MANAGERIAL ECONOMICS

SYLLABUS

Unit 1 Managerial economics: Meaning, nature and scope;

Economic theory and managerial economic;

Managerial economics and business decision making;

Role of managerial economics.

Unit 2 Demand Analysis: Meaning, types and determinants of

demand.

Unit 3 Cost Concepts: Cost function and cost output

relationship; Economics and diseconomies of scale;

Cost control and cost reduction.

Unit 4 Production Functions: Pricing and output decisions

under competitive conditions; Government control

over pricing; Price discrimination; Price discount and

differentials.

Unit 5 Profit: Measurement of profit; Profit planning and

forecasting; Profit maximization; Cost volume profit

analysis; Investment analysis.

Unit 6 National Income: Business cycle; Inflation and

deflation; Balance of payment; Their implications in

managerial decision.

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LESSON – 1

NATURE & SCOPE OF MANAGERIAL ECONOMICS

The terms Managerial Economics and Business Economics are often

used interchangeably. However, the terms Managerial Economics

has become more popular and seems to displace Business

Economics.

DECISION-MAKING AND FORWARD PLANNING

The chief function of a management executive in a business firm is

decision-making and forward planning. Decision-making refers to

the process of selecting one action from two or more alternative

courses of action. Forward planning on the other hand is arranging

plans for the future. In the functioning of a firm the question of

choice arises because the available resources such as capital, land,

labour and management, are limited and can be employed in

alternative uses. The decision-making function thus involves making

choices or decisions that will provide the most efficient means of

attaining an organisational objectives, for example profit

maximization. Once a decision is made about the particular goal to

be achieved, plans for the future regarding production, pricing,

capital, raw materials and labour are prepared. Forward planning

thus goes hand in hand with decision-making. The conditions in

which firms work and take decisions, is characterised with

uncertainty. And this uncertainty not only makes the function of

decision-making and forward planning complicated but also adds a

different dimension to it. If the knowledge of the future were

perfect, plans could be formulated without error and hence without

any need for subsequent revision. In the real world, however, the

business manager rarely has complete information about the future

sales, costs, profits, capital conditions. etc. Hence, decisions are

made and plans are formulated on the basis of past data, current

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information and the estimates about future that are predicted as

accurately as possible. While the plans are implemented over time,

more facts come into the knowledge of the businessman. In

accordance with these facts the plans may have to be revised, and

a different course of action needs to be adopted. Managers are thus

engaged n a continuous process of decision-making through an

uncertain future and the overall problem that they deal with is

adjusting to uncertainty.

To execute the function of ‘decision-making in an uncertain

frame-work’, economic theory can be applied with considerable

advantage. Economic theory deals with a number of concepts and

principles relating to profit, demand, cost, pricing, production,

competition, business cycles and national income, which are aided

by allied disciplines like accounting. Statistics and Mathematics also

can be used to solve or at least throw some light upon the problems

of business management. The way economic analysis can be used

towards solving business problems constitutes the subject matter of

Managerial Economics.

DEFINITION

According to McNair the Merriam, Managerial Economics consists of

the use of economic modes of thought to analyse business

situations.

Spencer and Siegelman have defined Managerial Economics

as “the integration of economic theory with business practice for the

purpose of facilitating decision-making and forward planning by

management.”

The above definitions suggest that Managerial economics is

the discipline, which deals with the application of economic theory

to business management. Managerial Economics thus lies on the

margin between economics and business management and serves

as the bridge between the two disciplines. The following Figure 1.1

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shows the relationship between economics, business management

and managerial economics.

APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT

The application of economics to business management or the

integration of economic theory with business practice, as Spencer

and Siegelman have put it, has the following aspects :

Reconciling traditional theoretical concepts of

economics in relation to the actual business behavior

and conditions: In economic theory, the technique of

analysis is that of model building. This involves making some

assumptions and, drawing conclusions on the basis of the

assumptions about the behavior of the firms. The

assumptions, however, make the theory of the firm unrealistic

since it fails to provide a satisfactory explanation of what the

firms actually do. Hence, there is need to reconcile the

theoretical principles based on simplified assumptions with

actual business practice and develop appropriate extensions

and reformulation of economic theory. For example, it is

usually assumed that firms aim at maximising profits. Based

on this, the theory of the firm suggests how much the firm

will produce and at what price it would sell. In practice,

however, firms do not always aim at maximum profits (as they

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may think of diversifying or introducing new product etc.) To

that extent, the theory of the firm fails to provide a

satisfactory explanation of the firm’s actual behavior.

Moreover, in actual business language, certain terms like

profits and costs have accounting concepts as distinguished

from economic concepts. In managerial economics, an

attempt is made to merge the accounting concepts with the

economics, an attempt is made to merge the accounting

concepts with the economic concepts. This helps in a more

effective use of financial data related to profits and costs to

suit the needs of decision-making and forward planning.

Estimating economic relationships: This involves the

measurement of various types of elasticities of demand such

as price elasticity, income elasticity, cross-elasticity,

promotional elasticity and cost-output relationships. The

estimates of these economic relationships are to be used for

the purpose of forecasting.

Predicting relevant economic quantities: Economic

quantities such as profit, demand, production, costs, pricing

and capital are predicated in numerical terms together with

their probabilities. As the business manager has to work in an

environment of uncertainty, the future needs to be foreseen

so that in the light of the predicted estimates, decision-making

and forward planning may be possible.

Using economic quantities in decision-making and

forward planning: This involves formulating business

policies for establishing future business plans. This nature of

economic forecasting indicates the degree of probability of

various possible outcomes, i.e., losses or gains that will occur

as a result of following each one of the available strategies.

Thus, a quantified picture gets set up, that indicates the

number of courses open, their possible outcomes and the

quantified probability of each outcome. Keeping this picture in

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view, the business manager is able to decide about which

strategy should be chosen.

Understanding significant external forces: Applying

economic theory to business management also involves

understanding the important external forces that constitute

the business environment and with which a business must

adjust. Business cycles, fluctuations in national income and

government policies pertaining to taxation, foreign trade,

labour relations, antimonopoly measures, industrial licensing

and price controls are typical examples. The business

manager has to appraise the relevance and impact of these

external forces in relation to the particular business unit and

its business policies.

CHARACTERISTICS OF MANAGERIAL ECONOMICS

There are certain chief characteristics of managerial economics,

which can help to understand the nature of the subject matter and

help in a clear understanding of the following terms:

Managerial economics is micro-economic in character. This is

because the unit of study is a firm and its problems.

Managerial economics does not deal with the entire economy

as a unit of study.

Managerial economics largely uses that body of economic

concepts and principles, which is known as Theory of the Firm

or Economics of the Firm. In addition, it also seeks to apply

profit theory, which forms part of distribution theories in

economics.

Managerial economics is concrete and realistic. I avoids

difficult abstract issues of economic theory. But it also

involves complications ignored in economic theory in order to

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face the overall situation in which decisions are made.

Economic theory ignores the variety of backgrounds and

training found in individual firms. Conversely, managerial

economics is concerned more with the particular environment

that influences decision-making.

Managerial economics belongs to normative economics rather

than positive economics. Normative economy is the branch of

economics in which judgments about the desirability of

various policies are made. Positive economics describes how

the economy behaves and predicts how it might change. In

other words, managerial economics is prescriptive rather than

descriptive. It remains confined to descriptive hypothesis.

Managerial economics also simplifies the relations among

different variables without judging what is desirable or

undesirable. For instance, the law of demand states that as

price increases, demand goes down or vice-versa but this

statement does not imply if the result is desirable or not.

Managerial economics, however, is concerned with what

decisions ought to be made and hence involves value

judgments. This further has two aspects: first, it tells what

aims and objectives a firm should pursue; and secondly, how

best to achieve these aims in particular situations. Managerial

economics, therefore, has been described as normative

microeconomics of the firm.

Macroeconomics is also useful to managerial economics since

it provides an intelligent understanding of the business

environment. This understanding enables a business

executive to adjust with the external forces that are beyond

the management’s control but which play a crucial role in the

well being of the firm. The important forces are: business

cycles, national income accounting, and economic policies of

the government like those relating to taxation foreign trade,

anti-monopoly measures and labour relations.

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DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND

ECONOMICS

The difference between managerial economics and economics can

be understood with the help of the following points:

Managerial economics involves application of economic

principles to the problems of a business firm whereas;

economics deals with the study of these principles only.

Economics ignores the application of economic principles to

the problems of a business firm.

Managerial economics is micro-economic in character,

however, Economics is both macro-economic and micro-

economic.

Managerial economics, though micro in character, deals only

with a firm and has nothing to do with an individual’s

economic problems. But microeconomics as a branch of

economics deals with both economics of the individual as well

as economics of a firm.

Under microeconomics, the distribution theories, viz., wages,

interest and profit, are also dealt with. Managerial economics

on the contrary is mainly concerned with profit theory and

does not consider other distribution theories. Thus, the scope

of economics is wider than that of managerial economics.

Economic theory assumes economic relationships and builds

economic models. Managerial economics adopts, modifies and

reformulates the economic models to suit the specific

conditions and serves the specific problem solving process.

Thus, economics gives the simplified model, whereas

managerial economics modifies and enlarges it.

Economics involves the study of certain assumptions like in

the law of proportion where it is assumed that “The variable

input as applied, unit by unit is homogeneous or identical in

amount and quality”. Managerial economics on the other

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hand, introduces certain feedbacks. These feedbacks are in

the form of objectives of the firm, multi-product nature of

manufacture, behavioral constraints, environmental aspects,

legal constraints, constraints on resource availability, etc.

Thus managerial economics, attempts to solve the

complexities in real life, which are assumed in economics. this

is done with the help of mathematics, statistics, econometrics,

accounting, operations research, etc.

OTHER TERMS FOR MANAGERIAL ECONOMICS

Certain other expressions like economic analysis for business

decisions and economics of business management have also been

used instead of managerial economics but they are not so popular.

Sometimes expressions like ‘Economics of the Enterprise’, ‘Theory

of the Firm’ or ‘Economics of the Firm’ have also been used for

managerial economics. It is, however, not appropriate t use theses

terms because managerial economics, though primarily related to

the economics of the firm, differs from it in the following respects:

First, ‘Economics of the Firm’ deals with the theory of the firm,

which is a body of economic principles relating to the firm

alone. Managerial economics on the other hand deals with

the, application of the same principles to business.

Secondly, the term ‘Economics of the firm’ is too simple in its

assumptions whereas managerial economics has to reckon

with actual business behaviour, which is much more complex.

SCOPE OF MANAGERIAL ECONOMICS

As regards the scope of managerial economics, there is no general

uniform pattern. However, the following aspects may be said to be

inclusive under managerial economics:

Demand analysis and forecasting.

Cost and production analysis.

Pricing decisions, policies and practices.

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Profit management.

Capital management.

These aspects may also be defined as the ‘Subject-Matter of

Managerial Economics’. In recent years, there is a trend towards

integrations of managerial economics and operations research.

Hence, techniques such as linear programming, inventory models

and theory of games have also been regarded as a part of

managerial economics.

Demand Analysis and Forecasting

A business firm is an economic Organisation, which transforms

productive resources into goods that are to be sold in a market. A

major part of managerial decision-making depends on accurate

estimates of demand. This is because before production schedules

can be prepared and resources are employed, a forecast of future

sales is essential. This forecast can also guide the management in

maintaining or strengthening the market position and enlarging

profits. The demand analysis helps to identify the various factors

influencing demand for a firm’s product and thus provides

guidelines to manipulate demand. Demand analysis and forecasting,

thus, is essential for business planning and occupies a strategic

place in managerial economics. It comprises of discovering the

forces determining sales and their measurement. The chief topics

covered in this are:

Demand determinants

Demand distinctions

Demand forecasting.

Cost and Production Analysis

A study of economic costs, combined with the data drawn from the

firm’s accounting records, can yield significant cost estimates.

These estimates are useful for management decisions. The factors

causing variations in costs must be recognised and thereby should

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be used for taking management decisions. This facilitates the

management to arrive at cost estimates, which are significant for

planning purposes. An element of cost uncertainty exists in this

because all the factors determining costs are not always known or

controllable. Therefore, it is essential to discover economic costs

and measure them for effective profit planning, cost control and

sound pricing practices. Production analysis is narrower in scope

than cost analysis. The chief topics covered under cost and

production analysis are:

Cost concepts and classifications

Cost-output relationships

Economics of scale

Production functions

Cost control.

Pricing Decisions, Policies and Practices

Pricing is a very important area of managerial economics. In fact

price is the origin of the revenue of a firm. As such the success of a

usiness firm largely depends on the accuracy of price decisions of

that firm. The important aspects dealt under area, are as follows:

Price determination in various market forms

Pricing methods

Differential pricing product-line pricing and price forecasting.

Profit Management

Business firms are generally organised with the purpose of making

profits. In the long run, profits provide the chief measure of success.

In this connection, an important point worth considering is the

element of uncertainty existing about profits. This uncertainty

occurs because of variations in costs and revenues. These are

caused by factors such as internal and external. If knowledge about

the future were perfect, profit analysis would have been a very easy

task. However, in a world of uncertainty, expectations are not

always realised. Thus profit planning and measurement make up the

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difficult area of managerial economics. The important aspects

covered under this area are:

Nature and measurement of profit.

Profit policies and techniques of profit planning.

Capital Management

Among the various types and classes of business problems, the

most complex and troublesome for the business manager are those

relating to the firm’s capital investments. Capital management

implies planning and control and capital expenditure. In this

procedure, relatively large sums are involved and the problems are

so complex that their disposal not only requires considerable time

and labour but also top-level decisions. The main elements dealt

with cost management are:

Cost of capital

Rate of return and selection of projects.

The various aspects outlined above represent the major

uncertainties, which a business firm has to consider viz., demand

uncertainty, cost uncertainty, price uncertainty, profit uncertainty

and capital uncertainty. We can, therefore, conclude that

managerial economics is mainly concerned with applying economic

principles and concepts to adjust with the various uncertainties

faced by a business firm.

MANAGERIAL ECONOMICS AND OTHER SUBJECTS

Yet another useful method of explaining the nature and scope of

managerial economics is to examine its relationship with other

subjects. The following discussion helps to understand relationship

between managerial economics and economics, statistics,

mathematics, accounting and operations research.

Managerial Economics and Economics

Managerial economics is defined as a subdivision of economics that

deals with decision-making. It may be viewed as a special branch of

economics bridging the gulf between pure economic theory and

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managerial practice. Economics has two main divisions-

microeconomics and Macroeconomics. Microeconomics has been

defined as that branch where the unit of study is an individual or a

firm. It is also called “price theory” (or Marshallian economics) and

is the main source of concepts and analytical tools for managerial

economics. To illustrate, various micro-economic concepts such as

elasticity of demand, marginal cost, the short and the long runs,

various market forms, etc., are all of great significance to

managerial economics.

Macroeconomics, on the other hand, is aggregative in

character and has the entire economy as a unit of study. The chief

contribution of macroeconomics to managerial economics is in the

area of forecasting. The modern theory of income and employment

has direct implications for forecasting general business conditions.

As the prospects of an individual firm often depend greatly on

general business conditions, individual firm forecasts rely on general

business forecasts.

A survey in the U.K. has shown that business economists have

found the following economic concepts quite useful and of frequent

application:

Price elasticity of demand

Income elasticity of demand

Opportunity cost

Multiplier

Propensity to consume

Marginal revenue product

Speculative motive

Production function

Liquidity preference

Business economists have also found the following main areas

of economics as useful in their work. Demand theory

Theory of firms – price, output and investment decisions

Business financing

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Public finance and fiscal policy

Money and banking

National income and social accounting

Theory of international trade

Economies of developing countries.

Thus, it is obvious that Managerial Economics is very closely

related to Economics.

Managerial Economics and Statistics

Statistics is important to managerial economics in several ways.

Managerial economics calls for the organising quantitative data and

deriving a useful measure of appropriate functional relationships

involved in decision-making. For instance, in order to base its pricing

decisions on demand and cost considerations, a firm should have

statistically derived or calculated demand and cost functions.

Managerial economics also employs statistical methods for

experimental testing of economic generalisations. The

generalisations can be accepted in practice only when they are

checked against the data from the world of reality and are found

valid. Managers do not have exact information about the variables

affecting decisions and have to deal with the uncertainty of future

events. The theory of probability, upon which statistics is based,

provides logic for dealing with such uncertainties.

Managerial Economics and Mathematics

Mathematics is yet another important subject closely related to

managerial economics. This is because managerial economics is

mathematical in character, as it involves estimating various

economic relationships, predicting relevant economic quantities and

using them in decision-making and forward planning. Knowledge of

geometry, trigonometry ad algebra is not only essential but also

certain mathematical tools and concepts such as logarithms and

exponential, vectors, determinants, matrix, algebra, calculus,

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differential as well as integral, are the most commonly used devices.

Further, operations research, which is closely related to managerial

economics, is mathematical in character. It provides and analyses

data ad develops models, benefiting from the experiences of

experts drawn from different disciplines, viz., psychology, sociology,

statistics and engineering.

MANAGERIAL ECONOMICS AND ACCOUNTING

Managerial economics is also closely related to accounting, which is

concerned with recording the financial operations of a business firm.

In fact, a managerial economist depends chiefly on the accounting

information as an important source of data required for his decision-

making purpose. for instance, the profit and loss statement of a firm

shows how well the firm has done and whether the information it

contains can be used by managerial economist to throw significant

light on the future course of action that is whether the firm should

improve its productivity or close down. Therefore, accounting data

require careful interpretation, reconstruction and adjustments

before they can be used safely and effectively. It is in this context

that the link between management accounting and managerial

economics deserves special mention. The main task of management

accounting is to provide the sort of data, which managers need if

they are to apply the ideas of managerial economics to solve

business problems correctly. The accounting data should be

provided in such a form that they fit easily into the concepts and

analysis of managerial economics.

Managerial Economics and Operations Research

Operations research is a subject field that emerged during the

Second World War and the years thereafter. A good deal of

interdisciplinary research was done in the USA. as well as other

western countries to solve the complex operational problems of

planning and resource allocation in defence and basic industries.

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Several experts like mathematicians, statisticians, engineers and

others teamed up together and developed models and analytical

tools leading to the emergence of this specialised subject. Much of

the development of techniques and concepts, such as linear

programming, inventory models, game theory, etc., emerged from

the working of the operation researchers. Several problems of

managerial economics are solved by the operation research

techniques. These highlight the significant relationship between

managerial economics and operations research. The problems

solved by operation research are as follows:

Allocation problems: An allocation problem confronts with

the issue that men, machines and other resources are scarce,

related to the number sand size of the jobs that need to be

completed. The examples are production programming and

transportation problems.

Competitive problems: competitive problems deal with

situations where managerial decision-making is to be made in

the face of competitive action. That is, one of the factors to be

considered is: “What will competitors do if certain steps are

taken?” Price reduction, for example, will not lead to increased

market share if rivals follow suit.

Waiting line problems : Waiting line problems arise when a

firm wants to know how many machines it should install in

order to ensure that the amount of ‘work-in-progress’ waiting

to be machined is neither too small nor too large. Such

situations arise when for example, a post office, or a bank

wants to know how many cash desks or counter clerks it

should employ in order to balance the business lost through

long guesses against the cost of installing more equipment or

hiring more labour.

Inventory problems: Inventory problems deal with the

principal question: “What is the optimum level of stocks of

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raw-materials, components or finished goods for the firm to

hold?”

The above discussion explains that the managerial economics is

closely related to certain subjects such as economics, statistics,

mathematics and accounting. A trained managerial economist

combines concepts and methods from all these subjects by bringing

them together to solve business problems. In particular, operations

research and management accounting are getting very close to

managerial economics.

USES OF MANAGERIAL ECONOMICS

Managerial economics achieves several objectives. The principal

objectives are as follows:

It presents those aspects of traditional economics, which are

relevant for business decision-making in real life. For this

purpose, it picks from economic theory those concepts,

principles and techniques of analysis, which are concerned

with the decision-making process. These are adapted or

modified in such a way that it enables the manager to take

better decisions. Thus, managerial economics attains the

objective of building a suitable tool kit from traditional

economics.

Managerial economics also incorporates useful ideas from

other disciplines such as psychology, sociology, etc. If they are

found relevant for decision-making. In fact, managerial

economics takes the aid of other academic disciplines that are

concerned with the business decisions of a manager in view of

the various explicit and implicit constraints subject to which

resource allocation is to be optimised.

It helps in reaching a variety of business decisions even in a

complicated environment. Certain examples of such decisions

are those decisions concerned with:

o The products and services to be produced

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o The inputs and production techniques to be used

o The quantity of output to be produced and the selling

prices to be subscribed

o The best sizes and locations of new plants

o Time of replacing the equipment

o Allocation of the available capital

Managerial economics helps a manager to become a more

competent model builder. Thus, he can pick out the essential

relationships, which characterise a situation and leave out the

other unwanted details and minor relationships.

At the level of the firm, functional specialists or functional

departments exist, e.g., finance, marketing, personnel,

production etc. For these various functional areas, managerial

economics serves as an integrating agent by co-ordinating the

different areas. It then applies the decisions of each

department or specialist, those implications, which are

pertaining to other functional areas. Thus managerial

economics enables business decision-making to operate not

with an inflexible and rigid but with an integrated perspective.

This integration is important because the functional

departments or specialists often enjoy considerable autonomy

and achieve conflicting goals.Managerial economics keeps in

mind the interaction between the firm and society and

accomplishes the key role of business as an agent in attaining

social economic welfare. There is a growing awareness that

besides its obligations to shareholders, business enterprise

has certain social obligations as well. Managerial economics

focuses on these social obligations while taking business

decisions. By doing so, it serves as an instrument of furthering

the economic welfare of the society through socially oriented

business decisions.

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Thus, it is evident that the applicability and usefulness of

managerial economics is obtained by performing the following

activates:

Borrowing and adopting the tool-kit from economic theory.

Incorporating relevant ideas from other disciplines to achieve

better business decisions.

Serving as a catalytic agent in the course of decision-making

by different functional departments/specialists at the firm’s

level.

Accomplishing a social purpose by adjusting business

decisions to social obligations.

ECONOMIC THEORY AND MANAGERIAL ECONOMICS

Economic theory offers a variety of concepts and analytical tools

that can assist the manager in the decision-making practices.

Problem solving in business has, however, found that there exists a

wide disparity between the economic theory of a firm and actual

observed practice, thus necessitating the use of many skills and be

quite useful to examine two aspects in this regard:

The basic tools of managerial economics which it has

borrowed from economics, and

The nature and extent of gap between the economic theory of

the firm and the managerial theory of the firm.

Basic Economic Tools in Managerial Economics

The most significant contribution of economics to managerial

economics lies in certain principles, which are basic to the entire

range of managerial economics. The basic principles may be

identified as follows:

1. Opportunity Cost Principle

The opportunity cost of a decision means the sacrifice of

alternatives required by that decision. This can be best understood

with the help of a few illustrations, which are as follows:

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The opportunity cost of the funds employed in one’s own

business is equal to the interest that could be earned on those

funds if they were employed in other ventures.

The opportunity cost of the time as an entrepreneur devotes

to his own business is equal to the salary he could earn by

seeking employment.

The opportunity cost of using a machine to produce one

product is equal to the earnings forgone which would have

been possible from other products.

The opportunity cost of using a machine that is useless for any

other purpose is zero since its use requires no sacrifice of

other opportunities.

If a machine can produce either X or Y, the opportunity cost of

producing a given quantity of X is equal to the quantity of Y,

which it would have produced. If that machine can produce 10

units of X or 20 units of Y, the opportunity cost of 1 X is equal

to 2 Y.

If no information is provided about quantities produced,

except about their prices then the opportunity cost can be

computed in terms of the ratio of their respective prices, say

Px/Py.

The opportunity cost of holding Rs. 500 as cash in hand for

one year is equal to the 10% rate of interest, which would

have been earned had the money been kept as fixed deposit

in a bank. Thus, it is clear that opportunity costs require the

ascertaining of sacrifices. If a decision involves no sacrifice, its

opportunity cost is nil.

For decision-making, opportunity costs are the only relevant

costs. The opportunity cost principle may be stated as under:

“The cost involved in any decision consists of the sacrifices of

alternatives required by that decision. If there are no sacrifices,

there is no cost.”

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Thus in macro sense, the opportunity cost of more guns in an

economy is less butter. That is the expenditure to national fund for

buying armour has cost the nation of losing an opportunity of buying

more butter. Similarly, a continued diversion of funds towards

defence spending, amounts to a heavy tax on alternative spending

required for growth and development.

2. Incremental Principle

The incremental concept is closely related to the marginal costs and

marginal revenues of economic theory. Incremental concept

involves two important activities which are as follows:

Estimating the impact of decision alternatives on costs and

revenues.

Emphasising the changes in total cost and total cost and total

revenue resulting from changes in prices, products,

procedures, investments or whatever may be at stake in the

decision.

The two basic components of incremental reasoning are as

follows:

Incremental cost: Incremental cost may be defined as the

change in total cost resulting from a particular decision.

Incremental revenue: Incremental revenue means the change

in total revenue resulting from a particular decision.

The incremental principle may be stated as under:

A decision is obviously a profitable one if:

o It increases revenue more than costs

o It decreases some costs to a greater extent than it

increases other costs

o It increases some revenues more than it decreases

other revenues

o It reduces costs more that revenues.

Some businessmen hold the view that to make an overall

profit, they must make a profit on every job. Consequently, they

refuse orders that do not cover full cost (labour, materials and

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overhead) plus a provision for profit. Incremental reasoning

indicates that this rule may be inconsistent with profit maximisation

in the short run. A refusal to accept business below full cost may

mean rejection of a possibility of adding more to revenue than cost.

The relevant cost is not the full cost but rather the incremental cost.

A simple problem will illustrate this point.

IIIustration

Suppose a new order is estimated to bring in additional revenue of Rs. 5,000. The

costs are estimated as under:

Labour Rs. 1,500

Material Rs. 2,000

Overhead (Allocated at 120% of labour cost) Rs. 1,800

Selling administrative expenses

(Allocated at 20% of labour and material

cost)

Rs. 700

Total Cost Rs. 6,000

The order at first appears to be unprofitable. However, suppose, if there is idle

capacity, which can be, utilised to execute this order then the order can be accepted. If

the order adds only Rs. 500 of overhead (that is, the added use of heat, power and

light, the added wear and tear on machinery, the added costs of supervision, and so

on), Rs. 1,000 by way of labour cost because some of the idle workers already on the

payroll will be deployed without added pay and no extra selling and administrative

cost then the incremental cost of accepting the order will be as follows.

Labour Rs. 1,500

Material Rs. 2,000

Overhead Rs. 500

Total Incremental Cost Rs. 3,500

While it appeared in the first instance that the order will result

in a loss of Rs. 1,000, it now appears that it will lead to an addition

of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning

does not mean that the firm should accept all orders at prices,

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which cover merely their incremental costs. The acceptance of the

Rs. 5,000 order depends upon the existence of idle capacity and

labour that would go unutilised in the absence of more profitable

opportunities. Earley’s study of “excellently managed” large firms

suggests that progressive corporations do make formal use of

incremental analysis. It is, however, impossible to generalise on the

use of incremental principle, since the observed behaviour is

variable.

3. Principle of Time Perspective

The economic concepts of the long run and the short run have

become part of everyday language. Managerial economists are also

concerned with the short-run and long-run effects of decisions on

revenues as well as on costs. The actual problem in decision-making

is to maintain the right balance between the long-run and short-run

considerations. A decision may be made on the basis of short-run

considerations, but may in the course of time offer long-run

repercussions, which make it more or less profitable than it

appeared at first. An illustration will make this point clear.

IIIustration

Suppose there is a firm with temporary idle capacity. An order for

5,000 units comes to management’s attention. The customer is

willing to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but

not more. The short-run incremental cost (ignoring the fixed cost) is

only Rs. 3.00. Therefore, the contribution to overhead and profit is

Re. 1.00 per unit (Rs. 5,000 for the lot. However, the long-run

repercussions of the order ought to be taken into account are as

follows:

If the management commits itself with too much of business

at lower prices or with a small contribution, it may not have

sufficient capacity to take up business with higher

contributions when the opportunity arises. The management

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may be compelled to consider the question of expansion of

capacity and in such cases; even the so-called fixed costs

may become variable.

If any particular set of customers come to know about this

low price, they may demand a similar low price. Such

customers may complain of being treated unfairly and feel

discriminated. In response, they may opt to patronise

manufacturers with more decent views on pricing. The

reduction or prices under conditions of excess capacity may

adversely affect the image of the company in the minds of its

clientele, which will in turn affect its sales.

It is, therefore, important to give due consideration to the time

perspective. The principle of time perspective may be stated as

under: ‘A decision should take into account both the short-run and

long-run effects on revenues and costs and maintain the right

balance between the long-run and short-run perspectives.”

Haynes, Mote and Paul have cited the case of a printing

company. This company pursued the policy of never quoting prices

below full cost though it often experienced idle capacity and the

management was fully aware that the incremental cost was far

below full cost. This was because the management realised that the

long-run repercussions of pricing below full cost would make up for

any short-run gain. The management felt that the reduction in rates

for some customers might have an undesirable effect on customer

goodwill particularly among regular customers not benefiting from

price reductions. It wanted to avoid crating such an “image” of the

firm that it exploited the market when demand was favorable but

which was willing to negotiate prices downward when demand was

unfavorable.

4. Discounting Principle

One of the fundamental ideas in economics is that a rupee

tomorrow is worth less than a rupee today. This seems similar to the

saying that a bird in hand is worth two in the bush. A simple

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example would make this point clear. Suppose a person is offered a

choice to make between a gift of Rs. 100 today or Rs. 100 next year.

Naturally he will choose the Rs. 100 today.

This is true for two reasons. First, the future is uncertain and there may be

uncertainty in getting Rs. 100 if the present opportunity is not availed of. Secondly,

even if he is sure to receive the gift in future, today’s Rs. 100 can be invested so as to

earn interest, say, at 8 percent so that. one year after the Rs. 100 of today will become

Rs. 108 whereas if he does not accept Rs. 100 today, he will get Rs. 100 only in the

next year. Naturally, he would prefer the first alternative because he is likely to gain

by Rs. 8 in future. Another way of saying the same thing is that the value of Rs. 100

after one year is not equal to the value of Rs. 100 of today but less than that. To find

out how much money today is equal to Rs. 100 would earn if one decides to invest the

money. Suppose the rate of interest is 8 percent. Then we shall have to discount Rs.

100 at 8 per cent in order to ascertain how much money today will become Rs. 100

one year after. The formula is:

V =

Rs. 100

1 + i

where,

V = present value

i = rate of interest.

Now, applying the formula, we get

V =

Rs. 100

1 + i

=

100

1.08

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

money, which will accumulate at 8 per cent after one year.

92.59 x 1.08 = 99.0072

= 1.00

The same reasoning applies to longer periods. A sum of Rs. 100 two years

from now is worth:

Rs. 100 Rs. 100 Rs. 100

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V = = =(1+i)2 (1.08)2 1.1664

Similarly, we can also check by computing how much the

cumulative interest will be after two years. The principle involved in

the above discussion is called the discounting principle and is stated

as follows: “If a decision affects costs and revenues at future dates,

it is necessary to discount those costs and revenues to present

values before a valid comparison of alternatives is possible.”

5. Equi-marginal Principle

This principle deals with the allocation of the available resource

among the alternative activities. According to this principle, an input

should be allocated in such a way that the value added by the last

unit is the same in all cases. This generalisation is called the equi-

marginal principle.

Suppose a firm has 100 units of labour at its disposal. The firm

is engaged in four activities, which need labour services, viz., A, B, C

and D. It can enhance any one of these activities by adding more

labour but sacrificing in return the cost of other activities. If the

value of the marginal product is higher in one activity than another,

then it should be assumed that an optimum allocation has not been

attained. Hence it would, be profitable to shift labour from low

marginal value activity to high marginal value activity, thus

increasing the total value of all products taken together. For

example, if the values of certain two activities are as follows:

Value of Marginal Product of labour

Activity A = Rs. 20

Activity B = Rs. 30

In this case it will be profitable to shift labour from A to

activity B thereby expanding activity B and reducing activity A. The

optimum will be reach when the value of the marginal product is

equal in all the four activities or, when in symbolic terms:

VMPLA = VMPLB = VMPLC = VMPLD

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Where the subscripts indicate labour in respective activities.

Certain aspects of the equi-marginal principle need

clarifications, which are as follows:

First, the values of marginal products are net of incremental

costs. In activity B, we may add one unit of labour with an

increase in physical output of 100 units. Each unit is worth 50

paise so that the 100 units will sell for Rs. 50. But the

increased output consumes raw materials, fuel and other

inputs so that variable costs in activity B (not counting the

labour cost) are higher. Let us say that the incremental costs

are Rs. 30 leaving a net addition of Rs. 20. The value of the

marginal product relevant for our purpose is thus Rs. 20.

