanged.
The price-demand relationship assumes a much greater significance
in the oligopolistic market in which outcome of price war between a
firm and its rivals determines the level of success of the firm. The
firms have to be fully aware of price elasticity of demand for their
own products and that of rival firm's goods.

2. Price of the Related Goods or Products

The demand for a good is also affected by the change in the price of
its related goods. The related goods may be the substitutes or
complementary goods.
Substitutes
Two goods are said to. be substitutes of each other if a change in
price of one good affects the deinand for the other in the same
direction. For instance goods X and Y are considered as substitutes
for each other if a rise in the price of X increase demand for Y, and
vice versa. Tea and coffee, hamburgers and hot-dog, alcohol and
drugs are some examples of substitutes in case of consumer goods
by definition, the relation between demand for a product and price of
its substitute is of positive nature. When, price of the substitute of a
product (tea) falls (or increase), the demand for the product falls (or
increases). The relationship of this nature is shown in Figure 2.1 and
2.2.

Complementary Goods
A good is said to be a complement for another when it complements
the use of the other or when the two goods are used together in such
a way that their demand changes (increases or decreases)
simultaneously. For example, petrol is a complement to car and
scooter, butter and jam to bread, milk and sugar to tea and 1 coffee,
mattress to cot, etc. Two goods are termed as complementary to
each other -i if an increase in the price of one causes a decrease in
demand for the other. By definition, there is an inverse relation
between the demand for a good and the price of its complement. For
instance, an increase in the price of petrol causes a decrease in the
demand for car and other petrol-run vehicles and vice versa while
other thing's remaining constant. The nature of relationship between
the demand
for a product and the price of its complement is given in Figure 2.2.

3. Consume's Income
Income is the basic determinant of market demand since it
determines the purchasing power of a consumer. Therefore,
people with higher current disposable income spend a larger
amount on goods and services than those with lower income.
Income-demand relationship is of more varied nature than that
between demand and its other determinants. While other
determinants of demand, e.g., product's own price and the price
ohts substitutes, are more significant in the short-run, income as a
determinant of demand is equally important in both short run and
long run. Before proceeding further to discuss income-demand
relationships, it will be useful to note that consumer goods of
different nature have different kinds of relationship with
consumers having different levels of income. Hence, the managers
need to be fully aware of the kinds of goods they are dealing with
and their relationship with the income of consumers, particularly
about the assessment of both existing and prospective demand for
a product.
For the purpose of income-demand analysis, goods and serv:ices
maybe grouped under four broad categories, which ate: (a) essential
consumer goods, (b) inferior goods, (c) normal goods, and (d)
prestige or luxury goods. To understand all these terms, it is essential
to understand the relationship between income and different kinds of
goods.
Esscntial Consumcr Goods (ECG): The goods and services of
this category are called 'basic needs' and are consumed by all
persons of a society such as food-grains, salt, vegetable oils,
matches, cooking fuel, a minimum clothing and housing.
Quantity demanded for these goods increases with increase in
consumer's income but only up to certain limit, even though
the total expenditure may increase in accordance with the
quality of goods consumed, other factors remaining the same.
The relationship between goods of this category and
consumer's income is shown by the curve ECG in Figure 2.3. As
the curve shows, consumer's demand for essential goods
increases only until his income rises to OY2. It tends to saturate
beyond this level of income.
Inferior goods: Inferior goods are those goods whose demand
decreases with the increase in consumer's income. For
example millet is inferior to wheat and rice; bidi (indigenous
cigarette) is inferior to cigarette, coarse, textiles are inferior to
refined ones, kerosene is inferior to cooking gas and travelling
by bus is inferior to travelling by taxi. The relation between
income and demand for an inferior good is shown by the curve
IG in Figure 2.3 under the assumption that other determinants
of demand remain the same demand for such goods rises only
up to a certain level of income, i.e., OY1 and declines as income
increases beyond this level.
 Normal goods: Normal goods are those goods whose demand
increases with increaseiri the consumer income. For example,
clothings, household furniture and automobiles. The relation
between income and demand for normal goods is shown by the
curve NG in Figure 2.3. As the curve shows, demand for such
goods increases with the increases in consumer income but at
different rates at different levels of income. Demand for normal
goods increases rapidly with the increase in the consumer's
income but slows down with further increase in income. It
should be noted froms Figure 2.3 that up to certain level of
income (YI) the relation between income and demand for all
type of goods is similar. The difference is of only degree. The
relation becomes distinctly different beyond YI level of income.
Therefore, it is important to view the income-demand relations
in the light of the nature of product and the level fconsumer's
income.

• Prestige and luxury goods: Prestige goods are those goods,

which are consu!TIed mostly by rich section of the society, e.g.,
precious stones, antiques, rare paintings, luxury cars and such
other items of show-bff. Whereas luxury goods include jewellery,
costly brands of cosmetics, TV sets, refrigerators, electrical
gadgets and cars. Demand for such goods arises beyond a
certain level of consumer's income, i.e., consumption enters the
area of luxury goods. Producers of such goods, while assessing
the demand for their goods, should consider the income changes
in the richer section of the society and not only the per capita
income. The relation between income and demand for such
goods is shown by the curve LG in Figure 2.3.

4. Consumer's taste and preference

Consumer's taste and preference play an important role in

detennihing demand for a product. Taste and preference depend,
generally, on the changing. life-style, social customs, religious
values attached to a good, habi of the people, the general levels of
living of the society and age and sex of the consumers. Change in
these factors changes consumer's taste and preferences. As a
result, consumers reduce or give up the consumption of some goods
and add new ones to their consumption pattern. For example,
following the change in fashion, people switch their consumption
pattern from cheaper, old-fashioned goods to costlier ‘mod’ goods,
as long as price differentials are proportionate with their
preferences. Consumers are prepared to pay higher prices for 'mod
goods' even if their virtual utility is the same as that of old-fashioned
goods. The manufacturers of goods and services that are subject to
frequent change in fashion and style, can take advantage of this
situation in two ways: (i) they can make quick profits by designing
new models of their goods and popularising them through
advertisement, and (ii) they can plan production in abetter way and
can even avoid over-productiorlifthey keep an eye on the changing
fashions.

5. Advertisel11ent Expenditure
Advertisement costs are incurred with the objective of increasing the
demand for the goods. This is done in the following ways:
• By informing the potential consumers about the availability of
the goods.
• By showing its superiority to the rival goods.
• By influencing consumers' choice against the rival goods, and
• By setting fashions and changing tastes.
The impact of such effects shifts the demand curve upward to the
right.
In other words, when other factors' remain same, the expenditure
on advertisement increases the volume of sales to the same extent.
The relation between advertisement outlay and sales is shown in
Figure 2.4.

Assumptions
Therelatiqnship between demand and advertisement cost as shown
in Figure 2.4 is based on the following assumptions:
• Consumers are fairly sensitive and responsive to various modes
of advertisement.
• The rival firms do not react to the advertisements made by a
firm.
• The level of demand has not already reached the saturation
point. Advertisement beyond this point will make only marginal
impact on demand.
• Per unit cost of advertisement added to the price does not
make the price prohibitive for consumers, as compared
particularly to the price of substitutes.
• Others determinants of demand, e.g., income and tastes, etc.,
are not operating in the reverse direction.
In the absence of these conditions, the advertisement effect on
sales may be unpredictable.
6. Consumers’ Expectations
Consumers’ expectations regarding the future prices, income and
supply position of goods play an important role in determining the
demand for goods and services in the short run. If consumers expect
a rise in the price of a storable good, they would buy more of it at its
current price with a view to avoiding the possibility of price rise
future. On the contrary, if consumers expect a fall in the price of
certain goods, they postpone their purchase with a view to take
advantage of lower prices in future, mainly in case of non-essential
goods. This behaviour of consumers reduces the current demand for
the goods whose prices are expected to decrease in future. Similarly,
an expected increase in income increases the demand for a product.
For example, announcement of ‘dearness allowance’, bonus and
revision of pay scale induces increase in current purchases. Besides,
if scarcity of certain goods is expected by the consumers on account
of reported fall in future production, strikes on a large scale and
diversion of civil supplies towards the military use causes the current
demand for such goods to increase more if their prices show an
upward trend. Consumer demand more for future consumption and
profiteers demand more to make money out of expected scarcity.

7. Demonstration Effect
When new goods or new models of existing ones appear in the
market, rich people buy them first. For instance, when a new model
of car appears in the market, rich people would mostly be the first
buyer, Colour TV sets and VCRs were first seen in the houses of the
rich families some people buy new goods or new models of goods
because they have genuine need for them. Some others do so
because they want to exhibit their affluence. But once new goods
come in fashion, many households buy them not because they have
a genuine need for them but because their neighbors have bought
the same goods. The purchase made by the latter category of the
buyers are made out of such feelings' as jealousy, competition,
equality in the peer group, social inferiority and the desire to raise
their social status. Purchases made on account of these factors are
the result of what economists call 'demonstration effect' or the
'Band-wagon-effect.' These effects have a positive effect on demand.
On the contrary, when goods become the thing of common use,
some people, mostly rich, decrease or give up the consumption of
such goods. This is known as 'Snob Effect'. It has a negative effect'on
the demand
for the related goods.

8. Consumer-Gredit Facility
Availability of credit to the cansumers fram the sellers, banks,
relatians and friends encourages the conSumers to buy more than
what they would buy in the aosence of credit availability. Therefore,
the consumers who can borrow more can consume more than those
who cannot borrow. Credit facility affects mostly the demand"for
durable goods, particularly those, which require bulk payment at the
time of purchase. The car-loan facility may be one reason why Delhi
has more cars than Calcutta, Chennai and Mumbai. Therefore, the
managers who are assessing the prospective demand for their
goods should take into account the availability of credit to the
consumers.

9. Population of the Country

The Jotal domestic demand for a good of mass consumption depends
also on the size' of the population. Therefore, larger the population
larger will be the demand for a product, when price, per capita
income, taste and preference are given. With an increase or
decrease in the size of population, employment percentage
remaining the same, demand for the product will either increase or
decrease.

10. Distribution of National Income

The level of national income is the basic determinant of the market
demand for a good. Therefore, pig her the national income higher
will be the demand for all normal goods and services. Apart from
this, the distribution pattern of the national income is also an
important determinant for demand of a good. If national income is
evenly distributed, market demand for normal goods will be the
largest. If national income is unevenly distributed, i.e., if majority of
population belongs to the lower income groups, market demand for
essential goods, including inferior ones, will be the largest whereas
the demand for other kinds of goods will be relatively less.

REVIEW QUESTIONS
1. Give short note on 'Demand Analysis'.
2. What are the determinants of market demand for a good? How
do the changes in the following factors affect the demand for a
good?
A. Price
B. Income
C. Price of the substitute
D. Advertisement
E. Population.
Also describe the nature of relationship between demand for a
good and these factors (consider one factor at a time assuming
other factors to remain constant).
3. Explain different types of determinants of demand.
 LESSON - 3
COST CONCEPTS

Business decisions are generally taken on the basis of money values

of the inputs and outputs. The cost production expressed in monetary
terms is an important factor in almost all business decisions, specially
those pertaining to (a) locating the weak points in production
management; (b), minimising the cost; (c) finding out the optjmum
level of output; and (d) estimating or projecting the cost of business
operations. Besides, the term 'cost' has different meanings under
different settings and is subject to varying interpretations. It is
therefore essential that only relevant concept of costs is used in the
business decisions.

CONCEPT OF COST

The concepts of cost, which are relevant to business operations and

decisions, can be grouped, on the basis of their purpose, under two
overlapping categories such as concepts used for accounting
purposes and concepts used in economic analysis of business
activities.

SOME ACCOUNTING CONCEPTS OF COST

Opportunity Cost and Actual Cost

Opportunity cost is the loss incurred due to the unavoidable

situations such as scarcity of resources. If resources were unlimited,
there would be no need to forego any income yielding opportunity
and, therefore, there would be no opportunity cost. Resources are
scarce but have alternative uses with different returns, Resource
owners who aim at maximising of income put their scarce resources
to their most productive use and forego the income expected from
the second best use of the resources. Thus, the opportunity cost may
be defined as the expected returns from the second best use of the
resources foregone due to the scarcity of resources. The opportunity
cost is also called the alternative cost.

For example, suppose that a person hps a sum of Rs. lOO,OOO

for which he has only two alternative uses. He can buy either a
printing machine or, alternatively, a lathe machine. From printing
machine, he expects an annual income of Rs. 20,000 and from the
lathe, Rs. 15,000. If he is a profit maximising investor, he would
invest his tnoney in printing machine and forego the expected
income from the lathe. The opportunity cost of his income from
printing machine is,· the expected income from the lathe machine,
i.e., Rs. l5,000. The opportunity cost arises because of the foregone
opportunities. Thus, the opportunity cost of using resources in
the'Printing business is the best opportunity ahdthe expected return
from the lathe machine is the second best alternative. In assessing
the alternative cost, both explicit and implicit costs are taken into
account.
Associated with the concept of opportunity cost is the concept of
economic rent or economic profit. In our example, economic rent of
the printing machine is the excess of its earning over the income
expected from the lathe machine (i.e., Rs. 20,000 - Rs. 15,000 = Rs.
5,000). The implication of this concept for a businessman is that
investing in printing machine is preferable as long as its economic
rent is greater than zero. Also, if firms have knowledge of the
economic rent of the various alternative uses of their resources, it
will be helpful for them to choose the best Investment A venue. In
contrast to opportunity cost, actual costs are those which are
actually incurred by the firm in the payment for labour, material,
plant, building, machinery, equipments, travelling and transport,
advertisement, etc. The total money expenditures, recorded in the'
books of accounts are, the actual costs, Therefore, the actual cost
comes under the accounting concept.
 Business Costs and Full Costs
Business.costs include all the expenses, which are incurred to carry
out a business. The concept of business costs is similar to the actual
or the real costs. Business costs include all the payments and'
contractual obligations made by the firm together with the book cost
of depreciation on plant and equipment. These cost concepts are
used for calculating business profits and losses, for filing returns for
income tax and for other legal purposes. The concept of full costs,
include business costs, opportunity cost and. normal profit. As stated
earlier the opportunity cost includes the expected earning from the
second best use of the resources, or the market rate of interest on
the total money capital and the value of entrepreneur's own
services, which are not charged for'in the current business. Normal
profit is a necessary minimum earning in addition to the opportunity
cost, which a firm must get to remain in its present occupation.

Explicit and Implicit or Imputed Costs

Explicit costs are those, which fall under actual or business costs
entered in the books of accounts. For example, the payments for
wages and salaries, materials, licence fee, insurance premium and
depreciation charges etc. These costs involve cash payment and, are
recorded in normal accounting practices. In contrast with these costs,
there are other costs, which neither take the form of cash outlays, nor
do they appear in the accounting system. Such costs are known as
implicit or imputed costs. Implicit costs may be defined as the
earning expected froin thesecond best alternative use of resources.
For example, suppose an entrepreneur does not utilise his services in
his own business and works as a manager in ·some other firm on a
salary basis. If he starts his own business, he foregoes his salary as a
manager. This loss of salary is the opportunity cost of income from
his business. This is an implicit cost of his business. The cost is
implicit, because the entrepreneur suffers the loss, but does not
charge it as the explicit cost of his own business. Implicit costs are
not taken into account while calculating the loss or gains of the
business, but they form an important consideration in whether or not
a factor would remain in its present occupation. The explicit and
implicit costs together make the economic cost.

Out-of-Pocket and Book Costs

The items of expenditure, which involve cash payments or cash
transfers recurring and non-recurring are known as out-of-pocket
costs. All the explicit costs such as wage, rent, interest and transport
expenditure. On the contrary, there are actual business costs, which
do not involve cash payments, but a provision is made for them in
the books of account. Thes costs are taken into account while
finalising the profit and loss accounts. Such expenses are known as
book costs. In a way, these are payments that the firm needs to pay
itself such as depreciation allowances and unpaid interest on the
businessman's own fund.

Fixed and Variable Costs

Fixed costs are those, which are fixed in volume for a given output.
Fixed cost does not vary with variation in the output between zero
and any certain level of output. The costs that do not vary for a
certain level of output are known as fixed cost. The fixed costs
include cost of managerial and administrative staff, depreciation of
machinery, building and other fixed assets and maintenance of land,
etc.

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

Total, Average and Marginal Costs

Total cost represents the value of the total resource requirement for
the production of goods and services. It refers to the total outlays of
money expenditure, both explicit and implicit, on the resources used
to produce a given level of output. It includes both fixed and variable
costs. The total cost for a given output is given by the cost function.
The Average Cost (AC) of a firm is of statistical nature and is not
the actual cost. It is obtained by dividing the total cost (TC) by the
total output (Q), i.e.,
TC
AC = Q = average cost

Marginal cost is the addition to the total cost on account of

producing an additional unit of the product. Or marginal cost is the
cost of marginal unit produced. Given the cost function, it may be
defined as
aTC
AC= aQ

These cost concepts are discussed in further detail in the

following section. Total, average and marginal cost concepts are used
in economic analysis of firm's producti on activities.

Short-run and Long-run Costs

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

Long-run costs are, by implication, same as fixed costs. In the

long-run, however, even the fixed costs become variable costs as the
size of the firm or scale of production increases. Broadly speaking,
the short-run costs are those associated with variables in the
utilisation of fixed plant or other facilities whereas long-run costs are
associated with the changes in the size and type of plant.

Incremental Costs and Sunk Costs

Conceptually, increment natal costs are closely related to the concept
of marginal sot. Whereas marginal cost refers to the cost of the
macgmalunit of output, incremental cost refers to the total additional
cost associated with the marginal batch of output. The concept of
incremental cost is based on a specific and factual principle. In the
real world, it is not practicable for lack of perfect divisibility of inputs
to employ factors for each unit of output separately. Besides, in the
long run, firms expand their production; hire more men, materials,
machinery, and equipments. The expenditures of this nature are the
incremental costs, anq not the marginal cost. Incremental· costs also
arise owing to the change in product lines, addition or introduction of
a new product, replacement of worn out plan and machinery,
replacement of old technique of production with a new one, etc.
The sunk costs are those, which cannot be altered, increased or
decreased, by varying the rate of output. For example, once it is
decided to make incremental investment expenditure and the funds
are allocated and spent, all the preceding costs are considered to be
the sunk· costs since they accord to the prior commitment and
cannot be revised or reversed when there is change in market
conditions orchange in business decisions.

Historical and Replacement Costs

Historical cost refers to the cost of an asset acquired· in the past
whereas replacement cost refers to the outlay, which has to be
made for replacing an old asset. These concepts own their
sigtlificance to unstable nature of price behaviour. Stable prices over
a period of time, other things given, keep historical and replacement
costs on par with each other. Instability in asset prices, however,
makes the two costs differ from each other.
Historical cost of assets is used for accounting purposes, in the
assessment of net worth of the firm.

Private and Social Costs

We have so far discussed the cost concepts that are related to the
working of the firm and those which are used in the cost-benefit
analysis of the business decision process. There are, however,
certain other costs, which arise due to functioning of the firm but do
not normally appear in business decisions. Such costs are neither
explicitly borne by the firms. The costs of this category are borne by-
the society. Thus, the total cost generated by a firm's working may
be divided into two categories:
• Those paid out or provided for by the firms,
• Those not paid or borne by the firm.
The costs that are not borne by the firm include use of resouces
freely available and the disutility created in the process of production.
The costs of the former category are known as private costs and of
the latter category are known as external or social costs. A few
examples of social cost are: Mathura Oil Refinery discharging its
wastage in the Yamuna River causes water pollution. Mills and
factories located in city cause air pollution by emitting smoke.
Similarly, plying cars, buses, trucks, etc., cause both air and noise
pollution; Such pollutions cause tremendous health hazards, which
involve health cost to the society as it whole Thes'e costs are termed
external costs from the firm's point of view and social cost from the
society's point of view. The relevance of the social costs lies in
understandipg the overall impact of firm's working on the society as a
whole and in working out the social cost of private gains. A further
distinction between private cost and social cost therefore, requires
discussion.
Private costs are those, which are actually incurred or provided
by an individual or a firm on the purchase of goods and services from
the market. For a firm, all the actual costs both explicit and implicit
are private costs. Private costs are the internalised cost that is
incorporated in the firm's total cost of production.
Social costs, on thehand refer to the total cost for the society
on account of production ofa commodity. Social cost can be the
private cost or the external cost. It includes the cost of resources for
which the firm is not compelled to pay a price such as rivers and
lakes, the public, utility services like roadways and drainage system,
the cost in the form of disutility created in through air, water and
noise pollution. This category is generally assumed to be equal to
total private and public expenditures. The private and public
expenditures, however, serve only as an indicator of public disutility.
They do not give exact measure of the public disutility or the social
costs.

COST-OUTPUT RELATIONS

The previous section discussed the variou cost concepts, which help
in the business decisions. The following section contains the
discussion of the behaviour of costs in relation to the change in
output. This is, in fact, the theory of production cost.

Cost-output relations play an importai)t role in business

decisions relating to cost minirnisalioil"Of'profiHnaximisation and
optimisation of output. Cost-output relations are specified through a
cost function expressed as
T(C) = f(Q) (1)
where,
TC = total cost
Q = quantity produced

Cost functions depend on production function and market-

supply function of inputs. Production function specifies the technical
relationship between the input, and the output. Production function of
a firm combined with the supply function of inputs or prices of inputs
determines the cost function of the firm. Precisely, cost function is a
function derived from the production function and the market supply
function. 'Depending on whether short or long-run is considered for
the production, there are two kinds of cost functions: such as short-
run cost-function and long-run cost function. Cost-output relations in
relation to the changing level of output will be discussed here u.nder
both kinds of cost-functions.

Short-run Cost Output Relations

The basic analytical cost concepts used in the analysis of cost

behaviour are total average and marginal costs. The totalcost (TC) is
defined as the actual cost that must be incurred to produce a given
quantity of output. The short-run TC is composed of two major
elements: total fixed cost (TFC) and total variable cost (TVC). That is,
in the short-run,
TC = TFC + TVC (2)

As mentioned earlier, TFC (i.e" the ·cost·of plant, building,

equipment, etc.) remains fixed in the short-run, where as TVC varies
with the variation in the output.
For a given quantity of output (Q), the average total cost, (AC),
average fixed cost (AFC) and, average var!able cost (AVC) can 'be
defined as follows:

TC TFC + TVC
AC = Q = Q

TFC
AFC = Q

TVC
AVC = Q

and AC = AFC +AVC (3)

Marginal cost (MC) is defined as the change in the total cost divided
by the change in the total output, i.e.,

∆TC aTC
MC = or
∆Q aQ
(4)
Since ∆TC = ∆TFC + ∆TVC and, in the short-run, ∆TFC = 0,

therefore, ∆TC=∆TVC

Furthermore, under marginality concept, where ∆Q = 1,MC =

∆TVC.

Cost Function and Cost-output Relations

The concepts AC, AFC and AVC give only a static relationship
between cost and output in the sense that they are related to a given
output. These cost concepts do not tell us anything about cost
behaviour, i.e., how AC, A VC and AFC behave when output changes.
This can be understood better with a cost function of empirical
nature.
Suppose the cost function (I) is specified as
TC = a + bQ - CQ2 + dQ3 (5)
(where a = TFC and b, c and d are variable-cost parameters)
And also the cost function is empirically estimated as
TC = 10 + 6Q - 0.9Q2 + 0.05Q3 (6)
and TVC = 6Q - 0.9Q2 + 0.05Q3 (7)

The TC and TVC, based on equations (6) and (7), respectively,

have been calculated for Q = I to 16 and is presented in Table 3.1.
The TFC, TVC and TC have been graphically presented in Figure 3.1.
As the figure shows, TFC remains fixed for the whole range of output,
and hghce, takes the form of a horizontal line, i.e., TFC. The
TVCcurve shows that the total variable cost first increases ata'i
decreasing rate and then at an increasing rate with the increase it
the total output. The rate of increase can be obtained from the slope
of TVC curve. The pattemof change in the TVC stems directly from
the law of increasing and diminishing returns to the variable inputs.
As output increases, larger quantities of variable inputs are required
to produce the same quantity of output due to diminishing returns.
This causes a subsequent increase in the variable cost for producing
the same output. The following Table 3.1 shows the cost output
relationship.
Table 3.1: Cost Output Relations

Q FC TVC TC AFC AVC AC MC

(I) (2) (3) (4) (5) (6) (7) (8)
0 10 0.0 10.00 - - - -
I 10 5.15 15.15 10.00 5.15 15.15 5.15
2 10 8.80 18.80 5:00 4.40 9.40 3.65
3 10 11.25 21.25 3.33 3.75 7.08 2.45
4 10 12.80 22.80 2.50 3.20 5.70 1.55
5 10 13.75 23.75 2.00 2.75 4.75 0.95
6 10 14.40 24.40 1.67 2.40 4.07 0.65
7 10 15.05 25.05 1.43 2.15 3.58 0.65
8 10 16.00 26.00 1.25 2.00 3.25 0.95
9 10 17.55 27.55 1.11 1.95 3.06 1.55
10 10 20.00 30.00 1.00 2.00 3.00 2.45
11 10 23.65 33.65 0.90 2.15 3.05 3.65
12 10 28,80 38.80 0.83 2.40 3.23 5.15
13 10 35.75 45.75 0.77 2.75 3.52 6.95
14 10 44.80 54.80 0.71 3.20 3.91 9.05
15 10 56.25 66.25 0.67 3.75 4.42 11.45
16 10 70.40 80.40 0.62 4.40 5.02 14.15

From equations (6) and (7), we may derive the behavioural

equations for AFC, AVC and AC. Let us first consider AFC.

Average Fixed Cost (AFC)

As already mentioned, the costs that remain fixed for a certain level
of output make the total fixed cost in the short-run. The fixed cost is
represented by the constant term 'a' in equation (6). We know that

TFC (8)
Q
AFC =

Substituting 10 for TFC in equation (8), we get

10 (9)
Q
AFC =
 Equation (9) expresses the behaviour of AFC in relation to
change in Q. The behaviour of AFC for Q from 1 to 16 is given in
Table 3.1 (col. 5) and is presented graphically by the AFC curve in
the Figure 3.1. The AFC curve is a rectangular hyperbola.

Average Variable Cost (AVC)

As defined above,
TVC
Q
AVC =

Given the TVC function in equation 7, we may express AVC as

follows:
6Q-0.9Q2+0.05Q3
Q = 6- 0.9Q+0.05Q3
AVC =
(10)

Having derived the A VC function (equation 10), we may easily

obtain the behaviour of A VC in response to change in Q. The
behaviour of A VC for Q from I to 16 is given in Table 3.1 (co 1. 6),
and is graphically presented in Figure 3.2 by the A VC curve.
Critical Value of A VC

From equation (10), we may compute the critical value or Q in

respect of A Vc. The critical value of Q (in respect of A VC) is that
value of Q at which A VCis minimum. The Ave will be minimum when
its decreasing rate of change is equal to zero. This can be
accomplished by differentiating equation (10) and setting it equal to
zero. Thus, critical value of Q can be obtained as
aAVC
Q= aQ
= 0.9+0.10Q=0
(11)

Q= 9

Thus, the critical value of Q=9. This can be verified from Table
3.1
Average Cost (AC)
The average cost in defined as
TC
AC = Q

Substituting equation (6) for TC in above equation, we get

10+6Q-09Q2+0.05Q3
(12a)
AC =
Q

10
= Q + 6-0.9Q+0.05Q2

The equation (l2a) gives the behaviour of AC in response to

change in Q. The behaviour of AC for Q from I to 16 is given in Table
3.1 and graphically presented in Figure 3.2 by the AC-curve. Note
that AC-curve is U-shaped.
From equation (12a), we may easily obtain the critical value of Q in
respect of AC. Here, the critical valuepf Q in respect of AC is one at
which AC is minimum. This can be obtained by differentiating
equation (l2a) and setting it equal to zero. This, critical vallie of Q in
respect of AC is given by
aAC 10
aQ = Q2 - 0.9 + 0.1Q = 0
(12b)

This equation takes the form of a quadratic equation as

-10 – 0.9Q2 + 0.1Q3 = 0
or, Q3 – 9Q2 = 100 = 0
By solving equation (12b), we get
Q = 10
Thus, the critical value of output in respect of AC is 10. That is,
AC reaches its minimum at Q = 10. This can be verified from Table.
3.1 shows short-run cost curves.

Marginal Cost (MC)

The concept of marginal cost (MC) is particularly useful in economic
analysis. MC is technically the first derivative of TC function. That is,
 aTC
MC = aQ

Given the TC function as in equation (6), the MC function can be

obtained as
aTC
aQ = 6-1.8Q+0.15Q2 (13)

Equation (13) represents the behaviour of MC. The behaviour of

MC for Q from 1 to 16 computed as MC = TCn - TCn- i is given in Table
3.1 (col. 8) and graphically presented by MC-curve in Figure 3'.2. The
critical 'value of Q in respect of MC is 6 or 7. It can be seen from
Table 3.1.
One method of solving quadratic equation is to factorise it and
find the solution.
Thus, Q3 – 9Q2 – 100 = 0
(Q – 10) (Q2 + Q + 10) = 0
For this to hold, one of the terms must be equal to zero,
Suppose (Q2 + Q + 10) = 0
Then, Q – 10 = 0 and Q = 10.

COST CURVES AND THE LAWS OF DIMINISHING RETURNS

We now return to the laws of variable proportions and explain it

through the .cost curves. Figures 3.1 and 3.2 clearly bring out the
short-term laws of production, i.e., the laws of diminishing returns.
Let us recall the law: it states that when more and more units of a
variable input are applied to those inputs which are held constant,
the returns from the marginal units of the variable input may initially
increase but will eventually decrease. The same law can also be
interpreted in term's of decreasing and increasing costs. The law can
then be stated as, if more and more units of a variable inputs are
applied to the given amount of a fixed input, the' marginal cost
initially decreases, but eventually increases. Both interpretations of
the law yield the same information: one in terms of marginal
productivity of the variable input, and the other, in terms of the
marginal cost. The former is expressed through production function
and the latter through a cost function.
Figure 3.2 represents the short-run laws of returns in terms of
cost of production. As the figure shows, in the initial stage of
production, both AFC and AVC are declining because of internal
economies. Since AC = AFC + AVC, AC is also declining, this shows
the operation of the law of increasing returns. But beyond a certain
level of output (i.e., 9 units in out example), while AFC continues to
fall, AVC starts increasing because of a faster increase in the TVC.
Consequently, the rate of fall in AC decreases. The AC reaches its
minimum when output increases to 10 units. Beyond this level of
output, AC starts increasing which shows that the law of diminishing
returns comes in operation. The MC, curve represents the pattern of
change in both the TVC and TC curves due to change in output. A
downward trend in the MC shows increasing marginal productivity of
the variable input mainly due to internal economy resulting from
increase in production. Similarly, an upward trend in the MC shows
increase in TVC, on the one hand, and decreasing marginal
productivity of the variable input, on the other.

SOME IMPORTANT COST RELATIONSHIPS

Some important relationships between costs used in analysing the
short-run cost behaviour may now be summed up as follows:
• As long as AFC and AVC fall, AC also falls because AC = AFC
+AVC.

• When AFC falls but A VC increases, change in AC depends on

the rate of change in AFC and AVC then any of the following
happens:
ο ifthereisdecrease in AFC and increase in A VC, AC falls,
 ο if the decrease on AFC is equal to increase in Ave, AC
remains constant, and
ο if the d~crease in AFC is less than increase in A VC, AC
increases.

• The relationship between AC and MC is of varied nature. It may

be described as follows:

ο When MC falls, AC follows, over a certain range of initial

output. When MCis failing, the rate of fall in MC is greater
than that of AC This is because in case of MC the decreasing
marginal cost is attributed, : to a single marginal unit while;
in case of AC, the decreasing marginal cost is distributed
overall the entire output. Therefore, AC decreases at a lower
rate than MC.

ο Similarly, when MC increase, AC also increases but at a lower

rate fbr the reason given in'the above point. There is however
a range of output over which this relationship does not exist.
For example, compare the behaviour of MC and AC over the
range of output frbm 6 units to 10 units (see Figure 3.2). Over
this range of ~utput, MC begins to increase while AC
continues to decrease. The reason for this can be seen in
Table. 3.1. When MC starts increasing, it increases at a
relatively lower rate, which is sufficient only to reduce the
rate of decrease in AC, i.e., not sufficient to push the AC up.
That is why AC continues to fall over some range of output
even, if MC falls.
MC iJ1tetsects AC at its minimum point. This is simply a
mathematical relationship between MC and AC curves when
both of them are obtained from the same TC function. In
simple words, when AC is at its minimum, then it is neither
increasing nor decreasing it is constant. When AC is constant,
AC = MC.

Optimum Output in Short-run

An optimum level of output is the one, which can be produced at a
minimum or least average cost, given the required technology is
available. Here, the least'tcost' combination of inputs can be
understood with the help of isoquants and isocosts. The least-cost
combination of inputs also indicates the optimum level of output at
given investment and factor prices. The AC and MC cost Curves can
also be used to find the optimum level of output, given the size of the
plant in the short-run. The point of intersection between AC and MC
curves deterinines the minimum level of AC. At this level of output AC
= MC. Production beloW or beyond thislevelwill be in optimal. If
production is less than 10 units (Figure 3.2) it will leave some scope
for reducing AC by producing more, because MC < AC. Similarly, if
production is greater than 10 units, reducing output can reduce AC.
Thus, the cost curves can be useful in finding the optimum level of
output. It may be noted here that optimum level of output is not
necessarily the maximum profit output. Profits cannot be known
unless the revenue curves of firms are known.

Long-run Cost-output Relations

By definition, in the long-run, all the inputs become variable. The

variability of inputs is based on the assumption that, in the long run,
supply of all the inputs, including those held constant in the short-run,
becomes elastic. The firms are, therefore, in a position to expand the
scale of their production by hiring a larger quantity of all the inputs.
The long-run cost-output relations, therefore, imply the relationship
between the changing scale of the firm and the total output;
conversely in the short-run this relationship is essentially one
between the total output and, the variable cost (labour). To
understand the long-run costoutput relations (lnd to derive long-run
cost curves it will be helpful to imagine that a long run is composed of
a series of short-run production decisions. As a' corollary of this, long-
run cost curves are composed of a series of short-run cost curves. We
may now derive the long-run cost curves and study their' relationship
with output.

Long-run Total Cost Curve (LTC)

In order to draw the long-run total cost curve, let us begin with a
short-run situation. Suppose that a firm having only one-plant has its
short-mn total cost curve as given-by STCl in panel (a) of Figure 3.3.
In this example if the firm decides to add two more plants to its size
over time, one after the other then in accordance two more short-run
total cost curves are added to STCl in the manner shown by STC2 and
STC3 in Figure 3.3 (a):. The LTC can now be drawn through the
minimum points of STCl, STC2 and STC3 as shown by the LTC curve
corresponding to each STC.

Long-run Average Cost Curve (LAC)

Combining the short-run average cost curves (SACs) derives the
long-run average cost curve (LAC). Note that there is one SAC
associated with each STC. Given the STC1 STC2, and STC3 curves in
panel (a) of Figure 3.3, there are three corresponding SAC curves as
given by SAC1 SAC2 arid SAC3 curves in panel (b) of Figure 3.3. Thus,
the firm has a series of SAC curves, each having a bottom point
showing the minimum SAC. For instance, C1Q1 is the minimum AC
when the firm has only one plant. The AC decreases to C2Q2 when the
second plant is added and then rises to C3Q3after the inclusion of the
third plant. The LAC carl be drawn through the bottom of SAC1 SAC2
and SAC3 as shown in Figure·3.3 (b) The LAC curve is also known as
‘Envelope Curve' or 'Planning Curve' as it serves as a guide to the
entrepreneur in his planning to expand production.

The SAC curves can be derived from the data given in the STC
schedule, from STC function or straightaway from the LTC-curve.
Similarly, LAC can be derived from LTC-schedule, LTC function or
from LTC-curve. The relationship between LTC and output, and
between LAC and output can now be easily derived. It is obvious.
from the LTC that the long-run cost-output relationship is similar to
the short-run cost-output relationship. With the subsequent increase
in the output, LTC first increases at a decreasing rate, and then at an
increasing rate. As a result, LAC initially decreases until the optimum
utilisation of the second plant and then it begins to increase. From
these relations are drawn the 'laws of returns to scale'. When the
scale of the firm expands, unit cost of production initially decreases,
but it ultimately increases as shown in Figure 3.3 (b).

Long-run Marginal Cost Curve

The long-run marginal, cost curve (LMC) is derived from the short-run
marginal cost curves (SMCs). The derivation of LMC is illustrated in
Figure 3.4 in which SAC3'and LAC arethe same as'in Figure 3.3(b). To
derive the LMC3, consider the points of tangency between SAC3 and
the LAC, i.e., points A, Band C. In the long-run production planning,
these points determine the output levels at the different levels of
production. For example, if we draw perpendiculars from points A,
Band C to the X-axis, the corresponding output levels will be OQ1 OQ2
and OQ3 The perpendicular AQ1 intersects the SMC1 at point M. It
means that at output BQ2, LMC, is MQ1. If output increases to OQ2,
LMC rises to BQ2. Similarly, CQ3 measures the LMC at output OQ3. A
curve drawn through points M3B and N, as shown by the LMC,
represents the behaviour of the marginal cost in the long run. This
curve is known as the long-run marginal cost curve, LMC. It shows the
trends in the marginal cost in response to the change in the scale of
production.

Some important inferences may be drawn from Figure 3.4. The

LMC must be equal to SMC for the output at which the corresponding
SAC is tangent to the LAC. At the point of tangency, LAC = SAC. For
all other levels of output (considering each SAC separately), SAC >
LAC. Similarly, for all levels of outout corresponding to LAC = SAC,
the LMC = SMC. For all other levels output, i:he LMC is either greater
or less than the SMC. Another important point to notice is that the
LMC intersects LAC when the latter is at its minimum, i.e., point B.
There, is one and only one short-run plant size whose minimum SAC
coincides with the minimum LAC. This point is B where, SAC2 = SMC2
= LAC = LMC.

Optimum Plant Size and Long-run Cost Curves

The short-run cost curves are helpful in showing how a firm can
decide on the optimum utilisation of the plant-which is the fixed
factor; or how it can determine the least-cost output level. Long-run
cost curves, on the other hand, can be used to show how the
management can decide on the optimum size of the firm. An
Optimum size of a firm is the one, which ensures the most efficient
utilisation of resources. Given the state: of technology overtime,
there is technically a unique size of the firm and lever of output
associated with the least cost Concept. This uriique size of the firm
can be obtained with the help of LAC and LMCIn Figur 3.4 the
optimum size consists of two plants, which produce OQ2 units of a
produd, at minimum long-run average cost (LAC) of BQ2.

The downtrend in the LAC ihdicates that until output reaches

the level of OQ2, the firm is of non-optimal size. Similarly, expansion
of the firm beyond production capacity OQ2 causes a rise in SMC as
well as LAC. It follows that given the technology, a firm trying to mini
mise its average cost over time must choose a plant which gives
minimum LAC where SAC = SMC = LAC = LMC. This size of plant
assures most efficient utilisation of the resource. Any change in
output level, i.e., increase or decrease, will make the firm enter the
area of in optimality.

ECONOMIES AND DISECONOMIES OF SCALE

Scale of enterprise or size of plant means the amount of investment
in relatively fixed factors of production (plant and fixed equipment).
Costs of production are generally lower in larger plants than in the
smaller ones. This is so because there are a number of economies of
large-scale production.

Economies of Scale
Marshall classified the economies of large-scale production into two
types:
1. ExternalEconomies
2. Internal Economies
External Economies are those, which are available to all the
firms in an industry, for example, the construction of a railway line in
a certain region, which would reduce transport cost for all the firms,
the discovery of a new machine, which can be purchased by all the
firms, the emergence of repair industries, rise of industries utilising
by-products, and the establishment of special technical schools for
training skilled labour and research institutes, etc. These economies
arise from the expansion in the size of an industry involving an
increase in the number and size of the firms engaged in it.
Internal Ecnomies are the economies, which are available to a
particular firm and give it an advantage over other firms engaged in
the industry. Internal economies arise from the expansion of the size
of a particular firm. From the managerial point of view, internal
economies are more important as they can be affected by managerial
decisions of an individual firm to change its size or scale.

Types of Internal Economies

There are various types of internal economies such as labour,
technical, managerial, marketing and so on. We will discuss the types
of internal economies in detail in the following section:

• Labour Economies: If an firm decides to expand its scale of

output, it will be possible for it to reduce the labour costs per unit by
practising division of labour. Economies of division of labour arise
due to increase in the skill of workers, and the saving of time
involved in changing from one operation to the other. Again, in many
cases, a large firm may find it economical to have a number of
operations performed mechanically rather than manuaily. These
economies will be of great use in firms where the product is complex
and the manufacturing processes can be sub-divided.

• Technical Economies: These are economies derived from the

use of subsize machines and such scientific processes like
those which can be carried out in large production units. A
small establishment cannot afford to use such machines and
processes, because their use would bring a saving only when
they are used intensively. On the other hand, their use will be
quite uneconomical if they were to lie idle over a considerable
part of the time. For example, a large electroplating plant costs
a great deal to keep it in operation. Therefore, the cost per unit
will be low only if the output is large. Similarly, a machine that
facilitates the pressing out a side of a motorcar will take a
week or more to be put ready for operation to produce a
particular design. The greater the output of cars of this
particular designs the lower the cost per unit of getting the
machine ready for operation. Similarly, if a dye is made to
produce a particular model of cars, the cost of dye per unit of
cars will depend upon the output of the cars. Very often large
firms may find it economical to produce or manufacture parts
and components for their products rather than buy them from
outside sources. For example, Hind Cycles, unlike small
mariufacturers, produced parts and components themselves.
Moreover, large firms may find it profitable to utilise their by-
 products and waste products. For example, Tata use the smoke
from their furnaces to manufacture coal tar, naphthalene, etc.
A small firm's output of smoke would not be large enough to
justifY setting up the .equipment necessary to do so.

• Managerial Economies: When the size of the fern increases,

the efficiency of the management usually increases because
there can be greater specialisationin managerial staff. In a
large firm, experts can be appointed to look after the various
sections or divisions of the business, such as purchasing, sales,
production, financing, personnel, etc. But a small firm cannot
provide full-time employm·entto these experts naturally, the
various aspects of the business have to be looked after by few
people only who may not necessarily be experts. Moreover, a
large firm can afford to set up data processing and mechanised
accounting, etc., whereas small firms cannot afford to do so.

• Marketing Economies: A large firm can secure economies in

its purchasing and sales. It can purchase its requirements in
bulk and thereby get better terms. It usually receives prompt
deliveries, careful attention and special facilities from its
suppliers. This is sometimes due to the fact that a large buyer
can exert more pressure·, at times compulsive in nature, for
specially favoured treatment. It can also get concessions from
transport agencies. Moreover, it can appoint expert buyers and
expert salesmen. Finally, a large firm can spread its advertising
cost over bigger output because advertising costs do not rise in
proportion to a rise in sales.

• Economies of Vertical integration: A large firm may decide to

have vertical integration by combining a number of stages of
production. Thisintegration has the advantage that the flow of
goods through various stages in production processes is more
readily controlled. Steady supplies of raw materials, on the one
hand, and steady outlets for these raw materials, on the other,
make production planning more certain and less subject to
 erratic and unpredictable changes. Vertical integration may also
facilitate cost control, as most of the costs become controllable
costs for the enterprise. Transport' costs may also be reduced by
planning transportation in such a way that cross hauling is
reduced to the minimum.

• Financial Economies: A large firm can offer better security and

is, therefore, in a position to secure better and easier credit
facilities both from its suppliers and its bankers. Due to a better
image, it enjoys easier access to the capital market.

• Economies of Risk-spreading: The larger the size of the

business, the greater is the scope for spreading of risks through
diversification. Diversification is possible.on two lines as follows:
o Diversification of Output: If there are many products,
the loss in the sale of one product may be covered by the profits from
others. By diversification, the firm avoids what may be called putting
all eggs in the same basket. For example, Vickers Ltd., make
aircrafts, ships, armaments, food-processing plant, rubber, plastics,
paints, instruments arid a wide range of other products. Many of the
larger firms have taken to diversification. ITC diversified to include
marine products and hotel business in its operations.
o Diversification of Markets: The larger producer is
glenerally in a position to sell his goods in many different and even
far-off places. By depending upon one market, he runs the risk of
heavy loss if sales in that market decline for one reason or the other.

Sargant Floren'ce and Economies of Scale

Sargant Florence has attributed the economies of scale the three
principles, which are in operation in a large-sized business, namely,
the principle of bulk transactions, the principle of massed reserves,
and the principle of multiples.

• Principle of Bulk Transactions: This principle implies that the

cost of dealing with a large batch is often no greater than the
 cost of dealing with a small batch, for example,' the cost of
placing an order, large or small; availability of discounts on bulk
orders, or annual purchase contracts; economies in the use
or'large containers such as tanks or trucks of special design, for
a container holding, say, twice as much as the other one, does
not cost double the amount.

• Principle of Massed Reserves: A large firm has a number of

departments or sections and its overall demand for services, say,
transport services, is likely to be fairly large. But it is unlikely
that all departments will make heavy demands of the particular
service at the saine time. Thus the firm can afford to have its
own transport fleet and fully utilise it and thereby ultimately
reduce its costs. The larger the firm, the greater are the
advantages.
• Principle of Multiples: This principle was first raised by
Babbage in 1832 and has also been referred to as 'Balancing of
Processes'. The principle can be better explained through an
example. Suppose a manufacturing, operation involves three
processes, first in which a machine (:an make 30 units a week;
second in which an automatic machine can make 1,000 units per
week; and a third in which a semi-automatic machine can make
400 units per week. Unles~ the output of the plant is some
common multiple of 30,1,000 anti 400, one or more of the
processes will have unutilised capacity. Their LCM is 6,000 and,
therefore, to best utilise all the machines the plant size must be
of at least 6,000 units or any of its multiples.

Economies of Scale and Empirical Evidence

According to the surveys conducted by the Pre-investment Survey
Group (FAG) and later on by the NCAER, it has been pf()Ved that in
paper industry, profitability decreases with lower scaly of operations
and bigger plants beneht from economies of scale. The report of the
Pre-investment Survey Group (FAG) reveals that the manufacturing
cost of writing and printing paper would fall from Rs. 1,489 in a 100-
tonne per day plant to Rs. 1,238 in a 200-tonne per day plant and
further to Rs. 1,104 in a 300-tonne per day plant. The following Table
3.2 further shows the capital cost of raw materials and operating cost
per tonne of paper according to the size of the unit, as estimated by
the NCAER.
Table 3.2: Paper Industry: Investment and Other
Costs of Paper Mills according to Size

Size Tonnes Fixed Cost of raw Operating

per day) investment cost ma terials per cost per tonne
'. per tonne tonne of paper of paper
100 • 4,473 324 1,307
200 4,070 263 1,116
250 3,945 258 1,056

Another study of cement industry by the Economic and

Scientific Research undation-shows that the per unit of capacity
capital investment of a 3,000 tonne per' day (TPD) capacity cement
plant islower than the plants of 50 TPD size. Thus a single cement
plant producing 3,200 TPD requires 46 per cent less capital
investment than 8 plants of 400 TPD productions would. As regards
cost of production, a 800 TPD plant has a 15 per cent cost advantage
over a 400 TPD plant. The difference between the cost of production
of a tonne of cement by a 3,000 TPD plant and of a50 TPD plant is as
high as Rs. 100 per tonne. In fact, there has been a perceptible
increase in the size of cement plants in India. For example, the 600
tonnes per day capacity cement plants during the early 1960s gave
way with their size going up to 1,200 tonnes per day. The latest
preference is for 3,200 tonnes per day capacity plants. A significant
policy implication of economics of scale is that in order to earn a
reasonable return and at the same time ensure a fair deal to the
consumers, the industry should go in for larger plants and expand the
existing plants to .the optimum level.
The 6/10 Rule
A useful rule that seeks to measure economies of scale is the 6/1 0
rule. According to this rule, if we want to double the volume of a
container, the material needed to make it will have to be increased
by 6/10, i.e., 60 per cent. A proofofthe'6/l0 rule is easy and can be
given here with its advantage. Let us begin with the volume of a
container and the material required to make it. Suppose the container
is of the shape of a Gube with its side. The volume of the container
then is:
Vo = ao x ao x ao = ao3
Now, to find out the area of material needed, we know that the
container will have six equal square faces, each of area an 2
so, the
area of total material needed IS:
Mo = 6 x ao2 = 6ao2
Suppose now, that the container's dimension increases from an
to all the volume of the container will then increase to al 3 and the
area of t~e material needed will increase to 6a12.
Thus, for two containers of dimensions an and al the ratio of the
areas of material needed will be:
M1 6a1/2 a1/2
M0 6a0/2 a0
= =

The corresponding ratio of the volumes will be:

V1 a1/3 a1/3
V0 a0/3 a0
= =

From the above, it follows that:

M1 a1/2 a1/3.2/3 V 1 2/3
M0 a0/2 a0 = V0
= =

Now, if we double the volume, i.e., if

 V1
V1 = 2V0 or V0 =2

Then,
M1 V1 2/3
M0 = V0 = (20) 2/3 = 1.59
M1 = 1.59 M0

In other words, doubling the volume requires 59 per cent

increase in material. This is rouJded off as 60 per cent, which is the
same as 6/1O. It may be added that, if in place of a cubical container,
we had taken the example of a spherical or a rectangular or a
cylindricai or for that matter a conical container, we would have
aijived at the same relationship, viz.,
M1 V12/3
M0 = V0

The 6/10 rule is of great practical significance. Its significance can

well be realised if we visualise, for example, blast furnaces as boxes
containing the ingredients needed to produce iron, or tankers as
large boxes containing oil.

