MBA 1st sem MANAGERIAL ECONOMICS:

Code : RMB102

Course Objective:
 Understand the relative importance of Managerial Economics
 Know how the application of the principles of managerial economics can aid in
achievement of business objectives
 Understand the modern managerial decision rules and optimization techniques.
 Be equipped with the tools necessary in analysis of consumer behavior as well as in
forecasting product demand
 Understand and be able to apply latest pricing strategies
 Understand and analyse the macro environment affecting the business decision making.

UNIT –I
Basic Concepts and principles: (6 Hrs)
Definition, Nature and Scope of Economics-Micro Economics and Macro Economics.
Managerial Economics and its relevance in business decisions. Fundamental Principles of
Managerial Economics - Incremental Principle, Marginal Principle, Opportunity Cost
Principle, Discounting Principle, Concept of Time Perspective. Equi-Marginal Principle.
Utility Analysis. Cardinal Utility and Ordinal Utility.

UNIT –II
Demand and Supply Analysis : (8Hrs)
Theory of Demand. Types of Demand. Determinants of demand , Demand
Function ,Demand Schedule , Demand curve , Law of Demand, Exceptions to the law of
Demand , Shifts in demand curve , Elasticity of Demand and its measurement. Price
Elasticity. Income Elasticity. Arc Elasticity. Cross Elasticity and Advertising Elasticity. Uses
of Elasticity of Demand for managerial decision making , Demand forecasting meaning,
significance and methods.( numerical Exercises)
Supply Analysis; Law of Supply, Supply Elasticity; Analysis and its uses for managerial
decision making.
Price of a Product under demand and supply forces

UNIT –III
Production and cost Analysis: (10Hrs)
Production concepts & analysis; Production function, Types of production function ,Laws of
production : Law of diminishing returns , Law of returns to scale.
Cost concept and analysis: Cost , Types of costs, Cost output relationship in the short-run.
Cost output relationship in the Long-run.
Estimation of Revenue. Average Revenue, Marginal Revenue

UNIT –IV
Market structures : (8Hrs)
Perfect and Imperfect Market Structures , Perfect Competition, features, determination of
price under perfect competition. Monopoly: Feature, pricing under monopoly, Price
Discrimination. Monopolistic: Features, pricing under monopolistic competition, product
differentiation. Oligopoly: Features, kinked demand curve, cartels, price leadership. Pricing
Strategies; Price determination, full cost pricing, product line pricing, price skimming,
penetration pricing

UNIT –V National Income; Concepts and various methods of its measurement,

Inflation, types and causes, Business (8Hrs) Employable Skills Measuring tool
Ability to forecast demand Exercise + Workshop
Ability to analyse various market structures Exercise + Workshop
Ability to appreciate the role of various
monetary policy tools in controlling inflation Exercise + Workshop

Text Books:
 Managerial Economics, GEETIKA, McGraw-Hill Education 2 nd Ed.
 Managerial Economics: Concepts and Applications (SIE), THOMAS &
MAURICE, McGraw-Hill Education, 9th Ed
 Managerial Economics, H.L Ahuja, S.Chand, 8th Ed
 Managerial Economics ,D.N.Dwivedi,Vikas Publication, 7 th Ed
 Managerial Economics – Theory and Applications, Dr.D.M.Mithani, Himalaya
Publications, 7th Ed.
UNIT –I
Definition, Nature and Scope of Economics-Micro Economics and Macro
Economics
Definition
According to Milton H Spencer and Louis Siegelman “Managerial Economics is the
integration of economic theory with business practices for the purpose of facilitating
decision making and forward planning by management”.

According to Mc Nair and Miriam, ‘Managerial Economics consists of the use of

economic modes of thoughts to analyze business situations’.

Nature and Scope of Economics

1. Managerial economics is concerned with the analysis of finding optimal solutions

to decision making problems of businesses/firms (micro economic in nature).

2. Managerial economics is a practical subject therefore it is pragmatic.

3. Managerial economics describes, what is the observed economic phenomenon

(positive economics) and prescribes what ought to be (normative economics)

4. Managerial economics is based on strong economic concepts.

(conceptual in nature)

5. Managerial economics analyses the problems of the firms in the

perspective of the economy as a whole ( macro in nature)

6. It helps to find optimal solution to the business problems (problem

solving)

Micro Economics and Macro Economics

• Micro Economics: ‘It is the study of particular firms, particular households,

individual prices, wages, incomes, individual industries, particular industries.”
• Some of the theories which come under Micro Economics,
–Theory of Individual/Market Demand.
–Theory of Production and Cost.
–Theory of Markets and price.
–Theory of profit, Etc…

• Macro Economics: ‘It deals not with individual quantities as such but with
aggregates of thesequantities, not with individual incomes but with
national income.’
• Some of the theories which come under Macro Economics,
 – Theory of total output and employment.
– General price level.
– Theory of Inflation.
– Theory of trade cycles
– Economic growth, Etc…

Fundamental Principles of Managerial Economics -

: Economics is the study of this allocation of resources, the choices that are made by
economic agents. An economy is a system which attempts to solve this basic economic
problem. There are different types of economies; household economy, local economy,
national economy and international economy but all economies face the same problem.
The major economic problems are (i) what to produce? (ii) How to produce? (iii) When
to produce and (iv) For whom to produce?

The following points highlight the seven fundamental concepts of managerial

economics. The concepts are:
1. The Incremental Concept
2. The Concept of Time Perspective
3. The Concept of Discounting Principle
4. The Opportunity Cost Concept
5. The Concept of Equi marginal Principle
6. The Contribution Concept
7. The Concept of Negotiation Principle.

Managerial Economics: Concept # 1.
The Incremental Concept:
It is easy to describe incremental reasoning. But it is very difficult to apply it. As T.J.
Coyne has put it, “It involves estimating the impact of decision alternatives on
costs and revenues, stressing the changes in total cost and total revenue that
result from changes in prices, products, procedures, investments or whatever
may be at stake in the decision”.
Two basic concepts lie at the heart of incremental analysis, viz., incremental cost and
incremental revenue. The former refers to the change in total cost resulting from a
decision. Likewise, the latter may be defined as the change in total revenue resulting
from a decision.

A decision is surely profitable if:

1. It increases revenues more than it increases cost.
2. It reduces some cost more than it increases others.

3. It increases some revenues more than it decreases others.

4. It decreases costs more than it decreases revenue.

We may now consider some of the implications of incremental reasoning which appears
to be too elementary. In general, businessmen think that in order to make an overall
profit they must make a profit on every activity (or job).

Consequently they refuse orders that do not cover cost (labour, materials and
overhead) and make a provision for profit. This is an unproved and probably a false
belief. Incremental reasoning makes it clear that this rule may be inconsistent with
short-rim profit maximization.

A refusal to accept a job below cost may imply rejection of a possibility of adding more
to revenue than to cost. Here the relevant cost for decision-making is not the full cost
but rather the incremental cost. The following example clarifies the point. Consider a
new order which is supposed to bring Rs. 9,000 additional revenue.

The costs are estimated as follows:

It apparently seems that the order is unprofitable. But suppose there is idle capacity in
the short run. This could be used to produce the order. Suppose acceptance of the
order will add only Rs. 900 of overhead.

Suppose neither extra selling cost nor extra administration cost is involved in the order.
Moreover, only part of the labour cost is incremental, since permanent workers; who are
sitting idle, may be put to work without extra pay.
Suppose the incremental cost of accepting the order is as follows:

Although at first sight it appeared that the order would results in a loss of Rs. 1200, it is
now clear that it will bring an additional profit of Rs. 2,800.

However, incremental reasoning does not mean that the firm should fix the price at
incremental cost or should accept all orders that just cover incremental costs. True,
‘charging what the market will bear’ is quite consistent with instrumentalism, for it
implies raising prices as long as the resulting revenues increase.

In our example, the acceptance of the Rs. 9,000 order is based on assumption that
there is idle capacity which could be fruitfully utilized to execute the order. It is also
implicitly assumed that there is no other profitable alternative. If there is a more
profitable alternative, it has to be accepted.

So the essence of the incremental principle is that: a decision is to be considered as

sound and rational if it increases revenue more than it increases cost, or reduces cost
more than it reduces revenue.

Marginalism:
Incremental reasoning is closely related to two important concepts of traditional ec-
onomics, viz., cost and marginal revenue. However, there are similarities and
differences.

The following two points may be noted in this context:

1. Marginal cost and revenue are always defined in terms of unit changes in output, but
incremental cost and revenue are not necessarily restricted to unit changes. Usually
marginal cost is expressed as the ratio of two absolute changes, viz., change in total
cost and change in output, i.e., MC = dC/dQ. Likewise MR = dTR/dQ where MR is
marginal revenue and TR is total revenue.
A simple example will illustrate the two concepts: the marginal concept and the
incremental concept. Suppose, the extra cost of producing one extra unit of output is
Rs. 10 and the extra revenue made by selling this extra unit is Rs. 15.

If a 5-unit increase in output increases total cost by say Rs. 45 (from say Rs. 350 to Rs.
395), and increases revenue by Rs. 70 (from say Rs. 400 to 470), we can speak of an
incremental cost of Rs. 45 and an incremental revenue of Rs. 70. In this case the unit
(average) MC over this range of output is Rs. 9 and unit (average) MR is Rs. 14.

2. Incremental concepts are more flexible than marginal concepts. In general we restrict
the two terms: MC and MR to the effects of changes in output. But managerial decision
making is not to be concerned with changed output at all. For example, the production
manager may be faced with the problem of substituting one process of production (or
activity) for another to produce the same output.

The problem here is one of comparing the cost of the first process with -that of the
alternative. Marginal analysis is not suited for this type of decision. It is, of course,
possible to compare the MC of one process with that of another but not of the MC of the
change.

However, the term ‘incremental cost’ may be used to refer to the change in cost brought
about by the changes in production process or activity.The following diagram may be
used to compare the marginal and incremental approaches. In Fig 1.1 the MC curve is
rising over most of its range.
Suppose the production manager is considering an increase in output from 2,000 to
3,000 units. In this case it is very difficult to measure the marginal cost of change. No
single MC cost figure will suffice. The MC is initially low, but subsequently it rises
rapidly.

However, another pattern of costs is common in industry. Several empirical studies

have discovered relatively constant marginal costs over wide range of outputs, as in Fig
1.2. Here MC does not change dramatically with the changes in output. Hence a single
MC cost figure can be used over the whole range.
For the firm illustrated in Fig 1.2, we assume that total fixed cost is Rs. 4,000 per unit of
time. The average variable cost is Rs. 2.50 per unit. The MC is also Rs. 2.50 per unit.
Suppose, the production manager has to choose between an output of 2,000 units and
one of 3,000 units. In this case MC is Rs. 250 but incremental cost is Rs. 2,500.

The pertinent question here is whether or not marginal costs are in fact constant and
justify the substitution of incremental cost measurements over large changes in output,
for measurements of cost changes for small (marginal) changes in output. If the short
run cost curves were linear throughout, the decision-making problem would be greatly
simplified.

Managerial Economics: Concept # 2.

The Concept of Time Perspective:

In economics, we often draw a distinction between the short-run and the long-run. This
distinction is not based on any calendar period, say, a month, a quarter or a year. It is
based in the speed with which decisions can be made and factors of production varied.

The period during which it is possible to vary some factors and not others is called the
short run. But the period during which all factors can be varied is called the long-run.
For example, more output can be produced in the short- run by using more labour and
raw materials. This is basically a short-term decision. But setting up a new factory or
building an entirely new plant is a long-term decision.

In reality, however, the distinction between the two often gets blurred. What remains is
an estimate of those costs that vary and those that do not by the decision under
consideration. In managerial economics we are concerned with the short-run and long-
run effects of decisions on revenues as well as on costs.

The line between the short-run and long-run revenue (or demand) is even less
transparent than that for costs. What is really important for managerial decision making
is maintaining the right balance among various runs, i.e., the long-run, short-run and
intermediate-run perspectives.

A decision may be made on the basis of certain short-term considerations but it may
have various long-term repercussions which, in turn, may make it more or less profitable
than it appeared at the first sight. A simple example will make this point clear.

Suppose there is a firm with temporary idle capacity. It now gets an order for 10,000
units. The prospective customer is willing to pay Rs. 3 per unit, or Rs. 30,000 for the
whole lot. The short-term incremental cost (which ignores the fixed cost is) is only Rs.
2.50. So the contribution to overhead and profit is 50 paise per unit (or Rs. 5,000 in all).

But the following two long-term repercussions must be taken into account:
1. If the management commits itself to a series of repeat orders at the same price, the
fixed costs (which are ignored temporarily) will become variable cost. For instance,
sooner or later it will become necessary to replace the machinery and equipment which
wear out. True enough, the gradual accumulation of orders may require an addition to
capacity, with added depreciation and added top-level supervision.

2. If lower price is charged for the extra order, old customers who pay higher price for
the same product may become annoyed. This practice will appear to be unethical and
may destroy the company image. This will be damaging in the long-run.

Now on the basis of our above discussion we can state the above principle — the
principle of time perspective — in the following words:

A decision should always take into consideration both the short-term and long-term
effects on revenues and costs, giving proper weight to the most relevant time periods.

However, the real problem is how to apply this principle in specific situations to arrive at
a decision.
An example:
A large reputed printing company in Calcutta maintains a policy of never quoting below
full cost even if it has some idle capacity. Although incremental cost is far below full
cost, management has found that the long-run repercussions of going below full cost
more than offset any short- run gain.

Prima facie, price reduction for some customers would have an undesirable effect on
customer goodwill, especially among regular customers who will not benefit from rate
reductions. Secondly, if the availability of idle capacity is unpredictable, there may be
pressure on capacity when demand is high.

In fact when the order becomes firm the situation might change, causing low-price
orders to interfere with regular price business. Management would like to avoid this sit-
uation.

Otherwise, it would be considered as a firm that exploits the market when demand is
unfavorable and allows price concessions when demand is favorable.

Managerial Economics: Concept # 3.

The Concept of Discounting Principle:

There is a famous proverb that a bird in the hand is worth two in the bush’. This proverb,
like many others, contains an element of truth. And one of the fundamental propositions
of economic theory is that a rupee to be received tomorrow is worth less than the same
rupee received today.

The above proverb is, however, slightly misleading in this context, implying that the
reason for discounting the future rupees is uncertainty about receiving them. Even in the
absence of uncertainty, it is necessary to discount future rupees to make them equiv-
alent to present day rupees.

A simple example will make clear the rationale of discounting. If an individual is offered
to choose between a gift of Rs. 1,000 today or Rs. 1,000 to be received after one year,
he would surely prefer the former (even if there is no uncertainty regarding the receipt of
either gift).
This is because in a world where the rate of interest is not zero there is scope for
investing Rs. 1,000 at the market rate of interest and accumulate interest on the prin-
cipal. If the rate of interest is 5%, today’s Rs. 1,000 will become Rs. 1,050 after one
year.

There is another way of illustrating the discounting principle. One may ask how much
money today would be equivalent to Rs. 100 a year from now.

If the rate of interest is 5% the present value of Rs. 100 to be received after one
year is:

Where PV = present value and

i = rate of interest

As a cross check one may multiply the PV of Rs. 95.24 by 1.05 to determine how much
money will have accumulated during the year at 5%. The answer is Rs. 95.24 x 1.05 =
Rs.100. In other words, Rs. 95.24 plus the interest on it will accumulate to an amount
exactly equal to Rs. 100.

An individual who can earn 5% on his (or her) money should be indifferent between
receiving Rs. 95.24 today and Rs. 100 after one year. So the present value of Rs. 100 is
Rs. 95.24.

The same analysis can be extended to any number of periods.

A sum of Rs. 100 two years from now is worth:

So a general pattern seems to be emerging.

In general, the present value of a sum to be received at any future date can be
found out by using the following formula:
in which PV = Present value

r = amount to be received in future

i = rate of interest

n = number of years lapsing between the receipt of R

If the receipts are made available over a number of years, the formula becomes:

where k can take any value from 1 through n.

These formulas are usually to be made use of in any discussion of investment decision
and capital budgeting.

The essence of the principle the discounting principle may now be summed up in the
following words: If a decision affects both costs and revenues at future dates, it is
absolutely essential to discount those cost and revenue so as to make them
comparable to some present value before a valid comparison of alternatives is possible.
We often find the application of the principle in the business world. Suppose one
borrows Rs. 10,000 from a bank on a note. If the note is for Rs. 10,000, the borrower
will not get the full value but rather the amount discounted at the appropriate rate of
interest.

If the discounting rate is 6% and if the note is for one year, the borrower will receive
approximately Rs. 9,420. In this case we can say that the present value to the bank of
the borrower’s promise to pay Rs. 1,000 in a year is only Rs. 942 at the time of the loan.

The principle operates in the bond market as well. The market price of a bond reflects
not only its face value at maturity and interest payments, but also the current discount
rate. As the market discount rates vary, bond price, vary inversely. Suppose you receive
a bond which promises to pay you Rs. 10 per annum, in perpetuity.

If the market rate of interest (the discount rate here) is 10% its PV will be Rs. 10/5% =
Rs. 200. If the rate of interest goes down to IM-f/o its market prices will rise to Rs.
10/5% = Rs. 400. So it is possible to make a capital gain of Rs. 200 by selling the bond.

The same principle can be applied in case of an individual firm. Suppose a firm is
considering buying a new machine. It should estimate the discounted value of the
added (net) earnings from that machine before venturing out.

The same principles applies if the firm is considering the acquisition (purchase) of
another firm or a merger. Likewise, a firm that produces output maturing at varying ages
cannot compare the profitability of changing the product mix without invoking the
discounting principle.

Managerial Economics: Concept # 4.

The Opportunity Cost Concept:
The opportunity cost of a decision means sacrificing alternatives. Opportunity cost
measures the value of the most valuable of the options that we have to forego in
choosing from a set of alternative options. Suppose a shipbuilder gets a contract to be
called Contract A.

After making the correct assessment of the associated incremental costs and revenues
he arrives at an estimated profit of Rs. 25,000 from the contract. Suppose, in the
meantime, two other contracts, B and C, have been brought to his attention.
These two are expected to give a profit of Rs. 15,000 and Rs. 20,000, respectively.
However, his yard’s capacity is so limited that he can accept only one of these. So, in
the absence of any other consideration, he would accept contract A, the most profitable
one.

His opportunity cost would then be Rs. 20,000, the sacrifice he must make of the profit
for the next best option. Had he chosen either B or C, his opportunity cost would have
been Rs. 25,000 profit that A would have earned.

An opportunity cost has arisen here only because some essential input, the yard’s
capacity, is scarce, i.e., grossly insufficient to take up all the options that are open and
desirable. In the absence of such a constraint no such sacrifice and hence no opportu-
nity cost would have arisen.

We will come across various examples of opportunity cost in this title because all
business activity is carried on within constraint (‘scarcities’) which force choices and
consequent sacrifices to be made.

The following examples help in understanding the meaning of the term:

1. The opportunity cost (O.C.) of using a machine is the most profitable alternative
sacrificed by employing the machine in its present use.

2. The O.C. of buying a colour TV is the interest or profit that could be earned by
investing the purchase money.

3. The O.C. of working for oneself in one’s own factory is the salary that one could earn
in others occupations.

4. The O.C. of funds tied in one’s own business is the interest (or profits adjusted for
difference in risk) that could be earned on those funds in other ventures.