Secondly, if the revenues resulting from the addition of labour

are to occur in future, these revenues should be discounted

before comparisons in the alternative activities are possible.

Activity A may produce revenue immediately but activities B,

C and D may take 2, 3 and 5 years respectively. Here the

discounting of these revenues will make them equivalent.

Thirdly, the measurement of value of the marginal product

may have to be corrected if the expansion of an activity

requires an alternative reduction in the prices of the output. If

activity B represents the production of radios and it is not

possible to sell more radios without a reduction in price, it is

necessary to make adjustment for the fall in price.

Fourthly, the equi-marginal principle may break under

sociological pressures. For instance, du to inertia, activities

are continued simply because they exist. Similarly, due to

their empire building ambitions, managers may keep on

expanding activities to fulfil their desire for power.

Department, which are already over-budgeted often, use

some of their excess resources to build up propaganda

machines (public relations offices) to win additional support.

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Governmental agencies are more prone to bureaucratic self-

perpetuation and inertia.

Gaps between Theory of the Firm and managerial Economics

The theory of the firm is a body of theory, which contains certain

assumptions, theorems and conclusions. These theorems deal with

the way in which businessmen make decisions about pricing, and

production under prescribed market conditions. It is concerned with

the study of the optimisation process.

For optimality to exist profit must be maximised and this can

occur only when marginal cost equals marginal revenue. Thus, the

optimum position of the firm is that which maximises net revenue.

Managerial economics, on the other hand, aims at developing a

managerial theory of the firm and for the purpose it takes the help

of economic theory of the firm. However, there are certain

difficulties in using economic theory as an aid to the study of

decision-making at the level of the firm. This is because for the

purposes of business decision-making it fails to provide sufficient

analytical tools that are useful to managers. Some of the reasons

are as follows:

Underlying all economic theory is the assumption that the

decision-maker is omniscient and rational or simply that he is

an economic man. Thus being omniscient means that he

knows the alternatives that are available to him as well as the

outcome of any action he chooses. The model of “economic

man” however as an omniscient person who is confronted

with a compete set of known or probabilistic outcomes is a

distorted representation of reality. The typical business

decision-maker usually has limited information at his disposal,

limited computing ability and a limited number of feasible

alternatives involving varying degrees of risk. Further, the net

revenue function, which he is expected to maximise, and the

marginal cost and marginal revenue functions, which he is

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expected to equate, require excessive knowledge of

information, which is not known and cannot be obtained even

by the most careful analysis. Hence, it is absurd to expect a

manager to maximise and equalise certain critical functional

relationships, which he does not know and cannot find out.

In micro-economic theory, the most profitable output is where

marginal cost (MC) and marginal revenue (MR) are equal. In

Figure 1.2, the most profitable output will be at ON where

MR=MC. This is the point at which the slope of the profit

function or marginal profit is zero. This is highlighted in Figure

1.3 where the most profitable output will be again at ON. In

economic theory, the decision-maker has to identify this

unique output level, which maximises profit.

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In real world, however, a complexity often arises, viz., certain

resource limitations exist. As a result, it is not possible to attain the

maximum output level (ON). In practical terms the maximum output

possible as a result of resource limitations is, say, OM. Now the

problem before the decision-maker is to find out whether the

output, which maximises profit, is OM or some other level of output

to the left of OM. It is obvious that economic theory is of no help for

ON level of output because it is not relevant in view of the resource

limitations. A managerial economist here has to take the aid of

linear programming, which enables the manager to optimise or

search for the best values within the limits set by inequality

conditions.

Another central assumption in the economic theory of the

firm is that the entrepreneur strives to maximise his

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residual share, or profit. Several criticisms of this

assumption have been made:

o The theory is ambiguous, as it doesn’t clarify.

Whether it is short or long run profit that is to be

maximised. For example, in the short run, profits

could be maximised by firing all research and

development personnel and thereby eliminating

considerable immediate expenses. This decision

would, however, have a substantial impact on long-

run profitability.

o Certain questions create some confusion around the

concept of profit maximisation. Should the firm seek

to maximise the amount of profit or the rate of profit?

What is the rate of profit? Is it profit in relation to

total capital or profit in relation to shareholders’

equity?

o There is no allowance for the existence of “psychic

income” (Income other than monetary, power,

prestige, or fame), which the entrepreneur might

obtain from the firm, quite apart from his monetary

income.

o The theory does not recognise that under modern

conditions, owners and managers are separate and

distinct groups of people and the latter may not be

motivated to maximise profits.

o Under imperfect competition, maximisation is an

ambiguous goal, because actions that are optimal for

one will depend on the actions of the other firms.

o The entrepreneur may not care to receive maximum

profits but may simply want to earn “satisfactory

profits”. This last point is particularly relevant from

the behavioural science standpoint because it

introduces a concept of satiation. The notion of

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satiation plays no role in classical economic theory.

To explain business behaviour in terms of this theory,

it is necessary to assume that the firm’s goals are not

concerned with maximising profit, but with attaining

a certain level or rate of profit, holding a certain

share of the market or a certain level of sales. Firms

would try to satisfy rather than maximise. But

according to Simon the satisfying model damages all

the conclusions that can be derived concerning

resource allocation under perfect competition. It

focuses on the fact that the classical theory of the

firm is empirically incorrect as a description of the

decision-making process. Based on this notion of

satiation, it appears that one of the main strengths of

classical economic theory has been seriously

weakened.

Most corporate undertakings involve the investment of

funds, which are expect to produce revenues over a

number of years. The profit maximisation criterion provides

no basis for comparing alternatives that can promise

varying flows of revenue and expenditure over time.

The practical application of profit maximisation concept

also has another limitation. It provides no explicit way of

considering the risk associated with alternative decisions.

Two projects generating similar expected revenues in the

future and requiring similar outlays might differ vastly as

regarding the degree of uncertainty with which the benefits

to be generated. The greater the uncertainty associated

with the benefits, the greater the risk associated with the

project.

Baumol on the other hand is of the view that firms do not

devote all their energies to maximising profit. Rather a

company will seek to maximise its sales revenue as long as

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a satisfactory level of profit is maintained. Thus Baumol has

substituted “Total sales revenue” for profits. Also, two

decision criteria or objectives have been advanced viz., a

satisfactory level of profit and the highest sales possible. In

other words, the firm is no longer viewed as working

towards one objective alone. Instead, it is portrayed as

aiming at balancing two competing and non-consistent

goals. Baumol’s model is based on the view that managers’

salaries, their status and other rewards often appear as

closely related to the companies’ size in which they work

and is measured by sales revenue rather than their

profitability. As such, managers may be more concerned to

increased size than profits. And the firm’s objective thus

becomes sales maximisation rather than profits

maximisation.

Empirical studies of pricing behaviour also give results that

differ from those of the economic theory of firm as can be

seen from the following examples:

o Several studies of the pricing practices of business

firms have indicated that managers tend to set

prices by applying some sort of a standard mark-up

on costs. They do not attempt to estimate marginal

costs, marginal revenues or demand elasticities,

even if these could be accurately measured.

o For many firms, prices are more often set to attain,

a particular target return on investment, say, 10 per

cent, than to maximise short or long-run profits.

o There is some evidence that firms experiencing

declining market shares in their industry strive

more vigorously to increase their sales than do

competing firms, which are experiencing steady or

increasing market shares.

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An alternative model to profit maximisation is the concept

of

wealth maximisation, which assumes that firms seek to

maximise the present value of expected net revenues over

all periods within the forecasted future.

As pointed out by Haynes and Henry, a study of the

behaviour of actual firms shows that their decisions are not

completely determined by the market. These firms have

some freedom to develop decisions, strategies or rules,

which become part of the decision-making system within

the firm. This gap in economic theory has led to what has

come to be known as ‘Behavioural Theory of the Firm’. This

theory, however, does not replace the former but rather

powerfully supplements it. The behavioural theory

represents the firm as an adoptive institution. It learns

from experience and has a memory. Organisational

behaviour, is embodies into decision rules and standard

operating procedures. These may be altered over long run

as the firm reacts to “feedback” from experience. However,

in the short run, decisions of the organisation are

dominated by its rules of thumb and standard methods.

CONCLUSION

The various gaps between the economic theory of the firm and the

actual decision-making process at the firm level are many in

number. They do, however, stress that economic theory seriously

needs major fixing up and substantial changes are in progress for

creating better and different models. Thus the classical economic

concepts like those of rational man is undergoing important

changes; the notion of satisfying is pushing aside the aim of

maximisation and newer lines and patterns of thoughts are being

developed for finding improved applications to managerial decision-

making. A strong emphasis is laid on quantitative model building,

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experimentation and empirical investigation and newer techniques

and concepts, such as linear programming, game theory, statistical

decision-making, etc., are being applied to revolutionise the

approaches to problem solving in business and economics.

MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIES

A managerial economist can play a very important role by assisting

the management in using the increasingly specialised skills and

sophisticated techniques, required to solve the difficult problems of

successful decision-making and forward planning. In business

concerns, the importance of the managerial economist is therefore

recognised a lot today. In advanced countries like the USA, large

companies employ one or more economists. In our country too, big

industrial houses have understood the need for managerial

economists. Such business firms like the Tatas, DCM and Hindustan

Lever employ economists. A managerial economist can contribute to

decision-making in business in specific terms. In this connection,

two important questions need be considered:

1. What role does he play in business, that is, what particular

management problems lend themselves to solution through

economic analysis?

2. How can the managerial economist best serve management,

that is, what are the responsibilities of a successful

managerial economist?

Role of a Managerial Economist

One of the principal objectives of any management in its decision-

making process is to determine the key factors, which will influence

the business over the period ahead. In general, these factors can be

divided into two categories:

External

Internal

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The external factors lie outside the control of management

because they are external to the firm and are said to constitute

business environment. The internal factors lie within the scope and

operations of a firm and hence within the control of management,

and they are known as business operations. To illustrate, a business

firm is free to take decisions about what to invest, where to invest,

how much labour to employ and what to pay for it, how to price its

products, and so on. But all these decisions are taken within the

framework of a particular business environment, and the firm’s

degree of freedom depends on such factors as the government’s

economic policy, the actions of its competitors and the like.

Environmental Studies of a Business Firm

An analysis and forecast of external factors constituting general

business conditions, for example, prices, national income and

output, volume of trade, etc., are of great significance since they

affect every business firm. Certain important relevant factors to be

considered in this connection are as follows:

The outlook for the national economy, the most important

local, regional or worldwide economic trends, the nature of

phase of the business cycle that lies immediately ahead.

Population shifts and the resultant ups and downs in regional

purchasing power.

The demand prospects in new as well as established markets.

Impact of changes in social behaviour and fashions, i.e.,

whether they will tend to expand or limit the sales of a

company’s products, or possibly make the products obsolete?

The areas in which the market and customer opportunities are

likely to expand or contract most rapidly.

Whether overseas markets expand or contract and the affect

of new foreign government legislations on the operation of the

overseas plants?

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Whether the availability and cost of credit tend to increase or

decrease buying, and whether money or credit conditions

ahead are likely to easy or tight?

The prices of raw materials and finished products.

Whether the competition will increase or decrease.

The main components of the five-year plan, the areas where

outlays have been increased and the segments, which have

suffered a cut in their outlays.

The outlook to government’s economic policies and

regulations and changes in defence expenditure, tax rates

tariffs and import restrictions.

Whether the Reserve Bank’s decisions will stimulate or

depress industrial production and consumer spending and how

will these decisions affect the company’s cost, credit, sales

and profits.

Reasonably accurate data regarding these factors can enable the

management to chalk out the scope and direction of their own

business plans effectively. It will also help them to determine the

timing of their specific actions. And it is these factors, which present

some of the areas where a managerial economist can make

effective contribution. The managerial economist has not only to

study the economic trends at the micro-level but also must interpret

their relevance to the particular industry or firm where he works. He

has to digest the ever-growing economic literature and advise top

management by means of short, business-like practical notes. In

mixed economy like that of India, the managerial economist

pragmatically interprets the intentions of controls and evaluates

their impact. He acts as a bridge between the government and the

industry, translating the government’s intentions and transmitting

the reactions of the industry. In fact, the government policies

emerge out of the performance of industry, the expectations of the

people and political expediency.

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Business Operations

A managerial economist can also be helpful to the management in

making decisions relating to the internal operations of a firm in

respect of such problems as price, rate of operations, investment,

expansion or contraction. Certain relevant questions in this

context would be as follows:

What will be a reasonable sales and profit budget for the

next year?

What will be the most appropriate production schedules

and inventory policies for the next six months?

What changes in wage and price policies should be made

now?

How much cash will be available next month and how

should it be invested?

Specific Functions

The managerial economists can play a further role, which can cover

the following specific functions as revealed by a survey pertaining to

Brittain conducted by K.J.W. Alexander and Alexander G. Kemp:

Sales forecasting.

Industrial market research.

Economic analysis of competing companies.

Pricing problems of industry.

Capital projects.

Production programmes.

Security / Investment analysis and forecasts.

Advice on trade and public relations.

Advice on primary commodities.

Advice on foreign exchange.

Economic analysis of agriculture.

Analysis of underdeveloped economics.

Environmental forecasting.

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The managerial economist has to gather economic data, analyse

all relevant information about the business environment and

prepare position papers on issues facing the firm and the industry.

In the case of industries prone to rapid theological advances, the

manager may have to make continuous assessment of tl1e impact

of changing technology. The manager' may need to evaluate the

capital budget in the light of short and long-range financial, profit

and market potentialities. Very often, he also needs to prepare

speeches for the corporate executives. It is thus clear that in

practice, managerial economists perform many and various

functions. However, of all these, the marketing functions, i.e., sales

force listing an industrial market research, are the most important.

For this purpose, the managers may collect statistical records of

the sales performance of their own business and those rehiring to

their rivals, carry out analysis of these records and report on trends

in demand, their market shares, and the relative efficiency of their

retail outlets. Thus, while carrying out heir functions, the managers

may have to undertake detailed statistical analysis. There are, of

course, differences in the relative importance of· the various

functions performed from firm to firm and in the degree of

sophistication of the methods used in performing these functions.

But there is no doubt that the job of a managerial economist

requires alertness and the ability to work uriderpressure.

Economic Intelligence

Besides these functions involving sophisticated analysis, managerial

economist may also provide general intelligence service. Thus the

economist may supply the management with economic information

of general interest such as competitors

prices and products, tax rates, tariff rates, etc.

Participating in Public Debates

Many well-known business economists participate in public debates.

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The government and society alike are seeking their advice and

views. Their practical experience in business and industry adds

prestige to their views. Their public recognition enhances their

protégé in the .firm itself.

Indian Context

In the Indian context, a managerial economist is expected to

perform the following functions:

Macro-forecasting for

demand and supply.

Production planning at macro and micro levels.

Capacity planning and product-mix determination.

Economics of various production lines.

Economic feasibility of new production lines / processes and

projects.

Assistance in preparation of overall development plans.

Preparation of periodical economic reports bearing on various

matters such as the company's product-lines, future growth

opportunities, market pricing situation, general business,. and

various national/international factors affecting industry and

business.

Preparing briefs; speeches, articles and papers for top

management for various chambers, Committees, Seminars,

Conferences, etc

Keeping management informed of various national and

International Developments on economic/industrial matters.

With the adoption of the new economic policy, the macro-

economic environment is changing fast and these changes have

tremendous implications for business. The managerial economists

have to playa much more significant role. They ha'1e to constantly

measure the possibilities of translating the rapidly changing

economic scenario into workable business opportunities. As India

marches towards globalisation, the managerial economists will have

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to interpret the global economic events and find out how the firm

can avail itself of the various export opportunities or of establishing

plants abroad either wholly owned or in association with local

partners.

Responsibilities of a Managerial Economist

Besides considering the opportunities that lie before a managerial

economist it is necessary to take into account the services that are

expected by the management. For this, it is necessary for a

managerial economist to thoroughly recognise the responsibilities

and obligations. A managerial economist can serve the mana-

gement best by recognising that the main objective of the

business, is to make a profit on its invested capital. Academic

training and the critical comments from people outside the

business may lead a managerial economist to adopt an apologetic

or defensive attitude towards profits. There should be a strong

personal conviction on part of the managerial economist that

profits are essential and it is necessary to help enhance the ability

of the firm to make profits. Otherwise it is difficult to succeed in

serving management.

Most management decisions necessarily concern the future,

which is rather uncertain. It is, therefore, absolutely essential that a

managerial economist recognises his responsibility to make

successful forecast. By making the best possible forecasts and

through constant efforts to improve, a managerial' ng, the risks

involved in uncertainties. This enables the management to· follow a

more orderly course of business planning. At times, it is required

for the managerial economist to reassure the management that an

important trend will continue. In other cases, it is necessary to

point out the probabilities of a turning point in some activity of

importance to management. In any case, managerial economist

must be willing to make fairly positive statements about impending

economic developments. These can be based upon the best

possible information and analysis. The management's confidence in

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a managerial economist increases more quickly and thoroughly

with

a record of successful forecasts, well documented in advance

and modestly evaluated when the actual results become

available.

A few consequences to the above proposition need also be

emphasised here.

First, a managerial economist has a major responsibility to alert

managelI1ent at the earliest possible moment in' case there is

an err6r' in his forecast. This will assist the mallagement in

making appropriate adjustment in policies and programmes

and strengthen his oWn position as a member of the

management team by keeplrighis fingers on the economic

pulse of the

business.

Secondly, a managerial economist must establish and maintain

many contacts with individuals and data sources: which would

not be immediately available to the other members of the

management. Extensive familiarity with reference sources and

material is essential. It is still more important that the known

individuals who are specialists in particular fields have a

bearing on tpe managerial economist's work. For this purpose,

it is required that managerial economist joins professional

associations and tak~ active part in them. In fact, one of the

best means of determining the quality of a managerial

economist is to evaluate his ability to obtain information

quickly by personal contacts rather than by lengthy research

from either readily available or obscure reference sources.

Within any business, there' may be a wealth of knowledge and

experience but the managerial economist would be really

useful ifit is possible pn his part to supplement the existing

know-how with additional information and in the quickest

possible manner.

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

management in successful decision-making and forward planning, it

is necessary'" to able to earn full status on the business team.

Readiness to take up special assignments, be that in study teams,

committees or special projects is another important requirement.

This is because it is necessary for the managerial economist to win

continuing support for himself and his professional ideas. Clarity of

expression and attempting to minimise the use of technical

terminology while communJcating his ideas to management

executives is also an essential role so as to win approval.

To conclude, a managerial economist has a very important role

to play by helping management in successful decision-making and

forward planning. But to discharge his role successfully, it is

necessary to recognise the 'relevant responsibilities and obligations.

To some business executives, however, a managerial economist is

still a luxury or perhaps even a necessary evil. It is not surprising,

therefore, to find that while tneir status is improving and their

impor;ance is gradually rising, managerial economists in certain

firms still 'feel quite insecure. Nevertheless, there is a definite and

growing realisation that they can contribute significantly to the

profitable growth of firms and effective solution oftMir problems,

and this' promises them a positive future.

REVIEW QUESTIONS

1. What is managerial economics? How does it differ from

traditional economics?

2. Discuss the nature and scopeofmanagerial economics.

3. Show the significance of economic analysis in business

decisions.

4. Managerial Economics is perspective rather than descriptive in

character? Examine this statement.

5. Assess the contribution and limitations of economic analysis to

business decision-making.

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6. Briefly explain the five principles, which are basic to the entire

gamut of managerial economics.

7. Explain the role of marginal analysis in determining optimal

solution if managerial economics. How does it compare with

break-even analysis?

8.Discuss some of the important economic concepts and

techniques that help busirless management.

9. Explain the various functions of a managerial economist. How

can he best serve the management?

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LESSON – 2

DEMAND ANALYSIS

Demand is one of the crucial requirements for the existence of

any business firm. Firms are interested in their profit and sales,

both of which depend partially upon the demand for the product.

The decisions, which management makes with respect to

production, advertising, cost allocation, pricing, inventory

holdings, etc. call for an analysis of demand. While how much a

firm can produce depends upon its capacity and demand for its

products. If there is no demand for a product, its production is

unworthy. If demand falls short of production, one way to

balance the two is to create new demand through more and

better advertisements. The more the future demand for a

product, the more inventories the firm would hold. The larger

the demand for a firm's product, the higher is the price it can

charge.

Demand analysis seeks to identify and measure the forces

that determine sales. Once this is done the alternative ways of

manipulating or managing demand can easily be inferred.

Although, demand for a finri's product reflects what the

consumers buy, this can be influenced through manipulating the

factors on which consumers base their demands. Demand

analysis attempts to estiinate the demand for a product in

future, which further helps to plan production based on the

estimated demand.

MEANING OF DEMAND

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

the product. It also includes willingness and ability of ail individual

to pay for the product. For example, a miser's desire for and his

ability to pay for a car is not demand, for he does not have the

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necessary will to pay for the car. Similarly, a poor person's desire

for· and his willingness to pay for a car is not demand because he

lacks the necessary purchasing power. One can also imagine an

individual, who possesses both the will and the purchasing power

to pay for a good. But this purchasing power is not the demand for

that good, this is because he does not have the desire to buy that

product. Therefore, demand is successful when there are all the

three factors: desire, willingness and ability. It should also be

noted that demand for any goods or services has no meaning

unless it is stated with reference to time, price, competing

product, consumer's incomes, tastes and preferences. This is

because demand varies with fluctuations in these factors. For

example, the demand for an Ambassador car in India is 40,000 is

meaningless unless it is stated that this was the demand ·in 1976

when an Ambassador car's price was around thirty thousand

rupees. The price of the competing cars’ prices were around the

same, a Bajaj scooter's price was around five thousand rupees and

petrol price was around three and a half rupees per litre. In 1977,

the demand for Ambassador cars could be different if any of the

above factors happened to be different. Furthermore, it should be

noted that a product is defined with reference to its particular

quality. If its quality changes it can be deemed as another

product. Thus, the demand for any product is the desire,

wi1lihigness and ability to buy the product with reference to a

partkular time and given values of variables on which it depends.

TYPES OF DEMAND

The demand for various kinds of goods is generally classified on

the basis of kinds of consumers, suppliers of goods, nature of

goods, duration of consumption goods, interdependence of

demand, period of demand and nature of use of goods

(intermediate or final), The major classifications of demand are as

follows:

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Individual and market demand

Demand for firm's prodtictand industry's products

Autonomous and derived demand

Demand for durable and non-durable goods

Short-term and long-term demand

Individual and Market Demand

The quantity of a product, which an individual is willing to buy at

a particular price during a specific time period, given his money

income, his taste, and prices of other commodities (particularly

substitutes and complements), is called 'individual's demand for a

product'. The total quantity, which all comsumers are willing to

buy at a given price per time unit, given their money income,

taste, and prices of other commodities is known as 'market

demand for the good'. In other words, the market demand for a

good is the sum of the individual demands of all the c6-nsumers

of a product, over a time period at given prices.

Demand for Firm's Product and Industry's Products

The quantity of a firm's yield, that can be disposed of at a given

price over a period refers to the demand for firm's product. The

aggregate demand for the product of all firms of an industry is

known as the market-demand or demand for industry's product.

This distinction between the two kinds of demand is not of much

use in a highly competitive market since it merely signifies the

distinction between a sum and its parts. However, where market

structure is oligopolistic, a distinction between the demand for

firm's product and industry's product is useful from managerial

point of view. The product of each firm is so differentiated from the

products of the rival firms that consumers treat each product

different from the other. This gives firms an opportunity to plan the

price of a product, advertise it in order to capture a larger market

share thereby to enhance profits. For instance, market of cars,

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radios, TV sets, refrigerators, scooters, toilet soaps and toothpaste,

all belong to this category of markets.

In case of monopoly and perfect competition, the distinction

between demand for a firm's product and industry's product is not

of much use from managerial point of view. In case of monopoly,

industry is one-firmindustiy andthe demand for firm's product is

the same as that of the industry. In case of perfect competition,

products of all firms .of the industry are homogeneous and price

for each firm is determined by industry. Firms have little

opportunity to plan the prices permissible under local conditions

and advertisement by a firm becomes effective for the whole

industry. Therefore, conceptual distinction between demand for

film's product and industry's product is not much use in business

decisions making.

Autonomous and Derived Demand

An Autonomous demand for a product is one that arises

independently of the demand for any other good whereas a derived

demand is one, which is derived from demand of some other good.

To look more closely at the distinction between the two kinds of

demand, consider the demand for commodities, which arise directly

from the biological or physical needs of the human beings, such as

demand for food, clothes and shelter. The demand for these goods

is autonomous demand. Autotnomous demand also arises as a'

result of demonstration effect, rise in income, and increase in

population and advertisement of new produCts. On the other hand,

the demand for a good that arises because of the demand for some

other good is called derived demand. For instance, demand for

land, fertiliser and agricultural tools and implements are derived

demand, since the demand of goods, depends on the demand of

food. Similarly, demand for steel, bricks, cement etc., is a derived

demand because it is derived from the demand for houses and

other kind of buildings. [n general, the demand for, producer goods

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or industrial inputs is a derived one. Besides, demand for

complementary goods (which complement the use of other goods)

or for supplementary goods (which supplement or provide

additional utility from the use of other goods) is a derived demand.

For instance petrol is a complementary goods for automobiles and

a chair is a complement to a table. Consider some examples of

supplement goods. Butter is supplement to bread, mattress is

supplement to cot and sugar is supplement to tea. Therefore,

demand for petrol, chair, and sugar would be considered as derived

demand. The conceptual distinction between autonomous demand

and derived demand would be useful according to the point of view

of a bllsinessman to the extent the former can serve as an indicator

of the latter.

Demand for Durable and Non-durable Goods

Demand is often classified under demand for durable and non-

durable goods. Durable goods are those goods whose total utility is

not exhausted in single or short-run use. Such goods can be used

continuously over a period of time. Durable goods may be consumer

goods as well as producer goods. Durable consumer goods include

clothes, shoes, house furniture, refrigerators, scooters, and cars.

The durable producer goods include mainly the items under fixed

assets, such as building, plant and machinery, office furniture and

fixture. The durable goods, both consumer and producer goods, may

be further classified as semi-durable goods such as, clothes and

furniture and durable goods such as residential and factory

buildings and cars. On the other harid, non-durable goods are those

goods, which can be used only once such as food items and their

total utility is exhausted in a single use. This category of goods can

also be grouped under non-durable consumer and producer goods.

All food items such as drinks, soap, cooking fuel, gas, kerosene, coal

and cosmetics fall in the former category whereas, goods such as

raw materials', fuel and power, finishing materials and packing

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items come in the latter category.

The demand for non-durable goods depends largely on their

current prices, consumers' income and fashion whereas the

expected price, income and change in technology influence the

demand for the durable good. The demand for durable goods

changes over a relatively longer period. There is another point of

distinction between demands for durable and non-durable goods.

Durable goods create demand for replacement or substitution of the

goods whereas non-durable goods do not. Also the demand for non-

durable goods increases or decreases with a fixed or constant rate

whereas the demand for durable goods increases or decreases

exponentially, i.e., it may depend· upon some factors such as

obsolescence of machinery, etg. For example, let us suppose that

the annual demand for cigarettes in a city is 10 million packets and

it increases at the rate of half-a-million packets per annum on

account of increase in population when other factors remain

constant. Thus, the total demand for cigarettes in the next year will

be 10.5 million packets and 11 million packets in the next to next

year and so on. This is a linear increase in the demand for a non-

durable good like cigarette. Now consider the demand for a durable

good, e.g., automobiles. Let us suppose: (i1 the existing number of

automobiles in a city, in a year is 10,000, (ii) the annual

replacement demand equals 10 per cent of the total demand, and

(iii) the annual autonomous increase ·in demand is 1000

automobiles. As such, the total annual clemand for automobiles in

four subsequent years is calculated and presented in Table 2.1.

Table 2.1: Annual Demand for Automobiles

Beginning Total no. of Replacement Annual Total Annualof the year automobiles demand autonomous demand increas

(Stock) demand in, demand

1st year 10,000 - - 10,000

_

-

2nd year 10,000 1000 1000 12,000 2000

-3id year 12,000 1200 1000 14,200 2200

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4th year 14,200 1420 1000 16,620 2420

Stock + Replacement + Autonomous demand = TotalDemand

It may be seen from the Table 2.1 that the total demand for

automobiles is increasing at an increasing rate due to

acceleration in the replacement demand. Another factor, which

might accelerate the demand for automobiles and such durable

goods, is the rate of obsolescence of this category of goods.

Short-term and Long-term Demand

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

demanoed over a short period. In this category fall mostly the

fashion consumer goods, goods of seasonal use and inferior

substitutes during the scarcity period of superior goods. For

instance, the demand for fashion wears is short-term demand

though the demand for the generic goods such as trousers, shoes

and ties continues to remain a longterm demand. Similarly, demand

for umbrella, raincoats, gumboots, cold drinks and ice creams is of

seasonal nature; 'The demand for such goods lasts till the season

lasts. Some goods of this category are demanded for a very short

period, i.e., 1-2 week, for example, new greeting cards, candles and

crackers on occasion of diwali.

Although some goods are used only seasonally but are durable in

pature, e.g., electric fans, woollen garments, etc. The demand for

such goods is of also durable in nature but it is subject to seasonal

fluctuations. Sometimes, demand for certain gools suddenly

increases because of scarcity of their superior substitutes. For

examp1e, when supply of cooking gas suddenly decreases, demand

for kerosene, cooking coal and charcoal increases. In such cases,

additional demand is of shGrtterm nature. The long-term demand,

on the hand, refers to the demand, which exists over a long-period.

The change in long-term demand is visible only after a long period.

Most generic goods have long-term demand. For example, demand

for consumer and producer goods, durable and non-durable goods,

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is long-term demand, though their different varieties or brands may

have only short-term demand. Short-term demand depends, by and

large, on the price of commodities, price of their substitutes, current

disposable income of the consumer, their ability to adjust their

consumption pattern and their susceptibility to advertisement of a

new product. The long-term demand depends on the long-term

income trends, availability of better substitutes, sales promotion,

and consumer credit facility. The short-term and lcmg-term

concepts of demand are useful in designing new products for

established producers, choice of products for the new

entrepreneurs, in pricing policy and in determining advertisement

expenditure.

DETERMIN!\NTS OF MARKET DEMAND

The knowledge of the determinants of market demand for a product

and the nature of relationship between the demand and its

determinants proves very helpful in analysing and estimating

demand for the product. It may be noted at the very outset that a

host of factors determines the demand for a product. In general,

following factors determine market demand for a good:

Price of the good- .

Price of the related goods-substitutes, complements and

supplements

Level of consumers' income

Consumers' taste and preference

Advertisement of the product

Consumers' expectations about future price and

supply position

Demonstration effect and 'bend-wagon effect’

Consumer-credit facility

Population of the country

Distribution pattern of national income.

These factors also include factors such as off-season discounts

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and gifts on purchase of a good, level of taxation and general social

and political environment of the country. However, all these factors

are not equally important. Besides, some of them are not

quantifiable. For example, consumer's preferences, utility,

demonstration effect and expectations, are difficult to measure.

However, both quantifiable and non-quantifiable determinants of

demand for a product will be discussed.

1. Price of the Product

The price of a product is one of the most important determinants of

demand in the long run and the only determinant in the short run.

The price and quantity demanded are inversely related to each

other. The law of demand states that the quantity demanded of a

good or a product, which its consumers would like to buy per unit of

time, increases when its price falls, and decreases when its price

increases, provided the other factors remain' same. The assumption

'other factors remaining same' implies that income of the

consumers, prices of the substitutes and complementary goods,

consumer's taste and preference and number of consumers remain

unchanged. The price-demand relationship assumes a much greater

significance in the oligopolistic market in which outcome of price

war between a firm and its rivals determines the level of success of

the firm. The firms have to be fully aware of price elasticity of

demand for their own products and that of rival firm's goods.

2. Price of the Related Goods or Products

The demand for a good is also affected by the change in the price

of its related goods. The related goods may be the substitutes or

complementary goods.

Substitutes

Two goods are said to. be substitutes of each other if a change in

price of one good affects the deinand for the other in the same

direction. For instance goods X and Y are considered as substitutes

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for each other if a rise in the price of X increase demand for Y, and

vice versa. Tea and coffee, hamburgers and hot-dog, alcohol and

drugs are some examples of substitutes in case of consumer goods

by definition, the relation between demand for a product and price

of its substitute is of positive nature. When, price of the substitute of

a product (tea) falls (or increase), the demand for the product falls

(or increases). The relationship of this nature is shown in Figure 2.1

and 2.2.

Complementary Goods

A good is said to be a complement for another when it complements

the use of the other or when the two goods are used together in

such a way that their demand changes (increases or decreases)

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simultaneously. For example, petrol is a complement to car and

scooter, butter and jam to bread, milk and sugar to tea and 1 coffee,

mattress to cot, etc. Two goods are termed as complementary to

each other -i if an increase in the price of one causes a decrease in

demand for the other. By definition, there is an inverse relation

between the demand for a good and the price of its complement.