Minimum Economic Capacity (MEC) Scheme

Small size firms do not enjoy economies of scale. As such, in
pursuance of government's policy to encourage minimum efficient
capacity in industrial und~i1akings, the Government of India has
introduced' MEC Scheme to petrochemical industries, for example,
Naphtha / Gas Cracker (3 to 4 lakhs tonnes), Bopp Film (56,000
tonnes), Polyster Film (5,000 tonnes), Polyster Filament Yam (25,000
tonnes), Acrylic Fibre (20,000 tonnes), MEG (One lakh tonnes), PTA
(2lakh tonnes), etc.

World Sdale
With re·cent trends towards globalisation of industries in India, the
concept of "World Scale" has emerged. The term 'World Scale' refers
to that scale or size of the enterprise, which is large enough to enable
the firm to reap various large-scale economies so as to compete
successfully on the world basis with global rivals. Thus Reliance
Industries Limited has recently announced to build a world scale
polyester facility at Hnzira and a cracker project with capacity
expanding from earlier 40,000 tonnes·to the world scale of 7,50,000
tonnes per annum.

Diseconomies of Scale
Economies of increasing size do not continue indefinitely. After a
certain point, any further expansion of the size leads to diseconomies
of scale. For example, after the division of labour has reached its
most efficient point, further increase in the number of workers will
lead to a duplication of workers. There will be too many workers per
machine for really efficient production. Moreover, the problem of co-
ordination of different processes may become difficult. There may be
divergence of views concerning policy problems among specialists in
management
and reconciliation may be difficult to arrive. Decision-making process
becomes slow resulting in missed opportunities. There may be too
much of formality, too many individuals between the managers and
workers, and supervision may' become difficult. The management
problems thus get out of hand with consequent adverse effects on
managerial efficiency.
The limit of scale economics is also often explained in terms of
the possible loss of control and consequent inefficiency. With the
growth in the size of the firm, the control by those at the top
becomes weaker. Adding one more hierarchical level removes the
superior further away from the subordinates. Again, as the firm
expands, the incidence of wrong judgements increases and errors in
judgement become costly.
Last be not the least, is the limitation where the larger the plant,
the larger is the attendant risks of loss from technological changes
as technologies are changing fast in modern times.
Diseconomies of Scale and Empirical Evidence
Large petro-chemical plants achieve economies in both full usage
and in utilisation of a wider range ofby-products, which would
otherwise, be wasted. But above 5,00,000 tonnes, diseconomies of
scale sets in because of the following occurrences:

• The plant becomes so large that on-site fabrication of some

parts is required which is much more expensive;

• Starting up costs are much higher, more capital is tied up and

delays in commissioning can be extremely expensive; and
• The technical limit to compressor size has been reached.
There is, however, no substantial evidence of diseconomies of
large-scale production. In the final analysis, however, a significant
test of efficiency is survival. If small firms tend to disappear and
large ones survive, as in the automobile industry, we must conclude
that small firms are relatively inefficient. If small firms survive and
large ones tend to disappear as in the textile industry, then large
firms are relatively inefficient. In reality, we find that in most
industries, firms of very different sizes tend to survive. Hence, it can
be concluded that usually there is no significant advantage or
disadvantage to size over a very wide range of outputs. It may
mean, of course, that the businessman in his planning decisions
determines that beyond a certain size, plants do have higher costs
and, therefore, does not build them.

Somewhat surprisingly, some Indian entrepreneurs have been

perceptive enough to attempt to derive the advantages of both large
and small-scale enterprises. In the late sixties, the Jay Engineering
Co. Ltd. evolved a strategy of blending large units with small
enterprises to obtain the best of both worlds. It manufactures its
Usha fans in three different plants (Calcutta, Hyderabad and Agra),
with each plant' manu facturing the same or a similar range of
products. Each unit is autonomous and is free to take operational
decisions except in highly strategic areas. Within each unit, the work-
force is kept small to carry out vital operations such as forgoing,
blanking, notching and final assembly. The rest of the work is sub-
contracted to neighbouring small-scale units, which over a period or
time have become almost integral parts of each plant. Loans for the
purchase of machinery are also advanced and technical know-how
and sometimes-eve training is provided to these ancillary units.
Payments are made promptly. The whole system operates like
families within a larger family. Managers in the US, who are always
quick in innovating, have also begun adopting this blended system
during the past few years. General Motors encourages the creation
ofa cluster of independent enterprises in an area, with adequate
autonomy granted to the company's area chief to encourage their
growth and developm.ent. Consequently, though a giant in the
automobile industry, General Motors enjoys a large number of the
privileges that acerue to small units and also reaps the special
benefits accruing to large business firms.

Economies of Scope
This concept is of recent development and is different from the
concept of economies of scale. Here, the cost efficiency in production
process is brought out by variety rather than volume, that is, the cost
advantages follow from variety of output, for example, product
diversification within the given scale of plant as against increase in
volume of production or scale 6f output. A firm can add new and
newer products if the size of plant and type of technology make it
possible. Here, the firm will enjoy scope-economies instead of scale
economies.

COST CONTROL AND COST REDUCTION

Cost Control
The long-run prosperity of a firm depends upon its ability to eam
sustaid profits. Profit depends upon the difference between the
selling price and the cost of production. Very often, the selling price is
not within the control of a firm but many costs are under its control.
The firm should therefore aim at doing whatever is done at the
minimum cost. In fact, cost control is ail essential element for the
successful operation of a business, Cost control by management
means a search for better and more economical ways of completing
each operation. In effect, cost control would mean a reduction in the
percentage of costs and, in turn, an increase in the percentage of
profits. Naturally, cost control is and will continue to be of perpetual
concern to the industry.
Cost control has two aspects' such as a reduction in specific
expenses and a more efficient use of every rupee spent. For
example, if sales can be increased with the same amount of
expenditure, say, on advertising and saTesmen, the cost as a
percentage of sales is cut down. In practice, cost control will
ultimately be achieved by looking into both these aspects and it is
impossible to assess the contribution, which each has made to the
overall savings. Potential savings in individual businesses will,
however, vary between wide extremes depending upon the levels of
efficiency already achieved before cost controls are introduced.
It is useful to bear in mind the following rules covering cost control
activities:
• It is easier to keep costs down than it is to bring costs down.

• The amount of effort put into cost control tends to increase

when business is bad and decrease when business is good.

• There is more profit in cost control when business is. good than
when I business is bad. Therefore, one should not be slack when
conditions are good.
Cost control helps a firm to improve its profitability and
competitiveness. Profits may be drastically reduced despite a large
and increasing sales volume in the absence of cost control. A big
sales volume does not necessarily mean a big profit. On the other
hand, it may create a false sense of prosperity while in reality;
increasing costs are eating up profits. Profit is in danger-when good
merchantdising and cost control do not go hand in hand. Cost control
may also help a firm in reducing its costs and thus reduce its prices. A
reduction in prices of a firm would lead to an increase in its
competitiveness. The aspect is of particular relevance to Indian
conditions because of high costs, India is being priced out of the
world markets.

Tools of Cost Control

Following ar.e the tools that are used for the cost control:

Standard Costs and Budgets: The technique of standard,

costing has been developed to establish standards of performance for
producing gvuus and services. These standards serve "as a goal for
the attainment and as basis of comparison with actual costs in
checking performance. The analysis of variance between actual and
standard costs will: (i) help fix the responsibility for non-standard
performance and (ii) focus attention on areas in which cost
improvement should be sought by pinpointing the source of loss and
inefficiency. The principle here is that or controlling by exception.
Instead of attempting to follow a mass of cost data, the attention of
those responsible for cost control is concentrated on significant
variances from the standard. If effective action is to be taken, the
cause and responsibility of a variance, as well as its amount, must be
established.
The prime objective of standard costs is to generate greater cost
consciousness and help in cost control by directing attention to
specific areas where action is needed. To those who are
immediately concerned, variances wou1d indicate whether any
action is required on their part. It must be noted that

• Costs are controlled at the points where they are incurred and
at the time of occurrence of events, and
• At the same time they may be uncontrolled at some points.
It is, therefore, necessary to understand the difference
between controllable and uncontrollable costs. The variances may
also be controllable and uncontrollable. For example, if the material
cost variance is due to rise in prices, it is not within the control of the
production manager. But if the variance is due to greater usage,
control action is certainly possible on his part. The higher
management can also deCide whether or not they should intervene
in the matter. Sometimes, variances may be so significant that a
complete reapRraisal of the standard costs themselves may be
needed.
For example, if the variances are always favourable, it may
point to the fact that the standards have not been properly fixed.
Standard costing can also provide the means for actual and standard
cost comparison by type of expense, by departments or cost centres.
Yields and spoilage can be compared with the standard allowance for
loss. Labour operations and overheads also can be checked for
efficiency. Flexible budgets constitute yet another effective technique
of cost control, especially control of factory overheads. Flexible
budgets, also known as variable budgets; provide a basis for
determining costs that are anticipated at various levels of activity. It
provides a flexible standard for comparing the costs of an actual
volume of activity with the cost that should be or should have been.
The variances can then be analysed and necessary action can be
taken in the matter. Table 3.3 gives a specimen flexible budget.

Table 3.3: Finishing Department, Modern Manufacturing Co.

Standard hours of direct labour

35,000 40,000 45,000
Labour cost hour at Rs. 3 per Rs. 1,05,000 Rs. 1,20,000 Rs. 1,35,000
Other variable costs 17500 20.000 22,500
Semi-variable costs 9,250 10,000 10,250
Fixed costs 50,000 50,000 50,000
Total Rs.l,81,75Q Rs. 2,00,000 Rs.2,17,750

The scientific establishment of standards of performance through

standard costs and budgets has not only provided better cost control
but has led to cost reduction in a number of companies. This has
been the case especiilIIy in companies where standards were tied to
wage-incentive plans and improyement in control is part of a general
programme of better management. The above table shows three
budgets, one each for 35,000, 40,000 and '45,000 standard hours of
work. In practice, one may come across 50 or more cost items in the
budget and not just four as shown in the table.

Ratio Analysis
RatIo is a statistical yardstick that provides a measure of the
relationship betweeri two figures. This relationship may be expressed
as a rate (costs per rupee of sales), as a per cent (cost of sales as a
percentage of sales), or as a quotient (sales as a certain number of
time the inventory). Ratios are commonly used in the analysis of
operations because the use of absolute figures might be misleading.
Ratios provide standards of comparison for appraising the
performance of a business firm. They can be used for cost control
purposes in two ways:

• A businessman may compare his firm's ratios for the period

under scrutiny with similar ratios of the previous periods. Such
a comparison would help him identify areas that need his
attention.

• The businessman can compare his ratios with the standard

ratios in his jndustry. Standard ratios are averages of the results
achieved by thousands, of firms in the same line of business.

If these comparisons reveal any significant differences,

thtYmanagement call analyse the reasons for these differences and
can take appropriate action to remove' the causeS responsible for
increase in costs. Some of the most commonly used ratios for cost
corrtparisons are given below:
• Not profits/sales.
• Gross profits/sales.
 • Net profits/total assets.
• Sales/totaLassets.
• Production costs/costs of sales.
• Selling Costs/costs of sales.
• Admiriistration costs/costs of sales.
• Sahes/iriventory or inventory turnover.
• Material costs/prod1, Jction costs.
• Labour costs/production costs.
• Overhead/prqduction costs.

Value Analysis: Value analysis is an approach to cost saving

that deals with product design. Here, before making or buying any
equipment or materials, a study is made of the purpose to which
these things serve. Would other lower-cost designs work as well?
Could another less costly item fill the need? Will less expensive
material, do the job? Can scrap be reduced by changing the design or
the type of raw materiaJ? Are the seller's costs as low as they ought
to be? Suppliers of alternative materIals can provide the ample data
to make the appropriate choice. Of course, absorbing and reviewing
the data will need some time. Thus the objective of value analysis is
the identification of such costs in a product that do not in any manner
contribute to its specifications or functional value. Hence, value
analysis is the process of reducing the cost of the prescribed function
without sacrificing the required standard of performance. The
emphasis is, first, on identificatiqn of the required function and,
secondly, on determination of the best way to perform it at a lower
cost. This novel method of cost reduction is not yet seriously
exploited, in our country. Value analysis is a supplementary device in
addition to the con~entional cost reduction methods.

Value analysis is closely related to value engineering, though

they are not identical. Value analysis refers to the work that
purchasing department does in-this direction whereas value
engineering usually refers to what engineers are doing in this area.
The purchasing department raises questions and consults the
engineering department and even the vendor company's department.
Value analysis thus requires wholehearted co-operation of not only
the firm's expertise in design, purchase, production and costing but
also that of the vendor and other company expertise, if necessary.
Some examples of savings through value analysis are given below:
• Discarding tailored products where standard components can
do.
• Dispensing with facilities not specified or not required by the
customer, for example, doing away with headphone in a radio
set.
• Use ofnewly-deyeloped, better and cheaper materials in place
of traditional materials.
Taking the specific case of TV industry, there are various
components of cost, which can be questioned. The various items are
as under:
• Whether to have vertical holding chassis or the chassis should
be tied down horizontally. In case, chassis is held vertically,
additional expenditure in terms of holding clamps is required.
• Whether to have plastic cabinet or wooden cabinet.
• Whether to have two speakers or one speaker.
• Whether to have sliding switches or stationary switches.
• Whether to have PVC back cover or wooden back cover.
• Whether to have costly knobs or cheaper knobs.
• Whether to have moulded mask or extruded plask.
• Whether to have Electronic Tuner or Turret Tuner.
• Whether to have digital operating unit or noble operating unit.

Cost control is applicable only to such costs, which can be

altered by the management on their own initiative. It may be noted in
this context that, by and large, non-controllable costs exceed far
more than controllable ones thereby restricting the scope of profit
impfoyement through cost, control. Of course, attempts may be made
to convert an uncontrollable cost into a controllable one. Vertical
combinations to secure control over sources of supply provide an
example. So also instead of buying a component, a firm may decide
to make the conversion possible.

AREAS OF COST CONTROL

Folloviing are the areas where the cost can be controlled:

1. Materials

There area number of ways that help in reducing the cost ofmatenals.
Ifbuying is done properly, a firm avails itself of quantity discounts.
While buying from a particular source, in addition to the cost of
materials, consideration should be given to freight charges. In some
cases, lower prices of materials may be offset by higher freiight to
the firm's godown. Whiie buying, one may attempt to buy from the
cheapbt source by inviting bids. At times, it may be possible to have
more economical substitutes for raw materials that the firm is using.
Many a times, improvell1ent in product design may lead to reduction
in material usage. It is desirable to concentrate attention on the
areas where saving potential is the highest.
Another area, which needs examination in this respect, is
whether to make or buy components from outside source. Very often
firm may find it advantageous to manufacture certain parts and
components in one's own factory rather than buying them. Yet in
many cases there are specific advantages in purchasing spares and
components from outside because suppliers may deliver goods at low
cost with high quality. For example, Ford and Chrysler of the US Auto
Industry purchase their components from outside source. But General
Motors could not do so because the firm has its own departments for
handling the process of production. This type of firm is referred as
vertically integrated firm where it owns the various aspects of making
seIling and delivering a product Hind Cycles, which has now been
taken over by the Government, manufactures all its components. But
manufacturers of Hero and Avon Cycles purchased most of their
components from outside source and successfully competed with
Hind Cycles.
Continuous Research and Development (R & D) may also lead
to a reduction in raw material costs. For example, Asian Paints made
high savings in costs of raw materials by its phenomenal success on
Research and Development front, by manufacturing synthetic resins
for captive consumption. Total materials consumed as a ratio of value
of production fell from 67.66 per cent in 1973 to 60-67 per cent in
1977. General Motors have reduced the weight of their cars to make
them more fuel-efficient. Better utilisation of materials' may also save
the cost of materials by avoiding wastes in storing, handling and
processing. Some of the factors, responsible for excessive wastage of
materials are: lack of laid down requirements for raw materials, bad
process planning, rejects due to faulty materials or poor
workmanship, lack of proper tools, jigs and fixtures, poor quality of
materials, loose packing, careless and negligent handling and
careless storage.
Exploration of the possibilities of the use of standardised parts
and components and the utilisation of waste and by-products, may
also lead to a significant reduction in the cost of materials.

Inventory control is yet another area for reducing materials

cost. Thro inventory control, it is possible to maintain the
investment in inventories at lowest amount consistent with the
production and the sales requirements of firm. The cost of carrying
inventories ranges from 15 to 20 per cent per annum account of
interest on capital, insurance, storage and handling charges, spilla
breakage, physical deterioration, pilferage and obsolescence. Again
50 per cent the gross working capital may be locked up in
inventories.

Some important ways of reducing inventories are:

• Improved production planning.
 • Having dependable sources of supplies, which can ensure
prompt deliver of materials at short notice.
• Elimination of slow-moving stocks and dropping of obsolete
items.
• Improved flow of part and materials leading to increased
machine
utilisation and shorter manufacturing cycles.
Packaging constitutes a significant proportion of raw materials
(9 to 24 per cent) and of the total manufacturing expenses (7 to 22
per cent). Firm should mal attempts to reduce the packaging costs
to the minimum. For example, instead discarding containers that the
materials come in it may be used for shipping tl goods and thus, the
packaging cost can be saved. The manufacturing firms such; cars
and motor bikes may request its customers to return the containers
in whic are goods were sent so that they could be used in future.
This is because packin of such goods as well as the materials used
for packing is very expensive.

2. Labour
Reduction in wages for reducing labour costs is out of question. On
the other hand, wages might have to be increased to provide
incentives to workers. Yet there is good scope for reduction in the
wage cost per unit. A reduction in labour costs is possible by proper
selection and training, improvement in productivity and by
automation, where possible. A study by cn (Confederation of Indian
Industry) showed that Hero Cycles improved their productivity per
employee by 6.4 per cent. 'Purolators' were able to increase their
productivity by 100 per cent. Work· study might result in a lot of
savings by reducing overtime and idle time and providing better
workloads. Labour productivity might increase if frequent change of
tools is avoided. Improvement in working conditions may reduce
absenteeism and thus reduce costs per unit. Scrutiny of overtime
may reveal substantial scope for savings.
 All efforts must be made to redllce wastage of human effort.
Wastage of human effort may be due to lack of co-ordination among
various departments by having more workers than necessary, ·under-
utilisation of existing manpower, shortage of materials, improper
scheduling, absenteeism, poor methods and poor morale. For
example, Metal Box adopted a Voluntary Severance Scheme in 1975-
76 to reduce their work force by 950 workers after they faced a huge
operating loss ofRs. 2.4 crores. General Motors eliminated 14,000
white-collar jobs through attrition to reduce cost. Japan's big 5 steel
producers announced substantial retrenchment programmes and
workers co-operated with the management. Attempts must be made
to secure co-operation of employees in cost reduction by inviting
suggestions from them. These suggestions should be carefully
examined and implemented if found satisfactory. Hindustan Lever
has a suggestion box scheme and employees who come out with
good suggestions receive awards. These suggestions may either lead
to savings or improve safety and work convenJence. The basic idea is
to motivate workers and make them perceive working in the firm as a
participative endeavour.

3. Overheads
Factory overheads may be reduced by proper selection of equipment,
effective utilisation of space and .equipment, proper maintenance of
equipment and reduction in power cost, lighting cost, etc. For
example, fluorescent lighting can reduce lighting cost. Faulty designs
may lead to excessive use of materials or multiplicity of components,
waste of steam, electricity, gas, lubricants, etc. A British team invited
by the Government of India to report on standards of fuel efficiency
in Indian industry found that fuel wastages might be as high as an
average of 25 per cent. Keeping them in check even in the face of
increasing sales may reduce overhead costs per unit. For example,
Metal Box maintained their fixed costs in 1976-77 even when there
was an increase in sales of over 18 per cent.
Taking advantage of truck or wagonloads may reduce
transportation cost. Careful planning of movements may also save
transportation cost. Another point to be examined is whether it would
be economical to use one's own transport or hire a transport. For
reasons of economy, many transport companies hire trucks rather
than owning them. This is because purchase and maintemince of
trucks can be more expensive. By chartering vehicles the problems of
maintenance is left to the owner who in turn Cuts cost for the firm.
Thus by keeping a smaller work force on rolls and by introducing a
contract rate linked to a safe delivery schedule it is possible to ensure
speedy point-to-point delivery of goods. Many firms now prefer to use
private taxis rather than have their own staff cars.
Reduction of wastes in general can also reduce manufacturing
costs considerably. Of course, a certain amount of waste and spoilage
is unavoidable because employees do make mistakes, machines do
get out of order and sometimes raw materials are faulty. However,
attempts can be made to reduce these mistakes and faulty handling
to the minimum. The normal figure for the waste and spoilage
depends upon the complexity of the product, the age of the
manufacturing plant, and the skill and experience of the workers.
Once normal wastage is found out, production reports must be
watched carefully to find out whether the wastages are excessive.
Wastes can be reduced considerably by educating operators in the
causes and cures of the wastes. Bad debt losses can be reduced
considerably by selecting customers carefully, and keeping an eye on
the receivables. Concentrating on areas and media can reduce
advertising costs, which give the best results.
Selling costs can be controlled by improving the supervision and
training of salesmen, rearrangement of sales territories, replanting
salesmen's routes and calls and redirecting of the sales efforts, to
achieve a more economic product mix. It may be possible to save
selling costs by the use of warehouses, making bulk shipments to the
warehouses and giving faster deliveries to the customers.
Centralisation, reduction, clerical and accounting work may also lead
to cost savings. A look at the telephone bills and the communication
cost in general may also reveal areas for substantial savings. For
example a telegram may be sent in place of a trunk call.

(a) Cost Reduction

The Institute of Cost and Works Accounts of London has defined cost
reduction as "the achievement of real and permanent reductions in
the unit costs of goods manufactured or services rendered without
impairing their suitability for the use intended". Thus, cost reduction
is confined to savings in the cost of manufacture, administration,
distribution and selling by eliminating wasteful and unnecessary
elements from the product design and from the techniques and
practices carried out in coilOection with cost reduction?

(b) Cost Contro/and Cost Reduction

According to the Institute of Cost and Works Accounts, London, "cost

control, as generally practised, lacks the dynamic approach to many
factors affecting costs, which determine the need of cost reduction."
For example, under cost control, the tendency is to accept standards
once they are fixed and leave them unchallenged over a period. In
cost reduction, on the other hand, standards must be constantly
challenged for improvement. And there is no phase of business,
which is exempted from the cost reduction. Products, processes,
procedures and personnel are subjected to continuous scrutiny to see
where and how they can be reduced in cost.
To achieve success in cost reduction, the management must be
convinced of the need for cost reduction. The formulation of a
detailed and co-ordinated plan of cost reduction demands a
systematic approach to the problem. The first step would be the
institution of a Cost Reduction Committee consisting of all the
departmental heads to locate the areas of potential savings and to
determine the priorities. The Committee should review progress and
assign responsibilities to appropriate personnel. Every business
operation should be approached in the belief that it is a potential
source of economy and may benefit from a completely new appraisal.
Often, it may be possible to dispense entirely with routines, which, by
tradition, have come to be regarded as a permanent feature of
concern. Cost reduction is just as much concerned with the stoppage
of unnecessary activity as with the curtailing of expenditure. It is
imperative that the cost of administering any scheme of cost
reduction must be kept within reasonable limits. What is reasonable
must be determined in all cases from the relationship between the
expenditure and the savings, which result from it.

Essentials for the Success of a Cost Reduction Programme

Following are the some of the points that firms should take care in
order to achieve success in the cost reduction programme:
Every individual within the firm should recognise· his
responsibility. The co-operation of every individual requires a careful
dissemination of the objectives and interest of the employees in the
achievement of the firm's goals.
Employee resistance to change should be minimised by
disseminating complete information about the proposed
changes and convincing the emplcyees that the changes are
concerned with the problems faced by the firm and that they
would ultimately benefit.
Efforts should be concentrated in the areas where the savings are
likely to be the maximum.
Cost reduction efforts should be continuously maintained.

• There should be periodic meetings with the employees to review

the progress made towards cost reduction.

(c) Factors Hampering Cost Control in India

The cost of raw material and other intermediate products is generally
high. In many cases: the cost of raw materials is substantially higher
than their international prices, which makes it difficult for the Indian
firms to compete in foreign markets. The sharp rise in oil prices in
recent years also gave a severe push to the cost of raw materials
with petrochemical base. Shortages of raw materials are a usual
phenomenon. With a view to insuring against these shortages,
manufacturers keep larger inventories, which result in increase in
their costs. This occurs especially in case of imported raw materials.
Wages are always being linked to cost of living. There are wage
boards for almost every industry and management has little control
on wage rates.
Overheads are also higher in India due to the following reasons:

• The size of the plant is very often uneconomic due to the

Government's desire to prevent concentration of economic
power. However, there is now a marked change in the policy. In
1986, the Government announced that 65 industries would be
started with minimum economic capacity so as to 'make India's
products competitive. This process got a boost after the new
Industrial Policy was announced in July 1991.

• There is under-utilisation of capacities due to lack of raw

materials and power shortage. However a manufacturer can
exceed his capacity by improving the techniques of production
process. Even after making improvements, a manufacturer
lacks the way to completely minimise the possibilities of
increase in the overheads.

• Machinery and equipment obtained under tied credits usually

cost 30 to 40 per cent more than what it wouid cost if
purchased in the open market.

• There are delays in the issue of licences and by the time

licences are issued, cost of equipment goes up. The number of
industries subject to licensing has now been drastically
reduced.

• Increase in administered prices for many items crucial to the

industrial production by the Government from time to time also
 pushes up costs.

• Finally, there is what lis called by businessmen as 'unseen

overheads' in the nature of demands for illegitl gratification by
various Government officials at different administrative levels.

There are indirect taxes, which also tend to raise the overall
costs of production in India. Excise duties and saies taxes also
heighten the impact of indirect taxes on the cost of production. India
is perhaps the only country where basic raw materials carry heavy
excise duties. According to an estimate by Mr. S. Moolgaokar,
Chairman, TELCO, as much as Rs. 25 crores of working capital is
locked up in inventories and work-in-progress with TELCO and its
suppliers solely due to the present tax structure.
Until recent times the Indian industrialists operated in a
sheltered domestic market. They were protected against foreign
competition by import controls and against domestic competition due
to industrial licensing. So long as this sellers' market prevailed
competition among sellers was absent and there was no compelling
reason for the industrialists to pay any attention to cost reduction.
Cost consciousness was thus by and large absent in India. The price
fixation for products under price control ensured that the rise in costs
was fully reflected in the prices. This made it possible for the
industrialists to pass on any increase in costs to the consumers.
However, now with the advent of recession tendencies, and
liberalisation in licensing policies, the Indian industrialist is compelled
to pay greater attention to cost reduction and cost control.
 APPENDIX - I

Calculation of Variances
The difference between the standard cost and the comparable actual,
cost for the same element and for the same period is known as cost
variance. The total of the variances consequently represents the
difference between the actual profits and the standard profits, i.e.,
the profits that ought to have been made. The variances are said to
be favourable or credit Variances when the actual performance
exceeds the standard performance or the actual costs are lower than
the standard costs. On the other hand, the variances are
unfavourableor debit variances when the actual, performance falls
short of the standard performance or the actual costs exceed the
standard costs. All variances must state the direction of the variance
as well as the amoUnt. Calculation of cost variances is an important
feature of standard costing. The formulae for calculating the various
variances are given below:

Material Cost Variance

(Actual Quantity x Actual Price) - (Standard Quanity x Standard
Price)
or, (AQ x AP) - (SQ x SP)
Material Price Variance
(Actual Price - Standard Price) x Actual Quantity
or, (AP - SP) x AQ

Material Usage or Quantity Variance

(Actual Quantity - Standard Quantity) x Standard Price
or, (AQ - SQ) x SP
Material usage variance can be further sub-divided into (i) Mix
variance and (ii) Yield variance. When the process uses several
different materials that are supposed to be combined in a standard
proportion, mix variance shows the effeclofvariations from the
standard proportion. The formula for calculating the mix variance is:
 (Actual Quantity - Standard Proportion) x Standard Price
Yield variance shows the loss due to the actual loss being more
or less than the standard loss. The formula for calculating the yield
variance is:
(Actual Loss - Standard Loss) x Average Standard Input Price

Labour CostVariance
(Actual Hours x Actual Rate)-(Standard Hours x Standard Rate)
or, (AH x AR) - (SH x SR)

Labour Rate (Price) Variance

(Actual Rate - Standard Rate) x Actual Number of Hours
or, (AR- SR) x AH

Overhead Efficiency Variance

The object is to test the efficiency achieved from the actual
production. The variance is thus, analogous in nature to the labour
efficiency variance. The formula for calculation of the variance is:
(Actual Hours - Standard Hours for Actual Production)
x Standard Overhead Rate
or, (AH - SH) x SOlt

Cost control ultimately depends on action, which is based on

variances. However, these actions can be taken only by people who
have the appropriate authority. It is, therefore, futile to present
variances to a person if those variances are related to matters, which
fall outside his guthority. Such variances are called uncontrollable
whereas those relating to matters within his authority ilre termed as
controllable variance.

APPENDIX II
Cost Control Drive in Coal India Limited (Cll)

CIL closed in 1984-85 with a provisionally estimated profit of Rs. 20

pro res after fully discharging its depreciation and loan repayment
obligations. The company had to initiate a series of stringent
measures to achieve the profit figure, the thrust being on controlling
costs. Four specific areas chosen include: salary and wages,
administration expenditure, stores and realisation of dues. In 1983-
84, the incidence of salary and wages being what it was, the cost of
manpower, per tonne of coal worked out to Rs. 97.04. In 1984-85, the
rise was contained at 88 paisa and the cost of manpower per tonne
came to Rs. 97.92.This was despite the fact that there was a rise of
51 points in the consumer price index. And then factors would have
justifledan increase of Rs. 6.44 in the cost of manpower per tonne of
coal but it was contained at 88 paisa.
The CIL Chairman pointed out that a major effort was made to
ensure gainful redeployment of manpower through persuasion and
motivation and at times even by force:' Empowered teams of senior
executives were sent to interview people and persuade them to
accept jobs that would suit them. Local redeployment was insisted
upon although in some places non-availability of residential
accommodation caused a problem. Secondly, increase of manpower
was controlled very strictly. Instructions were issued to subsidiary
companies that no new appointment was to be made without Director
of Finance and the Chairman approving it. Thirdly, a drastic reduction
was made in overtime allowance and for achieving this objective even
threat of sacking had to be administered.
In the sphere of administration expenditure, the thrust was on
cutting down the expenses on account of travelling allowance.
However, cost control measures were most effective in the sphere of
stores management. The system of 'fortress checks', introduced in
1984-85 resulted in straight saving of Rs. 30 crores. CIL's profit in
1984-85 would have been about Rs. 80 crores, ,if only there was an
appropriate system of pricing.

PRICE DISCOUNTS AND DIFFERENTIALS

Distributors' Discounts

Distributors' discounts are the price reductions that systematically

make the net price vary according to buyers' position in the chain of
distribution. They are called so because these discounts are given to
various distributors in the trade channel, for example, wholesale
factors, dealers and retailers. For the same reason, they are also
called as trade channel discounts. As these discoUnts create
differential prices for different customers on the basis of marketing
functions performed by them for example, whether they are
wholesalers or retailers, they are also called as functional discounts.
However, it must be pointed out that the special discounts may also
be given to persons other than distributors and not, associated with
distribution function. For example, special discounts may be given to
manufacturers who incorporate the product in their own product.
Tyres and tubes sold; to cycle manufactUrers for use in their bicycles,
is a typical example. Special prices may be charged to members of
the same industry; for example, one company may exchange
petroleum with another company at a special price. Again, special
prices may be quoted to Central and State Governments and to the
Universities; for example, Remington typewriters, Godrej safes, etc.,
are sold at low prices to these places.

Forms of Distributors Discounts

Distributors' discounts take different forms determined mainly by the
consent of all the business firms in an industry. Nevertheless, at
times firms may have to decide about the form in which discount is
to be offered. There are mainly three forms:

• Different net prices for different distributor levels. Net prices

are rarely used for quoting differential prices to distributors.
Manufacturers give them to certaii1iliithorised dealers. The simplicity
of this method enables some savings in invoicing and accounting.

• A uniform list price modified by a structure of discounts, each

rate applicable to a different level of distributor, List prices with
discounts are more common. This method makes it easy to deal with
diverse trade channels. It also facilitates cyclical 'and seasonal
adjustments in prices by merely varying the discounts. This may also
help in keeping actual prices a secret, not only among distributors
but also from competitors· and customers secret, not only among
distributors but also from competitors and customers.

• A single discount combined with different supplementary

discounts to different levels of distributors. For example, 5 per cent
to regional distributors.
Thus, the chief advantage of the prices with discounts is
greater flexibility. Further, this method helps the manufacturers to
exercise greater control over the realised' margin of different
categories of distributors. But real control is achieved only when such
discounts are coupled with resale price maintenance. A
supplementary discount gives the manufacturers, a picture of the
entire trade channel structure. These discounts may be intended to
reflect distributors cost at' different stages and competition between
different kinds of distributors. The supplementary discounts are very
descriptive in nature while their accounting is expensive. Distributors'
discounts differ widely in industries. They also differ among the
various business firms within industry.

How to Determine Distributors' Discounts

The economic function of distributors' discounts is to induce different
categories of distributors to perform their respective marketing
functions. As such, to build up a discount structure on sound
economic lines, it is essential to know the services to be performed
by the distributors, distributors' operating costs, discount structure of
competitors, effects of discounts on distributor population, cost of
selling to different channels and opportunities for market
segmentation.

• Services to be performed by the distributors at different

levels: The main objective of the manufacturer is to get the
distributor function performed most econoiIlically and effectively.
For this purpose, he may decide upon the various types of
services to be performed by the various types of distributors.
The larger is the number of services' to be performed by the
distributor concerned, the larger is the discount allowed to him,
and. vice versa. For example, a sewing machine manufacturer
might de£idethat the dealer will only display the various models
of the machine manufactured by the firm and settle the terms of
sale. The delivery and servicing of the machines may be given to
one distributor in the city. Naturally, in such a cast the discount
given to the dealer will be lower than in the case where he has to
stock the commodity and provide after-sales services as well.

• Distributors’ operating costs: Trade discounts should

naturally cover the operllting costs and the normal profits of the
distributors. In case of high margins, distributers would be
induced to make extra selling efforts. If margins do not cover
costs, the distributors concerned would not be interested in
pushing up the sale of the product. Sometimes distributors
belonging to the same category by name may be performing
widely diflcl'ing functions, Their operating cost is, therefore,
determined by the funel ions they perform, For example, if a
distributor is required to warehouse and ship the goods as and
when required by the actual users, he would require greater
discounts than a distributor who receives the consignments in
truckloads and merely reships them to the different actual users
without having to warehouse' them. Even when distributors are
pcrforming identical services, operating costs'may differ among
individual distrihutors depending upon variations in their
 operating efficiency. In such cases, the manufacturer has to
determine as to whose costs will he try to cover through trade
discounts. There are two possible alternatives: (I) the costs or
the most efficient two-thirds of the dealers plus normal profits, or
(2) an estimate of his own cost of performing the distribution
function. This is very oncn used when the manufacturer is
already engaged in some sort or distribution runction.

• Competitor’s discount structure: The discounts granted by

competitors arc usel'lII guides in framing the structure of
discounts. Their relevance becomes still greater when it is
realised that distributors' discounts are given in order to scek the
dealers' sales assist~nce in a, competitive market. In quite a
good number of trades, discount rates are fixed by custom and
manufacturers have no option but to fall in line. In many
industries, the actual discounts' granted by rival sellers vary. In
such a case, the manufacturer has to decide whether he should
be guided by the higher or the lower discounts. In case the
product of the manufacturer is' at some disadvantage in
consumer acceptance, he may decide to allow 'larger margins
than those of his competitors. The success of the policy,
however, would depend upon the following conditions: (a)
whether this high margin of discount merely, compensates for
the low turnover and whether the distributor gets any real
economic in~entive? (b) Whether the discount margin will be
adequate to induce the distributor to push the product? (c) How
much influence does the distributor have in pushing a particular
brand over that of the competitor? (d) Whether the dealer has
scope for profitable market segmentation and personal price
discrimination? And (e) Whether competitor are likely to meet
the wider discount margi varying their own? Thus, in general, the
success of a particular dis scheme requires that the consumers
are considerably indifferent to bl have great confidence in the
distributor and the manufacturers' IT share is so small that large
 competitors will not feel compelled to cI their own wider margins.
A related question is: should a lower p~i, offered to dealers who
handle a certain brand exclusively? Naturall exclusive dealer in
general will get a higher discount in addition to price advantage
arising from quantity discounts.

• Effect of discounts on distributors' population: Very often,

I discounts may be allowed to encourage the entry of new
distribute push up the sales of a new product line. Similarly,
smaller discounts In allowed when the number of distributors
has to be restricted.

• Costs of selling to different channels: There is asaving in

overheat selling to retailers as compared to consumers and· to
wholesalel compared to retailers and the regular system of
discounts has somethil do with this saving in overheads.

• Opportunities for market segmentation: Trade channel

discounts C2 used to achieve profitable market segmentation. In
some industries market is divided into several fairly distinct sub-
markets, each havin own peculiar competitive and demand
characteristics. For example, il tyre market, the following sub-
markets may be distinguished:
o Original equipment market characterised by skill and
bargai strength ofthe buyers and by big cyclicaJ
fluctuations in demand.
o Individual consumer replacement. Market characterise by
unskilled buying, brand preferences, and cyclical stability.
o Commercial operators' replacement market characterised
by I buyers who are price-wise and quality-wise, for
example, munic transport undertakings.
o Government sale in market characterised by large orders,
foil bids and publication of successful bidders' price.
o Export market characterised by international competition.
Each one of these sub-markets .has different elasticity of,
demand. There! The need to charge different prices in each market
segment arises from difference in the elasticities of demand in these
submarkets. The disc (structure can be so devised as to produce the
relevant differential prices suitable for each market segment. For
example, in the case of original equipment market, price has little
influence on the total number of tyres purchased because the price of
the tyrespaid by automobile manufacturers would form very small
percentage of the wholesale price of the car, say, less than 5 per
cent. As such, no feasible reduction in tyre prices would affect cat
prices enough to increase perceptibly the demand for cars and hence
of tyres. Very often, while pricing a product which is to be used as a
component of the finished product of another manufacturer, e.g.,
pricing of spark plugs or tyres, their manufacturers may be
influenced by such considerations as earning prestige through
associating the component with the finished product, getting
replacement business if the product is used as a component with
some well-known product, etc. Hence, while selling the component
product to the manufacturer of finished product; lower prices and for
that purpose higher discounts may be allowed. In case of individual
consumer replacement market, i.e., where buyers are consumers
demanding the product for replacement. The level of price affects the
timing of the demand within fairly regroups limits set by the age of
the product, say tyre. Here because of brand preferences, buyers'
responsiveness to price differences is lower than in other markets
where buyers' knowledge is greater.
Another pricing problem relating to individual consumer
replacement market arises because the manufacturer has to decide
whether to allow high discounts as to permit dealers to make-
individual concessions to customers. Here, a dealer can charge full
price from some customers who are averse to shopping and
bargaining but quite substantially lower prices to more careful and·
bargaining type of customers. Thus, allowing high discounts to
dealers provides them sufficient leeway to charge higher or lower
prices from their own customers according to their demand elasticity.
It is normally appropriate to allow the dealer large discounts and
thereby considerable latitude where the unit cost of the article is
high, where service concessions and trade-ins are provided to the
customers by way of veiled price concessions and where the
customer is not tied strictly to the dealer by continuity of service or
by customer relations.
A related pricing problem of the manufacturer is to decide
whether different distributor margins should be fixed for high-quality
high-price commodities, on the one hand, and low-quality low-price
products, on the other. The manufacturer has to consider whether he'
is to concentrate more on high quality or on low quality products in
view of their respective profitability. Market segmentation achieved
through differential distributors' discounts enables building big plants'
to reap economies of size. Manufacturers have sometimes built
bigger plants and to work them to full capacity, they have taken up
private label business (manufacturing _ goods to order with private
and exclusive brarids), allowing greater discounts till their own brand
becomes sufficiently popular and its demand increases sufficiently to
work the big plant fully. If so, they can discontinue the private label
business.

Distributors' demand elasticity higher than that of

consumers:
Distributors' demand for the competing brand of different
manufacturers is more elastic than the corresponding demand of
final consumers. The distributor is generally more capable of judging
price and quality than ultimate consumers who have insufficient
knowledge of the competing brands, and apprehend that a low price
may be synonymous with inferior quality. The consumer finds it
difficult to choose between different competing brands, and he often
allows himself to be guided by the retailers. It may be safely
asserted that even the smallest difference in price may cause a
dealer to switch over from one brand to another whereas an even
greater price change might not cause any reaction on the ultimate
consumers. It is, therefore, of decisive importance to the
manufacturers that they secure the goodwill of the distributors. In.
fact, the distributors' potential selling power is great and the
manufacturers should try to gain their promotional support.
However, in the case of a few highly advertised branded products,
which occupy a firm's position in the minds of the consumers,
distributors have to be content with very small margins. For example,
the retailer's margin in a 5-kilo Dalda tin comes to 1.5 per cent only.
It would be better for a manufacturer to adopt a standard discount
policy. With latitude in discount policy, there is much danger of
confusion, inequity, loss of goodwill and loss of sales. It may also be
noted that distributor discounts do not matter much in industrial
goods.

Quantity Discounts

Quantity discounts are price reductions related to the quantities

purchased. Quantity discounts may take several forms and may be
related to the size of the order being measured in terms of physical
units of a particular commodity. This is practicable where the
commodities are homogeneous or identical in nature, or where they
may be measured in terms of truckloads. However, this method is not
possible in case of heterogeneous commodities, which are hard to
add in terms of physical units, or truckloads. Drug industry and textile
industry offers examples of this type. Here, quantity discounts are
based upon the rupee value of the quantity ordered. Rupee becomes
a common denominator of value.

Quantity discounts based on physical units become important

where the cost of packing is a significant factor and orders of less
than standard quantities, say, less than a case of 6 pressure cookers,
may involve higher packing charges per cooker. Since the space
remains unutilised, the quantity discounts may be employed to
induce full-case purchasing. In some cases, sellers may clearly
mention that packing charges will be the same whether you purchase
a full case or less than a full case. Here also, the buyer may like to go
for a full case and in essence avail himself of the quantity discounts.
Discounts based on physical units are less likely to be distorted by
changes in prices.

In some cases, to prompt large orders, it may he specified that

orders up to a certain size will not be entitled to any discount. But
beyond this size, the customer would be entitled to a discount for his
extra purchases over and above the minimum size. The discount
rates may vary with successive slabs of quantities ordered.
Alternatively, discount may be allowed on the entire purchases
provided they exceed a certain minimum. In some cases, quantity
discounts mflY be based on the cumulative purchases made during
the particular period, usually at year or a. season, e.g., Diwali
discounts may be given on the basis of cumulative purchases made
during the Diwali season spread over September to Novembe'r. This
is different from quantity discounts based upon individual lots
ordered at a time. These discountS ensure customer loyalty and
discourage purchasing from several competitors simultaneously, but
the limitation of cumulative discounts is that, they do not tackle the
problem of high cost of servicing small orders, because, buyers get
no incentive to order for bigger lots and to avoid hand-to-mouth
purchasing. Buyers may be inclined to place larger orders towards
the end of the discount period to qualify for higher discounts. This
may disrupt the production schedule of the manufacture .
The following genital conclusions can be reached:

• Individual order size is a' better basis than cumulative

purchases made during a particular period.

• Discounts based on the quantity of individual commodities

ordered have advantages over those based on the total size of
mixed commodities ordered.

• Physical units are preferable to rupee value as a measure of

 order size on which to base quantity discounts.

Objectives of Quantity Discounts

One important objective of quuntity discountS' is to reduce the

number of small orders and thereby avoid the high cost of servicing
them. Quantity discounts can facilitate economic size orders in three
ways:

• A given set of customers is encouraged tbbuy the same

quantity batiste bigger lots.
• The customers may be 'induced to give the seller a larger: ihare
of their total requirements by giving preference over,
competitors.

• Small size purchasers may be discouraged and bigger size

customers may' be attracted.
Quantity discount system enables the dealer to reap
economies of buying in lager lots. These economies may enable the
dealer to charge lowler prices from the customers thereby benefiting
the customers. Finally, lower prices to customers may increase the
demand for the commodities, which in turn may enable the dealer to
purchase larger quantities, reaping still greater discounts, and the
manufacturer to reap economies of large-scale production, The
advantages to the manufacturer, dealer and customer are as such
circular. In fact, in many cases discounts become a matter of trade
custom.
A noted disadvantage of quantity discounts is that dealers may
often find it cheaper to purchase from wholesalers availing
themselves of these quantity , discounts than from the manufacturer
directly. This is because the wholesalers may pass on some of their
discounts to the dealers. This may ultimately affect the image of the
manufacturer in the minds of the dealers. Again, if the seller
becomes dependent upon a few buyers, they may be able to dictate,
his policies ap.d practices. But if his product is sufficiently
differentiated or his service' is unique, he may find it possible and
worthwhile to pursue an independent discount policy. Quantity
discounts are most useful in the marketing of materials and Applies
but are rarely used for marketing equipment and components.
Quantity discounts have attracted the attention of the Monopolies
and Restrictive Trade Practices Commission. The Commission
conceded the claim of Reckitt and Coleman of India Ltd., that it was
entitled to gateway under Section, 38(1) (h) of tlie Act in respect of
discounts given on larger orders. It was held that the Company’s
price structure did not directly or indirectly restricts competition to
any material degree. However, some time later, the Commission
extnicted an assutance from the five manufacturers of grinding
wheels that they would give up the practice of discounts based on
the quantity. Their practice of pricing on ‘slab’ Basis' was alleged to
give advantage to buyers of larger quantities compared to Players of
smaller quantities.

Cash Discounts
Cash discounts are price reductions based on promptness of
payment. An example of discount can be "2 per yent off if paid in ten
days, full invoice price in 30 days." In practice, the size of cash
discount may vary widely. Cash discount is a convenient device to
identify and overcome bad credit risks. In certain trades where credit
risk is high, cash discount would be high. If a buyer decides to
purchase goods on credit, this reflects his weak bargaining position,
and he has to pay a higher price by forgoing the cash discount.
There is another way to look at cash dis.counts. Though cash
discounts encourage prompt payment, yet allowing of cash discount
also involves certain costs.
These costs have to be compared with the cost of carrying the
account, viz., locking up of working capital, expense of operating a
credit and collection department- and risk of bad debts and
alternative ways of attaining prompt settlements. By prompt
collections, manufacturers reduce their working capital requirements
and thus save their interest costs. However, allowing discounts may
involve paying 36.5 per cent in order to save 15 per cent. Thus it is
the reduction in collection expenses and in risks rather than savings
on interest, which should be the guiding consideration for cash·
discounts. The main point of distinction between cash discounts and
quantity discounts is that the former are price reductions based on
promptness ·of payment whereas the latter are price reductions
depending on the quantities purchased (physical units or rupee value
of the quantity purchased). As such, cash discounts induce prompt
payments or collections whereas quantity discounts induce buying in
large quantities.