However, if machine has been lying idle for some time, the O.C. of bringing it into
production is nil. Similarly the O.C. of using idle space is obviously less than that of
using space needed for other activities. So O.C.s require the measurement of sacrifices,
real or monetary.
If a decision involves no sacrifices, it is cost free. The expenditure of cash (for raw-
materials, say) involves a sacrifice of other possible expenditures and is therefore an
O.C. Thus the only costs for decision-making are opportunity costs.

However, all O.C.s do not involve actual monetary payments. A man in a desert or in a
distant island (like Robinson Crusoe) might have the choice between picking coconuts
or fishing. The O.C. of coconuts is the amount of fish that might be obtained with the
same amount of time and effort — irrespective of how much the man likes shinning up
trees.

O.C.s are important when considering make-or- buy decisions, as also when deciding
whether or not to sell. For instance, the alternative to using business premises which
one owns as offices is to rent or sell them. The O.C.s is the rental forgone, or the
difference between the expected market value at the beginning and end of the year,
whichever is higher.

One form of opportunity cost which is likely to be used is in the analysis of capital
projects. The discount rate used to find out net present values when evaluating capital
projects is nothing but an opportunity cost of capital.

The alternative to carrying out the project is to invest the money in a safe alternative
and the evaluation is designed to ascertain whether the project yields a higher return.
This concept of O.C. is discussed in the context of capital expenditure decisions later.

Closely related to our above discussion is a distinction between explicit and implicit
costs. Explicit costs are those that are reflected in the book of accounts, such as
payments for raw-materials and labour.

On the contrary, implicit (or imputed) costs are those sacrifices (such as the interest on
the owner’s own investment) which are not reflected in accounts. Some writers equate
O.C.s with implicit costs. The truth is that O.C.s cover all sacrifices, implicit or explicit.

In reality, however, some explicit expenses may not involve sacrifices of alternatives.
For example, a company like Texmaco Ltd. paid wages to idle labour in periods of slack
activity. These wages were in the nature of a fixed cost and were not included in the
O.C. in a decision to use that labour in some other activity.
From the above discussion we can derive another principle — the O.C. principle
— as follows:
The cost involved in any decision is the sacrifices of alternatives required by that
decision. In case there is no sacrifice, there is no cost either.

Large firms often make uses of the O.C. concept. They use linear programming models,
replacement models and other optimization techniques. These are all based on the O.C.
concept.

Managerial Economics: Concept # 5.

The Concept of Equi-marginal Principle:
The cornerstone of the economists’ marginal analysis is that purchases, activities, or
productive resources should be allocated so as to ensure that the marginal utilities,
benefits, or value- added accruing from each, are identical in all uses. Optimality
requires that it should not be possible to increase the total benefit or reduce the total
cost by moving one unit from one application to another.

If this equimarginal condition is violated, the system is operating below its optimum and
it is possible to gain some improvement by reallocation of inputs or purchases. The key
assumption underlying this result is the law of diminishing returns or variable
proportions. For the equimarginal principle to operate, the law of diminishing returns is
held to apply.

The law implies that the marginal product will decline as more of one resource is
combined with fixed amounts of another. This proposition, in fact, holds good over a
wide range of economic activity. For example, successive applications of fertilizer tend
to raise cereal yields per acre, but increasing quantities of fertilizer are successively re-
quired to give equal output increases.

The micro-economic theory of the demand for labour asserts that the profit: maximising
entrepreneur will continue to employ labour so long as the resulting addition to his costs
is covered by the addition to his receipts from the sale of his products.

One of the fundamental principles of economics is the proposition that in input such as
labour it should be so allocated among different activities or lines of production that the
value added by the last unit is the same in all uses. This generalisation is known as the
equimarginal principle.
Consider a simple situation where a firm has 100 units of labour at its disposal. If this
remains fixed in the short-run, the total wage bill can be determined in advance. For
example, if each worker gets Rs. 300 per month the total payroll will be Rs. 30,000 per
month.

Suppose there are five different activities in the factory: A, B, C, D and E. Each activity
requires labour as an input. With limited supply of labour it is possible to expand any
one of these activities by employing more labour only by reducing the level of other
activities.

Suppose when one unit of labour is added to activity A, total output increases by, say,
10 units. By selling this output in the market at a price of Rs. 5 per unit the firm makes a
gain of Rs. 50. The value of this added output is called ‘the value of the marginal
product (V.M.P.) of labour’ in activity A.

In the same way, we can estimate the value of the marginal product of labour in other
activities, viz., B, C, D and E. If V.M.P. in activity A is greater than that in another
activity, an optimum has not been reached. Now it would be profitable for the firm to
shift labour from low-marginal value to high- marginal value uses.

This will surely raise the total value of all products taken together. For example, if
V.M.P. in activity A is Rs. 50 and that in activity B is Rs. 55, it will pay the firm to expand
activity B and reduce activity A. The optimum is reached when V.M.P. is the same in all
the five activities. In terms of symbol

VM PLA = VMPLB = … = VMPLE

Here the subscript l denotes labour and the other subscripts refer to the activities.

At this stage it is necessary to clarify three important points:

(1) Firstly, the values of the marginal products in the above formula are net of
incremental cost (the incremental costs, as we have noted, do not include the cost of
the input being allocated). But if one extra unit of labour is employed in activity A,
physical output may increase by 100 units. Each unit may sell at Rs. 25 and the total
revenue of the firm will rise by Rs. 2,500.

But in order to produce this output, some extra cost will have to be incurred because the
increased production will consume raw- materials, fuel and other inputs. So the variable
cost in activity A (not counting the labour cost) will be higher. If this extra cost is Rs.
1,500, the firm will be left with a net addition of Rs. 1,000. The value of the marginal
product relevant for decision making purpose is Rs. 1,000.

If the revenues resulting from this extra product are to be obtained in future, it is
necessary to apply the discounting principle. It is necessary to discount those revenues
to compare the alternative activities. Suppose activity B produces revenues immedi-
ately, but activity C takes five years to generate any revenue at all.

So the discounting of those revenues is absolutely essential for making these activities
comparable. This sort of reasoning applies in capital budgeting which is concerned with
allocation of capital expenditure over time.

In order to derive an optimum return from investment the firm should apply the funds
where the discounted values of the marginal products are greatest, expanding the high-
value activities and contracting the low value activities until a equality of marginal values
is achieved.

(2) So far we have implicitly assumed that there are diminishing returns to the inputs
being allocated. As more and more units of the variable factor (here labour) are added
in the production (fixed factor remaining unchanged) each extra unit of labour makes
less and less extra contribution to the total product.

Fig 1.3 shows that as more labour is added to activity A, the marginal product of labour
will diminish. This happens because each worker is gradually having less and less
capital to work with.

(3) It may also be noted that in order to sell the extra product the firm may have to
reduce the price of the product (if it operates in an imperfectly competitive market). In
this case the value of marginal product (marginal physical product times the market
price of the product — MPP x P) will diminish.

(4) Finally, one may refer to complementarity of demand: an increase in the availability
of one product may stimulate the sales of another.

Constant Marginal Products:

In many real life situations the law of diminishing returns may not operate in the same
way as described above. It is quite possible for a firm to increase the quantity of labour
in one department without encountering diminishing marginal product until some limit of
capacity is reached or until all the workers are employed.

In this case we may expect the curve for the value of the marginal product to be
horizontal up to full capacity, and then to drop to zero. Fig 1.4 illustrates such situation
for five different activities.

In this situation the values of the marginal products are not equal in all activities unless
there is surplus labour. Since the value of the marginal product is the highest in activity
E, the company may prefer to employ all of the labour to E. However, some constraint,
such as a limit of the capacity in E, or limits on other variable inputs required, will set a
limit on the amount of labour that may be used in E.

The net result of our above discussion is this:

We may retain the equimarginal principle as long as diminishing returns operate at
some stage of the production process; but when the values of the marginal products are
constant (horizontal) we make use of the following alternative principle:

We have to apply inputs first to activities with higher marginal product values before
moving to lower values.
The equimarginal principle can be applied in a variety of real life situations. We find its
widespread use in budgeting the objective of which is to allocate resources where they
are most productive.

But what is relevant for decision making is marginal productivity, not average
productivity. Even when it is very difficult to measure productivity, we can apply the
equimarginal principle in a rough or general way in order to avoid waste in useless ac-
tivities.

We always find an application of this principle in any discussion of budgeting. We shall

observe that whatever criterion is used in selecting a project, the goal is to isolate
investments with high rates of return, from those with low rates of return so as to ensure
optimum allocation of capital resources.

We also find an application of the principle in multiple product pricing.The equimarginal

principle may also be applied in allocating research expenditures. A profit- maximizing
firm is likely to expand research activities that have started paying off and to contract
activities that have reached (or likely to reach) their peak of usefulness.
Unless this comparison is made expenditure is likely to be made on non-essential
activities. In order to estimate the worth of alternative lines of research it is necessary to
evaluate each research programme individually.

Managerial Economics: Concept # 6.

The Contribution Concept:
The various concepts developed so far are interdependent. For example, in measuring
opportunity cost of capital we use a discount factor by following the discounting
principle. The same thing is true of the contribution concept.

Consider a simple product whose price is determined either by the market forces the
forces of demand and supply, or by some government agency like the Bureau of Costs
and Industrial Prices (Govt, of India, New Delhi). Assume this price is Rs. 93.

The total cost including allocated overheads is Rs. 105, but the incremental cost is only
Rs. 74. The loss on the item seems to be Rs. 12. So at first sight the firm may think of
dropping the product. However, if the contribution to overhead and profits is Rs. 19 =
(Rs. 93 – Rs. 74), further analysis is required before arriving at a decision.
It is not always worthwhile to retain a product simply because its contribution is positive.
If the company is having a package of orders on products (say, B, C or D) requiring the
same scarce resources per unit — production time or machine time and labour — and if
these products make larger contributions, viz., Rs. 50 or Rs. 40 or Rs. 30, there is no
point in sacrificing these larger contribution in favour of product A.

However, what is important is the comparison of contributions, not the comparison of

profits or losses based on full costs.

Suppose the only production constraint in a multi-product firm is machine-hours

available. Now we can convert the contribution per unit of output into contributions per
machine-hour. Table 1.1 illustrates such a situation in case of a company producing five
products.

At first sight product B appears to be the best. Since its contribution is the highest, it
deserves the top priority in allocation of capacity. But product B’s demand on capacity is
also maximum. By converting the contributions into contributions per hour of machine
time, we get the following results.

Now it is clear that the product E, which initially appeared to be the least profitable, is
now the largest contributor. Therefore, the principle should be almost the opposite to
those that appeared at first glance.

If there are more constraints, i.e., more than one capacity bottleneck and all products
pass through, say, four or five different processes, it will no longer be possible to
compute contributions in terms of one of the bottlenecks. We have to make use of linear
programming to reach an optimum solution (i.e., to choose an optimum product mix).
So long we assumed that demand for each product remained unchanged as also its
price. Now suppose the quantity demanded of product E increases at a lower price.
Now we can compare product E’s contribution of Rs. 2.50 at a price of Rs. 6 with its
contribution of Rs. 3 at a price of Rs. 5.50.

If sales at a higher price are 8,000 units and at the lower prices 15,000 units, the total
contribution from product E increases from Rs. 28,000 to Rs. 45,000. So, it is in the
Tightness of things to accept the lower unit contribution to obtain the higher volume,
even if other higher unit contribution products are sacrificed.

The contribution concept is often used in product- mix decisions, also in pricing
decisions. It is also applicable in make or buy decisions. Finally, in a discussion on
capital budgeting, it is usually discovered that the cash flows estimated by financial
analysis are closely related to the contribution concept.

Managerial Economics: Concept # 7.

The Concept of Negotiation Principle:
Changes in costs and revenues, all commitments made in the short or long run, interest
rates, net cash flows, the contribution margin that product E could (should) make to the
overall profitability of company, are all negotiable.

In fact, everything in the real commercial world is negotiable, such as housing prices
and terms and conditions of payment, equipment parts, specifications, and prices. Like-
wise, a businessman contemplating merger, acquisition, consolidation or other form of
corporate takeover is always in a position to negotiate a deal depending on his
bargaining strength.

In fact, each major commitment facing a firm can be negotiated. If a negotiation is

successful both the parties are happy. An example of this is collective bargaining
between the employer and the employee. An intelligent businessman must understand
the process by which negotiation takes place.

Negotiations refer “to the part of coming to terms in as friendly a manner as possible
with a party who represents interests that differ from one’s own.”

For example, if company A decides to own and operate company B, the management of
B must be convinced that it is to B’s advantage, however defined, to allow A to win.
Clearly, if the transaction is to B’s interest, B has also to win. Such win-win situations
are possible through negotiations.

In the absence of negotiation there may be a winner and a loser. In such an event, the
winner may proceed one or two step(s) at most, but the entire process may also be
started afresh.

For example, if labourers lose in a wage bargain, they are likely to oppose the wage
contract sooner or later. A knowledge of the negotiation principle is important because it
is conducive to one’s business success. However, negotiation is a very challenging area
of business activity.

A Textbook Example:
In his famous title:
Managerial Economics, Coyne considers a more complex situation, which has
relevance to the real world: the allocation of scarce resource to a variety of slowly
maturing products. He cites the example of garden nursery with a fixed plot of land and
a wide variety of planting opportunities.

The owner of the nursery faces the problem of determining which plants to propagate
and grow, what ages to assume in making such choices, what futures to assume and
how to fix prices on mature plants. Moreover, the decision maker must determine when
to reduce prices on plants so that they can be sold out quickly and land tied up in them
can be released for other (and more profitable) uses.

The solution to this problem requires a comparative evaluation (or estimate) of

the contributions of various plants over time, which, in its turn, requires:
(1) Separate estimates of revenues and incremental costs and

(2) The discounting of future revenues, costs and contributions to find out the present
value of such contributions at the time of making decisions on the use of the land.

True enough, “estimates of the present value of the contribution of all plants on an

acre basis would provide basis for rational decisions. These estimates would
make it possible to compare the contribution from rapidly maturing plants with
those of slowly maturing plants.”
Other applications of Managerial Economics:
The following two situations maybe considered:
(a) Decision on allocation of space in a retail store:
Limited floor space may be allocated among various products on the basis of their
relative contribution to overhead and profit above incremental cost.

(b) Decisions on advertising expenditures:

In order to determine the optimum advertising budget it becomes necessary for a firm to
measure the responsiveness of sales to advertising, along with measures of the added
cost of production of a larger volume

Fig. 1.5 illustrates how sales and profits would respond to increased advertising outlays.
Since advertising has a lagged effect it is very difficult to measure its effectiveness on
sales revenue or turnover. However, the principles may be used to assess the true
worth of advertising.
UNIT –II
Demand and Supply Analysis

Demand

It refers to the quantity of a commodity which a consumer is willing to buy at a particular

price during a particular period of time.

Demand function:

A demand function is a statement of the relation between the demand for a product and
all variables (factors) that affect demand. It is also defined as the relation between the
consumers’ optimal choice of the quantity of a goods and its price is called the demand
function.
Its formula for Demand Function is q= d(p)

Types of demand function

Individual Demand Function
Market Demand Function

Individual demand function

 It shows how demand for a commodity, by an individual consumer in the market, is

related to its various determinants.
Dx= f(Px,Px,Y,T,E)

 Price of commodity: Other things being equal, with the rise in price of commodity, its
demand contracts, and with a fall in price its demand extends. This inverse relationship
between price of the commodity and its demand is called Law of Demand.

 Price of other goods: Demand for good x is influenced by the price of other goods(z)
is called cross price demand.
Dx= f(Pz)

 Income of Consumer: Change in the income of the consumer also influences his
demand for different goods. The demand for normal goods tends to increase with
increase in income and vice versa. On the other hand, the demand for inferior goods
like coarse grain tends to decrease with the increase in income and vice versa.

 Taste and Preferences: The Demand for goods and services depends upon the
individual taste and preferences. They include fashion, habit, custom etc. Taste and
Preferences of the consumer influenced by advertisement, change in fashion, climate
and new inventions etc.

 Expectation: If the consumer expects that price in future will rise, he will buy more
quantity in present, at existing price. Likewise if the consumer expects that price in
future will fall, he will buy less quantity in present, or may even postpone his demand.

Market demand function

 Market Demand Function shows how market demand for a commodity is related to its
various determinants.It is expressed as under:
Mkt. Dx =f(Px,Pr,Y,T,E,N,Yd)

 Apart from the above factors, we can Say that only two types of new factors are
added in market demand function. This are:
N = Population Size
Yd = Distribution of Income.

Types of demand

i) Direct and Derived Demands: Direct demand refers to demand for goods
meant for final consumption; it is the demand for consumers’ goods like food
items, readymade garments and houses. By contrast, derived demand refers to
demand for goods which are needed for further production; it is the demand for
producers’ goods like industrial raw materials, machine tools and equipments.

ii) Domestic and Industrial Demands: The example of the refrigerator can be
restated to distinguish between the demand for domestic consumption and the demand
for industrial use. In case of certain industrial raw materials which are also used for
domestic purpose, this distinction is very meaningful.

iii) Autonomous and Induced Demand: When the demand for a product is tied to the
purchase of some parent product, its demand is called induced or derived.
Autonomous demand, on the other hand, is not derived or induced. Unless a product
is totally independent of the use of other products.

iv) Perishable and Durable Goods Demand: Both consumers’ goods and producers’
goods are further classified into perishable/nondurable/single-use goods and
durable/nonperishable/repeated-use goods. The former refers to final output like bread
or raw material like cement which can be used only once. The latter refers to items like
shirt, car or a machine which can be used repeatedly.

v) New and Replacement Demands: If the purchase or acquisition of an item is

meant as an addition to stock, it is a new demand. If the purchase of an item is meant
for maintaining the old stock of capital/asset, it is replacement demand. Such
replacement expenditure is to overcome depreciation in the existing stock.
vi) Final and Intermediate Demands: This distinction is again based on the type of
goods- final or intermediate. The demand for semi-finished products, industrial raw
materials and similar intermediate goods are all derived demands, i.e., induced by the
demand for final goods. In the context of input-output models, such distinction is often
employed.

Shift in Demand Curve: Increase and Decrease

Demand curve is drawn to show the relationship between price and quantity demanded
of a commodity, assuming all other factors being constant. However, other factors are
bound to change sooner or later. A change in one of ‘other factors’ shifts the demand
curve.

For example, suppose income of a consumer increases. Now, the consumer may
increase the demand for the product, even though the price has not changed. Such
increase in demand of any product, whose price has not changed, cannot be
represented by the original demand curve. It will shift the demand curve. When the
demand of a commodity changes due to change in any factor other than the own price
of the commodity, it is known as change in demand. It is expressed as a shift in the
demand curve.

Various Reasons for Shift in Demand Curve:

(i) Change in price of substitute goods;
(ii) Change in price of complementary goods;
(iii) Change in income of consumers;
(iv) Change in tastes and preferences;
(v) Expectation of change in price in future;
(vi) Change in population;
(vii) Change in distribution of income;
(viii) Change in season and weather.

Let us understand the concept of shift in demand curve with the help of diagram.

i. Increase in Demand is shown by rightward shift in demand curve from DD to D 1D1.