For instance, an increase in the price of petrol causes a decrease in

the demand for car and other petrol-run vehicles and vice versa

while other thing's remaining constant. The nature of relationship

between the demand

for a product and the price of its complement is given in Figure 2.2.

3. Consume's Income

Income is the basic determinant of market demand since it

determines the purchasing power of a consumer. Therefore,

people with higher current disposable income spend a larger

amount on goods and services than those with lower income.

Income-demand relationship is of more varied nature than that

between demand and its other determinants. While other

determinants of demand, e.g., product's own price and the price

ohts substitutes, are more significant in the short-run, income as

a determinant of demand is equally important in both short run

and long run. Before proceeding further to discuss income-

demand relationships, it will be useful to note that consumer

goods of different nature have different kinds of relationship with

consumers having different levels of income. Hence, the

managers need to be fully aware of the kinds of goods they are

dealing with and their relationship with the income of consumers,

particularly about the assessment of both existing and

prospective demand for a product.

For the purpose of income-demand analysis, goods and serv:ices

maybe grouped under four broad categories, which ate: (a)

essential consumer goods, (b) inferior goods, (c) normal goods, and

(d) prestige or luxury goods. To understand all these terms, it is

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essential to understand the relationship between income and

different kinds of goods.

Esscntial Consumcr Goods (ECG): The goods and services of

this category are called 'basic needs' and are consumed by all

persons of a society such as food-grains, salt, vegetable oils,

matches, cooking fuel, a minimum clothing and housing.

Quantity demanded for these goods increases with increase in

consumer's income but only up to certain limit, even though

the total expenditure may increase in accordance with the

quality of goods consumed, other factors remaining the same.

The relationship between goods of this category and

consumer's income is shown by the curve ECG in Figure 2.3.

As the curve shows, consumer's demand for essential goods

increases only until his income rises to OY2. It tends to

saturate beyond this level of income.

Inferior goods: Inferior goods are those goods whose demand

decreases with the increase in consumer's income. For

example millet is inferior to wheat and rice; bidi (indigenous

cigarette) is inferior to cigarette, coarse, textiles are inferior to

refined ones, kerosene is inferior to cooking gas and travelling

by bus is inferior to travelling by taxi. The relation between

income and demand for an inferior good is shown by the curve

IG in Figure 2.3 under the assumption that other determinants

of demand remain the same demand for such goods rises only

up to a certain level of income, i.e., OY1 and declines as

income increases beyond this level.

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Normal goods: Normal goods are those goods whose demand

increases with increaseiri the consumer income. For example,

clothings, household furniture and automobiles. The relation

between income and demand for normal goods is shown by

the curve NG in Figure 2.3. As the curve shows, demand for

such goods increases with the increases in consumer income

but at different rates at different levels of income. Demand for

normal goods increases rapidly with the increase in the

consumer's income but slows down with further increase in

income. It should be noted froms Figure 2.3 that up to certain

level of income (YI) the relation between income and demand

for all type of goods is similar. The difference is of only

degree. The relation becomes distinctly different beyond YI

level of income. Therefore, it is important to view the income-

demand relations in the light of the nature of product and the

level fconsumer's income.

Prestige and luxury goods: Prestige goods are those goods,

which are consu!TIed mostly by rich section of the society, e.g.,

precious stones, antiques, rare paintings, luxury cars and such

other items of show-bff. Whereas luxury goods include

jewellery, costly brands of cosmetics, TV sets, refrigerators,

electrical gadgets and cars. Demand for such goods arises

beyond a certain level of consumer's income, i.e., consumption

enters the area of luxury goods. Producers of such goods, while

assessing the demand for their goods, should consider the

income changes in the richer section of the society and not

only the per capita income. The relation between income and

demand for such goods is shown by the curve LG in Figure 2.3.

4. Consumer's taste and preference

Consumer's taste and preference play an important role in

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detennihing demand for a product. Taste and preference depend,

generally, on the changing. life-style, social customs, religious

values attached to a good, habi of the people, the general levels of

living of the society and age and sex of the consumers. Change in

these factors changes consumer's taste and preferences. As a

result, consumers reduce or give up the consumption of some

goods and add new ones to their consumption pattern. For

example, following the change in fashion, people switch their

consumption pattern from cheaper, old-fashioned goods to costlier

‘mod’ goods, as long as price differentials are proportionate with

their preferences. Consumers are prepared to pay higher prices for

'mod goods' even if their virtual utility is the same as that of old-

fashioned goods. The manufacturers of goods and services that are

subject to frequent change in fashion and style, can take

advantage of this situation in two ways: (i) they can make quick

profits by designing new models of their goods and popularising

them through advertisement, and (ii) they can plan production in

abetter way and can even avoid over-productiorlifthey keep an eye

on the changing fashions.

5. Advertisel11ent Expenditure

Advertisement costs are incurred with the objective of increasing

the demand for the goods. This is done in the following ways:

By informing the potential consumers about the availability of

the goods.

By showing its superiority to the rival goods.

By influencing consumers' choice against the rival goods, and

By setting fashions and changing tastes.

The impact of such effects shifts the demand curve upward to

the

right.

In other words, when other factors' remain same, the

expenditure on advertisement increases the volume of sales to the

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same extent. The relation between advertisement outlay and sales

is shown in Figure 2.4.

Assumptions

Therelatiqnship between demand and advertisement cost as shown

in Figure 2.4 is based on the following assumptions:

Consumers are fairly sensitive and responsive to various

modes

of advertisement.

The rival firms do not react to the advertisements made by a

firm.

The level of demand has not already reached the saturation

point. Advertisement beyond this point will make only

marginal impact on demand.

Per unit cost of advertisement added to the price does not

make the price prohibitive for consumers, as compared

particularly to the price of substitutes.

Others determinants of demand, e.g., income and tastes, etc.,

are not operating in the reverse direction.

In the absence of these conditions, the advertisement effect on

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sales may be unpredictable.

6. Consumers’ Expectations

Consumers’ expectations regarding the future prices, income and

supply position of goods play an important role in determining the

demand for goods and services in the short run. If consumers

expect a rise in the price of a storable good, they would buy more of

it at its current price with a view to avoiding the possibility of price

rise future. On the contrary, if consumers expect a fall in the price of

certain goods, they postpone their purchase with a view to take

advantage of lower prices in future, mainly in case of non-essential

goods. This behaviour of consumers reduces the current demand for

the goods whose prices are expected to decrease in future.

Similarly, an expected increase in income increases the demand for

a product. For example, announcement of ‘dearness allowance’,

bonus and revision of pay scale induces increase in current

purchases. Besides, if scarcity of certain goods is expected by the

consumers on account of reported fall in future production, strikes

on a large scale and diversion of civil supplies towards the military

use causes the current demand for such goods to increase more if

their prices show an upward trend. Consumer demand more for

future consumption and profiteers demand more to make money

out of expected scarcity.

7. Demonstration Effect

When new goods or new models of existing ones appear in the

market, rich people buy them first. For instance, when a new model

of car appears in the market, rich people would mostly be the first

buyer, Colour TV sets and VCRs were first seen in the houses of the

rich families some people buy new goods or new models of goods

because they have genuine need for them. Some others do so

because they want to exhibit their affluence. But once new goods

come in fashion, many households buy them not because they

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have a genuine need for them but because their neighbors have

bought the same goods. The purchase made by the latter category

of the buyers are made out of such feelings' as jealousy,

competition, equality in the peer group, social inferiority and the

desire to raise their social status. Purchases made on account of

these factors are the result of what economists call 'demonstration

effect' or the 'Band-wagon-effect.' These effects have a positive

effect on demand. On the contrary, when goods become the thing

of common use, some people, mostly rich, decrease or give up the

consumption of such goods. This is known as 'Snob Effect'. It has a

negative effect'on the demand

for the related goods.

8. Consumer-Gredit Facility

Availability of credit to the cansumers fram the sellers, banks,

relatians and friends encourages the conSumers to buy more than

what they would buy in the aosence of credit availability.

Therefore, the consumers who can borrow more can consume

more than those who cannot borrow. Credit facility affects mostly

the demand"for durable goods, particularly those, which require

bulk payment at the time of purchase. The car-loan facility may be

one reason why Delhi has more cars than Calcutta, Chennai and

Mumbai. Therefore, the managers who are assessing the

prospective demand for their goods should take into account the

availability of credit to the consumers.

9. Population of the Country

The Jotal domestic demand for a good of mass consumption

depends also on the size' of the population. Therefore, larger the

population larger will be the demand for a product, when price, per

capita income, taste and preference are given. With an increase or

decrease in the size of population, employment percentage

remaining the same, demand for the product will either increase or

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decrease.

10. Distribution of National Income

The level of national income is the basic determinant of the market

demand for a good. Therefore, pig her the national income higher

will be the demand for all normal goods and services. Apart from

this, the distribution pattern of the national income is also an

important determinant for demand of a good. If national income is

evenly distributed, market demand for normal goods will be the

largest. If national income is unevenly distributed, i.e., if majority of

population belongs to the lower income groups, market demand for

essential goods, including inferior ones, will be the largest whereas

the demand for other kinds of goods will be relatively less.

REVIEW QUESTIONS

1. Give short note on 'Demand Analysis'.

2. What are the determinants of market demand for a good? How

do the changes in the following factors affect the demand for a

good?

A. Price

B. Income

C. Price of the substitute

D. Advertisement

E. Population.

Also describe the nature of relationship between demand for a

good and these factors (consider one factor at a time assuming

other factors to remain constant).

3. Explain different types of determinants of demand.

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LESSON - 3

COST CONCEPTS

Business decisions are generally taken on the basis of money values

of the inputs and outputs. The cost production expressed in

monetary terms is an important factor in almost all business

decisions, specially those pertaining to (a) locating the weak points

in production management; (b), minimising the cost; (c) finding out

the optjmum level of output; and (d) estimating or projecting the

cost of business operations. Besides, the term 'cost' has different

meanings under different settings and is subject to varying

interpretations. It is therefore essential that only relevant concept of

costs is used in the business decisions.

CONCEPT OF COST

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

decisions, can be grouped, on the basis of their purpose, under two

overlapping categories such as concepts used for accounting

purposes and concepts used in economic analysis of business

activities.

SOME ACCOUNTING CONCEPTS OF COST

Opportunity Cost and Actual Cost

Opportunity cost is the loss incurred due to the unavoidable

situations such as scarcity of resources. If resources were unlimited,

there would be no need to forego any income yielding opportunity

and, therefore, there would be no opportunity cost. Resources are

scarce but have alternative uses with different returns, Resource

owners who aim at maximising of income put their scarce resources

to their most productive use and forego the income expected from

the second best use of the resources. Thus, the opportunity cost

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may be defined as the expected returns from the second best use of

the resources foregone due to the scarcity of resources. The

opportunity cost is also called the alternative cost.

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

for which he has only two alternative uses. He can buy either a

printing machine or, alternatively, a lathe machine. From printing

machine, he expects an annual income of Rs. 20,000 and from the

lathe, Rs. 15,000. If he is a profit maximising investor, he would

invest his tnoney in printing machine and forego the expected

income from the lathe. The opportunity cost of his income from

printing machine is,· the expected income from the lathe machine,

i.e., Rs. l5,000. The opportunity cost arises because of the foregone

opportunities. Thus, the opportunity cost of using resources in

the'Printing business is the best opportunity ahdthe expected

return from the lathe machine is the second best alternative. In

assessing the alternative cost, both explicit and implicit costs are

taken into account.

Associated with the concept of opportunity cost is the concept

of economic rent or economic profit. In our example, economic rent

of the printing machine is the excess of its earning over the income

expected from the lathe machine (i.e., Rs. 20,000 - Rs. 15,000 =

Rs. 5,000). The implication of this concept for a businessman is

that investing in printing machine is preferable as long as its

economic rent is greater than zero. Also, if firms have knowledge

of the economic rent of the various alternative uses of their

resources, it will be helpful for them to choose the best Investment

A venue. In contrast to opportunity cost, actual costs are those

which are actually incurred by the firm in the payment for labour,

material, plant, building, machinery, equipments, travelling and

transport, advertisement, etc. The total money expenditures,

recorded in the' books of accounts are, the actual costs, Therefore,

the actual cost comes under the accounting concept.

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Business Costs and Full Costs

Business.costs include all the expenses, which are incurred to carry

out a business. The concept of business costs is similar to the

actual or the real costs. Business costs include all the payments

and' contractual obligations made by the firm together with the

book cost of depreciation on plant and equipment. These cost

concepts are used for calculating business profits and losses, for

filing returns for income tax and for other legal purposes. The

concept of full costs, include business costs, opportunity cost and.

normal profit. As stated earlier the opportunity cost includes the

expected earning from the second best use of the resources, or the

market rate of interest on the total money capital and the value of

entrepreneur's own services, which are not charged for'in the

current business. Normal profit is a necessary minimum earning in

addition to the opportunity cost, which a firm must get to remain in

its present occupation.

Explicit and Implicit or Imputed Costs

Explicit costs are those, which fall under actual or business costs

entered in the books of accounts. For example, the payments for

wages and salaries, materials, licence fee, insurance premium and

depreciation charges etc. These costs involve cash payment and,

are recorded in normal accounting practices. In contrast with these

costs, there are other costs, which neither take the form of cash

outlays, nor do they appear in the accounting system. Such costs

are known as implicit or imputed costs. Implicit costs may be

defined as the earning expected froin thesecond best alternative

use of resources. For example, suppose an entrepreneur does not

utilise his services in his own business and works as a manager in

·some other firm on a salary basis. If he starts his own business, he

foregoes his salary as a manager. This loss of salary is the

opportunity cost of income from his business. This is an implicit cost

of his business. The cost is implicit, because the entrepreneur

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suffers the loss, but does not charge it as the explicit cost of his own

business. Implicit costs are not taken into account while calculating

the loss or gains of the business, but they form an important

consideration in whether or not a factor would remain in its present

occupation. The explicit and implicit costs together make the

economic cost.

Out-of-Pocket and Book Costs

The items of expenditure, which involve cash payments or cash

transfers recurring and non-recurring are known as out-of-pocket

costs. All the explicit costs such as wage, rent, interest and

transport expenditure. On the contrary, there are actual business

costs, which do not involve cash payments, but a provision is made

for them in the books of account. Thes costs are taken into account

while finalising the profit and loss accounts. Such expenses are

known as book costs. In a way, these are payments that the firm

needs to pay itself such as depreciation allowances and unpaid

interest on the businessman's own fund.

Fixed and Variable Costs

Fixed costs are those, which are fixed in volume for a given output.

Fixed cost does not vary with variation in the output between zero

and any certain level of output. The costs that do not vary for a

certain level of output are known as fixed cost. The fixed costs

include cost of managerial and administrative staff, depreciation of

machinery, building and other fixed assets and maintenance of

land, etc.

Variable costs are those, which vary with the variation in the

total output. They are a function of output. Variable costs inclue

cost of raw materials, running cost on fixed capital, such as fuel,

repairs, routine maintenance expenditure, direct labour charges

associated with the level of output and the costs of all other inputs

that vary with the output.

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Total, Average and Marginal Costs

Total cost represents the value of the total resource requirement for

the production of goods and services. It refers to the total outlays of

money expenditure, both explicit and implicit, on the resources

used to produce a given level of output. It includes both fixed and

variable costs. The total cost for a given output is given by the cost

function.

The Average Cost (AC) of a firm is of statistical nature and is not

the actual cost. It is obtained by dividing the total cost (TC) by the

total output (Q), i.e.,

AC =TC

= average cost Q

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

producing an additional unit of the product. Or marginal cost is the

cost of marginal unit produced. Given the cost function, it may be

defined as

These cost concepts are discussed in further detail in the

following section. Total, average and marginal cost concepts are

used in economic analysis of firm's producti on activities.

Short-run and Long-run Costs

Short-run and long-run cost concepts are related to variable and

fixed costs, respectively, and often appear in economic analysi.s

interchangeably. Short-run costs are those costs, which change with

the variation in output, the size of the firm remaining the same. In

other words, short-run costs are the same as variable costs. Long-

run costs, on the other hand, are the costs, which are incurred on

the fixed assets like plant, building, machinery, etc. Such costs

have long-run implication in the sense that these are not used up in

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AC=aTC

aQ

the single batch of production.

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

long-run, however, even the fixed costs become variable costs as

the size of the firm or scale of production increases. Broadly

speaking, the short-run costs are those associated with variables in

the utilisation of fixed plant or other facilities whereas long-run

costs are associated with the changes in the size and type of plant.

Incremental Costs and Sunk Costs

Conceptually, increment natal costs are closely related to the

concept of marginal sot. Whereas marginal cost refers to the cost of

the macgmalunit of output, incremental cost refers to the total

additional cost associated with the marginal batch of output. The

concept of incremental cost is based on a specific and factual

principle. In the real world, it is not practicable for lack of perfect

divisibility of inputs to employ factors for each unit of output

separately. Besides, in the long run, firms expand their production;

hire more men, materials, machinery, and equipments. The

expenditures of this nature are the incremental costs, anq not the

marginal cost. Incremental· costs also arise owing to the change in

product lines, addition or introduction of a new product,

replacement of worn out plan and machinery, replacement of old

technique of production with a new one, etc.

The sunk costs are those, which cannot be altered, increased or

decreased, by varying the rate of output. For example, once it is

decided to make incremental investment expenditure and the

funds are allocated and spent, all the preceding costs are

considered to be the sunk· costs since they accord to the prior

commitment and cannot be revised or reversed when there is

change in market conditions orchange in business decisions.

Historical and Replacement Costs

Historical cost refers to the cost of an asset acquired· in the past

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whereas replacement cost refers to the outlay, which has to be

made for replacing an old asset. These concepts own their

sigtlificance to unstable nature of price behaviour. Stable prices

over a period of time, other things given, keep historical and

replacement costs on par with each other. Instability in asset

prices, however, makes the two costs differ from each other.

Historical cost of assets is used for accounting purposes, in

the assessment of net worth of the firm.

Private and Social Costs

We have so far discussed the cost concepts that are related to the

working of the firm and those which are used in the cost-benefit

analysis of the business decision process. There are, however,

certain other costs, which arise due to functioning of the firm but

do not normally appear in business decisions. Such costs are

neither explicitly borne by the firms. The costs of this category are

borne by-the society. Thus, the total cost generated by a firm's

working may be divided into two categories:

• Those paid out or provided for by the firms,

• Those not paid or borne by the firm.

The costs that are not borne by the firm include use of resouces

freely available and the disutility created in the process of

production. The costs of the former category are known as private

costs and of the latter category are known as external or social

costs. A few examples of social cost are: Mathura Oil Refinery

discharging its wastage in the Yamuna River causes water pollution.

Mills and factories located in city cause air pollution by emitting

smoke. Similarly, plying cars, buses, trucks, etc., cause both air and

noise pollution; Such pollutions cause tremendous health hazards,

which involve health cost to the society as it whole Thes'e costs are

termed external costs from the firm's point of view and social cost

from the society's point of view. The relevance of the social costs

lies in understandipg the overall impact of firm's working on the

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society as a whole and in working out the social cost of private

gains. A further distinction between private cost and social cost

therefore, requires discussion.

Private costs are those, which are actually incurred or

provided by an individual or a firm on the purchase of goods and

services from the market. For a firm, all the actual costs both

explicit and implicit are private costs. Private costs are the

internalised cost that is incorporated in the firm's total cost of

production.

Social costs, on thehand refer to the total cost for the society

on account of production ofa commodity. Social cost can be the

private cost or the external cost. It includes the cost of resources for

which the firm is not compelled to pay a price such as rivers and

lakes, the public, utility services like roadways and drainage

system, the cost in the form of disutility created in through air,

water and noise pollution. This category is generally assumed to be

equal to total private and public expenditures. The private and

public expenditures, however, serve only as an indicator of public

disutility. They do not give exact measure of the public disutility or

the social costs.

COST-OUTPUT RELATIONS

The previous section discussed the variou cost concepts, which help

in the business decisions. The following section contains the

discussion of the behaviour of costs in relation to the change in

output. This is, in fact, the theory of production cost.

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

decisions relating to cost minirnisalioil"Of'profiHnaximisation and

optimisation of output. Cost-output relations are specified through a

cost function expressed as

T(C) = f(Q) (1)

where,

TC = total cost

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Q = quantity produced

Cost functions depend on production function and market-

supply function of inputs. Production function specifies the technical

relationship between the input, and the output. Production function

of a firm combined with the supply function of inputs or prices of

inputs determines the cost function of the firm. Precisely, cost

function is a function derived from the production function and the

market supply function. 'Depending on whether short or long-run is

considered for the production, there are two kinds of cost functions:

such as short-run cost-function and long-run cost function. Cost-

output relations in relation to the changing level of output will be

discussed here u.nder both kinds of cost-functions.

Short-run Cost Output Relations

The basic analytical cost concepts used in the analysis of cost

behaviour are total average and marginal costs. The totalcost (TC)

is defined as the actual cost that must be incurred to produce a

given quantity of output. The short-run TC is composed of two

major elements: total fixed cost (TFC) and total variable cost (TVC).

That is, in the short-run,

TC = TFC + TVC (2)

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

equipment, etc.) remains fixed in the short-run, where as TVC varies

with the variation in the output.

For a given quantity of output (Q), the average total cost,

(AC), average fixed cost (AFC) and, average var!able cost (AVC) can

'be defined as follows:

AC =TC

=TFC + TVC

Q Q

TFC

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AFC = Q

AVC =TVC

Q

and AC = AFC +AVC (3)

Marginal cost (MC) is defined as the change in the total cost divided

by the change in the total output, i.e.,

MC =∆TC

oraTC

∆Q aQ

(4)

Since ∆TC = ∆TFC + ∆TVC and, in the short-run, ∆TFC = 0,

therefore, ∆TC=∆TVC

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

∆TVC.

Cost Function and Cost-output Relations

The concepts AC, AFC and AVC give only a static relationship

between cost and output in the sense that they are related to a

given output. These cost concepts do not tell us anything about cost

behaviour, i.e., how AC, A VC and AFC behave when output

changes. This can be understood better with a cost function of

empirical nature.

Suppose the cost function (I) is specified as

TC = a + bQ - CQ2 + dQ3 (5)

(where a = TFC and b, c and d are variable-cost parameters)

And also the cost function is empirically estimated as

TC = 10 + 6Q - 0.9Q2 + 0.05Q3 (6)

and TVC = 6Q - 0.9Q2 + 0.05Q3 (7)

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

have been calculated for Q = I to 16 and is presented in Table 3.1.

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The TFC, TVC and TC have been graphically presented in Figure 3.1.

As the figure shows, TFC remains fixed for the whole range of

output, and hghce, takes the form of a horizontal line, i.e., TFC. The

TVCcurve shows that the total variable cost first increases ata'i

decreasing rate and then at an increasing rate with the increase it

the total output. The rate of increase can be obtained from the

slope of TVC curve. The pattemof change in the TVC stems directly

from the law of increasing and diminishing returns to the variable

inputs. As output increases, larger quantities of variable inputs are

required to produce the same quantity of output due to diminishing

returns. This causes a subsequent increase in the variable cost for

producing the same output. The following Table 3.1 shows the cost

output relationship.

Table 3.1: Cost Output Relations

Q FC TVC TC AFC AVC AC MC(I) (2) (3) (4) (5) (6) (7) (8)0 10 0.0 10.00 - - - -I 10 5.15 15.15 10.00 5.15 15.15 5.152 10 8.80 18.80 5:00 4.40 9.40 3.653 10 11.25 21.25 3.33 3.75 7.08 2.454 10 12.80 22.80 2.50 3.20 5.70 1.555 10 13.75 23.75 2.00 2.75 4.75 0.956 10 14.40 24.40 1.67 2.40 4.07 0.657 10 15.05 25.05 1.43 2.15 3.58 0.658 10 16.00 26.00 1.25 2.00 3.25 0.959 10 17.55 27.55 1.11 1.95 3.06 1.5510 10 20.00 30.00 1.00 2.00 3.00 2.4511 10 23.65 33.65 0.90 2.15 3.05 3.6512 10 28,80 38.80 0.83 2.40 3.23 5.1513 10 35.75 45.75 0.77 2.75 3.52 6.9514 10 44.80 54.80 0.71 3.20 3.91 9.0515 10 56.25 66.25 0.67 3.75 4.42 11.4516 10 70.40 80.40 0.62 4.40 5.02 14.15

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

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

Average Fixed Cost (AFC)

As already mentioned, the costs that remain fixed for a certain level

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of output make the total fixed cost in the short-run. The fixed cost is

represented by the constant term 'a' in equation (6). We know that

AFC =

TFC (8)

Q

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

AFC =

10 (9)

Q

Equation (9) expresses the behaviour of AFC in relation to

change in Q. The behaviour of AFC for Q from 1 to 16 is given in

Table 3.1 (col. 5) and is presented graphically by the AFC curve in

the Figure 3.1. The AFC curve is a rectangular hyperbola.

Average Variable Cost (AVC)

As defined above,

AVC =

TVC

Q

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

AVC =

6Q-0.9Q2+0.05Q3

= 6- 0.9Q+0.05Q3

(10)Q

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

obtain the behaviour of A VC in response to change in Q. The

behaviour of A VC for Q from I to 16 is given in Table 3.1 (co 1. 6),

and is graphically presented in Figure 3.2 by the A VC curve.

Critical Value of A VC

From equation (10), we may compute the critical value or Q in respect of A Vc. The

critical value of Q (in respect of A VC) is that value of Q at which A VCis minimum.

The Ave will be minimum when its decreasing rate of change is equal to zero. This

can be accomplished by differentiating equation (10) and setting it equal to zero.

Thus, critical value of Q can be obtained as

Q=aAVC

= 0.9+0.10Q=0

(11)

aQ

Q= 9

Thus, the critical value of Q=9. This can be verified from Table

3.1

Average Cost (AC)

The average cost in defined as

AC =TC

Q

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

10+6Q-09Q2+0.05Q3

(12a)

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AC =Q

=

10

+ 6-0.9Q+0.05Q2Q

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

change in Q. The behaviour of AC for Q from I to 16 is given in Table

3.1 and graphically presented in Figure 3.2 by the AC-curve. Note

that AC-curve is U-shaped.

From equation (12a), we may easily obtain the critical value of Q in

respect of AC. Here, the critical valuepf Q in respect of AC is one at

which AC is minimum. This can be obtained by differentiating

equation (l2a) and setting it equal to zero. This, critical vallie of Q in

respect of AC is given by

aAC

=

10- 0.9 + 0.1Q = 0

(12b)aQ Q2

This equation takes the form of a quadratic equation as

-10 – 0.9Q2 + 0.1Q3 = 0

or, Q3 – 9Q2 = 100 = 0

By solving equation (12b), we get

Q = 10

Thus, the critical value of output in respect of AC is 10. That is,

AC reaches its minimum at Q = 10. This can be verified from Table.

3.1 shows short-run cost curves.

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Marginal Cost (MC)

The concept of marginal cost (MC) is particularly useful in economic

analysis. MC is technically the first derivative of TC function. That is,

MC =aTC

aQ

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

aTC

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

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

MC for Q from 1 to 16 computed as MC = TCn - TCn- i is given in

Table 3.1 (col. 8) and graphically presented by MC-curve in Figure

3'.2. The critical 'value of Q in respect of MC is 6 or 7. It can be

seen from Table 3.1.

One method of solving quadratic equation is to factorise it and

find the solution.

Thus, Q3 – 9Q2 – 100 = 0

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(Q – 10) (Q2 + Q + 10) = 0

For this to hold, one of the terms must be equal to zero,

Suppose (Q2 + Q + 10) = 0

Then, Q – 10 = 0 and Q = 10.

COST CURVES AND THE LAWS OF DIMINISHING RETURNS

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

through the .cost curves. Figures 3.1 and 3.2 clearly bring out the

short-term laws of production, i.e., the laws of diminishing returns.

Let us recall the law: it states that when more and more units of a

variable input are applied to those inputs which are held constant,

the returns from the marginal units of the variable input may

initially increase but will eventually decrease. The same law can also

be interpreted in term's of decreasing and increasing costs. The law

can then be stated as, if more and more units of a variable inputs

are applied to the given amount of a fixed input, the' marginal cost

initially decreases, but eventually increases. Both interpretations of

the law yield the same information: one in terms of marginal

productivity of the variable input, and the other, in terms of the

marginal cost. The former is expressed through production function

and the latter through a cost function.

Figure 3.2 represents the short-run laws of returns in terms of

cost of production. As the figure shows, in the initial stage of

production, both AFC and AVC are declining because of internal

economies. Since AC = AFC + AVC, AC is also declining, this shows

the operation of the law of increasing returns. But beyond a certain

level of output (i.e., 9 units in out example), while AFC continues to

fall, AVC starts increasing because of a faster increase in the TVC.

Consequently, the rate of fall in AC decreases. The AC reaches its

minimum when output increases to 10 units. Beyond this level of

output, AC starts increasing which shows that the law of diminishing

returns comes in operation. The MC, curve represents the pattern of

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change in both the TVC and TC curves due to change in output. A

downward trend in the MC shows increasing marginal productivity of

the variable input mainly due to internal economy resulting from

increase in production. Similarly, an upward trend in the MC shows

increase in TVC, on the one hand, and decreasing marginal

productivity of the variable input, on the other.

SOME IMPORTANT COST RELATIONSHIPS

Some important relationships between costs used in analysing the

short-run cost behaviour may now be summed up as follows:

As long as AFC and AVC fall, AC also falls because AC = AFC

+AVC.

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

the rate of change in AFC and AVC then any of the following

happens:

ifthereisdecrease in AFC and increase in A VC, AC falls,

if the decrease on AFC is equal to increase in Ave, AC

remains constant, and

if the d~crease in AFC is less than increase in A VC, AC

increases.

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

be described as follows:

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

output. When MCis failing, the rate of fall in MC is greater

than that of AC This is because in case of MC the decreasing

marginal cost is attributed, : to a single marginal unit while;

in case of AC, the decreasing marginal cost is distributed

overall the entire output. Therefore, AC decreases at a lower

rate than MC.

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

lower rate fbr the reason given in'the above point. There is

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however a range of output over which this relationship does

not exist. For example, compare the behaviour of MC and

AC over the range of output frbm 6 units to 10 units (see

Figure 3.2). Over this range of ~utput, MC begins to

increase while AC continues to decrease. The reason for this

can be seen in Table. 3.1. When MC starts increasing, it

increases at a relatively lower rate, which is sufficient only

to reduce the rate of decrease in AC, i.e., not sufficient to

push the AC up. That is why AC continues to fall over some

range of output even, if MC falls.

MC iJ1tetsects AC at its minimum point. This is simply a

mathematical relationship between MC and AC curves when

both of them are obtained from the same TC function. In

simple words, when AC is at its minimum, then it is neither

increasing nor decreasing it is constant. When AC is

constant, AC = MC.

Optimum Output in Short-run

An optimum level of output is the one, which can be produced at a

minimum or least average cost, given the required technology is

available. Here, the least'tcost' combination of inputs can be

understood with the help of isoquants and isocosts. The least-cost

combination of inputs also indicates the optimum level of output at

given investment and factor prices. The AC and MC cost Curves can

also be used to find the optimum level of output, given the size of

the plant in the short-run. The point of intersection between AC and

MC curves deterinines the minimum level of AC. At this level of

output AC = MC. Production beloW or beyond thislevelwill be in

optimal. If production is less than 10 units (Figure 3.2) it will leave

some scope for reducing AC by producing more, because MC < AC.

Similarly, if production is greater than 10 units, reducing output can

reduce AC. Thus, the cost curves can be useful in finding the

optimum level of output. It may be noted here that optimum level of

output is not necessarily the maximum profit output. Profits cannot

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be known unless the revenue curves of firms are known.

Long-run Cost-output Relations

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

variability of inputs is based on the assumption that, in the long run,

supply of all the inputs, including those held constant in the short-

run, becomes elastic. The firms are, therefore, in a position to

expand the scale of their production by hiring a larger quantity of all

the inputs. The long-run cost-output relations, therefore, imply the

relationship between the changing scale of the firm and the total

output; conversely in the short-run this relationship is essentially

one between the total output and, the variable cost (labour). To

understand the long-run costoutput relations (lnd to derive long-run

cost curves it will be helpful to imagine that a long run is composed

of a series of short-run production decisions. As a' corollary of this,

long-run cost curves are composed of a series of short-run cost

curves. We may now derive the long-run cost curves and study

their' relationship with output.