Time Differentials
Charging different prices on the basis of time is another kind of price
discrimination. Here the objective of the seller is to take advantage of
the fact that buyer' demand elasticity varies over time. Two broad
types of time differentials may be distinguished:
• Clock-time differentials,
• Calendar-time differentials.
Clock-time Differentials: When different prices are charged for
the sMne service or commodity at different times within a 24 hours
period, the price differentials are known as clock-time differentials.
The common examples of these are the differences between the day
and night rates on trunk calls, differences between morning and
regular shows in cinema houses, and different tates charged' for
electricity sold to industrial users during peak load hours (day time)
and offpeak load hours. In the case of telephone services, day timing
is the period of more inelastic demand and the night time is the more
elastic demand period. Two conditions, which make the clock-time
differentials profitable are as follows:

• Buyers must have a definite and strong preference for

 purchasing at certain timings over others giving rise to
significant differences in demand elasticity.

• The product or service must be non-storable either wholly or in

parts, i.e., the buyer must consume the entire product at one
time when and for which he pays. In case the product is storable,
it will be purchased at lower rates to be used later when needed
making price differential a losing proposition.
Calendar-time Differentials: Here price differences are
based on a period longer than 24 hours; for example, seasonal price
variations in the case of winter clothing's, or betel accommodation at
hill and tourist stations. Here, the objective is also to exploit the time
preferences of the buyers.

Geographical Price Differentials

Geographical price differentials refer to price differentials based on
buyers location. The objective here again is to minimise the
differences in transport costs due to the varying distances between
the locations of the plants and the customers. There are various
types of geographical price differential, which are explained below:

FOB factory pricing: It implies that the buyer pays all the
freight and is responsible for the risks occurring during transport
except those that are assumed by the carrier. The advantages of
FOB factory pricing are as follows:

• It assures u uniform net price on nIl shipments regardless of

where they go.

• No risk is assumed by the seller.

• The seller is not responsible for delay in carriage.

Postage stamp pricing: Postage stamp pric1rg means charging

the same delivered price for all destinations irrespective of buyers'
location. The quoted price naturally includes the estimated average
transportation costs. In effect, these prices become discriminatory,
that the short distance buyers have to pay more for transportation
than the actual costs involved while long distance buyers have to pay
less than the actual costs of transporting goods. Postage stamp
pricing is most Hnmonly employed for goods of popular brands and
having nation wide distribution. The basic idea is to maintain a
uniform retail price at all places. This common retail price can also be
advertised throughout the country. Bata footwears provide the best
example of postage stamp pricing other examples are Usha sewing
machines and fans, radios, pressure cookers, typewriters, drugs and
medicines, newspapers and magazines, etc.,
Postage stamp pricing is most suitable in case of products
where transportation costs are significant. It can also be used with
advantage by manufacturers to avoid the disadvantage of location
being far away from the main customers who if charged on the basis
of actual costs might have to pay much more and hence refrain from
purchasing. This advantage is particularly striking in the case of
products involving high transportation costs. This pricing gives a
manufacturer access to all markets regardless of his location. Market
access is particularly important when products of the rivals are
substantially the same.
Zone pricing: Under zone pricing, the seller divides the
country into zones and regions and charges the same delivered price
within each zone, but different prices between different zones. For
example, Parle Company has divided the country into 9 zones, the
intra-regional price differentials ranging between 5 and 15 per cent
approximately. Generally speaking, zone pricing is preferred where
the transportation cost on goods is too high to permit their sale
throughout the country at uniform price. The more significant the
transportation costs, the greater the number of zones and smaller
their size. Conversely, for product involving lower transportation
costs, zones are generally few but big in size. In India, zone pricing
has been widely used invanaspati and sugar industries.
Basing point pricing a basing point price consists of a factory price
plus transportation charges calculated with reference to a particular
basing point. Under this system, the delivered price may be
computed by using either single basing point or multiple basing
points. In the single basing point system, all sellers (irrespective of
the locations) quote delivered prices, which arc the sum of the basing
point price and cost of transport from the basing point to the
particular point of delivery. Thus, the delivered prices quoted by all
sellers for a given point of delivey are uniform regardless of the point
from which delivery is made. In the multiple point pricing system, two
or more producing centres are selected as basing points, and the
seller then quotes a delivered price equal to the factory price plus
transportation costs from the basing point nearest to the buyer.
Rasing-point pricing has been widely used in the USA, especially in
the steel industry where at first the single basing-point system known
as Pitts burgh plus was employed. It was followed by mulliple basing
point pricing when Pittsburgh plus was declared illegal.

Consumer Category Price Differentials

Price discrimination is frequently practised according to consumer
categories in the case of public utilities, for examples, electricity,
transportation, etc. Electricity firms quote different rates for
residential consumers and industrial consumers. The rates may also
differ for domestic power, light and fan. Railways also charge
differently from children to adults. They also charge differently -on
different classes of goods and different classes of passengers.

Personal Price Discrimination

Price concessions are commonly made to individuals at times for
personal considerations. For instance, special prices may be given to
companies own employees, shareholders or personal acquaintances.
These special prices may take several forms such as additional
services free of cost, leniency in fixation of prices for used goods in
exchange of new ones and extending credit, interest-free credit.

REVIEW QUESTIONS
1. Explain with illustration the distinction between the following:
A. Fixed cost and variable costs
B. Acquisition cost and opportunity cost.
2. What is opportunity cost? Give some examples. How are these
costs relevant for managerial decisions?
3. When MC changes, AC changes (a) at the sane rate, (b) as a
higher rate, or (c) at a lower rate? Illustrate your answer with
the help of diagrams.

4. Explain the relationship between marginal cost, average cost,

and total cost.
5. Distinguish between the following:
A. Marginal cost rind incremental cost;
B. Business cost and full cost;
C. Actual cost and imputed cost;
D. Private cost and social cost of private business.
6. Discuss the various economies or scale. Also discuss Sargent
Florence's principles in this regard.
7. "Economics of scale may be either external or internal; they
may
be technical, managerial, financial or risk-bearing." Elucidate.
8. Discuss the various economies of scale. Do they result in
monopolies?
9. What are the advantages and limitations of large-scale
production?
10. State the importance of cost control in profit planning
and
discuss the various areas of cost control.
11. Distinguish between cost control and cost reduction.
What are
the essentials for the succcss of a cost reduction programmc?
 LESSON – 4
PRODUCTION FUNCTION

The term "production function" refers to the relationship between

inputs used and outputs produced by a firm. The terms "factors of
production" and "resources" are used interchangeably with the term
"inputs". The relationship is purely physical or technological in
character and therefore it ignores the prices of inputs and outputs.
The study of the production function is aimed at achieving the
maximum output. This can be done with a given set of resources or
inputs, and with a given state of technology. The production function
can be expressed in the form of a schedule. Table 4.1 shows two
inputs viz; labour [X], i.e., number of workers, and capital [Y], i;e.,
size of machine in terms of horsepower, and one output (Q), i.e., the
number of tonnes of iron produced with the various combinations of
inputs.
Table 4.1: Production Function

Capital (Y) - Size of machines (in horse power)

250 1,000 1,500 2,000
Labour (X) 1 2 20 32 26
(Number of 2 4 48 58 88
workers) 3 8 88 110 100
4 12 110 120 110
5 32 120 124 120
6 58 124 126 124
7 88 126 128 128
8 100 126 130 130
9 110 126 130 132
10 104 124 130 134

The production function can also be stated in a form of an

eqation:
Q = f (X1, X2, etc.),
Where Q = A function ofthedesired output as a result of utili sing
the quantity of two or more inputs
Xl = units of labour,
 X2 = units of machinery.
Some factors of production are assumed to be fixed (i.e., not
varying with changes in output); and hence are not included in the
equation. The production function is estimated by the method of least
squares.
In economic theory, we are concerned with three types of
production functions, viz.,
• Production function with one variable input.
• Production function with two variable inputs.
• Production function with all variable inputs.

PROPUCTION FUNCTION WITH ONE VARIABLE INPUT

In economics, the production function with one variable input is

explained with the help of'Law of Variable Proportions', which is as
follows:

Law of Variable Proportions

The law of variable proportion is one of the fundamental laws of
economics. It is also known as the 'Law of Diminishing Marginal
Returns' or the 'Law of Diminishing Marginal Productivity.' This Law of
variable proportion shows the input-outPut relationship or production
function with one variable factor, i.e., a factor, which can be changed,
while other factors of production are kept constant. This is explained
with the help of the following example:
Suppose a farmer has 20 acres of land to cultivate. The land
has some fixed investment, Le., capital in the form of a tube well,
farmhouse and farm maehinery. The amount of land and capital is
supposed to be fixed factors of production. However, the farmer can
vary the number of workers employed on its land. Labour is thus the
variable factor of production. The change in the number of workers
will change the output.

The point worth noting here is that the law does not state that
each and every increase in the amount of the variable factor that is
employed in the production process will yield diminishing marginal
returns. It is, however, possible that preliminary increases in the
amount of a variable factor may yield increasing marginal returns.
While increasing the amount of the variable factor, a point will " be
reached though, where the; marginal increases in total output or the
marginal retums will begin declining.

Assumptions for Law of Variable Proportions

The law of variable proportions functions is based on following
assumptions:

• Constant technology: The technology is assumed to be

constant because technological changes will result into rise of
marginal and average product.

• Snort-run: The law operates in the short-run because it is here

that some factors are fixed and others are variable. In the long-
run, all factors are variable.

• Homogeneous input: The variable input employed is

homogeneous or identical in amount and quality.

• Use of varying amount of variable factor: It is possible to

use various amounts of a variable factor on the fixed factors of
production.

Three Stages of Production

A graphic description of the production function is shown in following
figure 4.1. The total, marginal and average product curves in Figure
4.1, demonstrates the law of variable proportions. The figure also
shows three stages of production associated with law of variable
proportions. The total product curve is divided info three segments
popularly known as three stages of production, which are as follows:
Stage I
The figure 4.1 shows stage 1 as the segment from the origin to
pointX2. Here, total product (TP) rises at an increasing rate. At this
point, the marginal product (MP) of X equals its average product (AP).
X2 is, also the point at which the average product is maximised. In
this stage, the production function is characterised first by increasing
marginal returns from the origin to point X1and then by diminishing
marginal returns, from X1to X2. It should not be assumed that in stage
1, only increasing marginal returns take place. Because increasing
returns may occur until a certain point, and thereafter diminishing
returns may take place. Stage I should not therefore be identified
with increasing marginal returns only. Here, both AP and MP increase.
In this stage, a firm can move towards optimum combination of
factors of production and increasing returns, by adding more and
more variable units to fixed factors.

Stage II
The stage II is depicted by the figure in the range from X2 to X3. In
othcr words, stage II begins where the average product of the
variable factor is maximised. It continues till the point at which total
product is maximised and marginal product is zero. Here, TP rises at
diminishing rate. This stage is thus, called the stage of diminishing
returns, where a firm decides its level of production.

Stage III
Finally, we have stage III, which is depicted by the area beyond X3
where the total product curve starts decreasing. Here, too much
variable input is being used as related to the available fixed inputs
and thus variable inputs' are overutilized. The efficiency of both
variable inputs and fixed inputs decline through out this stage. In this
range, the marginal product of the variable factor is negative. It
starts from the point where MP is nil and TP is maximum and covers
the whole range of negative marginal productivity. The following
Table 4.2 shows the various stages.

Table 4.2: Stages of Production

Total Physical Product Marginal Physical Average Physical
Product Product
Stage I
Increasing at an Increases, reaches its Increases and reaches
increasing rate maxiIhum and then its maximum
declines till MR = AP
Stage II
Increases at diminishing Is diminishing and Starts diminishing
rate till it reaches becomes equal to
maximum
Stage III
Starts declining Becomes negative Continues to decline
From this stage-wise description of the production function we
can reach two conclusions, which are as follows:

Stage II is Rational
Only stage II is rational and denotes the relevant range-within which a
rationai firm should operate. In Stage I, it is profitable for the fiim to
keep on increasing the use of labour and in Stage, III, MP is negative
and hence it is inadvisable to use additional labour. The firm,
therefore, has a strong incentive to expand through Stage I into
Stage II.

Stages I and /II are Irrational

Stages I and III are described as irrational stages. They are called so
because management, if it is to maxi mise profits will never
intentionally apply the variable to the fixed factors in any
combination, which will yield a total product falling in either of these
two stages.

PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

To understand a production function with two variable inputs, it is
necessary to explain what is an ' Isoquant'.

Isoquants
An isoquant is also known as an 'iso-product curve', 'equal product
curve' or a 'production indifferent curve'. These curves show the
various combinations of two variable inputs resulting in the same
level of output. Table 4.3 shows how different pairs of labour and
capital result in the same output.

Table 4.3: Different Pairs of Labour and Capital

Labour Capital Output

(Units) (Units) (Units)
I 5 10
2 3 10
3 2 10
4 1 10
5 0 10

It is evident that output is the same either when 4 units of

labour with 1 unit of capital or 5 units of labour with 0 units of capital
are employed. This relationship, when shown graphically results in an
isoquant. Thus, by graphing a production function with two variable
inputs, one can derive the isoquant that helps in tracing all the
combinations of the two factors of production that yield the same
output. Thus, an isoquant can be defined as "the curve passing
through the plotted points representing all the combinations of the
two factors of production, which will produce the given output."
Figure 4.2 depicts a typical isoquant digram in which by an upward
movement to the right, one can obtain higher levels of outputs, using
larger quantities of output. For each level of output, there will be
different isoquant. When the whole array of isoquants is represented
on a graph, it is called 'isoquant map'.

Substitutability of Inputs
An important assumption regarding the isoquant diagram is that the
inputs can be substituted for each other. For example a particular
combination of X and Y results in output quantity of 600 units. By
moving along the isoquant 600, one finds other quantities of the
inputs resulting in the same output. Let us suppose that X
represents labour and Y represents machinery. If the quantity of the
labour (X) is reduced, the quantity of machinery (Y) must be
increased in order to produce the same output. The following Figure
4.2 shows a typical isoquant.
Marginal Rate of Technical Substitution (MRTS)
The slope of the isoquant has a technical name; Marginal Rate of
Technical Substitution (MRTS) or sometimes, the marginal rate of
substitution in prodtltioti.) Thus, in terms of inputs of capital
services K and Labour L.
MRTS = aK/dL
MRTS is similar to MRS, I.e., Marginal Rate of Substitution, (which
is slope, of an indifference curve).

Types of Isoquants
Isoquants assume different shapes depending upon the degree of
substitutability of inputs under consideration. Based on this the
types of isoquants can be enlisted as follows:
• Linear Isoquants: In the case of linearisoquants, there is
perfect substitutability of inputs. For example, a given output say 100
units can be produced by using only capital or only labour or by a
number of combinations of labour and capital, say 1 unit of labour
and 5 units of capital, or 2 units of labour and 3 units of capital, and
so on. Likewise, a giyen power plant that is equipped to burn either
oil or gas, for producing various amounts of electric power can do so
by burning either gas or oil, or varying amounts of each. Gas and oil
are perfect substitutes here. Hence, the isoquants are straight lines.
The following Figure 4.3 shows the isoquant for oil and gas.

• Right Angle Isoquant: When there is complete non-

substitutability between the inputs (or strict complimentarily) then
the isoquant curves take the form of right angle isoquants. For
example, exactly two wheels and one frame are required to produce
a bicycle and in no way can wheels be substituted for frames or vice-
versa. Likewise, two wheels and one chassis (The rectangular, steel
frame, supported on springs and attached to the axles, that holds
thepody and motor of an automotive vehicle) are required for
acooter. This is also known as 'Leontief Isoquant' or Input-output
isoquant. The following Figure 4.4 shows the isoquant for chasis and
wheels.

• Convex Isoquant: This form of isoquants assumes

substitutability of inputs but the substitutability is not perfect. For
example, in Figure. 4.5 a shirt can be made with relatively small
amount of labour (L1) and a large amount of cloth (C1). The same shirt
can be as well made with less cloth (C2), if more, labour (L2) is used
because the tailor will have to cut the cloth more carefully and
reduce wastage. Finally, the shirt can be made with still less cloth
(C3) but the tailor must take extreme pains" so that JabourinpiJt
requirement increases to C3. So, while a relatively small addition of
labour from L1 to L2 allows the input of cloth to be reduced from C1 to
C2, a very large increase in labour from L2 to L3 is needed to obtain a
small reduction in cloth from C2 to C3. Thus the substitutability of
labour for cloth diminishes from L1 to L2 to L3. The following Figure 4.5
shows isoquant for cloth and labour.

Main Properties of Isoquants

All the above-mentioned isoquants are featured with some common

properties, which are as follows:

• An isoquant is downward sloping to the right, i.e., negatively

inclined. This implies that for the same level of output, the quantity
of one variable will have to be reduced in order to increase the
quantity of other variable.

• A higher isoquant represents larger output. Jhat is, with the

same quantity, of one input and larger quantity of the other input,
larger output will be produced.

• No two isoquants intersect or touch each other. If two

isoqua~tsinter.seCt or touch each other, this would mean that there
will be a common point the Two curves; and this would imply that
the 'same amount of two inputs could produce two different levels of
output (i.e., 400 and 500 units), which is absurd.

• Isoquant is convex to the origin. This means that its slope

declines from left to right along the curve. In other words, when we
go on increasing the quantity of one input say labour by reducing
that quantity of other input say capital, we see that less units of
capital are sacrificed for the additional units of labour.

PRODUCTION FUNCTIONS WITH ALL VARIABLE INPUTS

A closely related question in production .economics is how a

proportionate increase in all the input factors will affect total
production. This is the question of returns to scale, which brings to
mind three possible situations:

• If the proportional increase in all inputs is equal to the

proportional increase in output, returns to scale are constant.
For instance, if a simultaneous doubling of all inputs results in a
doubling of production then returns to scale are constant. The
following figure 4.6 shows a constant rate to scale.

• If the proportional increase in output is larger than that of the

inputs, then we have increasing returns to scale. The following
Figure 4.7 shows increasing returns to scale.
 • If output increases less than proprotionally with input increase,
we have decreasing returns to scale. The following Figure 4.8
shows decreasing returns to scale.

The most typical situation is for a productin function to have

first increasing then decreasing returns to scale is shown in Figure
4.9.
 The increasing returns to scale attribute to specialisation. As
output increases, specialised labour can be used and efficient, large-
scale machinery can be employed in the production process. However
beyond some scale of operations further gains from specialisation are
limited, and co-ordination problems may begin to increase costs
substantially. When co-ordination price is more than offset additional
benefits of specialisation, decreasing returns to scale begin.

Returns to Scale and Returns to an Input

Two important features of production functions are returns to scale

and returns to input, which are explained as follows:
Returns to scale: These describe the impact on the output
when the same proportion increases each input rate. If output
increases by a larger percentage than the increase in each input then
there are increasing returns to scale. Conversely, if output increases
by a smaller percentage, there are diminishing returns to scale and if
it increases by the same proportions there are constant returns to
scale.
Returns to input: These describe the impact on the output
when only one input is varied, holding all others constant. These
returns may be increasing,' diminishing, or constant.
Optimal Input Combinations
From the overall discussion so far itisobvious that production
function, has a pure 'physical or technological' character. However, it
does not tell which input combinations are optimal. For that purpose,
one has to take into account the input prices. The following Figure
4.10 shows the iscost curves.

Isocost Curves
In this connection, one has to consider yet another but important
diagram consisting of isocost curves. Here also, the axes represent
quantities of the inputs X and Y. Suppose that the prices of the inputs
are given, and there are no quantity discounts for the firm to get
larger quantities at lower prices. The next step will be to plot the
various quantities of X and Y which may be obtained from the given
monetary outlays. Figure 4.10 shows the resulting isocost curyes,
which are straight lines under the assumption made here. One isocost
showing the quantities of X and Y that can be purchased for Rs. 1,000
and another isocost curve showing the quantities of X and Y which
can be purchased for an expenditure of Rs. 2,000 and so on.
Now we can easily superimpose the isocost diagram on the
isoquant diagram (as the axes in both the cases represent the same
variables). With the help of Figure 4.11, it can be ascertained that the
maximum output for a given outlay, is say Rs. 2,000. The isoquant
tangent represents this maximum output, which is possible with this
outlay, to the isocost curve. The optimum combination of inputs is
represented by point E, the point of tangency. At this point, the
marginal rate6f substitution (MRS, sometimes known as the rate of
technical substitution), between the inputs is equal to the ratio
between the prices of the inputs.
Likewise, in order to mini mise the cost for a given output, one
may again refer to the isoquant and isocost curves in Figure 4.11. In
this case one moves along the isoquant representing the desired
output. It should be clear that the minimum cost for this input is
represented by isocost line tangent to the isoquant.

Firm's Expansion Path

A firm's expansion path is defined by the cost-minimising
combination of several inputs for each output level. Thus the line
representing least cost combination for different levels of output is
called firm's expansion path or the scale line shown by line ABC in
Figure 4.12.
MEASUREMENT OF PRODUCTION FUNCTION

Several types of mathematical functions are commonly used for

measuring production function but in applied research, four types are
used extensively. These are linear functions, power functions,
quadratic functions and cubic functions.

(1) Linear Function

A linear production function is expressed as follows:
Total product: Y = a + bX, where Y = output and X = input. From
this function, equation for average product will be
Y/X=a/X+b
The equation for the marginal product will
be Y/X = b

(2) Power Function

A power function expresses output, Y, as a function of input X in the
form:
Y = aXb
Some important distinctive properties of such power functions are:

• The exponents are the elasticities of production. Thus, in the

above function, the exponent 'b' represents the elasticity of
production.

• The equation is linear in the logarithms, that is, it can be written

 as: log Y = log a + b log X
When the power function is expressed in logarithmic form as
above, the coefficient represents the elasticity of production.

• If one input is increased while all others are held constant,

marginal product will decline.

(3) Quadratic ProductionFunction

The production function may be quadratic and is expressed as
follows:
Y = a + bX = cX2
Where the dependent variable, Y, represents total output and the
independent variable, X, denotes input. The small letters are
parameters and their probable values are determined by a statistical
analysis ofthe data.
The distinctive properties of the quadratic production function are
as follows:
• The minus sign in the last term denotes diminishing marginal
returns.

• The equation allows for decreasing marginal product but not for
both inerellsing and decreasing marginal products.
• The elasticity of production is not constant at all points along
the curve as in a power function, but declineswiih input
magnitude.
• The equaItion never allows fotan increasing marginal product

When X = 0, Y = a, this means that there is some output even

when no variable input is applied.
• The quadratic equation has only one bend as compared with a
linear equation, which has no bends.

(4) Cubic Production Function

The cubic production [unction is expressed as follows:
Y = a -I- bX -I- cX2 – dX3
Some important distinctivc properties of a cubic production
function arc as follows:
• It allows for both increasing and decreasing marginal
productivity.
• The elasticity of production varies at each point along the curve.
• Marginal productivity decreases at an increasing rate in the later
stages.

PRODUCTION FUNCTION AND EMPIRICAL STUDIES

The measurement of production function dates back to a century

when certain r pioneer studies were made in the field of agriculture.
And though economic concepts and statistical techniques have now
advanced a lot, its major work is still in agriculture.

Cobb-Douglas Function
A very popular production function, which deserves special mention,
is the CobbI Douglas function. It relates output in American
manufacturing industries from 1899 to 1922 to labour and capital
inputs, taking the form.
P = bLaC1 - a
Where,
P = Total output
L=Index of employment of labour in manufacturing
C = Index of fixed capital in manufacturing.
The exponents ‘a’ and ‘1 – a’ are the elasticity of production
that is, ‘a’ and ‘1- a’ measure the percentage rexsponse of output to
percentage changes in labour and capital respectively. The function
estimated for the USA by Cobb and Douglas is:
P = 1.01L.75C25
R2 = .94.09
This production function shows that a 1 per cent change in
labour input, with the capital remaining constant, is associated with a
0.75 per cent change in output. Similarly, a 1 per cent change in
capital, with the labour remaining constant, is associated with a 0.25
per cent change in output. The coefficient of determination (R2)
means that 94 per cent of the variations on the dependent variable
(P) were accounted for, by the variations in the independent variables
(L and C).
An inportant point to note is that the Cobb-Douglas function
indicates constant returns to scale. That is, if factors of production
are each increased by 1 per cent, the output will increase by 1 per
cent. In other words, one can assume constant avberage and
marginal production costs for the US industries during the period. The
following Figure 4.13 shows the graph of Cobb-Douglas production.

Criticism
• The production function ordianrily discussed in economics is a
rigorously developed micro-economic concept. However, Douglas and
his colleagues, estimated production function for nation’s economies
for manufacturing sectors and even for industries. Thus they
“transferred” strictly micro- economic concept to a macro-econornic
setting, without sufficiently justifying their act on logical economic
grounds. Therefore, the result of their studies, in the form of
equations which they derived, may be incorrect, and hence the
interpretations based on their equations are uncertain.

• The production function of economic theory assumes that the

quantities of inputs used are those that are actually used in
production. Therefore no variable input is ever redundant. In the
 Douglas studies however, only labour was measured by the
quantity actually used in production, while capital was
measured by the capital investment, i.e., the quantity available
for production. Therefore, with the possible' exception of the
years in which full employment and prosperity prevailed and
industry made reasonably fuil use of the available inputs, the
measure of capital employed was not theoretically correct one.
If annual capital input always remained as a constant proportion
of total capital investment, then only the elasticity would be the
same. In spite of this criticism, the Cobb-Douglas type of
production function has been found useful for interpreting
economic results, since the elasticity of production; is given
directly by the exponents when the data are in original form, or
by the regression coefficients when the data are in logarithmic
form.

MANAGERIAL USE OF PRODUCTION FUNCTIONS

Though production functions may seem to be highly abstract and

unrealistic, in fact, they are both logical and useful. If the price of a
factor of production declines whereas that of another goes up, the
former is likely to substitute the latter. The usefulness of the
production function can be explained with the help of an example,
dairy economists are interested in minimising the cost of feeding
cows in milk production. Taking a cow as a single firm, and grain and
roughage as inputs, the question arises: What proportion of grain and
roughage would be economical in feeding the cow? In the past, there
has been some tendency to prescribe a fixed ratio, but economic
analysis suggests that the optimal ratio depends on the inptlt prices.
For instance, if we draw isoquantsrelating various quantities of grain
and roughage, to various levels of milk output and then superimpose
isocost curves on the isoquant diagram, the optimum point of largest
output for a given outlay or of minimum outlay for a given output-
would depend on the prices of the factors of production, and it would
change as these prices change. The dairy farmer can use such
analysis for increasing the return from his expenditure on feeds.

Certain economists have focused especially on the application

of their findings. For instance, Earl Heady and his associates have
developed a mechaniclIl device known as Pork Postulator, which
facilitates the farmer to determine the most profitable ration for
feeding pigs under different price conditions.
Production functions thus are not just theoretical and futile
devices. They can also be used as aids in decision-making because
they can give guidance in two directions regarding:
• Obtainfng the maximum output from a given set of inputs
• Obtaining a given output from the minimum aggregation of
inputs
Of course, in more complex problems, with larger numbers of
inputs and outputs, the mathematics of optimisation becomes
complicated. But recently, the development of linear programming
has made it possible to handle these complex problems. The use of
complex production functions in managerial decisiull making is going
to be further facilitated with the development of electrollic
computers.

DERIVING INPUT COMBINATIONS FROM

PRODUCTION FUNCTION
Given a production function for a certain output, one can derive all
the combinations of the factors of production that will yield the same
output. This can be illustrated as follows:

IIIustration
Suppose the production function is:
0= 0.196 H 0.880 N 1.815
Where,
0= output oftransformers in terms of kilovolt-ampere (kVA)
produced
 H = average hours worked per day
N = number of men.
Now, to derive the input combinations for an output level of
1,200 kVA, we will have to set the above equation equal to 1,200:
1,200 = 0.196 H 0.880 N 1.815
Then, substituting any value of H (or N) in the equation, we can
obtain the associated value of N (or H). We compute below the
number of hours required (H) for an output of 1,200 kVA, if 38 men
are employed.

1,200 = 0.196 H 0.880 N 1.815

log 1,200 = log 0.196 + 0.880 log H + 1.815 log N
= log 1,200 = log 0.196+ 0.880 log H + 1.815 log 38
In the same way, we can derive the value of H, if N is 40, 42, 44
and so on, if the desired output level is 1,200 KVA. We can also derive
various combinations ofH and N for other levels, say, 1,300 KVA or
1,400 KVA.

PRICE AND OUTPUT DECISION UNDER

VARIOUS MARKET SITUATIONS
To understand the concept of market and its various conditions, it is
necessary to study the thcory orthe firm. This is discussed as follows:

The Theory of the Firm

The basic, assumptions of the theory of the linn are as follows:
• The objective of a firm is to maximise net revenue in the face
of given prices and technologically determined production function.
• A price incrcase far a product raises its supply, whereas prices
increase for a factor reduccs its demand.
• The theory or lhe firm deals with the role of business firms in
the resource allocation process. It uses aggregation as a tactic and
attempts to specify total market supply and demand curves.
• The firm operates with perfect knowledge of all relevant
variable involved in making a decision and it acts rationally while
doing so.
• Originally the theory assumed that the firm is operating within
a perfectly competitive market. But it has now been extended to
cover other market situutions.
The theory has been criticised in the context that profit
maximisation is not the only objective of a firm. It has been
suggested that long-run survival is the primary motive of an
entrepreneur. Though the importance of profit has not been denied,
many economists have argued that profit maximisation should be
replaced with a gonl of makll1g satisfactory profits. However, there is
a general agreement that the theory or the firm explains at a general
level, the way in which resources are alloclIted by the price system,
when profit is the main criterion used by the firms.

From the viewpoint of price analysis, it is very important for

business management to gain a proper understanding of the nature
and process of competition in the modem industrial society. The
management should undcrstllnd the rationale of the free enterprise
system within which its own business decisions have to be made and
the purpose and limitations of that system. Next it musl hnve full
knowledge of the markets and market situations in which its own
business operates. It should be aware of the policies appropriate to
those market situations. The management should also have an
understanding of the competitive process and the way variables
involved in the process such as price; product innovnt ion and
promotional activity may be manipulated in enlarging the firm's
market share. The firms having monopoly power should be familiar
with the nature and llie purpose of the law relating to monopoly and
restrictive practices. The management must also be alert and should
be able to recognise when market conditions change. Experienced
executiv.es cannot gain the intimate knowledge of the ways or llicir
competitors. Consequently it is necessary to obtain, an understanding
of the nature of competition, which can provide an insight into the
probable behaviour pnlll'llls of the competitors. To study how prices
are determined the types of market situations need to be studied are
as follows:

• Perfect competition.

• Imperfect competition

o Monopoly and monopsony

o Monopolistic competition

o Oligopoly and oligopsony.

PURE AND PERFECT COMPETITION

Perfect competition is a market situation where large number of
buyers and scllns operate freely and commodity sells at a uniform
price. In such a situation no seller or buyer has any influence on the
market price. In this market, a firm is the price taker and industry is
the price maker.

Main Features
The main features of perfect competition are as follows:
• There are a large number of buyers and sellers. Each seller
must be small and the quantity supplied by any ne seller must
be so insignificant that no increase or decrease in his output
can appreciably affect the total supply and the market price.
So also, each buyer must be small and the quantity bought by
any of the buyers should be so insignificant that no increase
or decrease in his purchases can· appreciably affect the total
demand and the price. As a result, each seller will accept the
market price as it is. So also each buyer will regard the price
as determined by forces beyond his control.
• Each competitor offers a homogenous product, i.e. the
products are similar to ach other in terms of quality, size,
design and colour. Thus one product could be substituted for
the other if the price is lower. Again, the commodity dealt in
must be supplied in quantity.
 • There is no obstacle with regard to entry or exit of the firms.
When these aforesaid three conditions arc fulfilled there is a
market condition that can be defined as a pure competitive
market.
• The market iil which the commodity is bought and sold is well
organised and trading is continuous. Therefore, buyers and
sellers are well informed about the price of the commodities.
• There are many competitors (whether buyers or sellers), each
acting independently. There must be no restraint upon the
independence of any seller or buyer, either by custom,
contract, collusion, and fear of reprisals by the competitors, or
by the imposition of government control.
• The market price is flexible over a period of time. In other
words, it rises or falls constantly in response to the changing
conditions of supply and demand.
• All the firms have equal access to production technologies and
techniques.
• There are no patents, proprietary designs or special skills that
allow an individual firm to do the job better than its
competitors.
• Firms also have equal access to all their inputs, which are
available on similar terms.
Thus, perfect competition in an extreme case and is rarely to
be found. Actual competition always departs from the ideal of
perfection Perfect competition is a mere concept, a standard by
which to measure the varying degrees of imperfect competition.
Sometimes, a distinction is made between perfect competition
and pure I competition. But the line of distinction drawn between the
two is very fine. That is why many economists have preferred to use
the two terms synonymously. Hence, from managerial viewpoint,
there does not seem to be any difference between the two. The
underlying presumption in a free competition (close to perfect
cmpetition) is that it social interest interest unless the contrary can
be proved. Competition safeguards the consumer against exploitation
by providing the buyer with alternatives, and makes it unnecessary
for the state to intervene by regulating process and production in
order to protect him.

Determination of Price
The forces of demand and supply determine prices under perfect
competition. The equilibrium price is obtained at the intersection of
demand and supply curves as shown in following Figure 4.14. The
equilibrium price will change only with changes in forces of demand
and supply.

Price and Quantity Variability

Responses to a cnange in demand or to a change in supply may be
primarily in price or quantity. If the demand is highly elastic,
consumers will respond readily to price changes by dropping out of
the market when prices are lowered'a little. As a result, most of the
adjustments to changes in supply (an increase leading to a reduction
in price and a decrease leading to an increase.in price) would be
those in quantity purchased, if the demand is highly elastic. If the
demand is inelastic, the adjustments will take place primarily in price.
Similarly, if sellers respond readily by greatly increasing their
offerings on slight increases in price or by heavy withdrawals in slight
price drops, the adjustments to changes in demand willbe largely in
quantity exchanged. If sellers are quite responsive to, price in their
offerihgs (if supply is very inelastic), the adjustments to changes in
demand, will take place largely through shifts in price. In view of the
above explanation, 'we may state thefollowing rules:

• If demand rises then price goes up and vice versa. For example,
in Figure. 4.15, the demand curve shifts. upwards, to the right from
DD to D’D’ whereas the supply curve remains the same. As a result,
the price goes up from OP to OP1. Thus, the sales increase from OQ to
OQ1. If supply rises then the price decreases and vice versa. For
example, in Figure. 4.16, the supply curve shifts downward to the
right from SS to S’S’ while the demand curve remains unchanged.
The result is that price falls from OP to OP1. Dul the sales increase
from OQ to OQ1. The following Figures 4.15 and 4.16 shows shift in
demand curve and shift in supply curve due to increase in price,
respectively.

Given a shin in the demand curve the following can occur:

• Price will rise less or falllcss if the supply curve is elastic (flat)
• Price will rise more or fall more if the supply curve is inelastic
(steep)
• If the rise in price is more than the rise in sales will be less
• If the rise in price is less than the rise in sales will be more
For example, in Figure 4.17, the demand eurve shifts from DD to
D’D’.
 The supply curve S"S" is steep. Another supply curve S'S' is
rather flat. Both the supply curves cut the original demand curve at
point E giving the equilibrium prices as OP. The flat supply curve S'S'
cuts the new demand curve D'D' at E2 giving the equilibrium price as
OP2, which is less than OP1 and more than OP.

• In the same way the following will occur when there is a shift in
the supply curve

o The price will rise less or fall less if demand curve is elastic

o The price will rise more or fall more if demand curve is inelastic.

For example, in Figure 4.18, SS is the original supply curve, S'S'

is the new supply curve, D'D' is the steep demand curve (indicating
relatively inelastic demand) and D”D” is the flat curve intersecting
the supply curve at point E. After the shift in the supply curve,
however, the S'S' cuts the D'D' curve at point E' giving OP' as the
equilibrium price. But the SS curve cuts the D"D" curve at point E
giving the equilibrium price as OP which is higher than OP'.

• If both demand and supply increase, sales are bound to increase

but the price mayor may not increase. In this case there case can be
two possibilities

o Price will rise if the amount, which will be demandedattheold price

exceeds the supply, which will be made at that old price as shown in
Figure 4.19.
o But the price will fall if the amount, which will be supplied
at the old price, is more than the amount demanded currently at that
price as shown in Figure 4.20. In other words, if at the old price, new
demand exceeds the new supply, the price will rise but if the new
demand is less than the new supply, the price will fall.

An increase in demand with a simultaneous decrease in supply

will raise price and increase sales if the new demand price for the old
equilibrium amount is higher than its new supply price. Similarly, the
price will rise and sales will dimfnish if the new supply price for the
old amount is higher than itsnew demand

GOVERNMENT INTERVENTION IN PRICE FIXING

Quite often the government interferes with the normal process of

price determination by fixing prices either above the equilibrium level
or below it. In order to make these attempts by the government
about artificial price fixation successful, government intervention is
required with the forces of supply or demand or both, through
elaborate administrative regulations.

Difficulties in Price Fixing

The government has to face several difficulties while fixing prices due
to certain reasons. There can be elaborated as follows:

• Attempts to fix prices above an equilibrium level are illustrated

by minimum wage legislation and price support policies. When the
Government undertakes the activity of fixing a minimum price say,
Rs. 375 per quintal for wheat much above the equilibrium price say,
Rs. 300 per quintal, consumers restrict their consumption of 'wheat'
(postpone their purchases at all levels). Conversely, farmers are
encouraged to increase their production under the incentive of
higher' prices. This results in disequilibrium between the demand and
supply. As such, there are only two ways to maintain prices at a high
level:
o The government can buy large quantities to absorb the
difference between the quantity supplied and quantity demanded.
o The government can ask the farmers to limit their output.

• The government also tries to set maximum prices below the

equilibrium level. This is illustrated by the price control on sugar, on
steel and a number of othcr commodities. Let us assume that the
equilibrium price of sugar is Rs. 10.00 per kilo but price has been
controlled at Rs. 7.00. The suppliers would hold back their supplies
and this would leave a large body of unsatisficd consumers. The
problem would arise as to who should get a sharclof the limited
supply of sugar. There would be long queues for the available supply.
In short, lots of difficulties would arise. The government would have
t.o adopt both-or either of the following measures:
o Introduction of rationing
o Payment of subsidey to sugar producers to neutralise the
effects of low prices and to encourage them to produce
more.
In this way, the Government would substitute ration cards for
the rationing mechanism of a free-market system and it would
substitute subsidies for the price incentive of a free market the
following Figure 4.21 and 4.22 shows the demand for wheat and
sugar, respectively.
Effect of Time Upon Supply
Economists find it important to discuss the way in which supply
changes in the course of time. The reason why such a study is
necessary lies in the technical conditions of production, i.e., it always
takes time to make those adjustmcl'lts ill the size and organisation of
a factory, which are necessary for greater production. For the
purpose of analysis in this connection, it is usual to follow the method
of analysis used by Marshall. Marshall suggested three periods of
time namely market period, short period and long period. Marshall
considered the market period as being only a single day or few days.
The fundamental feature of the market period is that it is supposed to
be so short that supplies of the commodity in question will be limited
to the existing stocks or at the most to the supplies in sight.
Graphically, the supply curve will be vertical, i.e., the supply remains
fixed irrespective of the price.

The 'market period' supply curve is not applicable in all cases. lt

is particularly important in the case of perishable goods, which are
difficult or impossible to store, and in case of demand, which is
subject to short-run fluctuations.

Marshall defined short period as "a period long enough for the
supplies of a commodity to be altered by increase or decrease in
current output but not long enough for the fixed equipment to be
changed to produce a larger or a smaller output." In other words; the
short-run cost curve remains the same. Here, the supply curve would
be a slopmg lme, moving upward Irom left to right thereby indicating
that as price goes up, supply increases.

In the long period, as defined by Marshall, there is time to build

additional plants or clear more land for crops; or alternatively, old
machines and factories can be closed down. A firm producing at
overtime rates or by using standby equipment will usually plan to
increase output by buying new plants and machinery. It will do so
when provided that it thinks the increased demand will be
maintained. The long-period supply curve will, therefore, tend to
have a flatter slope than the shortrun supply curve indicating
thereby that given a price increase, the supply tends lo be larger
than in the short-run period.

EQUILIBRIUM AND TIME

The following discussion now concentrates on how price would be

determined in different time periods, given a change in demand.

• In the market period, an upward shift in the demand curve

would result in an immediate rise in price, as there will be no increase
in supply.

• This will be followed by greater production during the short

period and a fall in the price as firms increase their output.
Later, as more capital equipment is installed the output would
increase still further and prices would again drop. Conversely, a
downward shift in the demand curve would not immediately
affect the quantity supplies but the price would drop sharply,
followed by some recovery as the firms reduce output in the
short period.

• In the long period, firms would see more profitable uses for
their plants and would decide not to replace capital output as it
wears out. This would reduce equipment still further and permit
some recovery in price.
 Illustration
To take an example, in Figure 4.23 DD shows the demand for fish
whereas SS, S'S', and S"S" represent the market-period, short-period
and long-period supply curves respectively. Suppose the demand for
fish in the market shifts to D'D'.

Now, supply of fish cannot be increased immediately and hence

market or momentary equilibrium is established at price OP”.

In the short run, however, fish supply can be increased by a

more intensive use of the existing equipment, viz., boats and nets
and by working for longer hours. As a result, the price drops to OP".
In the long run, supply can be fully adjusted to meet the demand
conditions. New fishermen would be attracted (entry of new firms),
new boats; nets and other equipment would be produced and
employed in service. As a result, supply would increase further and
the long-run equilibrium would take place at a still lower price OP".

The Firm in Pure Competition

In pure competition, the firm has to accept the given market price.
At this given price, it can sell all the products, which it desires but at
any higherprice, it cannot sell anything. If the market price is below
its cost, it has to either take the loss or withdraw from the market. As
a result, any single firm in a purely competitive situation has to adjust
its production and sales policies to the given market price. However,
the market prices arc determined through the mutual consent of all
the individual competitive buyers and sellers together. But any
individual firm has no control over the price. Since a purely
competitive seller has no control over the price at which he sells, his
average marginal revenue schedule is infinitely elastic. In perfect
competition, marginal revenue is equal to the average re.xenue,
because every unit is sold at the same market price, irrespective of
the' quantity sold. Graphically, a horizontal line at the market price
represents it. As expansion of sales does not require any reduction in
the price at all; the greater the quantity sold, the larger is the
revenue. Under ordinary circumstances, the owner· of a linn will not
question whether to produce or not to produce. Rather he will have to
decide whether it will be bettcr to producc, say, 10,000 units or
11,000 units. In order to answer this question, hc will compare thc
incremental cost and tIll' incremental revenue resulting (i'om thc
altcrnative courses of action. To express in technical terms, the
maximum profit (or the minimum loss) position can be attained by
in.creasing output so long as the marginal revenue continues to
exceed the marginal cost. When marginal cost is above the marginal
revenue, an increase in output would reduce profits and it would be
better to decrease the output. If the amount of marginal rcvenuc is
greater than the marginal cost, it would be beneficial to increase the
output. Thus, profit is maximised, or the loss is minimised, by
increasing the output just up to the point a.t which marginal cost
equals marginal revenue.

Output Decisions and Consumer Interests

An entrepreneur will expand his output so long as the addition to his

cost is less than the worth of the incrcase in output price to the
consumers. In this respect, the entreprencur acts consistently with
the interests of the consumers though his purpose is merely to
maximise his own profits.

This rcquires continuing the hiring of additional workers and

buying additional raw materials so long as the wage paid for the
labour and the price paid for the matcrials is less than the amount
that every unit of output will add to his revenues. In this rcspect, the
entrepreneur acts in harmony with the interests of the sellers of
labour and raw materials though his purpose is to maximise his own
profits. A consistcney with the consumer preferences is also
maintained in bidding for the additional units of input for his firm.
Without being in the least a philanthropist, the purely competitive
entrepreneur seeking to maximise profits provides a very cffective
service in helping the allocation of resources in consistence with
consumer preferences and with the interests"of resource owners.

The Firm and Shutdown Point

The amount that a particular firm offers for scale in the short-run at
different prices for its product depends upon the cost conditions of
the firm. In case there is any price that is lower than the lowest
variable cost per unit, the firm will have to be shut down. It would not
be useful to operate even in the short run at a price lower than this,
sincc variablc costs are not covered. It is not held, however, that in
the short run, the average total costs play no role in the output
decisions of the prbfit-.seeking entrepreneur. This is because the
fixed costs, which are a component of the average total costs, would
remain unaffected by the decision to shut down.

The Decision to Operate at Loss or Shut down

The above discussion shows that in the short run any firm may decide
to operate at a loss but try to minimise it. However, the question may
well arise: Why should a firm operate at all when it is suffering losses,
and why should it not.shut down? The explanation to the above
question lies in the fixed costs, which a firm has to incur any way. In
the short-run, certain costs, for example, rent, interest, etc., are
fixed. They continue to exist whether the firm operates or not. Even if
the firm shuts down, it cannot avoid these costs in the short-run. If,
for example, these fixed costs are Rs. 1,000 per month, the firm will
lose this amount every· month even if it decides to cease operations.
Under these circumstances, it will be clearly beneficial to the firm
to continue operating if it can cover its variable costs and still have
something left to contribute towards its irreducible Rs. 1,000 every
month. Thus, supposing till' price is Rs. 40, output is 70 units and the
average variable cost is Rs. 35, the firm's receipts would be Rs. 800.
Total variable cost will be Rs. 2,450 and the finll would be left with Rs.
350 to meet part of its fixed costs. The net .loss to be suffered would
be RS.650 only. If the firm were to close down, its loss would have
been Rs. 1,000; hence it would decide to operate even at a loss
because by so doing, its losses would be less than they would have
been in the case of firm's shutdown.
If, however, the price comes down to Rs. 35 only and the
average variabe cost is Rs. 35, the sales receipts would just cover
total variable cost, leaving nothing towards covering the finn's fixed
costs. Hence, the firm would be indifferent and perhaps decide to
shut down. If price is below the average variable cost (Rs. 35), the
firm would fail to recover even its variable costs and would certainly
shut down. To conclude, therefore, the shutdown point is whcre
AVC=AR.

Consequences of Pure Competition

The consequences of pure competition can be enlisted as follows:

• If the market price is below the cost of production of a

particular produccr, he can do nothing but to take a loss (in the short
run). If tbe price remains below his cost of production for a
sufficiently long period, he has no alternative but to go out of
business.

• A firm can increase its profits by selling more units.

• Products subject to a competitive market situation, face a

greater degree of price instability than is the case with differentiated
products.

• No useful purpose is served by advertising. When products sold

by individual sellers are identical, advertising by anyone seller would
have a negligible effect on the demand for his product.

Equilibrium of Industry
The short-term and long-term adjustment processes can be clearly
identified by understanding the concept of equilibrium of an industry.
These are explained as follow.

Meaning of Industry
The term industries are sometimes used in a broad sense so as to
include all the producers of a similar type of commodity such as
vanaspati industry or cigarette industry. It is sometimes used in a
narrow sense to include only the producers of commodities, which
are identical from the point of view of purchasers such as wheat or
more precisely still a particular grade of wheat. In a purely
competitive industry, however, the commodity is uniform and there is
no product differentiation, even in the slightest way. As such, under
perfect competition, an industry may be said to consist of all firms
producing a uniform commodity. It may be further added that a firm,
which produces more than one product, may be said to participate in
more than one industry. Strictly speaking, different brands of
cigarettes may be regarded as different commodities because there
are set consumer preferences for one brand over another. Yet, these
consumer preferences are so slight that for many purposes all the
standard brands may be regarded as one commodity and the
industry as a whole, for example, the cigarette industry. Of course,
the industry is said to be characterised by product differentiation as
different brands have different characteristics to attract consumers.