Demand rises from OQ to OQ1 due to favourable change in other factors at the same
price OP

ii. Decrease in Demand is shown by leftward shift in demand curve from DD to D 2D2.
Demand falls from OQ to OQ2 due to unfavourable change in other factors at the same
price OP

In Fig. 3.7, demand for the commodity is OQ at a price of OP. Change in other factors
leads to a rightward or leftward shift in the demand curve:

i. Rightward Shift:

When demand rises from OQ to OQ1 (known as increase in demand) at the same price

of OP, it leads to a rightward shift in demand curve from DD to D 1D1.

ii. Leftward Shift:

On the other hand, fall in demand from OQ to OQ 2 (known as decrease in demand) at

the same price of OP, leads to a leftward shift in demand curve from DD to D 2D2.
Supply analyses and law of supply

In a broad sense, supply analysis is a system of input and output equations used to

determine supply responses to changing circumstances by producers (including
households). Supply analysis takes into account changes in both output supply and
input/factor demand.

Law of supply
The law of supply is a fundamental principle of economic theory which states that,
keeping other factors constant, an increase in price results in an increase in quantity
supplied. In other words, there is a direct relationship between price and quantity:
quantities respond in the same direction as price changes.

Meaning of Elasticity of Demand:

Demand extends or contracts respectively with a fall or rise in price. This quality of
demand by virtue of which it changes (increases or decreases) when price changes
(decreases or increases) is called Elasticity of Demand.

“The elasticity (or responsiveness) of demand in a market is great or small according as

the amount demanded increases much or little for a given fall in price, and diminishes
much or little for a given rise in price”. – Dr. Marshall.
Elasticity means sensitiveness or responsiveness of demand to the change in price.

This change, sensitiveness or responsiveness, may be small or great. Take the case of
salt. Even a big fall in its price may not induce an appreciable ex appreciable extension
in its demand. On the other hand, a slight fall in the price of oranges may cause a
considerable extension in their demand. That is why we say that the demand in the
former case is ‘inelastic’ and in the latter case it is ‘elastic’.

The demand is elastic when with a small change in price there is a great change in
demand; it is inelastic or less elastic when even a big change in price induces only a
slight change in demand. In the words of Dr. Marshall, “The elasticity (or
responsiveness) of demand in a market is great or small according as the amount
demanded increases much or little for a given fall in price, and diminishes much or little
for a given rise in price.”But the demand cannot be perfectly ‘elastic’ or ‘inelastic’.

Completely elastic demand will mean that a slight fall (or rise) in the price of the
commodity concerned induces an infinite extension (or contraction) in its demand.
Completely inelastic demand will mean that any amount of fall (or rise) in the price of
the commodity would not induce any extension (or contraction) in its demand. Both
these conditions are unrealistic. That is why we say that elasticity of demand may be
‘more or less’, but it is seldom perfectly elastic or absolutely inelastic.

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

Degrees of Elasticity of Demand:

We have seen above that some commodities have very elastic demand, while others
have less elastic demand. Let us now try to understand the different degrees of
elasticity of demand with the help of curves.

(a) Infinite or Perfect Elasticity of Demand:

Let as first take one extreme case of elasticity of demand, viz., when it is infinite or
perfect. Elasticity of demand is infinity when even a negligible fall in the price of the
commodity leads to an infinite extension in the demand for it. In Fig. 10.1 the horizontal
straight line DD’ shows infinite elasticity of demand. Even when the price remains the
same, the demand goes on changing.
(b) Perfectly Inelastic Demand:
The other extreme limit is when demand is perfectly inelastic. It means that howsoever
great the rise or fall in the price of the commodity in question, its demand remains
absolutely unchanged. In Fig. 10.2, the vertical line DD’ shows a perfectly inelastic
demand. In other words, in this case elasticity of demand is zero. No amount of change
in price induces a change in demand.

In the real world, there is no commodity the demand for which may be absolutely
inelastic, i.e., changes in its price will fail to bring about any change at all in the demand
for it. Some extension/contraction is bound to occur that is why economists say that
elasticity of demand is a matter of degree only. In the same manner, there are few
commodities in whose case the demand is perfectly elastic. Thus, in real life, the
elasticity of demand of most goods and services lies between the two limits given
above, viz., infinity and zero. Some have highly elastic demand while others have less
elastic demand.

(c) Very Elastic Demand:

Demand is said to be very elastic when even a small change in the price of a
commodity leads to a considerable extension/contraction of the amount demanded of it.
In Fig. 10.3, DD’ curve illustrates such a demand. As a result of change of T in the price,
the quantity demanded extends/contracts by MM’, which clearly is comparatively a large
change in demand.

(d) Less Elastic Demand:

When even a substantial change in price brings only a small extension/contraction in
demand, it is said to be less elastic. In Fig. 10.4, DD’ shows less elastic demand. A fall

of NN’ in price extends demand by MM’ only, which is very small.

Elasticity’s of Demand: Price, Income and Cross-Elasticity of Demand

There are as many elasticity’s of demand as its determinants.

The most important of these elasticity’s are:

(a) The price elasticity,

(b) The income elasticity,

(c) The cross-elasticity of demand.

The price elasticity of demand:

The price elasticity is a measure of the responsiveness of demand to changes in the
commodity’s own price. If the changes in price are very small we use as a measure of
the responsiveness of demand the point elasticity of demand. If the changes in price are
not small we use the arc elasticity of demand as the relevant measure. The point
elasticity of demand is defined as the proportionate change in the quantity demanded
resulting from a very small proportionate change in price. Symbolically we may write

which implies that the elasticity changes at the various points of the linear-demand
curve. Graphically the point elasticity of a linear-demand curve is shown by the ratio of
the segments of the line to the right and to the left of the particular point. In figure 2.33
the elasticity of the linear-demand curve at point F is the ratio
Given this graphical measurement of point elasticity it is obvious that at the mid-point of
a linear-demand curve ep — 1 (point M in figure 2.34). At any point to the right of M

the point elasticity is less than unity (ep < 1); finally at any point to the left of M, ep > 1. At
point D the ep → ∞, while at point D’ the ep = 0. The price elasticity is always negative
because of the inverse relationship between Q and P implied by the ‘law of demand’.
However, traditionally the negative sign is omitted when writing the formula of the
elasticity.
The range of values of the elasticity is

0 ≤ ep ≤ ∞
If ep = 0, the demand is perfectly inelastic (figure 2.35)
If ep = 1, the demand has unitary elasticity (figure 2.36)
If ep = ∞, the demand is perfectly elastic (figure 2.37)
If 0 < e < 1, we say that the demand is inelastic.

If 1 < e < ∞, we say that the demand is elastic.

The basic determinants of the elasticity of demand of a commodity with respect

to its own price are:
(1) The availability of substitutes; the demand for a commodity is more elastic if there
are close substitutes for it.

(2) The nature of the need that the commodity satisfies. In general, luxury goods are
price elastic, while necessities are price inelastic.

(3) The time period. Demand is more elastic in the long run.

(4) The number of uses to which a commodity can be put. The more the possible uses
of a commodity the greater its price elasticity will be.

(5) The proportion of income spent on the particular commodity.

The above formula for the price elasticity is applicable only for infinitesimal changes in
the price. If the price changes appreciably we use the following formula, which
measures the arc elasticity of demand
They are elasticity is a measure of the average elasticity, that is, the elasticity at the
midpoint of the chord that connects the two points (A and B) on the demand curve
defined by the initial and the new price levels (figure 2.38). It should be clear that the
measure of the arc elasticity is an approximation of the true elasticity of the section AB
of the demand curve, which is used when we know only the two points A and B from the
demand curve, but not the intermediate ones. Clearly the more convex to the origin the
demand curve is, the poorer the linear approximation attained by the arc elasticity
formula.

The income elasticity of demand:

The income elasticity is defined as the proportionate change in the quantity demanded
resulting from a proportionate change in income. Symbolically we may write

The income elasticity is positive for normal goods. Some writers have used income
elasticity in order to classify goods into ‘luxuries’ and ‘necessities’. A commodity is
considered to be a ‘luxury’ if its income elasticity is greater than unity. A commodity is a
‘necessity’ if its income elasticity is small (less than unity, usually).

The main determinants of income elasticity are:

1. The nature of the need that the commodity covers the percentage of income spent on
food declines as income increases (this is known as Engel’s Law and has sometimes
been used as a measure of welfare and of the development stage of an economy).
2. The initial level of income of a country. For example, a TV set is a luxury in an
underdeveloped, poor country while it is a ‘necessity’ in a country with high per capita
income.

3. The time period, because consumption patterns adjust with a time-lag to changes in
income.

The cross-elasticity of demand:

We have already talked about the price cross-elasticity with connection to the classific-
ation of commodities into substitutes and complements (see section I).

The cross-elasticity of demand is defined as the proportionate change in the quantity

demanded of x resulting from a proportionate change in the price of y. Symbolically we
have

The sign of the cross-elasticity is negative if x and y are complementary goods, and
positive if x and y are substitutes. The higher the value of the cross-elasticity the
stronger will be the degree of substitutability or complementarity of x and y. The main
determinant of the cross-elasticity is the nature of the commodities relative to their uses.
If two commodities can satisfy equally well the same need, the cross- elasticity is high,
and vice versa. The cross-elasticity has been used for the definition of the firms which
form an industry.

Demand Forecasting: Concept, Significance, Objectives and Factors

An organization faces several internal and external risks, such as high competition,
failure of technology, labor unrest, inflation, recession, and change in government laws.

Therefore, most of the business decisions of an organization are made under the
conditions of risk and uncertainty.

An organization can lessen the adverse effects of risks by determining the demand or
sales prospects for its products and services in future. Demand forecasting is a
systematic process that involves anticipating the demand for the product and services of
an organization in future under a set of uncontrollable and competitive forces.
Some of the popular definitions of demand forecasting are as follows:
According to Evan J. Douglas, “Demand estimation (forecasting) may be defined as a
process of finding values for demand in future time periods.”

In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a
specified future period based on proposed marketing plan and a set of particular
uncontrollable and competitive forces.”

Demand forecasting enables an organization to take various business decisions, such

as planning the production process, purchasing raw materials, managing funds, and
deciding the price of the product. An organization can forecast demand by making own
estimates called guess estimate or taking the help of specialized consultants or market
research agencies. Let us discuss the significance of demand forecasting in the next
section.

Significance of Demand Forecasting:

Demand plays a crucial role in the management of every business. It helps an
organization to reduce risks involved in business activities and make important business
decisions. Apart from this, demand forecasting provides an insight into the
organization’s capital investment and expansion decisions.

The significance of demand forecasting is shown in the following points:

i. Fulfilling objectives:
Implies that every business unit starts with certain pre-decided objectives. Demand
forecasting helps in fulfilling these objectives. An organization estimates the current
demand for its products and services in the market and move forward to achieve the set
goals.

For example, an organization has set a target of selling 50, 000 units of its products. In
such a case, the organization would perform demand forecasting for its products. If the
demand for the organization’s products is low, the organization would take corrective
actions, so that the set objective can be achieved.

ii. Preparing the budget:

Plays a crucial role in making budget by estimating costs and expected revenues. For
instance, an organization has forecasted that the demand for its product, which is priced
at Rs. 10, would be 10, 00, 00 units. In such a case, the total expected revenue would
be 10* 100000 = Rs. 10, 00, 000. In this way, demand forecasting enables
organizations to prepare their budget.

iii. Stabilizing employment and production:

Helps an organization to control its production and recruitment activities. Producing
according to the forecasted demand of products helps in avoiding the wastage of the
resources of an organization. This further helps an organization to hire human resource
according to requirement. For example, if an organization expects a rise in the demand
for its products, it may opt for extra labor to fulfill the increased demand.

iv. Expanding organizations:

Implies that demand forecasting helps in deciding about the expansion of the business
of the organization. If the expected demand for products is higher, then the organization
may plan to expand further. On the other hand, if the demand for products is expected
to fall, the organization may cut down the investment in the business.

v. Taking Management Decisions:

Helps in making critical decisions, such as deciding the plant capacity, determining the
requirement of raw material, and ensuring the availability of labor and capital.

vi. Evaluating Performance:

Helps in making corrections. For example, if the demand for an organization’s products
is less, it may take corrective actions and improve the level of demand by enhancing the
quality of its products or spending more on advertisements.

vii. Helping Government:

Enables the government to coordinate import and export activities and plan international
trade.

Objectives of Demand Forecasting:

Demand forecasting constitutes an important part in making crucial business decisions.

The objectives of demand forecasting are divided into short and long-term
objectives, which are shown in Figure-1:
The objectives of demand forecasting (as shown in Figure-1) are discussed as
follows:
i. Short-term Objectives:
Include the following:
a. Formulating production policy:
Helps in covering the gap between the demand and supply of the product. The demand
forecasting helps in estimating the requirement of raw material in future, so that the
regular supply of raw material can be maintained. It further helps in maximum utilization
of resources as operations are planned according to forecasts. Similarly, human
resource requirements are easily met with the help of demand forecasting.

b. Formulating price policy:

Refers to one of the most important objectives of demand forecasting. An organization
sets prices of its products according to their demand. For example, if an economy
enters into depression or recession phase, the demand for products falls. In such a
case, the organization sets low prices of its products.

c. Controlling sales:
Helps in setting sales targets, which act as a basis for evaluating sales performance. An
organization make demand forecasts for different regions and fix sales targets for each
region accordingly.

d. Arranging finance:
Implies that the financial requirements of the enterprise are estimated with the help of
demand forecasting. This helps in ensuring proper liquidity within the organization.

ii. Long-term Objectives:

Include the following:
a. Deciding the production capacity:
Implies that with the help of demand forecasting, an organization can determine the size
of the plant required for production. The size of the plant should conform to the sales
requirement of the organization.

b. Planning long-term activities:

Implies that demand forecasting helps in planning for long term. For example, if the
forecasted demand for the organization’s products is high, then it may plan to invest in
various expansion and development projects in the long term.

Factors Influencing Demand Forecasting:

Demand forecasting is a proactive process that helps in determining what products are
needed where, when, and in what quantities. There are a number of factors that affect
demand forecasting.

Some of the factors that influence demand forecasting are shown in Figure-2:

The various factors that influence demand forecasting (“as shown in Figure-2) are
explained as follows:
i. Types of Goods:
Affect the demand forecasting process to a larger extent. Goods can be producer’s
goods, consumer goods, or services. Apart from this, goods can be established and
new goods. Established goods are those goods which already exist in the market,
whereas new goods are those which are yet to be introduced in the market.

Information regarding the demand, substitutes and level of competition of goods is

known only in case of established goods. On the other hand, it is difficult to forecast
demand for the new goods. Therefore, forecasting is different for different types of
goods.

ii. Competition Level:

Influence the process of demand forecasting. In a highly competitive market, demand
for products also depend on the number of competitors existing in the market.
Moreover, in a highly competitive market, there is always a risk of new entrants. In such
a case, demand forecasting becomes difficult and challenging.

iii. Price of Goods:

Acts as a major factor that influences the demand forecasting process. The demand
forecasts of organizations are highly affected by change in their pricing policies. In such
a scenario, it is difficult to estimate the exact demand of products.

iv. Level of Technology:

Constitutes an important factor in obtaining reliable demand forecasts. If there is a rapid
change in technology, the existing technology or products may become obsolete. For
example, there is a high decline in the demand of floppy disks with the introduction of
compact disks (CDs) and pen drives for saving data in computer. In such a case, it is
difficult to forecast demand for existing products in future.

v. Economic Viewpoint:
Play a crucial role in obtaining demand forecasts. For example, if there is a positive
development in an economy, such as globalization and high level of investment, the
demand forecasts of organizations would also be positive.

Apart from aforementioned factors, following are some of the other important
factors that influence demand forecasting:
a. Time Period of Forecasts:
Act as a crucial factor that affect demand forecasting. The accuracy of demand
forecasting depends on its time period.

Forecasts can be of three types, which are explained as follows:

1. Short Period Forecasts:
Refer to the forecasts that are generally for one year and based upon the judgment of
the experienced staff. Short period forecasts are important for deciding the production
policy, price policy, credit policy, and distribution policy of the organization.

2. Long Period Forecasts:

Refer to the forecasts that are for a period of 5-10 years and based on scientific
analysis and statistical methods. The forecasts help in deciding about the introduction of
a new product, expansion of the business, or requirement of extra funds.

3. Very Long Period Forecasts:

Refer to the forecasts that are for a period of more than 10 years. These forecasts are
carried to determine the growth of population, development of the economy, political
situation in a country, and changes in international trade in future.

Among the aforementioned forecasts, short period forecast deals with deviation in long
period forecast. Therefore, short period forecasts are more accurate than long period
forecasts.

4. Level of Forecasts:
Influences demand forecasting to a larger extent. A demand forecast can be carried at
three levels, namely, macro level, industry level, and firm level. At macro level, forecasts
are undertaken for general economic conditions, such as industrial production and
allocation of national income. At the industry level, forecasts are prepared by trade
associations and based on the statistical data.

Moreover, at the industry level, forecasts deal with products whose sales are dependent
on the specific policy of a particular industry. On the other hand, at the firm level,
forecasts are done to estimate the demand of those products whose sales depends on
the specific policy of a particular firm. A firm considers various factors, such as changes
in income, consumer’s tastes and preferences, technology, and competitive strategies,
while forecasting demand for its products.

5. Nature of Forecasts:
Constitutes an important factor that affects demand forecasting. A forecast can be
specific or general. A general forecast provides a global picture of business
environment, while a specific forecast provides an insight into the business environment
in which an organization operates. Generally, organizations opt for both the forecasts
together because over-generalization restricts accurate estimation of demand and too
specific information provides an inadequate basis for planning and execution.

Steps of Demand Forecasting:

The Demand forecasting process of an organization can be effective only when it is
conducted systematically and scientifically.

It involves a number of steps, which are shown in Figure-3:

The steps involved in demand forecasting (as shown in Figure-3) are explained as
follows:
1. Setting the Objective:
Refers to first and foremost step of the demand forecasting process. An organization
needs to clearly state the purpose of demand forecasting before initiating it.

Setting objective of demand forecasting involves the following:

a. Deciding the time period of forecasting whether an organization should opt for short-
term forecasting or long-term forecasting

b. Deciding whether to forecast the overall demand for a product in the market or only-
for the organizations own products

c. Deciding whether to forecast the demand for the whole market or for the segment of
the market

d. Deciding whether to forecast the market share of the organization

2. Determining Time Period:

Involves deciding the time perspective for demand forecasting. Demand can be
forecasted for a long period or short period. In the short run, determinants of demand
may not change significantly or may remain constant, whereas in the long run, there is a
significant change in the determinants of demand. Therefore, an organization
determines the time period on the basis of its set objectives.

3. Selecting a Method for Demand Forecasting:

Constitutes one of the most important steps of the demand forecasting process Demand
can be forecasted by using various methods. The method of demand forecasting differs
from organization to organization depending on the purpose of forecasting, time frame,
and data requirement and its availability. Selecting the suitable method is necessary for
saving time and cost and ensuring the reliability of the data.

4. Collecting Data:
Requires gathering primary or secondary data. Primary’ data refers to the data that is
collected by researchers through observation, interviews, and questionnaires for a
particular research. On the other hand, secondary data refers to the data that is
collected in the past; but can be utilized in the present scenario/research work.

5. Estimating Results:
Involves making an estimate of the forecasted demand for predetermined years. The
results should be easily interpreted and presented in a usable form. The results should
be easy to understand by the readers or management of the organization.