Long-run Total Cost Curve (LTC)

In order to draw the long-run total cost curve, let us begin with a

short-run situation. Suppose that a firm having only one-plant has

its short-mn total cost curve as given-by STCl in panel (a) of Figure

3.3. In this example if the firm decides to add two more plants to its

size over time, one after the other then in accordance two more

short-run total cost curves are added to STCl in the manner shown

by STC2 and STC3 in Figure 3.3 (a):. The LTC can now be drawn

through the minimum points of STCl, STC2 and STC3 as shown by the

LTC curve

corresponding to each STC.

Long-run Average Cost Curve (LAC)

Combining the short-run average cost curves (SACs) derives the

long-run average cost curve (LAC). Note that there is one SAC

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associated with each STC. Given the STC1 STC2, and STC3 curves in

panel (a) of Figure 3.3, there are three corresponding SAC curves as

given by SAC1 SAC2 arid SAC3 curves in panel (b) of Figure 3.3. Thus,

the firm has a series of SAC curves, each having a bottom point

showing the minimum SAC. For instance, C1Q1 is the minimum AC

when the firm has only one plant. The AC decreases to C2Q2 when

the second plant is added and then rises to C3Q3after the inclusion

of the third plant. The LAC carl be drawn through the bottom of

SAC1 SAC2 and SAC3 as shown in Figure·3.3 (b) The LAC curve is also

known as ‘Envelope Curve' or 'Planning Curve' as it serves as a

guide to the entrepreneur in his planning to expand production.

The SAC curves can be derived from the data given in the STC

schedule, from STC function or straightaway from the LTC-curve.

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Similarly, LAC can be derived from LTC-schedule, LTC function or

from LTC-curve. The relationship between LTC and output, and

between LAC and output can now be easily derived. It is obvious.

from the LTC that the long-run cost-output relationship is similar to

the short-run cost-output relationship. With the subsequent

increase in the output, LTC first increases at a decreasing rate, and

then at an increasing rate. As a result, LAC initially decreases until

the optimum utilisation of the second plant and then it begins to

increase. From these relations are drawn the 'laws of returns to

scale'. When the scale of the firm expands, unit cost of production

initially decreases, but it ultimately increases as shown in Figure

3.3 (b).

Long-run Marginal Cost Curve

The long-run marginal, cost curve (LMC) is derived from the short-

run marginal cost curves (SMCs). The derivation of LMC is illustrated

in Figure 3.4 in which SAC3'and LAC arethe same as'in Figure 3.3(b).

To derive the LMC3, consider the points of tangency between SAC3

and the LAC, i.e., points A, Band C. In the long-run production

planning, these points determine the output levels at the different

levels of production. For example, if we draw perpendiculars from

points A, Band C to the X-axis, the corresponding output levels will

be OQ1 OQ2 and OQ3 The perpendicular AQ1 intersects the SMC1 at

point M. It means that at output BQ2, LMC, is MQ1. If output

increases to OQ2, LMC rises to BQ2. Similarly, CQ3 measures the LMC

at output OQ3. A curve drawn through points M3B and N, as shown

by the LMC, represents the behaviour of the marginal cost in the

long run. This curve is known as the long-run marginal cost curve,

LMC. It shows the trends in the marginal cost in response to the

change in the scale of production.

Some important inferences may be drawn from Figure 3.4. The

LMC must be equal to SMC for the output at which the

corresponding SAC is tangent to the LAC. At the point of tangency,

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LAC = SAC. For all other levels of output (considering each SAC

separately), SAC > LAC. Similarly, for all levels of outout

corresponding to LAC = SAC, the LMC = SMC. For all other levels

output, i:he LMC is either greater or less than the SMC. Another

important point to notice is that the LMC intersects LAC when the

latter is at its minimum, i.e., point B. There, is one and only one

short-run plant size whose minimum SAC coincides with the

minimum LAC. This point is B where, SAC2 = SMC2 = LAC = LMC.

Optimum Plant Size and Long-run Cost Curves

The short-run cost curves are helpful in showing how a firm can

decide on the optimum utilisation of the plant-which is the fixed

factor; or how it can determine the least-cost output level. Long-run

cost curves, on the other hand, can be used to show how the

management can decide on the optimum size of the firm. An

Optimum size of a firm is the one, which ensures the most efficient

utilisation of resources. Given the state: of technology overtime,

there is technically a unique size of the firm and lever of output

associated with the least cost Concept. This uriique size of the firm

can be obtained with the help of LAC and LMCIn Figur 3.4 the

optimum size consists of two plants, which produce OQ2 units of a

produd, at minimum long-run average cost (LAC) of BQ2.

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The downtrend in the LAC ihdicates that until output reaches

the level of OQ2, the firm is of non-optimal size. Similarly, expansion

of the firm beyond production capacity OQ2 causes a rise in SMC as

well as LAC. It follows that given the technology, a firm trying to

mini mise its average cost over time must choose a plant which

gives minimum LAC where SAC = SMC = LAC = LMC. This size of

plant assures most efficient utilisation of the resource. Any change

in output level, i.e., increase or decrease, will make the firm enter

the area of in optimality.

ECONOMIES AND DISECONOMIES OF SCALE

Scale of enterprise or size of plant means the amount of investment

in relatively fixed factors of production (plant and fixed equipment).

Costs of production are generally lower in larger plants than in the

smaller ones. This is so because there are a number of economies

of large-scale production.

Economies of Scale

Marshall classified the economies of large-scale production into two

types:

1. ExternalEconomies

2. Internal Economies

External Economies are those, which are available to all the

firms in an industry, for example, the construction of a railway line

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in a certain region, which would reduce transport cost for all the

firms, the discovery of a new machine, which can be purchased by

all the firms, the emergence of repair industries, rise of industries

utilising by-products, and the establishment of special technical

schools for training skilled labour and research institutes, etc. These

economies arise from the expansion in the size of an industry

involving an increase in the number and size of the firms engaged in

it.

Internal Ecnomies are the economies, which are available to

a particular firm and give it an advantage over other firms engaged

in the industry. Internal economies arise from the expansion of the

size of a particular firm. From the managerial point of view, internal

economies are more important as they can be affected by

managerial decisions of an individual firm to change its size or

scale.

Types of Internal Economies

There are various types of internal economies such as labour,

technical, managerial, marketing and so on. We will discuss the

types of internal economies in detail in the following section:

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

output, it will be possible for it to reduce the labour costs per

unit by practising division of labour. Economies of division of

labour arise due to increase in the skill of workers, and the

saving of time involved in changing from one operation to the

other. Again, in many cases, a large firm may find it

economical to have a number of operations performed

mechanically rather than manuaily. These economies will be

of great use in firms where the product is complex and the

manufacturing processes can be sub-divided.

Technical Economies: These are economies derived from

the use of subsize machines and such scientific processes like

those which can be carried out in large production units. A

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small establishment cannot afford to use such machines and

processes, because their use would bring a saving only when

they are used intensively. On the other hand, their use will be

quite uneconomical if they were to lie idle over a considerable

part of the time. For example, a large electroplating plant

costs a great deal to keep it in operation. Therefore, the cost

per unit will be low only if the output is large. Similarly, a

machine that facilitates the pressing out a side of a motorcar

will take a week or more to be put ready for operation to

produce a particular design. The greater the output of cars of

this particular designs the lower the cost per unit of getting

the machine ready for operation. Similarly, if a dye is made to

produce a particular model of cars, the cost of dye per unit of

cars will depend upon the output of the cars. Very often large

firms may find it economical to produce or manufacture parts

and components for their products rather than buy them from

outside sources. For example, Hind Cycles, unlike small

mariufacturers, produced parts and components themselves.

Moreover, large firms may find it profitable to utilise their by-

products and waste products. For example, Tata use the

smoke from their furnaces to manufacture coal tar,

naphthalene, etc. A small firm's output of smoke would not be

large enough to justifY setting up the .equipment necessary to

do so.

Managerial Economies: When the size of the fern increases,

the efficiency of the management usually increases because

there can be greater specialisationin managerial staff. In a

large firm, experts can be appointed to look after the various

sections or divisions of the business, such as purchasing,

sales, production, financing, personnel, etc. But a small firm

cannot provide full-time employm·entto these experts

naturally, the various aspects of the business have to be

looked after by few people only who may not necessarily be

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experts. Moreover, a large firm can afford to set up data

processing and mechanised accounting, etc., whereas small

firms cannot afford to do so.

Marketing Economies: A large firm can secure economies in

its purchasing and sales. It can purchase its requirements in

bulk and thereby get better terms. It usually receives prompt

deliveries, careful attention and special facilities from its

suppliers. This is sometimes due to the fact that a large buyer

can exert more pressure·, at times compulsive in nature, for

specially favoured treatment. It can also get concessions from

transport agencies. Moreover, it can appoint expert buyers and

expert salesmen. Finally, a large firm can spread its advertising

cost over bigger output because advertising costs do not rise in

proportion to a rise in sales.

Economies of Vertical integration: A large firm may decide

to have vertical integration by combining a number of stages of

production. Thisintegration has the advantage that the flow of

goods through various stages in production processes is more

readily controlled. Steady supplies of raw materials, on the one

hand, and steady outlets for these raw materials, on the other,

make production planning more certain and less subject to

erratic and unpredictable changes. Vertical integration may also

facilitate cost control, as most of the costs become controllable

costs for the enterprise. Transport' costs may also be reduced

by planning transportation in such a way that cross hauling is

reduced to the minimum.

Financial Economies: A large firm can offer better security and

is, therefore, in a position to secure better and easier credit

facilities both from its suppliers and its bankers. Due to a better

image, it enjoys easier access to the capital market.

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

business, the greater is the scope for spreading of risks through

diversification. Diversification is possible.on two lines as follows:

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o Diversification of Output: If there are many products,

the loss in the sale of one product may be covered by

the profits from others. By diversification, the firm

avoids what may be called putting all eggs in the same

basket. For example, Vickers Ltd., make aircrafts, ships,

armaments, food-processing plant, rubber, plastics,

paints, instruments arid a wide range of other products.

Many of the larger firms have taken to diversification.

ITC diversified to include marine products and hotel

business in its operations.

o Diversification of Markets: The larger producer is

glenerally in a position to sell his goods in many

different and even far-off places. By depending upon

one market, he runs the risk of heavy loss if sales in

that market decline for one reason or the other.

Sargant Floren'ce and Economies of Scale

Sargant Florence has attributed the economies of scale the three

principles, which are in operation in a large-sized business, namely,

the principle of bulk transactions, the principle of massed reserves,

and the principle of multiples.

Principle of Bulk Transactions: This principle implies that

the cost of dealing with a large batch is often no greater than

the cost of dealing with a small batch, for example,' the cost of

placing an order, large or small; availability of discounts on

bulk orders, or annual purchase contracts; economies in the

use or'large containers such as tanks or trucks of special

design, for a container holding, say, twice as much as the other

one, does not cost double the amount.

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

departments or sections and its overall demand for services,

say, transport services, is likely to be fairly large. But it is

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unlikely that all departments will make heavy demands of the

particular service at the saine time. Thus the firm can afford to

have its own transport fleet and fully utilise it and thereby

ultimately reduce its costs. The larger the firm, the greater are

the advantages.

Principle of Multiples: This principle was first raised by

Babbage in 1832 and has also been referred to as 'Balancing of

Processes'. The principle can be better explained through an

example. Suppose a manufacturing, operation involves three

processes, first in which a machine (:an make 30 units a week;

second in which an automatic machine can make 1,000 units

per week; and a third in which a semi-automatic machine can

make 400 units per week. Unles~ the output of the plant is

some common multiple of 30,1,000 anti 400, one or more of the

processes will have unutilised capacity. Their LCM is 6,000 and,

therefore, to best utilise all the machines the plant size must be

of at least 6,000 units or any of its multiples.

Economies of Scale and Empirical Evidence

According to the surveys conducted by the Pre-investment Survey

Group (FAG) and later on by the NCAER, it has been pf()Ved that in

paper industry, profitability decreases with lower scaly of operations

and bigger plants beneht from economies of scale. The report of the

Pre-investment Survey Group (FAG) reveals that the manufacturing

cost of writing and printing paper would fall from Rs. 1,489 in a 100-

tonne per day plant to Rs. 1,238 in a 200-tonne per day plant and

further to Rs. 1,104 in a 300-tonne per day plant. The following

Table 3.2 further shows the capital cost of raw materials and

operating cost per tonne of paper according to the size of the unit,

as estimated by the NCAER.

Table 3.2: Paper Industry: Investment and Other

Costs of Paper Mills according to Size

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Size Tonnes Fixed Cost of raw Operatingper day) investment cost ma terials per cost per tonne

'. per tonne tonne of paper of paper100 • 4,473 324 1,307200 4,070 263 1,116

250 3,945 258 1,056

Another study of cement industry by the Economic and

Scientific Research undation-shows that the per unit of capacity

capital investment of a 3,000 tonne per' day (TPD) capacity cement

plant islower than the plants of 50 TPD size. Thus a single cement

plant producing 3,200 TPD requires 46 per cent less capital

investment than 8 plants of 400 TPD productions would. As regards

cost of production, a 800 TPD plant has a 15 per cent cost

advantage over a 400 TPD plant. The difference between the cost of

production of a tonne of cement by a 3,000 TPD plant and of a50

TPD plant is as high as Rs. 100 per tonne. In fact, there has been a

perceptible increase in the size of cement plants in India. For

example, the 600 tonnes per day capacity cement plants during the

early 1960s gave way with their size going up to 1,200 tonnes per

day. The latest preference is for 3,200 tonnes per day capacity

plants. A significant policy implication of economics of scale is that

in order to earn a reasonable return and at the same time ensure a

fair deal to the consumers, the industry should go in for larger

plants and expand the existing plants to .the optimum level.

The 6/10 Rule

A useful rule that seeks to measure economies of scale is the 6/1 0

rule. According to this rule, if we want to double the volume of a

container, the material needed to make it will have to be increased

by 6/10, i.e., 60 per cent. A proofofthe'6/l0 rule is easy and can be

given here with its advantage. Let us begin with the volume of a

container and the material required to make it. Suppose the

container is of the shape of a Gube with its side. The volume of the

container then is:

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Vo = ao x ao x ao = ao3

Now, to find out the area of material needed, we know that the

container will have six equal square faces, each of area an 2 so, the

area of total material needed IS:

Mo = 6 x ao2 = 6ao2

Suppose now, that the container's dimension increases from an

to all the volume of the container will then increase to al3 and the

area of t~e material needed will increase to 6a12.

Thus, for two containers of dimensions an and al the ratio of the

areas of material needed will be:

M1

=

6a1/2

=

a1/2

M0 6a0/2 a0

The corresponding ratio of the volumes will be:

V1

=

a1/3

=

a1/3

V0 a0/3 a0

From the above, it follows that:

M1

=

a1/2

=

a1/3.2/3=

V 1 2/3

M0 a0/2 a0 V0

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

V1 = 2V0 orV1

=2V0

Then,

M1=

V1 2/3= (20) 2/3 = 1.59

M0 V0

M1 = 1.59 M0

In other words, doubling the volume requires 59 per cent

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increase in material. This is rouJded off as 60 per cent, which is the

same as 6/1O. It may be added that, if in place of a cubical container, we had

taken the example of a spherical or a rectangular or a cylindricai or for that matter a

conical container, we would have aijived at the same relationship, viz.,

M1

=V12/3

M0 V0

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

can well be realised if we visualise, for example, blast furnaces as

boxes containing the ingredients needed to produce iron, or tankers

as large boxes containing oil.

Minimum Economic Capacity (MEC) Scheme

Small size firms do not enjoy economies of scale. As such, in

pursuance of government's policy to encourage minimum efficient

capacity in industrial und~i1akings, the Government of India has

introduced' MEC Scheme to petrochemical industries, for example,

Naphtha / Gas Cracker (3 to 4 lakhs tonnes), Bopp Film (56,000

tonnes), Polyster Film (5,000 tonnes), Polyster Filament Yam

(25,000 tonnes), Acrylic Fibre (20,000 tonnes), MEG (One lakh

tonnes), PTA (2lakh tonnes), etc.

World Sdale

With re·cent trends towards globalisation of industries in India, the

concept of "World Scale" has emerged. The term 'World Scale' refers

to that scale or size of the enterprise, which is large enough to

enable the firm to reap various large-scale economies so as to

compete successfully on the world basis with global rivals. Thus

Reliance Industries Limited has recently announced to build a world

scale polyester facility at Hnzira and a cracker project with capacity

expanding from earlier 40,000 tonnes·to the world scale of 7,50,000

tonnes per annum.

Diseconomies of Scale

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Economies of increasing size do not continue indefinitely. After a

certain point, any further expansion of the size leads to

diseconomies of scale. For example, after the division of labour has

reached its most efficient point, further increase in the number of

workers will lead to a duplication of workers. There will be too many

workers per machine for really efficient production. Moreover, the

problem of co-ordination of different processes may become

difficult. There may be divergence of views concerning policy

problems among specialists in management

and reconciliation may be difficult to arrive. Decision-making

process becomes slow resulting in missed opportunities. There may

be too much of formality, too many individuals between the

managers and workers, and supervision may' become difficult. The

management problems thus get out of hand with consequent

adverse effects on managerial efficiency.

The limit of scale economics is also often explained in terms of

the possible loss of control and consequent inefficiency. With the

growth in the size of the firm, the control by those at the top

becomes weaker. Adding one more hierarchical level removes the

superior further away from the subordinates. Again, as the firm

expands, the incidence of wrong judgements increases and errors

in judgement become costly.

Last be not the least, is the limitation where the larger the

plant, the larger is the attendant risks of loss from technological

changes as technologies are changing fast in modern times.

Diseconomies of Scale and Empirical Evidence

Large petro-chemical plants achieve economies in both full usage

and in utilisation of a wider range ofby-products, which would

otherwise, be wasted. But above 5,00,000 tonnes, diseconomies of

scale sets in because of the following occurrences:

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

parts is required which is much more expensive;

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

delays in commissioning can be extremely expensive; and

The technical limit to compressor size has been reached.

There is, however, no substantial evidence of diseconomies of

large-scale production. In the final analysis, however, a significant

test of efficiency is survival. If small firms tend to disappear and

large ones survive, as in the automobile industry, we must

conclude that small firms are relatively inefficient. If small firms

survive and large ones tend to disappear as in the textile industry,

then large firms are relatively inefficient. In reality, we find that in

most industries, firms of very different sizes tend to survive.

Hence, it can be concluded that usually there is no significant

advantage or disadvantage to size over a very wide range of

outputs. It may mean, of course, that the businessman in his

planning decisions determines that beyond a certain size, plants do

have higher costs and, therefore, does not build them.

Somewhat surprisingly, some Indian entrepreneurs have been

perceptive enough to attempt to derive the advantages of both

large and small-scale enterprises. In the late sixties, the Jay

Engineering Co. Ltd. evolved a strategy of blending large units with

small enterprises to obtain the best of both worlds. It manufactures

its Usha fans in three different plants (Calcutta, Hyderabad and

Agra), with each plant' manu facturing the same or a similar range

of products. Each unit is autonomous and is free to take operational

decisions except in highly strategic areas. Within each unit, the

work-force is kept small to carry out vital operations such as

forgoing, blanking, notching and final assembly. The rest of the

work is sub-contracted to neighbouring small-scale units, which

over a period or time have become almost integral parts of each

plant. Loans for the purchase of machinery are also advanced and

technical know-how and sometimes-eve training is provided to

these ancillary units.

Payments are made promptly. The whole system operates like

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families within a larger family. Managers in the US, who are always

quick in innovating, have also begun adopting this blended system

during the past few years. General Motors encourages the creation

ofa cluster of independent enterprises in an area, with adequate

autonomy granted to the company's area chief to encourage their

growth and developm.ent. Consequently, though a giant in the

automobile industry, General Motors enjoys a large number of the

privileges that acerue to small units and also reaps the special

benefits accruing to large business firms.

Economies of Scope

This concept is of recent development and is different from the

concept of economies of scale. Here, the cost efficiency in

production process is brought out by variety rather than volume,

that is, the cost advantages follow from variety of output, for

example, product diversification within the given scale of plant as

against increase in volume of production or scale 6f output. A firm

can add new and newer products if the size of plant and type of

technology make it possible. Here, the firm will enjoy scope-

economies instead of scale economies.

COST CONTROL AND COST REDUCTION

Cost Control

The long-run prosperity of a firm depends upon its ability to eam

sustaid profits. Profit depends upon the difference between the

selling price and the cost of production. Very often, the selling price

is not within the control of a firm but many costs are under its

control. The firm should therefore aim at doing whatever is done at

the minimum cost. In fact, cost control is ail essential element for

the successful operation of a business, Cost control by management

means a search for better and more economical ways of completing

each operation. In effect, cost control would mean a reduction in the

percentage of costs and, in turn, an increase in the percentage of

profits. Naturally, cost control is and will continue to be of perpetual

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concern to the industry.

Cost control has two aspects' such as a reduction in specific

expenses and a more efficient use of every rupee spent. For

example, if sales can be increased with the same amount of

expenditure, say, on advertising and saTesmen, the cost as a

percentage of sales is cut down. In practice, cost control will

ultimately be achieved by looking into both these aspects and it is

impossible to assess the contribution, which each has made to the

overall savings. Potential savings in individual businesses will,

however, vary between wide extremes depending upon the levels of

efficiency already achieved before cost controls are introduced.

It is useful to bear in mind the following rules covering cost

control activities:

It is easier to keep costs down than it is to bring costs down.

The amount of effort put into cost control tends to increase

when business is bad and decrease when business is good.

There is more profit in cost control when business is. good than

when I business is bad. Therefore, one should not be slack

when conditions are good.

Cost control helps a firm to improve its profitability and

competitiveness. Profits may be drastically reduced despite a large

and increasing sales volume in the absence of cost control. A big

sales volume does not necessarily mean a big profit. On the other

hand, it may create a false sense of prosperity while in reality;

increasing costs are eating up profits. Profit is in danger-when good

merchantdising and cost control do not go hand in hand. Cost

control may also help a firm in reducing its costs and thus reduce its

prices. A reduction in prices of a firm would lead to an increase in its

competitiveness. The aspect is of particular relevance to Indian

conditions because of high costs, India is being priced out of the

world markets.

Tools of Cost Control

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

Standard Costs and Budgets: The technique of standard,

costing has been developed to establish standards of performance

for producing gvuus and services. These standards serve "as a goal

for the attainment and as basis of comparison with actual costs in

checking performance. The analysis of variance between actual and

standard costs will: (i) help fix the responsibility for non-standard

performance and (ii) focus attention on areas in which cost

improvement should be sought by pinpointing the source of loss and

inefficiency. The principle here is that or controlling by exception.

Instead of attempting to follow a mass of cost data, the attention of

those responsible for cost control is concentrated on significant

variances from the standard. If effective action is to be taken, the

cause and responsibility of a variance, as well as its amount, must

be established.

The prime objective of standard costs is to generate greater

cost consciousness and help in cost control by directing attention

to specific areas where action is needed. To those who are

immediately concerned, variances wou1d indicate whether any

action is required on their part. It must be noted that

Costs are controlled at the points where they are incurred and

at the time of occurrence of events, and

At the same time they may be uncontrolled at some points.

It is, therefore, necessary to understand the difference

between controllable and uncontrollable costs. The variances may

also be controllable and uncontrollable. For example, if the material

cost variance is due to rise in prices, it is not within the control of

the production manager. But if the variance is due to greater usage,

control action is certainly possible on his part. The higher

management can also deCide whether or not they should intervene

in the matter. Sometimes, variances may be so significant that a

complete reapRraisal of the standard costs themselves may be

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needed.

For example, if the variances are always favourable, it may

point to the fact that the standards have not been properly fixed.

Standard costing can also provide the means for actual and

standard cost comparison by type of expense, by departments or

cost centres. Yields and spoilage can be compared with the

standard allowance for loss. Labour operations and overheads also

can be checked for efficiency. Flexible budgets constitute yet

another effective technique of cost control, especially control of

factory overheads. Flexible budgets, also known as variable

budgets; provide a basis for determining costs that are anticipated

at various levels of activity. It provides a flexible standard for

comparing the costs of an actual volume of activity with the cost

that should be or should have been. The variances can then be

analysed and necessary action can be taken in the matter. Table

3.3 gives a specimen flexible budget.

Table 3.3: Finishing Department, Modern Manufacturing Co.

Standard hours of direct labour35,000 40,000 45,000

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

The scientific establishment of standards of performance

through standard costs and budgets has not only provided better

cost control but has led to cost reduction in a number of

companies. This has been the case especiilIIy in companies where

standards were tied to wage-incentive plans and improyement in

control is part of a general programme of better management. The

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above table shows three budgets, one each for 35,000, 40,000 and

'45,000 standard hours of work. In practice, one may come across

50 or more cost items in the budget and not just four as shown in

the table.

Ratio Analysis

RatIo is a statistical yardstick that provides a measure of the

relationship betweeri two figures. This relationship may be

expressed as a rate (costs per rupee of sales), as a per cent (cost of

sales as a percentage of sales), or as a quotient (sales as a certain

number of time the inventory). Ratios are commonly used in the

analysis of operations because the use of absolute figures might be

misleading. Ratios provide standards of comparison for appraising

the performance of a business firm. They can be used for cost

control purposes in two ways:

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

under scrutiny with similar ratios of the previous periods. Such

a comparison would help him identify areas that need his

attention.

• The businessman can compare his ratios with the standard

ratios in his jndustry. Standard ratios are averages of the

results achieved by thousands, of firms in the same line of

business.

If these comparisons reveal any significant differences,

thtYmanagement call analyse the reasons for these differences and

can take appropriate action to remove' the causeS responsible for

increase in costs. Some of the most commonly used ratios for cost

corrtparisons are given below:

• Not profits/sales.

Gross profits/sales.

Net profits/total assets.

Sales/totaLassets.

• Production costs/costs of sales.

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Selling Costs/costs of sales.

Admiriistration costs/costs of sales.

Sahes/iriventory or inventory turnover.

Material costs/prod1, Jction costs.

Labour costs/production

costs.

Overhead/prqduction costs.

Value Analysis: Value analysis is an approach to cost saving

that deals with product design. Here, before making or buying any

equipment or materials, a study is made of the purpose to which

these things serve. Would other lower-cost designs work as well?

Could another less costly item fill the need? Will less expensive

material, do the job? Can scrap be reduced by changing the design

or the type of raw materiaJ? Are the seller's costs as low as they

ought to be? Suppliers of alternative materIals can provide the

ample data to make the appropriate choice. Of course, absorbing

and reviewing the data will need some time. Thus the objective of

value analysis is the identification of such costs in a product that do

not in any manner contribute to its specifications or functional

value. Hence, value analysis is the process of reducing the cost of

the prescribed function without sacrificing the required standard of

performance. The emphasis is, first, on identificatiqn of the required

function and, secondly, on determination of the best way to perform

it at a lower cost. This novel method of cost reduction is not yet

seriously exploited, in our country. Value analysis is a

supplementary device in addition to the con~entional cost reduction

methods.

Value analysis is closely related to value engineering, though

they are not identical. Value analysis refers to the work that

purchasing department does in-this direction whereas value

engineering usually refers to what engineers are doing in this area.

The purchasing department raises questions and consults the

engineering department and even the vendor company's

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department. Value analysis thus requires wholehearted co-operation

of not only the firm's expertise in design, purchase, production and

costing but also that of the vendor and other company expertise, if

necessary. Some examples of savings through value analysis are

given below:

Discarding tailored products where standard components can

do.

Dispensing with facilities not specified or not required by the

customer, for example, doing away with headphone in a radio

set.

Use ofnewly-deyeloped, better and cheaper materials in place

of traditional materials.

Taking the specific case of TV industry, there are various

components of cost, which can be questioned. The various items are

as under:

Whether to have vertical holding chassis or the chassis should

be tied down horizontally. In case, chassis is held vertically,

additional expenditure in terms of holding clamps is required.

Whether to have plastic cabinet or wooden cabinet.

Whether to have two speakers or one speaker.

Whether to have sliding switches or stationary switches.

Whether to have PVC back cover or wooden back cover.

Whether to have costly knobs or cheaper knobs.

Whether to have moulded mask or extruded plask.

Whether to have Electronic Tuner or Turret Tuner.

Whether to have digital operating unit or noble operating unit.

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

altered by the management on their own initiative. It may be noted

in this context that, by and large, non-controllable costs exceed far

more than controllable ones thereby restricting the scope of profit

impfoyement through cost, control. Of course, attempts may be

made to convert an uncontrollable cost into a controllable one.

Vertical combinations to secure control over sources of supply

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provide an example. So also instead of buying a component, a firm

may decide to make the conversion possible.

AREAS OF COST CONTROL

Folloviing are the areas where the cost can be controlled:

1. Materials

There area number of ways that help in reducing the cost

ofmatenals. Ifbuying is done properly, a firm avails itself of quantity

discounts. While buying from a particular source, in addition to the

cost of materials, consideration should be given to freight charges.

In some cases, lower prices of materials may be offset by higher

freiight to the firm's godown. Whiie buying, one may attempt to buy

from the cheapbt source by inviting bids. At times, it may be

possible to have more economical substitutes for raw materials that

the firm is using. Many a times, improvell1ent in product design

may lead to reduction in material usage. It is desirable to

concentrate attention on the areas where saving potential is the

highest.

Another area, which needs examination in this respect, is

whether to make or buy components from outside source. Very

often firm may find it advantageous to manufacture certain parts

and components in one's own factory rather than buying them. Yet

in many cases there are specific advantages in purchasing spares

and components from outside because suppliers may deliver goods

at low cost with high quality. For example, Ford and Chrysler of the

US Auto Industry purchase their components from outside source.

But General Motors could not do so because the firm has its own

departments for handling the process of production. This type of

firm is referred as vertically integrated firm where it owns the

various aspects of making seIling and delivering a product Hind

Cycles, which has now been taken over by the Government,

manufactures all its components. But manufacturers of Hero and

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Avon Cycles purchased most of their components from outside

source and successfully competed with Hind Cycles.

Continuous Research and Development (R & D) may also lead

to a reduction in raw material costs. For example, Asian Paints

made high savings in costs of raw materials by its phenomenal

success on Research and Development front, by manufacturing

synthetic resins for captive consumption. Total materials consumed

as a ratio of value of production fell from 67.66 per cent in 1973 to

60-67 per cent in 1977. General Motors have reduced the weight of

their cars to make them more fuel-efficient. Better utilisation of

materials' may also save the cost of materials by avoiding wastes in

storing, handling and processing. Some of the factors, responsible

for excessive wastage of materials are: lack of laid down

requirements for raw materials, bad process planning, rejects due to

faulty materials or poor workmanship, lack of proper tools, jigs and

fixtures, poor quality of materials, loose packing, careless and

negligent handling and careless storage.

Exploration of the possibilities of the use of standardised parts

and components and the utilisation of waste and by-products, may

also lead to a significant reduction in the cost of materials.

Inventory control is yet another area for reducing materials

cost. Thro inventory control, it is possible to maintain the

investment in inventories at lowest amount consistent with the

production and the sales requirements of firm. The cost of

carrying inventories ranges from 15 to 20 per cent per annum

account of interest on capital, insurance, storage and handling

charges, spilla breakage, physical deterioration, pilferage and

obsolescence. Again 50 per cent the gross working capital may be

locked up in inventories.

Some important ways of reducing inventories are:

Improved production planning.

Having dependable sources of supplies, which can ensure

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prompt deliver of materials at short notice.

Elimination of slow-moving stocks and dropping of obsolete

items.

Improved flow of part and materials leading to increased

machine

utilisation and shorter manufacturing cycles.

Packaging constitutes a significant proportion of raw

materials (9 to 24 per cent) and of the total manufacturing

expenses (7 to 22 per cent). Firm should mal attempts to reduce

the packaging costs to the minimum. For example, instead

discarding containers that the materials come in it may be used for

shipping tl goods and thus, the packaging cost can be saved. The

manufacturing firms such; cars and motor bikes may request its

customers to return the containers in whic are goods were sent so

that they could be used in future. This is because packin of such

goods as well as the materials used for packing is very expensive.

2. Labour

Reduction in wages for reducing labour costs is out of question. On

the other hand, wages might have to be increased to provide

incentives to workers. Yet there is good scope for reduction in the

wage cost per unit. A reduction in labour costs is possible by proper

selection and training, improvement in productivity and by

automation, where possible. A study by cn (Confederation of Indian

Industry) showed that Hero Cycles improved their productivity per

employee by 6.4 per cent. 'Purolators' were able to increase their

productivity by 100 per cent. Work· study might result in a lot of

savings by reducing overtime and idle time and providing better

workloads. Labour productivity might increase if frequent change of

tools is avoided. Improvement in working conditions may reduce

absenteeism and thus reduce costs per unit. Scrutiny of overtime

may reveal substantial scope for savings.

All efforts must be made to redllce wastage of human effort.

Wastage of human effort may be due to lack of co-ordination among

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various departments by having more workers than necessary,

·under-utilisation of existing manpower, shortage of materials,

improper scheduling, absenteeism, poor methods and poor morale.