Adjustment Process Towards Long-run Equilibrium in Industry

An industry is said to be in equilibrium when there is no tendency on

the part of the firms within the industry to leave it or on the part of
the firms outside; to enter the industry. Long-run adjustments in an
industry take place through the entry or withdrawal of firms. These
are adjustments that take place over a time period I.ong enough to
permit such a shifting of firms and of relatively fixed productive
agents used by the firms. An industry is said to be in equilibrium
when there is no advantage to any productive agent in moving into or
out of the industry, or when there is no incentive for entrepreneurs to
inaugurate or withdraw firrtls from the industry.
Firms will move into or drop out of the .inqustry until expectations
of profits and losses have been roughly eliminated or until it is no
longer possible for anyone to better his position by moving into or out
of the industry in question. Under pure competition, this equilibrium
will be reached when price is almost equal to the lowest cost on the
typical firm's total unit cost curve. Under competition, the price
cannot stay higher for long; and withdrawal of firms will keep it from
staying lower for a long period.

Survival of the Fittest

At any given time, there may be firms of varying sizes and efficiency
in an industry, possibly some making profits and others incurring
losses. Ellt so long as industry is open for anyone to enter freely, an
excess of price over the attainable average total costs will encourage
the entry of new firms. As such new firms move in, they compete with
existing firms and the most inefficient firms are eliminated. In the
long-run, therefore, only those firms will remain in the industry, which
have the lowest average total costs, as low as those, which would be
incurred by new enterprises in optimal scale adjustments. If a long-
run equilibrium position is linally attained, there might still be many
differences between firms but the lowest average total costs of all
firms would be the same. For instance, some entrcpr.eneurs may be
more efficient than others, some firms may be located near markets
and may be paying higher rents whereas others are more distant and
may be paying lower rents. Again, some firms may be small with
close personal supervision and hence with greater efficiency whereas
others may be large and with mass production methods, In view of
these differences, the firms may not be having identical or similar
cost curves. Still, each firm must produce at an average cost as low
as that of its competitors. In other words, though there may be
differences between firms, these may be balanced by balancing
advantages and disadvantages giving rise to uniformity of minimum
average total costs.

To illustrate, two manufacturers of cotton textiles may be

differently located; one may qave the advantage of nearness to
buyers but the disadvantage of higher rent. The other may be located
away from the buyers and as such may have the advantage of lower
rent but the disadvantage of higher transport costs. Here the
advantages and disadvantages may balance so that the two firms
have the same lowest average costs. Another example is that of one
firm having a more efficient manager than the other. Here the
efficient firm may have the advantage of higher productivity but
disadvantage of higher salary payments as' compared to the less
efficient firm. On balance, the two firms may have the same lowest
average costs.
In an industry adjustments towards long-run equilibrium do not
necessarily I take place smoothly. In fact, too many firms may enter·
a profitable industry. Thus, by the time they are turning out finished
products, market price may drop below costs. As a result, firms may
start withdrawing from the industry so much so that too many firms
withdraw with opposite effects. This is most likely to occur where
initial investments are relatively small or where given fixed
equipment can be' utilised in other industries. This is because these
conditions facilitate quick entry as well as withdrawal. Agriculture
provides an example of this type where the same fixed assets can be
utilised alternatively as, for example, either for producing wheat or
cotton, jute or rice.
Restrictions on Firm's Entry and Withdrawal

Free entry'of new firms is usually restricted through

• Financial or technical barriers to entry into costly

and complex technological processes;

• Government intervention and legal restrictions; and

• Collusion among producers on prices, market shares,

tendering, etc.
Until 1991, the Indian economy was regulated by numerous
Government decisions on wages, price, size and scope of production,
industrial relations, foreign exchange, etc. Due to these Government
regulations, hardly any industry was free to decide on its scale and
methods of production, wage policies retrenchment, equipment etc.
Again, the Indian industrialist operated in a completely sheltered
market. He was protected against external (foreign) competition by
import and exchange controls. The requirement of a licence before
starting a large-scale unit further protected him from internal (Indian)
competition. Thus, entry and withdrawal of firms was highly restricted
in Indian conditions. However, now the entrepreneurs are free to
decide about the industry they want to establish and its size except
in a limited number of industries, which are still subject to
Government regulation.

VARIANTS OF PERFECT COMPETITION

1. Effective or Workable Competition

Competition among the sellers, even though it may not be perfect,
can be regarded as effective if it offers real alternatives to consumers
that are sufficient to compel sellers to vary quality, service and price
substantially with a view to attract buyers.
The prerequisites of effective competition are as follows:
• Ready substitution of one product for another.
 • General availability of essential information about a1ternati (its
significance lies in that buyers cannot influence the behaviour of
the sellers unless alternatives are known)

• Presence of several sellers, each of them possessing the

capacity to survive and grow

• Preservation of conditions which keep alive the basis or

potential competition from others

• Substantial independence of action that is each selIn must be

able and willing constantly to reconsider his policy and to
modify it in the light or changing conditions of demand and
supply.

Effective competition cannot be expected in fields where sellers

are so few ill number, capital requirements so large, and the
pressure of fixed charges so strong that price warfare, or its threat of
will lead almost inevitably to collusive (deceitful) understanding
among the members of the trade of. the industry concerned. In brief,
competition is said to be effective whenever it operates over time to
provide alternatives to buyers and to afford them substantial
protection against exploitation. The concept of effective competition,
though less definite, is more realistic and relevant than that of
perfect competition.

2. Potential Competition

Potential competition may restrain producers from overcharging

those to whom they sell or from underpaying those from whom they
buy. The essential precondition for potential competition is the
preservation of freedom to enter or to leave the market. The
exclusive ownership of scarce resource, the heavy investment
required for entry into many fields, the fixed character of much of the
existing equipment, high costs of transportation, restrictive tariffs,
exclusive franchises, and patent rights constantly operate to destroy
the hasis of potential' competition. Science, invention and the
development of technology constantly operate to keep this
potentiality alive. Potential competition, insofar as its basis continues,
may compensate in part for the shortcomings of the, lack of perfect
competition.

Key Lessons of Perfect Competition of Managers

The key lessons of perfect competition or competitiveness for
managers in highly competitive market environment are as under:

• It is important to enter a growing market as far ahead of the

competitors as possiblc. Smart managers should take advantage
well before the competitors enter the market when supply is low
and price is high. This requires entrepreneurial skill to take a
risk.

• A firm, which is earning an economic profit (distinguished from

norm.al profit), cannot afford to be complacent or unprepared
for increasing cOlllpditioll hccausc cconomic profit will eventually
attract new entrants encouraging mare production and
enhancing supply, drive prices down down and reduce economic
profits. Here, it is impossible for a firm in a pcrkclly compclitive
market to compete based on product differentiation. Therefore,
the only way that it can earn or maintain profit in the face of
added supply and lower prices is to keep its costs as low as
possible. The lesson that one can learn from understanding the
perfectly competitive model is that a firm is to be amongst the
lowest cost producer to ensure its survival.

PRICE AND OUTPUT DECISIONS UNDER MONOPOLY

Monopolistic market situation allows an individual seller or groups of

sellers, which arc acting as a unit, to exercise direct control over
price. Similarly, any such control on the part of buyers is called a
monopsonistic market situation. The monopo.listic and monopsonistic
market situations may be distinguished according to the nature and
extent of the deviation from the perfect competition. A useful
classification Can be: (i) monopoly and monopsony; (ii) monopolistic
competition; and (iii) oligopoly and oligopsony. However, in this
chapter, the discussion is confineclto monopoly only.

Main Features of Monopoly

The essential features of monopoly are as follows:
• Single seller: There is only one producer or firm of a
commodity in the market. This is because there remains no
distinction between an industry and a firm in a monopolistic
market. Here, the firm itself becomes the industry and thus has
full control over supply of the commodity. The monopolist may
be an individual, a firm or a group of firms or even Government
itself. There are many buyers of the commodities produced by
a monopolist, against a single seller.
• No close substitutes of the commodity: The commodity
sold by the monopolist has no close substitutes. This implies
that the cross-elasticity of demand between the monopofist'"s
product or commodity is very low. Though substitutes of
products are· available but they are not close substitutes.
• Difficult entry of a new firm: The monopolist controls the
market situation in such a way that it every new firm finds it to
be very difficult to enter the monopoly market and also to
compete with the monopolistic firm to produce either the
homogeneous or identical product. This makes the monopolist,
the price maker himself.
• Negatively sloped demand curve: The demand curve of a
monopolist firm is negatively sloped, which means that a
monopolist can sell more products only at a lower price and not
at a higher price.
Keeping in mind the features of a monopoly, it can be said that
the monopolist is in a position to set the price himself and also enjoys
the market power.
The strength of a monopolist lies in his power to raise his prices
without the fear to loose his customers. However, the extent to which
he can raise depends on the elasticity of demand for his particular
product. This, in turn, depends on the extent to which substitutes for
his products are available. In most cases, there is an endless series of
closely competing substitutes. Therefore, exclusive monopolies like
railways or telephones also consider the possible competition by
alternative services. In this case, any increase in the rates by
railways, may lead to their substitution by motor transport and of
telephone calls by telegrams. In fact, it is very difficult to draw a line
between what is and what is not a monopoly. The truth is that there
is a continuous shift between competition and monopoly, just as
there is between light and darkness, or between health and sickness.

Even in those industries, which appear to be monopolised at

any time, monopoly has a constant tendency to break down. First,
there have been shifts in consumer demand. Secondly, inventions
may develop numerous substitutes for the monopolist's product.
Thirdly, the monopolist may suffer from lack of stimulus to efficiency
provided by competition. He may not devote attention to the
improvement of his product. In addition, new competitors may arise
to fill the gap. Finally, the Government may intervene.

Causes of Monopoly

• The government may grant a licence to any particular person or

persons for operating public utilities such as gas company, an
electricity undertaking, etc. In public utility services, economies
of scale are so prominent that it seems almost unbelievable to
have several firms performing the same service again. In such a
case, the Government may reserve the right of foreign trade
related to any commodity for itself or may give the right to any
other person. In all these cases, the statutory grant of special
privileges by the State creates the condition of monopoly.

• The use of certain scarce raw materials, patent rights, special

methods of production or specialised skill, might also give a
producer monopoly power. For example, Hoechst, held a
 monopoly for some time in oral medicines for diabetes because
they were the first to find out the methods of reducing blood
sugar by an oral dose.

• Monopoly also arises where the minimum efficient scale of

operations is very large. For example, it is so for making some
chemicals In fact, monopoly tends to arise in industries
characterised by decreasing long-run costs.

• Ignorance, laziness and injustice on the part of the buyers may

create monopoly in favour of a particular producer.

Revenue and Cost of Monopolists

The revenue and costs of monopolistic firm can be understood with
the following explanations:

• Average Revenue: By raising the prices slightly, a monopolist

can sell less, but there will be some buyers of his product. He
can increase his sales only by reducing his price. In this
situation, his average revenue (demand curve) will slope
downwards to the right. Such a change in AR curve shows that
larger quantities can be sold at lower prices whereas smaller
quantities can be sold at higher prices.

• Marginal Revenue and the Sale Value of the Incremental

Output: In the market situation of pure competition, both
marginal revenue and the sale value of the incremental output
are identical. But this is not in the case of monopolly. A
monopolist needs to reduce his prices, to sell additional units of
his commodities. This reduction in price will apply both to old as
well as· new customers. Lei us assume that a shirt manufacturer
retails his shirts at Rs. 40 per unit. Total sales are 1,000 shirts.
To sell 1,100 shirts, he reduces his price to Rs. 38. The sale
value of the additional output will be Rs. 3,800 where as the
marginal revenue will be Rs. 1,800 only. Thus, under monopoly
conditions marginal revenue will always be less than the sale
value of the additional output. However, after a stage, the
 marginal revenue may even become negative.

Adjustments under Monopoly

A firm under this market situation can choose to sell many units at a
lower price or fewer units at a higher price. For maximisation of profit
or minirnisation of loss, a monopolistic firm would minimise or reduce
the use of inputs and outputs to the level at which the marginal
revenue equals the marginal cost. However, there is a significant
difference between a purely competitive firm and a monopoly. The
difference lies in the fact that for a purely competitive firm, marginal
revenue equals the average revenue while in a monopolistic firm,
marginal revenue is less than the average revenue. Therefore, a
monopolist in purely competitive firm can only produce up to the
point where average revenue equals the marginal cost. This can be
understood with the help of the Figures 4.24 and 4.25 are givefl
below:

With reference to these figures, under perfect competition,

output would be OQP (Figure 4.24) as MR curve or the horizontal AR
curve, interesects the MC curve at point Ep. Butunder monopoly, MR
= MC at a point Em corresponding to output OQm (Figure 4.24),
which is less than OQP. Under monopoly, the MR curve is not equal
to AR curve, but lies below it. Thus, the monopolist's output will be
lower, and the use of productive services is also less than it that in
the case of pure comprtition, where adjustments are made to suit
consumers' preferences. In other words, in ll1uximising the profits,
the monopolist does not take into consideration the interests of the
consumers and the resource owners. It is the total profit that guides
the monopolist in his price and output policy. The total profit is
calculated by multiplying the profit per unit by the number of units
sold. By using the process of trial uilci error with di fferent levels of
price and output, a monopolist fixes a price-output combination that
yields him the highest total profit.

Disadvantages of Monopoly

• Under monopolistic condition, a monopolist exercises the

market power by restricting supplies. By doing so, he is likely to
become richer than he' would have been if he had no market power.
He also docs this even at the expense of those who consume his
products.

• In a monopolistic situation, a consumer choice is restricted. A

consumer depends on the monopolist’s decisions on the mutters
related to price, and the amount the direction of research and
development in the industry, the services offered, etc.

• Under monopoly, there is a complete absence of competition,

which means that there will be no prcssure on the monopolist firm to
be economical and to keep its costs down. By keeping its prices
higher, a monopolist tends to wastc its cost or production. This is a
biggest drawback of a monopolistic tinn.

• By exercising the monopolistic power, a monopolist is likely

to misalloeate the resources from society's point of view. As the
monopolist restricts output, his output becomes too small. He
employs too little of society's resources. As aresult, of this, too much
of these resources are used into the production of the goods with low
consumer preferences. Thus, resources are mislilioclited or wasted.

• A firm enjoying monopoly position in a strategic sector is a big

a risk for an economy. For example, any failure related to the
 power engineering facilities of a firm, is a hindrance for an
economy, In one BHEL, a firm is full of'risk, as any natural or
man made causes, which may lead to slowdown or stoppage
of production is a severe setback to the economy.

Long-run Considerations and Price Policies of a Monopolist

In deciding the current price policy, monopolists commonly take into
account' some long-run considerations, which may lead to a more
moderate price policy than would be followed by a firm taking into
account short-term factors only:
• Price elasticity of demand: The ability to increase profits by
restricting supplies is the criterion of monopoly or market power. In
this respect, the more elastic the demalld for the products, the
weaker is the position or Ihc monopolist. But there will always be a
price, above which the demand is so elastic that it will not cost
anything to the monopolist to incur the loss related to less sales by
raising the prices higher. In the long-run, consumer receptiveness to
price may be much greater than in the short run. Thererore, an
intelligent monopolist must consider this factor before exercising
monopolistic power. If a monopolist's prices are held at high lewis,
consumers may stop utilising that commodity. This will result in
decreased consumption. On the other hand, if the prices remain
lower over extended periods, the consumers will get used to that
product, more people will be interested in it and those already
consuming it may increase their consumption as well.
• Potential competition from new tirms: If a firm is very well
established, exercise strong and exclusive control over essential
raw materials, possess indispensable patents, and licensing
regulations, it may pursue extremely high price policies without
great concern for the competition that these prices may attract.
If, on the other hand, its controls over firms are not so strong, it
depends primarily on unfair competition and uncclillin
manipulation, then the fear of potential competition may
 become an important factor to modify the monopolist's policies.

• State of public opinion: Public hostility to unfair practices and

exploitHI ion may appear in many forms like consumer boycotts,
both formal and informal, and legal restrictions and controls.
Hostile public opinion is wry important to be ignored irrespective
of the form in which it is. Many times it may temper the
behaviour of the monopolist seeking to maximise his profits.
If a monopolist is cautious, he needs not to work against public
interest. This is because the monopolists, being big concerns can
enjoy the economies of largescale production. They are in a better
position to maintain regular and satisfactory supplies. They can also
avail the benefits of large-scale buying ar1d selling. In fact they can
operate a better level of efficiency. If they restrain themselves and
do not exploit the consumers, they may not only build up a good
image in the market. By doing this, they are also likely to avoid
potential competition and Government interference.

Differenco between Monopoly and Pure Competition

The salient points of difference between monopoly and perfect
competition are as follows:

• Under perfect competition, there are a large number of sellers

or firms whercns in monopoly, there is a single seller or firm.

• Under perfect competition, the individual seller has no control

over the market pries whereas under monopoly, the seller is in a
position to nlllnipulnte the output in order to control the prices.

• Under perfect competition, the commodity produced by the

firms is homogeneous in nature whereas there is no close substitute
of the commodities produced by monopoly.

• Under perfect competition, a firm is a price taker and not a

price maker whereas in monopoly a firm is a price maker.

• Under perfect competition, there is free entry and exit of the

firms in the market whereas monopoly this is not so.

• Under perfect competition, firms get only normal profits in the

long period whercas in monopoly, there is the possibility of

super-normal profits to take place.

• Under perfect competition, there is no possibility of price

discrimination whereas in monopoly, price discrimination is

possible.

MONOPSONY
It is a market situation in which there is single buyer to buy the
commodities but there may be many sellers to sell the identical or
homogeneous commodity.

Features of Monopsony
The essential features of monopsony are as follows:
• There is only onc buyer or the goods or services.
• Rivalry from buyers, who offer the close substitutes of the
product, is so remote to make it insignificant.

• As a result, the buyer is in a position to determine the price,

which he pays for the goods or commodities.

Actual causes closely approximating monopsony are rare. An,

example, approximating monopsony is that of Indian Railways in
relation to the wagon industry. Monopsony may also arise where
resources are immobile. If for reason, workers are unable to move
to other localities or other firms within same area, their existing
employer has, in effect, a inonopsony position over them.

Costs of Monopsonists
The monopsonist must choose between paying higher wages that will
enable him to employ more workers or limiting his working force to
the analler number workers, who can be employed at lower wages.
This means that when additional worker is added to the labour force,
an employer has to bear both, I wage of the new worker and also the
total increase in the wages to be paid to t old employees at the new
rate. Thus, in monopsonistic market situation, margir expenditure of
each input level exceeds average expenditure (Table I aild Figu 4.26).
Suppose a tailor employs six workers at Rs. 500 per month. To have I
additional worker, he must pay Rs. 550 per month to each worker. If
he employs the seventh worker, his total costs, thus, will increase by
Rs. 850. To represent the position graphically, two curves are needed,
one to show the average expenditur and the other to show the
marginal expenditure. The marginal expenditure (ME) is consistently
higher than the average expenditure (AE) and the slope of thl
marginal expenditure cutve is steeper than that of the average
expenditure curve.

The following Table 4.4 shows the cost of a monopsonistic firm

hiring workers.

Table 4.4: Cost of a monopsonistic firm hiring workers

----Workers -- -- ..•. _. _.-
Total .. ~- .... - .- -
Marginal
Averange Expenditure Expenditure
Expenditure (TE) (ME)
per Worker (Rs.) (Rs.)
(AE)
(Rs.)
 6 500 3,000 -
7 550 3,850 850
8 600 4,800 950
9 650 5,850 1,050
10 700 7,000 1, 150
11 750 8,250 1,250

Price Discrimination
Price discrimination, may be defined as the practice by a seller of
charging different prices to thL: samc buyer or to different buyers for
the same commodity or service without corresponding difference in
the cost. It is also known as differential pricing. Differences in rates
are somewhat related to the in costs. For example, it may cost less to
serve one class of customers than another to sell in large quantities
than in smaller lots. !frates or prices are proportional to cost, some
buyers will pay more and others less, but this will not take place in
price discrimination. In such a situation, charging uniform price will
amount to discriminat ion. There arc three classes of price
discrimination, which are as follows:
First-degree discrimination: The seller charges, the same
buyer a different price, for euch unit bought. For exumple,
prices that are determined by bargaining with individual
customers or prices, which are quoted for tenders floated by
government authorities.
Second degree discrimination: The seller charges different
prices for blocks of units, instead of, for individual units. For
example, different rates charged by an ekctrieity undertaking
for light and fan, for domestic power and for industrial use.
• Third degree discrimination: The seller segregates buyers
according to income, geographic location, individual tastes, kinds of
uses for the product, etc. and charges different prices to each group
or market despite of charging equivalent costs from them. If the
demand elasticities among different buyers are unequal, it will be
profitable for the seller to put the buyer into separate classes
according to elasticity and thereby, to charge each class a different
price. It is also referred as market segmentation and involves dividing
the total market into homogeneous sub-groups according to some
economic criterion, usually the demand elasticity.

Conditions for Price Discrimination

The conditions for price discrimination arc as follows:

• Multiple demand elasticities: There must be difference in

demand elasticities among buyers due to differences in income,
location, available alternatives, tastes, etc.

• Market segmentation: The seller must be able to divide the

total market by separating the buyers into groups or sub-
markets according to elasticity.

• Market sealing: The seller must be able to prevent any

significant resale of goods from the lower to the higher price
sub-market. Any resale by buyers among the sub-markets will,
beyond minimum critical levels, neutralisc the effect of different
prices.

Market Segmentation
Haynes, Mote and Paul have identified certain criteria according to
which market segmentation is practised. These criteria are given
below:

• Segmentation by income and wealth: This can be

understood by considering an example, in which the doctors
separate patients with high incomes from patients with low
incomes. The fact that doctor's treatment is a direct personal
 service prevents its resale.

• Segmentation by quantity of purchase: Traders often

distinguish between large and small purchasers, offering
quantity discounts to large purchasers. The big buyers because
of their bargaining power are able to extract special quantity
discounts. However, if the quantity discounts are in proportion to
the marginal costs of selling to big and small buyers, they will
not be counted in price discrimination.

• Segmentation by social or professional status of the

customer: Special prices may be quoted to Central and State
Governments or to Universities. Students are given concessions
in cinema tickets, railway fare and bus travel. Profes'sional
journals usually carry lower student subscription rates. Faculty
members or teachers are also sometimes offered books at
special discounts.

• Segmentation by geography: This can be understood by

considering an example. For example, business houses, which
are sold abroad at prices, lower than the domestic price.

• Segmentation by time of purchase: Reduced rates are often

quoted during festival seasons such as dussehra, diwali, etc. off-
season discounts are also popuinr in case of fans, refrigerators,
etc.

• Segmentation by preferences for brand names and other

sales promotion devices: Some firms sell the same type of
product under different branp names at, different prices. In this
case, ignorance on the part of consumer regarding similarity in
the quality of products prevents a large-scale of customcrs to
shift from one brand to another. Market segmentation also
ensures, the manufactures, a certain degree of flexibility in
pricing. Apart from this is also to be ensured that it should
remain present in every segment of market. For example,
Hindustan Lever supplies liril to satisfy the top-end of Ihe
 market, lifebuoy to the lowest end and lux to the middleend.

Objectives
The objectives of pricc discrimination are as follows:

• To adjust the consumer's surplus in such a way that it accrues

to the producer and not to the consumer.
• To dispose of occasional or irregula surpluses.
• To develop a new market.
• To make the maximum and proper use of the unutilised
capacity.
• To earn monopoly profits.
• To enter into or retain report markets.
• To destroy or to forestall competition or to make the
competition amenable to Ihc wishes of the seller adopting price
discrimination. It may be called predatory or discriminatory
competition. The test of perdition of intent.

• To raise the future sales. Quoting lower rates in the present

develop in future a taste for the similar commodities producecl by the
same manufacturer. For example, Reader's Digest sells children's
edition at lower rates. This develops the taste of children towards the
magazine and they are expected to continue purchasing it even
when they become adults.

Single Monopoly Price Vs. Price Discrimination

To examine the policy of price discrimination, is more useful rather
than to charge a single monopoly price. This can be done in following
ways:

• First of all, a discriminating monopolist can increase his profits

by charging different prices to different buyers or groups of buyers
rather than to charge a single price to all the buyers.

• Secondly, the policy of price discrimination is in the interests of

the consumers as well. Bigger' output is made available to a large
number of customers. This is of special significance in the case of
public utility services. The larger the consumption of these services,
the greater is the economic welfare. Moreover, the consumers may
be charged according to their ability to pay, which is quite fair and
reasonable.

• Finally, the policy of price discrimination enables better

utilisation of capacity, preventing waste of social resources. This can
be understood with the help of following Table 4.5.

Table 4.5: Costs, Prices and Sales of a Monopolist

Price Sales Total Cost
(Rs.) (Rs.) (Rs.)
9.00 100 1,400
8.00 200 1,750
7.00 300 2,050
6.00 400 - 2,300
5.00 500 2,500
4.00 700 3,000
3.00 1,000 3,400
2.50 1,400 4,100
2.00 2,000 5,000
1.50 2,800 6,400
1.00 3,600 8,000
The above Table gives the number of units, a monopolist can sell
at various prices and the total cost involved in producing them.
Answer the following questions related to the table.

• How much should the monopolist prodllce find what price

should be charge, if' he sells his entire output at a single price? How
much profit will he earn?

• How much should be produced if the monopolist fixes II

discriminatory price, dividing his customers into separate groups
according to their ability to pay and charging maximum prices from
each group? How much will be the profit, which the monopolist will
earn?
• Will the monopolist be better off if he charges a single price or
discriminating prices and by how much?

• Will it be in the interest of the consumers if the monopolist

charges discriminating prices? Explain.

• Will the policy of price discrimination enable better utilisation of

capacity' as compared to a single price?

• How much maximum profit would the monopolist earn if he is

allowed price discrimination but cannot charge more than RS.2?
Would it make any difference to capacity utilisation and
availability of supply the consumers?
Solution
If the monopolist sells the output at a single price, he will choose that
price, which will yield the largest profit, He will, therefore, produce
400 units and charge Rs. 6. The maximum profit he will earn is Rs.
100. This will be clear from the following Table 4.6:
Table 4.6: Monopolist Selling at a Single Price
Price Sales Total Total Profit or
(Rs.) (Uuits) Revenue Cost Loss
(Rs.) (Rs.) (Rs.)
9.00 100 1,600 1,400 -500
8.00 200 2,100 1,750 -150
7.00 300 2,400 2,050 50
6.00 400 2,500 2,300 100
5.00 500 2,SOO 2,500 0
4.00 700 3,000 3,000 -200
3.00 1,000 3,500 3,400 -400
2.50 1,400 4,000 4,100 -600
2.00 2,000 4,200 5,000 -1.000
1.50 2,800 3,600 6,400 -2,200
1.00 3.600 8,000 -4,400
 If the monopolist discriminates, dividing his customers into
groups according to their ability to pay and charging different
prices from each group, the results would be as given in the
following Table 4.7:

Table 4.7: Monopolist Selling at Discriminatory Prices

Price Sales Sales in Revenue Total Total Profit or

(Rs.) (Units) each from each Revenue Cost Loss
Catego category (Rs.) (Rs.) (Rs.)
(units) (Rs.)
1 2 3 4 5 6 7
9.00 100 100 900 900 1,400 -500
8.00 200 100 800 1,600 1,750 -150
7.00 300 100 700 2,100 2,050 " 50
6.00 400 100 600 2,400 2,300 1000
5.00 500 200 500 2,500 2,500 -200
4.00 700 300 800 2,800 3,000 -400
3.00 1,000 400 900 3,000 3,400 -600
2.50 1,400 600 1,000 3,500 4,100 -1,000
2.00 2,000 800 1,200 4,000 5,000 -2,200
1.50 2,800 800 1,200 4,200 6,400 4,400
1.00 3,600 800 3,600 .8,000

Here, the prices, sales and total costs are the same as they
were in Table 4.5. But the monopolist divides his customers into
separate groups and charges different prices from each group. The
basis of dividing the customers is as follows:

When price is Rs. 9 per unit, 100 units are sold, when the price is
Rs. 8 per unit, 200 units are sold. This means that 100 units can be
sold for Rs. 9 per unit and another 100 for Rs. 9 per unit. Similarly, by
charging Rs. 7 per unit, the monopolist can sell another 100 units. In
this way, other categories have also been formed as shown in column
3. Column 4 gives revenue from each category, which is calculated
by multiplying the figures of column 3 with the corresponding figures
of column 1. Column 5 gives tot21 revenue obtained by selling goods
to various categories of the customers. Column 6 gives total cost and
column 7 gives profit or loss.

In this situation, a. discriminating monopolist will also seek the

maximum profit, which cen be obtained by creating a category of
customers and charging Rs. 9 from those on the top class and Rs. 2
from those in the bottom of the category. With such a differential
price structure, the monopolist will sell 2,000 units and earn a
maximum profit of Rs. 2,400.

The monopolist will be better off by Rs. 2,300 by charging the

discriminating prices he will earn as much as Rs. 2,400 as
against a maximum of Rs. 100 by charging the single price of
Rs. 6.

The policy of discriminating prices is in the interest of the

customers as well. Larger output of 2,000 units, is beneficial to
a larger number of customers. Moreover, each customer is
charged according to his ability to pay. Therefore, the policy is
fair as well as reasonable.

The policy of price discrimination will enable better utilisation of

capacity. Assuming the monopolist has a capacity to produce
3,600 units, he would operate at a level of 2,000 units which is
much' closer to full capacity as against the level of 400 units,
where the monopolist will operate if he chmges the single price
of Rs. 6.

If the maximum price that can be charged is Rs. 2, the monopolist

will earn a maximum profit of Rs. 200 by practising price
 discrimination as shown in the following Table 4.8.

Table 4.8.: A Regulated Monopolist Discriminating in

Price but Charging not more than Rs. 3

Price Sales Sales in Revenue Total Total Profit or

(Rs.) (Units) each from Revenue Cost Loss
Category each (Rs.) (Rs.) (Rs.)
(units) category
(Rs.)
1 2 3 4 5 6 7
3.00 1,000 1,000 3,000 3,000 3,400 -400
2.50 1,400 400 1,000 4,100 4,100 -100
2.00 2,000 600 1,200 5,200 5,000 200
1.50 2,800 800 1,200 6,400 6,400 0
1.00 3,600 800 800 7,200 8,000 -800

But capacity utilisation and availability of supplies will remain

unaltered.

APPENDIX 1

Price Discrimination - Diagrammatic Exposition

A diagrammatic exposition of the theory of price discrimination is
shown below. Figure 4.27 presents the diagram of price discriminate
adopted in traditional economic theory.
 Let us suppose that the market for a product consists of two
segments, one with a more elastic demand curve than the other D1
shows the demand in the more elastic segment and D2 shows the
demand in the less elastic segment. MR. and MR2 represent the
corresponding marginal revenue curves. The total marginal, revenue
cllrve MRT adds together the quantities in both market segments at
each marginal revenue. Thus MRT = MR1+ MR2. On the cost side, the
diagram shows a marginal cost curve MC, which alone is relevant. It
may be noted that only one I marginal cost curw exists because it
makes no difference from the cost point of view whethcr the products
sell in market segment 1 or market segment 2, since the product is
the same.
As usual, profit will be maximised where marginal revenue is
cquallo marginal cost. Such equality exists at point E in the diagram
where 'the total margimil revel1lie curve (MRT) intersects the
ll1argin::d cost curve (MC). A horizontal line drawn from this point of
intersection E, back to the Y-axis cuts the two marginal revenue
curves MR, and MR2 at points F and G respectively. These roints
determine the quantities to be sold in each market segment and the
prices which shall prevail in each market segment. For this purpose
one should first draw a perpendicular line frolll point F on X-axis,
showing OX, as the quantity in market segment 1. Agai by extending
this perpendicular line upward to meet the demand curve 0" one gets
p. as the price for this market segment. Similarly, frol1l point drawing
the perpendicular to X-axis and thereafter extending it to the
demand c.urve D2, we get OX2 as·the quantity to be sold and P2 as
the price to be charged in market segment 2. The quantity sold in
market segment 1 (OXI) plus the quantity sold in market segment 2
(OX2) exhausts the total quantity OQ (i.e., OX1 + OX2 = OQ).
Further, the price PI is lower than the price P2 thus indicating that the
price in the more elastic market segment (DI) shall be less than the
price in the less elastic market segment (D2). The two prices PI and
P2 provide different margins of contribution to profit. It should also be
noted that (he solution equates the marginal revenue in each
segment (i.e., X2G = X.F) besides equating the total marginal
revenue to marginal cost at point F. If MR. was greater than MR2, the
firm could increase profits by transferring units of product from
market segment 2 to-market segments I. This is an illustration of the
equi-marginal principle. If either MR1 or MR2 were greater than me,
an expansion of output would be profitable. Optimisation thus
requires that MR1 = MR2 = Me.
 APPENDIX 2

Measures of Monopoly Power

Several economistS have given different measures of monopoly

power. These are discussed below:
Lerner's measure: According to Lerner, the difference between
price dnd marginal cost, measures the gegree of monopoly power. In
other words, a seller's monopoly power depends upon his ability to
sell the commodity at a price above its marginal cost. A perfectly
competitive seller enjoys no monopoly power and in his case:
Price = Marginal cost (or P - MC = 0).
But as monopoly po~er emerges, P - MC becomes greater than
zero and as the power increases, the gap between price and MC
increases. Thus, the degree or index of monopoly power can be
measured as being equal to:
MC
P= P

For instance, if price is Rs. 20 and marginal cost is Rs.12, the

degree of monopoly power is
20-12
20 = 0.4

Lerner also relates the monopoly power to price-elasticity of

demand. Accordingly, higher the price-elasticity of demand, smaller is
the degree of monopoly power. Also, the degree of monopoly power
is the reciprocal of the price-elasticity of demand. That is, if elasticity
is 2, the degree of monopoly is V*.
Bain's measure: Bain measures degree of monopoly power in
 terms of supernormal profits. The supernormal profits are equal
to (P - AC) Q, where P = Price, AC = average cost, and Q is
output.
Rotbscbilds' measure: Rothschilos defines degree of monopoly
power, in terms of the proportion of the slopes of the firms and
industry demand curves, i.e.,

Slope of the firm’s demand curve

degree of monopoly power Slope of the industry’s demand curve
=

• Triffin's measure: Trimn measures degree of monopoly power

in terms of price cross-elasticity of demand. Price cross-elasticity of
demand means the extent of substitution between the products of
two firms when one of them changes the price of its product. If cross-
elasticity of demand is zero, this implies that the firm has an absolute
monopoly power.
 REVIEW QUESTIONS
1. Define a production function. Explain and illustrate
isoquants and isocost curves.
2. Explain the nature mid managerial uses of production
function.
3. Discuss the equilibrium of the organisation with the
technique of' isoquants.
4. Distinguish between production function and cost
function. How would you develop the production function? What are
its uses?
5. What are the main features of pure competition? How
does an organisation adjust its policies to a purely competitive
situation?
6. What is the short-down point? Explain why a
organisation suffering losses still decides to operate and not shut
down.
7. Explain the following propositions:
A. If demand rises, price goes up.
B. If supply rises, price goes down.
C. If both demand and supply increase, sales is bound to
increase but price mayor may not.
8. Explain the possible effect of an increase in demand with
a simultaneous decrease in supply on sales and price.
9. Explain the effects of government intervention in price
fixation. What steps are necessary to make this intervention
effective?
10. How does a company determiae the prices of its
products? Examine in this connection the validity of the theory that
long-period price is equal to cost.
11. Explain very short period, short period and long period
situations in a market. Show price equilibrium under very short and
iong periods.
12. What is meant by 'price discrimination'? What are its
objectives? Is price discrimination anti-social?
13. What does differential pricing mean? Discuss the various
types of geographical price differentials and explain how they are
determined.
14. Comment on the various types of discounts and the
effects of each on sales.
15. How does the equilibrium of the organisation under
perfect competition differ from that of a monopolist? Is it true that in
the long run II perfectly competitive organisation earns no super-
normal profits?
16. Explain and illustrate the conditions for the establishment
of organisation's equilibrium under perfect competition.
17. Examine the weaknesses of the traditional theory of
pricing from the point of view of an individual organisation.
 LESSON - 5

PROFIT

MEANNING
Profit means different things to different people. The word ‘profit’ has
different meanings to business, accountants, tax collectors workers
and economists. In a general sense, profit is regarded as income of
the equity shareholders. Similarly wages getting accumulated of a
labor, rent accruing to the owners of any land or building and interest
getting due to the investors of capital of a business, are a kind of
profit for labours, land owners and investors. To an account, profit
means the excess of revenue over all paid out costs including both
manufacturing and overhead expenses. It is much similar to net
profit. In accountancy, profit or business income means profit of a
business including its non allowance expenses. In economic, Profit is
called pure profit, which may be defined as a residual left after all
contractual costs have been met, including the transfer costs of
management insurable risks, depreciation and payment to
shareholders, sufficient to maintain investment at its current level.
Therefore pure profit can be calculated with the help of following
formula.
Pure Profit = Total Revenue - (explicit costs + implicit costs).
Economic or pure profit also makes provision for insurable risks,
depreciation and necessary minimum payments to shareholders to
prevent them from withdrawing their capital. Pure profit is considered
to be a short – term phenomenon. It does not exist in the long run,
especially under perfectly conditions. Because of this, they may
either be positive or negative for a single firm in a single year.
The concept of economic profit differs from that of accounting
profit Economic profit takes into account also the implicit or imputed
costs. The implicit cost is also called opportunity cost. If an
entrepreneur uses his labor in his own business, he foregoes his
income or salary, which he might have earned by working as a
manager in another firm. Similarly, by using assets like and building
and his own business, he foregoes the market rent, which might have
earned otherwise. All these foregone incomes such as interest, salary
and rent, are called opportunity costs or transfer costs. Accounting
profit does not consider the opportunity cost.

THEORIES OF PROFIT AND SOURCES OF PROFIT

There are various theories of profit, given by several economists,
which are as follows:

Walker’s Theory of: Profit as Rent of Ability

This theory is pounded by F.A. Walker. According to F.A. Walker,
“Profit is the rent of exceptional abilities that an entrepreneur may
possess over others. Rent is the difference between the yields of the
least and the most efficient entrepreneurs. In formulating this theory,
Walker assumed a state of perfect completion in which all firms are
presumed to possess equal managerial ability each firm receives only
the wages which in Walker view forms no part of pure profit. Hen
considered wages of management as ordinary wages thus, under
perfectly competitive conditions, there would be no pure profit and all
firms would earn only wages, which is known as normal profit.

Clark’s Dynamic Theory

This theory is propounded by J.B. Clark According to him, “profits
arise in a dynamic economy and not in static economy.”
A static economy and the firms under it, has the following features:
• Absolute freedom of completion
• Population and capital are stationary
• Production process remains unchanged over time.
• Homogeneous goods
• Factors of production enjoy freedom of mobility but do not
move because their marginal product in very industry is the
same.
 • There is no uncertainly and risk. If there is any risk, It is
insurable
• All firms make only normal profit

A dynamic economy is characterized by the following features:

• Increase in population
• Increase In capital
• Improvement in production techniques.
• Changes in the forms of business organization

The major function of entrepreneurs or managers in a dynamic

economic is to take the advantage of all of the above features and
promote their business by expanding their sales and reducing their
costs of production.
According to J.B. Clark, “Profit is an elusive sum, which
entrepreneurs grasp but cannot hold. It slips through their fingers and
bestows itself on all members of the society”. This result in rise in
demand for factors pf production and therefore rises in factor prices
and subsequent rise in the cost of production. On the other hand,
because of rise in cost of production and the subsequent fall in selling
price of the commodities, the profit disappears. Disappearing of profit
does not mean that profit arise in dynamic economy once only, but it
means that the managers take the advantage of the changes taking
place in the economy and thereby making profits.

Howley’s Risk Theory of Profit

The risk theory pf profit is propounded by F.B. Hawley’s in 1893. Risk
in business may arise due to obsolescence of a product, sudden fall in
prices, non-availability of certain materials, introduction of a better
substitute by a competitor and risks due to fire, war, etc. Hawley’s
considered risk taking as an inevitable element of production and
those who take risk are more likely to earn larger profits. According to
Hawley, Profit is simply the price paid by society assuming business
risks. In his opinion in excess of predetermined risk. They also look for
a return in excess of the wags for bearing risk is that the assumption
of risk is irrelevant and gives to trouble and anxiety. According to
Hawley, Profit consists of two part, which are as follows:-
• One Part represents compensation for actual or average loss
supplementing the various classes of risk.
• The other part represents a penalty to suffer the consequences
of being exposed to risk in the entrepreneurial activities.
Hawley believed that profits arise from factor ownership as long
as ownership involves risk. According to Hawle’y an entrepreneur has
to assume risk to earn more and more profit. In case of absence of
risks, an entrepreneur would cease to be an entrepreneur and would
not receive any profit. In this theory, profits arise out of uninsured
risks. The amount of reward cannot be determined, until the
uncertainly ends with the sale of entrepreneur products profit in his
opinion is a residue and therefore. Hawley theory is also called a
residential theory of Profit.

Knight’s Theory of Profit

This theory of profit is propounded by frank H. Knight who treated
profit as a residual return because of uncertainly, and not because of
risk bearing. Knight made a distinction between risk and uncertainly
by dividing risk into two categories, calculable and non-calculable
risks. They are explained as below:-
• Calculable risks are those, the prodigality of occurrence of
which van be calculated on the basis of available data. For
example risk, due to fire theft accidents etc. are calculable and
such risks are insurable.
• Incalculable risks are those the probability of occurrence of
which cannot be calculated. For Instance there may be a
certain elements of cost, which may not be accurately
calculable and the strategies of the competitors may not be
 precisely assessable. These risk are called includable risks. The
risk element of such incalculable costs is also insurable.
It is in the area of uncertainly which makes decision-making a
crucial function for an entrepreneur. If his decisions prove to be right,
the entrepreneur makes profit, Thus according to knight profit arises
from the decisions taken and implemented under the conditions of
uncertainly. The profits may arises as a result of decision related to
the state of market such as decision, which increase the degree of
monopoly, decisions regarding holding of stocks that give rise to
windfall gains and the decisions taken to introduce new techniques
or innovations.

Schumpeter’s Innovation Theory of Profit

Joseph A. Schumpeter developed the innovation theory of Profit.
According to Joseph A. Schumpeter, factors like emergence of Interest
and profits, recurrence of trade cycles only supplement the distinct
process of economic development to explain the phenomenon of
economic development and profit, Schumpeter starts from the state
of a stationary equilibrium, which is characterized by the equilibrium
in all the spheres. Under these conditions stationary equilibrium, the
total receipts from the business are exactly equal to the cost. This
means that there will be no profit. The profit can be earned only by
introducing innovations in manufacturing technique and the methods
of supplying the goods innovations may include the following
activities.
• Introduction of a new commodity or a new quality of goods.
• Introduction of a new method of production.
• Introduction of a new market.
• Finding the new sources of raw material
• Organizing the industry in an innovative manner with the new
techniques.
The factor prices tend to increase while the supply of factors
remains the same. As a result, cost of production increase. On the
other hand with other firms adopting innovations, supply of goods
and services increases resulting in a fall in their prices. Thus, on one
hand, cost per unit of output goes up and on the other revenue per
unit decrease. Finally, a stage comes when there is no difference
between costs and receipts. As a result there are no profits at all.
Here, economy has reached a state of equilibrium, but there is the
possibility of existence of profits. Such profits are in the nature of
Quasi-rent arising due to some special characteristics of productive
services. Furthermore, where profits arise due to factors such as
patents, trusts, etc. they will be in the nature of monopoly revenue
rather than entrepreneurial profits.

MONOPLOY PROFIT
Monopoly is a market situation in which there is a single seller of a
commodity without a close substitute. Monopoly may arise due to
economies of scale, sole ownership of raw materials, legal sanction,
protection, mergers and take–overs. A monopolist may earn pure
profit, which is also called monopoly profit in the case of a monopoly,
and maintain it in the long run by using its monopoly powers.
Monopoly powers are as follows:-
• Powers to control supply and price.
• Powers to prevent the entry of competitors by reducing the
prices.
The Monopoly powers help a monopoly firm to make pure profit
or monopoly profit. In such cases, monopoly is the source of pure
profit.

PROBLEMS IN PROFIT MEASURMENT

Accounting profit is the difference between all explicit costs and
economic profit or subtracting the difference of explicit and implicit
costs from revenue. Once profit is defined, it is easier for a firm to
measure the profit for a given period. The problems regarding the
measurement of profits are as follows:
 • The choice between the two concepts of profits, to be given
preference while using.
• The determination of the various costs to be included in the
implicit and explicit costs.
The solutions to these problems are as follows:-
• The use of a profit concept depends on the purpose of
measuring profit.
• According concept of profit is used when the purpose is to
produce a profit figure for any of the following.
o The shareholders, to inform them of progress of the firm
o Financiers and creditors, who would be interested in the
firm’s progress
o The Managers to assess their own performance
o For computation of tax-liability.
To measure accounting profit for these purposes, necessary
revenue and cost data are, in general, obtained from the firm books
of account. It must, however, be noted that accounting profit may
present an overstatement or understand of actual profit, if it is based
on illogical allocation of revnues and costs to a given accounting
period.
On the other hand, if the objective is to measure true profit, the
concept of economic profit should be used. However true profitability
of any investment or business has been completely done. But then
the life of a business firm is unending therefore , true profit can be
measured only in terms of maximum amount that can be distributed
as dividends without harming the earning power of the firm. This
concept of business income is however, unattainable and therefore, is
of little practical use. It helps in income measurement even from
businessman point of view. From the above discussion, it is clear that,
for all practical purpose, profits have to be measured on the basis of
accounting concept. But measuring even the accounting profit is not
an easy task. The main problem is to decide as to what should be and
what should not be included in the cost one might feel that profit and
loss accounts and balance sheet of the firms provide all the
necessary data to measure accounting profit there are, however
three specific items of cost and revenue which cause problems, such
as depreciation, capital gains and losses and current vs. historical
costs. These problems are related to measurement and may arise
because of the differences between economists and accountants view
on these items. The concept of current costs can be used understood
from the following description.

CURRENT vs. HISTORICAL COSTS

Meaning of Historical Costs
The income statements are prepared in terms of Historical costs and
not in terms of current price. Historical costs is the purchase price of
any asset ands includes the following.
• Money spent in the acquisition of the asset including
transportation costs as well as the insurance cost.
• Costs of installation such as wages paid for erection of
machinery and the amount spent on repairs at the time of
installation.
The reasons for using historical costs for calculating
depreciation rather than current costs are as follows:-
• Historical costs produce more accurate measurement of
Income.
• Historical costs are easily determined and more objective than
the values based on the use of current value on asset.
• Accountants also record historical costs and consider them to
be more relevant, The accountants approach ignores certain
important changes in earnings and looses of the firms, which
may be any of the following:
o The value of asset pretended in the books of accounts is
understand at the time of inflation and overstated at the
time of deflation.
 o Depreciation is understated during deflation. The
historical cost recorded in the books of account does not
reflect these changes in values of assets and profits. This
problem becomes more critical in case of inventories and
stock. The problem is how to evaluate the value of
inventory and the stocks.

Methods of Inventory Valuation

There are three popular methods of Inventory valuation, first in first
out (FIFO), last in fist out (LIFO) and weighted average cost (WAC)
Under FIFO method, material is taken out of stock for further
processing in the order in which they are acquired. The stocks,
therefore, appear in firms balance sheet at their actual cost price.
This method overstates profits at the time of rising prices.
Under LIFO method, the stock purchased most recently become
the costs of the raw material in the current production under WAC
method, the weighted average of the costs of materials purchased at
different prices and different point of time is calculated to evaluate
the inventory.
All these methods have their own disadvantages and do not
reflect the true profit of the business. So the problem of evaluating
inventories to yield a true profit remains unsolved.