Techniques of Demand Forecasting (Survey and Statistical Methods)

The main challenge to forecast demand is to select an effective technique.

There is no particular method that enables organizations to anticipate risks and

uncertainties in future. Generally, there are two approaches to demand forecasting.

The first approach involves forecasting demand by collecting information regarding the
buying behavior of consumers from experts or through conducting surveys. On the other
hand, the second method is to forecast demand by using the past data through
statistical techniques.

Thus, we can say that the techniques of demand forecasting are divided into survey
methods and statistical methods. The survey method is generally for short-term
forecasting, whereas statistical methods are used to forecast demand in the long run.

These two approaches are shown in Figure-10:

Let us discuss these techniques (as shown in Figure-10).

Survey Method:
Survey method is one of the most common and direct methods of forecasting demand
in the short term. This method encompasses the future purchase plans of consumers
and their intentions. In this method, an organization conducts surveys with consumers
to determine the demand for their existing products and services and anticipate the
future demand accordingly.

The survey method undertakes three exercises, which are shown in Figure-11:

The exercises undertaken in the survey method (as shown in Figure-11) are
discussed as follows:
i. Experts’ Opinion Poll:
Refers to a method in which experts are requested to provide their opinion about the
product. Generally, in an organization, sales representatives act as experts who can
assess the demand for the product in different areas, regions, or cities.

Sales representatives are in close touch with consumers; therefore, they are well aware
of the consumers’ future purchase plans, their reactions to market change, and their
perceptions for other competing products. They provide an approximate estimate of the
demand for the organization’s products. This method is quite simple and less
expensive.

However, it has its own limitations, which are discussed as follows:

a. Provides estimates that are dependent on the market skills of experts and their
experience. These skills differ from individual to individual. In this way, making exact
demand forecasts becomes difficult.

b. Involves subjective judgment of the assessor, which may lead to over or under-
estimation.

c. Depends on data provided by sales representatives who may have inadequate

information about the market.
d. Ignores factors, such as change in Gross National Product, availability of credit, and
future prospects of the industry, which may prove helpful in demand forecasting.

ii. Delphi Method:

Refers to a group decision-making technique of forecasting demand. In this method,
questions are individually asked from a group of experts to obtain their opinions on
demand for products in future. These questions are repeatedly asked until a consensus
is obtained.

In addition, in this method, each expert is provided information regarding the estimates
made by other experts in the group, so that he/she can revise his/her estimates with
respect to others’ estimates. In this way, the forecasts are cross checked among
experts to reach more accurate decision making.

Ever expert is allowed to react or provide suggestions on others’ estimates. However,

the names of experts are kept anonymous while exchanging estimates among experts
to facilitate fair judgment and reduce halo effect.

The main advantage of this method is that it is time and cost effective as a number of
experts are approached in a short time without spending on other resources. However,
this method may lead to subjective decision making.

iii. Market Experiment Method:

Involves collecting necessary information regarding the current and future demand for a
product. This method carries out the studies and experiments on consumer behavior
under actual market conditions. In this method, some areas of markets are selected with
similar features, such as population, income levels, cultural background, and tastes of
consumers.

The market experiments are carried out with the help of changing prices and
expenditure, so that the resultant changes in the demand are recorded. These results
help in forecasting future demand.

There are various limitations of this method, which are as follows:

a. Refers to an expensive method; therefore, it may not be affordable by small-scale
organizations
b. Affects the results of experiments due to various social-economic conditions, such as
strikes, political instability, natural calamities

Statistical Methods:
Statistical methods are complex set of methods of demand forecasting. These methods
are used to forecast demand in the long term. In this method, demand is forecasted on
the basis of historical data and cross-sectional data.

Historical data refers to the past data obtained from various sources, such as previous
years’ balance sheets and market survey reports. On the other hand, cross-sectional
data is collected by conducting interviews with individuals and performing market
surveys. Unlike survey methods, statistical methods are cost effective and reliable as
the element of subjectivity is minimum in these methods.

These different statistical methods are shown in Figure-12:

The different statistical methods (as shown in Figure-12).

Trend Projection Method:

Trend projection or least square method is the classical method of business forecasting.
In this method, a large amount of reliable data is required for forecasting demand. In
addition, this method assumes that the factors, such as sales and demand, responsible
for past trends would remain the same in future.

In this method, sales forecasts are made through analysis of past data taken from
previous year’s books of accounts. In case of new organizations, sales data is taken
from organizations already existing in the same industry. This method uses time-series
data on sales for forecasting the demand of a product.

Table-1 shows the time-series data of XYZ Organization:

The trend projection method undertakes three more methods in account, which
are as follows:
i. Graphical Method:
Helps in forecasting the future sales of an organization with the help of a graph. The
sales data is plotted on a graph and a line is drawn on plotted points.

Let us learn this through a graph shown in Figure-13:

Figure-13 shows a curve which is plotted by taking into the account the sales data of
XYZ Organization (Table-1). Line P is drawn through mid-points of the curve and S is a
straight line. These lines are extended to get the future sales for year 2010 which is
approximately 47 tons. This method is very simple and less expensive; however, the
projections made by this method may be based on the personal bias of the forecaster.

ii. Fitting Trend Method:

Implies a least square method in which a trend line (curve) is fitted to the time-series
data of sales with the help of statistical techniques.
In this method, there are two types of trends taken into account, which are
explained as follows:
a. Linear Trend:
Implies a trend in which sales show a rising trend.

In linear trend, following straight line trend equation is fitted:

S = A+BT

Where

S= annual sales

T=time (in years)

A and B are constant

B gives the measure of annual increase in sales

b. Exponential Trend:
Implies a trend in which sales increase over the past years at an increasing rate or
constant rate.

The appropriate trend equation used is as follows:

Y = aTb
Where

Y= annual sales

T= time in years

a and b are constant

Converting this into logarithm, the equation would be:

Log Y = Log a + b Log T

The main advantage of this method is that it is simple to use. Moreover, the data
requirement of this method is very limited (as only sales data is required), thus it is
inexpensive method.
However, this method also suffers from certain limitations, which are as follows:
1. Assumes that the past rate of changes in variables will remain same in future too,
which is not applicable in the practical situations.

2. Fails to be applied for short-term estimates and where trend is cyclical with lot of
fluctuations

3. Fails to measure relationship between dependent and independent variables.

iii. Box-Jenkins Method:

Refers to a method that is used only for short-term predictions. This method forecasts
demand only with stationary time-series data that does not reveal the long-term trend. It
is used in those situations where time series data depicts monthly or seasonal
variations with some degrees of regularity. For instance, this method can be used for
estimating the sales forecasts of woolen clothes during the winter season.

Barometric Method:
In barometric method, demand is predicted on the basis of past events or key variables
occurring in the present. This method is also used to predict various economic
indicators, such as saving, investment, and income. This method was introduced by
Harvard Economic Service in 1920 and further revised by National Bureau of Economic
Research (NBER) in 1930s.

This technique helps in determining the general trend of business activities. For
example, suppose government allots land to the XYZ society for constructing buildings.
This indicates that there would be high demand for cement, bricks, and steel.

The main advantage of this method is that it is applicable even in the absence of past
data. However, this method is not applicable in case of new products. In addition, it
loses its applicability when there is no time lag between economic indicator and
demand.

Econometric Methods:
Econometric methods combine statistical tools with economic theories for forecasting.
The forecasts made by this method are very reliable than any other method. An
econometric model consists of two types of methods namely, regression model and
simultaneous equations model.
These two types of methods are explained as follows:
i. Regression Methods:
Refer to the most popular method of demand forecasting. In regression method, the
demand function for a product is estimated where demand is dependent variable and
variables that determine the demand are independent variable.

If only one variable affects the demand, then it is called single variable demand function.
Thus, simple regression techniques are used. If demand is affected by many variables,
then it is called multi-variable demand function. Therefore, in such a case, multiple
regression is used.

The simple and multiple regression techniques are discussed as follows:

a. Simple Regression:
Refers to studying the relationship between two variables where one is independent
variable and the other is dependent variable.

The equation to calculate simple regression is as follows:

Y = a + bx

Where, Y = Estimated value of Y for a given value of X

b = Amount of change in Y produced by a unit change in X

a and b = Constants

The equations to calculate a and b are as follows:

Let us learn to calculate simple regression with the help of an example. Suppose a
researcher wants to study the relationship between the employee (sales group)
satisfaction and sales of an organization.

He/she has taken the feedback from the employees in the form of questionnaire and
asked them to rate their satisfaction level on a 10-pointer scale where 10 is the highest
and 1 is the lowest. The researcher has taken the sales data for every individual
member of the sales group. He/she has taken the average of monthly sales for an year
for every individual.

The collected data is arranged in Table-2:

The calculation of mean for employee satisfaction (X) and sales is as follows:
This is the regression equation in which the researcher can take any value of X to find
the estimated value of Y.

For example, if the value of X is 9, then the value of Y would be calculated as

follows:
Y = -1.39 + 1.61X

Y = -1.39 + 1.61(9)

Y= 13.1

With the help of preceding example, it can be concluded that if an employee is satisfied,
then his/her output would increase.

b. Multiple Regression:
Refers to studying the relationship between more than one independent and dependent
variables.

In case of two independent variables and one dependent variable, following

equation is used to calculate multiple regression:
Y = a + b1X1 +b2X2
Where, Y (Dependent variable) = Estimated value of Y for a given value of X1 and X1

X1 and X2 = Independent variables

b1 = Amount of change in Y produced by a unit change in X1

b2 = Amount of change in Y produced by a unit change in X2

a, b1 and b2 = Constants

The equations used to calculate a and b values are as follows:

The number of equations depends on the number of independent variables. If there are
two independent variables, then there would be three equations and so on.

Let us learn to calculate multiple regression with the help of an example. Suppose the
researcher wants to study the relationship between intermediate percentage, graduation
percentage, and MAT percentile of a group of 25 students.

It is important to note that intermediate percentage and graduation percentage are

independent variables and MAT percentile is dependent variable. The researcher wants
to find out whether the percentile in MAT depends on the percentage of intermediate
and graduation or not.

The collected data is shown in Table-3:

The equations required to calculate multiple regression are as follows:

These equations are used to solve the multiple regression equation manually. However,
you can also use SPSS to find out multiple regression.

If we use SPSS in the preceding example, we would get the output shown in
Table-4:
Table-5 shows the summary of the regression model. In this table, R is the correlation
coefficient between the independent and dependent variables, which is very high in this
case. R Square shows that a large part of variation in the model is shown by
employment opportunities in a state. Standard error of estimate is quite low that is 1.97.
It also indicates that the variation in the present data is less.

Table-6 shows the coefficients of regression model:

Table-6 shows that the calculated t value is greater than the significance t value. Thus,
the coefficients show cause and effect relationship between the independent and
dependent variables.

Table-7 shows the AN OVA table for the two variables under study:

Table-7 shows the analysis of variation in the model. The regression row shows the
variation occurred due to regression model. However, the residual row shows the
variation that occurred by chance. In Table-7, the value of sum of squares for
regression row is greater than the value of sum of squares for residual row; therefore,
most of the variations are produced only due to model.

The calculated F value is very large as compared to the significance value. Therefore,
we can say that the intermediate percentage and graduation percentage have a strong
effect on the MAT percentile of a student.

Simultaneous Equations:
Involve several simultaneous equations.

There are two types of variables that are included in this model, which are as
follows:
i. Endogenous Variables:
Refer to inputs that are determined within the model. These are controlled variables.

ii. Exogenous Variables:

Refer to inputs of the model. Examples are time, government spending, and weather
conditions. These variables are determined outside the model.

For developing a complete model, endogenous and exogenous variables are

determined first. After that, necessary data on both exogenous and endogenous
variables are collected. Sometimes, data is not available in required form, thus, it needs
to be adjusted into the model.

After the development of necessary data, the model is estimated through some
appropriate method. Finally, the model is solved for each endogenous variable in terms
of exogenous variable. The prediction is finally made.

Other Statistical Measures:

Apart from statistical methods, there are other methods for demand forecasting. These
measures are very specific and used for only particular datasets. Therefore, there
usage cannot be generalized for all types of research.

These measures are shown in Figure-14:

The different types of statistical measures (as shown in Figure-14) are discussed
as follows:
iii. Index Number:
Refers to the measures used to study the fluctuations in a variable or group of related
variables with respect to time period/base period. They are most commonly used in
economics and financial research to study various factors, such as price and quantity of
a product. The factors that are responsible for the problem are identified and calculated.

There are mainly four types of index numbers, which are as follows:
a. Simple index number:
Refers to the number that measures a relative change in a single variable with respect
to the base year.

b. Composite index number:

Refers to the number that measures a relative change in a group of related variables
with respect to the base year.

c. Price index number:

Refers to the number that measures a relative change in the price of a commodity in
different time periods.

d. Quantity index number:

Refers to the number that measures a relative change in the physical quantity of goods
produced, consumed or sold for a commodity in different time periods.

Time Series Analysis: Refers to the analysis of a series of observations over a period of
equally spaced time intervals. For example analyzing the growth of a company from its
incorporation to the present situation. Time series analysis is applicable in various
fields, such as public sector, economics, and research.

There are various components of time series analysis, which are as follows:
a. Secular Trend:
Refers to the trend that is denoted by T and prevalent over a period of time. Secular
trend for a data series can be upward or downward. The upward trend shows the
increase in a variable, such as increase in prices of commodities; whereas, the
downward trend shows the declining phases, such as decline in the rate of diseases
and sales for a particular product.

b. Short Time Oscillation:

Refers to a trend that remains for a shorter period of time.

It can be classified into the following three trends:

1. Seasonal trend:
Refers to the trend that is denoted by S and occurs year after year for a particular
period. The reason for such trends is weather conditions, festivals, and some other
customs. Examples of seasonal trend are the increase in the demand for woolens in
winters and increase in sales for sweet near Diwali.

2. Cyclical Trend:
Refers to the trend that is denoted by C and lasts more than for an year. Cyclical trends
are neither continuous nor seasonal in nature. An example of cyclical trend is business
cycle.

3. Irregular trend:
Refers to the trend that is denoted by I and is short and unpredictable in nature.
Examples of irregular trends are earthquakes, volcano eruptions, and floods.

Decision Tree Analysis:

Refers to the model that is used to take decision in an organization. In the decision tree
analysis, a tree-type structure is drawn to decide the best solution for a problem. In this
analysis, we first find out different options that we can apply to solve a particular
problem.

After that, we can find out the outcome of each option. These options/decisions are
connected with a square node while the outcomes are demonstrated with a circle node.
The flow of a decision tree should be from left to right.

The shape of the decision tree is shown in Figure-15:

Let us understand the working of a decision tree with the help of an example. Suppose
an organization wants to decide the type of segmentation to increase the customer
base.

This problem can be solved by using the decision tree shown in Figure-16:

In Figure-16, the decision tree shows two types of segmentation, namely demographic
segmentation and geographical segmentation. Now, we would analyze the outcomes of
these two segmentations. To analyze the demographic segmentation, the company has
to incur S 40,000 (estimated cost). The outcome of the demographic segmentation can
be good, moderate, and poor.

The estimated revenue projected for three years for the three options (good,
moderate, and poor) are as follows:
Good = $ 21500000

Moderate = $ 950000

Poor= S300000

The probabilities assigned to the outcomes are 0.4 for good, 0.5 for moderate, and 0.1
for poor.
Now, we calculate the outcomes of demographic segmentation in the following
manner:
Good= 0.4*2100000 = 840000

Moderate = 0.5*950000=475000

Poor = 0.1*300000= 30000

Similarly, in case of geographical segmentation, the cost incurred is $ 70000 (estimated

cost). The outcome of the geographical segmentation can be good and poor.

The estimated revenue projected for three years for the two options (good and
poor) are as follows:
Good = $ 1350000

Poor= $ 260000

The probabilities assigned to the outcomes are 0.6 for good and 0.4 for poor.

Now, we calculate the outcomes of geographical segmentation in the following

manner:
Good= 0.6*1350000 = $ 810000

Poor = 0.4*260000 = $ 104000

Now, we would analyze the two outcomes for taking a decision to select one
segmentation out of the two segmentations in the following manner:
For demographic segmentation:
Good= 840000-40000= $ 800000

Moderate = 475000-40000= $ 435000

Poor = 30000-40000= $ (10000)

Similarly, for geographical segmentation:

Good= 810000-70000= $ 740000

Poor =104000-70000= $ 340000

As we can see from the calculation that if we select the demographic segmentation,
then the maximum estimated profit would be $ 800000. In demographic segmentation,
there are chances of incurring losses (10,000), if the product is not successful in the
market.

If we select geographical segmentation, then the maximum estimated profit would be$
740000. In geographical segmentation, we would earn less profit (S 340000), if the
product is not successful in the market. Therefore, it is better to use geographical
segmentation for marketing the product, as no loss is involved in it.
Unit 3

Production and cost analysis

Production concept and analysis

Production Process:
The business firm is basically a producing unit it is a technical unit in which inputs are
converted into output for sale to consumers, other firms and various government
departments.

Production is a process in which economic resources or inputs (composed of natural

resources like land, labour and capital equipment) are combined by entrepreneurs to
create economic goods and services (also referred to as outputs or products).

Inputs are the beginning of the production process and output is the end of the process.
Fig. 13.1 is a simple schematic presentation of the production process, which can be
conceived of as transforming inputs into outputs.

It is to be noted at the outset that the process may produce as joint products both goods
and services (which are desired by consumers) and commodities such as pollution
(which is not desired by consumers).
IMPORTANT NOTES.

1. In traditional economics, the term ‘production’ is used in a broad sense. It refers

to the provision of goods and services for sale in the market with a view to
satisfying human needs and wants.

2. In Business economics, however, the term is used in a narrow sense to refer to

the processes of physical transformation of resources, such as the transforma-
tion of iron ore into steel or the production and assembly of components into
a finished car.

This definition surely includes other and equally vital forms of transformation such as
that of location, whereby the finished car is moved from the factory to the showroom of
the dealer from whom it can be purchased. Here we concerned with production in the
narrow sense of physical transformation, with particular reference to economic problems
connected with production in the factory.

3. The production system can be seen as consisting of three elements – inputs, the
production process and outputs. In reality, the outputs are the starting point of the
operation in as much as they must be considered in the light of the market
possibilities.

4. Inputs take the form of labour of all types, the required raw materials and sources
of energy. All these involve cost outlays. Thus the theory of cost and theory of
production are interrelated. In fact, the former is derived from the latter.

5. The production system can be shown as a continuous, smooth flow of resources

through the process ending in an outflow of a homogeneous product or two or
more products (in fixed or variable proportions).

6. Time also plays a very important role in the theory of production. We usually
draw a distinction between the short run and the long-run. The distinction is not
based on any time period but is made on the basis of the possibility of factor
substitution.

7. In the short run, it is assumed that some factors (such as capital or plant size)
remain fixed and others are variable. In the long run, it is assumed that all factors
are variable. From this we drive the proposition that the short run costs are partly
fixed and partly variable; in the long run all costs are variable.

Finally, in traditional economics it is assumed that the techniques of production are

‘given’. But in managerial economics, however, it is assumed that there are usually
various alternatives open to the manager from which one has to be selected.
Production Decision:
The theory of production lies at the heart of financial economics. It forms the foundation
for the theory of supply, which, is one of the basic concepts in the determination of
prices. Furthermore, production decisions are an important part of managerial decision
making.