For example, Metal Box adopted a Voluntary Severance Scheme in

197576 to reduce their work force by 950 workers after they faced a

huge operating loss ofRs. 2.4 crores. General Motors eliminated

14,000 white-collar jobs through attrition to reduce cost. Japan's big

5 steel producers announced substantial retrenchment programmes

and workers co-operated with the management. Attempts must be

made to secure co-operation of employees in cost reduction by

inviting suggestions from them. These suggestions should be

carefully examined and implemented if found satisfactory.

Hindustan Lever has a suggestion box scheme and employees who

come out with good suggestions receive awards. These suggestions

may either lead to savings or improve safety and work convenJence.

The basic idea is to motivate workers and make them perceive

working in the firm as a participative endeavour.

3. Overheads

Factory overheads may be reduced by proper selection of

equipment, effective utilisation of space and .equipment, proper

maintenance of equipment and reduction in power cost, lighting

cost, etc. For example, fluorescent lighting can reduce lighting cost.

Faulty designs may lead to excessive use of materials or multiplicity

of components, waste of steam, electricity, gas, lubricants, etc. A

British team invited by the Government of India to report on

standards of fuel efficiency in Indian industry found that fuel

wastages might be as high as an average of 25 per cent. Keeping

them in check even in the face of increasing sales may reduce

overhead costs per unit. For example, Metal Box maintained their

fixed costs in 1976-77 even when there was an increase in sales of

over 18 per cent.

Taking advantage of truck or wagonloads may reduce

transportation cost. Careful planning of movements may also save

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transportation cost. Another point to be examined is whether it

would be economical to use one's own transport or hire a transport.

For reasons of economy, many transport companies hire trucks

rather than owning them. This is because purchase and

maintemince of trucks can be more expensive. By chartering

vehicles the problems of maintenance is left to the owner who in

turn Cuts cost for the firm. Thus by keeping a smaller work force on

rolls and by introducing a contract rate linked to a safe delivery

schedule it is possible to ensure speedy point-to-point delivery of

goods. Many firms now prefer to use private taxis rather than have

their own staff cars.

Reduction of wastes in general can also reduce manufacturing

costs considerably. Of course, a certain amount of waste and

spoilage is unavoidable because employees do make mistakes,

machines do get out of order and sometimes raw materials are

faulty. However, attempts can be made to reduce these mistakes

and faulty handling to the minimum. The normal figure for the waste

and spoilage depends upon the complexity of the product, the age

of the manufacturing plant, and the skill and experience of the

workers. Once normal wastage is found out, production reports must

be watched carefully to find out whether the wastages are

excessive. Wastes can be reduced considerably by educating

operators in the causes and cures of the wastes. Bad debt losses

can be reduced considerably by selecting customers carefully, and

keeping an eye on the receivables. Concentrating on areas and

media can reduce advertising costs, which give the best results.

Selling costs can be controlled by improving the supervision and

training of salesmen, rearrangement of sales territories, replanting

salesmen's routes and calls and redirecting of the sales efforts, to

achieve a more economic product mix. It may be possible to save

selling costs by the use of warehouses, making bulk shipments to

the warehouses and giving faster deliveries to the customers.

Centralisation, reduction, clerical and accounting work may also lead

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to cost savings. A look at the telephone bills and the communication

cost in general may also reveal areas for substantial savings. For

example a telegram may be sent in place of a trunk call.

(a) Cost Reduction

The Institute of Cost and Works Accounts of London has defined cost

reduction as "the achievement of real and permanent reductions in

the unit costs of goods manufactured or services rendered without

impairing their suitability for the use intended". Thus, cost reduction

is confined to savings in the cost of manufacture, administration,

distribution and selling by eliminating wasteful and unnecessary

elements from the product design and from the techniques and

practices carried out in coilOection with cost reduction?

(b) Cost Contro/and Cost Reduction

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

"cost control, as generally practised, lacks the dynamic approach to

many factors affecting costs, which determine the need of cost

reduction." For example, under cost control, the tendency is to

accept standards once they are fixed and leave them unchallenged

over a period. In cost reduction, on the other hand, standards must

be constantly challenged for improvement. And there is no phase of

business, which is exempted from the cost reduction. Products,

processes, procedures and personnel are subjected to continuous

scrutiny to see where and how they can be reduced in cost.

To achieve success in cost reduction, the management must

be convinced of the need for cost reduction. The formulation of a

detailed and co-ordinated plan of cost reduction demands a

systematic approach to the problem. The first step would be the

institution of a Cost Reduction Committee consisting of all the

departmental heads to locate the areas of potential savings and to

determine the priorities. The Committee should review progress and

assign responsibilities to appropriate personnel. Every business

operation should be approached in the belief that it is a potential

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source of economy and may benefit from a completely new

appraisal. Often, it may be possible to dispense entirely with

routines, which, by tradition, have come to be regarded as a

permanent feature of concern. Cost reduction is just as much

concerned with the stoppage of unnecessary activity as with the

curtailing of expenditure. It is imperative that the cost of

administering any scheme of cost reduction must be kept within

reasonable limits. What is reasonable must be determined in all

cases from the relationship between the expenditure and the

savings, which result from it.

Essentials for the Success of a Cost Reduction Programme

Following are the some of the points that firms should take care in

order to achieve success in the cost reduction programme:

Every individual within the firm should recognise· his

responsibility. The co-operation of every individual requires a careful

dissemination of the objectives and interest of the employees in the

achievement of the firm's goals.

Employee resistance to change should be minimised by

disseminating complete information about the proposed

changes and convincing the emplcyees that the changes are

concerned with the problems faced by the firm and that they

would ultimately benefit.

Efforts should be concentrated in the areas where the savings

are likely to be the maximum.

Cost reduction efforts should be continuously maintained.

There should be periodic meetings with the employees to

review the progress made towards cost reduction.

(c) Factors Hampering Cost Control in India

The cost of raw material and other intermediate products is

generally high. In many cases: the cost of raw materials is

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substantially higher than their international prices, which makes it

difficult for the Indian firms to compete in foreign markets. The

sharp rise in oil prices in recent years also gave a severe push to the

cost of raw materials with petrochemical base. Shortages of raw

materials are a usual phenomenon. With a view to insuring against

these shortages, manufacturers keep larger inventories, which

result in increase in their costs. This occurs especially in case of

imported raw materials. Wages are always being linked to cost of

living. There are wage boards for almost every industry and

management has little control on wage rates.

Overheads are also higher in India due to the following reasons:

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

Government's desire to prevent concentration of economic

power. However, there is now a marked change in the policy.

In 1986, the Government announced that 65 industries would

be started with minimum economic capacity so as to 'make

India's products competitive. This process got a boost after the

new Industrial Policy was announced in July 1991.

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

materials and power shortage. However a manufacturer can

exceed his capacity by improving the techniques of production

process. Even after making improvements, a manufacturer

lacks the way to completely minimise the possibilities of

increase in the overheads.

Machinery and equipment obtained under tied credits usually

cost 30 to 40 per cent more than what it wouid cost if

purchased in the open market.

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

licences are issued, cost of equipment goes up. The number of

industries subject to licensing has now been drastically

reduced.

Increase in administered prices for many items crucial to the

industrial production by the Government from time to time

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also pushes up costs.

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

overheads' in the nature of demands for illegitl gratification by

various Government officials at different administrative levels.

There are indirect taxes, which also tend to raise the overall

costs of production in India. Excise duties and saies taxes also

heighten the impact of indirect taxes on the cost of production.

India is perhaps the only country where basic raw materials carry

heavy excise duties. According to an estimate by Mr. S. Moolgaokar,

Chairman, TELCO, as much as Rs. 25 crores of working capital is

locked up in inventories and work-in-progress with TELCO and its

suppliers solely due to the present tax structure.

Until recent times the Indian industrialists operated in a

sheltered domestic market. They were protected against foreign

competition by import controls and against domestic competition

due to industrial licensing. So long as this sellers' market prevailed

competition among sellers was absent and there was no compelling

reason for the industrialists to pay any attention to cost reduction.

Cost consciousness was thus by and large absent in India. The price

fixation for products under price control ensured that the rise in

costs was fully reflected in the prices. This made it possible for the

industrialists to pass on any increase in costs to the consumers.

However, now with the advent of recession tendencies, and

liberalisation in licensing policies, the Indian industrialist is

compelled to pay greater attention to cost reduction and cost

control.

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APPENDIX - I

Calculation of Variances

The difference between the standard cost and the comparable

actual, cost for the same element and for the same period is known

as cost variance. The total of the variances consequently represents

the difference between the actual profits and the standard profits,

i.e., the profits that ought to have been made. The variances are

said to be favourable or credit Variances when the actual

performance exceeds the standard performance or the actual costs

are lower than the standard costs. On the other hand, the variances

are unfavourableor debit variances when the actual, performance

falls short of the standard performance or the actual costs exceed

the standard costs. All variances must state the direction of the

variance as well as the amoUnt. Calculation of cost variances is an

important feature of standard costing. The formulae for calculating

the various variances are given below:

Material Cost Variance

(Actual Quantity x Actual Price) - (Standard Quanity x Standard

Price)

or, (AQ x AP) - (SQ x SP)

Material Price Variance

(Actual Price - Standard Price) x Actual Quantity

or, (AP - SP) x AQ

Material Usage or Quantity Variance

(Actual Quantity - Standard Quantity) x Standard Price

or, (AQ - SQ) x SP

Material usage variance can be further sub-divided into (i) Mix

variance and (ii) Yield variance. When the process uses several

different materials that are supposed to be combined in a standard

proportion, mix variance shows the effeclofvariations from the

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standard proportion. The formula for calculating the mix variance is:

(Actual Quantity - Standard Proportion) x Standard Price

Yield variance shows the loss due to the actual loss being more

or less than the standard loss. The formula for calculating the yield

variance is:

(Actual Loss - Standard Loss) x Average Standard Input Price

Labour CostVariance

(Actual Hours x Actual Rate)-(Standard Hours x Standard Rate)

or, (AH x AR) - (SH x SR)

Labour Rate (Price) Variance

(Actual Rate - Standard Rate) x Actual Number of Hours

or, (AR- SR) x AH

Overhead Efficiency Variance

The object is to test the efficiency achieved from the actual

production. The variance is thus, analogous in nature to the labour

efficiency variance. The formula for calculation of the variance is:

(Actual Hours - Standard Hours for Actual Production)

x Standard Overhead Rate

or, (AH - SH) x SOlt

Cost control ultimately depends on action, which is based on

variances. However, these actions can be taken only by people who

have the appropriate authority. It is, therefore, futile to present

variances to a person if those variances are related to matters,

which fall outside his guthority. Such variances are called

uncontrollable whereas those relating to matters within his

authority ilre termed as controllable variance.

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APPENDIX II

Cost Control Drive in Coal India Limited (Cll)

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

pro res after fully discharging its depreciation and loan repayment

obligations. The company had to initiate a series of stringent

measures to achieve the profit figure, the thrust being on controlling

costs. Four specific areas chosen include: salary and wages,

administration expenditure, stores and realisation of dues. In 1983-

84, the incidence of salary and wages being what it was, the cost of

manpower, per tonne of coal worked out to Rs. 97.04. In 1984-85,

the rise was contained at 88 paisa and the cost of manpower per

tonne came to Rs. 97.92.This was despite the fact that there was a

rise of 51 points in the consumer price index. And then factors

would have justifledan increase of Rs. 6.44 in the cost of manpower

per tonne of coal but it was contained at 88 paisa.

The CIL Chairman pointed out that a major effort was made to

ensure gainful redeployment of manpower through persuasion and

motivation and at times even by force:' Empowered teams of senior

executives were sent to interview people and persuade them to

accept jobs that would suit them. Local redeployment was insisted

upon although in some places non-availability of residential

accommodation caused a problem. Secondly, increase of manpower

was controlled very strictly. Instructions were issued to subsidiary

companies that no new appointment was to be made without

Director of Finance and the Chairman approving it. Thirdly, a drastic

reduction was made in overtime allowance and for achieving this

objective even threat of sacking had to be administered.

In the sphere of administration expenditure, the thrust was on

cutting down the expenses on account of travelling allowance.

However, cost control measures were most effective in the sphere

of stores management. The system of 'fortress checks', introduced

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in 1984-85 resulted in straight saving of Rs. 30 crores. CIL's profit in

1984-85 would have been about Rs. 80 crores, ,if only there was an

appropriate system of pricing.

PRICE DISCOUNTS AND DIFFERENTIALS

Distributors' Discounts

Distributors' discounts are the price reductions that systematically

make the net price vary according to buyers' position in the chain of

distribution. They are called so because these discounts are given to

various distributors in the trade channel, for example, wholesale

factors, dealers and retailers. For the same reason, they are also

called as trade channel discounts. As these discoUnts create

differential prices for different customers on the basis of marketing

functions performed by them for example, whether they are

wholesalers or retailers, they are also called as functional discounts.

However, it must be pointed out that the special discounts may also

be given to persons other than distributors and not, associated with

distribution function. For example, special discounts may be given

to manufacturers who incorporate the product in their own product.

Tyres and tubes sold; to cycle manufactUrers for use in their

bicycles, is a typical example. Special prices may be charged to

members of the same industry; for example, one company may

exchange petroleum with another company at a special price.

Again, special prices may be quoted to Central and State

Governments and to the Universities; for example, Remington

typewriters, Godrej safes, etc., are sold at low prices to these

places.

Forms of Distributors Discounts

Distributors' discounts take different forms determined mainly by

the consent of all the business firms in an industry. Nevertheless, at

times firms may have to decide about the form in which discount is

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to be offered. There are mainly three forms:

Different net prices for different distributor levels. Net prices

are rarely used for quoting differential prices to distributors.

Manufacturers give them to certaii1iliithorised dealers. The

simplicity of this method enables some savings in invoicing

and accounting.

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

rate applicable to a different level of distributor, List prices

with discounts are more common. This method makes it easy

to deal with diverse trade channels. It also facilitates cyclical

'and seasonal adjustments in prices by merely varying the

discounts. This may also help in keeping actual prices a

secret, not only among distributors but also from competitors·

and customers secret, not only among distributors but also

from competitors and customers.

A single discount combined with different supplementary

discounts to different levels of distributors. For example, 5

per cent to regional distributors.

Thus, the chief advantage of the prices with discounts is

greater flexibility. Further, this method helps the manufacturers to

exercise greater control over the realised' margin of different

categories of distributors. But real control is achieved only when

such discounts are coupled with resale price maintenance. A

supplementary discount gives the manufacturers, a picture of the

entire trade channel structure. These discounts may be intended to

reflect distributors cost at' different stages and competition

between different kinds of distributors. The supplementary

discounts are very descriptive in nature while their accounting is

expensive. Distributors' discounts differ widely in industries. They

also differ among the various business firms within industry.

How to Determine Distributors' Discounts

The economic function of distributors' discounts is to induce

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different categories of distributors to perform their respective

marketing functions. As such, to build up a discount structure on

sound economic lines, it is essential to know the services to be

performed by the distributors, distributors' operating costs, discount

structure of competitors, effects of discounts on distributor

population, cost of selling to different channels and opportunities

for market segmentation.

Services to be performed by the distributors at different

levels: The main objective of the manufacturer is to get the

distributor function performed most econoiIlically and

effectively. For this purpose, he may decide upon the various

types of services to be performed by the various types of

distributors. The larger is the number of services' to be

performed by the distributor concerned, the larger is the

discount allowed to him, and. vice versa. For example, a sewing

machine manufacturer might de£idethat the dealer will only

display the various models of the machine manufactured by the

firm and settle the terms of sale. The delivery and servicing of

the machines may be given to one distributor in the city.

Naturally, in such a cast the discount given to the dealer will be

lower than in the case where he has to stock the commodity

and provide after-sales services as well.

Distributors’ operating costs: Trade discounts should

naturally cover the operllting costs and the normal profits of the

distributors. In case of high margins, distributers would be

induced to make extra selling efforts. If margins do not cover

costs, the distributors concerned would not be interested in

pushing up the sale of the product. Sometimes distributors

belonging to the same category by name may be performing

widely diflcl'ing functions, Their operating cost is, therefore,

determined by the funel ions they perform, For example, if a

distributor is required to warehouse and ship the goods as and

when required by the actual users, he would require greater

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discounts than a distributor who receives the consignments in

truckloads and merely reships them to the different actual

users without having to warehouse' them. Even when

distributors are pcrforming identical services, operating

costs'may differ among individual distrihutors depending upon

variations in their operating efficiency. In such cases, the

manufacturer has to determine as to whose costs will he try to

cover through trade discounts. There are two possible

alternatives: (I) the costs or the most efficient two-thirds of the

dealers plus normal profits, or (2) an estimate of his own cost of

performing the distribution function. This is very oncn used

when the manufacturer is already engaged in some sort or

distribution runction.

Competitor’s discount structure: The discounts granted by

competitors arc usel'lII guides in framing the structure of

discounts. Their relevance becomes still greater when it is

realised that distributors' discounts are given in order to scek

the dealers' sales assist~nce in a, competitive market. In quite

a good number of trades, discount rates are fixed by custom

and manufacturers have no option but to fall in line. In many

industries, the actual discounts' granted by rival sellers vary. In

such a case, the manufacturer has to decide whether he should

be guided by the higher or the lower discounts. In case the

product of the manufacturer is' at some disadvantage in

consumer acceptance, he may decide to allow 'larger margins

than those of his competitors. The success of the policy,

however, would depend upon the following conditions: (a)

whether this high margin of discount merely, compensates for

the low turnover and whether the distributor gets any real

economic in~entive? (b) Whether the discount margin will be

adequate to induce the distributor to push the product? (c) How

much influence does the distributor have in pushing a particular

brand over that of the competitor? (d) Whether the dealer has

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scope for profitable market segmentation and personal price

discrimination? And (e) Whether competitor are likely to meet

the wider discount margi varying their own? Thus, in general,

the success of a particular dis scheme requires that the

consumers are considerably indifferent to bl have great

confidence in the distributor and the manufacturers' IT share is

so small that large competitors will not feel compelled to cI

their own wider margins. A related question is: should a lower

p~i, offered to dealers who handle a certain brand exclusively?

Naturall exclusive dealer in general will get a higher discount in

addition to price advantage arising from quantity discounts.

Effect of discounts on distributors' population: Very

often, I discounts may be allowed to encourage the entry of

new distribute push up the sales of a new product line.

Similarly, smaller discounts In allowed when the number of

distributors has to be restricted.

Costs of selling to different channels: There is asaving in

overheat selling to retailers as compared to consumers and· to

wholesalel compared to retailers and the regular system of

discounts has somethil do with this saving in overheads.

Opportunities for market segmentation: Trade channel

discounts C2 used to achieve profitable market segmentation.

In some industries market is divided into several fairly distinct

sub-markets, each havin own peculiar competitive and

demand characteristics. For example, il tyre market, the

following sub-markets may be distinguished:

o Original equipment market characterised by skill and

bargai strength ofthe buyers and by big cyclicaJ

fluctuations in demand.

o Individual consumer replacement. Market characterise by

unskilled buying, brand preferences, and cyclical stability.

o Commercial operators' replacement market characterised

by I buyers who are price-wise and quality-wise, for

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example, munic transport undertakings.

o Government sale in market characterised by large orders,

foil bids and publication of successful bidders' price.

o Export market characterised by international competition.

Each one of these sub-markets .has different elasticity of,

demand. There! The need to charge different prices in each market

segment arises from difference in the elasticities of demand in

these submarkets. The disc (structure can be so devised as to

produce the relevant differential prices suitable for each market

segment. For example, in the case of original equipment market,

price has little influence on the total number of tyres purchased

because the price of the tyrespaid by automobile manufacturers

would form very small percentage of the wholesale price of the car,

say, less than 5 per cent. As such, no feasible reduction in tyre

prices would affect cat prices enough to increase perceptibly the

demand for cars and hence of tyres. Very often, while pricing a

product which is to be used as a component of the finished product

of another manufacturer, e.g., pricing of spark plugs or tyres, their

manufacturers may be influenced by such considerations as earning

prestige through associating the component with the finished

product, getting replacement business if the product is used as a

component with some well-known product, etc. Hence, while selling

the component product to the manufacturer of finished product;

lower prices and for that purpose higher discounts may be allowed.

In case of individual consumer replacement market, i.e., where

buyers are consumers demanding the product for replacement. The

level of price affects the timing of the demand within fairly regroups

limits set by the age of the product, say tyre. Here because of brand

preferences, buyers' responsiveness to price differences is lower

than in other markets where buyers' knowledge is greater.

Another pricing problem relating to individual consumer

replacement market arises because the manufacturer has to decide

whether to allow high discounts as to permit dealers to make-

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individual concessions to customers. Here, a dealer can charge full

price from some customers who are averse to shopping and

bargaining but quite substantially lower prices to more careful and·

bargaining type of customers. Thus, allowing high discounts to

dealers provides them sufficient leeway to charge higher or lower

prices from their own customers according to their demand

elasticity. It is normally appropriate to allow the dealer large

discounts and thereby considerable latitude where the unit cost of

the article is high, where service concessions and trade-ins are

provided to the customers by way of veiled price concessions and

where the customer is not tied strictly to the dealer by continuity of

service or by customer relations.

A related pricing problem of the manufacturer is to decide

whether different distributor margins should be fixed for high-

quality high-price commodities, on the one hand, and low-quality

low-price products, on the other. The manufacturer has to consider

whether he' is to concentrate more on high quality or on low quality

products in view of their respective profitability. Market

segmentation achieved through differential distributors' discounts

enables building big plants' to reap economies of size.

Manufacturers have sometimes built bigger plants and to work them

to full capacity, they have taken up private label business

(manufacturing _ goods to order with private and exclusive brarids),

allowing greater discounts till their own brand becomes sufficiently

popular and its demand increases sufficiently to work the big plant

fully. If so, they can discontinue the private label business.

Distributors' demand elasticity higher than that of

consumers:

Distributors' demand for the competing brand of different

manufacturers is more elastic than the corresponding demand of

final consumers. The distributor is generally more capable of

judging price and quality than ultimate consumers who have

insufficient knowledge of the competing brands, and apprehend

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that a low price may be synonymous with inferior quality. The

consumer finds it difficult to choose between different competing

brands, and he often allows himself to be guided by the retailers. It

may be safely asserted that even the smallest difference in price

may cause a dealer to switch over from one brand to another

whereas an even greater price change might not cause any

reaction on the ultimate consumers. It is, therefore, of decisive

importance to the manufacturers that they secure the goodwill of

the distributors. In. fact, the distributors' potential selling power is

great and the manufacturers should try to gain their promotional

support.

However, in the case of a few highly advertised branded

products, which occupy a firm's position in the minds of the

consumers, distributors have to be content with very small margins.

For example, the retailer's margin in a 5-kilo Dalda tin comes to 1.5

per cent only. It would be better for a manufacturer to adopt a

standard discount policy. With latitude in discount policy, there is

much danger of confusion, inequity, loss of goodwill and loss of

sales. It may also be noted that distributor discounts do not matter

much in industrial goods.

Quantity Discounts

Quantity discounts are price reductions related to the quantities

purchased. Quantity discounts may take several forms and may be

related to the size of the order being measured in terms of physical

units of a particular commodity. This is practicable where the

commodities are homogeneous or identical in nature, or where they

may be measured in terms of truckloads. However, this method is

not possible in case of heterogeneous commodities, which are hard

to add in terms of physical units, or truckloads. Drug industry and

textile industry offers examples of this type. Here, quantity

discounts are based upon the rupee value of the quantity ordered.

Rupee becomes a common denominator of value.

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Quantity discounts based on physical units become important

where the cost of packing is a significant factor and orders of less

than standard quantities, say, less than a case of 6 pressure

cookers, may involve higher packing charges per cooker. Since the

space remains unutilised, the quantity discounts may be employed

to induce full-case purchasing. In some cases, sellers may clearly

mention that packing charges will be the same whether you

purchase a full case or less than a full case. Here also, the buyer

may like to go for a full case and in essence avail himself of the

quantity discounts. Discounts based on physical units are less likely

to be distorted by changes in prices.

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

that orders up to a certain size will not be entitled to any discount.

But beyond this size, the customer would be entitled to a discount

for his extra purchases over and above the minimum size. The

discount rates may vary with successive slabs of quantities ordered.

Alternatively, discount may be allowed on the entire purchases

provided they exceed a certain minimum. In some cases, quantity

discounts mflY be based on the cumulative purchases made during

the particular period, usually at year or a. season, e.g., Diwali

discounts may be given on the basis of cumulative purchases made

during the Diwali season spread over September to Novembe'r. This

is different from quantity discounts based upon individual lots

ordered at a time. These discountS ensure customer loyalty and

discourage purchasing from several competitors simultaneously, but

the limitation of cumulative discounts is that, they do not tackle the

problem of high cost of servicing small orders, because, buyers get

no incentive to order for bigger lots and to avoid hand-to-mouth

purchasing. Buyers may be inclined to place larger orders towards

the end of the discount period to qualify for higher discounts. This

may disrupt the production schedule of the manufacture .

The following genital conclusions can be reached:

• Individual order size is a' better basis than cumulative

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purchases made during a particular period.

Discounts based on the quantity of individual commodities

ordered have advantages over those based on the total size

of mixed commodities ordered.

Physical units are preferable to rupee value as a measure of

order size on which to base quantity discounts.

Objectives of Quantity Discounts

One important objective of quuntity discountS' is to reduce the

number of small orders and thereby avoid the high cost of servicing

them. Quantity discounts can facilitate economic size orders in

three ways:

A given set of customers is encouraged tbbuy the same

quantity batiste bigger lots.

The customers may be 'induced to give the seller a larger: ihare

of their total requirements by giving preference over,

competitors.

Small size purchasers may be discouraged and bigger size

customers may' be attracted.

Quantity discount system enables the dealer to reap

economies of buying in lager lots. These economies may enable

the dealer to charge lowler prices from the customers thereby

benefiting the customers. Finally, lower prices to customers may

increase the demand for the commodities, which in turn may

enable the dealer to purchase larger quantities, reaping still

greater discounts, and the manufacturer to reap economies of

large-scale production, The advantages to the manufacturer, dealer

and customer are as such circular. In fact, in many cases discounts

become a matter of trade custom.

A noted disadvantage of quantity discounts is that dealers may

often find it cheaper to purchase from wholesalers availing

themselves of these quantity , discounts than from the

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manufacturer directly. This is because the wholesalers may pass on

some of their discounts to the dealers. This may ultimately affect

the image of the manufacturer in the minds of the dealers. Again, if

the seller becomes dependent upon a few buyers, they may be

able to dictate, his policies ap.d practices. But if his product is

sufficiently differentiated or his service' is unique, he may find it

possible and worthwhile to pursue an independent discount policy.

Quantity discounts are most useful in the marketing of materials

and Applies but are rarely used for marketing equipment and

components.

Quantity discounts have attracted the attention of the

Monopolies and Restrictive Trade Practices Commission. The

Commission conceded the claim of Reckitt and Coleman of India

Ltd., that it was entitled to gateway under Section, 38(1) (h) of tlie

Act in respect of discounts given on larger orders. It was held that

the Company’s price structure did not directly or indirectly restricts

competition to any material degree. However, some time later, the

Commission extnicted an assutance from the five manufacturers of

grinding wheels that they would give up the practice of discounts

based on the quantity. Their practice of pricing on ‘slab’ Basis' was

alleged to give advantage to buyers of larger quantities compared

to Players of smaller quantities.

Cash Discounts

Cash discounts are price reductions based on promptness of

payment. An example of discount can be "2 per yent off if paid in

ten days, full invoice price in 30 days." In practice, the size of cash

discount may vary widely. Cash discount is a convenient device to

identify and overcome bad credit risks. In certain trades where

credit risk is high, cash discount would be high. If a buyer decides

to purchase goods on credit, this reflects his weak bargaining

position, and he has to pay a higher price by forgoing the cash

discount. There is another way to look at cash dis.counts. Though

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cash discounts encourage prompt payment, yet allowing of cash

discount also involves certain costs.

These costs have to be compared with the cost of carrying the

account, viz., locking up of working capital, expense of operating a

credit and collection department- and risk of bad debts and

alternative ways of attaining prompt settlements. By prompt

collections, manufacturers reduce their working capital

requirements and thus save their interest costs. However, allowing

discounts may involve paying 36.5 per cent in order to save 15 per

cent. Thus it is the reduction in collection expenses and in risks

rather than savings on interest, which should be the guiding

consideration for cash· discounts. The main point of distinction

between cash discounts and quantity discounts is that the former

are price reductions based on promptness ·of payment whereas the

latter are price reductions depending on the quantities purchased

(physical units or rupee value of the quantity purchased). As such,

cash discounts induce prompt payments or collections whereas

quantity discounts induce buying in large quantities.

Time Differentials

Charging different prices on the basis of time is another kind of

price

discrimination. Here the objective of the seller is to take advantage

of

the fact that buyer' demand elasticity varies over time. Two broad

types of time differentials may be distinguished:

Clock-time differentials,

Calendar-time differentials.

Clock-time Differentials: When different prices are charged

for the sMne service or commodity at different times within a 24

hours period, the price differentials are known as clock-time

differentials. The common examples of these are the differences

between the day and night rates on trunk calls, differences between

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morning and regular shows in cinema houses, and different tates

charged' for electricity sold to industrial users during peak load

hours (day time) and offpeak load hours. In the case of telephone

services, day timing is the period of more inelastic demand and the

night time is the more elastic demand period. Two conditions, which

make the clock-time differentials profitable are as follows:

Buyers must have a definite and strong preference for

purchasing at certain timings over others giving rise to

significant differences in demand elasticity.

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

parts, i.e., the buyer must consume the entire product at one

time when and for which he pays. In case the product is

storable, it will be purchased at lower rates to be used later

when needed making price differential a losing proposition.

Calendar-time Differentials: Here price differences are

based on a period longer than 24 hours; for example, seasonal price

variations in the case of winter clothing's, or betel accommodation

at hill and tourist stations. Here, the objective is also to exploit the

time preferences of the buyers.

Geographical Price Differentials

Geographical price differentials refer to price differentials based on

buyers location. The objective here again is to minimise the

differences in transport costs due to the varying distances between

the locations of the plants and the customers. There are various

types of geographical price differential, which are explained below:

FOB factory pricing: It implies that the buyer pays all the

freight and is responsible for the risks occurring during transport

except those that are assumed by the carrier. The advantages of

FOB factory pricing are as follows:

It assures u uniform net price on nIl shipments regardless of

where they go.

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No risk is assumed by the seller.

The seller is not responsible for delay in carriage.

Postage stamp pricing: Postage stamp pric1rg means

charging the same delivered price for all destinations irrespective of

buyers' location. The quoted price naturally includes the estimated

average transportation costs. In effect, these prices become

discriminatory, that the short distance buyers have to pay more for

transportation than the actual costs involved while long distance

buyers have to pay less than the actual costs of transporting goods.

Postage stamp pricing is most Hnmonly employed for goods of

popular brands and having nation wide distribution. The basic idea

is to maintain a uniform retail price at all places. This common retail

price can also be advertised throughout the country. Bata footwears

provide the best example of postage stamp pricing other examples

are Usha sewing machines and fans, radios, pressure cookers,

typewriters, drugs and medicines, newspapers and magazines, etc.,

Postage stamp pricing is most suitable in case of products

where transportation costs are significant. It can also be used with

advantage by manufacturers to avoid the disadvantage of location

being far away from the main customers who if charged on the basis

of actual costs might have to pay much more and hence refrain

from purchasing. This advantage is particularly striking in the case

of products involving high transportation costs. This pricing gives a

manufacturer access to all markets regardless of his location.

Market access is particularly important when products of the rivals

are substantially the same.

Zone pricing: Under zone pricing, the seller divides the

country into zones and regions and charges the same delivered

price within each zone, but different prices between different zones.

For example, Parle Company has divided the country into 9 zones,

the intra-regional price differentials ranging between 5 and 15 per

cent approximately. Generally speaking, zone pricing is preferred

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where the transportation cost on goods is too high to permit their

sale throughout the country at uniform price. The more significant

the transportation costs, the greater the number of zones and

smaller their size. Conversely, for product involving lower

transportation costs, zones are generally few but big in size. In

India, zone pricing has been widely used invanaspati and sugar

industries.

Basing point pricing a basing point price consists of a factory price

plus transportation charges calculated with reference to a particular

basing point. Under this system, the delivered price may be

computed by using either single basing point or multiple basing

points. In the single basing point system, all sellers (irrespective of

the locations) quote delivered prices, which arc the sum of the

basing point price and cost of transport from the basing point to the

particular point of delivery. Thus, the delivered prices quoted by all

sellers for a given point of delivey are uniform regardless of the

point from which delivery is made. In the multiple point pricing

system, two or more producing centres are selected as basing

points, and the seller then quotes a delivered price equal to the

factory price plus transportation costs from the basing point nearest

to the buyer. Rasing-point pricing has been widely used in the USA,

especially in the steel industry where at first the single basing-point

system known as Pitts burgh plus was employed. It was followed by

mulliple basing point pricing when Pittsburgh plus was declared

illegal.