Problems is Measuring Depreciation

Economists consider depreciation as capital consumption. For them,
there are two distinct ways of charging depreciation either by
assuming the value of depreciation of equipment to its opportunity
cost or to its replacement cost that will produce comparable earning.
Opportunity cost of equipment is the most profitable alternate
use of that is foregone by putting it to its present use. The problem is
to measure the opportunity cost. One method of measuring the
opportunity cost. One method of measuring the opportunity cost, as
suggested by Joel Dean, is to measure the fall in value during a year.
By using this method cannot be applied when capital equipment has
no alternative use, like a hydropower project In such cases,
replacement cost is an appropriate measure of depreciation. Under
this method, the cost of the new asset and the residual value of the
old asset are taken as the depreciation of the asset. But depreciation
is recorded only at the time of replacement of an asset. This method
is used in public utility concerns like railway, electricity companies. To
accountants, depreciation is an allocation of under expenditure over
time. Such allocation or charging depreciation is made under
unrealistic assumptions such as stable prices and a given rate of
obsolescence. There are different methods of charging depreciation,
which are of utmost importance. The use of different levels of profit
reported by the accountants. It will be clearer after considering the
following example: Suppose a firm purchases a machine for Rs.
10,000/- with an estimated life of 10 yrs. The firm can apply any of
the following four methods of charging depreciation and the amount
of depreciation for the given example by using the different methods
is as follows:
• Straight Balance Method
• Annuity Method
• Sum-of the years digit approaches
Under the straight – line method, the amount of depreciation
remains the same throughout the life of the asset. Depreciation is
calculated according to a fixed percentage on the original cost. The
amount and rate of depreciation is calculated as under:
Historical cost-residual value
Amount of depreciation = Economic life of the asset

Rate of depreciation = Amount of depreciation x 100/Historical

cost
Residual value is the realizable value of an asset at the end of
its economic life. Keeping in view the above example, the amount of
depreciation will be 10,000/10 = Rs. 1,000. It will be same for each
year. The rate of depreciation will be
1000 x 100/10,000 = 10
Under the reducing balance method, depreciation is charged at
a constant rate or percent of annually written down values of the
machine or any equipment. Assuming a depreciation rate of 20 per
cent, the amount of depreciation for different years will be calculated
as under :
Amount of Depreciation = Historical value x rate of depreciation /100

But the amount of depreciation for the first year will be

deducted from the successive years. Therefore Rs. 2000 in the first
year, Rs. 1600 in the second year, Rs. 1280 in the third year, and so
on.
Under annuity method, rate of depreciation is fixed and is calculated
as under:-
d = (C + Cr )/n, where n is the total number of years of capital, C is
the total capital and r is the interest rate. The amount of depreciation
in this method is calculated with the help of annuity table.
Finally under sum-or-the year’s digits approach, the total years
of equipment life are aggregated. Depreciation is then charged at the
rate of the ratio of the last years digits to the total of the years. With
respect to the given example, the aggregated years of the
equipment’s life’s will be 1+ 2 + 3 +... +10 = 55. Depreciation in the
1st year will be 10,000 x 10/55 = Rs. 1818.18, in the 2nd year it will be
1,000 x 9/55 = Rs. 1636.36 and in 3rd year it will be 10,000 x 8/55 =
Rs. 1454.54, and so on. These four methods of depreciation results in
different methods of depreciation and subsequently different levels of
profit.

TREATMENT OF CAPITAL GAINS AND LOSSES

Capital gains and losses arc regardea as windfalls. Fluctuation in the

stock market prices is one of the most common sources of wind Ellis.
According to Dean, capital losses are, greater than capital gains in a
progressive society. Many of the capital losses arc of insurable nature
and the excess becomes the capital gain.

Profit is also affeckd by the way capital gains and losses are
treated in accounting. According to Dean, "a sound accounting policy
to follow concerning windfalls is never to record them until they are
turned into cash by a purchase or sale of assets, since it is never
clear until then exactly how large they are". But, in practice, some
firms do not record capital gains until it is realised in money terms,
but they do write off capital losses from the current profit. The use of
different policies result in different profits. But an economist is not
concerned with the accounting practice or principle, which is followed
in recording the past events. An economist is concerned mainly with
what happens in future. According to an economist, the management
should be aware of the approximate magnitude of such windfalls
before they are accepted by the accountants. This would be helpful in
taking the right decision with respect of those assets, which are
affected by the use of policies given by the economists.

PROFIT MAXIMISATION AS BUSINESS OBJECTIVE

Profit maximisation is the most important assumption, which helps

the economists to introduce the price and production theories. The
traditional economic theory assumes that the profit maximisation is
the only objective of business firms. According to this theory, profits
must be earned by business to provide for its own survival, coverage
of risks, growth and expansion. It is a necessary motivating force and
it is in terms of profits that the efficiency of a business is measured. It
forms the basis of conventional price theory. Profit maximisation is
regarded as the most reasonable and analytically the most
productive business objective.

The profit maximisation assumption in this theory helps in

predicting the behaviour of business firms and also the behaviour of
price and out pet under different market conditions. No alternative
hypothesis or assumption explains and predicts the behaviour of
firms better than the profit maximisation assumption. According to
this theory, total profit is the difference between total revenue and
total cost and is calculated as below:
TP = -TR – TC (1)
where,
TR = total revenue
TC = total cost
The total cost includes fixed cost and variable cost. The cost,
which remains same at different levels or output, is called fixed cost.
The sum of all t~ose costs, which vary directly with the level of
output, is called variable cost. In context with the profit maximisation
objective, the total profit or the difference between total· cost and
total profit is to be maximised. There are two conditions that must be
fulfilled for TR- TC to be maximum. These conditions are divided into
two categories, which are necessary or first order condition and
secondary or supplementary condition. These conditions are
explained as below:
• The necessary or the first order condition states that marginal
revenue (MR) must be equal to marginal cost (MC). Marginal
revenue is the revenue obtained from the production and sale
of one additional unit of output. Marginal cost is the cost arising
due to the production of one additional unit of output.

• The secondary or the second order condition states that the first
order condition must show the decreasing MR and rising MC.
The secondary condition is fulfilled only when both the MC is
rising as well as the MR is decreasing. This condition is
illustrated by point P2 in Figure 5.1.
 Let us suppose that the total revenue and total cost functions
are, respectively given as below:
TR = TC = f (Q)
where, Q = quantity produced and sold.
Substituting total revenue and total cost functions In Equation
(I), profit function can be written as below:
TP = f(Q)TR - f(Q)TC (2)
With the help of equation (2), The first order condition and the
secondary. Condition can be understood easily.

First-order Condition
The first-order condition of maximising a function is that the first
derivative of the profit function must be equal to zero. By
differentiating the total profit function and equating it to zero, the
following equation is obtained:
aTP aTR aTC
aQ = aQ - aQ =0
(3)
This condition holds only when
aTR aTC
aQ = aQ
 In Equation (3), the term aTR/aQ is the slope of the total
revenue curve, which is equal to the marginal revenue (MR).
Similarly, the term aTC/aQ is the slope of the total cost curve,
which is equal to the marginal cost (MC). Thus, the first-order
condition for profit maximisation can be stated as:
MR=MC
The first-order condition is also called necessary condition, as it
is so important that its non-fulfilment results in non-occurrence of
the secondary condition and thereby the profit maximisation
objective is not attained.

Second-order Condition
The second-order condition of profit maxirnisation requires that the
first order condition is satisfied under rising MC and decreasing MR.
This condition is illustrated in Fig. I. The MC and MR curves are the
usual marginal cost and marginal revenue curves, respectively. MC
and MR curves intersect at two points, PI and P2. Thus, the first order
condition is satisfied at both the points but mathematically, the
second order condition requires that its second derivative of the profit
function is negative. When second derivative of profit function is
negative, it shows that the total profit curve has bent downward after
reaching the highest point on the profit scale. The second derivative
of the total profit function is given as:

a2TR a2TP a2TR a2TC

aQ2 = aQ2 = aQ2 - aQ2 <0
(4)

But it requires:

a2TR a2TC
aQ2 - aQ2 <0

a2TR a2TC
 aQ2 < aQ2 <0

Since & TR/aQ2 is the slope of MR and & a2 TC/aQ2 is the slope of
MC, the second-order condition can also be written as:

Slope of MR < Slope of MC. It implies that MC curve must

intersect the MR curve. To conclude, profit is maximised where both
the first and second order conditions are satisfied.
Example
It is known that:
TR = P.Q
where, (5)
P = Price of a single quantity and
Q = Total quantity.
Suppose price (P) function is given as
P = 100 – 2Q
(6)
Then TR = (100 – 2Q) Q
Or, TR = 100Q – 2Q2 (7)
And also suppose that the total cost function as given as
TC = 10 + 0.5Q2
(8)
Applying the first order condition of profit maximisation and
finding the profit maximising output. It is known that profit is
maximum where:
MR – MC
or,
aTR aTC
aQ aQ
=
(9)
Putting the values of Equation (7) and (8) in (9)
aTR aTC
MR = aQ < aQ = 100 – 4Q
and
 aTC
MC = =Q
aQ

Thus, profit is maximum where

MR = MC
100 – 4Q = Q
5Q = 100
Q = 20
The output 20 satisfies the second order condition also. The
second order condition requires that:
a2TR a2TC
aQ2 < aQ2 <0

In order words, the second-order condition requires that

aMR aMC
Q - Q <0

Or
a(100 – 40) a(Q)
aQ aQ
- <0

- 4 – 1 <0
Thus, the second-order condition is also satisfied at output 20.

CONTROVERSY OVER PROFIT MAXIMISATION OBJECTIVE:

THEORY vs. PRACTICE

According to the traditional theory, profit maximisation is the sole

objective of a business firm. In practice, however, firms have been
found to be pursuing objectivies other than profit maximisation. For
the large business firms, pursuing goals other thon profit
maximisation is the distinction between the ownership and
management. The separntion of manllgement from the ownership
gives managers an opportunity to set goals for the firms other than
protit maximisation. Large firms pursue goals such as sales
maximisalioll, mllximisulioll of lilllllagcrial utility function,
maximisation of firm's growth rate, making a target profit, retaining
market share, building up the net worth of the firm, etc. Secondly,
traditionnl theory assumes perfect knowledge about current murket
conditions and the future developments in the business environment
of the firm. Thus a business firm is fully aware of its demand and cost
functions in both short and long runs. The market conditions (Ire
assumed to be certain. On the contrary, it is also recognised that the
firms do not possess the perfect knowledge of their costs, revenue,
and their environment. They operate in the world of uncertainty. Most
of the price and output decisions are based on probabilities.
Finally, the marginality principle in which MC and MR are same
has been found to be absent in the decision-making process of the
business firms. Hall and Hitch have found, in their study of pricing
practices in UK, that the firms do not pursue the objective of profit
maximisation and that they do not use the marginal principle of
equalising MR and MC in their price and output decisions. Most firms
aim at long-run profit maximisation. In the short-run, they set the
price of their product on the basis of average cost principle to cover
average cost and its components, average variable cost and average
fixed cost.
It also takes into account normal profit usually 10 per cent.
Gordon, a famous economist, has concluded that the real business
world is much more complex than the one which is based on
hypothesis and assumptions. The extreme complexity of the real
business world and ever-changing conditions makes it difficult for a
business firm to use its past experience in order to forecast demand,
price and costs. The average-cost principle of Rricing is widely used
by the firms and the marginal costs and marginal revenu~ are
ignored. On the basis of many such studies, it can be said that the
pricing practices are related to pricing theories.
THE FAVOUR OF PROFIT MAXIMISATION

The arguments against the profit-maximisation assumption, however,

should not mean that pricing theory is not related to the actual
pricing policy of the business firms. Many economists has strongly
supported the profit maximisation objective and the marginal
principle of pricing and output decisions. The empirical and
theoretical policies support the marginal rule of pricing in the
following way:

In two empirical studies of 110 business firms, J.S.Earley has

concluded that the firms do apply the marginal rules in their pricing
and output decisions. Fritz Maclup has argued that empirical studies
by Hall and Hitch, and Lester do not provide conclusive evidence
against the marginal rule and these studies have their own
weaknesses. He further argued that there has been a
misundestanding regarding the purpose of traditional theory. The
traditional theory explains market mechanism, resource allocation
through price mechanism and has a predictive valu. The significance
of marginal rules in actual pricing system of firms could not be
considcred becausc of lack of communication between the
busincssmcn and the researchers as they use different terminology
like MR, Me and clasticitics. Also, Maclup is of the opinion that the
practices of setting price equal to the average variable cost plus a
profit margin, is not inequitable with the marginal rule of pricing.

ARGUMENTS IN FAVOUR OF PROFIT MAXIMISATION

HYPOTHESIS

The traditional theory supports the profit maximisation hypothesis

also on the following grounds:

• Profit is essential for survival of a business: The survival

of all the profitoriented firms in the long run depends on their ability
to make a reasonable profit depending on the business conditions
and the level of competitior. Profit is the biggest incentive for work.
It is the driving force behind the business enterprise. It encourages a
man to work to do the best of his ability and capacity. Making a
profit is a necessary condition for the survival of the firm. Once the
firms are able to make profit, they try to maximise it.

• Achieving other objectives depends on the ability of a

business to make profit: Many other objectives of business are
maximisation of managerial utility function, maximisation of long-run
growth, maximisation of sales revenue. The achievement of such
alternative objectives depends wholly or partly on the primary
objective of making profit.

• Profit maximisation objective has a greater predicting

power: As comparcd to other business objectives, profit
maximistion assumption has been found 10 be good in predicting
ccrtain aspects relatcd to a business. Friedman supports this by
saying that the profit maxilllisation is considered to be good only if it
predicts the business behaviour and the business trends correctly.

• Profit is a more reliable measure of efficiency of a

business: Thought not perfect, profit is the most efficient and
reliable measure of the efficiency of a firm. It is also the source of
internal finance. The recent trend shows a growing dependence on
the internal finance in the indlstrially advanced countries. In fact, in
developed countries, internal sources of finance contribute more
than three-fourths or lotal linance. Keeping this in mind, it can be
said that profit maximisation is a more valid business objective.

Alternative objectives of Business Firms

The traditional theory does not distinguish between owners and
managers' interests. The recent theories of firm, which arc also called
managerial and behavioural theories of firm, assume owners and
managers to be separate entities in large corporations with different
goals and motivation. Berle and Means were the two economists, who
pointed out the distinction between the ownership and the
management, which is also known as Berle-Means-Galbraith (BMG)
hypothesis. The B-M-G hypothesis states the following:
 The owners controlled business firms have higher profit rates than
manager controlled business firms, and
The managers have no in::entive for profit maximisation. The
managers of large corporations, instead of maximising profits,
set goals for themselves that helps in controlling the owners
also. In this section, some important alternative objectives of
business firms, especially of large business corporations are also
discussed.

Baumol's Hypothesis of Sales Revenue Maximisation

According to Baumol, "maximisation of sales revenue is an
alternative to profitmaximisation objective". The reason behind this
objective is to clearly distinct ownership and management in large
business firms. This distinction helps the managers to set their goals
other than profit maximisation goal. Under this situation, managers
maxi mise their own utility function. According to Baumol, the most
reasonable factor in managers' utility functions is maximisation of the
sales revenue.
The factors, which help in explaining these goals by the
managers, are following:
Salary and other earnings of managers are more closely related
to seals revenue than to profits.
• Banks and financial corporations look at sales revenue while
financing the corporation.
• Trend in sale revenue is a good indicator of the performance of
the business firm. It also helps in handling the personnel
problems.
• Increasing sales revenue helps in enhancing the prestige of
managers while profits go to the owners.

• Managers find profit maximisation a difficult objective to fulfil

consistently over tillle and at the same level. Profits may fluctuate
with changing conditions.

• Growing sales strengthen competitive spirit of the business firm

in the nlilrkd and vice versa.
So far as cmpirical validity of sales revenue maximisation
objective is concerned, realistic evidences are unsatisfying. Most
empirical studies are, in fact, based on inadequate data because the
necessary data is mostly not available. If total cost lilllction intersects
the total revenue function (TR) function before it reaches its highest
point, Baumol's theory fails. It is also argued that, in the long run,
sales maximisation and profit maximisation objective can be merged
into one. In the long rnll, sales maximisation lends to yield only
normal levels of profit, which turns out to be the maximum under
competitive conditions. Thus, profit maximisation is not inequitab!c
with sales maximisation objective.

MARRIS's HYPOTHESIS OF MAXIMISATION OF FIRM'S

GHOWTH RATE

According to Robin Marris, managers maximise firm's growth rate

subject to managerial and financial constraints. Marris defines firms'
balanced growth rate (G) as follows:
G = Gd = Gc

where,

Jd = growth rate of dcmand for firms product.

Gc = growth rate of capital supply to the firm.

In simple words, a firm's growth rate is considered to be
balanced when demand for its product and supply of capital to the
firm increase at the same rate. The two growth rates according to
Marris, are translated into two utility functions such as:

• Manager’s ut i I ity function

• Owner’s utility function

The manager’s utility function (Um) and owner's utility function

(Uo) may be specified as follows:
• Um = f (salary, powcr, job security, prestige, status) and

• Un = f (output, capital, market-share, profit, public esteem).

Owner's utility function (Vo) implies growth of demand for firms'

products and supply of capital. Therefore, maximisation of Uo mcans
maximisation of demand for a firm's products or growth of supply of
capital.
According to Marris, by maximising these variables, managers
maximise both their utility function and that of the owner's. The,
managers can do so because most of the variables such as salarics,
status, job security, power, etc., appearing in their own utility
function and those appearing in the utility function of the owners
such as profit, capital market, share, etc. are positively and strongly
correlated with the size of the firm. These variables depend on the
maximisation of the growth rate of the firms. The managers,
therefore, seek to maximise a steady growth rate. Marris's theory,
though more accurate and sophisticated than Baumol's sales revenue
maximisation, has its own weaknesses. It fails to deal satisfactorily
with the market condition of oligopolistic interdependence. Another
serious shortcoming is that it ignores price determination, which is
the main concern of profit maximisatioll hypothesis. In tbe opinion of
many economists, Marris's model too, does not seriously challenge
the profit maximisation hypothesis.

Williamson's Hypothesis of Maximisation of Managerial Utility

Function
Like Baulmol and Marris, Willamson argues that managers are very
careful in pursuing the objectives other than profit maximisation. The
managers seek to maxi mise their own utility function subject to a
minimum level of profit. Managers' utility function (U) is expressed
below: V = f(S, M, ID)
where,
S = additional expenditure on staff
M = Managerial emoluments
 ID = Discretionary investments
According to Williamson's hypothesis, managers maximise their
utility function subject to a satisfactory profit. A minimum profit is
necessary to satisfy the shareholders and also to secure the job of
managers. The utility fU'1ctions which managers seek to maximise,
include both quantifiable variables like salary and slack earnings anti
non-quantitative variable such as prestige power, status, job security,
professional excellence, etc. The non-quantifiable variables are
expressed in order to make them work effectively in terms of ex;
ense preference defined as satisfaction derived out of certain types
of expenditures. Like other alternative hypotheses, Williamson's
theory too suffers from certain weaknesses. His model fails to deal
with the problem of oligopolistic interdependcncc, Willinmsoli's theory
is said to hold only where rivalry between firms is not strong. In case
there is slrong rivalry, profit maximisation is claimed to be a more
appropriate hypothesis. Thus, Williamson’s managerial utility function
too does not offer a more satisfactory hypothesis than profit
maximisation.

Cyert-March Hypothesis of Satisfying Behaviour

Cyert-March hypothesis is an extension of Simon's hypothesis of
firms' satisfying behaviour. Simon had argued that the real business
world is full of uncertainly liS accurate and adequate data are not
readily available, If data are available, managers have little time and
ability to process them, Managers alsc work under a number of
constraints. Under such conditions it is not possible for the firms to
act in terms of consistency assumed under profit maximisation
hypothesis. Nor do the firms seek to maximise sales and growth.
Instead they seek to achieve a satisfactory profit or a satisfactory
growth and so on. This behaviour of business firms is termed as
satisfaction behaviour.
Cyert and March added that, apart from dealing with uncertainty,
managers need to satisfy a variety of groups of people such as
managerial staff, labour, shareholders, customers, financiers, input
suppliers, accountants, lawyers, etc. All these groups have confiicting
interests in the business firms. The manager's responsibility is to
satisfy all of them. According to the Cyert-March, "firm's behaviour is
satisfying behaviour, which implies satisfying various interest groups
by sacrificing firm's interest or objectives." The basic assumption of
satisfying behaviour is that a firm is an association of different groups
related to various activities of the firms such as shareholders,
managers, workers, input supplier, customers, bankers, tax
authorities, and so on. All these groups have some expectations from
the firm, which are needed to be satisfied by the business firms. In
order to clear up the conflicting interests and goals, managers fonn
an objective level of the firm by taking into consideration goals such
as production, sales and market, inventory and profit.
These goals and objective level are set on the basis of the
managers past experience and their assessment of the future market
conditions. The objective level is also modified and revised on the
basis of achievements and changing business environment. But the
behaviouraI theory has been criticised on the following grounds:

• Though the behavioural theory deals with the activities of the

business firms, it does not explain the firm's behaviour under
dynamic conditions in the long run.
• It cannot be used to predict the firm's activities in the future.
• This theory does not deal with the equilibrium of the business
industry.
• This theory fails to deal with interdependecne or the linns and its
impact on linn's behaviour.

ROTHSCHILD's HYPOTHESIS OF LONG-RUN SURVIVAL AND

MARKET SHARE GOALS
Rothschild suggested another alternative objective and alternative to
profit maximisation to a business firm. Accordingto Rothschild, the
primary goal of the firm is long-run survival. Some other economists
have suggested that attainment and 'retention of a market share
constantly, is an additional objective of the business firms. The
managers, therefore, seek to secure their market share and long-run
survival. The firms may seek to maxi mise their profit in the long run
though it is not certain.

Entry-prevention and Risk-avoidancel

Another alternative objective of firms as suggested by some
economists is to prevent the entry of new business firms into the
industry. The motive behind entry prevention may be any of the
following:

• Profit maximisation in the long run.

• Securing a constant market share.

• Avoidance of risk caused by the unpredictable behaviour of

new firms.
The evidence related to the firms to maximise their profits in the
long run, is not certain. Some economists argue that if management
is kept separate from the ownership, the possibility of profit
maximisation is reduced. This means that only those firms with the
objective of profit maximisation can survive in the long run. A
business firm can achieve all other subsidiary goals easily by
maximising its profits. The motive of business firms behind entry-
prevention is also to secure a constant share in the market. Securing
constant market share also favours the main objective of business
firms of profit maximisation.

A Reasonable Profit Target

A business firm has variolls objectives to achieve. The survival of a
firmdepends on the profit it can make. So, whatever the goal of the
firm may be, it has to be a profitable firm. The other goals of a
business firm can be sales revenue maximisation, maximisation of
firm's growth, maximisation of managers’ utility function, long-run
survival, market share or entry-prevention. In technical sensc,
maximisation of profit, as a business objective, may not sound
practical , but profit has to be there in the objective function of the
firms for its survival. The firms may differ on the level of profit and
the extent to which it is to be achieved by various firms. Some firms
set standard profit as their objective, while some of them may set
target profit and some reasonable profit as their objective to be
achieved. A reasonable profit, as a business objective, is the most
common objective. The policy question related to setting standard or
criteria for reasonable profits are as follows:

• Why do modem corporations aim at a reasonable profit rather

than attempting to maximise profit?
• What are the criteria for a reasonable profit?
• How should reasonable profits be determined?
Following are the suggestions as given by various economists to
answer the above policy questions:
1. Preventing entry of competitors: Under imperfect
market conditions, profit maximisation generally leads to a high pure
profit, which attracts competitors, especially ill case of a weak
monopoly. Therefore, the firms adopt a pricing and a profit policy
that assures them a reasonable profit. At the same time, it also keeps
the potential competitors away.
2. Maintaining a good public image: It is often
necessary for large corporations to project and maintain a good
public image. This is because if public opinion turns against it and
government officials 'start questioning the profit figures, firms may
find it difficult to work smoothly. So most firms set their prices lower
than that to earn the maximum profit but higher enough to ensure a
reasonable profit.
3. Restraining trade union demands: High profits make
trade unions feel that they have a share in the high profit and
therefore they demand for wage-hike. Wage-hike may interrupt the
firm’s objective of maximising profit. Any delay in profit is sometimes
used as a weapon against trade union activities.
4. Maintaining customer goodwill: Customer's goodwill
plays a significant role in maintaining and promoting demand for the
product of a firm. Customer's goodwill depends on Jhe quality of the
product and its fair price to a large extent. Firms aiming at bcllcr
profit prospects in the long run, give up their short-run profit
maximisation objective in favour of a reasonable profit.
5. Other factors: The other factors that interrupts the
profit maximisation objective include the following:
A. Managerial utility function, which is preferable for,
profits maximisation to firms.
B. Friendly relations between executive levels within
the firm.
C. Maintaining internal control over management by
restricting firm's size and profit.

Standards of Reasonable Profits

Standards of reasonable profits are determined when a firm chooses
to make only reasonable profits rather than to maximise its profit.
The questions that arise in this regard are as follows:

• What form of profit standards should be used?

• How should reasonable profits be determined?

These questions can be understood after going through the
following explanatory points.

FORMS OF PROFIT STANDARDS

Profit standards is determined in terms of the following:
• Aggregate money terms
• Percentage of sales, and
• Percentage return on investment.
All these standards are determined for each product separately.
Among all the fonns of profit standards, the total net profit of the firm
 is more common than other standards. But when the purpose is to
discourage the competitors, then the target rate of return on
investment is the appropriate profit standard, provided the cost
curves of competitors' are similar. The profit standard in terms of
ratio to sales is not an appropriate standard because this ratio varies
widely from linn to firm, evens irthey nil hove the snme return on
capital invested. These differences are following:

• Vertieal integration of production process

• Intensity of mechanisation
• Capital structure
• Turnover

SETTING THE PROFIT STANDARD

The following arc the important criteria that are considered while
selling the standards for a reasonable profit.

• Capital-attracting standard: An important criterion of profit

standard is that it must be high enough to attract external
capital such as debt and equity. For example, if the firm's stocks
are sold in the market at 5 times their current earnings, it is
necessary for a firm to earn a profit of 20 per cent of the total
investment But there are certain problems associated with this
criterion, which are as follows:

ο Capital structure of the firms such as the proportions of

bonds, equity and preference shares, which affects the cost
of capital and thereby the rate of profit.

ο If the profit standard is based on current or long run

average cost of capital or not. The problem in this case
arises as it may also vary widely from company to
company.

• Plough-back' standard: This standard is appropriate in case

company depends on its own sources for financing its growth.

 This standard involves the aggregate profit that provides for an
adequate plough-back for financing a desired growth of the
company without resorting to the capital market. This standard
of profit is used when liquidity is to be maintained by a firm and
a debt is to be avoided as per the profit policy of the firm. This
standard is socially less acceptable than capital attracting
standard. From society's point of view, it is more desirable that
all carnings are distributed to stockholders and they should
decide the further investment pattern. This is based on a belicf
that an individual is the best judge of his resource use and the
market forces allocate funds more efficiently, On the other
hand, retained eamings, which are under the control or the
managemcnt are likely to be wasted on low-earning projects
within a business firm. But to choose the most suitable policy
among marketing and management the abilities of the
management and outside investors are to be considered. This
helps in estimating the earnings prospects of a firm.

• Normal earnings standard: Another important criterion for

setting standard of reasonable profit is the normal earnings of firms
of an industry over a period. This serves as a valid criterion of
reasonable profit, provided it should take into consider the following
points:
o Attracting external capital

o Discouraging growth of competition

o Keeping stockholders satisfied.

When average of normal earnings of a group of firms is used,

then only comparable firms are chosen. However, none of these
standards of profits is perfect. A standard should, therefore be
chosen after giving due consideration to the existing marke
conditions and public attitudes. Different standards arc used for
different purposes because no single criterion satisfies all conditions
of the customers.
PROFIT AS CONTROL MEASURE

An important aspect of profit is its use in measuring and controlling

perfonnances of the individuals of the large business firms.
Researches have concluded that the business individuab of middle
and high ranks often deviate from profit objective and try 10
maximise their own utility functions. They give importance to job
security, personal ambitions for promotion, larger perks, etc. But this
often conflicts with firms' profit-making objective. The reasons for
conflicts as given by Keith Powlson are as follows:

• More energy is spent in expanding sales volume and product

lines than in raising profitability.

• Subordinates spend too much time and money doing jobs

perfectly regardless of its cost and usefulness.

• Individuals depend more to the needs of job security in the

absence of any reward.

In order to control the conllicts and directing the individuals

towards the profit objective, the top management uses
decentralisation and control-by-profit techniques. Decentralisation is
achieved by changing over from functional division of business
activities such as production branch, sales division, purchase
department, etc. to a system of commodity wise division. By doing
so, managerial responsibilities are fixed in terms of profit. Under the
general policy framework, managers enjoy self-sufficiency in their
operations. They are allotted a certain amount to spend and a profit
target to be achieved by the particular division. Profit is then-the
measure of performance of each individual, not of the sales or
quality. This kind of reorganisation of management helps in assessing
profit-performance of every individual. The two important problems
that arise in the determination of profits are as follows:

• Either the profit goals are set in terms of total net profit for the
divisions or they should be restricted to their share in the total net
profit.
• Determination of divisional profits when there is a vertical
integration. The most appropriate profit standard of divisional
performance is calculated by deducting current expenses from
revenue of the firm.
Profit is essential for survival of a business. In the absence of
profits, the organisations will use up their own capital and close
down. It also helps in replacing obsolete machinery and equipment
and thus ensures the continuity of a business.

Conclusion
Profit maximisation is the most popular hypothesis in economic
analysis, but there are many other important objectives, which are
not to be avoided by any firm. Modem business firms pursue multiple
objectives. The economists consider a number of alternative
objectives of business firms. The main factor behind the multiplicity
of the objectives, especially in case of large business firms, is the
separation of management from the- ownership. Moreover, profit
maximisatjon hypothesis is based on time. The empirical evidence
against this hypothesis is not conclU3ive and unambiguous. The
alternative hypotheses are also not so strong to repiace the profit
maximisation hypothesis. In addition to it, profit maximisation
hypothesis has a greater explanatory and predictive power than any
of the alternative hypotheses. Therefore, profil maximisation
hypothesis still fornls the basis of firms' behaviour.

PROFIT PLANNING AND FORECASTING

A business is considered to be sound if it includes consistency in

earning profit while considering the various risks as well. A firm is
faced with a number of untertainties. 1bese uncertainties are in
-terms of nature of consumer needs, the diverse nature of
competition, the uncontrollable nature of most elements of cost and
the continuous technological developments. The uncertainty about
the pattern and extent of consumer demand for a particular product
increases the degree of risk faced by the firm. The nature of
competition is related to either product, price or to both
simultaneously. Prodoct competition is more important till 'the
product reaches the stage of maturity. Price competition begins a fier
the product is established and reaches the maurity stage. During the
growth stage, the risk of obsolescence of a product and shortening of
the product life cycle is more. The degree of risk involved in product
competition is greater than in price competition. When the prices rise
continuously, no firm can be certain of its internal cost structure. This
is because it does not have any control over the prices of raw
materials or the wages to be paid to the individuals. In course of
time, continuous technological improvements may make production
completely obsolete. If an improved process is available, a firm can
restrict its risk by neglecting its fixed investment. If it does not have
an access to the improved processes, it may have to go out of
business. Unless a firm is prepared to face the uncertainties, as a
result of risk element, its profits will be changed. To plan for profits, a
thorough understanding of the relationship of cost, price and volume
is ext~emely helpful to business individuals. The most important
method of determining the cost-volumeprofit relationship is break-
even analysis, also known as cost-volume-profit (C-V-P) analysis.
Break-even analysis involves the study of revenues and costs of a
firm in relation to its volume of sales. It also includes the
determination of that volume at which the firm's costs and revenues
will be equal. The break-even point (BEP) may be defined as that
level of sales at which total revenue is equal to the total costs and
the net income is zero. This is known as no-profit no-loss point. The
main objective of the break-even analysis is not simply to find out
the BEP, but to develop an understanding between the relationships
of cost, price and volume.

DETERMINATION OF THE BREAK-EVEN POINT

It may be determined either in terms of physical units or in money

terms. This method is convenient for a firm producing single
prdducts only. The break-even volume is the number of units of the
product, which must be sold to earn revenue. This revenue should
be enough to cover all expenses, both fixed and variable. The selling
price of all units covers not only its variable cost but also leaves a
margin called contribution )l1argin to contribute towards the fixed
costs. The break-even point is reached when sufficient number of
units has been sold so that the total contribution margin of the units
sold is equal to the fixed costs. The formula for calculating the
break-even point is:
Fixed costs
BEP = contribution margin per unit
Where the contribution margin is: selling price Variable costs per unit.
Example 1: Suppose the fixed costs of a Factory are Rs. 10,000 per
yenr, the variable costs are Rs. 2.00 per unit and the selling price is
Rs. 4.00 per unit. The break~even point would be:
Rs. 10,000
BEP = (4-2) = 5,000 units

In other words, the company would not make any loss or profit at
a sales volume of 5,000 units as shown below:

Sales RS.20,000
Cost of goods sold:
Variable cost @
Rs 10,000
Rs.2.00
Fixed costs Rs. 10,000 Rs.20,OOO
Net Profit Nil

Solution. Multi-product firms are not in a position to measure the

break-even point in terms of any common unit of product. It is
convenient for them to determine their break-even point in terms of
total rupee sales. The break-even point is the point where the
contribution margin is equal to the fixed costs. The contribution
margin is expressed as a ratio to sales. For example, if the sales is Rs.
200 and the variable costs of these sales is Rs. 140, the contribution
margin, ratio is (200 - 140)/200 or 0.3.
The formula for calculating the break-even point is:
Fixed costs
BEP = contribution margin ratio

Example 2:
Sales Rs. 10,000
Variable costs Rs. 6,000
Fixed costs RS. 3,000
With the help of given information, calculate net profit.

Solution. The contribution margin ratio is (10,000-6,000)/10,000

= 0.4
Fixed costs
BEP = contribution margin ratio

3,000
0.4 = Rs. 7 500

Sales value Rs.7,500

Less: Variable costs Rs.4,500
(0.6 x 7,500)
Fixed costs Rs.3,000
Net profit Nil

Example 3: Sales were Rs. 15,000 producing a profit of Rs. 400 in

a week. In the next week, sales amount to Rs. 19,000 producing a
profit of Rs. 1,200. Find out the BEP.

Solution.
Increase in sales 19,000 - 15,000 = Rs. 4,000
Increase in profit 1,200 - 400 = Rs. 800
Increase in variable costs 4,000 - 800 = Rs. 3,200
Over sales of Rs. 4,000, variable costs are Rs. 3,200.
Hence VC per rupee of sale is 3,200 + 4,000 = 0.80.
Fixed costs will be as under:
 Variable cost 15,000 x 0.80 12,000
Profit 400
VC + Profit 12,400
Sales value 15,000
Fixed cost 2,600

S–V 15,000 – 12,000 3,000

= S = 15,000 = 15,000 = 0.2

FC
Contribution margin ratio
Now, BEP =

2,600
= 0.2 = Rs. 13,000

Break-even Point as a Percentage of Full Capacity

Full capacity can be defined as the maximum possible volume

attainable with the firm's existing fixed equipment, operating policies
and practices. Break-even point is usually expressed as a percentage
of full capacity. Considering the example I, the full capacity of the
firm is 10,000 units; the break-even point at 5,000 units can be
expressed as 50 per cent of full capacity.

Multi-product Manufacturer and Break-even Analysis

Most manufacturers produce more than one type of product. The

determination of BEP in such cases is a little complicated and is
illustrated below:

Example 4: A manufacturer makes and sells tables, lamps and

chairs. The cost accounting department and the sales department
have supplied the following data:
~
Product VC % of rupee
Selling Price
Per unit Sales volume
Rs. Rs.
Tables 40 30 20
 Lamps 50 40 30
Chairs 70 50 50

Capacity of the firm is Rs. 1,50,000 of total sales value.

Annual fixed cost - Rs. 20,000
Calculate (1) BEP and (2) Profit if firm works at 50 per cent of
capacity.

Solution. The contribution towards fixed cost in each case is:

.Table Rs. 10
Lamps Rs. 10
Chairs Rs. 20
Now, these contributions are to be converted into percentages of
selling prices, the formula to be applied is:
Selling price - VC
Contribution percentage = Selling price x 100

Thus, the contribution percentage for individual items is:

40 - 30 1
Table ---x 100 = - xl 00 = 25 per cent
40 4
50 - 40 1
---x 100 = - xl 00 = 20 per cent
50 5
70 - 50 2
---x 100 = -x 100 = 28.57 per cent
70 7

Now, we multiply the contribution percentage of each of the

products by the percentage of sales volume for that particular
product and add the figures obtained. This gives the total
contribution per rupee of sales volume for tables, lamps and chairs.
This is done as follows:
Contribution % of Sales
 Tables 25.00 % X 20 % = 5.00 %
Lamps 20.00 % X 30 % = 6.00 %
Chairs 28.57 % X 50%= 14.28%·

25.28 % say 25 %
--

This 25 per cent is the total contribution per rupee of overall

sales given the present product sales mix. The calculations required
in the question are as follows:

1. BEP: The BEP orthe firm is calculated as under:

Fixed costs 20,000

BEP = Contribution marginper unit = 25% Rs. 80,000

2. Profit: Calculation of profit or loss at various volumes can also

be made easily. If the firm produces at 80 per cent of capacity,
the profit will be calculated as under:
Profit = Total revenue - Total costs
= 80% of (1,50,000) - Fixed costs - Variable costs
= 1,20,000 - 20,000 - 75% of (1,20,000)
= 1,20,000 - 20,000 - 90,000
= Rs. 10,000

Break-even Charts
Break-even analysis is very commonly presented by means of
break even charts. Break-even charts are also known as profit-
graphs. A break-even chart prepared on the basis of example 1 above
is given in Figure 5.2. In this figure, units of product are shown on the
horizontal axis OX while revenues and costs are shown on the vertical
axis OY. The fixed costs of Rs. 10,000 are shown by a straight line
parallel to the horizontal axis. Variable costs are then plotted over
and above the fixed costs. The resultant line is the total cost line,
combining both variable and fixed costs. There is no variable cost line
in the graph. The vertical distance between the fixed cost and th~
total cost lines represents variable costs. The total cost at any point is
the SU!TI of Rs. 10,000 plus Rs. 2.00 per unit of variable cost
multiplied by the number of units sold at that point. Total revenue at
any point is the unit price of Rs. 4.00 multiplied by the number of
units sold. The break-even point corresponds to the point of
intersection of the total revenue and the total cost lines. A
perpendicular from the BEP to the horizontal axis shows the break-
even point in units of the product. Dropping a perpendicular from BEP
to the vertical axis shows the break-even sales value in rupees. The
firm would suffer a loss at any point below the BEP. Total costs are
more than total revenue. Above the BEP, total revenue exceeds total
costs and the firm makes profits. Since profit or loss occurs between
costs and revenue lines, the space between them is known as the
profit zone, which is to the right of the BEP, and the loss zone, which
is to the len of the BEP. The following Figure 5.2 shows Break-even
Chart.

The break-even chart remains where the BEP is measured in

terms of sales value rather than in physical units. The only difference
is that the volume on the X-axis is measured in terms of sales value.
In that case, a perpendicular frqm the point BEP to either axis would
show the break-even rupee sales value. The same type of chart could
be used to depict the BEP in relation to full capacity. In this case the
horizontal axis would represent the percentage of full capacity,
instead of physical units or the sale value.

Break-even Chart-A Variation

The break-even chart is a variation of the traditional break-even
graph. This graph is prepared with the variable cost line instead of
fixed cost line, starting at the zero axis. On it is superimposed the
total cost, the line which includes the fixed cost and is, therefore,
parallel to the variable cost line. This graph is as much useful as the
contribution to fixed cost and profit. It is more deafly shown below in
the Figure 5.3.

Profit-Volume Analysis

It is very similar to the break-even analysis and is based on the

relationship of profits to sales volume. The profit-volume graph shows
the relationship ofa firm's profit to its volume. Total profit or loss is
measured on the vertical axis above the X-axis and the loss below it.
The volume is measured on the X-axis, which is drawn at the point of
'Zero-Profit'. Volume is usually expressed in tenns of percentage of
full capacity. The maximum loss, which occurs at zero sales volume,
is equal to the fixed cost and is shown on the vertical axis below the
X-axis. The maximum profit is earned when the firm works at full
capacity. The point of maximum profit is shown on the vertical axis
above the X-axis. The two points of maximum loss and the maximum
profit are joined by a line, which is known as the profit line, also
called PN line. The profit line can also be established by detennining
the profit at any two points within the given range of volume and
drawing a straight line through these points. The point, at which the
profit line intersects the X-axis, is the break-even point. The space
between the X-axis and the profit line shows the profit zone, which is
to the right of BEP, and the loss zone, which is to the left of BEP. The
usefulness of the graph lise in the fact that it shows the profit or loss
earned by the firm by working at different levels of its full capacity.
The following Figure 5.4 shows the profit volume analysis.

Assumptions
1. All costs are either variable or fixed over the entire range of the
volume of production. But in practice, this assumption may not
hold well over the entire range of production.
2. All revenue is variable in nature. This assumption may Lot be
valid in all cases such as the case where lower prices are
 charged to large customers.
3. The volume of sales and the volume of production are equal.
The total products, produced by the firm, are sold and here is
no change in the closing inventory. In practice, sales and
production volumes may differ significantly. However, these
assumptions are not so unrealistic so as to weaken the validity
of the break-even analysis.
4. In the case of multi-product firms, the product-mix shoulu be
stable. Fora multi-product firm, the BEP is determined by
dividing total fixed costs by an average ratio of variable profit,
also called contribution to'sales. If each product has the same
contribution ratio, the BEP is not affected by changes in the
product-mix.
However, if different products have different contribution ratios,
shift in the product-mix may cause a shift in the break-even point. In
real life, the assumption of stable product-mix is somewhat
unrealistic.

Managerial Uses of Break-even Analysis

To the management, the utility of break-even analysis lies in the fact
that it presents a picture of the profit struture of a business firm.
Break-even analysis not only highlights the areas of economic
strength and weaknesses in the firm but also sharpens the focus on
certaIn leverages which cun be opernted upon to enhance its
profitability. Through brenk-even analysis, it is possible for the
management to examine the profit structure of a business firm to the
possible changes in business conditions. For example, sales
prospects, changes in Cust structure, etc. Through break-even
analysis, it is possible to use managerial actions to maintain and
enhance profitability of the firm. The break-even analysis can be used
for the following purposes:
• Safety margin
• Volume needed to attaintarget profit
• Change in price Change in price
• Expansion of capacity
• Effect of alternative prices
• Drop or add decision
• Make or buy decision
• Choosing promotion-mix
• Equipment selection
• Improving profit performance
• Production planning

Safety Margin
The break-even chart helps the management to know the profits
generated at the various levels of sales. But while deciding the
volume at which the firm would operate, apart from the demand, the
management should consider the safety margin associated with the
proposed volume. The safety margin refers to the extent to which the
firm can afford a decline in sales before it starts occurring losses. The
formula to determine the safety margin is:
(Sales – BEP) x 100
Safety Margin = Sales

Example 5: Assume that our sales in Example 1 are 8,000 units.

(8,000-5,000) x 100
Safety Margin = 8,000 = 37.5%

Before incurring a loss, a business firm can afford to loose sales

up to 37.5 per cent of the present level. A decreasing safety margin
indicates that the firm's resistance capacity to avoid losses has
become poorer. A margin of safety can also be negative. A negative
safety margin is the percentage increase in sales necessary to reach
the BEP in order to avoid losses. Thus, it reveals the minimum extent
of effort in terms of sales expected by the management. Suppose in
the same example sales are us low as 4,000 units. The safety margin
would be:
 (4,000-5,000) x 100
Safety Margin = 4,000

= 25%

In other words, the management must strive to increase sales at

least by 25 per cent to avoid losses.

Volume Needed to Attain Target Profit

Break-even analysis is also utilised for determining the volume of
sales, necessary to achieve a target profit. The formula for target
sales volume is:
Fixed costs + Target profit
Target Sales Volume = Contribution margin per unit
.

Example 6: Continuing with the same example, if the desired

profit is Rs. 6,000, the target sales volume would be calculated as
follows:
10,000 + 6,000
= 8000 units
2

Change in Price
The management is also faced with a problem whether to reduce the
prices or not. The management will have to consider a number of
points before taking a decision related to the change in the prices. A
reduction in price results in a reduction in the contribution margin as
well. This means that the volume of sales will have to be increased to
maintain the previous level of profit. The higher the reduction in the
contribution margin, the higher will be the increase in sales needed
to maintain the previous level of profit. However, reduction in prices
may not always lead to an equal increase in the sales volume, which
is affected by the elasticity of demand. But the information about
elasticity of demand may not be easily available. Breakeven analysis
helps the management to know the required sales volume to
maintain the previous level of profit. On the basis of this knowledge
and experience, it becomes much easier for -the management to
judge whether the required increase it sales will be feasible or not.
The formula to determine the new sales volume to maintain the same
level of profit, given a reduction in price, would be as under:
FC + P
Qn = SPn - VC
where Qn = New volume of sales
FC = Fixed cost
P = Profit
SPn = New selling price
VC = Variable cost per unit (n denotes new)
Example 6(a): Continuing with the same example 6, if we
propose a reduction of 10 per cent in price from Rs. 4.00 to Rs. 3.60,
the new sales volume needed to maintain the previous profit ofRs.
6,000 will be:
10, 000 + 6,000 16, 000
3.60 – 2.00 = 1.60 = 10,000 units

This shows that there is an increase of 2,000 units or 25 per cent

in sales. The management can also easily decide whether this
increase in sales volume is profitable for t~e business firm or not.
If a firm proposes the price increase, the question to be
considered is by how much the sales volume should decline before
profitable effect of the price increase gets eliminated.
Example 6(b): If the firm in example 6 considers an increase in
price by 12Y2per cent to Rs. 4.50, the new volume to maintain the
old profit would be:
10, 000 + 6,000 16, 000
Q2= 4.50 – 2.00 = 2.50 = 6,400 units

In other words, if the fall in sales, due to an increase in price, were

less than 1,600 units or 20 per cent, it would be profitable for the firm
to increase the price. But if the decline were more than 1,600 units,
the proposed price increase would reduce the profit.

Change in Costs
 Break-even analysis' helps to analyse the changes in variable
cost and fixed cost, which are explained as follows.
Change in variable cost: An increase in variable costs leads
to a reduction in the contribution margin. In such a situation, a firm
determines the total sales volume needed to maintain the prescnt
profits withcut any increase in price. A firm also determines the price
lhut should be set to maintain the present level of profit without any
change in sales volume. The formulae to determine the new quantity
or the new selling price, given a change in variable costs, are:
1. The new quantity will be:
FC +P
Qn = SP - VC n

2. The new selling price will be:

SPn = SP + (VCn- VC)
Example 6(c): Continuing with the example 6, if variable cost
increases from Rs. 2 to Rs. 2.50 per unit.

10, 000 + 6,000 15, 000

Q2= 4 – 2.50 = 1.50 = 10,667 units

SPn = 4 + (2.50 - 2) = Rs. 4.50

Change in fixed cost: An increase in fixed costs of a firm is
caused either by external circumstances such as an increase in
property taxes or by a managerial decision such as an increase in
executive salaries. In both the cases, the affect is to raise the break-
even point of the firm, while keeping the prices unchanged. The same
determination is undertaken by the firm regarding the sales volume
while keeping the profit level same as before. The formulae to
determine the new quantity or the new price, given a change in fixed
costs, would be:
1.
FCn – FC
Qn= Q + SP - VC

2.
 FCn – FC
SPn = SP + Q

Example 6 (d): Continuing with the same example 6, if fixed

cost increases from Rs. 10,000 to Rs. 15,000.

Expansion of Capacity

The management may also be interested in knowing whether to

expand production capacity or not, through the installation
equipment. Though even analysis, it wuuld be possible to examine
the various applkutions of this proposal or installation of the
additional equipment. The following example illustrates the points
involved.
Example 7: A textile mill is considering a proposal to increase
its investment in fixed assets. If it decides to do so, fixed expenses
will go up by Rs. 5,00,000 per year without affecting the percentage
of variable expenses. With the present plant, the maximum
production is estimated at an amount, which would enable the
company to make annual sales of Rs. 60,00,000. The increased
production with the additional plant would permit the company to
make annual sales of Rs. 80,00,000. The relevant cost, sales and
profit data for 1997 are:

Sales Rs. 50,00,000

Costs and expenses:
Fixed Rs. 15,00,000
Variable Rs. 32,00,000 Rs. 47,00,000
Net profit Rs. 3,00,000

There are a number of points involved in the decision on

expansion of capacity. The information regarding the expansion of
capacity is as follows:

Existing Plant Expanded Plant

 Capacity 0% 100 % 0% 100 %
Rs. (in Lakhs) Rs. (in Lakhs)
Sales - 60 - 80
Fixed costs 15 15 20 20
Variable costs - 38.4 - 51.2
Profit (Loss) (15) 6.6 (20) 8.8
The expansion of capacity, to enable the firm so as to expand its
sales potential from Rs. 60,00,000 to Rs. 80,00,000, will increase
the maximum profit potential of the firm from Rs. 6,60,000 to Rs.
8,80,000. But there are certain risks involved. Answer the following
on the basis of above information:

1. How will the expansion of the firm's capacity will affect the

break-even point?

