CHAPTER

2
Some Basic Concepts in
Business Economics
The Concept of Cost
❖ Private Costs and Social Costs
❖ Opportunity Cost
❖ Money Cost : Explicit and Implicit Costs
Marginalism
❖ From Marginalism to £qui-Marginal Principle
lncrementalism
Time Perspective
r
Time Value of Money-Discounting Principle
Risk and Uncertainty
The Concept of Profit
+ Gross Profit and Net Profit
+ Normal and Supernormal Profit
b Firm, Industry and Market
+ Firm
+ Industry ...
+ Market
-- - - - - - - - - - ·--- --- - - - - • - 0..--C - .~ ~ ·-

- T~E CONCEPT OF CO~T . .

Private Costs and Social Costs
Every firm requires various inputs to produce a good. In order to secure a command over ·
ln .....11h, T¥> r,ri.mmnn nol"lonrP thP
 .:.=------------_;:~:;;;;;:;;;~::::~:::::U:.;)~lNEss e
-- 0
" . iaid is known '.
, Jl ·ouonusls, however,
•1s cosl, ..,c
I

1 ·
•

. duccr on pure iasmg (or hirin )

•
coNo I
include in th e Pti. ~l~
~•~
~
ant~~vo~: ~:~;c~~ i\urc Incurred .~y /'~~}:1fs 0 the imputed cost of all thos/se:, fact :~
no do1·t:101l (or inputs) from the nuu <e : ate cost of
ptoduciion of any output th Ices \vL, ~ft
j)l'O uc .d ' The pnv ll d . '"4y 01•111 ,
the p1'0duccr himself prov1 ~s. r the imputed value of a pro_ ?Clive services this~ d
ddined a~ either lhl' pur~Jias:l~alcnt lo the total monelaty sacrifice of the fil'!n Used\~
producing the output and is eq llladel I
·1 • ' h I
serure 1. l th j
l
1 d 'h
11ists inclu e ' e following expenditure m t e· cost: (i) cost f 1

General l', econo th (iii) interest payments on capital loans, (iv) 0 er;
materials. (ii} wages of e labo_u:e;s~osts of machines and depreciation, (vi) tax p;ent 1
1
*,
~:~
land and the buildings,(~) :C~~m~vii)
0 imputed wage payment to the Producer for :e%~ 0
the go1·emment and l~~a. interest pa:vment for the capital invested by the e %11
p~rfor~1e~ by himf,I(v11d1) m:f:uildings owned by the producer himself, and (x) nonn Plr Oduee,
lumself (u} rent o an an . • d d• h . a Ptofi~
' This. shows th at three types of expenditures are me1u e m t e Prtvate cost·· (,,r1 t~
of the firm. . . h .
urrhase ·ce of tlte factors of production employed m t e production Process, (i1) i111p111
;rice of a:':esources provided by tlte producer himself; mid (iii) norma1 profits. ti
Social costs differ from private costs on account of two reasons :

First, externalities are not induded in private costs. For example, a factoiy located in the
residential area by polluting the atmosphere will expose the residents of the colony to van
ailments and will thereby raise their medical expenditures. Though these costs are quite 0115
of
relevant from the point of view of the society they will never be considered by the finn as part
its costs.

Seanzilly, market prices of goods· may not reflect their social value and tltus tltere may be
divergence between /lrivate and Socia/ <XJSts. The imposition of government taxes, subsidies, and
controls of various kinds distort free market prices. Further, prices Of factors of productioo
may overstate or understate the opportunity cost of using those factors (the concept of
opportunity cost is discussed below). In heavily populated countries where widespread
disguised unemploYment is found in the agricultural sector, the industrial wages often exce:ds
th
the opportunity cost of the labour which is drawn from the agricultural sector. In computing
th st costs, adjusted market prices for goods and factors of production are used. While
e social
e adjuas sociaJ
termed for factors are called sltadow prices' the adjusted prices for goods are
Pria!s.
ed Prices
Opportunity Cost 1

0
In modern ec n · 1 • f th factors of
• • omic ana ys1s, the problem of choice arising out of the e . of the
production is considered to be the ma.in problem. It is this problem that forms Othe basis ally
concept
most of Opportunity cost, sometimes
bof the factors hav It . called alternative cost. We all know ath~t ou a
Jobgen;:f
num1 er of alternative
1 . 1·obs
e a Lernattve
t uses. For example ' a graduate can c rnose1 in some bank or
1
t' t h . . · e us suppose that he can become either a c1eH . lt neously.
b;h ic {: c ~c ce~1t{allways, Naturally, he cannot assume both of these jobs s1:\:ooses to
ere ore, . e w1 checker
a ticket h hiobII Which
c oose that h he regards as most beneficial
. bto him. If a eb an k clerkt
ming
ecome
.
S1mdarly,
of . we
. resources;
if andcanweproduce Sa quJntaJs
• e 100
choasa.ta . ave toofforego opportumty
the ~",.
Wheat,,, _, " of.. eco. , .____ .maun
 SOME BASIC CONCEPTS IN BUSYNESS ECONOMICS
19

from both of these options we st 11 1

cotton. The economists di ~ t~n ,ave to forego the oppor lunity of producing 30 bale of
only. ~ s uss c concept of alternative or opportunity cost from this angle