Consumer Category Price Differentials

Price discrimination is frequently practised according to consumer

categories in the case of public utilities, for examples, electricity,

transportation, etc. Electricity firms quote different rates for

residential consumers and industrial consumers. The rates may also

differ for domestic power, light and fan. Railways also charge

differently from children to adults. They also charge differently -on

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different classes of goods and different classes of passengers.

Personal Price Discrimination

Price concessions are commonly made to individuals at times for

personal considerations. For instance, special prices may be given

to companies own employees, shareholders or personal

acquaintances. These special prices may take several forms such as

additional services free of cost, leniency in fixation of prices for

used goods in exchange of new ones and extending credit, interest-

free credit.

REVIEW QUESTIONS

1. Explain with illustration the distinction between the following:

A. Fixed cost and variable costs

B. Acquisition cost and opportunity cost.

2. What is opportunity cost? Give some examples. How are

these costs relevant for managerial decisions?

3. When MC changes, AC changes (a) at the sane rate, (b) as a

higher rate, or (c) at a lower rate? Illustrate your answer with

the help of diagrams.

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

and total cost.

5. Distinguish between the following:

A. Marginal cost rind incremental cost;

B. Business cost and full cost;

C. Actual cost and imputed cost;

D. Private cost and social cost of private business.

6. Discuss the various economies or scale. Also discuss Sargent

Florence's principles in this regard.

7. "Economics of scale may be either external or internal; they

may

be technical, managerial, financial or risk-bearing." Elucidate.

8. Discuss the various economies of scale. Do they result in

monopolies?

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9. What are the advantages and limitations of large-scale

production?

10. State the importance of cost control in profit planning

and

discuss the various areas of cost control.

11. Distinguish between cost control and cost reduction.

What are

the essentials for the succcss of a cost reduction programmc?

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LESSON – 4

PRODUCTION FUNCTION

The term "production function" refers to the relationship between

inputs used and outputs produced by a firm. The terms "factors of

production" and "resources" are used interchangeably with the term

"inputs". The relationship is purely physical or technological in

character and therefore it ignores the prices of inputs and outputs.

The study of the production function is aimed at achieving the

maximum output. This can be done with a given set of resources or

inputs, and with a given state of technology. The production

function can be expressed in the form of a schedule. Table 4.1

shows two inputs viz; labour [X], i.e., number of workers, and capital

[Y], i;e., size of machine in terms of horsepower, and one output (Q),

i.e., the number of tonnes of iron produced with the various

combinations of inputs.

Table 4.1: Production Function

Capital (Y) - Size of machines (in horse power)250 1,000 1,500 2,000

Labour (X) 1 2 20 32 26(Number of 2 4 48 58 88workers) 3 8 88 110 100

4 12 110 120 1105 32 120 124 1206 58 124 126 1247 88 126 128 1288 100 126 130 1309 110 126 130 13210 104 124 130 134

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

eqation:

Q = f (X1, X2, etc.),

Where Q = A function ofthedesired output as a result of utili

sing the quantity of two or more inputs

Xl = units of labour,

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X2 = units of machinery.

Some factors of production are assumed to be fixed (i.e., not

varying with changes in output); and hence are not included in the

equation. The production function is estimated by the method of

least squares.

In economic theory, we are concerned with three types of

production functions, viz.,

Production function with one variable input.

Production function with two variable inputs.

Production function with all variable inputs.

PROPUCTION FUNCTION WITH ONE VARIABLE INPUT

In economics, the production function with one variable input is

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

follows:

Law of Variable Proportions

The law of variable proportion is one of the fundamental laws of

economics. It is also known as the 'Law of Diminishing Marginal

Returns' or the 'Law of Diminishing Marginal Productivity.' This Law

of variable proportion shows the input-outPut relationship or

production function with one variable factor, i.e., a factor, which can

be changed, while other factors of production are kept constant.

This is explained with the help of the following example:

Suppose a farmer has 20 acres of land to cultivate. The land

has some fixed investment, Le., capital in the form of a tube well,

farmhouse and farm maehinery. The amount of land and capital is

supposed to be fixed factors of production. However, the farmer can

vary the number of workers employed on its land. Labour is thus the

variable factor of production. The change in the number of workers

will change the output.

The point worth noting here is that the law does not state that

each and every increase in the amount of the variable factor that is

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employed in the production process will yield diminishing marginal

returns. It is, however, possible that preliminary increases in the

amount of a variable factor may yield increasing marginal returns.

While increasing the amount of the variable factor, a point will " be

reached though, where the; marginal increases in total output or

the marginal retums will begin declining.

Assumptions for Law of Variable Proportions

The law of variable proportions functions is based on following

assumptions:

Constant technology: The technology is assumed to be

constant because technological changes will result into rise of

marginal and average product.

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

here that some factors are fixed and others are variable. In

the long-run, all factors are variable.

Homogeneous input: The variable input employed is

homogeneous or identical in amount and quality.

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

use various amounts of a variable factor on the fixed factors

of production.

Three Stages of Production

A graphic description of the production function is shown in

following figure 4.1. The total, marginal and average product curves

in Figure 4.1, demonstrates the law of variable proportions. The

figure also shows three stages of production associated with law of

variable proportions. The total product curve is divided info three

segments popularly known as three stages of production, which are

as follows:

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Stage I

The figure 4.1 shows stage 1 as the segment from the origin to

pointX2. Here, total product (TP) rises at an increasing rate. At this

point, the marginal product (MP) of X equals its average product

(AP). X2 is, also the point at which the average product is

maximised. In this stage, the production function is characterised

first by increasing marginal returns from the origin to point X1and

then by diminishing marginal returns, from X1to X2. It should not be

assumed that in stage 1, only increasing marginal returns take

place. Because increasing returns may occur until a certain point,

and thereafter diminishing returns may take place. Stage I should

not therefore be identified with increasing marginal returns only.

Here, both AP and MP increase. In this stage, a firm can move

towards optimum combination of factors of production and

increasing returns, by adding more and more variable units to fixed

factors.

Stage II

The stage II is depicted by the figure in the range from X2 to X3. In

othcr words, stage II begins where the average product of the

variable factor is maximised. It continues till the point at which total

product is maximised and marginal product is zero. Here, TP rises at

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diminishing rate. This stage is thus, called the stage of diminishing

returns, where a firm decides its level of production.

Stage III

Finally, we have stage III, which is depicted by the area beyond X3

where the total product curve starts decreasing. Here, too much

variable input is being used as related to the available fixed inputs

and thus variable inputs' are overutilized. The efficiency of both

variable inputs and fixed inputs decline through out this stage. In

this range, the marginal product of the variable factor is negative. It

starts from the point where MP is nil and TP is maximum and covers

the whole range of negative marginal productivity. The following

Table 4.2 shows the various stages.

Table 4.2: Stages of Production

Total Physical

Product

Marginal Physical Average PhysicalProduct Product

Stage IIncreasing at an Increases, reaches Increases and reachesincreasing rate maxiIhum and then its maximum

declines till MR = APStage IIIncreases at diminishing Is diminishing and Starts diminishingrate till it reaches becomes equal to maximumStage IIIStarts declining Becomes negative Continues to decline

From this stage-wise description of the production function we

can reach two conclusions, which are as follows:

Stage II is Rational

Only stage II is rational and denotes the relevant range-within which

a rationai firm should operate. In Stage I, it is profitable for the fiim

to keep on increasing the use of labour and in Stage, III, MP is

negative and hence it is inadvisable to use additional labour. The

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firm, therefore, has a strong incentive to expand through Stage I

into Stage II.

Stages I and /II are Irrational

Stages I and III are described as irrational stages. They are called so

because management, if it is to maxi mise profits will never

intentionally apply the variable to the fixed factors in any

combination, which will yield a total product falling in either of these

two stages.

PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

To understand a production function with two variable inputs, it is

necessary to explain what is an ' Isoquant'.

Isoquants

An isoquant is also known as an 'iso-product curve', 'equal product

curve' or a 'production indifferent curve'. These curves show the

various combinations of two variable inputs resulting in the same

level of output. Table 4.3 shows how different pairs of labour and

capital result in the same output.

Table 4.3: Different Pairs of Labour and Capital

Labour Capital Output(Units) (Units) (Units)

I 5 10

2 3 10

3 2 10

4 1 10

5 0 10

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

labour with 1 unit of capital or 5 units of labour with 0 units of

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capital are employed. This relationship, when shown graphically

results in an isoquant. Thus, by graphing a production function with

two variable inputs, one can derive the isoquant that helps in

tracing all the combinations of the two factors of production that

yield the same output. Thus, an isoquant can be defined as "the

curve passing through the plotted points representing all the

combinations of the two factors of production, which will produce

the given output." Figure 4.2 depicts a typical isoquant digram in

which by an upward movement to the right, one can obtain higher

levels of outputs, using larger quantities of output. For each level of

output, there will be different isoquant. When the whole array of

isoquants is represented on a graph, it is called 'isoquant map'.

Substitutability of Inputs

An important assumption regarding the isoquant diagram is that

the inputs can be substituted for each other. For example a

particular combination of X and Y results in output quantity of 600

units. By moving along the isoquant 600, one finds other

quantities of the inputs resulting in the same output. Let us

suppose that X represents labour and Y represents machinery. If

the quantity of the labour (X) is reduced, the quantity of

machinery (Y) must be increased in order to produce the same

output. The following Figure 4.2 shows a typical isoquant.

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Marginal Rate of Technical Substitution (MRTS)

The slope of the isoquant has a technical name; Marginal Rate of

Technical Substitution (MRTS) or sometimes, the marginal rate of

substitution in prodtltioti.) Thus, in terms of inputs of capital

services K and Labour L.

MRTS = aK/dL

MRTS is similar to MRS, I.e., Marginal Rate of Substitution,

(which is slope, of an indifference curve).

Types of Isoquants

Isoquants assume different shapes depending upon the degree of

substitutability of inputs under consideration. Based on this the

types of isoquants can be enlisted as follows:

Linear Isoquants: In the case of linearisoquants, there is

perfect substitutability of inputs. For example, a given output

say 100 units can be produced by using only capital or only

labour or by a number of combinations of labour and capital,

say 1 unit of labour and 5 units of capital, or 2 units of labour

and 3 units of capital, and so on. Likewise, a giyen power

plant that is equipped to burn either oil or gas, for producing

various amounts of electric power can do so by burning either

gas or oil, or varying amounts of each. Gas and oil are perfect

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substitutes here. Hence, the isoquants are straight lines. The

following Figure 4.3 shows the isoquant for oil and gas.

Right Angle Isoquant: When there is complete non-

substitutability between the inputs (or strict complimentarily)

then the isoquant curves take the form of right angle

isoquants. For example, exactly two wheels and one frame

are required to produce a bicycle and in no way can wheels be

substituted for frames or vice-versa. Likewise, two wheels and

one chassis (The rectangular, steel frame, supported on

springs and attached to the axles, that holds thepody and

motor of an automotive vehicle) are required for acooter. This

is also known as 'Leontief Isoquant' or Input-output isoquant.

The following Figure 4.4 shows the isoquant for chasis and

wheels.

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Convex Isoquant: This form of isoquants assumes

substitutability of inputs but the substitutability is not perfect.

For example, in Figure. 4.5 a shirt can be made with relatively

small amount of labour (L1) and a large amount of cloth (C1).

The same shirt can be as well made with less cloth (C2), if

more, labour (L2) is used because the tailor will have to cut

the cloth more carefully and reduce wastage. Finally, the shirt

can be made with still less cloth (C3) but the tailor must take

extreme pains" so that JabourinpiJt requirement increases to

C3. So, while a relatively small addition of labour from L1 to L2

allows the input of cloth to be reduced from C1 to C2, a very

large increase in labour from L2 to L3 is needed to obtain a

small reduction in cloth from C2 to C3. Thus the substitutability

of labour for cloth diminishes from L1 to L2 to L3. The following

Figure 4.5 shows isoquant for cloth and labour.

Main Properties of Isoquants

All the above-mentioned isoquants are featured with some

common properties, which are as follows:

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

inclined. This implies that for the same level of output, the

quantity of one variable will have to be reduced in order to

increase the quantity of other variable.

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

same quantity, of one input and larger quantity of the other

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input, larger output will be produced.

No two isoquants intersect or touch each other. If two

isoqua~tsinter.seCt or touch each other, this would mean

that there will be a common point the Two curves; and this

would imply that the 'same amount of two inputs could

produce two different levels of output (i.e., 400 and 500

units), which is absurd.

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

declines from left to right along the curve. In other words,

when we go on increasing the quantity of one input say

labour by reducing that quantity of other input say capital,

we see that less units of capital are sacrificed for the

additional units of labour.

PRODUCTION FUNCTIONS WITH ALL VARIABLE INPUTS

A closely related question in production .economics is how a

proportionate increase in all the input factors will affect total

production. This is the question of returns to scale, which brings to

mind three possible situations:

If the proportional increase in all inputs is equal to the

proportional increase in output, returns to scale are constant.

For instance, if a simultaneous doubling of all inputs results in

a doubling of production then returns to scale are constant.

The following figure 4.6 shows a constant rate to scale.

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

inputs, then we have increasing returns to scale. The following

Figure 4.7 shows increasing returns to scale.

If output increases less than proprotionally with input

increase, we have decreasing returns to scale. The following

Figure 4.8 shows decreasing returns to scale.

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The most typical situation is for a productin function to have

first increasing then decreasing returns to scale is shown in Figure

4.9.

The increasing returns to scale attribute to specialisation. As

output increases, specialised labour can be used and efficient, large-

scale machinery can be employed in the production process.

However beyond some scale of operations further gains from

specialisation are limited, and co-ordination problems may begin to

increase costs substantially. When co-ordination price is more than

offset additional benefits of specialisation, decreasing returns to

scale begin.

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Returns to Scale and Returns to an Input

Two important features of production functions are returns to scale

and returns to input, which are explained as follows:

Returns to scale: These describe the impact on the output

when the same proportion increases each input rate. If output

increases by a larger percentage than the increase in each input

then there are increasing returns to scale. Conversely, if output

increases by a smaller percentage, there are diminishing returns to

scale and if it increases by the same proportions there are constant

returns to scale.

Returns to input: These describe the impact on the output

when only one input is varied, holding all others constant. These

returns may be increasing,' diminishing, or constant.

Optimal Input Combinations

From the overall discussion so far itisobvious that production

function, has a pure 'physical or technological' character. However,

it does not tell which input combinations are optimal. For that

purpose, one has to take into account the input prices. The following

Figure 4.10 shows the iscost curves.

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Isocost Curves

In this connection, one has to consider yet another but important

diagram consisting of isocost curves. Here also, the axes represent

quantities of the inputs X and Y. Suppose that the prices of the

inputs are given, and there are no quantity discounts for the firm to

get larger quantities at lower prices. The next step will be to plot the

various quantities of X and Y which may be obtained from the given

monetary outlays. Figure 4.10 shows the resulting isocost curyes,

which are straight lines under the assumption made here. One

isocost showing the quantities of X and Y that can be purchased for

Rs. 1,000 and another isocost curve showing the quantities of X and

Y which can be purchased for an expenditure of Rs. 2,000 and so on.

Now we can easily superimpose the isocost diagram on the

isoquant diagram (as the axes in both the cases represent the same

variables). With the help of Figure 4.11, it can be ascertained that

the maximum output for a given outlay, is say Rs. 2,000. The

isoquant tangent represents this maximum output, which is possible

with this outlay, to the isocost curve. The optimum combination of

inputs is represented by point E, the point of tangency. At this point,

the marginal rate6f substitution (MRS, sometimes known as the rate

of technical substitution), between the inputs is equal to the ratio

between the prices of the inputs.

Likewise, in order to mini mise the cost for a given output, one

may again refer to the isoquant and isocost curves in Figure 4.11. In

this case one moves along the isoquant representing the desired

output. It should be clear that the minimum cost for this input is

represented by isocost line tangent to the isoquant.

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Firm's Expansion Path

A firm's expansion path is defined by the cost-minimising

combination of several inputs for each output level. Thus the line

representing least cost combination for different levels of output is

called firm's expansion path or the scale line shown by line ABC in

Figure 4.12.

MEASUREMENT OF PRODUCTION FUNCTION

Several types of mathematical functions are commonly used for

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measuring production function but in applied research, four types

are used extensively. These are linear functions, power functions,

quadratic functions and cubic functions.

(1) Linear Function

A linear production function is expressed as follows:

Total product: Y = a + bX, where Y = output and X = input. From

this function, equation for average product will be

Y/X=a/X+b

The equation for the marginal product will

be Y/X = b

(2) Power Function

A power function expresses output, Y, as a function of input X in the

form:

Y = aXb

Some important distinctive properties of such power functions

are:

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

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

production.

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

written as: log Y = log a + b log X

When the power function is expressed in logarithmic form as

above, the coefficient represents the elasticity of production.

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

marginal product will decline.

(3) Quadratic ProductionFunction

The production function may be quadratic and is expressed as

follows:

Y = a + bX = cX2

Where the dependent variable, Y, represents total output and the

independent variable, X, denotes input. The small letters are

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parameters and their probable values are determined by a

statistical analysis ofthe data.

The distinctive properties of the quadratic production function

are

as follows:

The minus sign in the last term denotes diminishing marginal

returns.

The equation allows for decreasing marginal product but not

for both inerellsing and decreasing marginal products.

The elasticity of production is not constant at all points along

the curve as in a power function, but declineswiih input

magnitude.

The equaItion never allows fotan increasing marginal product

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

when no variable input is applied.

The quadratic equation has only one bend as compared with a

linear equation, which has no bends.

(4) Cubic Production Function

The cubic production [unction is expressed as follows:

Y = a -I- bX -I- cX2 – dX3

Some important distinctivc properties of a cubic production

function arc as follows:

It allows for both increasing and decreasing marginal

productivity.

The elasticity of production varies at each point along the

curve.

Marginal productivity decreases at an increasing rate in the

later stages.

PRODUCTION FUNCTION AND EMPIRICAL STUDIES

The measurement of production function dates back to a century

when certain r pioneer studies were made in the field of agriculture.

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And though economic concepts and statistical techniques have now

advanced a lot, its major work is still in agriculture.

Cobb-Douglas Function

A very popular production function, which deserves special mention,

is the CobbI Douglas function. It relates output in American

manufacturing industries from 1899 to 1922 to labour and capital

inputs, taking the form.

P = bLaC1 - a

Where,

P = Total output

L=Index of employment of labour in manufacturing

C = Index of fixed capital in manufacturing.

The exponents ‘a’ and ‘1 – a’ are the elasticity of production

that is, ‘a’ and ‘1- a’ measure the percentage rexsponse of output

to percentage changes in labour and capital respectively. The

function estimated for the USA by Cobb and Douglas is:

P = 1.01L.75C25

R2 = .94.09

This production function shows that a 1 per cent change in

labour input, with the capital remaining constant, is associated with

a 0.75 per cent change in output. Similarly, a 1 per cent change in

capital, with the labour remaining constant, is associated with a

0.25 per cent change in output. The coefficient of determination (R2)

means that 94 per cent of the variations on the dependent variable

(P) were accounted for, by the variations in the independent

variables (L and C).

An inportant point to note is that the Cobb-Douglas function

indicates constant returns to scale. That is, if factors of production

are each increased by 1 per cent, the output will increase by 1 per

cent. In other words, one can assume constant avberage and

marginal production costs for the US industries during the period.

The following Figure 4.13 shows the graph of Cobb-Douglas

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production.

Criticism

The production function ordianrily discussed in economics is a

rigorously developed micro-economic concept. However,

Douglas and his colleagues, estimated production function for

nation’s economies for manufacturing sectors and even for

industries. Thus they “transferred” strictly micro- economic

concept to a macro-econornic setting, without sufficiently

justifying their act on logical economic grounds. Therefore,

the result of their studies, in the form of equations which they

derived, may be incorrect, and hence the interpretations

based on their equations are uncertain.

The production function of economic theory assumes that the

quantities of inputs used are those that are actually used in

production. Therefore no variable input is ever redundant. In

the Douglas studies however, only labour was measured by

the quantity actually used in production, while capital was

measured by the capital investment, i.e., the quantity

available for production. Therefore, with the possible'

exception of the years in which full employment and

prosperity prevailed and industry made reasonably fuil use of

the available inputs, the measure of capital employed was not

theoretically correct one. If annual capital input always

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remained as a constant proportion of total capital investment,

then only the elasticity would be the same. In spite of this

criticism, the Cobb-Douglas type of production function has

been found useful for interpreting economic results, since the

elasticity of production; is given directly by the exponents

when the data are in original form, or by the regression

coefficients when the data are in logarithmic form.

MANAGERIAL USE OF PRODUCTION FUNCTIONS

Though production functions may seem to be highly abstract and

unrealistic, in fact, they are both logical and useful. If the price of a

factor of production declines whereas that of another goes up, the

former is likely to substitute the latter. The usefulness of the

production function can be explained with the help of an example,

dairy economists are interested in minimising the cost of feeding

cows in milk production. Taking a cow as a single firm, and grain

and roughage as inputs, the question arises: What proportion of

grain and roughage would be economical in feeding the cow? In the

past, there has been some tendency to prescribe a fixed ratio, but

economic analysis suggests that the optimal ratio depends on the

inptlt prices. For instance, if we draw isoquantsrelating various

quantities of grain and roughage, to various levels of milk output

and then superimpose isocost curves on the isoquant diagram, the

optimum point of largest output for a given outlay or of minimum

outlay for a given output-would depend on the prices of the factors

of production, and it would change as these prices change. The

dairy farmer can use such analysis for increasing the return from his

expenditure on feeds.

Certain economists have focused especially on the application

of their findings. For instance, Earl Heady and his associates have

developed a mechaniclIl device known as Pork Postulator, which

facilitates the farmer to determine the most profitable ration for

feeding pigs under different price conditions.

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Production functions thus are not just theoretical and futile

devices. They can also be used as aids in decision-making because

they can give guidance in two directions regarding:

Obtainfng the maximum output from a given set of inputs

Obtaining a given output from the minimum aggregation of

inputs

Of course, in more complex problems, with larger numbers of

inputs and outputs, the mathematics of optimisation becomes

complicated. But recently, the development of linear programming

has made it possible to handle these complex problems. The use of

complex production functions in managerial decisiull making is

going to be further facilitated with the development of electrollic

computers.

DERIVING INPUT COMBINATIONS FROM

PRODUCTION FUNCTION Given a production function for a certain output, one can derive all

the combinations of the factors of production that will yield the

same output. This can be illustrated as follows:

IIIustration

Suppose the production function is:

0= 0.196 H 0.880 N 1.815

Where,

0= output oftransformers in terms of kilovolt-ampere (kVA)

produced

H = average hours worked per day

N = number of men.

Now, to derive the input combinations for an output level of

1,200 kVA, we will have to set the above equation equal to 1,200:

1,200 = 0.196 H 0.880 N 1.815

Then, substituting any value of H (or N) in the equation, we can

obtain the associated value of N (or H). We compute below the

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number of hours required (H) for an output of 1,200 kVA, if 38 men

are employed.

1,200 = 0.196 H 0.880 N 1.815

log 1,200 = log 0.196 + 0.880 log H + 1.815 log N

= log 1,200 = log 0.196+ 0.880 log H + 1.815 log 38

In the same way, we can derive the value of H, if N is 40, 42,

44 and so on, if the desired output level is 1,200 KVA. We can also

derive various combinations ofH and N for other levels, say, 1,300

KVA or 1,400 KVA.

PRICE AND OUTPUT DECISION UNDER

VARIOUS MARKET SITUATIONS To understand the concept of market and its various conditions, it is

necessary to study the thcory orthe firm. This is discussed as

follows:

The Theory of the Firm

The basic, assumptions of the theory of the linn are as follows:

The objective of a firm is to maximise net revenue in the face

of given prices and technologically determined production

function.

A price incrcase far a product raises its supply, whereas prices

increase for a factor reduccs its demand.

The theory or lhe firm deals with the role of business firms in

the resource allocation process. It uses aggregation as a tactic

and attempts to specify total market supply and demand

curves.

The firm operates with perfect knowledge of all relevant

variable involved in making a decision and it acts rationally

while doing so.

Originally the theory assumed that the firm is operating within

a perfectly competitive market. But it has now been extended

to cover other market situutions.

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The theory has been criticised in the context that profit

maximisation is not the only objective of a firm. It has been

suggested that long-run survival is the primary motive of an

entrepreneur. Though the importance of profit has not been denied,

many economists have argued that profit maximisation should be

replaced with a gonl of makll1g satisfactory profits. However, there

is a general agreement that the theory or the firm explains at a

general level, the way in which resources are alloclIted by the price

system, when profit is the main criterion used by the firms.

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

business management to gain a proper understanding of the nature

and process of competition in the modem industrial society. The

management should undcrstllnd the rationale of the free enterprise

system within which its own business decisions have to be made

and the purpose and limitations of that system. Next it musl hnve

full knowledge of the markets and market situations in which its own

business operates. It should be aware of the policies appropriate to

those market situations. The management should also have an

understanding of the competitive process and the way variables

involved in the process such as price; product innovnt ion and

promotional activity may be manipulated in enlarging the firm's

market share. The firms having monopoly power should be familiar

with the nature and llie purpose of the law relating to monopoly and

restrictive practices. The management must also be alert and

should be able to recognise when market conditions change.

Experienced executiv.es cannot gain the intimate knowledge of the

ways or llicir competitors. Consequently it is necessary to obtain, an

understanding of the nature of competition, which can provide an

insight into the probable behaviour pnlll'llls of the competitors. To

study how prices are determined the types of market situations

need to be studied are as follows:

Perfect competition.

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Imperfect competition

o Monopoly and monopsony

o Monopolistic competition

o Oligopoly and oligopsony.

PURE AND PERFECT COMPETITION

Perfect competition is a market situation where large number of

buyers and scllns operate freely and commodity sells at a uniform

price. In such a situation no seller or buyer has any influence on the

market price. In this market, a firm is the price taker and industry is

the price maker.

Main Features

The main features of perfect competition are as follows:

There are a large number of buyers and sellers. Each seller

must be small and the quantity supplied by any ne seller

must be so insignificant that no increase or decrease in his

output can appreciably affect the total supply and the

market price. So also, each buyer must be small and the

quantity bought by any of the buyers should be so

insignificant that no increase or decrease in his purchases

can· appreciably affect the total demand and the price. As a

result, each seller will accept the market price as it is. So

also each buyer will regard the price as determined by forces

beyond his control.

Each competitor offers a homogenous product, i.e. the

products are similar to ach other in terms of quality, size,

design and colour. Thus one product could be substituted for

the other if the price is lower. Again, the commodity dealt in

must be supplied in quantity.

There is no obstacle with regard to entry or exit of the firms.

When these aforesaid three conditions arc fulfilled there is a

market condition that can be defined as a pure competitive

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market.

The market iil which the commodity is bought and sold is

well organised and trading is continuous. Therefore, buyers

and sellers are well informed about the price of the

commodities.

There are many competitors (whether buyers or sellers),

each acting independently. There must be no restraint upon

the independence of any seller or buyer, either by custom,

contract, collusion, and fear of reprisals by the competitors,

or by the imposition of government control.

The market price is flexible over a period of time. In other

words, it rises or falls constantly in response to the changing

conditions of supply and demand.

All the firms have equal access to production technologies

and techniques.

There are no patents, proprietary designs or special skills

that allow an individual firm to do the job better than its

competitors.

Firms also have equal access to all their inputs, which are

available on similar terms.

Thus, perfect competition in an extreme case and is rarely to

be found. Actual competition always departs from the ideal of

perfection Perfect competition is a mere concept, a standard by

which to measure the varying degrees of imperfect competition.

Sometimes, a distinction is made between perfect competition

and pure I competition. But the line of distinction drawn between

the two is very fine. That is why many economists have preferred to

use the two terms synonymously. Hence, from managerial

viewpoint, there does not seem to be any difference between the

two. The underlying presumption in a free competition (close to

perfect cmpetition) is that it social interest interest unless the

contrary can be proved. Competition safeguards the consumer

against exploitation by providing the buyer with alternatives, and

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makes it unnecessary for the state to intervene by regulating

process and production in order to protect him.

Determination of Price

The forces of demand and supply determine prices under perfect

competition. The equilibrium price is obtained at the intersection of

demand and supply curves as shown in following Figure 4.14. The

equilibrium price will change only with changes in forces of

demand and supply.

Price and Quantity Variability

Responses to a cnange in demand or to a change in supply may be

primarily in price or quantity. If the demand is highly elastic,

consumers will respond readily to price changes by dropping out of

the market when prices are lowered'a little. As a result, most of the

adjustments to changes in supply (an increase leading to a

reduction in price and a decrease leading to an increase.in price)

would be those in quantity purchased, if the demand is highly

elastic. If the demand is inelastic, the adjustments will take place

primarily in price. Similarly, if sellers respond readily by greatly

increasing their offerings on slight increases in price or by heavy

withdrawals in slight price drops, the adjustments to changes in

demand willbe largely in quantity exchanged. If sellers are quite

responsive to, price in their offerihgs (if supply is very inelastic), the

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adjustments to changes in demand, will take place largely through

shifts in price. In view of the above explanation, 'we may state

thefollowing rules:

If demand rises then price goes up and vice versa. For

example, in Figure. 4.15, the demand curve shifts. upwards, to

the right from DD to D’D’ whereas the supply curve remains

the same. As a result, the price goes up from OP to OP1. Thus,

the sales increase from OQ to OQ1. If supply rises then the

price decreases and vice versa. For example, in Figure. 4.16,

the supply curve shifts downward to the right from SS to S’S’

while the demand curve remains unchanged. The result is that

price falls from OP to OP1. Dul the sales increase from OQ to

OQ1. The following Figures 4.15 and 4.16 shows shift in

demand curve and shift in supply curve due to increase in

price, respectively.

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

Price will rise less or falllcss if the supply curve is elastic

(flat)

Price will rise more or fall more if the supply curve is

inelastic (steep)

If the rise in price is more than the rise in sales will be less

If the rise in price is less than the rise in sales will be more

For example, in Figure 4.17, the demand eurve shifts from DD to

D’D’.

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The supply curve S"S" is steep. Another supply curve S'S' is

rather flat. Both the supply curves cut the original demand curve at

point E giving the equilibrium prices as OP. The flat supply curve S'S'

cuts the new demand curve D'D' at E2 giving the equilibrium price as

OP2, which is less than OP1 and more than OP.

In the same way the following will occur when there is a shift

in the supply curve

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

elastic

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

inelastic.

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

S'S' is the new supply curve, D'D' is the steep demand curve

(indicating relatively inelastic demand) and D”D” is the flat curve

intersecting the supply curve at point E. After the shift in the supply

curve, however, the S'S' cuts the D'D' curve at point E' giving OP' as

the equilibrium price. But the SS curve cuts the D"D" curve at point

E giving the equilibrium price as OP which is higher than OP'.

If both demand and supply increase, sales are bound to

increase but the price mayor may not increase. In this case

there case can be two possibilities

o Price will rise if the amount, which will be

demandedattheold price exceeds the supply, which will

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be made at that old price as shown in Figure 4.19.

o But the price will fall if the amount, which will be

supplied at the old price, is more than the amount

demanded currently at that price as shown in Figure

4.20. In other words, if at the old price, new demand

exceeds the new supply, the price will rise but if the new

demand is less than the new supply, the price will fall.

An increase in demand with a simultaneous decrease in

supply will raise price and increase sales if the new demand price

for the old equilibrium amount is higher than its new supply price.

Similarly, the price will rise and sales will dimfnish if the new supply

price for the old amount is higher than itsnew demand

GOVERNMENT INTERVENTION IN PRICE FIXING

Quite often the government interferes with the normal process of

price determination by fixing prices either above the equilibrium

level or below it. In order to make these attempts by the

government about artificial price fixation successful, government

intervention is required with the forces of supply or demand or both,

through elaborate administrative regulations.

Difficulties in Price Fixing

The government has to face several difficulties while fixing prices

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due to certain reasons. There can be elaborated as follows:

Attempts to fix prices above an equilibrium level are

illustrated by minimum wage legislation and price support

policies. When the Government undertakes the activity of

fixing a minimum price say, Rs. 375 per quintal for wheat

much above the equilibrium price say, Rs. 300 per quintal,

consumers restrict their consumption of 'wheat' (postpone

their purchases at all levels). Conversely, farmers are

encouraged to increase their production under the incentive

of higher' prices. This results in disequilibrium between the

demand and supply. As such, there are only two ways to

maintain prices at a high level:

o The government can buy large quantities to absorb the

difference between the quantity supplied and quantity

demanded.

o The government can ask the farmers to limit their

output.