Managers are required to make four different but interrelated production

decisions:

(1) Whether or not to actually produce or to shut down;

(2) How much to produce;

(3) What input combination to use and

(4) What type of technology to use.

The theory of production is just an application of the constrained optimization technique.

The firm seeks either to minimize the cost of producing a given level of output or to
maximize the output attainable with a given level of cost.

In fact, the key concept in the theory of production is the production function, which is a
technical relation showing how inputs are converted into output.

Production Function

A production function is usually defined as a schedule (or table, or mathematical

equation) showing the maximum amount of output that can be produced from a fixed
amount of resources, given the existing technology or the art of production. In short, the
production function is a catalogue of a firm’s output possibilities.

Various inputs are normally used in production. So as a general rule, we can define
maximum output, Q to be a function of the level of usage of the various inputs, X, that
is,

Q = f (X1X2,…Xn).
But in our discussions we shall focus on the simpler case of one output produced using
either one input (labour) or two inputs (capital and labour). Hence, the production
function may be expressed as

Q = f (K, L).

However, the principles we will develop can be extended to cover situations involving
more than two inputs.

We have noted earlier that the production function shows the maximum amount of
output that can be produced from specified levels of input usage. For example, suppose
the production function indicates that by combining 10 units of capital with 40 units of
labour (however measured) we can produce 100 units of output per period.

However, 10 units of capital and 40 units of labour could produce less than 100 units of
output if they are used inefficiently, but they can produce no more. If we want more out-
put we have to increase either labour or capital, or both.

The Law of Diminishing Returns

                    The key to understanding the pattern for change in Q is the phenomenon

known as the law of diminishing returns.  This law states :
                    As additional units of variable input are combined with a fixed input, at
some point the additional output (i.e. marginal product) starts to diminish.
                    Diminishing returns are illustrated in both the numerical example in Table
and the graph of these same numbers in Figure.  As you examine this information, think
“Change” as you see the word “marginal”.  Therefore, the “Total product” of an input
such as labor is the change in output resulting from an additional units of input.
                    There are two key concerns of a practical nature that we advise readers to
keep in mind when considering the impact of the law of diminishing returns in actual
business situations.  First, there is nothing in the law that states when diminishing
returns will start to take effect.  The law merely says that if additional units of a variable
input are combined with a fixed input, at some point, the marginal product of the input
will start to diminish.  Therefore, it is reasonable to assume that a manager will only
discover the point of diminishing returns by experience and trial and error, Hindsight will
be more valuable than foresight.  Second, when economists first stated this law, they
made some  restrictive assumptions about the nature of the variable inputs being
used.  Essentially, they assumed that all inputs added to the production process were
exactly the same in individual productivity.  The only reason why a particular unit of
input’s marginal product would be higher or lower than the other used was because of
the order in which it was added to the production process.

The Three states of Production in the Short Run:

                    The short-run production function can be divided into three distinct stages
of production.  To illustrate this phenomenon, let us return to the data in Figure 7.1 has
been reproduced as Figure 7.2.  As the figure indicates.
Stage – I
                   Stage I runs from Zero to four units of the variable input L (i.e. to the point at
which average product reaches its maximum)
Stage – II
                   Stage II begins from five units of variable input and proceeds to seven units
of input L (i.e. to the point at which total product is maximized).
Stage – III
                   Stage III Continues on from that point.
                   According to economic theory, in the short run, “rational” firms should only
be operating in stage II.  It is clear why stage III is irrational; the firm would be using
more of its variable input to produce less output !  However, it may not be as apparent
why stage I is also considered irrational.  The reason is that if a firm were operating in
stage I, it would be grossly underutilizing its fixed capacity.  That is, it would have so
much fixed capacity relative to its usage of variable inputs that is could increase the
output per unit of variable input (i.e., average product) simply by adding more variable
inputs to this capacity.  Figure 7.3a summarizes the three stages of production and the
reasons that the rational firm operates in stage II of the short-run production function.

The Long-Run Production Function :

                   In the long run, a firm has time enough to change the amount of all of its
inputs.  Thus, there is really no difference between fixed and variable inputs.  Table 7.5
uses the data first presented in Table 7.1 and illustrates what happens total output as
the data first presented in Table 7.1 and illustrates what happens to total output as both
inputs X and Y increase one unit at a time.  The resulting increase in the total output as
the two inputs increase is called returns to scale.
                    Looking more closely at Table we see for example that if the firm uses 1 unit
of X and 1 unit of Y, it will produce 4 units of output.  If it doubles its inputs (i.e. 2 units of
X and 2 and units of Y) it will produce 18 units of output.  Thus, a doubling of inputs has
produced more than a fourfold increase in output.  Proceeding further, we notice that an
additional doubling of inputs (i.e. 4 units for X and 4 units of & Y) results in more than a
threefold increase in output, from 18 to 60.  What we are observing in this table is
increasing returns to scale.

Units of
Output Quantity
Employed

8 37 60 83 96 107 117 127 (128)

7 42 64 78 90 101 110 (119) 120

6 37 52 64 73 82 (90) 97 104

5 31 47 58 67 (75) 82 89 95

4 24 39 52 (60) 67 73 79 85

3 17 29 (41) 52 58 64 69 73

2 8 (18) 29 39 47 52 56 52

1 (4) 8 14 20 27 24 21 17

1 2 3 4 5 6 7 8

                   According to economic theory, if an increase in a firm’s inputs by some

proportion results in an increase output by a greater proportion, the firm experiences
increasing returns to scale.  If output increases by the same proportion as the inputs
increase, the firm experiences constant returns to scale.  A less than proportional
increase in output is called decreasing returns to scale.
                   You might simply assume that firms generally experience constant returns
to scale.  For example, if a firm has a factory of a particular size, then doubling its size
along with a doubling of workers and machinery should lead to a doubling of
output.  Why should it result in a greater than proportional or, for that matter, a smaller
than proportional increase ?  For one thing, a larger scale of production might enable a
firm to divide up tasks into more specialized activities, thereby increasing labor
productivity.  Also a larger scale of operation might enable a company to justify the
purchase of more sophisticated (hence, more productive) machinery.  These factors
help to explain why a firm can experience increasing returns to scale.  ON the other
hand, operating on a larger scale might create certain managerial inefficiencies (e.g.
communications problems, bureaucratic red tape) and hence cause increasing or
decreasing returns to scale in the next chapter, when we discuss the related concepts
of economies diseconomies of scale.

                   One way to measure returns to scale is to use a coefficient of output

elasticity.

                   EQ = Percentage change in Q
                             Percentage change in all inputs
Thus,
          If E > 1, we have increasing returns to scale (IRTS).
          If E = 1, we have constant returns to scale (CRTS).
          If E < 1, we have decreasing returns to scale (DRTS)

Returns to factors:

                   Returns to factors are also called as factor productivities, (Productivity, is

the ratio of output to the inputs)

                   The productivity of a particular factor of production may be measured by

assuming the other production factors to be constant and only that particular factor
under study is charged.
                    Returns to factors shows the percentage increase or decrease in the
production due to percentage increase or decrease in a particular factor such as labors
(or) capital, assuming other factors to be constant.  These returns may be increasing
diminishing or constant.

                   The change in productivity can be measured in terms of the following.

1.           Total Productivity:  The total output obtained at varied levels of particular input factor
(while other factors remain constant) is called total productivity.
2.           Average Productivity :  Average productivity can be determined by dividing the total
physical product (production) with the number of particular input factor that is used.
3.           Marginal Productivity:  The marginal productivity is the additional output generated by
adding an additional unit of that particular factor keeping the other factors remains
constant.

Cost and Types of Costs

 
A list and definition of different types of economic costs

Fixed Costs (FC). The costs which don’t vary with changing output. Fixed costs might
include the cost of building a factory, insurance and legal bills. Even if your output
changes or you don’t produce anything, your fixed costs stay the same. In the above
example, fixed costs are always £1,000.

Variable Costs (VC). Costs which depend on the output produced. For example, if you
produce more cars, you have to use more raw materials such as metal. This is a
variable cost.
Semi-Variable Cost. Labor might be a semi-variable cost. If you produce more cars,
you need to employ more workers; this is a variable cost. However, even if you didn’t
produce any cars, you may still need some workers to look after empty factory.

Total Costs (TC)  = Fixed + Variable Costs

Marginal Costs – Marginal cost is the cost of producing an extra unit. If the total cost of
3 units is 1550, and the total cost of 4 units is 1900. The marginal cost of the 4th unit is
350.

Opportunity Cost – Opportunity cost is the next best alternative foregone. If you invest
£1million in developing a cure for pancreatic cancer, the opportunity cost is that you
can’t use that money to invest in developing a cure for skin cancer.

Economic Cost. Economic cost includes both the actual direct costs (accounting costs)
plus the opportunity cost. For example, if you take time off work to a training scheme.
You may lose a weeks pay of £350, plus also have to pay the direct cost of £200. Thus
the total economic cost = £550.

Accounting Costs – this is the monetary outlay for producing a certain good.
Accounting costs will include your variable and fixed costs you have to pay.

Sunk Costs. These are costs that have been incurred and cannot be recouped. If you
left the industry, you could not reclaim sunk costs. For example, if you spend money on
advertising to enter an industry, you can never claim these costs back. If you buy a
machine, you might be able to sell if you leave the industry.

Avoidable Costs. Costs that can be avoided. If you stop producing cars, you don’t
have to pay for extra raw materials and electricity. Sometimes known as an escapable
cost.

 Diagram of Costs

For diagrams of costs see: Diagrams of cost curves

Average Cost Curves

 ATC (Average Total Cost) = Total Cost / quantity
 AVC (Average Variable Cost) = Variable cost / quantity
 AFC (Average Fixed Cost) = Fixed cost / quantity

Revenue Types : Total, Average and Marginal Revenue

Revenue Types : Total, Average and Marginal Revenue!

The term revenue refers to the income obtained by a firm through the sale of goods at
different prices. In the words of Dooley, ‘the revenue of a firm is its sales, receipts or
income’.

The revenue concepts are concerned with Total Revenue, Average Revenue and
Marginal Revenue.

1. Total Revenue:
The income earned by a seller or producer after selling the output is called the total
revenue. In fact, total revenue is the multiple of price and output. The behavior of total
revenue depends on the market where the firm produces or sells.

“Total revenue is the sum of all sales, receipts or income of a firm.” Dooley
Total revenue may be defined as the “product of planned sales (output) and expected
selling price.” Clower and Due

“Total revenue at any output is equal to price per unit multiplied by quantity sold.”
Stonier and Hague

2. Average Revenue:
Average revenue refers to the revenue obtained by the seller by selling the per unit
commodity. It is obtained by dividing the total revenue by total output.

“The average revenue curve shows that the price of the firm’s product is the same at
each level of output.” Stonier and Hague

3. Marginal Revenue:
Marginal revenue is the net revenue obtained by selling an additional unit of the
commodity. “Marginal revenue is the change in total revenue which results from the sale
of one more or one less unit of output.” Ferguson. Thus, marginal revenue is the
addition made to the total revenue by selling one more unit of the good. In algebraic
terms, marginal revenue is the net addition to the total revenue by selling n units of a
commodity instead of n – 1.

Therefore,

A. Koutsoyiannis, “The marginal revenue is the change in total revenue resulting from
selling an additional unit of the commodity.”

If total revenue from (n) units is 110 and from (n – 1) units is 100.

in that case

MRnth = TRn – TRn _ 1 = 100 – 100

MRnth = 10
MR in mathematical terms is the ratio of change in total revenue to change in output

MR = ∆TR/∆q or dR/dq = MR

Total Revenue, Average Revenue and Marginal Revenue:

The relation of total revenue, average revenue and marginal revenue can be explained
with the help of table and fig.

Table Representation:
The relationship between TR, AR and MR can be expressed with the help of a table 1.

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

The formula to calculate TR, AR and MR is as under:

TR = P x q
Or TR = MR1 + MR2 + MR3 + MR3 +….. MR„
TR

AR = TR/q MR = TRn – TRn _ x

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

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

Similarly, in the figure 1 (B) average revenue curves are sloping downward. It means
average revenue falls as more and more units are sold.
In fig. 1 (B) MR is the marginal revenue curve which slopes downward. It signifies the
fact that MR with the sale of every additional unit tends to diminish. Moreover, it is also
clear from the fig. that when both AR and MR are falling, MR is less than AR. MR can
be zero, positive or negative but AR is always positive.
Unit 4
Market structure

Perfect vs. Imperfect Competition: What's the Difference?

 

Perfect vs. Imperfect Competition: An Overview

Perfect competition is a concept in microeconomics that describes a market structure
controlled entirely by market forces. If and when these forces are not met, the market is
said to have imperfect competition.

While no market has clearly defined perfect competition, all real-world markets are
classified as imperfect. That being said, a perfect market is used as a standard by which
the effectiveness and efficiency of real-world markets can be measured.

Perfect Competition
Perfect competition is an abstract concept that occurs in economics textbooks, but not
in the real world. That's because it's impossible to attain in real life.

Theoretically, resources would be divided among companies equally and fairly in a

market with perfect competition, and no monopoly would exist. Each company would
have the same industry knowledge and they would all sell the same products. There
would be plenty of buyers and sellers in this market, and demand would help set prices
evenly across the board.

In order for a market to have perfect competition, there must be:

 Identical products sold by companies

 An environment in which prices are determined by supply and demand, meaning
companies cannot control the market prices of their products
 Equal market share between companies
 Complete information about prices and products available to all buyers
 An industry with low or no barriers to entry or exit

 
The entry and exit in perfect market competition is not regulated, which means the
government has no control over the players in any given industry.
When it comes to their bottom lines, companies typically make just enough profit to stay
in business. No one business is more profitable than the next. That's because the
dynamics in the market cause them to operate on an equal playing field, thereby
canceling out any possible edge one may have over another.

Since perfect competition is merely a theoretical concept, it is difficult to find a real-world

example. But there are instances in the market that may appear to have a perfectly
competitive environment. A flea market or farmer's market are two examples. Consider
the stalls of four crafters or farmers in the market who sell the same products. This
market environment is characterized by a small number of buyers and sellers. There
may be little to differentiate between the products each crafter or farmer sells, as well as
their prices, which are typically set evenly among them.

Imperfect Competition
Imperfect competition occurs in a market when one of the conditions in a perfectly
competitive market are left unmet. This type of market is very common. In fact, every
industry has some type of imperfect competition. This includes a marketplace with
different products and services, prices that are not set by supply and demand,
competition for market share, buyers who may not have complete information about
products and prices, and high barriers to entry and exit.

Imperfect competition can be found in the following types of market structures:

monopolies, oligopolies, monopolistic competition, monopsonies, and oligopsonies.

In monopolies, there is only one (dominant) seller. That company offers a product to the
market that has no substitute. Monopolies have high barriers to entry, a single seller
which is a price maker. That means the firm sets the price at which its product will be
sold regardless of supply or demand. Finally, the firm can change the price at any time,
without notice to consumers.

In an oligopoly, there are many buyers but only a few sellers. Oil companies, grocery
stores, cellphone companies, and tire manufacturers are examples of oligopolies.
Because there are a few players controlling the market, they may bar others from
entering the industry. The firms in this market structure set prices for products and
services collectively or, in the case of a cartel, they may do so if one takes the lead.

Monopolistic competition occurs when there are many sellers who offer similar products
that aren't necessarily substituted. Although the barriers to entry are fairly low and the
companies in this structure are price makers, the overall business decisions of one
company do not affect its competition. Examples include fast food restaurants like
McDonald's and Burger King. Although they are in direct competition, they offer similar
products that cannot be substituted—think Big Mac vs. Whopper.

Monopsonies and oligopsonies are counterpoints to monopolies and oligopolies.

Instead of being made up of many buyers and few sellers, these unique markets have
many sellers but few buyers. Many firms create products and services and attempt to
sell them to a singular buyer—the U.S. military, which constitutes a monopsony. An
example of an oligopsony is the tobacco industry. Almost all of the tobacco grown in the
world is purchased by less than five companies, which use it to produce cigarettes and
smokeless tobacco products. In a monopsony or an oligopsony, it is the buyer, not the
seller, who can manipulate market prices by playing firms against one another.
 Kinked Demand Curve
In an oligopolistic market, firms cannot have a fixed demand curve since it keeps
changing as competitors change the prices/quantity of output. Since an oligopolist is not
aware of the demand curve, economists have designed various price-output models
based on the behavior pattern of other firms in the industry.

Kinked Demand Curve

In many oligopolist markets, it has been observed that prices tend to remain inflexible
for a very long time. Even in the face of declining costs, they tend to change
infrequently. American economist Sweezy came up with the kinked demand curve
hypothesis to explain the reason behind this price rigidity under  oligopoly.

According to the kinked demand curve hypothesis, the demand curve facing an

oligopolist has a kink at the level of the prevailing price. This kink exists because of two
reasons:

1. The segment above the prevailing price level is highly elastic.

2. The segment below the prevailing price level is inelastic.

The following figure shows a kinked demand curve dD with a kink at point P.

From the figure, we know that

i. The prevailing price level = P

ii. The firm produces and sells output = OM
iii. Also, the upper segment (dP) of the demand curve (dD) is elastic.
iv. The lower segment (PD) of the demand curve (dD) is relatively inelastic.
This difference in elasticity’s is due to an assumption of the kinked demand

curve hypothesis.

Assumption:

Each firm in an oligopoly believes the following two things:

1. If a firm lowers the price below the prevailing level, then the competitors will follow
him.
2. If a firm increases the price above the prevailing level, then the competitors will
not follow him.

(a)There is logical reasoning behind this assumption. When an oligopolistic lowers the
price of his product, the competitors feel that if they don’t follow the price cut, then their
customers will leave them and buy from the firm who is offering a lower price.

Therefore, they lower their prices too in order to maintain their customers. Hence, the
lower portion of the curve is inelastic. It implies that if an oligopolist lowers the price, he
can obtain very little sales.

(b)On the other hand, when a firm increases the price of its product, it experiences a
substantial reduction in sales. The reason is simple – consumers will buy the
same/similar product from its competitors.

This increases the competitors’ sales and they will have no motivation to match the
price rise. Therefore, the firm that raises the price suffers a loss and hence refrain from
increasing the price.

This behavior of oligopolists can help us understand the elasticity of the upper
portion of the demand curve (dP). The figure shows that if a firm raises the price of
a product, then it experiences a large fall in sales.

Hence, no firm in an oligopolistic market will try to increase the price and a kink is

formed at the prevailing price. This is how the kinked demand curve hypothesis
explains the rigid or sticky prices.
Definition of 'Pricing Strategies' and types of pricing

Definition: Price is the value that is put to a product or service and is the result of a
complex set of calculations, research and understanding and risk taking ability. A pricing
strategy takes into account segments, ability to pay, market conditions, competitor
actions, trade margins and input costs, amongst others. It is targeted at the defined
customers and against competitors.

Description: There are several pricing strategies:

Premium pricing: high price is used as a defining criterion. Such pricing strategies

work in segments and industries where a strong competitive advantage exists for the
company. Example: Porche in cars and Gillette in blades.

Penetration pricing: price is set artificially low to gain market share quickly. This is
done when a new product is being launched. It is understood that prices will be raised
once the promotion period is over and market share objectives are achieved. Example:
Mobile phone rates in India; housing loans etc.