An opportunity cost or alt .

employment. crnuttvc cost is the value of a resource Jn a foregone

The concept of opportunit , .

concept of cost \Vheth . y c? st 15 very nnportant. Actua1ly, it forms the basis of the
e1 we examme th.e qucs t'1011 0 f cost from the point of view of the firm
or the entire economy th ·
decision to produce ~, e con~ept of opportunity cost is of immense value. While making a
value of the altemati some parh~ular commodity, the firm will always have to consider the
nO\\' producing Th velcomfmodity that it has abandoned in favour of the commodity that it is
the 0 ood that the · fi e va· ue o the alternativ
. e comma d't · fact, be th:e opportunity cost of
1 YWI·11 , m
t, rm IS now producmg. ~

To.) understand
Le the concept Of opportumty . cost, consider . the following· examples:
(z . of X m . a specified period or 10
t usofsuppose
units sama ma ~ h'me ~ai:i pro d uce ~O umts
yin thethat
for the producti
. _ on °f ,
ie~10d. If It Is ~ngaged m the production of X, it cannot be used
1.e., product10n of X entails the 'sacrifice' of the opportunity
. to produce Y. In this example, opportunity cost of 1 X is½ Y.
(zi) If a person _decides ~o hold cash instead of investing it somewhere, the opportunity
.. cost of holding cash IS the amount of interest that he has sacrificed for the purpose.
(zzz1 The opportunity cost of putting one's labour in one's own business is the income one
could have earned by working somewhere else. ----
As is clear from above, calculation of opportunity costs involves the ~eas1nement of
acrifice Since resources are limited, sacrifices are always involved in any economic decision.
erefore, the concept of opportunity cost is very important.

oney Cost : Explicit and Implicit Costs

The concept of money cost in contrast to the concept of opportunity cost is simple. The
ney cost of production of any output is considered to be equivalent to tile total monetary _
rfice made to obtain that output. Thus costs are not sacrified alternatives but monetary
ayments. However, this conception of money cost is narrow and is used for accounting
;urposes. From the point of view of the economists, this concept of cost is not very relevant.
,ince economists wish to study as to how costs affect output choices, employment decisions,
p.d the like, costs should include imputed value of all the inputs provided by the producer
~mself in addition to outright money expenses. Accordingly, costs are· divided into (i) explicit
osts, and (ii) impUcit costs.
Explidt costs arise from transact,ions between the firm and other patties itt rvlliclt tlte /onner
urchases inputs or ser1Jices of inputs for carrying out the p1·0,t11ction. These costs are usually
1e costs shown in the accounting statements and include wage payments, raw material costs,
1terest on loans, payments for insurance, electricity as so on . lmp/icit costs al'e tlte costs
ssodated with the use of the firm's own resources. Since the resources will bring some return
employed elsewhere, their imputed values constitute the implicit costs. Implicit costs _are,
:iwever, difficult to measure. Economists nonetheless assert that they must be taken mto
a c• •
 20

MARGINALfSM
•
- - =-c>-"--'-'- ~
' 'c
f;

~ hH an t¼lhliltonnl umt of labour or capital should be

\\ ht
--
hi1 dl"Ch
ncc-d tt kno,\ the additional output expeclcd therefr om. As 1employ
i~;g
1
l
tutn -c~c Cl'ds th~ cost of additional unit of labour (or capita]) as ad
at un1t Worth

1~ t: ·t : t.. re the business decision\\ ould be as follows :

.
ue Co produce the commodity as long as marginal
The firm shoul d contin
p f' . re
• :a are maxunJscd at the point where marginal Ven1
e ceeds margma1 cost ro ,ts
revenoe
• equal t-0 marginal cost.
•~
But hat exactly are ·marginal revenue' and 'marginal cost' ? Consider marginal rev
•ir,....,.; nrrr • "'1.-J: d ' l'eceived by selling £moth ( er
rsL ·um5u uu 1'e"Je11Ilf lS 1.K.J&ltC as the amount of IIIOlleJ-
mar~ 'i'1"rg;
urJt of the ronzmodity. For instance, if n units of a good are sold, then the gina reve!:
of the .ih unit is defined as
MRn = TRn - TRn _1
L, a similar ,va.!7, marginal cost of nth unit will be
A1Cn = TCn - TC,1- I
than the c
As long as the revenue obtained by selling the marginal unit is greater
tes profit. Therefu:>
·ncurred in producing it (i.e. as long as MR exceeds MC), the firm genera
from selling i
it will produce that unit. It will stop at that point where revenue obtained
where MR= \1
additional unit is equal to the cost incurred in producing it. i.e., at the point
This is .due to the reason that if production is carried on beyond this
point, MR will be'tll
than A1C, i.e., firm will incur loss on the marninal unit.