The government also tries to set maximum prices below the

equilibrium level. This is illustrated by the price control on

sugar, on steel and a number of othcr commodities. Let us

assume that the equilibrium price of sugar is Rs. 10.00 per

kilo but price has been controlled at Rs. 7.00. The suppliers

would hold back their supplies and this would leave a large

body of unsatisficd consumers. The problem would arise as to

who should get a sharclof the limited supply of sugar. There

would be long queues for the available supply. In short, lots of

difficulties would arise. The government would have t.o adopt

both-or either of the following measures:

o Introduction of rationing

o Payment of subsidey to sugar producers to neutralise

the

effects of low prices and to encourage them to produce

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more.

In this way, the Government would substitute ration cards for

the rationing mechanism of a free-market system and it would

substitute subsidies for the price incentive of a free market the

following Figure 4.21 and 4.22 shows the demand for wheat and

sugar, respectively.

Effect of Time Upon Supply

Economists find it important to discuss the way in which supply

changes in the course of time. The reason why such a study is

necessary lies in the technical conditions of production, i.e., it

always takes time to make those adjustmcl'lts ill the size and

organisation of a factory, which are necessary for greater

production. For the purpose of analysis in this connection, it is usual

to follow the method of analysis used by Marshall. Marshall

suggested three periods of time namely market period, short period

and long period. Marshall considered the market period as being

only a single day or few days. The fundamental feature of the

market period is that it is supposed to be so short that supplies of

the commodity in question will be limited to the existing stocks or at

the most to the supplies in sight. Graphically, the supply curve will

be vertical, i.e., the supply remains fixed irrespective of the price.

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

is particularly important in the case of perishable goods, which are

difficult or impossible to store, and in case of demand, which is

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subject to short-run fluctuations.

Marshall defined short period as "a period long enough for the

supplies of a commodity to be altered by increase or decrease in

current output but not long enough for the fixed equipment to be

changed to produce a larger or a smaller output." In other words;

the short-run cost curve remains the same. Here, the supply curve

would be a slopmg lme, moving upward Irom left to right thereby

indicating that as price goes up, supply increases.

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

additional plants or clear more land for crops; or alternatively, old

machines and factories can be closed down. A firm producing at

overtime rates or by using standby equipment will usually plan to

increase output by buying new plants and machinery. It will do so

when provided that it thinks the increased demand will be

maintained. The long-period supply curve will, therefore, tend to

have a flatter slope than the shortrun supply curve indicating

thereby that given a price increase, the supply tends lo be larger

than in the short-run period.

EQUILIBRIUM AND TIME

The following discussion now concentrates on how price would be

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

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

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

increase in supply.

This will be followed by greater production during the short

period and a fall in the price as firms increase their output.

Later, as more capital equipment is installed the output would

increase still further and prices would again drop. Conversely,

a downward shift in the demand curve would not immediately

affect the quantity supplies but the price would drop sharply,

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followed by some recovery as the firms reduce output in the

short period.

In the long period, firms would see more profitable uses for

their plants and would decide not to replace capital output as

it wears out. This would reduce equipment still further and

permit some recovery in price.

Illustration

To take an example, in Figure 4.23 DD shows the demand for fish

whereas SS, S'S', and S"S" represent the market-period, short-

period and long-period supply curves respectively. Suppose the

demand for fish in the market shifts to D'D'.

Now, supply of fish cannot be increased immediately and hence

market or momentary equilibrium is established at price OP”.

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

more intensive use of the existing equipment, viz., boats and nets

and by working for longer hours. As a result, the price drops to OP".

In the long run, supply can be fully adjusted to meet the demand

conditions. New fishermen would be attracted (entry of new firms),

new boats; nets and other equipment would be produced and

employed in service. As a result, supply would increase further and

the long-run equilibrium would take place at a still lower price OP".

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The Firm in Pure Competition

In pure competition, the firm has to accept the given market

price. At this given price, it can sell all the products, which it desires

but at any higherprice, it cannot sell anything. If the market price is

below its cost, it has to either take the loss or withdraw from the

market. As a result, any single firm in a purely competitive situation

has to adjust its production and sales policies to the given market

price. However, the market prices arc determined through the

mutual consent of all the individual competitive buyers and sellers

together. But any individual firm has no control over the price. Since

a purely competitive seller has no control over the price at which he

sells, his average marginal revenue schedule is infinitely elastic. In

perfect competition, marginal revenue is equal to the average

re.xenue, because every unit is sold at the same market price,

irrespective of the' quantity sold. Graphically, a horizontal line at the

market price represents it. As expansion of sales does not require

any reduction in the price at all; the greater the quantity sold, the

larger is the revenue. Under ordinary circumstances, the owner· of a

linn will not question whether to produce or not to produce. Rather

he will have to decide whether it will be bettcr to producc, say,

10,000 units or 11,000 units. In order to answer this question, hc will

compare thc incremental cost and tIll' incremental revenue resulting

(i'om thc altcrnative courses of action. To express in technical

terms, the maximum profit (or the minimum loss) position can be

attained by in.creasing output so long as the marginal revenue

continues to exceed the marginal cost. When marginal cost is above

the marginal revenue, an increase in output would reduce profits

and it would be better to decrease the output. If the amount of

marginal rcvenuc is greater than the marginal cost, it would be

beneficial to increase the output. Thus, profit is maximised, or the

loss is minimised, by increasing the output just up to the point a.t

which marginal cost equals marginal revenue.

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Output Decisions and Consumer Interests

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

cost is less than the worth of the incrcase in output price to the

consumers. In this respect, the entreprencur acts consistently with

the interests of the consumers though his purpose is merely to

maximise his own profits.

This rcquires continuing the hiring of additional workers and

buying additional raw materials so long as the wage paid for the

labour and the price paid for the matcrials is less than the amount

that every unit of output will add to his revenues. In this rcspect, the

entrepreneur acts in harmony with the interests of the sellers of

labour and raw materials though his purpose is to maximise his own

profits. A consistcney with the consumer preferences is also

maintained in bidding for the additional units of input for his firm.

Without being in the least a philanthropist, the purely competitive

entrepreneur seeking to maximise profits provides a very cffective

service in helping the allocation of resources in consistence with

consumer preferences and with the interests"of resource owners.

The Firm and Shutdown Point

The amount that a particular firm offers for scale in the short-run at

different prices for its product depends upon the cost conditions of

the firm. In case there is any price that is lower than the lowest

variable cost per unit, the firm will have to be shut down. It would

not be useful to operate even in the short run at a price lower than

this, sincc variablc costs are not covered. It is not held, however,

that in the short run, the average total costs play no role in the

output decisions of the prbfit-.seeking entrepreneur. This is because

the fixed costs, which are a component of the average total costs,

would remain unaffected by the decision to shut down.

The Decision to Operate at Loss or Shut down

The above discussion shows that in the short run any firm may

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decide to operate at a loss but try to minimise it. However, the

question may well arise: Why should a firm operate at all when it is

suffering losses, and why should it not.shut down? The explanation

to the above question lies in the fixed costs, which a firm has to

incur any way. In the short-run, certain costs, for example, rent,

interest, etc., are fixed. They continue to exist whether the firm

operates or not. Even if the firm shuts down, it cannot avoid these

costs in the short-run. If, for example, these fixed costs are Rs.

1,000 per month, the firm will lose this amount every· month even if

it decides to cease operations.

Under these circumstances, it will be clearly beneficial to the firm

to continue operating if it can cover its variable costs and still have

something left to contribute towards its irreducible Rs. 1,000 every

month. Thus, supposing till' price is Rs. 40, output is 70 units and

the average variable cost is Rs. 35, the firm's receipts would be Rs.

800. Total variable cost will be Rs. 2,450 and the finll would be left

with Rs. 350 to meet part of its fixed costs. The net .loss to be

suffered would be RS.650 only. If the firm were to close down, its

loss would have been Rs. 1,000; hence it would decide to operate

even at a loss because by so doing, its losses would be less than

they would have been in the case of firm's shutdown.

If, however, the price comes down to Rs. 35 only and the

average variabe cost is Rs. 35, the sales receipts would just cover

total variable cost, leaving nothing towards covering the finn's fixed

costs. Hence, the firm would be indifferent and perhaps decide to

shut down. If price is below the average variable cost (Rs. 35), the

firm would fail to recover even its variable costs and would certainly

shut down. To conclude, therefore, the shutdown point is whcre

AVC=AR.

Consequences of Pure Competition

The consequences of pure competition can be enlisted as follows:

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

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particular produccr, he can do nothing but to take a loss (in

the short run). If tbe price remains below his cost of

production for a sufficiently long period, he has no alternative

but to go out of business.

A firm can increase its profits by selling more units.

Products subject to a competitive market situation, face a

greater degree of price instability than is the case with

differentiated products.

No useful purpose is served by advertising. When products

sold by individual sellers are identical, advertising by anyone

seller would have a negligible effect on the demand for his

product.

Equilibrium of Industry

The short-term and long-term adjustment processes can be clearly

identified by understanding the concept of equilibrium of an

industry. These are explained as follow.

Meaning of Industry

The term industries are sometimes used in a broad sense so as to

include all the producers of a similar type of commodity such as

vanaspati industry or cigarette industry. It is sometimes used in a

narrow sense to include only the producers of commodities, which

are identical from the point of view of purchasers such as wheat or

more precisely still a particular grade of wheat. In a purely

competitive industry, however, the commodity is uniform and there

is no product differentiation, even in the slightest way. As such,

under perfect competition, an industry may be said to consist of all

firms producing a uniform commodity. It may be further added that

a firm, which produces more than one product, may be said to

participate in more than one industry. Strictly speaking, different

brands of cigarettes may be regarded as different commodities

because there are set consumer preferences for one brand over

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another. Yet, these consumer preferences are so slight that for

many purposes all the standard brands may be regarded as one

commodity and the industry as a whole, for example, the cigarette

industry. Of course, the industry is said to be characterised by

product differentiation as different brands have different

characteristics to attract consumers.

Adjustment Process Towards Long-run Equilibrium in

Industry

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

the part of the firms within the industry to leave it or on the part of

the firms outside; to enter the industry. Long-run adjustments in an

industry take place through the entry or withdrawal of firms. These

are adjustments that take place over a time period I.ong enough to

permit such a shifting of firms and of relatively fixed productive

agents used by the firms. An industry is said to be in equilibrium

when there is no advantage to any productive agent in moving into

or out of the industry, or when there is no incentive for

entrepreneurs to inaugurate or withdraw firrtls from the industry.

Firms will move into or drop out of the .inqustry until

expectations of profits and losses have been roughly eliminated or

until it is no longer possible for anyone to better his position by

moving into or out of the industry in question. Under pure

competition, this equilibrium will be reached when price is almost

equal to the lowest cost on the typical firm's total unit cost curve.

Under competition, the price cannot stay higher for long; and

withdrawal of firms will keep it from staying lower for a long period.

Survival of the Fittest

At any given time, there may be firms of varying sizes and

efficiency in an industry, possibly some making profits and others

incurring losses. Ellt so long as industry is open for anyone to enter

freely, an excess of price over the attainable average total costs will

encourage the entry of new firms. As such new firms move in, they

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compete with existing firms and the most inefficient firms are

eliminated. In the long-run, therefore, only those firms will remain in

the industry, which have the lowest average total costs, as low as

those, which would be incurred by new enterprises in optimal scale

adjustments. If a long-run equilibrium position is linally attained,

there might still be many differences between firms but the lowest

average total costs of all firms would be the same. For instance,

some entrcpr.eneurs may be more efficient than others, some firms

may be located near markets and may be paying higher rents

whereas others are more distant and may be paying lower rents.

Again, some firms may be small with close personal supervision and

hence with greater efficiency whereas others may be large and with

mass production methods, In view of these differences, the firms

may not be having identical or similar cost curves. Still, each firm

must produce at an average cost as low as that of its competitors.

In other words, though there may be differences between firms,

these may be balanced by balancing advantages and disadvantages

giving rise to uniformity of minimum average total costs.

To illustrate, two manufacturers of cotton textiles may be

differently located; one may qave the advantage of nearness to

buyers but the disadvantage of higher rent. The other may be

located away from the buyers and as such may have the advantage

of lower rent but the disadvantage of higher transport costs. Here

the advantages and disadvantages may balance so that the two

firms have the same lowest average costs. Another example is that

of one firm having a more efficient manager than the other. Here

the efficient firm may have the advantage of higher productivity but

disadvantage of higher salary payments as' compared to the less

efficient firm. On balance, the two firms may have the same lowest

average costs.

In an industry adjustments towards long-run equilibrium do

not necessarily I take place smoothly. In fact, too many firms may

enter· a profitable industry. Thus, by the time they are turning out

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finished products, market price may drop below costs. As a result,

firms may start withdrawing from the industry so much so that too

many firms withdraw with opposite effects. This is most likely to

occur where initial investments are relatively small or where given

fixed equipment can be' utilised in other industries. This is because

these conditions facilitate quick entry as well as withdrawal.

Agriculture provides an example of this type where the same fixed

assets can be utilised alternatively as, for example, either for

producing wheat or cotton, jute or rice.

Restrictions on Firm's Entry and Withdrawal

Free entry'of new firms is usually restricted through

Financial or technical barriers to entry into costly

and complex technological processes;

Government intervention and legal restrictions; and

Collusion among producers on prices, market shares,

tendering, etc.

Until 1991, the Indian economy was regulated by numerous

Government decisions on wages, price, size and scope of

production, industrial relations, foreign exchange, etc. Due to these

Government regulations, hardly any industry was free to decide on

its scale and methods of production, wage policies retrenchment,

equipment etc. Again, the Indian industrialist operated in a

completely sheltered market. He was protected against external

(foreign) competition by import and exchange controls. The

requirement of a licence before starting a large-scale unit further

protected him from internal (Indian) competition. Thus, entry and

withdrawal of firms was highly restricted in Indian conditions.

However, now the entrepreneurs are free to decide about the

industry they want to establish and its size except in a limited

number of industries, which are still subject to Government

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regulation.

VARIANTS OF PERFECT COMPETITION

1. Effective or Workable Competition

Competition among the sellers, even though it may not be perfect,

can be regarded as effective if it offers real alternatives to

consumers that are sufficient to compel sellers to vary quality,

service and price substantially with a view to attract buyers.

The prerequisites of effective competition are as follows:

Ready substitution of one product for another.

General availability of essential information about a1ternati (its

significance lies in that buyers cannot influence the behaviour

of the sellers unless alternatives are known)

Presence of several sellers, each of them possessing the

capacity to survive and grow

Preservation of conditions which keep alive the basis or

potential competition from others

Substantial independence of action that is each selIn must be

able and willing constantly to reconsider his policy and to

modify it in the light or changing conditions of demand and

supply.

Effective competition cannot be expected in fields where sellers

are so few ill number, capital requirements so large, and the

pressure of fixed charges so strong that price warfare, or its threat

of will lead almost inevitably to collusive (deceitful) understanding

among the members of the trade of. the industry concerned. In

brief, competition is said to be effective whenever it operates over

time to provide alternatives to buyers and to afford them

substantial protection against exploitation. The concept of effective

competition, though less definite, is more realistic and relevant

than that of perfect competition.

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2. Potential Competition

Potential competition may restrain producers from overcharging

those to whom they sell or from underpaying those from whom they

buy. The essential precondition for potential competition is the

preservation of freedom to enter or to leave the market. The

exclusive ownership of scarce resource, the heavy investment

required for entry into many fields, the fixed character of much of

the existing equipment, high costs of transportation, restrictive

tariffs, exclusive franchises, and patent rights constantly operate to

destroy the hasis of potential' competition. Science, invention and

the development of technology constantly operate to keep this

potentiality alive. Potential competition, insofar as its basis

continues, may compensate in part for the shortcomings of the, lack

of perfect competition.

Key Lessons of Perfect Competition of Managers

The key lessons of perfect competition or competitiveness for

managers in highly competitive market environment are as under:

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

competitors as possiblc. Smart managers should take

advantage well before the competitors enter the market when

supply is low and price is high. This requires entrepreneurial

skill to take a risk.

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

norm.al profit), cannot afford to be complacent or unprepared

for increasing cOlllpditioll hccausc cconomic profit will

eventually attract new entrants encouraging mare production

and enhancing supply, drive prices down down and reduce

economic profits. Here, it is impossible for a firm in a pcrkclly

compclitive market to compete based on product

differentiation. Therefore, the only way that it can earn or

maintain profit in the face of added supply and lower prices is

to keep its costs as low as possible. The lesson that one can

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learn from understanding the perfectly competitive model is

that a firm is to be amongst the lowest cost producer to ensure

its survival.

PRICE AND OUTPUT DECISIONS UNDER MONOPOLY

Monopolistic market situation allows an individual seller or groups of

sellers, which arc acting as a unit, to exercise direct control over

price. Similarly, any such control on the part of buyers is called a

monopsonistic market situation. The monopo.listic and

monopsonistic market situations may be distinguished according to

the nature and extent of the deviation from the perfect competition.

A useful classification Can be: (i) monopoly and monopsony; (ii)

monopolistic competition; and (iii) oligopoly and oligopsony.

However, in this chapter, the discussion is confineclto monopoly

only.

Main Features of Monopoly

The essential features of monopoly are as follows:

Single seller: There is only one producer or firm of a

commodity in the market. This is because there remains no

distinction between an industry and a firm in a monopolistic

market. Here, the firm itself becomes the industry and thus

has full control over supply of the commodity. The monopolist

may be an individual, a firm or a group of firms or even

Government itself. There are many buyers of the commodities

produced by a monopolist, against a single seller.

No close substitutes of the commodity: The commodity

sold by the monopolist has no close substitutes. This implies

that the cross-elasticity of demand between the monopofist'"s

product or commodity is very low. Though substitutes of

products are· available but they are not close substitutes.

Difficult entry of a new firm: The monopolist controls the

market situation in such a way that it every new firm finds it

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to be very difficult to enter the monopoly market and also to

compete with the monopolistic firm to produce either the

homogeneous or identical product. This makes the

monopolist, the price maker himself.

Negatively sloped demand curve: The demand curve of a

monopolist firm is negatively sloped, which means that a

monopolist can sell more products only at a lower price and

not at a higher price.

Keeping in mind the features of a monopoly, it can be said

that the monopolist is in a position to set the price himself and also

enjoys the market power.

The strength of a monopolist lies in his power to raise his

prices without the fear to loose his customers. However, the extent

to which he can raise depends on the elasticity of demand for his

particular product. This, in turn, depends on the extent to which

substitutes for his products are available. In most cases, there is an

endless series of closely competing substitutes. Therefore, exclusive

monopolies like railways or telephones also consider the possible

competition by alternative services. In this case, any increase in the

rates by railways, may lead to their substitution by motor transport

and of telephone calls by telegrams. In fact, it is very difficult to

draw a line between what is and what is not a monopoly. The truth

is that there is a continuous shift between competition and

monopoly, just as there is between light and darkness, or between

health and sickness.

Even in those industries, which appear to be monopolised at

any time, monopoly has a constant tendency to break down. First,

there have been shifts in consumer demand. Secondly, inventions

may develop numerous substitutes for the monopolist's product.

Thirdly, the monopolist may suffer from lack of stimulus to

efficiency provided by competition. He may not devote attention to

the improvement of his product. In addition, new competitors may

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arise to fill the gap. Finally, the Government may intervene.

Causes of Monopoly

The government may grant a licence to any particular person

or persons for operating public utilities such as gas company,

an electricity undertaking, etc. In public utility services,

economies of scale are so prominent that it seems almost

unbelievable to have several firms performing the same

service again. In such a case, the Government may reserve the

right of foreign trade related to any commodity for itself or may

give the right to any other person. In all these cases, the

statutory grant of special privileges by the State creates the

condition of monopoly.

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

methods of production or specialised skill, might also give a

producer monopoly power. For example, Hoechst, held a

monopoly for some time in oral medicines for diabetes because

they were the first to find out the methods of reducing blood

sugar by an oral dose.

Monopoly also arises where the minimum efficient scale of

operations is very large. For example, it is so for making some

chemicals In fact, monopoly tends to arise in industries

characterised by decreasing long-run costs.

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

create monopoly in favour of a particular producer.

Revenue and Cost of Monopolists

The revenue and costs of monopolistic firm can be understood with

the following explanations:

Average Revenue: By raising the prices slightly, a monopolist

can sell less, but there will be some buyers of his product. He

can increase his sales only by reducing his price. In this

situation, his average revenue (demand curve) will slope

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downwards to the right. Such a change in AR curve shows that

larger quantities can be sold at lower prices whereas smaller

quantities can be sold at higher prices.

Marginal Revenue and the Sale Value of the Incremental

Output: In the market situation of pure competition, both

marginal revenue and the sale value of the incremental output

are identical. But this is not in the case of monopolly. A

monopolist needs to reduce his prices, to sell additional units

of his commodities. This reduction in price will apply both to

old as well as· new customers. Lei us assume that a shirt

manufacturer retails his shirts at Rs. 40 per unit. Total sales are

1,000 shirts. To sell 1,100 shirts, he reduces his price to Rs. 38.

The sale value of the additional output will be Rs. 3,800 where

as the marginal revenue will be Rs. 1,800 only. Thus, under

monopoly conditions marginal revenue will always be less than

the sale value of the additional output. However, after a stage,

the marginal revenue may even become negative.

Adjustments under Monopoly

A firm under this market situation can choose to sell many units at a

lower price or fewer units at a higher price. For maximisation of

profit or minirnisation of loss, a monopolistic firm would minimise or

reduce the use of inputs and outputs to the level at which the

marginal revenue equals the marginal cost. However, there is a

significant difference between a purely competitive firm and a

monopoly. The difference lies in the fact that for a purely

competitive firm, marginal revenue equals the average revenue

while in a monopolistic firm, marginal revenue is less than the

average revenue. Therefore, a monopolist in purely competitive firm

can only produce up to the point where average revenue equals the

marginal cost. This can be understood with the help of the Figures

4.24 and 4.25 are givefl below:

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With reference to these figures, under perfect competition,

output would be OQP (Figure 4.24) as MR curve or the horizontal AR

curve, interesects the MC curve at point Ep. Butunder monopoly,

MR = MC at a point Em corresponding to output OQm (Figure 4.24),

which is less than OQP. Under monopoly, the MR curve is not equal

to AR curve, but lies below it. Thus, the monopolist's output will be

lower, and the use of productive services is also less than it that in

the case of pure comprtition, where adjustments are made to suit

consumers' preferences. In other words, in ll1uximising the profits,

the monopolist does not take into consideration the interests of the

consumers and the resource owners. It is the total profit that guides

the monopolist in his price and output policy. The total profit is

calculated by multiplying the profit per unit by the number of units

sold. By using the process of trial uilci error with di fferent levels of

price and output, a monopolist fixes a price-output combination

that yields him the highest total profit.

Disadvantages of Monopoly

Under monopolistic condition, a monopolist exercises the

market power by restricting supplies. By doing so, he is

likely to become richer than he' would have been if he had

no market power. He also docs this even at the expense of

those who consume his products.

In a monopolistic situation, a consumer choice is restricted.

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A consumer depends on the monopolist’s decisions on the

mutters related to price, and the amount the direction of

research and development in the industry, the services

offered, etc.

Under monopoly, there is a complete absence of

competition, which means that there will be no prcssure on

the monopolist firm to be economical and to keep its costs

down. By keeping its prices higher, a monopolist tends to

wastc its cost or production. This is a biggest drawback of a

monopolistic tinn.

By exercising the monopolistic power, a monopolist is likely

to misalloeate the resources from society's point of view. As

the monopolist restricts output, his output becomes too

small. He employs too little of society's resources. As

aresult, of this, too much of these resources are used into

the production of the goods with low consumer preferences.

Thus, resources are mislilioclited or wasted.

A firm enjoying monopoly position in a strategic sector is a

big a risk for an economy. For example, any failure related

to the power engineering facilities of a firm, is a hindrance

for an economy, In one BHEL, a firm is full of'risk, as any

natural or man made causes, which may lead to slowdown

or stoppage of production is a severe setback to the

economy.

Long-run Considerations and Price Policies of a Monopolist

In deciding the current price policy, monopolists commonly take into

account' some long-run considerations, which may lead to a more

moderate price policy than would be followed by a firm taking into

account short-term factors only:

Price elasticity of demand: The ability to increase profits

by restricting supplies is the criterion of monopoly or market

power. In this respect, the more elastic the demalld for the

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products, the weaker is the position or Ihc monopolist. But

there will always be a price, above which the demand is so

elastic that it will not cost anything to the monopolist to incur

the loss related to less sales by raising the prices higher. In

the long-run, consumer receptiveness to price may be much

greater than in the short run. Thererore, an intelligent

monopolist must consider this factor before exercising

monopolistic power. If a monopolist's prices are held at high

lewis, consumers may stop utilising that commodity. This will

result in decreased consumption. On the other hand, if the

prices remain lower over extended periods, the consumers

will get used to that product, more people will be interested in

it and those already consuming it may increase their

consumption as well.

Potential competition from new tirms: If a firm is very well

established, exercise strong and exclusive control over

essential raw materials, possess indispensable patents, and

licensing regulations, it may pursue extremely high price

policies without great concern for the competition that these

prices may attract. If, on the other hand, its controls over firms

are not so strong, it depends primarily on unfair competition

and uncclillin manipulation, then the fear of potential

competition may become an important factor to modify the

monopolist's policies.

State of public opinion: Public hostility to unfair practices

and exploitHI ion may appear in many forms like consumer

boycotts, both formal and informal, and legal restrictions and

controls. Hostile public opinion is wry important to be ignored

irrespective of the form in which it is. Many times it may

temper the behaviour of the monopolist seeking to maximise

his profits.

If a monopolist is cautious, he needs not to work against public

interest. This is because the monopolists, being big concerns can

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enjoy the economies of largescale production. They are in a better

position to maintain regular and satisfactory supplies. They can also

avail the benefits of large-scale buying ar1d selling. In fact they can

operate a better level of efficiency. If they restrain themselves and

do not exploit the consumers, they may not only build up a good

image in the market. By doing this, they are also likely to avoid

potential competition and Government interference.

Differenco between Monopoly and Pure Competition

The salient points of difference between monopoly and perfect

competition are as follows:

Under perfect competition, there are a large number of

sellers

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

Under perfect competition, the individual seller has no control

over the market pries whereas under monopoly, the seller is

in a position to nlllnipulnte the output in order to control the

prices.

Under perfect competition, the commodity produced by the

firms is homogeneous in nature whereas there is no close

substitute of the commodities produced by monopoly.

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

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

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

firms in the market whereas monopoly this is not so.

Under perfect competition, firms get only normal profits in

the

long period whercas in monopoly, there is the possibility of

super-normal profits to take place.

Under perfect competition, there is no possibility of price

discrimination whereas in monopoly, price discrimination is

possible.

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MONOPSONY

It is a market situation in which there is single buyer to buy the

commodities but there may be many sellers to sell the identical or

homogeneous commodity.

Features of Monopsony

The essential features of monopsony are as follows:

There is only onc buyer or the goods or services.

Rivalry from buyers, who offer the close substitutes of the

product, is so remote to make it insignificant.

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

which he pays for the goods or commodities.

Actual causes closely approximating monopsony are rare.

An, example, approximating monopsony is that of Indian Railways

in relation to the wagon industry. Monopsony may also arise

where resources are immobile. If for reason, workers are unable

to move to other localities or other firms within same area, their

existing employer has, in effect, a inonopsony position over them.

Costs of Monopsonists

The monopsonist must choose between paying higher wages that

will enable him to employ more workers or limiting his working force

to the analler number workers, who can be employed at lower

wages. This means that when additional worker is added to the

labour force, an employer has to bear both, I wage of the new

worker and also the total increase in the wages to be paid to t old

employees at the new rate. Thus, in monopsonistic market situation,

margir expenditure of each input level exceeds average expenditure

(Table I aild Figu 4.26). Suppose a tailor employs six workers at Rs.

500 per month. To have I additional worker, he must pay Rs. 550

per month to each worker. If he employs the seventh worker, his

total costs, thus, will increase by Rs. 850. To represent the position

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graphically, two curves are needed, one to show the average

expenditur and the other to show the marginal expenditure. The

marginal expenditure (ME) is consistently higher than the average

expenditure (AE) and the slope of thl marginal expenditure cutve is

steeper than that of the average expenditure curve.

The following Table 4.4 shows the cost of a monopsonistic firm

hiring workers.

Table 4.4: Cost of a monopsonistic firm hiring workers

---- -- -- ..•. _. _.- .. ~- .... - .- - WorkersAverange

Expenditureper Worker

(AE)(Rs.)

TotalExpenditure

(TE)(Rs.)

MarginalExpenditure

(ME)(Rs.)

6

7

8

9

10

11

500

550

600

650

700

750

3,000

3,850

4,800

5,850

7,000

8,250

-

850

950

1,050

1, 150

1,250

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Price Discrimination

Price discrimination, may be defined as the practice by a seller of

charging different prices to thL: samc buyer or to different buyers

for the same commodity or service without corresponding difference

in the cost. It is also known as differential pricing. Differences in

rates are somewhat related to the in costs. For example, it may cost

less to serve one class of customers than another to sell in large

quantities than in smaller lots. !frates or prices are proportional to

cost, some buyers will pay more and others less, but this will not

take place in price discrimination. In such a situation, charging

uniform price will amount to discriminat ion. There arc three classes

of price discrimination, which are as follows:

First-degree discrimination: The seller charges, the same

buyer a different price, for euch unit bought. For exumple,

prices that are determined by bargaining with individual

customers or prices, which are quoted for tenders floated by

government authorities.

Second degree discrimination: The seller charges different

prices for blocks of units, instead of, for individual units. For

example, different rates charged by an ekctrieity undertaking

for light and fan, for domestic power and for industrial use.

Third degree discrimination: The seller segregates buyers

according to income, geographic location, individual tastes,

kinds of uses for the product, etc. and charges different prices

to each group or market despite of charging equivalent costs

from them. If the demand elasticities among different buyers

are unequal, it will be profitable for the seller to put the buyer

into separate classes according to elasticity and thereby, to

charge each class a different price. It is also referred as

market segmentation and involves dividing the total market

into homogeneous sub-groups according to some economic

criterion, usually the demand elasticity.

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Conditions for Price Discrimination

The conditions for price discrimination arc as follows:

Multiple demand elasticities: There must be difference in

demand elasticities among buyers due to differences in

income, location, available alternatives, tastes, etc.

Market segmentation: The seller must be able to divide the

total market by separating the buyers into groups or sub-

markets according to elasticity.

Market sealing: The seller must be able to prevent any

significant resale of goods from the lower to the higher price

sub-market. Any resale by buyers among the sub-markets will,

beyond minimum critical levels, neutralisc the effect of

different prices.

Market Segmentation

Haynes, Mote and Paul have identified certain criteria according to

which market segmentation is practised. These criteria are given

below:

Segmentation by income and wealth: This can be

understood by considering an example, in which the doctors

separate patients with high incomes from patients with low

incomes. The fact that doctor's treatment is a direct personal

service prevents its resale.

Segmentation by quantity of purchase: Traders often

distinguish between large and small purchasers, offering

quantity discounts to large purchasers. The big buyers because

of their bargaining power are able to extract special quantity

discounts. However, if the quantity discounts are in proportion

to the marginal costs of selling to big and small buyers, they

will not be counted in price discrimination.

Segmentation by social or professional status of the

customer: Special prices may be quoted to Central and State

Governments or to Universities. Students are given

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concessions in cinema tickets, railway fare and bus travel.

Profes'sional journals usually carry lower student subscription

rates. Faculty members or teachers are also sometimes offered

books at special discounts.

Segmentation by geography: This can be understood by

considering an example. For example, business houses, which

are sold abroad at prices, lower than the domestic price.

Segmentation by time of purchase: Reduced rates are

often quoted during festival seasons such as dussehra, diwali,

etc. off-season discounts are also popuinr in case of fans,

refrigerators, etc.

Segmentation by preferences for brand names and

other sales promotion devices: Some firms sell the same

type of product under different branp names at, different

prices. In this case, ignorance on the part of consumer

regarding similarity in the quality of products prevents a large-

scale of customcrs to shift from one brand to another. Market

segmentation also ensures, the manufactures, a certain degree

of flexibility in pricing. Apart from this is also to be ensured

that it should remain present in every segment of market. For

example, Hindustan Lever supplies liril to satisfy the top-end of

Ihe market, lifebuoy to the lowest end and lux to the middle-

end.

Objectives

The objectives of pricc discrimination are as follows:

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

to the producer and not to the consumer.

To dispose of occasional or irregula surpluses.

To develop a new market.

To make the maximum and proper use of the unutilised

capacity.

To earn monopoly profits.

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To enter into or retain report markets.