Economy pricing: no-frills price. Margins are wafer thin; overheads like marketing and
advertising costs are very low. Targets the mass market and high market share.
Example: Friendly wash detergents; Nirma; local tea producers.

Skimming strategy: high price is charged for a product till such time as competitors
allow after which prices can be dropped. The idea is to recover maximum money before
the product or segment attracts more competitors who will lower profits for all
concerned. Example: the earliest prices for mobile phones, VCRs and other electronic
items where a few players ruled attracted lower cost Asian players.

These are the four basic strategies, variations of which are used in the industry.
Unit 5
National Income: Definition, Concepts and Methods of Measuring National
Income

Introduction:

National income is an uncertain term which is used interchangeably with national

dividend, national output and national expenditure. On this basis, national income has

been defined in a number of ways. In common parlance, national income means the

total value of goods and services produced annually in a country.

In other words, the total amount of income accruing to a country from economic

activities in a year’s time is known as national income. It includes payments made to all

resources in the form of wages, interest, rent and profits.

1. Definitions of National Income:

The definitions of national income can be grouped into two classes: One, the traditional

definitions advanced by Marshall, Pigou and Fisher; and two, modern definitions.

The Marshallian Definition:

According to Marshall: “The labour and capital of a country acting on its natural

resources produce annually a certain net aggregate of commodities, material and

immaterial including services of all kinds. This is the true net annual income or revenue

of the country or national dividend.” In this definition, the word ‘net’ refers to deductions

from the gross national income in respect of depreciation and wearing out of machines.

And to this, must be added income from abroad.

The Pigouvian Definition:

A.C. Pigou has in his definition of national income included that income which can be

measured in terms of money. In the words of Pigou, “National income is that part of

objective income of the community, including of course income derived from abroad

which can be measured in money.”

This definition is better than the Marshallian definition. It has proved to be more practical

also. While calculating the national income now-a- days, estimates are prepared in

accordance with the two criteria laid down in this definition.

First, avoiding double counting, the goods and services which can be measured in

money are included in national income. Second, income received on account of

investment in foreign countries is included in national income.

Fisher’s Definition:

Fisher adopted ‘consumption’ as the criterion of national income whereas Marshall and

Pigou regarded it to be production. According to Fisher, “The National dividend or

income consists solely of services as received by ultimate consumers, whether from

their material or from the human environments. Thus, a piano, or an overcoat made for

me this year is not a part of this year’s income, but an addition to the capital. Only the

services rendered to me during this year by these things are income.”

Fisher’s definition is considered to be better than that of Marshall or Pigou, because

Fisher’s definition provides an adequate concept of economic welfare which is

dependent on consumption and consumption represents our standard of living.

2. Concepts of National Income:

There are a number of concepts pertaining to national income and methods of

measurement relating to them.

(A) Gross Domestic Product (GDP):

GDP is the total value of goods and services produced within the country during a year.

This is calculated at market prices and is known as GDP at market prices. Dernberg

defines GDP at market price as “the market value of the output of final goods and

services produced in the domestic territory of a country during an accounting year.”

There are three different ways to measure GDP:

Product Method, Income Method and Expenditure Method.

These three methods of calculating GDP yield the same result because National

Product = National Income = National Expenditure.

1. The Product Method:

In this method, the value of all goods and services produced in different industries

during the year is added up. This is also known as the value added method to GDP or

GDP at factor cost by industry of origin. The following items are included in India in this:

agriculture and allied services; mining; manufacturing, construction, electricity, gas and

water supply; transport, communication and trade; banking and insurance, real estates

and ownership of dwellings and business services; and public administration and

defense and other services (or government services). In other words, it is the sum of

gross value added.

2. The Income Method:

The people of a country who produce GDP during a year receive incomes from their

work. Thus GDP by income method is the sum of all factor incomes: Wages and

Salaries (compensation of employees) + Rent + Interest + Profit.

3. Expenditure Method:

This method focuses on goods and services produced within the country during one

year.

GDP by expenditure method includes:

(1) Consumer expenditure on services and durable and non-durable goods (C),
(2) Investment in fixed capital such as residential and non-residential building,

machinery, and inventories (I),

(3) Government expenditure on final goods and services (G),

(4) Export of goods and services produced by the people of country (X),

(5) Less imports (M). That part of consumption, investment and government expenditure

which is spent on imports is subtracted from GDP. Similarly, any imported component,
such as raw materials, which is used in the manufacture of export goods, is also

excluded.

Thus GDP by expenditure method at market prices = C+ I + G + (X – M), where (X-M) is

net export which can be positive or negative.

(B) GDP at Factor Cost:

GDP at factor cost is the sum of net value added by all producers within the country.

Since the net value added gets distributed as income to the owners of factors of

production, GDP is the sum of domestic factor incomes and fixed capital consumption

(or depreciation).

Thus GDP at Factor Cost = Net value added + Depreciation.

GDP at factor cost includes:

(i) Compensation of employees i.e., wages, salaries, etc.

(ii) Operating surplus which is the business profit of both incorporated and

unincorporated firms. [Operating Surplus = Gross Value Added at Factor Cost—

Compensation of Employees—Depreciation]
(iii) Mixed Income of Self- employed.

Conceptually, GDP at factor cost and GDP at market price must be identical/This is

because the factor cost (payments to factors) of producing goods must equal the final

value of goods and services at market prices. However, the market value of goods and

services is different from the earnings of the factors of production.

In GDP at market price are included indirect taxes and are excluded subsidies by the

government. Therefore, in order to arrive at GDP at factor cost, indirect taxes are

subtracted and subsidies are added to GDP at market price.

Thus, GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies.

(C) Net Domestic Product (NDP):

NDP is the value of net output of the economy during the year. Some of the country’s

capital equipment wears out or becomes obsolete each year during the production

process. The value of this capital consumption is some percentage of gross investment

which is deducted from GDP. Thus Net Domestic Product = GDP at Factor Cost –

Depreciation.

(D) Nominal and Real GDP:

When GDP is measured on the basis of current price, it is called GDP at current prices

or nominal GDP. On the other hand, when GDP is calculated on the basis of fixed

prices in some year, it is called GDP at constant prices or real GDP.

Nominal GDP is the value of goods and services produced in a year and measured in

terms of rupees (money) at current (market) prices. In comparing one year with another,

we are faced with the problem that the rupee is not a stable measure of purchasing
power. GDP may rise a great deal in a year, not because the economy has been

growing rapidly but because of rise in prices (or inflation).

On the contrary, GDP may increase as a result of fall in prices in a year but actually it

may be less as compared to the last year. In both 5 cases, GDP does not show the real

state of the economy. To rectify the underestimation and overestimation of GDP, we

need a measure that adjusts for rising and falling prices.

This can be done by measuring GDP at constant prices which is called real GDP. To

find out the real GDP, a base year is chosen when the general price level is normal, i.e.,

it is neither too high nor too low. The prices are set to 100 (or 1) in the base year.

Now the general price level of the year for which real GDP is to be calculated is

related to the base year on the basis of the following formula which is called the

deflator index:

Suppose 1990-91 is the base year and GDP for 1999-2000 is Rs. 6, 00,000 crores and

the price index for this year is 300.

Thus, Real GDP for 1999-2000 = Rs. 6, 00,000 x 100/300 = Rs. 2, 00,000 crores

(E) GDP Deflator:

GDP deflator is an index of price changes of goods and services included in GDP. It is a

price index which is calculated by dividing the nominal GDP in a given year by the real

GDP for the same year and multiplying it by 100. Thus,

It shows that at constant prices (1993-94), GDP in 1997-98 increased by 135.9% due to

inflation (or rise in prices) from Rs. 1049.2 thousand crores in 1993-94 to Rs. 1426.7

thousand crores in 1997-98.

(F) Gross National Product (GNP):

GNP is the total measure of the flow of goods and services at market value resulting

from current production during a year in a country, including net income from abroad.

GNP includes four types of final goods and services:

(1) Consumers’ goods and services to satisfy the immediate wants of the people;

(2) Gross private domestic investment in capital goods consisting of fixed capital

formation, residential construction and inventories of finished and unfinished goods;

(3) Goods and services produced by the government; and

(4) Net exports of goods and services, i.e., the difference between value of exports and

imports of goods and services, known as net income from abroad.

In this concept of GNP, there are certain factors that have to be taken into

consideration: First, GNP is the measure of money, in which all kinds of goods and

services produced in a country during one year are measured in terms of money at

current prices and then added together.

But in this manner, due to an increase or decrease in the prices, the GNP shows a rise

or decline, which may not be real. To guard against erring on this account, a particular

year (say for instance 1990-91) when prices be normal, is taken as the base year and

the GNP is adjusted in accordance with the index number for that year. This will be

known as GNP at 1990-91 prices or at constant prices.

Second, in estimating GNP of the economy, the market price of only the final products

should be taken into account. Many of the products pass through a number of stages

before they are ultimately purchased by consumers.

If those products were counted at every stage, they would be included many a time in

the national product. Consequently, the GNP would increase too much. To avoid double

counting, therefore, only the final products and not the intermediary goods should be

taken into account.

Third, goods and services rendered free of charge are not included in the GNP,

because it is not possible to have a correct estimate of their market price. For example,

the bringing up of a child by the mother, imparting instructions to his son by a teacher,

recitals to his friends by a musician, etc.

Fourth, the transactions which do not arise from the produce of current year or which do

not contribute in any way to production are not included in the GNP. The sale and

purchase of old goods, and of shares, bonds and assets of existing companies are not

included in GNP because these do not make any addition to the national product, and

the goods are simply transferred.

Fifth, the payments received under social security, e.g., unemployment insurance

allowance, old age pension, and interest on public loans are also not included in GNP,

because the recipients do not provide any service in lieu of them. But the depreciation

of machines, plants and other capital goods is not deducted from GNP.

Sixth, the profits earned or losses incurred on account of changes in capital assets as a

result of fluctuations in market prices are not included in the GNP if they are not

responsible for current production or economic activity.

For example, if the price of a house or a piece of land increases due to inflation, the

profit earned by selling it will not be a part of GNP. But if, during the current year, a

portion of a house is constructed anew, the increase in the value of the house (after

subtracting the cost of the newly constructed portion) will be included in the GNP.

Similarly, variations in the value of assets, that can be ascertained beforehand and are

insured against flood or fire, are not included in the GNP.

Last, the income earned through illegal activities is not included in the GNP. Although

the goods sold in the black market are priced and fulfill the needs of the people, but as

they are not useful from the social point of view, the income received from their sale and

purchase is always excluded from the GNP.

There are two main reasons for this. One, it is not known whether these things were

produced during the current year or the preceding years. Two, many of these goods are

foreign made and smuggled and hence not included in the GNP.

Three Approaches to GNP:

After having studied the fundamental constituents of GNP, it is essential to know how it

is estimated. Three approaches are employed for this purpose. One, the income

method to GNP; two, the expenditure method to GNP and three, the value added

method to GNP. Since gross income equals gross expenditure, GNP estimated by all

these methods would be the same with appropriate adjustments.

1. Income Method to GNP:

The income method to GNP consists of the remuneration paid in terms of money to the

factors of production annually in a country.

Thus GNP is the sum total of the following items:

(i) Wages and salaries:

Under this head are included all forms of wages and salaries earned through productive

activities by workers and entrepreneurs. It includes all sums received or deposited

during a year by way of all types of contributions like overtime, commission, provident

fund, insurance, etc.

(ii) Rents:

Total rent includes the rents of land, shop, house, factory, etc. and the estimated rents

of all such assets as are used by the owners themselves.

(iii) Interest:

Under interest comes the income by way of interest received by the individual of a

country from different sources. To this is added, the estimated interest on that private

capital which is invested and not borrowed by the businessman in his personal

business. But the interest received on governmental loans has to be excluded, because

it is a mere transfer of national income.

(iv) Dividends:

Dividends earned by the shareholders from companies are included in the GNP.

(v) Undistributed corporate profits:

Profits which are not distributed by companies and are retained by them are included in

the GNP.

(vi) Mixed incomes:

These include profits of unincorporated business, self-employed persons and

partnerships. They form part of GNP.

(vii) Direct taxes:

Taxes levied on individuals, corporations and other businesses are included in the GNP.
(viii) Indirect taxes:

The government levies a number of indirect taxes, like excise duties and sales tax.

These taxes are included in the price of commodities. But revenue from these goes to

the government treasury and not to the factors of production. Therefore, the income due

to such taxes is added to the GNP.

(ix) Depreciation:

Every corporation makes allowance for expenditure on wearing out and depreciation of

machines, plants and other capital equipment. Since this sum also is not a part of the

income received by the factors of production, it is, therefore, also included in the GNP.

(x) Net income earned from abroad:

This is the difference between the value of exports of goods and services and the value

of imports of goods and services. If this difference is positive, it is added to the GNP and

if it is negative, it is deducted from the GNP.

Thus GNP according to the Income Method = Wages and Salaries + Rents + Interest +

Dividends + Undistributed Corporate Profits + Mixed Income + Direct Taxes + Indirect

Taxes + Depreciation + Net Income from abroad.

2. Expenditure Method to GNP:

From the expenditure view point, GNP is the sum total of expenditure incurred on goods

and services during one year in a country.

It includes the following items:

(i) Private consumption expenditure:

It includes all types of expenditure on personal consumption by the individuals of a

country. It comprises expenses on durable goods like watch, bicycle, radio, etc.,
expenditure on single-used consumers’ goods like milk, bread, ghee, clothes, etc., as

also the expenditure incurred on services of all kinds like fees for school, doctor, lawyer

and transport. All these are taken as final goods.

(ii) Gross domestic private investment:

Under this comes the expenditure incurred by private enterprise on new investment and

on replacement of old capital. It includes expenditure on house construction, factory-

buildings, and all types of machinery, plants and capital equipment.

In particular, the increase or decrease in inventory is added to or subtracted from it. The

inventory includes produced but unsold manufactured and semi-manufactured goods

during the year and the stocks of raw materials, which have to be accounted for in GNP.

It does not take into account the financial exchange of shares and stocks because their

sale and purchase is not real investment. But depreciation is added.

(iii) Net foreign investment:

It means the difference between exports and imports or export surplus. Every country

exports to or imports from certain foreign countries. The imported goods are not

produced within the country and hence cannot be included in national income, but the

exported goods are manufactured within the country. Therefore, the difference of value

between exports (X) and imports (M), whether positive or negative, is included in the

GNP.

(iv) Government expenditure on goods and services:

The expenditure incurred by the government on goods and services is a part of the

GNP. Central, state or local governments spend a lot on their employees, police and

army. To run the offices, the governments have also to spend on contingencies which

include paper, pen, pencil and various types of stationery, cloth, furniture, cars, etc.
It also includes the expenditure on government enterprises. But expenditure on transfer

payments is not added, because these payments are not made in exchange for goods

and services produced during the current year.

Thus GNP according to the Expenditure Method=Private Consumption Expenditure (C)

+ Gross Domestic Private Investment (I) + Net Foreign Investment (X-M) + Government

Expenditure on Goods and Services (G) = C+ I + (X-M) + G.

As already pointed out above, GNP estimated by either the income or the expenditure

method would work out to be the same, if all the items are correctly calculated.

3. Value Added Method to GNP:

Another method of measuring GNP is by value added. In calculating GNP, the money

value of final goods and services produced at current prices during a year is taken into

account. This is one of the ways to avoid double counting. But it is difficult to distinguish

properly between a final product and an intermediate product.

For instance, raw materials, semi-finished products, fuels and services, etc. are sold as

inputs by one industry to the other. They may be final goods for one industry and

intermediate for others. So, to avoid duplication, the value of intermediate products used

in manufacturing final products must be subtracted from the value of total output of each

industry in the economy.

Thus, the difference between the value of material outputs and inputs at each stage of

production is called the value added. If all such differences are added up for all

industries in the economy, we arrive at the GNP by value added. GNP by value added =

Gross value added + net income from abroad. Its calculation is shown in Tables 1, 2

and 3.
Table 1 is constructed on the supposition that the entire economy for purposes of total

production consists of three sectors. They are agriculture, manufacturing, and others,

consisting of the tertiary sector.

Out of the value of total output of each sector is deducted the value of its intermediate

purchases (or primary inputs) to arrive at the value added for the entire economy. Thus

the value of total output of the entire economy as per Table 1, is Rs. 155 crores and the

value of its primary inputs comes to Rs. 80 crores. Thus the GDP by value added is Rs.

75 crores (Rs. 155 minus Rs. 80 crores).

The total value added equals the value of gross domestic product of the economy. Out

of this value added, the major portion goes in the form wages and salaries, rent, interest
and profits, a small portion goes to the government as indirect taxes and the remaining

amount is meant for depreciation. This is shown in Table 3.

Thus we find that the total gross value added of an economy equals the value of its

gross domestic product. If depreciation is deducted from the gross value added, we

have net value added which comes to Rs. 67 crores (Rs. 75 minus Rs. 8 crores).

This is nothing but net domestic product at market prices. Again, if indirect taxes (Rs. 7

crores) are deducted from the net domestic product of Rs. 67 crores, we get Rs. 60
crores as the net value added at factor cost which is equivalent to net domestic product

at factor cost. This is illustrated in Table 2.

Net value added at factor cost is equal to the net domestic product at factor cost, as

given by the total of items 1 to 4 of Table 2 (Rs. 45+3+4+8 crores=Rs. 60 crores). By

adding indirect taxes (Rs 7 crores) and depreciation (Rs 8 crores), we get gross value

added or GDP which comes to Rs 75 crores.

If we add net income received from abroad to the gross value added, this gives -us,

gross national income. Suppose net income from abroad is Rs. 5 crores. Then the gross

national income is Rs. 80 crores (Rs. 75 crores + Rs. 5 crores) as shown in Table 3.

It’s Importance:
The value added method for measuring national income is more realistic than the

product and income methods because it avoids the problem of double counting by

excluding the value of intermediate products. Thus this method establishes the

importance of intermediate products in the national economy. Second, by studying the

national income accounts relating to value added, the contribution of each production

sector to the value of the GNP can be found out.

For instance, it can tell us whether agriculture is contributing more or the share of

manufacturing is falling, or of the tertiary sector is increasing in the current year as

compared to some previous years. Third, this method is highly useful because “it

provides a means of checking the GNP estimates obtained by summing the various

types of commodity purchases.”

It’s Difficulties:

However, difficulties arise in the calculation of value added in the case of certain public

services like police, military, health, education, etc. which cannot be estimated

accurately in money terms. Similarly, it is difficult to estimate the contribution made to

value added by profits earned on irrigation and power projects.

(G) GNP at Market Prices:

When we multiply the total output produced in one year by their market prices prevalent

during that year in a country, we get the Gross National Product at market prices. Thus

GNP at market prices means the gross value of final goods and services produced

annually in a country plus net income from abroad. It includes the gross value of output

of all items from (1) to (4) mentioned under GNP. GNP at Market Prices = GDP at

Market Prices + Net Income from Abroad.

(H) GNP at Factor Cost:

GNP at factor cost is the sum of the money value of the income produced by and

accruing to the various factors of production in one year in a country. It includes all

items mentioned above under income method to GNP less indirect taxes.

GNP at market prices always includes indirect taxes levied by the government on goods

which raise their prices. But GNP at factor cost is the income which the factors of

production receive in return for their services alone. It is the cost of production.