From Marginalism to Equi-Marginal Principle

uses
According to the equi-marginal prindple, an input must be allocated among various
all tlte use~~
such a way that the value added by the last unit of the i1tput is the same in
a firm working
results in maximum returns for the firm in question. To illustrate, consider
2.1 illustrateS m
three different projects A, B and C and possessing six units of labour. Table
marginal outputs from different units of labour employed in these projects.
TABLE 2.l : IJlustration of Equi-Marginal Principle

rers
No. of
Project A___
Marginal outpu
--- ~·~
~
-- - -
B
17.E}ect
t from
------------
Pro~C
14
-- -labou
1st 18 16
12
14
2nd 16 10
12
3rd 14
JO
4th 12
8
5th 10
6
8
6th
 21
...._
SOME BASIC CONCEPTS I N BUSINESS ECONOMlCS

A little working
3 labourers on the on
are employed ~
P; 1,ows th at the o~limum
Tabl" . , of labour 1s
allocation . that wherein
maximum total product 0 J_ccl
A, 2 on l'roiccl ll and 1 on Project C as in this case a
allocation would result . almountmg to 48 + 30 + 14 92 units is obtained Any other
~
each project. a total t m ower
f output F . I
· 01 exnmp c, ' '1 2 . of 1ab our are employed on
umts
other options. Ou put O 34 + 3 o + 26 = 90 units is obtained. The student can work out

firm\\Te
employs
h8\ e more
considered
th the .casc Of one mput
. (labour) in the above example. However, the
productivities MP ,.:; on~ mput. If th e firm employs th ree inputs A, B and C with marginal
the equi-maroinal a, . _b ~n M~, respectively and their prices are Pa, Pb and P, respectively,
b pnncip e requires the fulfillm ent of the fol.lowing condition :

'J\1Pa 'J\1P A!P

- -= ----c
Pa Pb - Pc
The ratio of ~arginal productivity of each input (or factor) to its price should be the
same for all the inputs (or factors of production).

, ~e c?nc~pt of •~cremen_talism' is basic in undertaking business decisions. It is similar to

margtnalism but with a .difference. In the discussion above, we have stated that the
'marginal' concept is associated with 'a unit' change. However, in most of the cases, business
firms produce and sell their products in bulk and not in units. Therefore, the business firms
take their decisions on the basis of incremental revenue and incremental cost and not on the
basis of marginal revenue and marginal cost.
Let us now try to understand what incremental cost and incremental revenue is.
Jnaemental cost is defined as the change in total cost that arises due to business decision (i.e.,
as a result of a change in the level of output, investment etc.) In a similar way, incremental
revenue is defined as the change in total revenue that arises due to a business ilecision (i.e. as a
result of a change in the level of output, investment etc.) Correct incremental analysis requires
that all direct and indirect changes in revenue and costs resulting from a particular course of
action be taken into consideration. The business decision rule would be as follows :
I

The firm should change the price of a product or its output, introduce a new product,
or a new version of a given product, accept a new order, etc., if the increase in total
revenue or incremental revenue from the action exceeds the increase in total or

incremental cost. 1
To illustrate, let us suppose that a business firm receives an order for the supply of 50
additional units of its product. Let us suppose that meeting this order w_ould add to cost _of
production b} Rs 10 lakh ( Hs 'l lakh in terms of labour cost, Rs. 5 lakh m terms of ~ater1al
ost and Rs 2 takh in terms ol overhead cos() ln other words, the incremental cost ts _Rs. 10
lak h lf the addi •ional prod uc u un 1s expected to increase the total revenue of t!te firm by

1. Dominick Salvatore, Managerial Economics in a Global Economy (Thomson Asia Pvt. Ltd.,
,---.J:. :.n.n 3003).,_ . 504.
 22 BUSINEss E

. .
!{s. 12 lakh, the tncrcmcnlal revenue wmtld he Rs. 12 lakh. Smee m this cast
. -~
th order. '\ 60MEBAS1
mcrcmcntal rcv('nue exceeds inctemcutal cosl, the Orm shouJc.l accept c
.It. is clear from the discussion above, both 'marginaJ' an.cl 'incremc_nt~l' concepts . than R.
18
l . adchtional production or sule. However while the rnargmal analysis
. ' ' t d b a ·
related t ¼ R 110,
o
cIiangc 111 production, the incremental analysis is not rc 1r1c e Y unit change ~
5 uffered
• · any number of · · 111 110 nex1
word s, mcrcmcntal analysis could be related with a change in units
110 one
Tl sh
As. C
· - · . • ( ') market period f Qt -,ery sh
E~cononusts generally classify time penod mto z • • on l'tJ
short run and (iii) long run. 111 market period, the supply 01output ~s total~ fixed. l'heref.
'bl · 1·t As agamst •his in L_ •
response to demand changes, no changes are poss1 e in · : ' s,.vrt l'ltir, wew
increases in the supply of output are possible by increasing ~he use of vanable fa_ctors like~ Q1+
a11d ,·aw material or by better utilisation of existing capacity. Ho~ever, fixed mputs like then
th 1 t
and machinery cannot be altered. Nor can new firms enter e ~duS ry. In the long.'IQ
factors are variable, i.e. there are no fixed inputs. Therefore, a1:y mput can be changec_
t
plants are machinery can be set up and new firms can enter the mduS ry.
The above time perspective is crucial for the manager of ~ firm. However, his
distinction is slightly different from ~he economist's time perspective. Instead of viewin
perspective according to whether inputs are variable or not, he sees it in tenns of ' ~
future' and 'remote future'. Therefore, short-run for a manager is immediate future whiu,.
run is remote future. He studies the present problem in the light of past data to ar6
certain conprete decisions. The decisions should be such as take account of short-run
long-run implications. Thus, the decision of the manager should consider the implic~
both in the immediate future and the remote future. To illustrate, let us suppose ti:
manager takes into account only the immediate ~ture and raises the price of his pre.
exorbitantly to increase profits. This will undoubtedly raise his profits in the immediate fr:
but can lead to serious fall in his sales in the remote future leading, in turn, to a sharp dt~
~ in profits .. Consider another example. Let U$ suppose that in a bid to cut down on costs.
management of a company cuts down expenditure on labour welfare. From a short··
perspective, th~s might help the_ company in reducing costs and increasing profits. Howe\?
!
the 0 g-run, th_is can have a serious adverse effect on labour productivity leading, in turn, r
fall m production (and, hence; profitability). ·
~oth the examples considered above show that the management of a company sh1
dta ke. mto
. A · t e fu ture and the remote future while arriving at anv ~
account both the im me d Ia
ec1s10n. proper balance between the short-run perspective and the long run persp~c~·
a must. -