2. What would be the sales volume required to maintain the

present profit with the increased fixed costs?
Solution. It is evident that the break-even point of the firm would
be pushed up from Rs. 41, 66,667 to Rs. 55, 55,556. This means that
if the sales remain at the present level, the firm would operate at a
loss.
The minimum sales volume needed to maintain the present profit
would be Rs. 63,88,889, i.e., an increase of about 28 per cent there is
another aspect. To earn the maximum profit possible at the present
sales capacity, i.e., Rs. 6,60,000 with the increase in fixed costs, the
minimum sales volume needed would be Rs. 73,88,889, i.e., an
increase of 48 per cent. So the decision on the question of expanding
capacity hinges on the possibilities of expanding sales by the various
percentages indicated above. The fact that the present sales volume
is 20 per cent less than the maximum possible sales volume of the
existing plant may be an indication that if may be difficult to expand
sales. Another way of presenting the same infonnation is the profit-
volume chart. On the assumption that production efficiency and
prices will remain unchanged, the profit-volume chart can help in
presenting the following:
• The break-even points before and after expansion, and
 • At what capacity utilisation, the profit will be the same as at 100
percent capacity utilisation before expansion. The following
Figure 5.5. shows the profit volume chart.

In order to arrive at the data to plot on the figure, the sales, cost
and profit at either 100 per cent or nil capacity for both existing and
expanded plants should be calculated:
As can be seen from Figure 5.4, the break-even point for both the
plants lies above 70 per cent capacity utilisation. The capacity
utilisation of the expanded plant, which gives the same profit as 100
per cent capacity utilisation of the existing plant, can be easily found.
At 92 per cent of capacity utilisation, the expanded plant will give a
profit of Rs. 6,60,000.

Effect of Alternative Prices

The break-even chart can be modified to show the profit position at
difTerent price levels under assumed conditions of demand and costs.
Figure 5.5 shows the pr,ofit position at alternative prices for the firm
in example 1. As can be seen from the figure, the break-even point
becomes lower as the price increases. But it is not necessary that the
profit potential at higher prices may actually be achieved by the firm.
A price of Rs. 4 per unit with a demand at 7,000 units will give a
higher profit than a price of Rs. 5 with a demand at 4,000 units. It is
not desirable for a firm to take every price into consideration. The
analyst, while choosing a trial price, relies largely upon their
experience and judgement. Customary price is one such price. The
following Figure 5.6 shows the effect of BEP in alternative prices.

Drop or Add Decision

An economist takes the decisions regarding the following:
• Addition of a new product keeping in consideration, its cslimated
revenue and cost.

• Deletion of a product from the product-line keeping in

consideration, its consequent effects on revenue and cost.
Break-even analysis is also useful in taking decisions related to
product planning. It can be understood with the help of following
example:
Example 8: The following are the present cost and output data of
a manufacturer:
Product PrLe Variable costs % of
(Rs.) Per unit sales
(Rs.)
Book-cases 60 40 30
Tables 100 60 20
Beds 200 120 50
 Total fixed costs per year: Rs. 75,000
Sales last year: Rs. 2,50,000.
The manufacturer is considering whether to drop the line of taoles
and replace it with cabinets. If this drop-and-add decision is taken,
the cost and output data would be as follows:

Product Price Variable costs % of sales

(Rs.) Per unit
(Rs.)
Book-cases 60 40 50
Tables 160 60 10
Beds 200 120 40

Total fixed cost per year: Rs. 75,000

Sales this year: Rs. 2,60,000.
On the basis of ubove informntion delermine if the change worth
undertaking by the business firm?
Solution. On the basis of the information given in the question,
the profit on the present product line is computed as follows:

Rs. 60 - 40
60 x 30% = 0.10

Rs. 100 - 60
100 x 20% = 0.08

Rs. 200 - 120

200 x 50% = 0.20/0.38

Thus, the contribution ratio is 0.38, by adding 0.10, 0.08 and 0.20.
Total contribution = Rs. 2,50,000 x 0.38 = Rs. 95,000.
Profit = Rs. 95,000 - Rs. 75,000 = Rs. 20,000.
Profit on the proposed product line would be as under:
Rs. 60 - 40
60 x 50% = 0.17
 Rs. 160 - 60
160 x 10% = 0.06

Rs. 200 - 120

200 x 40% = 0.16

Thus, the contribution ratio is 0.39.

Total contribution = Rs. 2,60,000 x 0.39 = Rs. 1,01,400.
Profit = Rs. 1, 01,400 - 75,000 - Rs. 26,400.
Hence the proposed change is worth undertaking.

Make or Buy Decision

Many business firms may opt to produce certain components or
ingredients, which are part of there finished products, or purchasing
them from outside suppliers. For instance, an automobile
manufacturer can make spark plugs or buy them. Breakeven analysis
can enable the manufacturer to decide whether to make or buy. With
the help of following example, this can be easily understood:
Example 9: A manufacturer of sc.ooters buys certain
components at Rs. 8 each. In case he makes it himself, his fixed and
variable costs would be Rs. 10,000 and Rs. 3 per component
respectively. Should the manufacturer make or buy the component?
If the manufacturer needs more than 2,000 components per year,
to make or produce the components is more profitable than to buy.
There are some special considerations, which helps in choosing the
best option, are as follows:
Solution. This can be detennined after calculating break-even
point of the manufacturer's firm, The break-even point is as follows:
Fixed costs
BEP = Purchse price – Variable Cost

10,000
= 8-3
 10,000
= 5 = 2,000

• Quality: By manufacturing a certain part of the product itself,

the firm is able to exercise control over quality. This may also lead to
reduction in assembly costs and increase in consumer goodwill. This
helps in enhancing the future sales. The outside suppliers may also
possess a highly specialised knowledge, which may outshine the
know-how of the firm. In this situation a firm, a firm may feel that it
cannot match with the quality assured by outsiders. Here, a firm is
advisable to buy the high quality products from other firms so as to
avoid the loss due to poor quality. This could also result in fewer
sales.

• Assurance of supply: By producing a product itself, a firm

may secure the advantage of co-ordinating the flow of parts more
effectively. Sometimes, the suppliers are unable to meet the demand
or make deliveries within the required time period. So, this is also an
advantage for the firm to produce high quality products and to give
its best for the betterment of society.

• Defence against monopoly: A firm can also manufacture

parts to protect itself against a monopoly in supply. If a firm produces
some of it products itself, the other firms are less likely to overcharge
or dictate thelT: in any respect. So producing a part of the product is
also beneficial for a firm.

Choosing Promotion-mix
Sellers often use several methods of sales promotion, such as
personal selling, advertising, etc. But the proportion of all these
methods in the promotion mix varies from seller to seller. A retail
shop may have to consider whether or not to employ a certain
number, say, five additional salesmen. Similarly, a manufacturer may
have to decide if he should spend an additional sum of Rs. 20,000 on
advertising his product or not. Break-even analysis enables him to
take appropriate decisions by showing how the additional fixed costs
influence the break-even points. This can be explained with the help
of the following illustration:
Example 10: A manufacturer sells his product at Rs. 5 each.
Variable costs are Rs. 2 per unit and the fixed costs amount to Rs.
60,000. Find the following:
1. The break-even point.
2. The profit if the firm sells 30,000 units.
3. The BEP if the firm spends Rs. 3,000 on advertising.

4. The sale of manufacturer to make a profit of Rs. 30,000 after

spending Rs. 3,000 for advertisement.

Solution: Tle calculations are as follows:

FC
BEP = SP - VC

60,000
= 5-2 = 20,000 units
Profit = Total revenue - Fixed cost - Variable cost
= (5 x 30,000) - 60,000 - (2 x 30,000)
= 1,50,000 - 60,000 - 60,000
= Rs.30,000

If the firm spends Rs. 3,000 on advertising, fixed costs would

rIse by Rs. 3,000, i.e., Rs. 63,000. Hence, BEP would be:
FC
BEP = SP - VC

63,000
= 5-2 = 21,000 units

The formula for finding out the volume of sales· necessary to

achieve the age! Profit is:
Fixed cost + Target profit
Target sales volume Contribution margin
 =

63,000 + 30,000
= 3

93,000
= 3 = 31,000 units

Equipment Selection
Break-even analysis can also be used to compare different ways
o(doing jobs. For instance, use of simple machines, is usually best for
small quantities. But when bigger quantities are to be produced,
faster but usually costlier machines are to be employed. Sometimes,
a choice is to be made in between three or more methods, depending
upon the most economical one. The following example explains how
to determine these ranges.
Example 11: A manufacturer has to choose from amongst three
machines for his factory. The conditions, which he wants to be
fulfilled regarding the three machines, are as follows:
1. An automatic machine which will add Rs. 20,000 a year to his
fixed costs but the variable costs per unit will be only 40 p.
2. A semi-automatic machine which will add Rs. 8,000 a year to
his fixed costs but variable cost$ per unit will be Rs. 2 and
3. A hand-operated machine which will add only Rs. 2,000 a year
to his fixed costs but will cause variable costs per unit of Rs. 4.
Calculate the range of output over which automatic, semi-
automatic and hand-operated machines would be most economical.
How would you choose between hand-operated and automatic
machines, supposing the semi automatic machine does not exist?
Solution. The cost formulae for the three machines would be,

Machine Cost formula

Automatic Rs. 20,000 + 0.40 S
 Semi-automatic Rs. 8,000 + 2.00 S
Hand-operated Rs. 2,000 + 4.00 S

Now setting pairs of equations to each other, and solving

them to final the Value of S:
1. Automatic vs. Semi- Nutomatie

Rs. 20,000 + 0. 40S = Rs. 8,000 + 2S

or, 1.60S = 12,000
12000
or, S = = 7,500 units
1.60
2. Semi-automatic vs. Hand-operated:

Rs. 8,000 + 2.00S = Rs. 2,000 + 4S

or, 2S = 6,000
or, 8 = 3,000 units

Thus, up to 3,000 units, hand-operated machine is to be used.

The semiautomatic machine is to be used over the range of 3,000 -
7,500 units.

Beyond 7,500 units, automatic machine should be used. If,

however, the choice is to be made between hand-operated and
automatic machines, the former; is to be used up to 5,000 units and,
thereafter, the latter would be more economical. This is calculated as
under:
2,000 + 48 = Rs. 20,000 + 0.40
or, 3.60S = 18,000
or, 8 = 5,000 units.

IMPROVING PROFIT PERFORMANCE

There are four specific ways in which profit performance of a

business can be improved, which are as follows:

• Increasing the volume of sales: Considering the example I,

the present volume of sales is 8,000 units and the maximum
production capacity 10,000 units. If the sales are increased to the
maximum production capacity, there will be an increase in variable
expenses only. The profit will increase from, Rs.6,000 to Rs. 10,000.
It will be seen that though the increase in sales volume has been
only to the extent of 25 per cent, profit has increased by 67 per cent.

• Increasing the seIling price: An increase in the price

increases the contribution margin and reduces the break-even point.
Continuing with Example I, if the selling price is increased by 10 per
cent, the profit will increase from Rs. 6,000 to Rs. 9,200 showing an
increase of more than 50 per cent.

• Reducing the variable expenses per unit: If the variable

expenses are reduced by 10 per cent to Rs. 1.80, the profit will
increase from Rs. 6,000 to Rs. 7,600 at the present volume of sales.
This increase is more than 25 per cent, which is more than the
percentage reduction in variable expenses. In cost-volume-profit
relationship, the higher proportionate increase in profit than the
change in selling price or the volume of sales or the variable
expenses is called the leverage effect. At times, it is not possible to
increase the prices, but to increase the volume of sales and to
reduce the variable expenses is possible.

• Reducing the fixed cost: A reduction in fixed costs, without

a change in variable expenses and the selling price, would lead to an
equal change in the profits. For example, if the fixed expenses are
reduced from Rs. 10,000 to Rs. 9,000 in the above illustration, profit
will increase from Rs. 6,000 to Rs. 7,000. As a change in the fixed
costs does not change the contribution margin per unit, there is no
leverage effect.

Production planning

Break-even analysis can also help in production is planning so as to

give maximum contribution towards profit and fixed costs. This will
be clearly understood from-the following illustration:
 Example 12: The management of Swadeshi Cotton Mills, Kanpur,
is interested in finding out the quantities of cloth X and Y for
production in a week in order to maximiese profits. The total hours
required to produce 100 metres of each cloth are 20 and 25
respectively. The total hours available per week are 9,600. The
maximum possible sales of cloth X and Y for one week as estimated
are: X = 30,000 metres, Y for 40,000 metres.
The following table shows, the variable costs and selling price per
metre:
-
Pcr mctrc
Particulars
Cloth X Cloth Y
Variable cost Rs.2.00 RS.3.00
Selling price RS.2.60 RS.3.80

The total expenses for one week are estimatcd at Rs. 21,400. Find
out the production plan, which the, company should follow. How
much profit shall be earned by following this production plan?

Solution. The contributions of Cloth X and Yare Re. 0.60 and Re.
0.80 per metre respectively, which are calculated by subtracting
variable cost of each from selling price. Hence, priority should be
gi~en to the production of cloth Y as it contributes more towards
meeting the fixed cost. The maximum of cloth Y that can be sold is
40,000 metres, which would require 10,000 hours. However, the total
hours available are 9,600. Hence, the maximum of cloth Y that can
be produced is 38,400 metres (9,600 x 4). The production plan to be
followed is given below:

_._--
Cloth X Nil
Cloth Y 38,400 metres
This plan shall provide profits as shown below:
Total Revenue = Rs. 38,400 x 3.80 = Rs. 1,45,920
Total cost:

Variable cost = Rs. 38,400 x 3 = Rs. 1,15,200

 Fixed cost 21,400 1,36,600
Net porfit Rs. 9,320

Policy Guidelines Originating from Break-even Analysis

There are certain useful conclusions in terms of policy guidelines,
which may be drawn from break-even analysis as a result of the
effect of changing conditions on a firm's operations, policies and
actions. A high BEP indicates the weakness regarding the profit
position of the firm. To reduce the BEI therefore, the selling price
should be increased, variable and fixed costs should be reduced. If
the variable costs per unit asre large (Business 8 in Example 13), an
increase in selling price or a reduction in variable costs would be
morc eLective. Whether it is more desirable to raise prices or
practicable to cut down variable costs, depends upon competitive
market conditions, the elasticity of demand for firm's product and the
efficiency of its operations. When the cOi.lribution margin rer unit is
comparatively large (Business A in Example 13), the firm is advised to
lower the BEP by reducing the level of fixed costs.

The higher the contribution margin, the higher is the survival of

business or vice-versa. Business A with a higher contribution margin
can survive even if the prices drop to 50 paise per unit. Business B
with a lower contribution margin will have to close down its
operations if prices drop to 50 paise. In a period of boom, whcn both
the prices as well as sales rise, a firm with a higher percentage of
fixed costs to sales earns higher profits as compared to a business
with a higher percentage of variable expenses to sales. On the other
hand, in a period of depression, when both the prices as well as sales
decrease, the business with a higher percentage of fixed costs to
sales suffers greater losses than the business with a higher
percentage of variable expenses.
Example 13: The following example of two businesses, A and B,
illustrates some of the points contained in the text above.
 Business A Business B
Selling price per unit Re. 1.00 Re.I.OO

Variable cost per unit Re.0.20 Re.0.60

Fixed costs per year RS.5,000 Rs.2,500

With the help of above infonnation, find which of the businesses

among A and B is profitable for the business firm to suspend
operations? Give explanations to support your answer.
Solution. The break-even point of both the businesses is
6,250 units or Rs. 6,250. If the sales are 10 pefcent above the BEP,
business A gains Rs. 500 while business B gains only Rs. 250. If the
sales are below the BEP, say 5,000 units, business A loses Rs. 1,000
and business B loses only.
Rs. 500. If the market collapses and the prices also go down to
50 paise per unit and sales drop to, say, 3,000, business A suffers a
loss of Rs. 4, 100 while business B suffers a loss of only Rs. 2.500
(the amount of fixed expenses only ns it would find it unprofitable to
continue operntions). But one signifiennt point is that whilc business
A can continue to operate and contribute 30 paise per unit, sold
towards fixed expenses. Business B will find it profitable to suspend
operations.

Limitation of Break-even Analysis

There arc some important limitations of break-even analysis, which
arc to be kept in mind while using break-even analysis. These
limitations are as follows:

• When break-even analysis is based on accounting data, it

may suffer from various limitations of such data, such as
negligence towards imputed costs, arbitrary depreciation estimates
and inappropriate allocation of overhead costs. Break-even
analysis, therefore, can be sound and useful only if the firm in
question maintains a good accounting system and uses proper
managerial accounting techniques and procedures. The figures
must also be adequate and sound. If break-even analysis is based
on past data, the same should be adjusted for changes in wages
and price of raw materials.

• Break-even analysis is static in character. It is based on the

assumption of given relationship between costs and revenues. On
the one hand and input, on the other. Costs and revenues may
change over time making the projection, based on past data wrong.
Therefore, break-even analysis is more useful only in situations
relatively stable while it does not work effectively in volatile, erratic
and widely changing ones.

• Costs in a particular period may not be caused entirely by the

output in that period. For example, maintenance expenses may be
the result of past output or a preparation for future output. It may
therefore, be difficult to relate them to a particular period.

• Selling costs are especially difficult to handle in break-even

analysis. This is because changes in selling costs are a cause and
not a result of changes in output and sales.
A straight-line total revenue curve prcsumcs that any quantity
should be sold at onc price only. This implies a horizonwl
demand curve and is true only under conditions of perfect
competition. The situation of perfect ~ competition is rare in
real world, which restricts the application of many total revenue
curves.

• A basic assumption in break-even analysis is that the cost-

revenue-volume relationship is linear. This is realistic only over
narrow ranges of output. For example, this type of analysis is
worthwhile in deciding if the selling price should be 50 or 60 paise,
volume should be attempted at 80 per cent of capacity rather than 85
per cent, advertising expenditure should total Rs. 1,00,000 or Rs.
1,15,000 or the product should be put in a package costing 70 paise
rather than 90 paise.

• Break-even analysis is not an effective tool for long-range use

and its use should be restricted to the short run only. The break-even
analysis should better be limited to the budget period of the firm,
which is usually the· calendar year.

• The area included in the break-even analysis should be limited

if too many products, departments and plants are taken together and
graphed on a single break-even chart: it will be difficult for the fim1
to distinguish between the good and bad performances of the
business firm.

• Break-even analysis assumes that profits arc a function of

output ignoring the fact that they arc also caused by other factors
such as technological change, improved management, changes in the
scale of the fixed factors of production and so on.
To conclude, it can be said that break-even analysis is a
device, simple, easy to understand and inexpensive and is there fore,
useful to management. Its usefulness varies from a firm to another
firm and also among industries. Industries suffering from frequent
and unpredictable changes in input prices, rapid technological
changes and constant shifts in product mix will not benefit much
from break-even analysis. Finally, break-even analysis should be
viewed as a guide to decision-making and not as a substitute for
judgement, logical thinking.

PROFIT FORECASTING

Profit planning cannot be done without proper profit forecasting.

Profit forecasting means projection of future earnings after
considering all the factors affecting the siz.e of business profits, such
as firm's pricing policies, costing policies, depreciation policy, and so
on. A thorough study including a proper estimation of both economic
as well as non-economic variables may be necessary for a firm to
project its sales volume, costs and subsequently the profits in future.
According to joel Dean, a famous cconomist, there are three
approaches to profit forecasting, which are as follows:

• Spot Projection: Spot projection includes projecting the profit

and loss statement of a business firm for a specified future period.
Projecting of profit land loss statement means forecasting each
important element separately. Forecasts are made about sales
volume, prices and costs of producing the expected sales. The
prediction of profits of a firm is subject to wide margins of error, from
forecasting revenues to the inter-relation of the various components
of the income statement.

• Brcak-even analysis: It helps in identifying functional

relations of both revenues and costs to output rate, kecping in
consideration the way in which output is related to the prolits. It also
helps in doing so by relating profits fo output directly by th.e usual
data used in break-even analysis.

• Environmcntal analysis: It helps in relating the company's

profits to key variabk, in the economic environment such as the
general business activity and the general price level. These variables
are not considered by a business firm.

All those factors that control profits move in regular and related
patterns such as the rate of output, prices, wages, material costs and
efficiency, which are all inter-related by their connections with the
national markets and also by their interactions in business activity.
Theories of business cycles are based on the hypothesis, which is
shown by the national values of production, employment, wages and
prices during any fluctuation in business activities. There is no clear
pattern in detailed analysis. These patterns helps in increasing the
possibility that the profits of a business firm, can be forecast directly
by finding a relation to key variables. The need is to find a direct
functional relation between profits of a business firm and activities at
national level that shows statistical signi ticance.
In practice, these three approaches need not be mutually
exclusive. Theses approaches can also be used jointly for maximum
information. In projecting the profit and lo.ss statement, the
functional relations can be used, arising out of the ratio of cost to
output and to its other determinants. In the same way, by measuring
the impact of outside economic forces upon the firms' profit helps in
facilitating good spot guesses. It can also enhance the accuracy of
break-even analysis.

REVIEW QUESTIONS
1. Distinguish between the following concepts or profit:
A. Accounting profit and economic profit.
B. Normal profit and monopoly profit.
C. Pure profit and opportunity cost.
2. Examine critically profit maximisation as the objective of
business firms. What are the alternative objectives of business
firms?
3. Explain the first and second order conditions of profit
maximisation.

4. Profit maximisation is theoretically the most sound but

practically unattainable objective of business firms. Do your
agree with this statement? Give reasons for your answer.
5. Explain how profit is used as a control measure. 'What
problems are associated with the use of profit figures as a
control measure?
 LESSON NO-6
NATIONAL INCOME

National income is the final outcome of total economic activities of a

nation. Economic activities generate two kinds of flow in a modern
economy namely, product-flow and money-flow. Product-flow refers
to flow of goods and services from producers to final consumers.
Money flow refers to flow of money in exchange of goods and
services. In this exchange of goods and services, money income is
generated in the form of wages, rent, interest and profits, which is
known as factor earning. Based on these two kinds of flows, national
income is defined in terms of:
• Product flow
• Money flow

DEFINITION OF NATIONAL INCOME

National Income in Terms of Product Flow

National income is the sum of money value of goods and services
generated from total economic activities of a nation. Economic
activities result into production of goods and services and make net
addition to the national stock of capital. These together constitute
the national income of closed economy'. Closed economy refers to an
economy, which has no economic transactions with the rest of the
world. I lowcvcr, in an opcn ecollomy, natiollul incomc ulso includes
the net results of its transactions with the rest of the world, i.e.,
exports less imports.
Economic activities should be distinguished from the non-
economic activities from national income point of view. Broadly
speaking, economic activities include all human activities, which
create goods and services that can be valued at market price.
Economic activities include production by farmers (whether for
household consumption or for market), production by firms in
industrial sector, production of goods and scrvices by thc
govcfl1ment cntcrpriscs, and services produced by business
intermediaries (wholesaler and retailcr), banks and other financial
organisations, universities, colleges and hospitals. On the other hand,
noneconomic activities arc those activities, which produce goods and
serviccs that do 110t have economic value. The non-economic
activities include spiritual, psychological, social and political services,
hobbies, service to selr serviccs of housewives services of members
of family to other mcmbers and cxchangc of mutual services
between neighbours.

National Income in Terms of Money Flow

While economic activities generate flow of goods and services, on the
other hand, they also generate money-flow in the form of f~lctor
payments such as, wages, interest, rent, prolits and earnings of self-
employed. Thus, national insome can also be obtained by adding the
factor earnings after adjusting the sum for indirect taxes, and
subsidies. The national income thus obtained is known as national
income at factor cost.
The concept of national income is linked to the society as a whole.
However, it differs fundamentally from the concept of private income.
Conceptually, national income refers to the money value of the final
goods and services resulting from all economic activities of a country.
However, this is 110t true for the private income in addition, there
are certain receipts of money or of goods and services that are not
ordinarily included in private incomes but are included in the national
incomes and vice versa. National income includes items such as
employer's contribution to the social security and welfare funds for
the benefit of employees, profits of public enterprises and servIces of
owner occupied houses. However, it excludes the interest on war-
loans, social security benefits and pensions. Instead, these items are
included in the private incomes. The national income is therefore, not
merely an aggregation of the private incomes. However, an estimate
of national income can be obtain by summing up the private incomes
after making necessary adjustment for the items excluded from the
national income.

MEASURES OF NATIONAL INCOME

The various measures of national income are as follows:

Gross National Product (GNP)

There are several measures of national income used in the analysis of

national income. GNP is the most important and widely used measure
of national income. GNP is defined as the value of final goods and
services produced during a specific period, usually one ycar, plus the
diflcrence between foreign receipts and" pnyment. The GNP so
defined is identical to the concept of 'Gross National Income (GNl)',
Thus, GNP = GNI. The difference between the two is that while GNP is
estimated on the basis of product-flows, the GNI is estimated on the
basis of money flows.

Net National Product (NNP)

Net National Product (NNP) is the total market value of all final
goods and services produced by citizens of an economy during a
given period of time minus depreciation, i.e., Gross Nationnl Product
less depreciation.
NNP = GNP - Depreciation
Depreciation is that part of total productive assets, which is used
to replace the capital worn out in the process of creating GNP. In
other words, while producing goods and services including capital
goods, a part of total stock of capital is used up. This part of capital
that is used up is termed as depreciation. An estimated value of
depreciation is deducted from the GNP to arrive at NNP.
The NNP, as defined above, gives the measure of net output
available for consumptionhy the society (including consumers,
producers and the government), NNP is the real measure of the
national income. In other words, NNP is same as the national income
at factor cost. It should be noted that NNP is measured at market
prices including direct taxes. However, indirect taxes are not
included in the actual cost of production. Therefore, to obtain real
national income, indirect taxes are deducted from the NNP. Thus,
National income = NNP - Indirect taxes
National income: Some accounting relationships
• Relations at market price GNP = GNI
o Gross Domestic Product (GDP) = GNP less net income
from abroad
o NNP = GNP less depreciation
o NDP (Net Domestic Product) == NNP less net income
from abroad
• Relations at factor cost
o GNP at factor cost = GNP at market price less net indirect
taxes.
o NNP at factor cost = NNP at market price less net indirect
taxes
o NDP at factor cost = NNP at market price less net income
from ahroad
o NOP at factor cost = NDP at market price less net indirect
taxes
o NOP at factor cost = GOP at market price less
depreciation

Methods of Measuring National Income

For mcasuring the national income, the national economy is viewed
as follows:
• The national economy is considered as an aggregate of
producing units combining different sectors such as agriculture,
mining, manufacturing and trade and commerce.
• The whole national economy is viewed as a combination of
individuals and household owning different kinds of factors of
production, which they use themselves or sell-their factor services to
make their livelihood.
• National economy is also viewed as a collection of consuming,
saving and investing units (individuals, households and government).
The above notions of a national economy helps to measure
national Income by following three different methods:
• Net output method
• Factor-income method
• Expenditure method

These methods are followed in measuring national income in a

‘closed economy',

Net Output Method

This is also called as net product method or value-added method.
This method is used when whole national economy is considered as
an aggregate of producing units. In its standard form, this method
consists of three stages:
1. Measurement of gross value of domestic output in
the
various branches of production: For measuring the
gross value of domestic product, output is classified
under various categories on the basis of the nature of
activities from which they originate. The output
classification varics from country to country dey'ending
on (i) the nature of domestic activities, (ii) their
significance in aggregate economic activities and (iii)
availability ofrecjuisite data. For example, in USA, about
seventy-one divisions and sub-divisions are used to
classify the national output, in Canada and Netherlands,
classification ranges from a dozen to a score and in
Russia, only half-a-dozen divisions are used. According to
the CSO publication, If fleen sub-categories are currently
used in India. After the output is classified under the
various categories the value of gross output is is
computed in two alternative ways by:
A. Multiplying the output of each earegory of acctor
by their respective market price and adding them together.
B. Collecting data regarding the gross sales and
changes in inventories from the account of the manufacturing firms
to compute the value of GDP. If there arc gaps in data then some
estimates are made to fill the gaps.
2. Estimation of cost of materials and services
used
arid depreciation of physical assets: The next step
in estimating the net national income is to estimate (he
cost of production including depreciation. Estimating
cost of production is, however, a relatively more
complicated and difficult task because of non-
availability of adequate and requisite data. Much morc
difficult task is to estimate depreciation since it involves
both conceptual and statistical problems. For this
reason, many countries adopt faclorincome method for
estimating their national income. However, countries
adopting net-product method find some means to
calculate the deductible cost. The costs are estimated
either in absolute terms (where input data are
adequately available) or as an overall ratio of input to
the total output. The general practice in estimatmg
depreciation is to follow the usual business practice of
depreciation accounting. Traditionally, depreciation is
calculated at some percentage of capital, permissible
under the tax-laws. In some estimates of national
income, the estimators have deviated from the
traditional practice and have instead estimated
depreciation as some ratio of the currenL output of final
goods. FoI1owing a suitable method, deductible costs
including depreciation are estimated for each sector.
The cost estimates are then deducted from the sectoral
 gross output to ohtain the net sectoral products. The net
sectoral products are then added together. The total
thus obtained is taken to be· the measure of net nationa
I products or national income by product method.

3. Deduction of these costs and depreciation from gross value to

obtain the net value of domestic product: Net value of domestic
product is often called the value added or income product. Income
product is equal to the sum of wages, salaries, supplementary
labour incomes, interest, profits, and net rent paid or accrued.

Factor-Income Method
This method is also known as income method and factor-share
method. factorincome method is used when national economy is
considerl:d as a combination of factor-owners and users. Under this
method, the national income is calculated by adding up all the
inconlcs accruing to the basic factors of production used in producing
the national product. Factors of production are c1assi ficd as land,
labour, capital and organisation. Accordingly,
National income = Rent + Wages + Interest + Profits
However, it is conceptually very difficult in a modern economy to
make a distinction between earnings from land and capital and
between the (;arnings from ordinary labour and organisational efforts
including entrepreneurship. Therefore, for estimating national income
factors of production arc broadly grouped as labour lInd capital.
Accordingly, national income is supposed to originate from two
primary factors, viz., labour and capital. However, in some activities,
labour and capital are jointly supplied and it is difficult to separate
labour and capital from the total earnings of the supplier. Such
incomes are termed as mixed incomes. Thus, the total factor-incomes
are grouped under three categories:
• Labour incomes
• Capital income
 • Mixed incomes.
Labour Income: Labour incomes included in the national income
have five components:

• Wages and salaries paid to the residents of the country including

bonus, commission and social security payments.

• Supplementary labour incomes including employer's contribution

to social security and employee's welfare funds and direct
pension payments to retired employees.

• Supplementary labour incomes in kind such as free health,

education, food, clothing and accommodation.

• Compensations in kind in the form of domestic sr-rvants and

other free ofcost services provided to the employees arc
included in labour income.
Bonuses, pensions, service grants are not included in labour
income as they are regarded as 'transfer payments'. Certain
other categories of income such as incomes from incidental jobs,
gratuities and tips are ignored because of non-availability of
data.

Capital Incomes: According to Studenski, capital incomes include

following Incomes:

• Dividends excluding inter-corporate dividends

• Undistributed profits of corporation before-tax

• Interests on bonds, mortgages and savings deposits

(excluding
interests on bonds and on consumer credit)

• Interest. earned by insurance companies and credited to the

insurance policy reserves
• Net interest paid by commercial banks

• Net rents from land and buildings including imputed net rents
 on owneroccupied dwellings
• Royalties
• Profits of government enterprises.
The data for the first two incomes is obtained from the firms'
accounts submitted for taxation purposes. There exist difference in
definition of profit for national accounting purposes and taxation
purposes. Therefore, it is necessary to make some adjm.ments in
the income-tax data for obtaining these incomes. The income-tax
data adjustments generally pertain to (i) Excessive allowance of
depreciation made by tax authorities, (ii) Elimination of capital gains
and losses since these do not reflect the changes in current income,
and (iii) Elimination of under 0,' overvaluation of ir:ventories on
book-value,
Mixed Income: Mixed incomes include income from (a) fanning
(b) sole proprietorship (not included ,Ilnder profit or capital income)
(c) other professions such as legal and l.ledical practices,
consultancy services, trading and transporting. Mixed income also
includes incomes of those who earn their living through various
sources such as wages, rent on own property and interest on own
capital.
All the three kinds of incomes, viz., labour incomes, capital
incomes and Inixed incomes added together give the measure of
national income by factorincome method.

Expendit4re Method

The expenditure method, is also known as final product method. This

method is used when national economy is viewed as a collection of
spending units. It measures national income at the final expenditure
stages. In other words, this method measures final expenditure on
'GDP at market prices' at the stage of disposal of GDP during an
accounting year. In estimating the total national expenditure, any of
the following two methods are followed:
• First method: Undcr this mcthod all the 111011';y cxpcnditurc
III IIlllrkc( prkc arc computed and added up to arrive at total national
expenditure. The items of expenditure which are taken into account
under the first method are (a) private consumption expenditure, (b)
direct tax payments, (c) payment? to the non-pro;it-making
institutions and charitable organisations like schools, hospitals and
orphanage, and (d) private savings.

• Second Method: Under this method the value of all the products
finally disposed of are computed and added up to arrive at the
total national expenditure. Under the second method, the
following items are considered
ο Private consumer goods and services
ο Private investment goods
ο Public goods and services
ο Net investment from aboard.
This method is extensively used because the requisite da!J
required by this method can be collected with greater ease and
accuracy.

Treatment of Net Income from Abroad

• Net Factor Income From Abroad (NFIA); We have so far

discussed the methods of measuring national income of a
'closed economy'. However, most modem economics are 'open
economy'. These open economics exchange goods and services
with rest of the world. In this exchange of goods and services,
som\: nations make net income through foreign trade through
exports while some lose their income to the foreign nations
through imports. These incomes are called as Net Factor Income
from Abroa:d (NFIA). The net earnings or losses in foreign trade
affect the national income. Therefore, in measuring national
income the net results of external transactions are adjusted to
the total national income arrived through any of the three
methods. The total income from abroad is added and net losses
 to the foreigners are deducted from the total national income.
All the exports of merchandise and of services such as, shipping,
insurance, banking, tourism and gifts are added to the national
income. On the contrary, all the imports of the corresponding
items are deducted from the value of national output to arrive at
the approximate measure of national income.

• Net Investment From Abroad: Net investment from abroad refers

to the di ITerllliee between investment a nation made abroad
and the in vcst· mcnt 111nde h~, thc rc~t or Ill(' world ill Ihnt
1If1liOIl. Thi'1'\\ ill\',\~tll"\I1I~ <I' \ mldeu (0 the l\lIt i01l1l1 i
Ilcume clllcullllcd II lieI' addillg or deduct illg N I: 1..\ from it.

Choice of Methods

As discussed above, there are standard methods of measuring the

national incOJ11I.: such as net output method, factor-income method
and expenditure method. 1\11 the I three methods would give the
same measure of national income, provided rcquisitc data for each
method arc adequately available. Therefore, any of the three
methods can be adopted to measure the national income. However,
not all the methods arc suitable for all economies and purposes.
Hence, the problem of choice of method anses.
The two main considerations on the basis of which a particular
method is chosen are:
• The purpose of national income
analysis
• Availability of necessary data.

If objective is to analyse the net output, then the net output

method would be more suitable. In case, objective is to analyse the
factor-income distribution then, suitable method would be income
method. If objective at hand is to find out the expenditure pattern of
the national income then the expenditure method is more suitable.
However, availability of adequate and appropriate data is relatively
more important considerations in"selecting a method of estimating
national income.
However, the most common method is the net output method
because of the following reasons:

• It requires classification of economic activities and output,

which is much easier to classifY than the income or
expenditure.
• The most common practice is to collect and organise the
national illcom!.; data by the division of economic activities.
Therefore, easy availability of data on economic activities is the
main reason for the popularity of the .output method.
However, it should he borne in mind that no single method can
give an accurate measure of national income. This is because no
country's statistical system provides the total data requirements for
a particular method.

The usual practice is therefore, to combine two or more methods

to measure the national income. The combination of methods again
depends on the nature of required data and the sectoral breakdown
of the available data.

Measurement of National Income in India

In India, a systematic measurement of national income was first

attempted in 1949. Earlier, some individuals and institutions made
many attempts. Dadabh'\i Narojoji made the earliest estimate of
India's national income in 1876 for the year 1867-68. Since then,
mostly the economists and the government authurities made many
attempts to estimate India's national income.

These estimates differ in coverage, concepts and methodology

and they are not comparable. Besides, earlier estimates were made
mostly for one year, only some estimates covered a period of 3-4
years. It was therefore, not possible to construct a consistent series
of national income and assess the pcrforniance of the economy over
a period of time. It was only in 1949 that National Income Committee
(NIC) was appointed with PC. Mahalanobis, as its Chairman and D.R.
Gadgil and V.K.R.V. Rao as its members. The NIC not only highlighted
the limitations of the statistical system that existed at that time but
also suggested ways and means to improve data collectiol1' systems.
On the recommendation of the Committee, the Directorate of
National Sample Survey was set up to collect additional data required
for estimating national income. Besides, the NIC estimated country's
national income for the period from 1948-49 to 1950-52. In its
estimates, NIC also provided the methodology for estimating national
income, which was followed until 1967.

After the NIC, the task of estimating national income was taken
over by the Central Statistical Organisation (CSO). Until 1967, the
CSO followed the methodology laid down by the NIC. Thereafter, the
CSO adopted a relatively improved methodology and procedure,
which had become possible due to increased availability of data. The
improvements pertain mainly to the industrial classification of the
activities. The CSO publishes its estimates in its publication Estimates
of National Income.

Methodology

Currently, output and income methods are used by the CSO to

estimate national income of our country. The output method is used
for agriculture and manufacturing sectors, i.e., the commodity
producing sectors. Income method is used for the service sec(ors
including trade, commerce, transport and governmeni' services. In its
conventional series of national income statistics from 1950-51 to
1966-67, the fSO had categorised the income in 13 sectors. However,
in the revised series, it had adopted the following 15 break-ups of the
national economy for estimating the national income.

(i) Agriculture (ii) Forestry and logging (iii) rishing. (iv) Mining and
quarrying (v) Large-scale manufacturing (vi) Small-scale
manufacturing (vii) Construction (viii) Electricity, gas and water
supply (ix) Transport and communication (x) Real estate and
dwellings (xi) Public Administration and Defence (xii) Other services
and (xiii) External transactions. The national income is estimated at
both constant ar.d current prices.

Growth and Composition of India's NaConallncome

The following Tables present the growth and change in composition

of India's national income, both at factor cost and current prices.
Table. 6.1 presents the decennial trends in national income
aggregates like GDP, GNP, NDP, NNP, Netfactor income from abroad,
capital consumption and indirect tax and subsidies. Table 6.2
presents the change in the composition of national income classified
under five broad categories. Table 6.3 presents the decennial annual
average growth rate of GNP and GDP at constant prices. It can be
seen from Table 6.2 that the composition of India's national income
has changed considerably over the past four decades. The share of
~griculture has declined from 55.8% in GDP in 195051 to 31.3% in
1994-95 and that of industrial sector increased from 15.26 to 27.5 %
during th; same period.

Table 6.1: National Income Aggregates-1960-61 to 1994-

95 (Decennial) (At current prices) (Rs. Crores)
National
A Income 1960- 1970- 1980-81 1990-91 1992-93
Aggregates 61 71
(At
F:actor C Jst)
Gross
1 Domestic 15,254 39,708 1,22,42 4,27,60 6,27,600
Prodllct (GDP 7 0

Fixed Capital 940 2,921 12,087 71,569

2. Consumption 51,884
Net Domestic 14,314 35,787 1,10,34 5,56,344
3. Product 0 4,20,77
(NDP) 5
= (1-2)
 Net Factor -72 -284 345 -11409
4. Income from 06,833
Abroad
Contd....

Indirect
5. Taxes 947 3,455 13,586 58,205 77,653
Less
Subsideis
Gross 6,16,504
6. National 15,182 39,424 122,772 4,65,82
Product 7
(GNP)
= (1 + 4)
Net National 14,242 36,503 1,10,68 5,44,935
7. Profit (NNP) 5 4,13,94
= (6-2) 3
GDP (at 16,201 43,163 1,36,01 705,566
8. market 3 5,30,86
prices) 5
= (1+5)
GNP (at 16,129 42,879 1,36,35 9,31,016
9. Market 8 5,24,032
price) = (8 +
3)
NDP (at 15,261 40,292 1,23,92 6,63,997
10. Market 6 4,78,98
price) = (8 – 1
2)
NNP (at 15,189 39,958 1,24,27 6,22,588
11. market 1 4,72,14
price) = (9 – 8
2)
Source : CMIE, Basic Statistics Relating to Indian Economy, Aug 1994
Table 13.3

Table 6.2: Change in Composition of National Income (GDP) (At

current prices) (Rs. Crores)

Sector Sectors 1960- 1970- 1980- 1990- 1994-95

s at 1980-
61 71 81 91 81
prices
Agricuitural and 31.3
1. Allied sectors 45.8 45.2 38.1 31.8
 Manufacturing 20.7 21.9 25.9 27.5
2. and Mining, etc. 28.8
Transport, 12.1 13.2 16.7 19.0
3. Trade and 19.6
Communication
Finance and 11.9 10.0 8.8 11.1
4. Real Estate 8.3
Community and
5. Personal 9.4 9.7 10.5 11.6 11.1
Services
Commodity 58.8
6. Sector (1 + 2) 66.5 67.1 64.0 60.5
Non-commodity 33.5 32.9 36.0 42.2
7. Sector (3 + 4 + 39.5
5)
All Sectors 100. 100. 100. 100.0
8. 0 0 0 100.0

Tavie 6.3: Annual Average Growth Rate of GNP and GDP (AT
Current Prices)(% share in GDP)
Period GNP (%) GDP (%)
1950-51 to 1960-61 4.08 4.09
1960-61 to 1970-71 3.74 3.78
1970-71 to 1980-81 3.47 3.34
1980-81 to 1990-91 5.57 5.76
1990-91 to 1994,-95 3:95 4.08
1950-51 to 1994-95 4.04 4.07
-- -----------
Inflation and Deflation
The term 'inflation' is used in many senses and it is difficult to give a
generally accepted, precise and scientific definition of the term.
Popularly, inflation refers 1O a rise in price level. Kemmerer states,
"Inflation is too much money and deposit currency that is too much
currency in relation to the physical volume of business being done."
This is what Coulburn also means when he defines inflation as, "Too
much money chasing too few goods". According to T.E. Gregory,
inflation is "abnormal increase in the quantity of money".
The implication in these definitions is that prices rise due to an
increase in the volume of money as compared to the supply of
goods. This is the quantity approach to the rise in the price level.
However, it should be noted that prices may rise due to other factors
also such as rise in wages and profits. Besides, there can be an
inflationary pressure on prices without actually rising of the prices.

Keynesian Definition
Kl:YlH:S rdales inl1ation to a price level that comes into existence
after the stage of full employment. While, the quantity approach
emphasises the volume of money to be responsible for rise in the
price level. Keynes distinguishes between two types of rise in prices
(a) rise in prices accompanied by increase in production (h) rise in
prices not accompanied by incrl:ase in production. If an economy is
working at a low level, with a large number of unemployed men and
unutilised resources then expansion of money or some other. factors
leading to an increase in demand will result not only in a rise in the
price level but also rise in the volume of goods and services in an
economy. This will continue until all unemployed men tind
employment arid capital and other resources are more fully utilised,
i.e., the stage of full employment. Beyond this stage, however, any
increase in the volume of money or rise in demand will lead to a rise
in prices but lIO corresponding rise in production or employment.
Keynes states that the initial rise in prices up to the stage of full
employment is a good thing far the country 'since there is an
increase in. output and employment. Reflation or partial inflation is
used to designate such a rise in the price level. The rise in prices
aller the stage of full employment is bad far the country since there
is no corresponding increase in production or employment. Inflation
is used to express such a rise in the price level. Therefore, inllation
refers
to a rise in the price level after full employment has been attained.
(
According to Keynes, "inflation" can be applied to an
underdeveloped country like India where unemployment of men and
resources exist side by side with inflationary rise in prices. This is
due to the existence of bottlenecks, such as limited amount of
capital, machinery, transport facilities and absence of technical
know-how. As a result of these bottlenecks and shortages, a rise in
the price level may not lead to increase output beyond a certain
stage, even though the country may not have reached the stage of
full employment. We can distinguish between three kinds of inflation
on the basis of their causes, viz., demand-pull, cost-push and
sectoral inflation.

Demand-pull Inflation
The most common cal;lse for inflation is the pressure of ever-rising
demand on a stagnant or less rapidly increasing supply of goods and
services. The expansion in aggregate demand may be due to rapidly
increasing private investment or expanding government expenditure
for war or economic development. At a time whe.n demand is
expanding and exerting pressure on prices'cattempts are made to
expand production. However, this may not be possible either due to
nonavailability o(uqemployed resources or shortages of transport,
power, capital and equipment. Expansion in aggregate demand,
after the level of full employment, results into rf~e in the price level.
In a developing economy I ike India, resources are used for growth,
for creating fixed assets and production of consumer goods.
Necessarily, large expenditure will create. large money income and
large demand but without a corresponding increase in supply of real
output.

We should emphasise here the role played by deficit financing and

increase in money supply on the level of prices in a developing
COU1Hry. Ollen. the government of a developing country resorts to
deficit spending Lo finance economic development i.e., borrowing
from the central bunk und cOllllllercial banks, which, in turn, leads to
increase in money supply in the country. This exerts a strong
pressure on the level of prices. An increase in" foreign demand for
the exports of a country may also raise the price level in a country.
Expansion in foreign demand aM consequent expansion in exports
will raise income of the people. This will push up demand for goods
and services within a country. In case the additional money income is
used to buy imports or is hoarded then it will not have inflationary
effect in the country. Thus, inflationary pressure is built by increasing
aggregate demand in excess of the available resources. The increase
in aggregate demand can be due to increase in government
expenditure or increase in private investment and private
consumption or release of pent up demand of consumers
immediately after a war or increase in exports and so on. Deficit
financing and increase in money supply further aggregate the
situation by boosting demand still further. In all these cases, inflation
is the result of demand-pull factors. It must be emphasised here that
demand-pull inflation cannot be sustained unless there is increase in
money supply.

Cost-push Inflation
In certain circumstances, prices are pushed up by wage increases,
forced upon the economy by labour leaders under the threat of strike.
Costs can also be raised by manufacturers through a system of fixing
a higher margin of profit. The common man generally blames
profiteers, speculators, hoards and others for pushing up the costs
and prices. Again, the government is responsible for raising the costs
by imposing new taxes and continuously raising the tax rates of
existing commodity. Therefore, rising rates of commodity taxes, in a
sellers market, will enable the producers to raise the prices by the full
amount of taxes. Under conditions of rising prices, business and
industrial units find it easy to pass on the burden of higher wages to
the consumers by raising the prices. 1 II us, rise in wages; profit
margin and taxation are responsible for cost-push inflation.
In periods when wages, prices and aggregate demand are all
rising and creating an inflationary situation, it is d-ifficult to find out
active and passive factor. In many cases, it is neither demand-pull
inflation nor cOSt-push inflation, but it is a combination of both.
However, it is possible and often useful to separate the dominant
factors. If aggregate de~and is responsible for the inflationary
situation, it may persist so long as excess demand persists and in the
extreme case, it may develop into hyperint1alion cwn thoug.h (osl-
push fOt'\'l'S nl".' nhsl'llt. t)11 the other hand, cost-push inllation
cannot pcrsist for long, unless thcrc is increase ill aggrcg:llc <lClll:1I\
(1. I r illf1ntillll is cOlllrolled lilnllip"l1llllli\('lilry IIIll! 1i""'111 Ill,'lli",h,
aimcd at controlling aggregate dCllland then we have demand-pull
inllation. Un thc other hand, if wages and prices continue to rise even
whcn demand ceases to grow, we have cost-push int1ation.