Thus GNP at market prices is always higher than GNP at factor cost. Therefore, in order

to arrive at GNP at factor cost, we deduct indirect taxes from GNP at market prices.

Again, it often happens that the cost of production of a commodity to the producer is

higher than a price of a similar commodity in the market.

In order to protect such producers, the government helps them by granting monetary

help in the form of a subsidy equal to the difference between the market price and the

cost of production of the commodity. As a result, the price of the commodity to the

producer is reduced and equals the market price of similar commodity.

For example if the market price of rice is Rs. 3 per kg but it costs the producers in

certain areas Rs. 3.50. The government gives a subsidy of 50 paisa per kg to them in

order to meet their cost of production. Thus in order to arrive at GNP at factor cost,

subsidies are added to GNP at market prices.

GNP at Factor Cost = GNP at Market Prices – Indirect Taxes + Subsidies.

(I) Net National Product (NNP):

NNP includes the value of total output of consumption goods and investment goods. But

the process of production uses up a certain amount of fixed capital. Some fixed
equipment wears out, its other components are damaged or destroyed, and still others

are rendered obsolete through technological changes.

All this process is termed depreciation or capital consumption allowance. In order to

arrive at NNP, we deduct depreciation from GNP. The word ‘net’ refers to the exclusion

of that part of total output which represents depreciation. So NNP = GNP—

Depreciation.

(J) NNP at Market Prices:

Net National Product at market prices is the net value of final goods and services

evaluated at market prices in the course of one year in a country. If we deduct

depreciation from GNP at market prices, we get NNP at market prices. So NNP at

Market Prices = GNP at Market Prices—Depreciation.

(K) NNP at Factor Cost:

Net National Product at factor cost is the net output evaluated at factor prices. It

includes income earned by factors of production through participation in the production

process such as wages and salaries, rents, profits, etc. It is also called National Income.

This measure differs from NNP at market prices in that indirect taxes are deducted and

subsidies are added to NNP at market prices in order to arrive at NNP at factor cost.

Thus

NNP at Factor Cost = NNP at Market Prices – Indirect taxes+ Subsidies

= GNP at Market Prices – Depreciation – Indirect taxes + Subsidies.

= National Income.
Normally, NNP at market prices is higher than NNP at factor cost because indirect taxes

exceed government subsidies. However, NNP at market prices can be less than NNP at

factor cost when government subsidies exceed indirect taxes.

(L) Domestic Income:

Income generated (or earned) by factors of production within the country from its own

resources is called domestic income or domestic product.

Domestic income includes:

(i) Wages and salaries, (ii) rents, including imputed house rents, (iii) interest, (iv)

dividends, (v) undistributed corporate profits, including surpluses of public undertakings,

(vi) mixed incomes consisting of profits of unincorporated firms, self- employed persons,

partnerships, etc., and (vii) direct taxes.

Since domestic income does not include income earned from abroad, it can also be

shown as: Domestic Income = National Income-Net income earned from abroad. Thus

the difference between domestic income f and national income is the net income earned

from abroad. If we add net income from abroad to domestic income, we get national

income, i.e., National Income = Domestic Income + Net income earned from abroad.

But the net national income earned from abroad may be positive or negative. If exports

exceed import, net income earned from abroad is positive. In this case, national income

is greater than domestic income. On the other hand, when imports exceed exports, net

income earned from abroad is negative and domestic income is greater than national

income.
(M) Private Income:

Private income is income obtained by private individuals from any source, productive or

otherwise, and the retained income of corporations. It can be arrived at from NNP at

Factor Cost by making certain additions and deductions.

The additions include transfer payments such as pensions, unemployment allowances,

sickness and other social security benefits, gifts and remittances from abroad, windfall

gains from lotteries or from horse racing, and interest on public debt. The deductions

include income from government departments as well as surpluses from public

undertakings, and employees’ contribution to social security schemes like provident

funds, life insurance, etc.

Thus Private Income = National Income (or NNP at Factor Cost) + Transfer Payments +

Interest on Public Debt — Social Security — Profits and Surpluses of Public

Undertakings.

(N) Personal Income:

Personal income is the total income received by the individuals of a country from all

sources before payment of direct taxes in one year. Personal income is never equal to

the national income, because the former includes the transfer payments whereas they

are not included in national income.

Personal income is derived from national income by deducting undistributed corporate

profits, profit taxes, and employees’ contributions to social security schemes. These

three components are excluded from national income because they do reach

individuals.

But business and government transfer payments, and transfer payments from abroad in

the form of gifts and remittances, windfall gains, and interest on public debt which are a
source of income for individuals are added to national income. Thus Personal Income =

National Income – Undistributed Corporate Profits – Profit Taxes – Social Security

Contribution + Transfer Payments + Interest on Public Debt.

Personal income differs from private income in that it is less than the latter because it

excludes undistributed corporate profits.

Thus Personal Income = Private Income – Undistributed Corporate Profits – Profit

Taxes.

(O) Disposable Income:

Disposable income or personal disposable income means the actual income which can

be spent on consumption by individuals and families. The whole of the personal income

cannot be spent on consumption, because it is the income that accrues before direct

taxes have actually been paid. Therefore, in order to obtain disposable income, direct

taxes are deducted from personal income. Thus Disposable Income=Personal Income –

Direct Taxes.

But the whole of disposable income is not spent on consumption and a part of it is

saved. Therefore, disposable income is divided into consumption expenditure and

savings. Thus Disposable Income = Consumption Expenditure + Savings.

If disposable income is to be deduced from national income, we deduct indirect taxes

plus subsidies, direct taxes on personal and on business, social security payments,

undistributed corporate profits or business savings from it and add transfer payments

and net income from abroad to it.

Thus Disposable Income = National Income – Business Savings – Indirect Taxes +

Subsidies – Direct Taxes on Persons – Direct Taxes on Business – Social Security

Payments + Transfer Payments + Net Income from abroad.

(P) Real Income:

Real income is national income expressed in terms of a general level of prices of a

particular year taken as base. National income is the value of goods and services

produced as expressed in terms of money at current prices. But it does not indicate the

real state of the economy.

It is possible that the net national product of goods and services this year might have

been less than that of the last year, but owing to an increase in prices, NNP might be

higher this year. On the contrary, it is also possible that NNP might have increased but

the price level might have fallen, as a result national income would appear to be less

than that of the last year. In both the situations, the national income does not depict the

real state of the country. To rectify such a mistake, the concept of real income has been

evolved.

In order to find out the real income of a country, a particular year is taken as the base

year when the general price level is neither too high nor too low and the price level for

that year is assumed to be 100. Now the general level of prices of the given year for

which the national income (real) is to be determined is assessed in accordance with the

prices of the base year. For this purpose the following formula is employed.

Real NNP = NNP for the Current Year x Base Year Index (=100) / Current Year Index

Suppose 1990-91 is the base year and the national income for 1999-2000 is Rs. 20,000

crores and the index number for this year is 250. Hence, Real National Income for
1999-2000 will be = 20000 x 100/250 = Rs. 8000 crores. This is also known as national

income at constant prices.

(Q) Per Capita Income:

The average income of the people of a country in a particular year is called Per Capita

Income for that year. This concept also refers to the measurement of income at current

prices and at constant prices. For instance, in order to find out the per capita income for

2001, at current prices, the national income of a country is divided by the population of

the country in that year.

Similarly, for the purpose of arriving at the Real Per Capita Income, this very formula is

used.

This concept enables us to know the average income and the standard of living of the

people. But it is not very reliable, because in every country due to unequal distribution of

national income, a major portion of it goes to the richer sections of the society and thus

income received by the common man is lower than the per capita income.

3. Methods of Measuring National Income:

There are four methods of measuring national income. Which method is to be used

depends on the availability of data in a country and the purpose in hand.

(1) Product Method:

According to this method, the total value of final goods and services produced in a

country during a year is calculated at market prices. To find out the GNP, the data of all

productive activities, such as agricultural products, wood received from forests, minerals

received from mines, commodities produced by industries, the contributions to

production made by transport, communications, insurance companies, lawyers, doctors,

teachers, etc. are collected and assessed at market prices. Only the final goods and

services are included and the intermediary goods and services are left out.

(2) Income Method:

According to this method, the net income payments received by all citizens of a country

in a particular year are added up, i.e., net incomes that accrue to all factors of

production by way of net rents, net wages, net interest and net profits are all added

together but incomes received in the form of transfer payments are not included in it.

The data pertaining to income are obtained from different sources, for instance, from

income tax department in respect of high income groups and in case of workers from

their wage bills.

(3) Expenditure Method:

According to this method, the total expenditure incurred by the society in a particular

year is added together and includes personal consumption expenditure, net domestic

investment, government expenditure on goods and services, and net foreign

investment. This concept is based on the assumption that national income equals

national expenditure.

(4) Value Added Method:

Another method of measuring national income is the value added by industries. The

difference between the value of material outputs and inputs at each stage of production

is the value added. If all such differences are added up for all industries in the economy,

we arrive at the gross domestic product.

4. Difficulties or Limitations in Measuring National Income:

There are many conceptual and statistical problems involved in measuring national

income by the income method, product method, and expenditure method.

We discuss them separately in the light of the three methods:
(A) Problems in Income Method:

The following problems arise in the computation of National Income by income

method:

1. Owner-occupied Houses:

A person who rents a house to another earns rental income, but if he occupies the

house himself, will the services of the house-owner be included in national income. The

services of the owner-occupied house are included in national income as if the owner

sells to himself as a tenant its services.

For the purpose of national income accounts, the amount of imputed rent is estimated

as the sum for which the owner-occupied house could have been rented. The imputed

net rent is calculated as that portion of the amount that would have accrued to the

house-owner after deducting all expenses.

2. Self-employed Persons:

Another problem arises with regard to the income of self-employed persons. In their

case, it is very difficult to find out the different inputs provided by the owner himself. He

might be contributing his capital, land, labour and his abilities in the business. But it is
not possible to estimate the value of each factor input to production. So he gets a mixed

income consisting of interest, rent, wage and profits for his factor services. This is

included in national income.

3. Goods meant for Self-consumption:

In under-developed countries like India, farmers keep a large portion of food and other

goods produced on the farm for self-consumption. The problem is whether that part of

the produce which is not sold in the market can be included in national income or not. If

the farmer were to sell his entire produce in the market, he will have to buy what he
needs for self-consumption out of his money income. If, instead he keeps some produce

for his self-consumption, it has money value which must be included in national income.

4. Wages and Salaries paid in Kind:

Another problem arises with regard to wages and salaries paid in kind to the employees

in the form of free food, lodging, dress and other amenities. Payments in kind by

employers are included in national income. This is because the employees would have

received money income equal to the value of free food, lodging, etc. from the employer

and spent the same in paying for food, lodging, etc.

(B) Problems in Product Method:

The following problems arise in the computation of national income by product

method:

1. Services of Housewives:

The estimation of the unpaid services of the housewife in the national income presents

a serious difficulty. A housewife renders a number of useful services like preparation of

meals, serving, tailoring, mending, washing, cleaning, bringing up children, etc.

She is not paid for them and her services are not including in national income. Such

services performed by paid servants are included in national income. The national

income is, therefore, underestimated by excluding the services of a housewife.

The reason for the exclusion of her services from national income is that the love and

affection of a housewife in performing her domestic work cannot be measured in

monetary terms. That is why when the owner of a firm marries his lady secretary, her

services are not included in national income when she stops working as a secretary and

becomes a housewife.
When a teacher teaches his own children, his work is also not included in national

income. Similarly, there are a number of goods and services which are difficult to be

assessed in money terms for the reason stated above, such as painting, singing,

dancing, etc. as hobbies.

2. Intermediate and Final Goods:

The greatest difficulty in estimating national income by product method is the failure to

distinguish properly between intermediate and final goods. There is always the

possibility of including a good or service more than once, whereas only final goods are

included in national income estimates. This leads to the problem of double counting

which leads to the overestimation of national income.

3. Second-hand Goods and Assets:

Another problem arises with regard to the sale and purchase of second-hand goods and

assets. We find that old scooters, cars, houses, machinery, etc. are transacted daily in

the country. But they are not included in national income because they were counted in

the national product in the year they were manufactured.

If they are included every time they are bought and sold, national income would

increase many times. Similarly, the sale and purchase of old stocks, shares, and bonds

of companies are not included in national income because they were included in

national income when the companies were started for the first time. Now they are simply

financial transactions and represent claims.

But the commission or fees charged by the brokers in the repurchase and resale of old

shares, bonds, houses, cars or scooters, etc. are included in national income. For these

are the payments they receive for their productive services during the year.

4. Illegal Activities:
Income earned through illegal activities like gambling, smuggling, illicit extraction of

wine, etc. is not included in national income. Such activities have value and satisfy the

wants of the people but they are not considered productive from the point of view of

society. But in countries like Nepal and Monaco where gambling is legalised, it is

included in national income. Similarly, horse-racing is a legal activity in England and is

included in national income.

5. Consumers’ Service:

There are a number of persons in society who render services to consumers but they do

not produce anything tangible. They are the actors, dancers, doctors, singers, teachers,

musicians, lawyers, barbers, etc. The problem arises about the inclusion of their

services in national income since they do not produce tangible commodities. But as they

satisfy human wants and receive payments for their services, their services are included

as final goods in estimating national income.

6. Capital Gains:

The problem also arises with regard to capital gains. Capital gains arise when a capital

asset such as a house, some other property, stocks or shares, etc. is sold at higher

price than was paid for it at the time of purchase. Capital gains are excluded from
national income because these do not arise from current economic activities. Similarly,

capital losses are not taken into account while estimating national income.

7. Inventory Changes:

All inventory changes (or changes in stocks) whether positive or negative are included

in national income. The procedure is to take changes in physical units of inventories for

the year valued at average current prices paid for them.

The value of changes in inventories may be positive or negative which is added or

subtracted from the current production of the firm. Remember, it is the change in

inventories and not total inventories for the year that are taken into account in national

income estimates.

8. Depreciation:

Depreciation is deducted from GNP in order to arrive at NNP. Thus depreciation lowers

the national income. But the problem is of estimating the current depreciated value of,

say, a machine, whose expected life is supposed to be thirty years. Firms calculate the

depreciation value on the original cost of machines for their expected life. This does not

solve the problem because the prices of machines change almost every year.

9. Price Changes:

National income by product method is measured by the value of final goods and

services at current market prices. But prices do not remain stable. They rise or fall.

When the price level rises, the national income also rises, though the national

production might have fallen.

On the contrary, with the fall in the price level, the national income also falls, though the

national production might have increased. So price changes do not adequately measure

national income. To solve this problem, economists calculate the real national income at

a constant price level by the consumer price index.

(C) Problems in Expenditure Method:

The following problems arise in the calculation of national income by expenditure

method:

(1) Government Services:

In calculating national income by, expenditure method, the problem of estimating

government services arises. Government provides a number of services, such as police

and military services, administrative and legal services. Should expenditure on

government services be included in national income?

If they are final goods, then only they would be included in national income. On the

other hand, if they are used as intermediate goods, meant for further production, they

would not be included in national income. There are many divergent views on this issue.

One view is that if police, military, legal and administrative services protect the lives,

property and liberty of the people, they are treated as final goods and hence form part of

national income. If they help in the smooth functioning of the production process by

maintaining peace and security, then they are like intermediate goods that do not enter

into national income.

In reality, it is not possible to make a clear demarcation as to which service protects the

people and which protects the productive process. Therefore, all such services are

regarded as final goods and are included in national income.

(2) Transfer Payments:

There arises the problem of including transfer payments in national income.

Government makes payments in the form of pensions, unemployment allowance,

subsidies, interest on national debt, etc. These are government expenditures but they

are not included in national income because they are paid without adding anything to

the production process during the current year.

For instance, pensions and unemployment allowances are paid to individuals by the

government without doing any productive work during the year. Subsidies tend to lower

the market price of the commodities. Interest on national or public debt is also
considered a transfer payment because it is paid by the government to individuals and

firms on their past savings without any productive work.

(3) Durable-use Consumers’ Goods:

Durable-use consumers’ goods also pose a problem. Such durable-use consumers’

goods as scooters, cars, fans, TVs, furniture’s, etc. are bought in one year but they are

used for a number of years. Should they be included under investment expenditure or

consumption expenditure in national income estimates? The expenditure on them is

regarded as final consumption expenditure because it is not possible to measure their

used up value for the subsequent years.

But there is one exception. The expenditure on a new house is regarded as investment

expenditure and not consumption expenditure. This is because the rental income or the

imputed rent which the house-owner gets is for making investment on the new house.

However, expenditure on a car by a household is consumption expenditure. But if he

spends the amount for using it as a taxi, it is investment expenditure.

(4) Public Expenditure:

Government spends on police, military, administrative and legal services, parks, street

lighting, irrigation, museums, education, public health, roads, canals, buildings, etc. The

problem is to find out which expenditure is consumption expenditure and which

investment expenditure is.

Expenses on education, museums, public health, police, parks, street lighting, civil and

judicial administration are consumption expenditure. Expenses on roads, canals,

buildings, etc. are investment expenditure. But expenses on defence equipment are

treated as consumption expenditure because they are consumed during a war as they
are destroyed or become obsolete. However, all such expenses including the salaries of

armed personnel are included in national income.

5. Importance of National Income Analysis:

The national income data have the following importance:

1. For the Economy:

National income data are of great importance for the economy of a country. These days

the national income data are regarded as accounts of the economy, which are known as

social accounts. These refer to net national income and net national expenditure, which

ultimately equal each other.

Social accounts tell us how the aggregates of a nation’s income, output and product

result from the income of different individuals, products of industries and transactions of

international trade. Their main constituents are inter-related and each particular account

can be used to verify the correctness of any other account.

2. National Policies:

National income data form the basis of national policies such as employment policy,

because these figures enable us to know the direction in which the industrial output,

investment and savings, etc. change, and proper measures can be adopted to bring the

economy to the right path.

3. Economic Planning:

In the present age of planning, the national data are of great importance. For economic

planning, it is essential that the data pertaining to a country’s gross income, output,

saving and consumption from different sources should be available. Without these,

planning is not possible.

4. Economic Models:
The economists propound short-run as well as long-run economic models or long-run

investment models in which the national income data are very widely used.

5. Research:

The national income data are also made use of by the research scholars of economics.

They make use of the various data of the country’s input, output, income, saving,

consumption, investment, employment, etc., which are obtained from social accounts.

6. Per Capita Income:

National income data are significant for a country’s per capita income which reflects the

economic welfare of the country. The higher the per capita income, the higher the

economic welfare of the country.

7. Distribution of Income:

National income statistics enable us to know about the distribution of income in the

country. From the data pertaining to wages, rent, interest and profits, we learn of the

disparities in the incomes of different sections of the society. Similarly, the regional

distribution of income is revealed.

It is only on the basis of these that the government can adopt measures to remove the

inequalities in income distribution and to restore regional equilibrium. With a view to

removing these personal and regional disequibria, the decisions to levy more taxes and

increase public expenditure also rest on national income statistics.

Inflation: Types, Causes and Effects (With Diagram)

Inflation and unemployment are the two most talked-about words in the contemporary
society.

These two are the big problems that plague all the economies.
Almost everyone is sure that he knows what inflation exactly is, but it remains a source
of great deal of confusion because it is difficult to define it unambiguously.