The concept of discounting is -based on th • . · ·· - .· h~

than rupee tomorrow. For exampl . I t e simple notion the a rupee today is wort I
today or Rs. 100 next year. Natura;; ~ us -:~ppose that a person is given a choice of Rs-¢
(i) the future is uncertain and one ny e wl1 choose Rs. 100 today. This is due to two r~ \1

. ever {nows wh t '11 h d ('') JV'

rece1ved today can be invested to . a WI appen tomorrow; an H ~,
earn interest so that by the end of the year, it will be
SOME BASIC CONCEPTS I N B USINESS ECONOMICS 23

than Rs. 100. For CXUlllJ)l 1·r l rate ir t

Rs. 110 at the end of thee,year.t 1cHnd •
11/ rt est Js 10 per cent per unnum, the person would get
suffered a loss of Rs. 10 . . opted for Rs l00 aflcr one year he would have thu
. 1 11 ts s11ows thnt 1'f ti 1 . '
11 0 next year would be cq• ,t' , c rnlc of interest is 10 per cent per annum Rss
110 one year hcncf• will be H
~ iva,cnt to Hs 100
'· . now. In other words, the pre ent worth of Rs.
, .

As 1s clear from this cxami>l ,111

ir
Thi~ shows that the present w:; 10 :~sd~y (if the rate of interest is 10 per cent per annum).
· OO one year hence would be less than Rs 100 today
T 1c present value (or ,vorlh) c, i 110w much less' .wou Id be d ctermmcd . by the rate of interest.
l T d 8 a 1so 1mown as 'discounted value'

o un erstand how present v 1 . .

one~ ear at the rate of interest . a ue 15 calculated, let us suppose that Rs. Qare invested for
\\C \\Ould get Rs. iQ as intere~/ :t~· tent: compounded annually. Thus, at the end of the year
Q(l +z) rupees. If the initial '"Us \\_11cd1, _with the return of principal Q, would give us Q + iQ =
then "e get the expression ., m 1s es1gnatcd as Q o an , d h
l e sum at the end of one year as Qi

Q1 = Qo (1 + i) ... (1)
If Qo is invested for another year, we would get
Qi= Q1 ( 1 + i )
after 2 years. However, since Q1 = Qo (1 + i) , it follows that
Qi= Qo (1 + i)2
If Qo is invested for 3 years, we would get
Q; = Qo ( 1 + i) 3
after 3 years, and so on. In general, if Q 0 is invested for t years, we would get
... (2)
Qi = Qo (1 + i) t
after t years.
Now, consider equation (1) again. This can be written as
Q1
Qo = 1+ i
Here ~i is known as the discount rate. ~ i is the discounted presmt t•alue of Q 1
1
receivable1one year from today. For example, if the opportunity rate of interest were 10 per
1
cent, i = 0.10 and the discount rate is + 0.l0 = / 10 . Thus we would conclude that Rs. 100
1
receivable at the end of one year has the present value of Rs. ~~~ = Rs. 90.91 because with 10
per cent opportunity rate of interest, Rs. 90.91 would grow to Rs. 100 in one year.
From equation (2) it can be seen that the present value Qo of Q, available t years hence is

given by
Q,
Qo = (1 + if
To illustrate, Jet us suppose that a firm hopes t_? cam Rs. 13,3 lQ ofter a period ?(3 years
and the opportunity rate of interest is 10 per cent. 'I he present value would then be given by
Q3 13,310 I 10 000
Qo = . 3 = (110)3 == ~s. ,
(1 + t) .
 011-4
m 11 . Ot.,•ts..
' 10 pe r ce nt pe r an nu c yi eld R ,,
ra te of
:i~·
.
e~sd li, 30 00
o
in
ye ar s.
ve st ed to da y, at th e
., , th .
, w ou
S, 13 3
' lo soME 1.

pp os e th at R i, ~'< 2 • p'J .. · 1'-11 a 1 c c. yi el ds of th c as se t Whose