Sectoral Demand Shift Theory of Inflation

Under dcmand-pull inflation, we have shown how expansion in
aggregatc demand without a proportionate increase in the supply of
goods and services leads to an inflationary situation. However, it is
not necessary to have a general increase in demand to bring about
inflationary pressure. Sometimes, the increase in demand may be
confined to some sector of the economy and this increase in demand
and the consequent rise in the price in a particular sector may spread
to other sectors Suppose the demand for agricultural goods rises
because of inadequate supplies of' these goods. There would be a
consequent rise in the price' of agricultural goods. Thus, the rise in
prices spreads to all other sectors in the economy, through rise in the
prices of raw materials and wages. The rise in prices in the
agricultural sector may push up prices in the industrial sector.
Therefore, the inflationary rise in the price level is due to sectoral
shifts in demand.
The "sectoral demand" emphasises the fact that prices are highly
flexible upwards but relatively rigid downwards, for example, there
may be rise in prices in the agricultural sector where there is scarcity
whereas price stability in the industrial sector where there .. is an
excess supply. However, in course of time, prices all over the
economy will assume an upward trend. The "sectoral demand" is also
useful to explain the simultaneous existence of inflation and
recession, i.e., inflation in some sectors and recession in certain other
sectors. Industries coming under inflationary pressure will experience
persistent rise in price but industries suffering from recession may
not experience a fall in the price level. Modern economists have
coined the word "Stagflation" to refer to this situation in which
stagnation in some sectors of the economy is present while other
sectors are subject to a highly inflationary situation.

Other Classifications of Inflation

• Open Inflation: Inflation is said to be open when prices rise

without any interruption. It may ultimately end into hyper-inflation.

• Suppressed inflation: Suppressed inflation refers to a situation in

which price level is not allowed to rise with the use of price
controls and rationing, even though conditions exist for rise in
the price levcl. The price level may rise when the control
measures are lifted.

• Suppressed inflation results in (a) postponement of present

demand to a future date (b) diversion of demand from one kind
of goods to another, i.e., from those goods which are subject to
price control. and rationing to those whose prices are
uncontrolled and non-rationed. Suppressed inflation has many
dangers. First, it creates administrative problems of controls and
rationing. Secondly, it leads to corruption of the price control
administration and risc of hlack IIlarkcls. Thirdly. it CHllses
1I1leCOIIOlllic diversion of productive resources from essential
goods industries whose prices are· tixed or controllable to
those . industries whose products are less essential but prices
are uncontrollable.

• Creeping, Running and Galloping Inflation: In the initial stage of

rise in the price level, prices may be rising slowly and this is
 referred as creeping inflation. In course of time, the rise in the
price level becomes more marked and alarming. This is referred
as running inflation. Ho.vcver, when the rise in the price level is
staggering and extremely rapid, it is often referred to as
galloping inflation or hyper-inflation, which a country should
avoid at all costs.

Consequences of Inflation on Production and Employment

Inflation affects both production and distribution of income in a
country. Inflationary rise in prices may not affect adversely the
production of national income. When all aV2.ilabk men and materials
are employed then the stock of real wealth in the form of land and
building is not diminished and the total real income or output
available for distribution between the different sections of people
remains the same. However, in course of time when inflation has
gone beyond a certain limit, it may lead to reduction in production
and increase in unemployment due to the following reasons:
• Firms may find it profitable to hoard rather than produce and
sell
• Agriculturists may refuse to sell their surplus stocks in the
hope of
getting higher prices
• Production may be interrupted by bitter labour strikes.

Therefore, beyond a certain stage, surplus stocks accumulate,

profits decline and invcstmcnt. prodllClillll and incomc rail and
lIncmpl()ymcnll\l·i~l's.

On Distribution of Income
It is true that in times of general rise in the price level, if all groups of
prices, such as agricultural prices, industrial prices, prices of
minerals, wages, rent and profit rise in the same direction and by the
same extent, there will be no net effect on any section of people in
the community. For example, if the prices of goods and services,
which a worker quys rises by 50 per cent and if the wage of the
worker also rises by 50 per cent then there is no change in the real
income of the worker, i:e., his standard of living will remain constant.
However, in practice, all prices do not move in same direction and- by
saine percentage. Hence, some classes of reople in the community
are affected more favourably than others. This is explained as
follows:

• Producing Classes: All producers, traders and specu!.ators gain

during
inflation because of the emergence of windfall profits. The prices
of
goods rise at a far greater rate than costs of production whereas
wages,
interest rates and insurance premium are all mere or less fixed.
Besides, the producers keep such assets, as commodities, real
estate, etc., whose prices rise much more than the general level
of prices. Thus, the producing and trading classes gain
enormously during an inflationary period. However, farmers may
gain only if their output is maintained or increased.

• Fixed Income Groups: Inflation is very severe on those who arc

living on past savings, fixed rents, pensions and other fixed
income groups called as the middle classes. Those persons who
are working in government and private concerns find their
money incomes more or less fixed while the prices of the goods
and services, which they buy are rising very rapidly. Those with
absolui~ly fixed incomes derived from interest and rent-known
as the renter class, realise that their money income is absolutely
worthless and their past savings have insignificant value in front
of high prices. In fact, the worst sufferers in inflation are the
middle classes who are considered as the backbone of any
stable society.
 Working Classe~: During inflation, the working classes also
suffer, firstly because wages do not rise as much as the prices of
those commodities and services, which the workers buy.
Secondly, there is also time lag between rise in th~.price level
and wages. However, these days, many groups of workers are
organised in trade unions and their wages rise simultaneously
with rise, in the cost of living. Therefore, it can be presumed that
organised workers may not suffer· much during inflation.
However, there are many grOlIl)S of workers who arc not
organised for example, the agricultural labourers, who find no
way of pushing up their wages in the face of rising prices and
cost of living.
Inflation, lilus, brings shi fts in the distribution of incomc hctwccn
di !Tcrellt sections of people. The producing classes such as
agriculturists, manufacturers and traders gain at the expense of
salaried and working classes. The rich become richer and the poor
becomes poorer. Thus, there is a transfer of income from poor to rich
classes. Inflation, therefore, is unjust. Besides, those who are hard hit
by inflation are the young, old, widows and-small savers, i.e., all
those who are unable to protect themselves. But the most
unfortunate thing is that monetary arid fiscal authorities which are
entrusted with the task of maintaining price stability are often
responsible for creating inhltionary conditions, for example, a country
at war resorts to printing of currency notes as one of the methods of
financing war. Similarly, the government of a developing economy
may resort to deficit financing as . one of the methods of financing
development projects; In these cases, inflationary finance, like
taxation, brings in additional revenue to the public authorities.
However, taxation cannot destroy an economy except in rare cases
by eliminating whole groups of people. Inflation, on the other hand,
can destroy fixed income group, pauperise the middle classes and
destroy the very foundations of an economy. No wonder inflation has
been termed as "a species of taxation, cruellest of all" and "open
robbery". Inflation, particularly the hyperinflation of the German type,
will therefore endanger the very fow(jations of the existing social and
economic system. It will create a sense of frustration distrust,
injustice and discontent and may force people to revolt against the
government. It is, therefore, "economically unsound, politically
dangerous and morally indefensible". Therefore, it should be avoided
and even if it occurs it should be controlled.

Control of Inflation
Inflation should be controlled in the beginning stage, otherwise it wiil
take the shape of hyper-inflation which will completely run the
country. The different methods used to control inflation are known as
anti-inflationary measures. These measures attempt mainly at
reducing aggregate demand for goods and services on the basic
assumption that inflationary rise in prices is due to an excess of
demand over a given supply of goods and services. Anti-inflationary
measures are of four types:
• Monetary policy
• Fiscal policy

• Price controlnnd mtioning

• Other methods

Monetary Policy
It is the policy of the central bank of the country, which is the
supreme monetary and banking authority in a country. The central
bank may use such methods as the bank rate, open market
operations, the reserve ratio and selective controls in order to
control the credit creation operation of commercial banks and thus
restrict the amounts of bank deposits in the country. 'this is known
as tight money policy. .\ Monetary policy to control inflation is
based on the assumption that a rise in prices is due to a larger
demand for goods and services, which is the direct result of
expansion of bank credit. To the extent this is true, the central
bank's policy wi}1 be successful.

Fiscal Policy
It is the policy of a government with regard to taxation,
expenditure and public borrowing. It has a very important influence
on business and economic activity. Taxes determine the size or the
volume of disposable income in the hands of the public. The proper
tax policy to control inflation will avoid tax cuts, introduce new
taxes and raise the rates of existing taxes. The purpose being to
reduce the volume of purchasing power in the hands of the public
and thus reduces their demand. A precisely similar effect will be
achieved if voluntary or compulsory savings are increased. Savings
will reduce current demand for goods and thus reduce the
inflationary rise in prices.
As an anti-inflationary measure, government expenditure
should be reduced. This .indicates that demand for goods and
services will be further reduced. This policy of increasing public
revenue through taxation and decreasing public expenditure is
known as surplus budgeting. However, there is one important
difficulty is this policy. It may be easy to increase revenue in times
of inflation when people have more money ineome !:Jut difficult to
reduce public expenditure. During war as well as during a period of
development expenditure it is absolutely impossible to reduce the
planned expenditure. If the government has already taken up a
scheme or a group of schemes, it is ruinous to give them up in the
middle.; Therefore, public expenditure cannot be used as an anti-
inflationary measure. Lastly, public debt, i.e., the debt of the
government may be managed in such a way that the supply of
money in the country may be controlled. The government should
avoid paying back any of its previous loans during inflation so as to
prevent an increase in the circulation of moneY: Moreover, ifthe
government manages to get a surplus budget it should be used to
cancel public debt held by the central bank. The result will be anti-
inflationary since money taken from the public and commercial
banks is being cancelled out and is removed from circulation. But
the problem is how to get abudgct surplus, \vhich is extremely
difficult, if not impossible.

Price Control and Rationing

This is the most important and effective method available during war
particularly oecause both monetary and fiscal policies are more or
less useless during this period. Price control implies the
establishment to legal upper limits beyond which prices of particular
goods should not risco The purpose of rationing, on the other hand, is
to distribute the goods in short supply in an equitable manner among
all people, irrespective of their wealth and social status. Price control
and rationing g.enerally go together. The chief objection behind use
of this method to fight inflation is that they restrict the freedom of
the consumers and thus limit their welfare. Besides, its success
depends on administrative efficiency, which in many underdeveloped
countries is very low.

Other Methods

• Another important anti-inflationary device is to increase the

supply of goods through either increased production or
imports. Production may be increased by shifting factors of
production from the production of less inflation sensitive
goods, which are in comparative abundance to the production
-of those goods which are in short supply and which are
inflation-sensitive~ Moreover, shortage of goods internally
may be relieved through imports of inflation sensitive goods,
either on credit or in exchange for export of luxury goods and
other non-essentials.

• A word may be added about the measures to control cost-

push inflation. It is suggested that wages, salaries and profit
margins should be controlled and fixed through a system of
income freeze. Business units may particularly welcome wage
 freeze. However, wage freeze is not so easy or just, unless
trade unions agree to the proposal and there is also freezing
of prices. At the same time, the Government should not raise
the rates of commodity taxes. Thus, it is difficult to control
c'ost push inflation through controlling wages and other
incomes. The best method is to bring a rapid increase in
production, which will automatically check prices and wages
also.

Inflation in an: Underdeveloped Economy

Basically, inflation is supposed to occur after reaching the stage of
full employment, for till that stage is reached an increase in effective
demand and price level will,be fr)lowed by an increase in output,
income and employment. It is after the stage of fuli employment
when all men are employed that a rise in the price level will not be
accompanied by an increase in production and employment.
Theoret.ically, therefore, it is not possible to imagine an inflationary
situation existing side by side with full employment. It is in this
context that the question of inflation in an under developed country
like India, which has both widespread unemployment and
underemployment is raised.

Bottleneck Inflation
It is interesting to observe that Keynes himself visualised the
possibility of an inflationary situation even before full employ·.lent
was reached. Such: a situation can arise even in advanced countries,
if there are difficulties in perfect G\lasticity of supply of goods and
services. It is possible that full employment is not reached but even
then, there is no scope for increased production. The factors
responsible for imperfect ela<;ticity of supply are law of diminishing
returns, absence of homogeneous factors and unemployed resources,
which cannot be used to increase production. All these factors are
lumped together and are known as bottlenecks. As monetary demand
increases with the increase in money supply, supply of goods does
not increase in proportion, due to imperfect elasticity. The difficulties
or handicaps, which prevent supply from increasing in the face of
rising demand, are known as bottlenecks. The result is that the cost
of production is pushed up and price level is raised. Apart from these,
other bottlenecks are as follows:

• Market imperfections' in underdeveloped countries, such as

imperfect knowledge on the part of producers and consumers,
mobility of factors, divisibility of factors and lack of
specialisation. All these are responsible f9r inefficient use of
resources. There is, thus, imperfect elasticity of supply in an
underdevelopeJ country.

• Underdeveloped countries face shortage of technical labour,

capital, equipment and transport and power facilities. Therefore,
these countries are unable to grow becauserofthese.bottlenecks.

Unemployment and underemployment are extensively present

in an underdeveloped country. The existence of unemployment
in the advanced country helps increase' output, whenever there
is increased demand. However, this is not so in a country like
India with a large magnitude of disguised unemployment and
open unemployment. According to or.V.K.R.V. Rao, disguised
unemployment is not so resrollsive to an increase in effective
demand.
• Underdeveloped countries generally have II high mnrginul
propensity to consume. or.Rao believes that this factor prevents an
increase in the supply of goods and services. For instance, in the field
of agriculture, increased production may be _ consumed at home
~nd, therefor;-:, less may be forthcoming to the market.

• A special feature of underdeveloped countries is that a large

volume of primary production is exported. Therefore, the supply
available for home consumption is reduced. The problem of
inflationary rise in prices i~ worsened whenever the income
 earned from exports is spent on domestiC goods and not on
imports.

• Since World War II, many of the underdeveloped countries have

started resorting to extensive borrowing from the banks and
deficit fi.nrmcing with the idea of speed ing up economic
develop!nent. For one thing, much of this expenditure is on
social and ccor:omic overheads, such as education, transport
and powcr and on capital goods industries such as development
of iron and steel industry. This implies that there is an increase
in the production of consumption goods. Therefore, the volume
of purchasing power with the general' public is increased,
resulting in increased demand for consumption goods.
All these factors explain the existence of inflationary pressure in
all underdeveloped country, even though the stage of full
employment has not been' reached. The existence of bottlenecks
such as· shortage of technical know-how and scarcity of capital
equipment has worsened the various problems related to
underdeveloped countries. It is, therefore, correct to use th~ concept
of inflation even in underdeveloped countries, provided we remember
the existence of special bottlenecks.

Deflation
I I' prices an; abnormally high, it is indeed desirable to have a fall in
prices. Such a fall in the price level is good for the community, as it
will not lead to a fall in the level of production or employment. The
process designed to reverse the inllationary trend in prices, without
creating unemployment, is generally known as disinflation. But if
prices fall from the level of full employment, then income and
employment will be adversely affected and this situation is termed as
deflation. The foll0wing Figure 6.1. shows if the price level continues
to rise even after the stage of full employment has been reached, it
is cnlled intlntiol\. Decline in prkt' level as a result of anti-inl1ationary
measures is known as disinflation. If prices litll below 1'1111
OlllploYlIlt'lll. lho ~illlr,li\l11 i~ ~\nlh'd 11011,,111111. Whllt'
11IC111lhlll IIIII,II\'~ excess demand over the avai lable supply.
uel1l1tion implies dcticiency of dcmand to lift what is supplied. While
inflation means rise in money incomes, deflation stands for fall in
money incomes.

Effects of Deflation
The following are the adverse effects of deflation:

• On production: Deflation has an adverse effect on the level of

production, business activity and employment. During
deflation, prices fall due contracting demand for goods and
services. Fall in price results in losses' and sometimes forcing
many firms to go into liquidation. In the face of declining
demand for goods, firms arc forced to close down either
completely or leave part of their plants idle. Thus, production of
income is curtailed and unemployment is increased. 111is is a
serious defect of deflation, as compared to inflation in which
normally there may not be an adverse effect on production and
employment.

On distribution: Deflation adversely affects distribution of

income too. In the first place, producers, merchants and
 speculators lose badly during this period because price~ of their
goods fall at a far greater rate than their costs, most of which
tend to be fixed or sticky. Besides, most of these people are
debtors who use borrowed funds in their businesses. They have
to repay their debts in money, which has now more value
because of deflation. For some debtors, who do not have
adequate means to repay their loans had to go into liquidation.

• Deflation implies fall in price level or rise in the value of money:

All those who have fixed incomes will be far better off because
their money income is fixed. In other words, the fixed income
groups will enjoy a rise in their real income. Therefore, it is
assumed that salaried persons and wage C<llners wi II bcnefit
by denatioll. Ilowcvcr, this is not completely true since there is
increasing unemployment. Therefore, only those who are
successful in keeping their jobs will be able to gain from the rise
in the value of money. As a matter of fact, during deflation,
there is great suffering and mystery all round and millions of
families are literally thrown onto the streets to make their living
through begging. The only group of people who may really gain
is that small minority, known as the renter class who get their
income by way of fixed interest and rents.

Methods of Control
Anti-deflation measures are the opposite of those, which are used to
combat inflation. Monetary policy aimed at controlling deflation
consists of using the discount rate, open-market operations and other
weapons of control available to the central bank of a country to raise
volume of credit of commercial banks. This policy is known as cheap
money policy. This is based on an idea that with the increase in the
volume of credit, there will be an increase in investment, production
and employment. However, monetary policy is basically weak, for it
assumes that the volume of credit can be expanded by the central
bank. This may not be so, because even when commercial banks are
prepared to lend more to businesses to enable them to expand their
investment, the latter may not be willing to do so for fear of possible
failure of their investments.
Fiscal policy to fight deflation is known as deficit financing, i.e.,
expenditure in excess of tax revenues. On one hand government
attempts to reduce the level of taxation to provide large amount of
purchasing power with the public. While, on the 'other hand, the
government increases its expenditure on public work programmes
such as irrigation, construction of roads and railways. By this
programme government will (:I) provide employment for those who
may be thrown out of employment in the private sector, (b) add tei
national wealth, and (c) counteract the deficiency of private demand
for goods and services. The budget deficit can be financed through
borrowing from the public of their idle cash balances or banks. The
basic idea of fiscal policy is to expand demand for goods or to
counteract the decline in private demand. Therefore, fiscal policy is
the most important policy for economic stabilisation.
Other measures to control deflation include price support
programmes, i.e., to prevent prices from falling beyond certain levels
and lowering wage and other costs to bring adjustment between
price and cost of production. Price support programme has been
extensively used in the USA in recent years but it is very difficult to
carry it through. The government will have to fix the prices below
which the commodities will not be sold and undertake to buy the
surplus stocks" It is difficult for the government to secure the
necessary funds for such transactions as well as to devise ways and
means to dispose of the surplus stocks in other countries. Therefore,
the best solution for deflation is to have a ready programme of public
works to be implemented as and when unemployment makes its
appearance.

Compariso!between Inflation and Deflation

Inflation is rise in prices unaccompanied by increase in employment,
while deflation is fall in prices accompanied by increasing
unemployment. Inflation distorts the distribution of income between
different groups of people in' the country in such an unjust manner
that the rich gain at the expense of the poor. Deflation, on the other
hand, reduces national income through contraction of production and
increas~ in unemployment.
Inflation is unjust and demoralising. Deflation, on the other hand,
inflicts on the people the harsh punishment of general
unemployment. There exist factories and mills on one hand and
workers ready to \';ork on the other hand, however, the whole team
remaining idle, on the other. Inflation at least implies that all factors
are employed in some way or the other. There is one more reason
why deflation is worse than inflation. Inflation can be controlled
except occasionally it gets out of control. However, deflation, if once
started, injects so much pessimism into businessmen and bankers
that it is highly difficult to control. However, there is nothing to
choose between the two and the proper objective should be to aim at
economic stabilisation at the level of full employment.

Inflationary and Deflationary Gaps

Keynes developed the concept of inflationary gap'. InfliJtionary gap
refers to, "excess of anticipated expenditures over the availahle
output al base pril'.c.~." Inflationary gap occurs when there is an
excess of demand over available supplies. Let us take a simple and
hypothetical example to illustrate the eme~gence of inflationary gap.
During 'a period of war, the volume of money expenditure in a
country increases, because or" the government's expenditure on the
armed forces and armaments. Increased government expenditure
resulting in increased income with the community will lead to
increased consumption expenditure and investment. The disposable
income of the community, which constitutes aggregate demand for
goods and services, is as follows:
 (Rs. Crores)
1. National income received during a given year:
20,000
2. Taxes paid to the government: 5,000
3. Gross disposable income (I -2): 15,000
4. Saving by the community at 10% oft',e income: 1,500
5. Net disposable income with the community: 13,500
The net disposable income with the people represents aggregate
demand for goods and services ofa community. As against the
aggregate demand, the aggregate supply comes from gross national
product. However, not all output is available for the community. The
government diverts some resources such as food grains, cloth, for
war purposes, then the total output available for civilian consumption
is less than the gross national pro,duct (GNP). For instance,
(Rs. CIJres)
1. National product (real income): 20,000
2. Appropriated for war purposes: 8,000
3. Available for civilian consumption: 12,000
Now the net disposable income, which the community will like to
spend is Rs. 13,500 crores but the available output for civilian
consumption is only Rs. 12,000 crores. There is excess of demand
o'Ver available supply ~') tne extent of Rs. 1,500 crores, which is
referred to as the inflationary gap. The basic fact is that so long as
the amount of disposable income with the people and the volume of
goods and services available for them are the same, there will be
price stability; but whcn thL~ forillcr is Illore' thnllthe lillieI', nn
i1t1llllinllllry lJ.lIp willllppc\;\r :ll\d IIIl' price level will rise; il~ 011 Ihe
olher hUlld. the volume of goods llnd services is InrgN 1111\11 lht'
VI""I1I\' Ill' dhl'".'lld"ll 1111'111111', "dI1lllllilllllll,\' gllp \\'ill i'l'llI'lll,
Though Keynes assoeialed un inflationary gap with war, we cun
I\lso spcak of inflationary gap during periods of economic
development Since 1951, India has undertaken economic
development, financed partly through created money. As a result,
there has been enormous increase in money expenditure and
money income but without a corresponding increase in the volume
of consumptioll goods (part of the increase in production has been
in capital goods). Besides, there is a ~' time interval or gap
between investment and output of goods and services. Naturally,
there is excess demand resulting in inflationary pressure on the
general price level. Inflationary gap can be illustrated by using the
Keynesian concepts of aggregate demand and aggregate supply,
The following Figure 6.2 shows the' inflationary gap.

In Figure 6.2, the horizontal axis represents volunie of income

and the vertical axis represents volume of total expenditure (C + I
+ G). The 450 vertical axis represents equilibrium line of Y = E and
line C + I + G represents the total expenditure. At point E, the
economy is in equilibrium because at E the supply of goods and
services or real income (OY) is equal to the demand for them at
EY. Therefore, OY is' regarded as equilibrium income as well as full
employment income at current prices.
Suppose, the Government increases its expenditure either for war or
development purposes, by an amount equal to EA. Then the new
aggregate demand is shifted upwards and beco~es C' +' l' + G'. C'
of- l' -\- G' is parallel to C + r + G line by the amount MEA. The real
output (or income)remains constant at OY but the mOlletary demand
for this output is not EY but Y A, there is, thus. an excess of demand
and equal. to.EA. EA, therefore, represents inflationary gap, which is
responsible for pushing up the price level.

Wiping out Inflationary Gap

The inflationary gap can be wiped out in various ways. Essentially, it

starts with additional expenditure by the government, which in turn
calls for additional expenditure by the community. Through economy
in government expenditure, the excess of aggregate demand can be
reduced. However, this is not always possible in practice, as
government expenditure cannot be cut down during wartime or
period of economic devdopment. To remove this inflationary gap.
various mtlhods can be adopted, such as:
• There cun be a rise ill voluntary saving by the community.

• The government may use the tax system to mop up the surplus
purchasing power with people; this will reduce C + I by the same
amount as the increase in government expenditure.

• The output of goods and services may be increased so as to

absorb the excess demand. In Figure 6.2, such an increase in
real income should be YY1• But, as mentioned already, there is
no scope for such an increase in real income, as the economy is
already at full employment level.

Deflationary Gap

Deflationary gap is the opposite of inflationary gap. If the volume

of goods and services is larger than the aggregate demand for them,
a deflationary gap will arise. Deflationary gap arises when the C + I
of- G line is pushed down to C' + I' + G'. The decline in demand may
be because of reduction in government expenditure or decline in
private investment or fall in private consumption demand. This is
shown in Figure 6.3. OY, = Volume of real income available for the
community
 As regards wiping out the deflationary gap, the government
should increase its expenditures or help to raise the expenditure of
the general public. The government can raise its own expenditure by
investing in public works and financing them by borrowing from
banks. The expenditure of the community C + I can be raised by
reducing laxes and other incentives. If the C' + j' + G' is raised to the
original level then the deflationary gap will disappear.

Stagflation

Inflationary gap occurs when aggregate demands exceeds the

available supply and deflationary gap occurs when aggregate
demand is less than the available supply. These are two opposite
situations. However, we may show how deflationary forces follow
inflation, which has not been controlled. For instance, when inflation
goes unchecked for sometimes and priCes reach very high levels,
aggregate demand contracts and slumps follows. Consumption
demand (C) declines because of high price levels. The middle and
lower income groups have to curtail th<f" consumption of many of
the goods. Increase in private investment (I) does not take place
because investors are afraid of future and there is decline in
consumer demand at the height of inflation. In fact, the decline in
consumer demand and private investment will reinforce each other
and create a deflationary situation. Further, un excessive rise in the
price 'level will affect exports adversely and thus create a slu1np in
the export industries as well. It is, thus, possible to visualise a
situation in which inflationary and deflationary pressures are present
simultaneously. The existence of an economic recession at the height
of inflation has been called as stagflation (stagnation + inflation).

Trade Cycles '

Wesley C. Mitchell, a noted American authority 011 business cycles,
wrote: "Business cycles are a species of fluctuations in the economic
activities of organised communities." The adjective ,'business'
restricts the concept to fluctuations in the activities, which are
systematically conducted on commercial basis. The noun 'cycles' bars
out fluctuations, which do not recur with a measure of regularity.
Mitchell has, thus, described all the important features of a business
cycle admirably. According to him, features of trade cycle are:
• It occurs only in organised communities, which are
money economies.
• Refers to fluctuations or changes in business
conditions.
• Implies regular and periodical changes in business and
economic activities.

According to Keynes, "A trade cycle is composed of periods of

good trade characterised by rising prices and low unemployment
percentage, alternating with periods of bad trade characterised by
falling prices and high unemployment percentage. "

Characteristics of Trade Cycles

From the above definition, it should ,be clear that trade cy~les is
rhythmic fluctuations of the economy, that is, periods of prosperity
followed by periods of depression. However, the waves of prosperity
and depression need not always be of the same length and
amplitude. Further, trade cycles varied tremendously in magnitude.
Whde some have smaller cyclical fluctuations in economic activity,
others have great intensity of fluctuations. Expansion in some cycles
reaches the full employment level and stays there. However, in some
cycles, the peak is reached even before full employment. Sometimes,
the cyclical fluctuations may be prolonged for one reason or the
other.
The American Economic Association emphasised the following
important characteristics of trade cycle:

• Prices IInd production gencrnlly risc 01' 1111\ togctht.'r, Till'

C:\l'l:ptl(\l\ i~ agricultllre, where during 1I dowllwlIrd phllsc or
business ey(k~, ",h,'1\ prices are falling. (he agricullurists may
tend to produce more, so liS to onset the loss of lillling prices
11I1l1 thus 11I1I1IIlH11I tht' SilIlI\: 11"\'c1 <If income.

• The total output and employment Jluctuate by a larger

percentage in durable and capital goods industries than in
non-durable and consumption goods industries.

• Large changes in total output, employment and the price level

are normally accompanied by large changes in currency, credit
and velocity of circulation of Illoney.

• Prices of manufactures are comparatively rigid while prices of

agricultural goods are normally flexible.
Profits fluctuate by a much larger percentage than other types of
income.

• Industries are so inter-connected that fluctuations in one will

be passed on to others also, Thus, cyclical fluctuations affect
all industries.

• Cyclical fluctuations tend to be international, in the sense that

prosperity and depression spread from one country to another
through foreign trade,

Phases of a Trade Cycle

Every trade cycle is characterised by two main phases namely, the

upward phase and the downward phase of'the trade cycle. These
two phases further have four or five different sub-phases, such as
depression, recovery, full employment, boom and recession. In
monetary terminology, the same phases . correspond to
depression, deflation, full employment, disinflation and deflation.

The following Figure 6.4 shows· the different stages· of a trade

cycle. FE represents the full employment line-it may be taken as the
dividing line. Above this line, there is business prosperity and boom
and below this line, there is business depression. As a trade eycle is a
continuous phenomenon, it is essential to break it som~where. It is
customary to start at the lowest point of the upward " phase, namely,
the depression.

• Depression: During depression, the level of economic activity is

extremely low. The price level is low, profit margins do not exist,
firms incur losses and unemployment is high. Interests, wages and
profits are all low. While all sections in the economy suffer, some
suffer more than others do. For instance, the producers of
agricultural goods suffer badly because the prices of agricultural
goods fall the most during depression. This is due to inability of the
farmers to adjust their output according to the market demilnd,
 which is low. The worst hits are the working classes that suffer
heavily because of unemployment. The depression is thus, a period
of great suffering, low income and unemployment.

• The phase of recovery: Depression gives place to recovery. There

is revival of business and economic activity. There is greater
demand for goods and services and consequently there is greater
production. Prices, wages, interests and profits all start rising.
Employment increases and so docs the national income. There is
increase in investment, bank loans and advances, velocity of
circulation of money due to more brisk tnide. Through multiplier
and acceleration effects, the economy is proceeding upward
steadily and rapidly. The process of revival and recovery becomes
cumulative. Increased receipts result in increased expenditure
causing further incrcasc in n:ceipts. which in turn, rcsult in further
increased expendllure and so on. The wave of recovery on'ce
initi"ted soon begins to feed upon itself.

• The phase of full employment: The cumulative process of recovery

continues until the economy reaches full employment. Full
employment implies that all the available men arc employed. The
economy has reached the optimum level of economic activity.
During this phase, there is an allround economic stability referring
to stability of output, wages, prices and income. Wages, interests
and profits are high, output is highest with the given technology
and employment is maximum. There may be small percentage of
unemployment, but it is not of an involuntary type but of voluntary
and frictional type. The period of full employment has become the
usual goal of most national economic policies.

• The phase of boom or inflation: The phase of recovery frequently

ends not in a stable state of full employment o~ prosperity but
further leads to a boom or inflation. Beyond the stage of full
employment, the rise in investment results in increas~d pressure
for the available men and materials and rise in wages and prices.
During this period, there is hectic activity going on everywhere in
 the economy such as new buildings come up, new factories are
commissioned and many new trades are started. In a matter of
weeks or months, full employment paves the way for overiiJlI
employment, i.e., a peculiar situation in which there are more jobs
than the available workers. Money wage rise, profits increase and
interest rates go up. The demand for bank credit increases and
there is all round optimism. At the same time, bottlen~.cks begin
to appear in the economy. Factors of production, particularly' raw
materials and labour becon~e scarce, commanding higher prices
and wages and thereby distort the cost calculations of the
entrepreneurs. They now realise that they have overstepped the
mark and become overcautious. Their over-optimism paves way for
their pessimism. Generally, the failure ·01' a firm or bank bursts
boom and lead to recession.

• Recession: The entrepreneurs realise their mistakes and find that

many of tht: ventures started in the rosy anticipation of the boom
are not profitable. The over oplimism of the boom gives way to
pessimism characterised by feelings of hesitation, doubt and fear.
Fresh enterprises are postponed for some remote future date and
those in hand are abandoned. Credit is suddenly curtailed sharply
as the banks are afraid of failure. Business l:xrnnsion stars. order~;
:1re cancelled and workers are laid off. Liquidity preference
suddenly rises and people pref~r to hoard rather thail invest
Building activity slows down and unemployment appears in
construction· industries. Unemployment spreads to other sectors
also because the multiplier effect begins to work in the downward
direction. Uncmployment leads to fall in income, expenditure,
prices, profits and industrial and trade activities. Panic prevai l~" in
the stock market and the prices of shares fall rapidly., Once
business and economic activity start declining, it becomes almost
difficult to stop this decline and finally ,ends in a hopeless
depression.
We have described the various phases of a trade cycle, but we
should note, that all these phases rarely display smoothness and
regularity. The movement at times may be irregular in such a
manner that one phase may not easily follow the other. Nor is the
length of each phase by any means always defined. Thus it is quite
likely that a state of fairly stable business depression may lead to
recovery or it may decline to further recession, as was tlie case with
England in 1929. Similarly, a recovery may turn into a recession
without allo''/ing for either full employment or even boom, as
witnessed in the United States in J 937. Sometimes, the depression
may be unstable and recover very rapid. So, alsc at times prosperity
phase may be fairly stable as was the case during the period
between 1924 and 1929.
Some of the important features of various phases 'of a trade
cycle should be 0 emphasised here. They are important when we
have to evaluate the worth of different trade cycle theories.

• The process of revival is generally very gradual but once it

picks up,
it becomes rapid.

• The boom period of the trade' cycle is marked by high level of

business activity.
• The crash of the boom is always sudden and sharp.
• The downward trend of the trade cycle is rather very' rapid.

• The depression period is prolonged and is painful because of

widespread unemployment.

Trade Cycle Theories

The complex phenomenon of a trade cycle has received the
gr,eatest attention from economist and there arc number of
theories Oil trade cyclc. The following theories on trade cycle are as
follows:

• Monctary llnd Non-monctary Thcorics: Trade cycle theories

can he classified into monetary lInd nOIHllOnctnry theories. The
forll\el' llll\phasbl's monetary factors as thc main cause for, while
the Ialler elllphnsis 1l1l!1IlIllm'lllr)' Ihe!ll),:-I, :-Illl'lI ll:ll'lilllillll'
l'lllltllllll'IIS. psyl'll\\hlgy \II' hIlSIIll'~~llh'll and innovations as, thc
main cause for the recurrence or econOllllC fluctuations.
• Climatic Theory: The climatic theory is one of the oldest
theories of
tradc cycle. The climatic theory, also known as the sunspot
theory because the spots that appear, on the face of the sun
largely influence climatic conditions. A bad climate causes the
failure of harvests, which in turn lead:i to depression in
business conditions because of a fall in the incomc of" farmers
and consequent fall in their demand for the products of
industries, A good climate, on the contrary, has quite the
opposite effect on trade and industry. The variations of climate
are said to be so regular that periods of good harvest are
followed by periods of bad Ones and consequently booms and
slumps follow each other just as the days and nights, This
theory has been discarded in modern times. While it is difficult
to deny the fact that the prospects of agriculture affect the
pwspects of industries, it is not easy to correlate such a
complex phenomenon of trade cycle exclusively with the
climatic conditions. If the theory has to be correct, then it
should accept th"t trade cycles are less important in non-
agricultural areas and when a nation becomes more completely
industrialised, trade cycles would disappear or at least diminish
in importance. This, however, is not the case; in fact, it is
advanced countries, which seem to suffer most from the trade
cycles.
• Psychological Theory: Pigou attempted to explain the trade
cycle with reference to the feeling of optimism and pessimism
among businessmen and bankers. Businessmen have their
moods. Sometimes they feel depressed and at· other times,
 they are jubilant and optimistic. Despair, hopelessness as well
as optimism are catching in nature. When 0ne businessman is
pessimistic, he passes it on to the others, similarly,. optimism
spreads 'from OIlC to another. Thus. lIccording 10 the
psychological thcory. industrial l1uctuations are thc outCOIllC
of" the waves or oplilllisl)/ among businessmen. Optimism
results in prosperity and - pessimism in recession and
depression. There is an element of truth in the psychological
theory in the sense that psychological waves of optimism and
pessimism do play an imp()rtant role ill trade cycles. But
busincss con !1dcncc or abSCIll"C of it is often the result rather
than the cause-ofbusiness conditions. Further, the theory
does /lot explain satisfactorily how depression starts or a
recovery begins.

• Over-Investment Theory of Von Hayek and Others: Prof.Von

Hayek in his books "Monetary Theory and the Trade Cycle" and
"Prices and Production", has developed theory of business
cycles in terms of monetary over-investment and consequent
over-production. According to him. there is a "natural" or
equilibrium rate of interest at which the demand for loanable
funds is equal to the supply of funds through voluntary saving.
At the same time, there is also market rate of interest based on
demand for and supply of loanable funds in the market.
According to Hayek's thesis as long as the market rate of
interest is same as the natural rate of interest. there will hc
stahility ill husillcss cOlldiliolls alld allY dispilrity bctwcen the
two will lead to busincss Iluctuations. For instance, a fall in the
market rate of interest below the natural rate wililcad to more
investment and, therclore, an upward swing in business
activity. On the other hand, a rise in the market rate of interest
over the natural rate of interest will lead to a fall in investment
and, therefore, a downward swing in business activity.
Now, the market rate of interest may fall below the natural rate of
interest because money supply increase in excess of demand for the
same. The banks lending to entrepreneurs; through whom it
eventually reaches the consumers bring about this increase in supply
of money. The increased money supply is made available to the
entrepreneurs by lowering the market rate of interest. There is a
spurt of investment activity. More capital intensive methods of
production are adopted. The demand for capital goods naturally
increases and accordingly their prices go up. As a direct consequence
of this rise in the prices of capital goods there is a diversion of
resources from the production of consumption goods to the
production of capital goods resulting in the reduction of the supply of
consumer goods. But this situation cannot continue for long, for
increase in the production of capital goods and higher prices for them
will result in larger income for the factor owners who, in turn, can
normally be expected to increase their consumption of goods. The
demand for consumption goods will also rise and their prices too will
go up. There will now be a competition between capital goods
industries and consumption goods industries for scarce resources.
Naturally, the prices ofJactor series will go up, raising the cost of
production of capital goods industries. The profit margins of capital
goods industries will, therefore, become unattractivc. At the same
time the banking system decides to reduce the rate of credit
expansion by mising the market rate of interest above the equilibrium
rate, causing illvt'~;tment to (all abruptly. Thus, on the one hand,
investment is unattractive because of lower yield, and on the other,
investment is made more expensive because of higher rate of
interest. The business expansion and boom brought about by IbW
market rate of interest and heavy investment activity crashes when
the banking system puts a stop to additiorlal lending to firms by
raising the rate of interest. Investment and production will decline
and depression will rise.
Hayek(basic thesis can now be summarised as follows. Alternating
stages of prosperity and depression are due to lengthening and
shortening processes of production brought about by a change in the
money supply, which causes a change in the market rate of interest
away from the natural rate of interest. The lengthening of the process
of production is brought about by increase in moncy supply, which
causes the market rate of interest to fall below the natural rate of
interest. Shortening of the process of production is brought about by
a Lleel ine in the supply of bank money, which raises the market rate
of interest above the natural rate of interest. Therefore, the failure of
the banking system to keep the supply of money constant is
responsible for business cycles. Therefore, to control cyclical
fluctuations, Hayek's solution is simple, i.e., to keep constant supply
of bank money, making allowance for such increases or decreases in
the velocity of circulation of money.

Weaknesses of Hayek's Approach

According to Von Hayek, a low rate of interest and large bank lending
to entrepreneurs result into expansion of investment and production
whereas a high rate of interest puts a stop to this expansion and
brings about a depression. Hayek's theory is, therefore, referred to as
monetary over-investment theory of business cycles. The basic
weakness of Hayek's approach is its emphasis on the rate of interest
and complete neglect of real factors such as technological changes
and innovations inC'Juencing the volume of investment. Further,
according to Hayek, the sole cause for change in the volume of
investment is the change in the market rate of interest relative to the
equilibrium rate of interest. A lower market rate of interest in relation
to equilibrium rate of interest induces entrepreneurs to adopt more
:capital-intensivep;1ethods of production, i.e., to change the capital-
output ratio. Hayek~;however, does not mention how investment is
related to consumer demand. Further more, the importance given to
the rate of interest by Hayek as the cause of change in the volume of
investment is also questioned. Keynes has shown that the rate of
interest is not an important factor for determining the' volume of
investment.
 Finally, critics do not accept Hayek's rcmedy. to the problem of
business cyclcs. Hayck suggests that the volume of money supply
should be kept neutral, so that business fluctuations may be
controlled. I r moncy supply is nol nClllml, investment will be either
encouraged (expansion of money) or cliscouraged (contraction of
money supply) and as a result there will be business fluctuations. This
is based on the old quantity theory of money, which does not
command general accepta'1ce .. Moreover, a change in the volume of
investment is not responsible for busines's fluctuations whereas
investment financed by involuntary savings or expansion of bank
credit is to be blamed for fluctuation.

Non-monetary Over-investment Theory

Some economists like Arthur Spiethofr and D.H. Robertson have also
subscribed to the over-investment theory but in a modified form.
Their approach is based on the assumption that Say's law of markets,
which oenies the possibility of overproduction, is valid in a barter
economy but not valid to a money economy in which transactions are
not direct but indirect through money.
Spiethoff believes that over-investment is a basic cause of
business slump but this is not due to low rate of interest or to
expansion of money supply, as Von Hayek has asserted. According to
Spiethoff, over-investment and over-production in one sector may be
passed on to others. For instance, during a business depression there
is excess capacity of durable capital goods. There will be no
investment in these or other related industries. When business
recovery starts, capital goods industries start expanding, and with
that other industries that serve capital goods industries also expand.
For example, expansion of iron and steel industry will lead to
expansion of coal, mining, manganese and transportation. When
these industries expand, income will increase and consequently
demand for consumption goqds will also increase. The upswing
continues till the investment in all industries has reached the
optimum point and in certain lines of production, there is even over-
investment. This leads to the crash of boom conditions.
D.H. Robertson believes that over-investment in some industries is
the result of indivisibilities and this imbalance is worsened by the
banking system, which brings in more money. In his opinion, the
course of economic progress is not generally smooth and as a malleI'
of (act, some degree of fluctuations may be necessary. The real
problem, however, is that the desirable fluctuations may create
excessive responses creating unstable conditions in the economy.
Robertson believes that part of this excessive response is due to
existence of indivisibility in certain investments. He cites the example
of a railway company that faced the problem of congestion on a
single tmck, wanted to go 1'01' a double track. I'll,' introduction of,i
second track would create excess capacity but the additlull:l1 traffic
Illa)' not he slIrticiclll 10 f,dly IItiiisc lill' secolld traele Ilo",('ver. lilc
rnilll':IY company has 110 allcllwlivL' hut 10 inll'tlducc Ihe Sl'l'(lIHI
ll'lll.'k. II\\'l'Slllll'l\IS h"il\~ lumpy in many hcavy capital-intensive
industries result in exceSs capacity. Besides such investmcnts arc
time-consuming because they have long gcst<ltiull periods, i.e., time
gap between the decision to undertake the project and the time
project is commissioned. Two problems are created as a result of
such investment. Firstly, undertaking heavy investment in excessive
of current demand would lead to blockage of capital and undertaking
smaller investment that would be insufficient to meet the current
demand. Secondly, in a competitive system, many entrepreneurs
may go in for investments with long gestation periods' that rt:sult into
over-investment, over-production and glut of goods in the market.
While over-investment and over-production ale results of
indivisibilities. they are encouraged by monetary factors. For
instance, the banking system may plJCC additional volume of money
at the disposal of entrepreneurs and thus increase the already
existing state of imbalance. Increase in money supply will cause
prices to rise, thereby misleading their appraisal of prospective
profits. This price rise encourages entrepreneurs to further over-
investment. Thus, D.H. Robertson successfully combines real and
monetary factors to explain business cycks. Overinvestment theory
has definite merit in the sense that the business boom is identified by
too much investment in general or particular industries. TIllS IS
largely true. However, the real weakness of the theory is its failure to
exp~ain revival from a business depr~ssion.

Over-Saving or Under-Consumption Theory

This is one of the earliest theories of trade cycle and has been stated
in different forms at different times. Such "Yell-known names as
Malthus, Marx and Hobson are associated with this theory. According
to this theory, in free capitalist society rich people have large
incomes but they are unable to spend all their incomes and hence
they save automatically. These savings are usually invested in
industry and hence they increase the volume of goods produced. At
the same time, the majority of people in the country have low
incomes and consequently have low propensity to consume. Thus,
consumption is not increasing correspondingly to production. As a
result, the market is flooded with goods and will be followed
bY,depression unless prices fall to a very low level in order to allow
the goods to be carried oll the market. The fundamental idea of the
under-consumption theory is based upon the conflict, which arises
from the double effect, that saving has on consumption and
production. It is the decrease in the demand lor and the increase in
t.he supply of consumer goods as a res'jlt of saving which seems to
create under-consumption and over-production.
Like all other theories of trade cycles, this theory too is not free
from defects. It does not explain complete trade cycle. It is pointed
out that the theory concentrates too much on over-saving and its
related evils and too little on the others. It considers savings
automatically linding their way into investments while in reality this is
not so. The availability of savings does not guide entrepreneurs in t!
lt.:ir investment policies. Thus, a mere increase in savings is
insufficient to explain occurrence of a boom.

Hawtroy's Monetary Theory

Hawtrey regards trade cycle as a purely monetary phenomenon.
According to him, non-monetary factors like wars, earthquakes,
strikes and crop failures may cause partial and temporary depression
in particular sectors of an economy. However, these non-monetary
factors cannot cause full and permanent depression involving general
unemployment of the factors of production in a trade cycle. On the
other hand, changes in the flow of money are the exclusive and
sufficient cause of changes in trade cycle. In Hawtrey's opinion, the
basic cause of trade cycle is the expansion and contraction of money
in a country. According to Hawtrey, changes in the volume of money
are brought about by changes in the rate of interest. For instance, if
banks reduce their rate of interest, producers and traders will be
induced to borrow more from banks so as to expand their business.
Borrowing from banks will lead to more bank money and rise in the
price level and business activity. On the other hand, if banks raise
their rate of interest, producers and traders will reduce their
borrowing from banks. This will reduce the price level and business
activity. Thus, in Hawtrey's analysis, changes in interest rates lead to
changes in borrowing from banks and, therefore, changes in the
supply of money. Changes in the supply of money lead to changes in
'Jusiness activity.

Trade Cycle in Just Inflation and Deflation

f-Iawtrey argues that the trade cycle is nothing but small-scale replica
of an outright money inflation and deflation. The upward phase of a
trade cycle, such as revival, prosperity and boom is brought about by
an expansion of money and bank credit and also by increase in
circulation of money supply. On the other hand, the downward swing
of money supply is nothing but a monetary denatibn.

Expansion of bank loans is made possibk by fall in rute of interest,

which induces the merchants to' increase their stocks since banks
grants loan more liberally. Therefore, merchants begin to place more
orders and increase production by employing more resources. There
is greater demand for factors of production all round and
consequently higher income and employment leading to further
increased demand of goods. In course of time, a cumulative upward
trend is set in motion. As the volume of business expands and factors
of production arc rendered fully employed, prices rise further and
further induce upward business expansion. resulting in inflationary
conditions or boom conditions. However, the boom crashes when the
ba'lking authorities suspend their policy of credit expansion.

Why the Boom Crashes Suddenly?

The banks suspend credit and call on the borrowers to return the
loans, ci'ther because banks have reached the maximum point
beyond which they cannot givc any more loans or they are afraid that
the phase of business expansion has reached a saturation point and
hence a downward trend may set in the immediate future. Now the
sudden suspension of credit facilities by the banks comes as a shock
to entrepreneurs and merchants. Until now entrepreneurs and
merchants were enjoying liberal policy of the banks and now,
contrary to their expectations, they receive sudden notices of
immediate call-back of loans to dispose of their stocks at any price in
order to repay bank loans. This general desire of businessmen to
dispose of their stocks will definitely depress the market and bring
down the prices. With every fall in prices, the desire to dispose of the
stocks as quickly as possible wi!! lead to confusion and collapse of
the market. Marginal and average fimls may even go into liq-uidation,
thus worsening the position still further and making the banks
extremely nervous. Banks will proceed to further contraction and like
the period of expansion, it will become cumulative. Producers curtail
output and consumers' income and outlays decrease and contraction
spirals in a downward direction, until it touches the lowest level
possible.
How the revival takes place?
When the economy is working at the level of depression, the rate of
interest is low and the bank,....: have large cash reserves. On one
hand, low interest rates make it profitable to 'borrow and invest. On
the other hand, large cash reserves induce banks to lend. This starts
the phase of revival, which because of its cumulative character, leads
to prosperity and boom conditions. This, according to Hawtrey, the
inherently unstable nature of the modem monetary and credit system
is the mother or economic fluctuations. This monetary explanation of
the trade cycle has received powerful support from Milton Freidman,
who says, "In every deep depression, monetary factors playa criticai
role~" According to Freidman, there is a direct relation between the
volume of money supply and the level or business activity in a
country. If the money supply increases at a rate faster than the
economy's real output of goods and services, prices will decline and
the economy is bound to contract. Thus, there is direct relation
between the level of income and economic activity, on the one side
and the volume of money supply on the other. If the 'economy has to
be stable, monetary expansi9n and contraction has to be avoided.