1. Meaning of Inflation:
Inflation is often defined in terms of its supposed causes. Inflation exists when money
supply exceeds available goods and services. Or inflation is attributed to budget deficit
financing. A deficit budget may be financed by the additional money creation. But the
situation of monetary expansion or budget deficit may not cause price level to rise.
Hence the difficulty of defining ‘inflation’.

Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and
not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and
appreciable rise in the general level or average of prices’. In other words, inflation is a
state of rising prices, but not high prices.

It is not high prices but rising price level that constitute inflation. It constitutes, thus, an
overall increase in price level. It can, thus, be viewed as the devaluing of the worth of
money. In other words, inflation reduces the purchasing power of money. A unit of
money now buys less. Inflation can also be seen as a recurring phenomenon.

While measuring inflation, we take into account a large number of goods and services
used by the people of a country and then calculate average increase in the prices of
those goods and services over a period of time. A small rise in prices or a sudden rise in
prices is not inflation since they may reflect the short term workings of the market.

It is to be pointed out here that inflation is a state of disequilibrium when there occurs a
sustained rise in price level. It is inflation if the prices of most goods go up. Such rate of
increases in prices may be both slow and rapid. However, it is difficult to detect whether
there is an upward trend in prices and whether this trend is sustained. That is why
inflation is difficult to define in an unambiguous sense.

Let’s measure inflation rate. Suppose, in December 2007, the consumer price index
was 193.6 and, in December 2008, it was 223.8. Thus, the inflation rate during the last
one year was

223.8- 193.6/ 193.6 x 100 = 15.6

As inflation is a state of rising prices, deflation may be defined as a state of falling prices
but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of
money or purchasing power of money. Disinflation is a slowing down of the rate of
inflation.

2. Types of Inflation:
As the nature of inflation is not uniform in an economy for all the time, it is wise to distin-
guish between different types of inflation. Such analysis is useful to study the distribu-
tional and other effects of inflation as well as to recommend anti-inflationary policies.
Inflation may be caused by a variety of factors. Its intensity or pace may be different at
different times. It may also be classified in accordance with the reactions of the
government toward inflation.

Thus, one may observe different types of inflation in the contemporary society:
A. On the Basis of Causes:
(i) Currency inflation:
This type of inflation is caused by the printing of currency notes.

(ii) Credit inflation:

Being profit-making institutions, commercial banks sanction more loans and advances
to the public than what the economy needs. Such credit expansion leads to a rise in
price level.

(iii) Deficit-induced inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To
meet this gap, the government may ask the central bank to print additional money.
Since pumping of additional money is required to meet the budget deficit, any price rise
may the be called the deficit-induced inflation.

(iv) Demand-pull inflation:

An increase in aggregate demand over the available output leads to a rise in the price
level. Such inflation is called demand-pull inflation (henceforth DPI). But why does
aggregate demand rise? Classical economists attribute this rise in aggregate demand to
money supply. If the supply of money in an economy exceeds the available goods and
services, DPI appears. It has been described by Coulborn as a situation of “too much
money chasing too few goods.”
Keynesians hold a different argument. They argue that there can be an autonomous
increase in aggregate demand or spending, such as a rise in consumption demand or
investment or government spending or a tax cut or a net increase in exports (i.e., C + I +
G + X – M) with no increase in money supply. This would prompt upward adjustment in
price. Thus, DPI is caused by monetary factors (classical adjustment) and non-
monetary factors (Keynesian argument).

DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal
axis and price level on the vertical axis. In Range 1, total spending is too short of full
employment output, YF. There is little or no rise in the price level. As demand now rises,
output will rise. The economy enters Range 2, where output approaches towards full
employment situation. Note that in this region price level begins to rise. Ultimately, the
economy reaches full employment situation, i.e., Range 3, where output does not rise
but price level is pulled upward. This is demand-pull inflation. The essence of this type
of inflation is that “too much spending chasing too few goods.”

(v) Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production.
This type of inflation is known as cost-push inflation (henceforth CPI). Cost of pro-
duction may rise due to an increase in the prices of raw materials, wages, etc. Often
trade unions are blamed for wage rise since wage rate is not completely market-
determinded. Higher wage means high cost of production. Prices of commodities are
thereby increased.

A wage-price spiral comes into operation. But, at the same time, firms are to be blamed
also for the price rise since they simply raise prices to expand their profit margins. Thus,
we have two important variants of CPI wage-push inflation and profit-push inflation.

Anyway, CPI stems from the leftward shift of the aggregate supply curve:

B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:
If the speed of upward thrust in prices is slow but small then we have creeping inflation.
What speed of annual price rise is a creeping one has not been stated by the
economists. To some, a creeping or mild inflation is one when annual price rise varies
between 2 p.c. and 3 p.c. If a rate of price rise is kept at this level, it is considered to be
helpful for economic development. Others argue that if annual price rise goes slightly
beyond 3 p.c. mark, still then it is considered to be of no danger.

(ii) Walking Inflation:

If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a
situation of walking inflation. When mild inflation is allowed to fan out, walking inflation
appears. These two types of inflation may be described as ‘moderate inflation’.

Often, one-digit inflation rate is called ‘moderate inflation’ which is not only predictable,
but also keep people’s faith on the monetary system of the country. Peoples’ confidence
get lost once moderately maintained rate of inflation goes out of control and the
economy is then caught with the galloping inflation.

(iii) Galloping and Hyperinflation:

Walking inflation may be converted into running inflation. Running inflation is danger-
ous. If it is not controlled, it may ultimately be converted to galloping or hyperinflation. It
is an extreme form of inflation when an economy gets shattered.”Inflation in the double
or triple digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”.
(iv) Government’s Reaction to Inflation:
Inflationary situation may be open or suppressed. Because of anti-inflationary policies
pursued by the government, inflation may not be an embarrassing one. For instance,
increase in income leads to an increase in consumption spending which pulls the price
level up.

If the consumption spending is countered by the government via price control and
rationing device, the inflationary situation may be called a suppressed one. Once the
government curbs are lifted, the suppressed inflation becomes open inflation. Open
inflation may then result in hyperinflation.

3. Causes of Inflation:
Inflation is mainly caused by excess demand/ or decline in aggregate supply or output.
Former leads to a rightward shift of the aggregate demand curve while the latter causes
aggregate supply curve to shift leftward. Former is called demand-pull inflation (DPI),
and the latter is called cost-push inflation (CPI). Before describing the factors, that lead
to a rise in aggregate demand and a decline in aggregate supply, we like to explain
“demand-pull” and “cost-push” theories of inflation.

(i) Demand-Pull Inflation Theory:

There are two theoretical approaches to the DPI—one is classical and other is the
Keynesian.

According to classical economists or monetarists, inflation is caused by an increase in

money supply which leads to a rightward shift in negative sloping aggregate demand
curve. Given a situation of full employment, classicists maintained that a change in
money supply brings about an equiproportionate change in price level.

That is why monetarists argue that inflation is always and everywhere a monetary
phenomenon. Keynesians do not find any link between money supply and price level
causing an upward shift in aggregate demand.
According to Keynesians, aggregate demand may rise due to a rise in consumer
demand or investment demand or government expenditure or net exports or the com-
bination of these four components of aggreate demand. Given full employment, such in-
crease in aggregate demand leads to an upward pressure in prices. Such a situation is
called DPI. This can be explained graphically.
Just like the price of a commodity, the level of prices is determined by the interaction of
aggregate demand and aggregate supply. In Fig. 4.3, aggregate demand curve is
negative sloping while aggregate supply curve before the full employment stage is
positive sloping and becomes vertical after the full employment stage is reached. AD1 is
the initial aggregate demand curve that intersects the aggregate supply curve AS at
point E1.
The price level, thus, determined is OP1. As aggregate demand curve shifts to AD2,
price level rises to OP2. Thus, an increase in aggregate demand at the full employment
stage leads to an increase in price level only, rather than the level of output. However,
how much price level will rise following an increase in aggregate demand depends on
the slope of the AS curve.
(ii) Causes of Demand-Pull Inflation:
DPI originates in the monetary sector. Monetarists’ argument that “only money matters”
is based on the assumption that at or near full employment excessive money supply will
increase aggregate demand and will, thus, cause inflation.

An increase in nominal money supply shifts aggregate demand curve rightward. This
enables people to hold excess cash balances. Spending of excess cash balances by
them causes price level to rise. Price level will continue to rise until aggregate demand
equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector or the real sector.
Aggregate demand may rise if there is an increase in consumption expenditure
following a tax cut. There may be an autonomous increase in business investment or
government expenditure. Government expenditure is inflationary if the needed money is
procured by the government by printing additional money.
In brief, increase in aggregate demand i.e., increase in (C + I + G + X – M) causes price
level to rise. However, aggregate demand may rise following an increase in money
supply generated by the printing of additional money (classical argument) which drives
prices upward. Thus, money plays a vital role. That is why Milton Friedman argues that
inflation is always and everywhere a monetary phenomenon.

There are other reasons that may push aggregate demand and, hence, price level up-
wards. For instance, growth of population stimulates aggregate demand. Higher export
earnings increase the purchasing power of the exporting countries. Additional
purchasing power means additional aggregate demand. Purchasing power and, hence,
aggregate demand may also go up if government repays public debt.

Again, there is a tendency on the part of the holders of black money to spend more on
conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is
caused by a variety of factors.

(iii) Cost-Push Inflation Theory:

In addition to aggregate demand, aggregate supply also generates inflationary process.
As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is
usually associated with non-monetary factors. CPI arises due to the increase in cost of
production. Cost of production may rise due to a rise in cost of raw materials or increase
in wages.

However, wage increase may lead to an increase in productivity of workers. If this hap-
pens, then the AS curve will shift to the right- ward not leftward—direction. We assume
here that productivity does not change in spite of an increase in wages.

Such increases in costs are passed on to consumers by firms by raising the prices of
the products. Rising wages lead to rising costs. Rising costs lead to rising prices. And,
rising prices again prompt trade unions to demand higher wages. Thus, an inflationary
wage-price spiral starts. This causes aggregate supply curve to shift leftward.
This can be demonstrated graphically where AS 1 is the initial aggregate supply curve.
Below the full employment stage this AS curve is positive sloping and at full em-
ployment stage it becomes perfectly inelastic.
Intersection point (E1) of AD1 and AS1 curves determine the price level (OP1). Now there
is a leftward shift of aggregate supply curve to AS 2. With no change in aggregate
demand, this causes price level to rise to OP2 and output to fall to OY2. With the
reduction in output, employment in the economy declines or unemployment rises.
Further shift in AS curve to AS3 results in a higher price level (OP3) and a lower volume
of aggregate output (OY3). Thus, CPI may arise even below the full employment (Y F)
stage.
(iv) Causes of Cost-Push Inflation:
It is the cost factors that pull the prices upward. One of the important causes of price
rise is the rise in price of raw materials. For instance, by an administrative order the
government may hike the price of petrol or diesel or freight rate. Firms buy these inputs
now at a higher price. This leads to an upward pressure on cost of production.

Not only this, CPI is often imported from outside the economy. Increase in the price of
petrol by OPEC compels the government to increase the price of petrol and diesel.
These two important raw materials are needed by every sector, especially the transport
sector. As a result, transport costs go up resulting in higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions
demand higher money wages as a compensation against inflationary price rise. If in-
crease in money wages exceed labour productivity, aggregate supply will shift upward
and leftward. Firms often exercise power by pushing prices up independently of
consumer demand to expand their profit margins.

Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in
cost of production. For instance, an overall increase in excise tax of mass consumption
goods is definitely inflationary. That is why government is then accused of causing
inflation.

Finally, production setbacks may result in decreases in output. Natural disaster, gradual
exhaustion of natural resources, work stoppages, electric power cuts, etc., may cause
aggregate output to decline. In the midst of this output reduction, artificial scarcity of any
goods created by traders and hoarders just simply ignite the situation.

Inefficiency, corruption, mismanagement of the economy may also be the other

reasons. Thus, inflation is caused by the interplay of various factors. A particular factor
cannot be held responsible for any inflationary price rise.

4. Effects of Inflation:
People’s desires are inconsistent. When they act as buyers they want prices of goods
and services to remain stable but as sellers they expect the prices of goods and
services should go up. Such a happy outcome may arise for some individuals; “but,
when this happens, others will be getting the worst of both worlds.”

When price level goes up, there is both a gainer and a loser. To evaluate the conse-
quence of inflation, one must identify the nature of inflation which may be anticipated
and unanticipated. If inflation is anticipated, people can adjust with the new situation
and costs of inflation to the society will be smaller.

In reality, people cannot predict accurately future events or people often make mistakes
in predicting the course of inflation. In other words, inflation may be unanticipated when
people fail to adjust completely. This creates various problems.

One can study the effects of unanticipated inflation under two broad headings:
(a) Effect on distribution of income and wealth; and

(b) Effect on economic growth.

(a) Effects of Inflation on Distribution of Income and Wealth:
During inflation, usually people experience rise in incomes. But some people gain
during inflation at the expense of others. Some individuals gain because their money
incomes rise more rapidly than the prices and some lose because prices rise more
rapidly than their incomes during inflation. Thus, it redistributes income and wealth.

Though no conclusive evidence can be cited, it can be asserted that following

categories of people are affected by inflation differently:
(i) Creditors and debtors:
Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms.
When debts are repaid their real value declines by the price level increase and, hence,
creditors lose. An individual may be interested in buying a house by taking loan of Rs. 7
lakh from an institution for 7 years.

The borrower now welcomes inflation since he will have to pay less in real terms than
when it was borrowed. Lender, in the process, loses since the rate of interest payable
remains unaltered as per agreement. Because of inflation, the borrower is given ‘dear’
rupees, but pays back ‘cheap’ rupees. However, if in an inflation-ridden economy
creditors chronically loose, it is wise not to advance loans or to shut down business.

Never does it happen. Rather, the loan-giving institution makes adequate safeguard
against the erosion of real value. Above all, banks do not pay any interest on current
account but charges interest on loans.

(ii) Bond and debenture-holders:

In an economy, there are some people who live on interest income—they suffer most.
Bondholders earn fixed interest income: These people suffer a reduction in real income
when prices rise. In other words, the value of one’s savings decline if the interest rate
falls short of inflation rate. Similarly, beneficiaries from life insurance programmes are
also hit badly by inflation since real value of savings deteriorate.

(iii) Investors:
People who put their money in shares during inflation are expected to gain since the
possibility of earning of business profit brightens. Higher profit induces owners of firm to
distribute profit among investors or shareholders.

(iv) Salaried people and wage-earners:

Anyone earning a fixed income is damaged by inflation. Sometimes, unionised worker
succeeds in raising wage rates of white-collar workers as a compensation against price
rise. But wage rate changes with a long time lag. In other words, wage rate increases
always lag behind price increases. Naturally, inflation results in a reduction in real
purchasing power of fixed income-earners.

On the other hand, people earning flexible incomes may gain during inflation. The
nominal incomes of such people outstrip the general price rise. As a result, real incomes
of this income group increase.

(v) Profit-earners, speculators and black marketers:

It is argued that profit-earners gain from inflation. Profit tends to rise during inflation.
Seeing inflation, businessmen raise the prices of their products. This results in a bigger
profit. Profit margin, however, may not be high when the rate of inflation climbs to a high
level.

However, speculators dealing in business in essential commodities usually stand to gain

by inflation. Black marketers are also benefited by inflation.

Thus, there occurs a redistribution of income and wealth. It is said that rich becomes
richer and poor becomes poorer during inflation. However, no such hard and fast gener-
alisation can be made. It is clear that someone wins and someone loses during inflation.

These effects of inflation may persist if inflation is unanticipated. However, the

redistributive burdens of inflation on income and wealth are most likely to be minimal if
inflation is anticipated by the people. With anticipated inflation, people can build up their
strategies to cope with inflation.

If the annual rate of inflation in an economy is anticipated correctly people will try to
protect them against losses resulting from inflation. Workers will demand 10 p.c. wage
increase if inflation is expected to rise by 10 p.c.

Similarly, a percentage of inflation premium will be demanded by creditors from debtors.

Business firms will also fix prices of their products in accordance with the anticipated
price rise. Now if the entire society “learn to live with inflation”, the redistributive effect of
inflation will be minimal.
However, it is difficult to anticipate properly every episode of inflation. Further, even if it
is anticipated it cannot be perfect. In addition, adjustment with the new expected infla-
tionary conditions may not be possible for all categories of people. Thus, adverse
redistributive effects are likely to occur.

Finally, anticipated inflation may also be costly to the society. If people’s expectation
regarding future price rise become stronger they will hold less liquid money. Mere hold-
ing of cash balances during inflation is unwise since its real value declines. That is why
people use their money balances in buying real estate, gold, jewellery, etc. Such
investment is referred to as unproductive investment. Thus, during inflation of
anticipated variety, there occurs a diversion of resources from priority to non-priority or
unproductive sectors.

(b) Effect on Production and Economic Growth:

Inflation may or may not result in higher output. Below the full employment stage,
inflation has a favourable effect on production. In general, profit is a rising function of
the price level. An inflationary situation gives an incentive to businessmen to raise
prices of their products so as to earn higher volume of profit. Rising price and rising
profit encourage firms to make larger investments.

As a result, the multiplier effect of investment will come into operation resulting in a
higher national output. However, such a favourable effect of inflation will be temporary if
wages and production costs rise very rapidly.

Further, inflationary situation may be associated with the fall in output, particularly if
inflation is of the cost-push variety. Thus, there is no strict relationship between prices
and output. An increase in aggregate demand will increase both prices and output, but a
supply shock will raise prices and lower output.

Inflation may also lower down further production levels. It is commonly assumed that if
inflationary tendencies nurtured by experienced inflation persist in future, people will
now save less and consume more. Rising saving propensities will result in lower further
outputs.

One may also argue that inflation creates an air of uncertainty in the minds of business
community, particularly when the rate of inflation fluctuates. In the midst of rising infla-
tionary trend, firms cannot accurately estimate their costs and revenues. That is, in a
situation of unanticipated inflation, a great deal of risk element exists.

It is because of uncertainty of expected inflation, investors become reluctant to invest in

their business and to make long-term commitments. Under the circumstance, business
firms may be deterred in investing. This will adversely affect the growth performance of
the economy.

However, slight dose of inflation is necessary for economic growth. Mild inflation has an
encouraging effect on national output. But it is difficult to make the price rise of a creep-
ing variety. High rate of inflation acts as a disincentive to long run economic growth. The
way the hyperinflation affects economic growth is summed up here. We know that
hyper-inflation discourages savings.

A fall in savings means a lower rate of capital formation. A low rate of capital formation
hinders economic growth. Further, during excessive price rise, there occurs an increase
in unproductive investment in real estate, gold, jewellery, etc. Above all, speculative
businesses flourish during inflation resulting in artificial scarcities and, hence, further
rise in prices.

Again, following hyperinflation, export earnings decline resulting in a wide imbalances in

the balance of payment account. Often galloping inflation results in a ‘flight’ of capital to
foreign countries since people lose confidence and faith over the monetary
arrangements of the country, thereby resulting in a scarcity of resources. Finally, real
value of tax revenue also declines under the impact of hyperinflation. Government then
experiences a shortfall in investible resources.

Thus economists and policymakers are unanimous regarding the dangers of high price
rise. But the consequence of hyperinflation are disastrous. In the past, some of the
world economies (e.g., Germany after the First World War (1914-1918), Latin American
countries in the 1980s) had been greatly ravaged by hyperinflation.