. i

In_ ge ne ra l, Je• t us su lh u
1 ·
es tim at ed an d P is its di sp os al vn lu c · Th en c pr es en t va ]u c of that,.,<1.sset iPres e~ ins
va ue is to be s&iv as s
by , ~ un f
R, R 1
P\ = R1 ') + R2 + + ... + (1 f.,,i) "+ (l + z) n
( 1 +1 (I + i) 2 (l 1- i)3
ng da ta :
t a co nc re te ex am pl e. A firm ha s th e fo llo wi
Le t us 11 0\V \\' Or k ou
1. Th e co ~t of th e pl
an t is Rs. 50 ,0 00 .
s.
ed us ef ul ec on om ic life of th e pl an t is 5 year
2. Th e ex pe ct
Its esti111 ate d di sp os al va lu e is Rs. 16 ,0 94 .1
3.
tu rn s sp re ad ov er 5 ye ar s ar e Rs. 16,094.1
ed re
4. Th e an nu al ex pe ct .
ity ra te of in te re st is 10 pe r ce nt pe r an nu m
5. Th e op po rt un
e pl an t is given by
Th e pr es en t va lu e of th 16 ,0 94 .1
16 ,0 94 .1 + 16 ,0 94 .1 + 16 ,0 94 .1
P\1 _ 16 ,0 94 .1 2 (1 .10)3 (1.10) + (1.10)6
5
- 1. 10 + (1 .1 0)
+ 10 ,9 33 + 9, 99 4 + 9, 99 4 = Rs. 71,005 of
= Rs. 14 ,6 31 + 13 ,3 01 + 12
,0 92
plant a
. 71 ,0 05 is gr ea te r ta n th e co st of th e 14
es en t va lu e Rs re
Since th e di sc ou nt ed pr re
50,000, this ipvestmen
t i~ pr of ita bl e.
to

kn ow n, there is an eleme
nt~ p
re . Si nc e fu tu re is un
d ou t fo r fu tu . A cc or di ng to Hawley, the 0
n
Al l pr od uc tio n is ca rr ie th e bu si ne ss de ci sio ns
ciated w ith m os t of se d. Th es e ar e replacement
risk an d uncertainty asso en tr ep re ne ur is ex po
w hi ch al m os t ev er y s fr om th e depreciatior f
ar e fo ur ty pe s of ris ks to e re pl ac em en t ris k ar ise
er an d un ce rta in ty . Th ph ys ic al life of the plan: b
ob so le sc en ce , ris k pr op n po ss ib le to kn ow th e
d m ac hi ne ry . It is of te po ss ib le to ca lc ul at e rep
lacemeili
of th e ex ist in g pl an t an . H ow ev er , it is no t
n is ca lc ul ab le y. Prices ha ve never rem
ained
an d th us th e de pr ec ia tio es su re s in th e ec on om
to in fla tio na ry pr ev er be su re as to how
mucn
co st w ith ce rta in ty du e en tr ep re ne ur ca n
ds , an d th er ef or e no rth er , ob so le sc en ce is n~v
e'.
st ab le ov er lo ng pe rio pl an t or m ac hi ne . Fu
re pl ac e hi s w or n ou t d qu al ity of technologtc
ai
fu nd s he w ou ld ne ed to ip at e th e sp ee d an
is no t po ss ib le to an tic th e marketability ~f thlhe
ca lc ul ab le be ca us e it e ri sk as so ci at ed w ith
aw le y, ris k pr op er is th e ca lc ul at io ns of ~
ch an ge . A cc or di ng to H an ge w hi ch up se t th
st es an d fa sh io ns ch sp on se to th e gr ow in g
derna~~e~
pr od uc e. O ve rt im e ta in th e in du st ry in re
es ne w fir m s jo r. A pa rt fr om the_se relat
;
en tre pr en eu rs . So m et im an of th e en tre pr en eu 1

y up se t th e sa le s pl th e bu si ne ss w hi ch rna
e
th e pr od uc t an d th er eb fo re se en fa ct or s in
e al w ay s so m e un
kn ow n fa ct or s th er e ar t in ac co rd an ce w ith th e pl
an s.
en tre p; en eu r to ac 01
difficult fo r th e h be tw ee n tw o typ es
of F. H . K ni gh t, ec on om is ts ~no w di st in gu is
. Following the lead d (i1) unforeseeable.
ns ks : (1) foreseeable an
fo re seen an d pr ov id ed ag ai ns t through insura:;
rl_sk ~h ic h ca n be re d tbro
. _Fo~eseeable risk is th at e sh ip et c. ar e fo re se ea bl e an d ca n be co ve
th at h, sm km g of th
Risks hk e fire, eft, de
 <; ::J::3' IC)C :.2: I V' + .Jll il