Weaknesses of the Monetary Expansion

The weakness of monetary expansion is as follows:

• Finance is the soul of commerce and trade in modern times and

the banking system plays quite an important part in financing trade
activities. However, it is correct to say that banks cause business
crises.

• Hawtrey's theory would have been all right in those days when
the gold standard was universal and when the volume of money
supply was fixed to gold reserves. Currency and credit could expand
only when gold reserves increases. These days, gold standard does
not exist clnd, therefore, Hawtrey's theory is really weak.

• Borrowing and investment will not depend upon the rate of

 interest, as Hawtrey believes. A high rate of interest will not
deter people· from borrowing for investment, and a low rate of
interest will always induce people to borrow and invest.

• Expansion and contraction of money alone cannot explain

prosperity and depression.

• According to Hawtrey, expansion and boon'! are the result of

expansion of bank credit, but it is pointed out that the mere
expansion of bank credit by itself cannot initiate a boom.

• Further, according to Hawtrey, a depression is marked by

contraction of bank loans and advances but actually, the
contraction of bank credit is the ·result of depression. .

• Lowering of interest rate and willingness of banks to - give loans

and advances cannot be a -sufficient reason to stimulate the
economy to revive. Businessmen will not borrow and invest
unless they are convinced that the economy will definitcly
I"cvivc 1I11d il will he prnntllbk to bOl'rnw Hnt! invest.
• In recenl years, lhe technique \It' tinlllll:ing has been changing
illlLl practically all finns, both big and small, havc becn resorting
to the policy or ploughing back of profits. The conclusion, which
follows, is that the banking system can accentuate a boom or a
depression but it cannot originate one. In other words,
expansion and contraction of bank credit can be a
supplementary cause but not the main cause of trade cycles.

Keynes' Theory of Trade Cycles

Keynes never worked out a pure theory of trade cycles, though he
made significant contributions to the trade cycle theory. Keynes
states, "The trade cycle can be described and ana lysed in terms of
the fluctuations of the marginal efficiency of capital relatively to the
rate of interest." According to Keynes, the level of income and
employment in a capitalist economy depends upon effective demand,
comprising of total consumption and investment expenditure.
Changes in total expenditure will imply changes in effective demand
and will lead to changes fn income and employment in the country.
Therefore, in the Keynesian system fluctuations in total expt(nditure
are responsible for fluctuations in business activity. Now, according to
Keynes, consumption expenditure is relatively stable, and
consequently it is the fluctuations in the volume of investment that
are responsible for changes in the level of employment, income and
output.
Investment depends up0l) two factors: (a) marginal efficiency of
capital, and (b) the rate of interest. Investment is carried on up to the
point where the marginal efficiency of capital (the profitability of
capital) is equal to the rate of interest (i.e., the cost of borrowing
capital). Keynes argues that the rate of interest will depend upon the
liquidity preference of the people in the country and the quantity of
money available. In the short period, the rate of interest will be stable
and hence it is not responsible for causing cyclical fluctuations in
trade cycles. According to Keynes the fluctuations in the marginal
efficiency of capital are the fundamental cause of fluctuation in trade
cycles.
The following Figure 6.5 shows how trade cycle depends upon the
marginal efficiency of capital, which according to Keynes, is the villain
of the piece. The substance of Keynes' theory is that an initial
investment outlay will generate multiplc amount of income and
employment under the int1uence of the multiplier and acceleration
effects. On the other hand, 'co;ntraction of investment will similarly
lead to multiple contractions of incom~and employment. But whether
a fresh investment will be Lindertaken will depend upon the marginal
efficiency of capital. We can explain these pOint$ a little more
elaborately.
How Recovery Starts?
Let us start at the bottom of a depression. At this point, the marginal
efficiency of capital will be high due to exhaustion of accumulated
stocks and necessity to replace capital goods. At the same time, the
rate of interest may be low because of large cash balances with
commercial banks or due to fall in the public liquidity preference. As
a result, the entrepreneurs may borrow fu~ds from banks and make
fresh investments. Under the impact of the multiplier an<i
acceleration effects, the process of increased investment and
employment gets an upward trend. There is heavy economic activity
everywhere in the primary, secondary and tertiary sectors of the
economic system. This sudden shoot in investment activity gives rise
to boom and as long as it lasts, the economic situution appears very
easy and bright.

How the Boom Crashes?

The boom conditions thcmselves contain the very seeds;of their own
destruction. Very soon goods are accumulated beyond the
expectations of entrepreneurs and competition among them to
dispose their accumulated stocks bring crash in prices. While the
prices of finished goods are declining, their costs of production
continuously rise because factors of production are bceoming scarce
and hence are commanding hi,!~her prices. The· marginal efficiency
of capital is sandwiched between rising costs of production-on the
one side and falling prices of finished goods :In the other. The
marginal efficiency of capital, therefore, collapses and brings about a
crash in the investment market.

Ineffectiveness of the Rate of Interest

Keynes believes that the rate of interest could have prevented the
collapse of the marginal efficiency of the capital and revives the
confidence among the entrepreneurs, by exerting its pressure to
reduce cost. Uut then, the rate of interest is very high, like all other
prices and wages. The rate of interest goes up due to a rise in the
liquidity preference of the people. The marginal efficiency of capital
falls below the current rate of interest and thus, the decline of
investment is aggravated. Keynes believes that at this stage a
reduction in the rate of interest is neither easy nor adequate to
restore confidence and revive investment. In Keynes' theory of trade
cycles, the margina~ efficiency of capital has great significance than
the rate of interest. In fact, it disturbs the equilibrium of the
economy and thereby causes fluctuations in the economy. The other
factor that occupies an equally important place in Keynes theory is
the "investment multiplier". However, for the active operation of
investment multiplier, the cycle needs to be milder in magnitude
than what it actually is.

Weaknesses of the Keynesian Analysis

Keynes' theory of the trade cycle has been regarded as quite
convincing since it explains cbm:ctly the cumulative processes, both
in the upswing as well as in the downswing. Besides, Keynes'
advocacy of fiscal policy to bring about business stability has been
widely used. However, critics have found some weaknesses in the
Keynesian analysis. First, according to Keynes, marginal efficiency of
capital is the most important factor that guides the investment
decisions of the entreprencurs. However, this important factor
depends on entrepreneurs' anticipation of future prospects that
further depend upon the psychology of investors. If'. such a .case,
Keynes' theory of trade cycles approaches close to Pigou's
psychological theory. Secondly, in Keynes' theory, the rate of
interest plays a minor role. Keynes expresses the opinion that
sizeable fall in the rate of interest can do something to. revive the
confidence among the entrepreneurs by exerting pressure on the
cost of production. However, Keynes himself has pointed out that
this has been sufficiently proved to be correct that the rate of
interest does not have any influence on investment. Thirdly, his
theory does not throw light on the periodicity aspect of the trade
cycle.
Finally, some critics like Hazlitt have pointed out that Keynes'
concept of the rate of interest does not tally with actual market
conditions. For instance, according to Keynes, in a period of recession
and depre~sion, the rate of ir:'erest ought to be high because of
strong liquidity preference but precisely during this period, the rate of
interest is low. Likewise during boom conditions, the rate of interest
ought to be lower because of the weak liquidity preference among
the people instead it is high.

Hicks' Theory of Trade Cycles

In his book "A Contribution to the Theory of the Trade Cycle," Hicks
has developed a theory mainly by combining the principles of the
'multipiier and acceleration, which he has borrowed from Keynes and
has combined the concepts of autonomous and induced investment,
a distinction originally made by Roy Harrod. The multiplier is related
to the autonomous investment of the Government. The acceleration
principle is based on induced investment.
 The above Figure 6.6 shows the influence of the two types of
investment on the level of income and cyclical fluctuations. The
horizontal axis represents the number of years and the vertical axis
represents the level of economic activity. Line AA' represents the
progress of autonomous investment over thc years and it slants
upward at a uniform rate to indicate that autonomous investment
grows over time at a constant rate. Line EE' represents the income
(or output) corresponding to the aUlononious investment line AA·. EE'
IS at a higher level than AI\" because it rerresents the eomhined
innllellce of mllitiplk'r flnd flccelerrllioll effects n.~ n result or
,lulollOlllllUS illvestl:lellt (AA '), III fact, the distallce bC1WL'Cil A/\' lIlld
EE' will depend upon the combined inlluence of the multiplier and
acceleration effects. Finally, line FF' represents the level of full
employment.

The Process of Cyclical Fluctuation

Suppose the economy is at point P in the Figure 6,6 and at this .point,
a certain invention is introduced. As a result, there is burst of
autonomous investment, which may be short-lived. But the induced
investment will push output and employment upward along the path
marked PP1, away from the EE' line. Th,e upward trend touches full
employment ceiling at PI and cannot ~ise further. At the most, the
expansion can "creep along" the' ceiling but only for a limited time.
When the path has encountered the edling, it must bounce off from it
and begin to move in a downward direction.

According to Hicks, this downward swing is predictable. The

initial burst of autonomous investment is short-lived and after a
stagc, it will fall to the usual level. But the induced investment, which
was the result of the initial autonomous investment and the initial
increase in output, would continue and push ahead on path PP1• But
the induced investment is not sufficient to support a growth of output
along the path FF' but it is sufficient to support an output which
expands along the equilibrium path EE', Output, therefore, will
bounce back from FF' towards EE'.

The downward swing is gradual along the path P2RRI and rapid
along P2RR2. At first, the downward swing may appear. to be
gradual but, in practice, it will be rapid. The reason is that once the
decline in output is initiated, it gathers momentum and tends to
proceed at a fast rdte. Hicks give a monetary explanation to this
phenomenon. As the downward movement starts, it becomes
increasingly di fficult to sell goods and consequently the burden of
fixed cost becomcs oppressive. Therefore, firm after firm becomes
bankrupt and liquidity preference records a sudden and abrupt rise
and reacts most adversely on credit situation. At [he same time the
stringent conditions in the credit market, forces business activity to
fall to the lowest ebb and thereby aggravate the situation. Thus,
Hicks' theory of trade cycles makes use of multiplier and
acceleration principles, which are combined, to the fluctuations of
autonomous and induced investment. It is induced investment,
which is finally rcsponsibleJor the upward push and downward swing
of output and income of prices and employment.

Schumpeter's Innovations Theory

Joseph Schumpeter has propounded a trade cycle theory in terms of

innovations. An innovation can be regarding new product or new
method of production, such as new machinery, new method of
organisation of factors of production, opening of a new market for
the product and development of new source of raw materials. In
other words, an innovation is anything that is introduced by a firm
or an industry to change the supply or demand conditions. An
innovation may be sufficient to cause changes in expectations of
entrepreneurs and their economic and business calculations. These
changes may cause the cost of production to change rapidly and
continuously and may shift the demand curve continuously in such
a manner that the final stage . becomes indeterminate. Any
innovation, thus, causes disequilibrium in the economic system,
making it necessary for the economic system to readjust itself at
some new equilibrium position. Thus, Schumpeter explains the un-
rhythmic movements of an economy by reference to innovations.

The Effect of Innovations

Suppose we start with an economy, which is functioning at full

employment level. Suppose an innovation in the form of a new
product has been introduced. The new industry will need to have
new plant and equipment. Since the economy is already working at
full employment level, the new plant and equipment required by the
new industry can be acquired only by withdrawing labour and other
resources from old industries. As a result of higher cost of factor of
production, the old industries will experience both an increase in
their cost of production as well as j~crease in their output. The
promoters of the new product will have to attract all f(!ctors of
production by offering higher rewarqs and the necessary finance
may ,:i: 'me out of additional bank loans. Since the factors of
production, both in the new ;tl'd the old industries, are getting
higher money remuneration therefore, they will ',~( 'nand more
goods and services and consequently will push up prices, Thus,'ill
'<'::IS<:U ucmanu [or anu the simultaneous decreased supply of the
old goods will ~ It:"h upward the prices of these goods. However, it
is not necessary that the in 'case in the demand alld costs of all
industries should nec~ssarily be equal. The i l_: industries, whose
demand for products rises more rapidly than production ~ lHS, will
reap abnormal profits and consequently will expand, To the extent
the l (1',1 involved in such expansion is financed by hank credit
therefore. the i d1:qi"":1r\' I'I'I":'nll'l' "11 I'rk"'l <111.1 ,'\1';1.'1 i .. :
Illt\gllilkd.

The Process of Rising Prices

When the new product introduced in the mark~, becomes

commercially successful and brings in profit for promoters, the rival
competing firms quickly introduce similar products and imitations.
The production of many competing varieties of products sets in
motion expansion in many related industries. Therefore, resulting
into a period of cumulative prosperity.

The Process of Falling Prices

The deflationary effect follows when the novelty of the innovation is

lost with the production of so many competing varieties or brands of
the S3me product. Abnormal profits are competed away. Some of the
firms may even incur losses and close down their businesses, thus
layoff labour and other agents of production. Therrfore, the demand
for goods is reduced. A similar deflationary effect is experienced
whcn the innovating firms return their bank loans out of their profits
and thus reduce the volume of money supply in the economy. The
"vicious circle of deflation" is generated in this manner.

Criticism

First, Schumpeter's theory is based upon two assumptions regarding

full employments of rf'sources in the economic system and financing
of innovation by means of bank loans. If an economy is working
below full employment, the introduction of an innovation need not
cause diversion of factors of production from older industries and
thus cause prices of goods to go up or their supply to iecline. Again,
innovation is generally financed by the promoter themselves and
hence, resort to bank .finance does not arise at all. Secondly,
innovation.s may be regarded as one cause for business fluctuations
but not the only cause, as there are many other causes also. As
Hayek correctly points out, innovations alone cannot explain the
phenomenon of trade cycles without a substantive monetary
explanation. We have described man;' theories of business cycles
and there are many morc. Therefore, none of the theories provides a
complete explanation of the causes of trade cycles. The reason for
this is that the trade cycle is not the result of anyone single factor but
is due to multiplicity of factors, of which sometimes one and
sometimes another becomes dominant.

Control of Trade Cycles

Thc trade cycle, which implies fluctuations in business activity, is not

beneficial to allY seetioll of a community. The period of expansion is
accompanied by large profits to producers and speculators but it
brings loss to lixcd income groups. The period of depression is one of
acute unemployment, poverty, suffering and misery to the poor and
of distress to the busin(;ss dass(;s as a .result of exlensive hlltlk lIlId
firms failures. Thus all sections of people in a country, especially the
working classes, are interested in preventing and avoid ing busihess
cycles .. On/ of the 1110st important objectives of economic policy is
the elimination of cyclical fluctuations and attainment of stability at
the level of full employment. This has been, in fact, the main
objective of both monetary and fiscal policies. We have already
explained the use of monetary policy and fiscal policy as wel'l as
direct control, to check inflations and deflations.
There is no full proof method for solving the problem of trade
cycles.
Karl Marx considered trade cycles as inevitable in a capitalist system
and the only rational method to solve the problem was to throw it
overboard and introduce a socialist economy. Like every business
firm prepares its annual balance sheet of transactions with a view to
know its assets and liabilities, every nation carrying out economic
transactions with foreign countries prepares its Balance of Payment
(BOP) Accounts periodically with a view to know stock of its assets
and liabilities and its receipts from and payments to the rest of the
world.

THE BALANCE OF PAYMENT

Definition

The balance of paYlllent is defined as a systematic record of all

economic transactions between the residents of a country and
reside~ts of foreign countries during a certain period of time.
Although the above definition of balance of payments is quite
revealing certain terms used in the definition may require some
clarification. The term's systematic record does not refer to any
particular system. However, the system generally adopted is double
entry book-keeping system. Economic transactions include all such
transactions that involve the transfer of title or ownership. While
some transactions involve physical transfer of goods, services, assets
and money along with the transfer of tille while other transactions do
not involve transfer of title. For example, suppose that a subsidiary
company of a foreign undertaking is operating in India and 'making
profit. This company may pay all its profits as dividend to the
shareholders abroad, or it may, alterilatively reinvest its profit in India
instead of paying dividends to its parent company abroad. Both kinds
of transactions arc recorded in the balance of payments accounts.
The trnnsl'l'I' 01' titk is important thlln lht: physi,l:l\llrl\nstl~r or
rCSlHlr\:cs. The term residcnts rcfcr to 'the nationals of thc rcporting
country, Tourists. diplllllll\t~;, IIlililmy I'cr:lllllllcl, 11'llIlHlmry "lid
llligrnllll)' IVllrl\l\I',~ 111111 Iii,' "n,,"·I,,'n of foreign companies
operating in the reporting clHllltr)' do not rail in till' category or
residents, Thc timc period for balance of payments is not speci fically
delincd. it can be of any period, The generally period is one financial
year of calendar.

Purpose

The balance of payment serves a very useful purpose as it yields

necessary information for the future policy formulation in regard to
domestic monetary and fiscal pulicies and foreign trade policy.

Following are the important uses of balance of payments:

• It provides useful data for the economic analysis of country's

weakness and strength as a partner in the international trade. By
comparing the statements contained in the balance of payments for
several successive years, one can find out whether international
economic position of the country is improving or deteriorating. In
case it is deteriorating, necessary corrective measures can be taken.

• It reveals the changes in the composition and magnitude of

foreign trade. The changes that curb ~conomic well-being of a
country are taken care by the government.

• It also pwvides indications of future repercussions based on

countries past trade performances. I f balance of payments shows
continuous and large deficits over time then it indicates growing
international indebtedness, which ultimately leads to financial
bankruptcy. Similarly. a continuous large-scalc surplus in the balance
of payments, particularly wht:n its magnitude goes beyond the
absorption capacity of the country indicates impending dangers of
inflation.
• Detailed balance of payments accounts also reveal weak and
strong points in the country's foreign trade rdationsund thereby
invite gove.-I1ll1cnt attention to the need for corrective
measures against the weak spots.

Balance of Payments Accounts

The economic transactions between a country and the rest oCthe
world may be grouped under two broad categories:

1. Current transactions: Current transactions pertain to export and

import of goods and services that change the current level of
consumption in the country or bring a change in the current
level of national income.

2. Capital transactions: Capital transactions arc those

transactions, which increase or decrease counlry's Iota I stock
of capital, instead of affecting the current level of consumption
or national income. In other words, current transactions arc
flow transactions. In accordance with the two kinds of
transactions, balance of payments account is divided into two
major accounts:
A. Current account
B. Capital accounts

Current Account

The items, which are entered in the current account of balance of

payments, are listed in the Table. 6.4 -in the order of their
importance. The categories of items presented in the table were
published by the IMf and are currently followed in India. In the 'credit'
column values receivable are entered and in 'debt' column values
payable ar.e entered. The net balance shows the excess of credit
over the debit for each item, can be negative (-) or positive (+). The
items listed in current account can be further grouped into visible and
invisible items. Merchandise trade, i.e:, export and imports of goods,
fall under the visible items. Rest all other items in the current
account-payment and receipt for the services, such as banking,
insurance and shipping are termed as invisible. Sometimes another
category, i.e., un-required transfer, is created to give a separate
treatment to the items like gifts, donations, military aid, and technical
assistance. These are different from other invisible items since they
involve unilateral transfers.
 The net balance on the visible items, i.e., the excess of
merchandise exports (Xg) over the merchandise imports (Mg) is called
as balance of trade. If Xg < Mg it is unfavourable. The overall balance
on the Current Account is known as 'Balance on Current Account.' The
'Balance on the Current Account' either surplus or deficit is carried
over to the Capital Account.

. Table 6.4: Balance of Pa}'ments Current Account

Transactions Credit Debit Net Balance

I. Merchandise Export. Import -
2. Foreign travel Earnings Payments -
3. Transportation Earnings Payments -
4. Insurance Receipts Payments -
(premium)
5. Investment Dividend Dividends -
Income
6. Government Receipts Payments -
Cr;:rchase and
sales of goods
and services)
7. Miscellaneous* Receipts Payments -
Current Account - Payments Surplus (+)
Balance Deficit (-)
* Includes motion picture royalties, telephones and telegraph
services, consultancy fees, etc.

Capital Account
As mentioned earlier, the items entered in the capital account of
balance of payments are those items, which affect the existing stock
of capital of the country. The broad categories of capital account
items are: (a) short-term capital movements; (b) long-term capital
movements; and (c) changes in the gold and exchange reserves.
Short-term capital movements include (i) purchase of shortterm
securities such as treasury. bills, commercial bills and acceptance
bills, etc.; (ii) speculative purchase of foreign currency; and (iii) cash
balances held by foreigners for suchfeasons as fear of war and
political instability. An item of short-term capital results often from
the net balances (positive or negative) in the Cljrrent Account. Long-
term capital movements include: (i) direct investment in shares,
bonds, real estate and physical assets such as plant, building and
equipments, in which investors hold a controlling power; (ii) portfolio
investments including all other stocks and bonds such as government
securities, securities of firms which do not entitle the holder with a
controlling power; and (iii) amortisation of capital, i.e., repurchase
and resale of securities carlier sold to or purchased from the
foreigners. Direct export or import of capital goods fall under the
category of direct investment. It should be noted that export of
capital is a debit item whereas export of merchandise is a credit item.
Export of goods result in inflow of foreign currency, which is an
addition to the circular flow of money income, whereas export of
capital results in outflow of foreign exchange which, amounts to
withdrawal from the foreign exchange reserves. Geld and foreign
exchange reserves make the third major category of items in the
capital account. Gofd and foreign exchange reserves are maintained
to stabilise the exchange rate of the home currency and to make
payments to the creditors in case there exists payment deficits on all
other accounts.

Balance of Payments is always in Balances

The balance of payments accounting is based on the double-entry
book-keeping system in which both sides of a transaction, i.e.,
receipts and payments are recorded. For example, exports involve
outtlow of goods and inflow of foreign currency. Similarly, imports in
volve inflo\\ of goods and outflow of foreign currency. Both, inflow
and outflow are recorded in this system. International borrowing and
lending give rise to credit to the lender and debit to the borrower.
Both are recorded in the balance of paymcnts. However, donations,
gifts, aids and assistance are unilateral transfers and do not involve
transfer of an equivalent value. In regard to these items, there is only
credit and no debit since they are nonrefundable. Yet, the receiving
country is debited to keep the record of nonrefundable amounts and
donator is credited for the record purposes. Such entries have
information value for non-economic purposes. Besides, these
transactions reduce the deficit in the current account of the reporting
country. Since in this system of balance of payments accounting
international transactions are entered on both debit and credit sides.
Balance of payments always balances from the accounting point of
view.

Disequilibrium in Balance of Payments

We have noted above that the balance-of payments is always in
balances from accounting point of view. Besides, in the accounting
procedure, a deficit in the current account is offset by a surplus in
capital account resulting from either borrowing from abroad or
running down the gold and foreign exchange reserves.

Similarly, a surplus in the current account is 011set by 1I

mlltdling Jl'licit in capital account resulting from loans llnd gills to
debtor country or by dcpklion (),' its gold and foreign exchange
reserves. In this sense also. lhe '11,lIallce (!I JlllYIJl!:lltS' 1IlwlI)'s
rcnlllills In hllllllll:C:. As :.udl. tbert' slllluid hc 1I11 qUC.Slll)11 1\1
disequilibrium in the balance of payments. However, disequilibrium
in lhe balall!:l: of payments does arise because total receipts during
the reference pl:riod need 1I0t be necessarily equal to the total
payments. When total receipts do not m<lleh with total payment of
the accounting period, this is a position of disequilibrium in the
balance of payments. The final balance of payments position is
obtained in the manner described below.
For assessing the over-all balance of payments position, the total
receipt and total payments arising out of transfer of goods and
services and long-run capital ' movements are taken into account. All
the transactions are regrouped into autonomous and induced
transactions. Autonomous transactions take place on their own all
account of people's desire to consumc morl: or to makc a larger
profit. For example, export and imports of items in current account
are undcrtaken with a view to, make profit or consume more goods.
Another autonomous item in the current account is gift or donations.
They are voluntary and deliberate. In the capital account, export and
import of long-term capital are autonomous transactions. In addition,
the short-term capital movements motivated by the desire
to invest abroad for higher return fall in the category of autonomous
transactions. Thus. all exports and imports of goods and services,
long-term and short-term capital movements motivated by the desire
to earn higher returns abroad or to give
gi fts and donation are the autonomous transactions. Exports and
imports take place irrespective of other trans~ctions included in the
balance of payments accounts. !-!ence, these are autonomous
transactions. If exports (Xg) equal imports (Mg) in value, there will be
no other transaction. However, if Xg is less than Mg, it leads
to short-run capital movements, e.g., international borrowing or
lending. Such international borrowings or lending are not undertaken
for their own sake, but for making payment for the deficit in the
balance of trade. Hence, these are called induced transactions. They
involve accommodating capital flows.
On the other hand, the short-term capital movemcnt's viz., gold
movemenls it and accommodating capital movements on accounts of
thc autonomous transactions are induced transactions. These
transactions lead to reduction in the <, gold and foreign exchange
reserves of the country.

In the assessment of balance of payments position only autonomous

transactions are taken into account. The total receipt and payments
resulting from the autonomous transaction determine the deficit or
surplus in the balance of payments. I f total receipts and payments
arc unequal, the balance of payments is in disequilibrium. I I' the total
payments exceed the lotal receipts, the balance or payment shows
deficit. On the contrary, if receipts from autonomous transactions
exceed the payments for autonomous transactions, the balance of
payments is in surplus. Naturally, if both are equal, there is neither
deficit nor surplus, and the balance of payments is i~1 equilibrium.
From the policy point of view, the depletion in the gold and foreign
exchange reserves is generally taken as an indicator of balance of
payments running into deficit, which is a matter of concern for the
government. However, if reserves are plentiful and the government
has adopted a deliberate policy to run it down, then the deficit in the
balance of payments is not an in he?lthy sign for the economy.
Besides, the disequilibrium of surplus nature except the one that
might cause inf1ation is not a serious matter as the disequilibrium of
deficit nature. We will be therefore, concerned here mainly with the
deficit kind of disequilibrium in the balance of payments.

Causes and Kinds of BOP Disequilibrium

The deficit kind of disequilibrium in the balance of payments arises
when a country's autonomous payments exceed its autonomous
receipts. The autonomous payments arise out of imports of goods
and services and export of capital. Similarly, autonomous receipts
result from the merchandise exports and import of capital. It may
therefore be said that disequilibrium of deficit nature arises when
total imports exceed total exports. However, imports and exports do
not determine themselves. The volume and value of imports and
exports are determined by a host of other factors. As regards the
determinants of imports, the total import of country depends upon
three factor: (i) internal demand for foreign goods, which largely
depends on the total purchasing power of the residents of the
importing country, (ii) the prices of imports and their domestic
substitutes, and (iii) people's preference for foreign goods. Similarly,
the total export of a country depends on (i) foreign demand for its
goods and services, (ii) competitiveness of its price and quality, and
(iii) exportable surplus.
Under static conditions, these factors remain constant. Therefore,
equilibrium in the balance of payments, once achieved, remains
stable. However, under dynamic conditions, factors that determine
imports and exports keep changing, sometimes gradually but often
violently and unexpectedly. The changes differ in their duration and
intensity from country to country and from time to time. The
changes, which occur as a result of disturbances ,in the domestic
economy and abroad, create conditions for dis-equilibrium in the
balance of payment.

Causes of Disequilibrium and the Associated Nature of

Imbalances

• Price Changes and Disequilibrium: The first and the major

cause of disequilibrium in the balance of payment is the change in
the price level. Price changes may be inflationary or deflationary.
Deflation normally causes surplus in the balance of payment. The
balance of payments surplus does no! cause a serious concern from
the country's point of view. It may, however lead to wasteful
expenditure and mal-allocation of resources. On he C1ther hand,
inflrtionary changes in prices causes deficits in the balance of
payments. The balance of payments deficit result in increased
indebtedness, depletion of gold reserves. loss of employment. and
disfort:ons in the domestic economy and causes other economic
problems in the deficit countries. Therefore, we will discuss only the
impact of inflationary price changes on the balance of payments
position.
Inflation causes a change in the relative prices of imports and
exports. While exchange rate remains same, inflation causes
increase in imports because domestic prices become relatively
higher than the impo;L prices. On the other hand, inflation
leads to decrease in exports because of decrease in foreign
demand due to increase in domestic prices. The increase in
imports depends also 011 price-elasticity of demand for imports
in the home market and decrease in the exports depends on
the price-elasticity of foreign demand for home-products. In
 case price-elasticity of imports and exports is not equal to zero,
imports are bound to exceed the exports. As a result, there will
be a deficit in the balance of payments. If inflationary
conditions perpetuate, it will produce long-run disequilibrium. If
the size of deficit is large and disequilibrium is inflexible, it is
termed as a fundamental disequjJibrium. The price changes or
fluctuations may be local, confined to one or few countries or it
may be global as it happened in the ec:(/y 1930s. If price
fluctuations take the form of business cycle, most countries
face depression and inflation almost simultaneously. Since
economic size of the nations differs, their imports are affected
in varying degrees. Deficits and surpluses in the balance of
payment vary from moderate to large. The countries with
higher marginal propensity to import accumulate larger deficits
during inflationary phase of trade cycle and a moderate deficit
or even surplus, during depression. Such disequilibrium is
known as;;' cyclical disequilibrium. This is however only a
theoretical possibility. Since little is known about the marginal
propensities to import, any generalisation would be unwise.

• Structural Changes and Dis-equilihriull1: Structural changes, in

an
economy arc caused by factors, such liS, (i) depletion orthe
cheap natural resources (ii) change in technology with which a
country is 110t in a position to keep pace, i.e., technology lag
and, (iii) change ill consulllers' !lIsle IInd preference. Such
changes incapacitate exporting countries and they lind it
difficult ,10 face competition in the intnnational market, due
toeither high cost of production or lack of foreign demand. To
quote the examples from P.T. ,Ellsworth the gradual exhaustion
of better coal in Great Britain resulted' in increased cost of coal
production despi!e improvement in technology. This factor
combined with labour problem converted Great Britain from a
net coal-exporting nation to a net-importing one.
 All such changes bring change in demand and supply
conditions. If size of foreign trade is fairly large, then the
balance of payments is adversely affected. The ultimate result
is disequilibrium in the balance of paym~nts. It is called
structural disequilibrium. The structural disequilibrium may also
originate from thc discovery of new resources, which may invite
foreign capital in a large measure. The large-scale capital inflow
may turn th~ balance of payments deficit into a surplus.

• Other Factors: In addition to the fundamental factors

responsible for disequilibrium in the balance of payments, there are
certain other factors, which may cause temporal disequilibrium, Some
of them are as follows:

ο Disturbances or crop failure particularly in the countries,

producing primary goods, for examplc, India.

ο Rapid growth in population leading to large-scale imports of

food materials.

ο Ambitious developmen! projects requiring heavy imports of

technology, equipmenCs,machinery and technical know-
how.

ο Demonstration-effect of advanced countries on the

consumption patternof less developed countries.

Balance of Payments Adjustments

The short-term and small deficits in the balance of payments are
quite likely to cmcrge in wide range of international transactions.
These cleficits do not call for immediate corrective actions. More
importantly, irregular short-term changes in the domestic economic
policies with a view toremove the short-term deficit in the balance of
payments may do morc harms than good to the economy. Since
these changes cause dislocations in the process of reallocation of
resour'ces and short- Icrm lluctUlItiolls in the cconomy, Therefore,
short-term del1dts of snHllkr magnitude :lrc ,not II Ill:ltler or serious
COlleCI'll I'or the policy-nlllkers. 11()\\'rn·l. const:lllt delicil or 1:l1'p.
('1' 111:1p"llillllk h:,,~ n wide 1':1111<1' or I'ClII\(lInie nlld 11Itlili.'nl
implil:alions, i\ constant delicil indicates country turning inlo an
l'tl'I'I\III h(\I'I'\I\I ,'( or depiction of' its lim:ign exchange lint! gold
resnves. These countries los~ till'ir international liquidity and
credibility. This situation often leads to compromiSe with economic
and political independence of these countries. India faced a similar
situation in July 1990. Therefore, a country facing constant large
deficits in ih balance of payments is forced to adopt corrective
measures, such as changes in its internal economic policies for
wiping out the deficits, or at leasl to bring it l(l •• manageable size. It
is a widely accepted view that the conditions for an automatic
corrcctive mcchanism visualised under gold standard, bascd on
international pricemechanism do not exist. Therefore, the
government has no option but to intervene . ~ with the market
conditions of demand and supply with the policy measures available
(0 them. It should be borne in mind that policy-mix in this regard may
vary from country to country and from time to time depending on the
prevailing economic conditions.

Measures used to Correct Deficits in Balance of Payments

The various measures used to correct deficits in balance of
payments are as follows:

• Indirect measures to correct adverse BOP: Under free trade

system, the deficits in the balance of payments arise either due to
greater aggregate domestic demand for goods and services than the
total domestic supply of goods and services or domestic prices are
significantly higher than the foreign prices. Thus, the deficit may be
removed either by increasing domestic production at an
internationally comparable cost of production or by reducing excess
demand orby using the two methods simultaneously. It may be very
difficult to increase the output in the short-run, specially when a
country is close to full-employment or when there ~re other limiting
factors to its industrial growth. Thcrcforl.:, thl.: only way to rcducl.:
ddicil is I to reduce the demand for foreign goods.
• Income and Expenditure Policies: Here we discuss how
reduction in . income can lead to reduction in demand and how it
helps reducing the deficit in the balance of payments. The t'.vo policy
tools to change disposable income are monetary llnd fiscal policies.
Monetary policy operates on the demand for and supply of money
while fiscal policy operates on the disppsable income of the people.
The working and efficacy on these policies as i,nstruments of solving
balance of payment problem is described below.

Monetary Policy
The instruments of mon~tary policy include discount 01" bank rate
policy, open market operations, statutory reserve ratios and selective
credit controls. Of these, first two instruments are adopted in the
context of balance of payment policy. This however should not mean
that other instruments are not relevant. The government is free to
choose any or all of these instruments amI adopt them
simultttneously.
To solve the problem of deficit in the balance of payments, a 'tight
maney policy' or 'dear money.p6Iicy' is ,idoptl:d. Under 'dear money'
policy, central Ilwlll:lar'y Clulil()ritics raise "[ilc discount rate.
Consequently, under nonna1 conditions, the demand 'for institutional
funds for investment decreases. With the fall in investment and
through its multiplier effect, income of the people decreases. lf
lnarginal propensity to consume is greater than zero, demand for
goods and services decreases. The decrease in demand also implies
a simultaneous decrease in imports while other things remain same.
This is how 'a tight money policy' corrects deficit in balance of
payments.
The effcacy of 'tig:,t money policy' is however doubtful under
following conditions: (i) when rates of returns are much higher than
the increased bank rate due to inflationary conditions, (ii) when
investors have already affected their investment in anticipation of
increase in the rate of interest. The tight money policy is then
combined with open market operation, i.e., sale of government bonds
and securities. These two instruments together help to reduce
demand for capital and other goods. Therefore, if all goes well then
the deficit in the balance of payments is bound to decrease.

Fiscal Policy
Fiscal policy as a tool of income regulation includes vanatlon in
taxation and public expenditure. Taxation reduces household
disposable income. Direct taxes directly transfer the houseilOld
income to the public reserves while indirectlaxes serve the same
purpose through increased prices of the taxed commodities. Direct
taxes reduce personal savings directly in a greater amount while
indirect taxe~ do it in a relatively smaller amount. Taxation reduces
the disposable income ofthe household and thereby the aggregate
demand including the demand for imports. Taxation also helps to
curtail investment by taxing capital at progressive rates.

The g~veinmeht can reduce income and demand also by

adopting the policy of surplus budgding in which the government
keeps its expenditure less than its revenue. Ll'~:>tion reduces
disposable income of household and public expenditure increases
household's income and their purchasing power. However, multiplier
effect of public expenditure is greater by one than the multiolier
effect of taxation. Therefore, while adopting surplus-budget policy
due consideration should be given to this fact. To account for this
fact, it is necessary that surplus is so largi.: that the total cumulative
effect of taxati?n on disposable income exceeds the effect of public
expenditure. The reduction in income that will be necessary to
achieve a certain given target of reducinG balance of payments
deficit depends on the rate foreign trade multiplier. .

Exchange Depreciation and Devaluation

Reducing 'excess demand through price measures involves changing
relative prices of imports and exports. Relati';e prices of imports and
exports can be changed through exchange depreciation and
devaluation. Exchange depreciation refers to fall in the value of
home currency in terms of foreign currency and devaluation refers
to fall in the value of home currency in terms of gold. However, ill
terms of purchasing power, parity between devaluation and
depreciation turns out to be the same and its impact on foreign
demand is also the same. Therefore, we shall consider them as one
in their role of correcting adverse balance of payments.
Devaluation and exchange depreciation change the relative
prices of imports and exports, i.e., import prices increase and export
prices decrease, though not necessarily in the proportion of
devaluation. As a result of change in relative prices of exports and
imports, the demand for imports decreases in the country, which
devalues its currency and foreign demand for its goods increases
provided foreign demand for imports is price elastic. Thus, if
devaluation or exchange depreciation is· effective, imports will
decrease and exports will increase. Country's payments for imports
would decrease and export earnings would increase. This ultimately
decreases the deficits in the balance of payments in due course of
time. However, whether expected results of devaluation or
exchange depreciation are achieved or not depends on the following
condition5.

• The most important condition in this regard is the Marshall-

Lerner conditidh. The Marshall-Lerner condition states that
devaluation will . improve the balance of payments only if the
sum of elasticises of home demand for imports and foreign
demand for exports is greater than unity. If (he sum of
elasticises is less than unity, the balance of payments can be
improved through revaluation instead of devaluation.
• Devaluation can be successful only if the alTectcd countries do
nol devalue their currency in retaliation.
• Devaluation must not change the cost-price structure in favour
 of imports.
• Finally, the government ensures that inflation. which may be the
result of deyaluation, is kept undcr control, so that the effect of
devaluatibn is not counter-balanced by the effect of inflation.

Direct Measure: Exchange Control

The exchange control refers to a set of restrictions imposed on the
international transactions and payments, by the government or the
exchange cotHrol authority. Exchange control may be partial,
confined to only few kinds of transactions or payments, or total
covering all kinds of international transactions depending on the
requirement of the country.
The main features of a full-fledged exchange control system are as
follows:
• The government acquires, through the legislative measures,
a
Complete domination over the foreign exchange transactions.
• The government monopolises the purchase and sale of
foreign
exchange.
• Law el iminates the sale and purchase of foreign exchange
by the resid~nt individuals. Even holding foreign exchange
without informing the exchange control authority ;s declared
illegal.
• All payments to the foreigners and receipts from them are
routed through the exchange control authority or the authorised
agents.

• Foreign exchange payments arc restricted, generally, to the

import of essential goods and service such as food items, raw
materials, other essential industrial inputs like petroleum
products.
• A system of rationing is adopted in the foreign exchange
allocation for essential imports.
 • To ensure the effectiveness of the exchange control system
and to prevent the possible evasion, strict, stringent laws like
FERA and/COFEPOSA in India arc enactec.
• The circuitous legal procedure of acquiring
import amI export
licences is brought in force. In the process, the convertibility
of the home-currency is sacri ficed.

Why Exchange Control?

The cxchange' control systcm as a mcasurc of' adjusting adverse
halance 01 plIYlllcnl diffcrs I'IldiclIlly (hllil lhe Indirect elHTt'di\'l'
nll'IISlIrl'·S. Wllik till" 1"lkl works through the markct forccs, the
fonncr works through a cOlllrol lIIechanism based on adhoc rules
and regulations. In contrast to the self-sustained and automatic
functioning of the market system, the exchange control requires a
cumbersome bureaucratic system of checks and controls. Yet,
many countries facing balance of payment deficits opt for exchange
control for lack of options. In fact, automatic adjustment in the
balance of payments requires the existence 0 I' thc following
conditions.
• International competitive strength of the deficit countries.
• A fairly high elasticity of demand for imports.
• Perfectly competitive international market mechanism.
• Absence of government intervention with the demand and
supply
conditions. .
The existence of these conditions has always been doubted.
Owing to differences in resource endowments technology, and the
level of industrial growth, countries differ in their economic strength
and their industries lack the competitiveness. The protectionist
policies adopted by various countries intervene with international
market mechanism. Besides, automatic method of balance of
payments adjustment requires a strict discipline, economic strength
and political will to bear the destabilising shocks which the
automatic method is expected to bring to a country in the process
of adjustment. Since these conditions rarely exist, the efficacy of
internati'onal market mechUl1ism to bring automatic balance of
payments adjustment is orten doubted.

For these reasons, exchange control remains the last resort for the
countries under severe str<lin of balancc or payments dclicits. The
e:-:ch:\llge contn)1 is qid to possess a superior effectiveness in
providing solutions to the deficit problem. Besides, it insulates an
economy against thc impact of eeonOl'nir. nlleluOItioliS i'1' "~I
foreign countries. Another positive advantage or exchange control
lies II' \lS cfrcctivcness in dealing with the problem or capital
movements. The governlllCnl'S I monopoly over the roreign exchange
can eflectively stop or reduce the eapit:li t"i movements by simply
refusing to release foreign exchange for capital transrcr. Many
countries, i.e., Germany, Denmark and Argentina, adopted exchange
control during 1930s because of this advantage. Although the
exchange control is positively a superior method of dealing with
disequilibrium in th~ balance of payments, it docs not pro' -ide a
perman<.:nt solution to the basic cau~es of deficit problem.
Exchange control may no doubt provide solution to balance of payment
deficits, but it also creates following problems:

• When restrictions on exchange control becomes wide spread then large

number of currencies are rendered inconvertible. This restricts foreign
trade and the gains from foreign 1rade are either lost or reduced to a
minimum.

• Even after the interest of an economy is secured, i.e., external deficit is

rCll1ov<.:d and insulation of e<.:onomy against external influence is
complete; the exchange-control countries instead of giving up
exchange control feel
lITe to gear their int<.:rnal policks, monetary and
fiscal, towards the promotion of economic growth, a<.:hieving full
employment and its maintenance. In doing so, they adopt easy
 monetary and promotional fiscal policies. Consequently, income and
prices tend to rise, and inflationary trend is set in the economy.

• Price also tends to rise, since in an insulted economy, import-competing

industries are not under compulsion to check cost increases and to
improve efficiency. As a result, exports become relatively costlier and
imports relatively cheaper and hence, exports tend to shrink and
imports tend to expand. These are the first outcome of overvaluation of
home-currency. The balance of payments is no doubt maintained in
equilibrium, but the init.ial advantage gradually disappears.
The countries confronted with the problems arising out of exchange
control ,II'C forced to find new outlets for their exports and new sources of
imports. The dTorts in this direction give rise to bilateral trade· agreements
between the countries having common interest. The basic feature of the
bilateral trade ;Igreements is to accept each other's inconvertible currency
for exports and use the same Jor imports. Under the trade agreements, the
commodities and their quan~ilt'es or values should
I also be specified.
Another outcome of exchange contr leading to bilateral trade agreement is
the emergence of disorderly cross cxcl ,anl',1.: r[lte~, i.e., the multiplicity of
inconsistent exchange rates. In other words,
i .. IlIhl(;rii~)1<; currencies
have different exchange ratep betweeI: them. -
''l(in'illeonvertible currency has different exchange relation with the
countries .. ~ p,\t
y to the bilateral trade agreement therefore, exchange rates

are not consis fent with each other. The multiplicity of inconsistent exchange
rates occom;;;s inevitable when countries having trade surplus and deficits
fix up official r;llt's frnlll timc to time dq1l'ndin!-,- nn their requirelllents
,ll1d
1ll,Iintain it througharbitrary rules. Exchange rates beconie multiple
also because 'exchange arbitrage', i.e., the simultaneous purchase
and sale of exchange in di fferent markets, becomes impossible.
Under the multiple exchange rate system, there may be a dual
exchange rate policy. In dual exchange rate policy, there is an official
rate for permissible private transactions and official transactions and
a market rate for all other kinds of transactions. However, the
multiple exchange rate system has its own shortcomings .. The
system adds complexity and uncertainty to international
transactions. Besides, it requires efficient and honest administrative
machinery in the absence of which it often leads to inefficient use of
resources. It is, therefore, desirable for the deficit countries to first
evaluate the consequence:>, efficacy and pract'::ability of exchanre
control and then decide on the course of action. It has been
suggested that exchange control, if adopted, should be moderate and
as temporary measure until the basic solution to the problems of
balance of payments deficit is obtaired. The exchange control
problem does not provide permanent solution to the balance-of-
payments deficit and therefore, it should be adopted only with proper
understanding.

REVIEW QUESTIONS
I. What is the relevance of national income statistics in business
decisions?
2. What kinds of business decisions are influenced by the change
in national income?
3. Describe the various methods of measuring national income.
How is a method chosen for measurfng national income?
4. Distinguish between net-product method and factor-income
method.
Which of these methods is followed in India?
5. What is value-added? Explain the value-added method of
estimating national income.
6. Define inflation. Explain its effect on (a) total output, and (b)
distribution of income between, different economic classes.
7. What are the causes of price inflation? Is it inevitable in the
course of economic developm.ent?
8. What is an inflationary gap? Explain methods used to close this
gap.
9. Distinguish clearly between demand-pull, cost-push and
sectoral infl~ltion.
10."Inflation is unjust and in~quitable and deflation is
inexpedient." Discuss this statement fully.
11.What is meant by a trade cycle? Describe carefully the di
fTcrcnt phuses of a trade cycle.
12: Distinguish trade cycles from other economic fluctuations.
What, in your opinion; is the most adequate explanation of a
trade cycle?
13.Describe the various phases of the trade cycle. What courses
can the Government ~dopt to control a boom?
14."T,he business cycle is purely a monetary phenomenon."
~iscuss.
15.Discuss the view that innovations alone cannot explain the
phenomenon of trade cycles without a substantial monetary
explanation.
16.Define balance of payments. If balances of payments always
balance, how is the deficit or surplus in balance of payments
known?
17.What are the causes of different kinds of disequilibrium in the
balance of payments? Suggest measure to correct an adverse
balance of payments.
18.What is the purpose of exchange control? Examine the efficacy
of exchange control as a measure to correct adverse balance
of payments.
19.What is meant by devaluation? What are the conditions for its
effectiveness as a corrective measure of un favourable balance
of payments?
20. What is the difference hetween balance of trade and balance of
payment?
 QUESTION PAPER
Paper 1.3: MANAGI;:HIAL ECONOMICS

Time: 3 Hours Max. Ma

SECTION~A
(5 x 8 = 40)
Answer any Five questions

Note: All questions carry equal marks

1. What is Managerial Ecor.omics? How does it differ from

traditional ece
2. Give short note on "Demand Analysis".
3. Explain the relationship between marginal cost, average cost,
and tot
4. What are the main features of pure competition? How does an
organisatil
its policies to a purely competitive situation?
5. Distinguish between the Pure Profit and opportunity Cost.
6. What is meant by Price discrimination? What are its objectives?
7. What is the difference between balance of trade and balance
ofpaymCi
8. What is value-added? Explain the value-added method of
 estimating Income.

SECTION -B

(4 x 15 = 60)
Answer any Four questions

9. Discuss some of the important economic concepts and

techniques busines~. management.
10. What are the advantages and limitations of large-scale
production', II. Distinguish between 'Production function' and
Cost filllc{ion', I iow \' dcvclop tllC production fUllction? Whlltun:
its uscs'!.
12. Explain the first and second order conditions of profit
maximization
13. Explain the effects of government interve.ntion in price fixation.
WI necessary to make this intervention effective?
14. "The Business Cycle is purely a monetary, phenomenon."
Discuss.
15. Define Inflation. Explain its effect on
(a) Total output
(b) Distribution of income between, different economic classes.