soME BASIC CONCEPTS IN BUSINESS ECONOMICS

- . nee. Unforeseeable risks m·c tltos ,• ., ,• d
25

msura · e 11s1<s ru,11clt cmmot be foresce11 l1y the eutl'epre11eur an ,

·as such, camiot ~e covered fltl'oug/r i1ls111·a1Lcc. For cxumple, the risk of commercial loss is an
unforeseeable nsk a_nd_ cannot be provided aguinsl. J(11igl,t calls unforeseeable risks as
'uncertai11t)'~ Uncertamttcs or non-insurable risks con be of the following four types:
1. Compct_itive unccrtaintie s. The firm always fears competilion from the other firms in
the mar!~et. It IS generally s:cn that_ whenever the prospects for earning high profits exist in a
certain mdu stry many new hrms brmg out somewhat differentiated (but similar) products and
increase the element of ~ompetition in the market. Many buyers are attracted towards these
new products that come mto the market and the old firm suffers setbacks as the price as well
as its profits tend to decline.
2. Technological uncertainties. Technological progress is taking place at a very rapid
pace in the modern day world and many plants and machinery become obsolete and useless
fairly early (in fact, long before depreciation renders them obsolete). At times, the old
machine gets obsolete immediately on the appearance of new machines. This rapid pace of
technical progress has created heavy uncertainty in many industries and other productive
activities.
3. Cyclical uncertainties. The capitalist economy has to pass through the cyclical phases
of booms and depressions. Under conditions of depression the demand in the market falls
and, consequently, prices also suffer a decline. Since depression in the capitalist system is the
result of internal contradictions within the systerri itself, the firm cannot hope to stop (or
reverse) it through its actions Even the giant companies of the Western world have no answer
to the risk arising out of depression.
4. Uncertainties caused by government policies. The governments at times anno"tmce
policies that have severe repercussion on the industrial activity. For instance, the government
may decide to enter into some production activity itself or it may remove import restFictions
or it may devalue its currency, etc. Some policy decisions of the government can have
favourable and some unfavourable effects on the activities in the private sector. Naturally the
usinessmen and entrepreneurs face uncertainty on account of this reason.
Business decision making in conditions of risk and uncertainty can be undertaken with
e help of the mathematical theory of probability.--This theory is used for calculating
athematical expectations of various possible alternative actions. That action is chosen which
~as the highest expected value. However, the use of probabilities involves making a number of
~sumptions and is therefore not totally reliable. It is ultimately the management's judgement
Uiat matters.

. ~-- ---- - - THE CONCEPT OF PROFIT .

'

~ In a capitalist economy the entrepreneur performs important functions in production and

he is rewarded for his services in the form of prpfit An entrepreneur generally performs two
kinds of functions:
First, he combines and organises the various factors of production in order to carry out
production according to his plans.
Second, he bears the risks or uncertainties associated with prnduction. These are certainly
-!------- - - - - - - - - - - - - - - ~---8:..:;USINess
!6
.
. . ~
y where product1011 1s und ertaken entirely f
ti rns m nn econ om
important fun~ < • ,. t . 1 over the price and sa 1cs. or t
ht soME s
1
and the producers huve lttt c con to . , .
, . ~ t importance to thi s role of entrepreneur m producr
Hawtcv attaches gt cu . I f ti lreprcncur 10 ~ ~
-~ . ·at". ¥profits with the risk-bcnrmg tas < o 1e en . . return
assoc1, ... s ' · · · h d b
Kni ht disagreeing with Hawley has d1 s tin gm ~ e_ etween insur retum

~~.:~~si}•;~hcc e~:.
~-H bl g .· . . He calls non -insurable risks as uncertainties an d asserts th ab
1
:~rencurs for bearing uncertainties ass~ciated with produ~tion
T.B. Clark has looked at profits from a somewhat different angle. In his opinion
a:~ ---1

static society eyerything can be anticipated, and thus entreprene~r ha~ no role to Pia-
static society, therefore, profits would not emerge. I~ a dynam~c soci ety, on the c~
changes occur in the size of population, product10n :echmques, forms of inc
organisation, supply of capital and human wants. While some of theses chant
introduced in the business by the producers themselves, some oth~rs are beyo~d their e;
\Vhatever be the causes of the changes the fact of the matter 1s that profits will ar
account of them. In order to stress this point, Clark has defined profit as a dynamics~
Joseph Schumpeter has seen the entrepreneur in the role of an innovator and pre
reward to him for this specific function. According to Schumpeter, innovation is not
some form of technological progress or resource discovery. In his opinion, the cone
innm·ation includes the introduction of a new good, the adoption of a new prodt, N
technique, the opening of a new market, the securing of control over a new source oh
of raw materials and the carrying out of new organisation in the industry.
In contrast to the views discussed above, some economists have described prot
non-functional income. M. Kalecki, Joan Robinson and E.H. Chamberlin have assoc
profits with the existence of monopoly elements in the market. In their opinion! ~
competition no longer exists anywhere and almost all economies have various kir.~
imperfections in the market giving rise to profits. Today the amount of profit which
entrepreneur earns depends greatly on the degree of his monopoly power.
Thus profits have been described differently by different economists. Clark has descr
profit as a dynamic surplus. Schumpeter views it as a return for the positive innof.
functions of the entrepreneur. Hawley and Knight underline the risk taking or uncert
bearing functions of the entrepreneurs. Perhaps each one of these factors causes emergeni
profit, but they ce_rtainly fail to account for the greater part of the profits earned b)
modern ~orpor~t10ns. Most of the profits earned by the modern corporations
non-fun~t10~al mcomes and can be explained only in the framework provided b,
economists f M. Kalecki, Joan Robinson and E.H • Chamb er1·m. BS
hke .r · t d feels th31
•. . . 1."-e1rs ea l
expositions O th e diff~rent theories of profit have taken only the partial view, and thU5
st ressed th e facto~ whic~
they thought is the most important from the point of vieW01
emergence of profit. Takmg a wider view he argues:

. "Pr~fit may come to exist as a result of monopoly or monopsony as a re-wa rd i

1
mnovatton as a reward fo th
to th • d '
' t' cu1
r e correct estimate of uncertainty factors either par 1
em ustry or general to the whole economy."2 '

2. B.S. Keirstead, Capital, Interest and Profit (Oxford : Basil Black 11) 6
we , p . .
SOME BASIC CONCEPTS IN BUSINESS ECONOMICS 27

\Ve have slated nbO\ c thl' concept of pro{it It should be now cl r th t n wag are the
return to labour, interest is \he 1 c:turn to cap,tul und tent i the return to l nd, profit 1 the
return to entrepreneur.

Gross Profit and Net Profit

Gross profit is the surplus that accrues to a firm after deducting total expenditure
from total receipts. In common usage profit l'cfers to gross profits. But there are some
items in gross profits \\ hich arc not 1n·ofits in the true sense of the term. When we
subtract these items from gross profits, we get net profits.

The most important item that has to be subtracted from gross profits to obtain net profits1
is depreciation and maintenance charges (these include the depreciation undergone by the
plant and machinery during the course of production and premiums paid by the firm on
insurance of its property, such as buildings, machinery, plant etc.). The entrepreneur often acts
as the manager of the firm himself. Therefore his salary as the manager should also be
deducted. Entrepreneurs invariably invest capital in their firms and, therefore, the imputed
value of the interest on capital invested in the firm by the entrepreneur should also be
subtracted from the gross profit

Nonnal and Supernormal Profit

Nonnal profit is a return to the entrepreneur which must be paid to him to induce
him to work.

In this sense it is as much a part of cost of production as wages and interest.

Supernormal profits are profits over and above the normal profits and are not
included in the cost of production.

According to Joan Robinson, normal profit neither attracts new firms into the industry nor
forces any of the existing firms to leave the industry. Therefore, when in some industry firms
earn only the normal profit, it is said to be in equilibrium. If the actual profit of some firms
exceeds the normal profit, new firms will join the industry and compete away the supernormal
profit If, on the contrary, actual profit is less than the supernormal profit, some of the existing
firms will leave the industry, and as a result price will be pushed up and normal profit will
reappear. Firms can enter or leave the industry in the long run only. Once this process of firms
entering or leaving the industry comes to an end, the industry finds itself in equilibrium with
all the firms in it earning only the normal profit.

FIRM, INDUSTRY ANO MARKET

Finn
Let us first consider the concept of a firm. It is defined as follows :
Plrm is a unit of production that employs factors of production (or inputs) to produce
IOOda and services under given state of technology.
 BUSINEss e
~
28 . , , producUon function . Opet .
•· the f1r111 s d f . ati~
' is defined vY .. r anises its pro uc IOn in such a ~
The 'state of tcchnologr function, {Ile Jfflll of. \1·ectivcs of the firm . Econonl' We
· tiroductton . , jevl o O .. 1sts
U1e structure of t I11s t • • 1 ccononusts v . . tlrn t th c fmn sec1{S to max,· :
r.
1
,. This 1s l tc J't rn1p 11cs ' 1111s
maximise its profits. . 11~ II ond rationo I ft , nd i{ seeks to maximise the C
that a firm operates ra~? !Ji. i° 1
firm's effort 15 P1 :ich implies that size of the tOf
Thus the molh ation be_ ~m ion ~f the marginal ru c ~, I rev en uc. However, many ;111 i
ooal is attained by apph\;at . 1 cost with rnargma . R L Hall and CJ Con
-detem1ined by equalising margma . f the: firm. For mstancc, . . . .. Bite
• ......1 tl . traditional thco1y o . th t firms do not attempt to maxim·
ha,,,e question"'--u u.s . • I studies a d S 1s1
amied on U1e basis of their cmptrt~; ut forward by R.A. Gor an ... ome econornis
pr~fits. Similar arguments have .be_e ti~n in each period as the trad1t10n~l theory Pos
amued that short-run profit maxmnsa . . tion in the long-run. In their opinion, b
~ I . ·ofit 111axim1sa . . t J •
does not necessarilv rcsu t m P1 f ach other dec1s10ns a {en m any Pen
. ., t . dependent o e ' . . b l .
different time penods are no m d will affect dec1s10ns to e ta {en m the
.. t I n in the past an . .
influenced by dec1s10ns a {e t that a firm attemptmg to equate margmaI co
. . lin f ument they asser . fi . h
Followmg tlus e o arg .' O
t cceed in maximising 1ts pro t m t e long p
marginal revenue in each perw~ mayf nt d~~onal theory that firms attempt to maxirnis
If thi . tru th the assumption o ra I .
s ~s e, . en . uld t be correct. It appears far more rat10nal that firms
profits m each t.Ime period wo . no .
be interested in maximising their long-run profit. .
But how to realise thi s obJ·ecti·ve ?• This question has been answered by econonusts ·
.::;a
altooeth er wueren t ways. Hall and Hitch , Andrews
., . , Barback. and Edwards . assert tha
obje~ti\~e of Jong~run profit maximizqtion _is:·~tt~ined by equatmg the pnce_ to average c
Bain, P. Sylos-Labini and Franco Mod1gham have formulated what 1s now kno
'limit-price' theory to explain how firms attempt to realise the goal of long-run p
maximisation.
Another line of argument against the traditional theory of the firm (which emph
profit maximisation) has been forward by the managerial theories of the firm developed o
the last few decades. According to these theories, with the managerial revolution during
last few decades, ownership of the firm has been divorced from management, and it is
manager who now enjoys considerable decision making power. With this assumption W
Baumo! argues th~t the sales revenue maximisation is the goal of a modern corpoi
enterpnse. Accordmg to R. Marris, the objective of the firm is the maximisation of
balanced rate of growth of the firm, that is, maximisation of the rate of growth of demand
the products of the firm, and the growth of its capital supply O Williamson asserts /
managers of a modern busine f' h d' , · · · t~
own tTt h ss mn ave iscretlon to pursue policies which maximise T,
· t b d. .
u 1 1 y rat er than profit th, t 18 0 e istnbuted among 'the shareholders.
behavioural theory fr· d a
o 1rm eveloped by HA s· d t that ~
firm exj~is as a coalitio f . · · unon an Cyert and March sugges s
resolved and the firm ~ o ,gr~ups .. w1th. conflicting interests. However these interests!'
aims at profit sattsf' . ' ' . I o!II'
wor ds, the objective of a mod r· . icing rather than profit maximisation. n
ern trm 1s satisfact f •
Industry · ory pro it and not maximum profit.
An industry includes fir h'
' I '· ms w tch are ·
c -~se.ness ts generally defined in terms f
en enon. ·
t1
so~e ~or111 related to each other closelY· f
o wo criteria. (r') pr d t . d ( •r') proc
~

· o uc criterion an l
 OMICS 29
soME BASIC CONCEPTS IN BUSINESS ECON

.. , t I1c f h ms m c grouJJcd in an in d ustry I·r th c r

J
~ Acc ordi ng to. the prod. uct c1•it cuon
5 htut cs. Acc01 ding to the process critcrJon the firms are grou
ped
products are clos e sub • J
• 1 an indu stry on the basi s of sum· '1 ori fy of processes - technology' use of raw matc ria s,
u '
methods of prod ucti on. chan nels of dish ibution etc.
s us to group the firms in term of
The _co~cept of indu stry is very useful because il help
his strategy and tactics by studying the
some .critena. Moreover, !he businessman designs
same industry. The government policy is
behav10~ of th~ othe r busmcssmcn operating in the
ies are industry specific.
also designed with reference to industry and most polic

Market
r place where goods are boug ht and
In com mon parlance, the mar ket refers to a particula
sold.
part icul ar market-place, but for a
Economists use the term market not to denote any
a part icul ar com mod ity are in regular
location or region in whi ch buyers and seUe rs of
communication.
as follows:
In Economics, mar ket structures are distinguished
L Perfect Competition . The perfect competition
is a market structure in which ther e is a
h so that no firm can influence the price.
very large num ber of fimzs in the indu stry so muc
Thus firms in a perf ect com peti tion are price take
rs not price makers. Each firm can sell as
ket price. Accordingly, ther e is no rivalry
much outp ut as it wish es at the prevailing mar
is homogeneity of prod uct whic h mea ns
among the indu stria l firms. The seco nd cond ition
to products of othe r firms in the industry.
that the prod uct of any one seller mus t be identical
of the prod uct must have full knowledge of
The third cond ition is that all buyers and sellers
ket supply in the part icula r time period.
the price at whic h mar ket dem and is equal to mar
to be mon opol y if thre e cond ition s are
2. Monopoly. A mar ket stru ctur e is cons ider ed
(this implies that the industry's supply curve
satisfied: (i) ther e is only one seller of the prod uct
titute for the monopolist>s prod uct
is the sam e as this firm's supply curve); (ii) there is no subs
com petit ion und er mon opol y; and (iii) the
which mea ns that ther e is com plet e abse nce of
ly blocked.
entry of new firms to the indu stry shou ld be complete
in whic h man y sellers of a prod uct
3. Monopolistic Competition. This is a mar ket form
y resp ects yet they are not com plet ely
exist. Alth ough they seJJ prod ucts simi lar in man
basic criterion of mon opol istic com peti tion
substitutable. In fact, prod uct differentiation is a
rent pric es for thei r prod ucts . The re is
and this allow s diffe rent prod ucer s to char ge diffe
ion. As is clea r from this discussion, each
freedom of entr y and exit in mon opol istic com petit
e degree of mon opo ly pow er subj ect to
firm und er mon opo listi c com peti tion enjoys som
competition from the rivals.
the num ber of sellers is small and every
4. Oligopoly. Olig opol y is a mar ket form in which
ur of other firms. Thu s prod ucer s und er
seller influences and -is influenced by the behavio
anotl1~r. The y are con scio us of this
oligopoly are mut uall y dep end ent upo n one
s' actio ns and reac tion s in prep arin g thei r
interdependence and, ther efor e, take note of rival
hom o eneo us or diffe rent