To destroy or to forestall competition or to make the

competition amenable to Ihc wishes of the seller adopting

price discrimination. It may be called predatory or

discriminatory competition. The test of perdition of intent.

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

develop in future a taste for the similar commodities

producecl by the same manufacturer. For example, Reader's

Digest sells children's edition at lower rates. This develops the

taste of children towards the magazine and they are expected

to continue purchasing it even when they become adults.

Single Monopoly Price Vs. Price Discrimination

To examine the policy of price discrimination, is more useful rather

than to charge a single monopoly price. This can be done in

following ways:

First of all, a discriminating monopolist can increase his profits

by charging different prices to different buyers or groups of

buyers rather than to charge a single price to all the buyers.

Secondly, the policy of price discrimination is in the interests

of the consumers as well. Bigger' output is made available to

a large number of customers. This is of special significance in

the case of public utility services. The larger the consumption

of these services, the greater is the economic welfare.

Moreover, the consumers may be charged according to their

ability to pay, which is quite fair and reasonable.

Finally, the policy of price discrimination enables better

utilisation of capacity, preventing waste of social resources.

This can be understood with the help of following Table 4.5.

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Table 4.5: Costs, Prices and Sales of a Monopolist

Price Sales Total Cost(Rs.) (Rs.) (Rs.)

9.00 100 1,4008.00 200 1,7507.00 300 2,0506.00 400 - 2,3005.00 500 2,5004.00 700 3,0003.00 1,000 3,4002.50 1,400 4,1002.00 2,000 5,0001.50 2,800 6,4001.00 3,600 8,000

The above Table gives the number of units, a monopolist can sell

at various prices and the total cost involved in producing them.

Answer the following questions related to the table.

How much should the monopolist prodllce find what price

should be charge, if' he sells his entire output at a single

price? How much profit will he earn?

How much should be produced if the monopolist fixes II

discriminatory price, dividing his customers into separate

groups according to their ability to pay and charging

maximum prices from each group? How much will be the

profit, which the monopolist will earn?

Will the monopolist be better off if he charges a single price or

discriminating prices and by how much?

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

charges discriminating prices? Explain.

Will the policy of price discrimination enable better utilisation of

capacity' as compared to a single price?

How much maximum profit would the monopolist earn if he is

allowed price discrimination but cannot charge more than

RS.2? Would it make any difference to capacity utilisation and

availability of supply the consumers?

Solution

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If the monopolist sells the output at a single price, he will choose

that price, which will yield the largest profit, He will, therefore,

produce 400 units and charge Rs. 6. The maximum profit he will

earn is Rs. 100. This will be clear from the following Table 4.6:

Table 4.6: Monopolist Selling at a Single Price

If the monopolist discriminates, dividing his customers into

groups according to their ability to pay and charging different

prices from each group, the results would be as given in the

following Table 4.7:

Table 4.7: Monopolist Selling at Discriminatory Prices

Price Sales Sales Revenue Total Total Profit or(Rs.) (Units) each from each Revenue Cost Loss

Catego category (Rs.) (Rs.) (Rs.)(units) (Rs.)

1 2 3 4 5 6 7

9.00 100 100 900 900 1,400 -500

8.00 200 100 800 1,600 1,750 -1507.00 300 100 700 2,100 2,050 " 506.00 400 100 600 2,400 2,300 10005.00 500 200 500 2,500 2,500 -2004.00 700 300 800 2,800 3,000 -4003.00 1,000 400 900 3,000 3,400 -6002.50 1,400 600 1,000 3,500 4,100 -1,0002.00 2,000 800 1,200 4,000 5,000 -2,200

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Price Sales Total Total Profit or(Rs.) (Uuits) Revenue Cost Loss

(Rs.) (Rs.) (Rs.) 9.00 100 1,600 1,400 -500

8.00 200 2,100 1,750 -150 7.00 300 2,400 2,050 50 6.00 400 2,500 2,300 100 5.00 500 2,SOO 2,500 0 4.00 700 3,000 3,000 -200

3.00 1,000 3,500 3,400 -400

2.50 1,400 4,000 4,100 -600

2.00 2,000 4,200 5,000 -1.000

1.50 2,800 3,600 6,400 -2,200

1.00 3.600 8,000 -4,400

1.50 2,800 800 1,200 4,200 6,400 4,4001.00 3,600 800 3,600 .8,000

Here, the prices, sales and total costs are the same as they

were in Table 4.5. But the monopolist divides his customers into

separate groups and charges different prices from each group. The

basis of dividing the customers is as follows:

When price is Rs. 9 per unit, 100 units are sold, when the price is

Rs. 8 per unit, 200 units are sold. This means that 100 units can be

sold for Rs. 9 per unit and another 100 for Rs. 9 per unit. Similarly,

by charging Rs. 7 per unit, the monopolist can sell another 100

units. In this way, other categories have also been formed as shown

in column 3. Column 4 gives revenue from each category, which is

calculated by multiplying the figures of column 3 with the

corresponding figures of column 1. Column 5 gives tot21 revenue

obtained by selling goods to various categories of the customers.

Column 6 gives total cost and column 7 gives profit or loss.

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

maximum profit, which cen be obtained by creating a category of

customers and charging Rs. 9 from those on the top class and Rs. 2

from those in the bottom of the category. With such a differential

price structure, the monopolist will sell 2,000 units and earn a

maximum profit of Rs. 2,400.

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

discriminating prices he will earn as much as Rs. 2,400 as

against a maximum of Rs. 100 by charging the single price of

Rs. 6.

The policy of discriminating prices is in the interest of the

customers as well. Larger output of 2,000 units, is beneficial

to a larger number of customers. Moreover, each customer is

charged according to his ability to pay. Therefore, the policy is

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fair as well as reasonable.

The policy of price discrimination will enable better utilisation of

capacity. Assuming the monopolist has a capacity to produce

3,600 units, he would operate at a level of 2,000 units which

is much' closer to full capacity as against the level of 400

units, where the monopolist will operate if he chmges the

single price of Rs. 6.

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

monopolist will earn a maximum profit of Rs. 200 by

practising price discrimination as shown in the following Table

4.8.

Table 4.8.: A Regulated Monopolist Discriminating in

Price but Charging not more than Rs. 3

Price Sales Sales in Revenue Total Total Profit or(Rs.) (Units) each from Revenue Cost Loss

Category each (Rs.) (Rs.) (Rs.)(units) category

(Rs.)

1 2 3 4 5 6 7

3.00 1,000 1,000 3,000 3,000 3,400 -400

2.50 1,400 400 1,000 4,100 4,100 -100

2.00 2,000 600 1,200 5,200 5,000 2001.50 2,800 800 1,200 6,400 6,400 01.00 3,600 800 800 7,200 8,000 -800

But capacity utilisation and availability of supplies will remain

unaltered.

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APPENDIX 1

Price Discrimination - Diagrammatic Exposition

A diagrammatic exposition of the theory of price discrimination is

shown below. Figure 4.27 presents the diagram of price

discriminate adopted in traditional economic theory.

Let us suppose that the market for a product consists of two

segments, one with a more elastic demand curve than the other D1

shows the demand in the more elastic segment and D2 shows the

demand in the less elastic segment. MR. and MR2 represent the

corresponding marginal revenue curves. The total marginal,

revenue cllrve MRT adds together the quantities in both market

segments at each marginal revenue. Thus MRT = MR1+ MR2. On the

cost side, the diagram shows a marginal cost curve MC, which alone

is relevant. It may be noted that only one I marginal cost curw

exists because it makes no difference from the cost point of view

whethcr the products sell in market segment 1 or market segment

2, since the product is the same.

As usual, profit will be maximised where marginal revenue is

cquallo marginal cost. Such equality exists at point E in the diagram

where 'the total margimil revel1lie curve (MRT) intersects the

ll1argin::d cost curve (MC). A horizontal line drawn from this point of

intersection E, back to the Y-axis cuts the two marginal revenue

curves MR, and MR2 at points F and G respectively. These roints

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determine the quantities to be sold in each market segment and the

prices which shall prevail in each market segment. For this purpose

one should first draw a perpendicular line frolll point F on X-axis,

showing OX, as the quantity in market segment 1. Agai by

extending this perpendicular line upward to meet the demand curve

0" one gets p. as the price for this market segment. Similarly, frol1l

point drawing the perpendicular to X-axis and thereafter extending

it to the demand c.urve D2, we get OX2 as·the quantity to be sold

and P2 as the price to be charged in market segment 2. The

quantity sold in market segment 1 (OXI) plus the quantity sold in

market segment 2 (OX2) exhausts the total quantity OQ (i.e., OX1 +

OX2 = OQ). Further, the price PI is lower than the price P2 thus

indicating that the price in the more elastic market segment (DI)

shall be less than the price in the less elastic market segment (D2).

The two prices PI and P2 provide different margins of contribution to

profit. It should also be noted that (he solution equates the marginal

revenue in each segment (i.e., X2G = X.F) besides equating the

total marginal revenue to marginal cost at point F. If MR. was

greater than MR2, the firm could increase profits by transferring

units of product from market segment 2 to-market segments I. This

is an illustration of the equi-marginal principle. If either MR1 or MR2

were greater than me, an expansion of output would be profitable.

Optimisation thus requires that MR1 = MR2 = Me.

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APPENDIX 2

Measures of Monopoly Power

Several economistS have given different measures of monopoly

power. These are discussed below:

Lerner's measure: According to Lerner, the difference between

price dnd marginal cost, measures the gegree of monopoly power.

In other words, a seller's monopoly power depends upon his ability

to sell the commodity at a price above its marginal cost. A perfectly

competitive seller enjoys no monopoly power and in his case:

Price = Marginal cost (or P - MC = 0).

But as monopoly po~er emerges, P - MC becomes greater than zero and as the

power increases, the gap between price and MC increases. Thus, the degree or index

of monopoly power can be measured as being equal to:

P =MC

P

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

degree of monopoly power is

20-12= 0.4

20

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Lerner also relates the monopoly power to price-elasticity of

demand. Accordingly, higher the price-elasticity of demand, smaller

is the degree of monopoly power. Also, the degree of monopoly

power is the reciprocal of the price-elasticity of demand. That is, if

elasticity is 2, the degree of monopoly is V*.

Bain's measure: Bain measures degree of monopoly power in

terms of supernormal profits. The supernormal profits are

equal to (P - AC) Q, where P = Price, AC = average cost, and Q

is output.

Rotbscbilds' measure: Rothschilos defines degree of monopoly

power, in terms of the proportion of the slopes of the firms

and industry demand curves, i.e.,

degree of monopoly power

=

Slope of the firm’s demand curve

Slope of the industry’s demand

curve

Triffin's measure: Trimn measures degree of monopoly

power in terms of price cross-elasticity of demand. Price cross-

elasticity of demand means the extent of substitution

between the products of two firms when one of them changes

the price of its product. If cross-elasticity of demand is zero,

this implies that the firm has an absolute monopoly power.

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REVIEW QUESTIONS

1. Define a production function. Explain and illustrate

isoquants and isocost curves.

2. Explain the nature mid managerial uses of production

function.

3. Discuss the equilibrium of the organisation with the

technique of' isoquants.

4. Distinguish between production function and cost

function. How would you develop the production

function? What are its uses?

5. What are the main features of pure competition? How

does an organisation adjust its policies to a purely

competitive situation?

6. What is the short-down point? Explain why a

organisation suffering losses still decides to operate

and not shut down.

7. Explain the following propositions:

A. If demand rises, price goes up.

B. If supply rises, price goes down.

C. If both demand and supply increase, sales is bound

to

increase but price mayor may not.

8. Explain the possible effect of an increase in demand

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with a simultaneous decrease in supply on sales and

price.

9. Explain the effects of government intervention in price

fixation. What steps are necessary to make this

intervention effective?

10. How does a company determiae the prices of its

products? Examine in this connection the validity of the

theory that long-period price is equal to cost.

11. Explain very short period, short period and long period

situations in a market. Show price equilibrium under

very short and iong periods.

12. What is meant by 'price discrimination'? What are its

objectives? Is price discrimination anti-social?

13. What does differential pricing mean? Discuss the

various types of geographical price differentials and

explain how they are determined.

14. Comment on the various types of discounts and the

effects of each on sales.

15. How does the equilibrium of the organisation under

perfect competition differ from that of a monopolist? Is it

true that in the long run II perfectly competitive

organisation earns no super-normal profits?

16. Explain and illustrate the conditions for the

establishment of organisation's equilibrium under

perfect competition.

17. Examine the weaknesses of the traditional theory of

pricing from the point of view of an individual

organisation.

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LESSON - 5

PROFIT

MEANNING

Profit means different things to different people. The word ‘profit’

has different meanings to business, accountants, tax collectors

workers and economists. In a general sense, profit is regarded as

income of the equity shareholders. Similarly wages getting

accumulated of a labor, rent accruing to the owners of any land or

building and interest getting due to the investors of capital of a

business, are a kind of profit for labours, land owners and investors.

To an account, profit means the excess of revenue over all paid out

costs including both manufacturing and overhead expenses. It is

much similar to net profit. In accountancy, profit or business income

means profit of a business including its non allowance expenses. In

economic, Profit is called pure profit, which may be defined as a

residual left after all contractual costs have been met, including the

transfer costs of management insurable risks, depreciation and

payment to shareholders, sufficient to maintain investment at its

current level. Therefore pure profit can be calculated with the help

of following formula.

Pure Profit = Total Revenue - (explicit costs + implicit costs).

Economic or pure profit also makes provision for insurable risks,

depreciation and necessary minimum payments to shareholders to

prevent them from withdrawing their capital. Pure profit is

considered to be a short – term phenomenon. It does not exist in the

long run, especially under perfectly conditions. Because of this, they

may either be positive or negative for a single firm in a single year.

The concept of economic profit differs from that of accounting

profit Economic profit takes into account also the implicit or imputed

costs. The implicit cost is also called opportunity cost. If an

entrepreneur uses his labor in his own business, he foregoes his

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income or salary, which he might have earned by working as a

manager in another firm. Similarly, by using assets like and building

and his own business, he foregoes the market rent, which might

have earned otherwise. All these foregone incomes such as interest,

salary and rent, are called opportunity costs or transfer costs.

Accounting profit does not consider the opportunity cost.

THEORIES OF PROFIT AND SOURCES OF PROFIT

There are various theories of profit, given by several economists,

which are as follows:

Walker’s Theory of: Profit as Rent of Ability

This theory is pounded by F.A. Walker. According to F.A. Walker,

“Profit is the rent of exceptional abilities that an entrepreneur may

possess over others. Rent is the difference between the yields of the

least and the most efficient entrepreneurs. In formulating this

theory, Walker assumed a state of perfect completion in which all

firms are presumed to possess equal managerial ability each firm

receives only the wages which in Walker view forms no part of pure

profit. Hen considered wages of management as ordinary wages

thus, under perfectly competitive conditions, there would be no pure

profit and all firms would earn only wages, which is known as

normal profit.

Clark’s Dynamic Theory

This theory is propounded by J.B. Clark According to him, “profits

arise in a dynamic economy and not in static economy.”

A static economy and the firms under it, has the following features:

Absolute freedom of completion

Population and capital are stationary

Production process remains unchanged over time.

Homogeneous goods

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Factors of production enjoy freedom of mobility but do not

move because their marginal product in very industry is the

same.

There is no uncertainly and risk. If there is any risk, It is

insurable

All firms make only normal profit

A dynamic economy is characterized by the following features:

Increase in population

Increase In capital

Improvement in production techniques.

Changes in the forms of business organization

The major function of entrepreneurs or managers in a

dynamic economic is to take the advantage of all of the above

features and promote their business by expanding their sales and

reducing their costs of production.

According to J.B. Clark, “Profit is an elusive sum, which

entrepreneurs grasp but cannot hold. It slips through their fingers

and bestows itself on all members of the society”. This result in rise

in demand for factors pf production and therefore rises in factor

prices and subsequent rise in the cost of production. On the other

hand, because of rise in cost of production and the subsequent fall

in selling price of the commodities, the profit disappears.

Disappearing of profit does not mean that profit arise in dynamic

economy once only, but it means that the managers take the

advantage of the changes taking place in the economy and thereby

making profits.

Howley’s Risk Theory of Profit

The risk theory pf profit is propounded by F.B. Hawley’s in 1893.

Risk in business may arise due to obsolescence of a product, sudden

fall in prices, non-availability of certain materials, introduction of a

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better substitute by a competitor and risks due to fire, war, etc.

Hawley’s considered risk taking as an inevitable element of

production and those who take risk are more likely to earn larger

profits. According to Hawley, Profit is simply the price paid by

society assuming business risks. In his opinion in excess of

predetermined risk. They also look for a return in excess of the wags

for bearing risk is that the assumption of risk is irrelevant and gives

to trouble and anxiety. According to Hawley, Profit consists of two

part, which are as follows:-

One Part represents compensation for actual or average loss

supplementing the various classes of risk.

The other part represents a penalty to suffer the

consequences of being exposed to risk in the entrepreneurial

activities.

Hawley believed that profits arise from factor ownership as

long as ownership involves risk. According to Hawle’y an

entrepreneur has to assume risk to earn more and more profit. In

case of absence of risks, an entrepreneur would cease to be an

entrepreneur and would not receive any profit. In this theory, profits

arise out of uninsured risks. The amount of reward cannot be

determined, until the uncertainly ends with the sale of entrepreneur

products profit in his opinion is a residue and therefore. Hawley

theory is also called a residential theory of Profit.

Knight’s Theory of Profit

This theory of profit is propounded by frank H. Knight who treated

profit as a residual return because of uncertainly, and not because

of risk bearing. Knight made a distinction between risk and

uncertainly by dividing risk into two categories, calculable and non-

calculable risks. They are explained as below:-

Calculable risks are those, the prodigality of occurrence of

which van be calculated on the basis of available data. For

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example risk, due to fire theft accidents etc. are calculable

and such risks are insurable.

Incalculable risks are those the probability of occurrence of

which cannot be calculated. For Instance there may be a

certain elements of cost, which may not be accurately

calculable and the strategies of the competitors may not be

precisely assessable. These risk are called includable risks.

The risk element of such incalculable costs is also insurable.

It is in the area of uncertainly which makes decision-making a

crucial function for an entrepreneur. If his decisions prove to be

right, the entrepreneur makes profit, Thus according to knight profit

arises from the decisions taken and implemented under the

conditions of uncertainly. The profits may arises as a result of

decision related to the state of market such as decision, which

increase the degree of monopoly, decisions regarding holding of

stocks that give rise to windfall gains and the decisions taken to

introduce new techniques or innovations.

Schumpeter’s Innovation Theory of Profit

Joseph A. Schumpeter developed the innovation theory of Profit.

According to Joseph A. Schumpeter, factors like emergence of

Interest and profits, recurrence of trade cycles only supplement the

distinct process of economic development to explain the

phenomenon of economic development and profit, Schumpeter

starts from the state of a stationary equilibrium, which is

characterized by the equilibrium in all the spheres. Under these

conditions stationary equilibrium, the total receipts from the

business are exactly equal to the cost. This means that there will be

no profit. The profit can be earned only by introducing innovations in

manufacturing technique and the methods of supplying the goods

innovations may include the following activities.

Introduction of a new commodity or a new quality of goods.

Introduction of a new method of production.

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Introduction of a new market.

Finding the new sources of raw material

Organizing the industry in an innovative manner with the new

techniques.

The factor prices tend to increase while the supply of factors

remains the same. As a result, cost of production increase. On the

other hand with other firms adopting innovations, supply of goods

and services increases resulting in a fall in their prices. Thus, on one

hand, cost per unit of output goes up and on the other revenue per

unit decrease. Finally, a stage comes when there is no difference

between costs and receipts. As a result there are no profits at all.

Here, economy has reached a state of equilibrium, but there is the

possibility of existence of profits. Such profits are in the nature of

Quasi-rent arising due to some special characteristics of productive

services. Furthermore, where profits arise due to factors such as

patents, trusts, etc. they will be in the nature of monopoly revenue

rather than entrepreneurial profits.

MONOPLOY PROFIT

Monopoly is a market situation in which there is a single seller of a

commodity without a close substitute. Monopoly may arise due to

economies of scale, sole ownership of raw materials, legal sanction,

protection, mergers and take–overs. A monopolist may earn pure

profit, which is also called monopoly profit in the case of a

monopoly, and maintain it in the long run by using its monopoly

powers. Monopoly powers are as follows:-

Powers to control supply and price.

Powers to prevent the entry of competitors by reducing the

prices.

The Monopoly powers help a monopoly firm to make pure

profit or monopoly profit. In such cases, monopoly is the source of

pure profit.

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PROBLEMS IN PROFIT MEASURMENT

Accounting profit is the difference between all explicit costs and

economic profit or subtracting the difference of explicit and implicit

costs from revenue. Once profit is defined, it is easier for a firm to

measure the profit for a given period. The problems regarding the

measurement of profits are as follows:

The choice between the two concepts of profits, to be given

preference while using.

The determination of the various costs to be included in the

implicit and explicit costs.

The solutions to these problems are as follows:-

The use of a profit concept depends on the purpose of

measuring profit.

According concept of profit is used when the purpose is to

produce a profit figure for any of the following.

o The shareholders, to inform them of progress of the firm

o Financiers and creditors, who would be interested in the

firm’s progress

o The Managers to assess their own performance

o For computation of tax-liability.

To measure accounting profit for these purposes, necessary

revenue and cost data are, in general, obtained from the firm books

of account. It must, however, be noted that accounting profit may

present an overstatement or understand of actual profit, if it is

based on illogical allocation of revnues and costs to a given

accounting period.

On the other hand, if the objective is to measure true profit,

the concept of economic profit should be used. However true

profitability of any investment or business has been completely

done. But then the life of a business firm is unending therefore , true

profit can be measured only in terms of maximum amount that can

be distributed as dividends without harming the earning power of

the firm. This concept of business income is however, unattainable

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and therefore, is of little practical use. It helps in income

measurement even from businessman point of view. From the

above discussion, it is clear that, for all practical purpose, profits

have to be measured on the basis of accounting concept. But

measuring even the accounting profit is not an easy task. The main

problem is to decide as to what should be and what should not be

included in the cost one might feel that profit and loss accounts and

balance sheet of the firms provide all the necessary data to

measure accounting profit there are, however three specific items of

cost and revenue which cause problems, such as depreciation,

capital gains and losses and current vs. historical costs. These

problems are related to measurement and may arise because of the

differences between economists and accountants view on these

items. The concept of current costs can be used understood from

the following description.

CURRENT vs. HISTORICAL COSTS

Meaning of Historical Costs

The income statements are prepared in terms of Historical costs and

not in terms of current price. Historical costs is the purchase price of

any asset ands includes the following.

Money spent in the acquisition of the asset including

transportation costs as well as the insurance cost.

Costs of installation such as wages paid for erection of

machinery and the amount spent on repairs at the time of

installation.

The reasons for using historical costs for calculating

depreciation rather than current costs are as follows:-

Historical costs produce more accurate measurement of

Income.

Historical costs are easily determined and more objective than

the values based on the use of current value on asset.

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Accountants also record historical costs and consider them to

be more relevant, The accountants approach ignores certain

important changes in earnings and looses of the firms, which

may be any of the following:

o The value of asset pretended in the books of accounts is

understand at the time of inflation and overstated at the

time of deflation.

o Depreciation is understated during deflation. The

historical cost recorded in the books of account does not

reflect these changes in values of assets and profits.

This problem becomes more critical in case of

inventories and stock. The problem is how to evaluate

the value of inventory and the stocks.

Methods of Inventory Valuation

There are three popular methods of Inventory valuation, first in first

out (FIFO), last in fist out (LIFO) and weighted average cost (WAC)

Under FIFO method, material is taken out of stock for further

processing in the order in which they are acquired. The stocks,

therefore, appear in firms balance sheet at their actual cost price.

This method overstates profits at the time of rising prices.

Under LIFO method, the stock purchased most recently

become the costs of the raw material in the current production

under WAC method, the weighted average of the costs of materials

purchased at different prices and different point of time is calculated

to evaluate the inventory.

All these methods have their own disadvantages and do not

reflect the true profit of the business. So the problem of evaluating

inventories to yield a true profit remains unsolved.

Problems is Measuring Depreciation

Economists consider depreciation as capital consumption. For them,

there are two distinct ways of charging depreciation either by

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assuming the value of depreciation of equipment to its opportunity

cost or to its replacement cost that will produce comparable

earning.

Opportunity cost of equipment is the most profitable alternate

use of that is foregone by putting it to its present use. The problem

is to measure the opportunity cost. One method of measuring the

opportunity cost. One method of measuring the opportunity cost, as

suggested by Joel Dean, is to measure the fall in value during a

year. By using this method cannot be applied when capital

equipment has no alternative use, like a hydropower project In such

cases, replacement cost is an appropriate measure of depreciation.

Under this method, the cost of the new asset and the residual value

of the old asset are taken as the depreciation of the asset. But

depreciation is recorded only at the time of replacement of an asset.

This method is used in public utility concerns like railway, electricity

companies. To accountants, depreciation is an allocation of under

expenditure over time. Such allocation or charging depreciation is

made under unrealistic assumptions such as stable prices and a

given rate of obsolescence. There are different methods of charging

depreciation, which are of utmost importance. The use of different

levels of profit reported by the accountants. It will be clearer after

considering the following example: Suppose a firm purchases a

machine for Rs. 10,000/- with an estimated life of 10 yrs. The firm

can apply any of the following four methods of charging

depreciation and the amount of depreciation for the given example

by using the different methods is as follows:

Straight Balance Method

Annuity Method

Sum-of the years digit approaches

Under the straight – line method, the amount of depreciation

remains the same throughout the life of the asset. Depreciation is

calculated according to a fixed percentage on the original cost. The

amount and rate of depreciation is calculated as under:

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Amount of depreciation =Historical cost-residual value

Economic life of the asset

Rate of depreciation = Amount of depreciation x

100/Historical cost

Residual value is the realizable value of an asset at the end of

its economic life. Keeping in view the above example, the amount of

depreciation will be 10,000/10 = Rs. 1,000. It will be same for each

year. The rate of depreciation will be

1000 x 100/10,000 = 10

Under the reducing balance method, depreciation is charged

at a constant rate or percent of annually written down values of the

machine or any equipment. Assuming a depreciation rate of 20 per

cent, the amount of depreciation for different years will be

calculated as under :

Amount of Depreciation = Historical value x rate of depreciation

/100

But the amount of depreciation for the first year will be

deducted from the successive years. Therefore Rs. 2000 in the first

year, Rs. 1600 in the second year, Rs. 1280 in the third year, and so

on.

Under annuity method, rate of depreciation is fixed and is calculated

as under:-

d = (C + Cr )/n, where n is the total number of years of capital, C is

the total capital and r is the interest rate. The amount of

depreciation in this method is calculated with the help of annuity

table.

Finally under sum-or-the year’s digits approach, the total

years of equipment life are aggregated. Depreciation is then

charged at the rate of the ratio of the last years digits to the total of

the years. With respect to the given example, the aggregated years

of the equipment’s life’s will be 1+ 2 + 3 +... +10 = 55.

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Depreciation in the 1st year will be 10,000 x 10/55 = Rs. 1818.18, in

the 2nd year it will be 1,000 x 9/55 = Rs. 1636.36 and in 3rd year it

will be 10,000 x 8/55 = Rs. 1454.54, and so on. These four methods

of depreciation results in different methods of depreciation and

subsequently different levels of profit.

TREATMENT OF CAPITAL GAINS AND LOSSES

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

stock market prices is one of the most common sources of wind

Ellis. According to Dean, capital losses are, greater than capital

gains in a progressive society. Many of the capital losses arc of

insurable nature and the excess becomes the capital gain.

Profit is also affeckd by the way capital gains and losses are

treated in accounting. According to Dean, "a sound accounting

policy to follow concerning windfalls is never to record them until

they are turned into cash by a purchase or sale of assets, since it is

never clear until then exactly how large they are". But, in practice,

some firms do not record capital gains until it is realised in money

terms, but they do write off capital losses from the current profit.

The use of different policies result in different profits. But an

economist is not concerned with the accounting practice or

principle, which is followed in recording the past events. An

economist is concerned mainly with what happens in future.

According to an economist, the management should be aware of the

approximate magnitude of such windfalls before they are accepted

by the accountants. This would be helpful in taking the right

decision with respect of those assets, which are affected by the use

of policies given by the economists.

PROFIT MAXIMISATION AS BUSINESS OBJECTIVE

Profit maximisation is the most important assumption, which helps

the economists to introduce the price and production theories. The

traditional economic theory assumes that the profit maximisation is

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the only objective of business firms. According to this theory, profits

must be earned by business to provide for its own survival,

coverage of risks, growth and expansion. It is a necessary

motivating force and it is in terms of profits that the efficiency of a

business is measured. It forms the basis of conventional price

theory. Profit maximisation is regarded as the most reasonable and

analytically the most productive business objective.

The profit maximisation assumption in this theory helps in

predicting the behaviour of business firms and also the behaviour of

price and out pet under different market conditions. No alternative

hypothesis or assumption explains and predicts the behaviour of

firms better than the profit maximisation assumption. According to

this theory, total profit is the difference between total revenue and

total cost and is calculated as below:

TP = -TR – TC (1)

where,

TR = total revenue

TC = total cost

The total cost includes fixed cost and variable cost. The cost,

which remains same at different levels or output, is called fixed

cost. The sum of all t~ose costs, which vary directly with the level of

output, is called variable cost. In context with the profit

maximisation objective, the total profit or the difference between

total· cost and total profit is to be maximised. There are two

conditions that must be fulfilled for TR- TC to be maximum. These

conditions are divided into two categories, which are necessary or

first order condition and secondary or supplementary condition.

These conditions are explained as below:

The necessary or the first order condition states that marginal

revenue (MR) must be equal to marginal cost (MC). Marginal

revenue is the revenue obtained from the production and sale

of one additional unit of output. Marginal cost is the cost

arising due to the production of one additional unit of output.

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The secondary or the second order condition states that the

first order condition must show the decreasing MR and rising

MC. The secondary condition is fulfilled only when both the MC

is rising as well as the MR is decreasing. This condition is

illustrated by point P2 in Figure 5.1.

Let us suppose that the total revenue and total cost functions

are, respectively given as below:

TR = TC = f (Q)

where, Q = quantity produced and sold.

Substituting total revenue and total cost functions In

Equation (I), profit function can be written as below:

TP = f(Q)TR - f(Q)TC (2)

With the help of equation (2), The first order condition and the

secondary. Condition can be understood easily.

First-order Condition

The first-order condition of maximising a function is that the first

derivative of the profit function must be equal to zero. By

differentiating the total profit function and equating it to zero, the

following equation is obtained:

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aTP=

aTR-

aTC=0

(3)aQ aQ aQ

This condition holds only when

aTR=

aTC

aQ aQ

In Equation (3), the term aTR/aQ is the slope of the total

revenue curve, which is equal to the marginal revenue (MR).

Similarly, the term aTC/aQ is the slope of the total cost curve,

which is equal to the marginal cost (MC). Thus, the first-order

condition for profit maximisation can be stated as:

MR=MC

The first-order condition is also called necessary condition, as

it is so important that its non-fulfilment results in non-occurrence

of the secondary condition and thereby the profit maximisation

objective is not attained.

Second-order Condition

The second-order condition of profit maxirnisation requires that the

first order condition is satisfied under rising MC and decreasing MR.

This condition is illustrated in Fig. I. The MC and MR curves are the

usual marginal cost and marginal revenue curves, respectively. MC

and MR curves intersect at two points, PI and P2. Thus, the first order

condition is satisfied at both the points but mathematically, the

second order condition requires that its second derivative of the

profit function is negative. When second derivative of profit function

is negative, it shows that the total profit curve has bent downward

after reaching the highest point on the profit scale. The second

derivative of the total profit function is given as:

a2TR a2TP a2TR a2TC

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= = - <0

(4)

aQ2 aQ2 aQ2 aQ2

But it requires:

a2TR-

a2TC< 0aQ2 aQ2

a2TR<

a2TC

< 0aQ2 aQ2

Since & TR/aQ2 is the slope of MR and & a2 TC/aQ2 is the slope

of MC, the second-order condition can also be written as:

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

intersect the MR curve. To conclude, profit is maximised where both

the first and second order conditions are satisfied.

Example

It is known that:

TR = P.Q

where,

(5)

P = Price of a single quantity and

Q = Total quantity.

Suppose price (P) function is given as

P = 100 – 2Q

(6)

Then TR = (100 – 2Q) Q

Or, TR = 100Q – 2Q2

(7)

And also suppose that the total cost function as given as

TC = 10 + 0.5Q2

(8)

Applying the first order condition of profit maximisation and

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finding the profit maximising output. It is known that profit is

maximum where:

MR – MC

or,

aTR

=

aTC

aQ aQ

(9)

Putting the values of Equation (7) and (8) in (9)

MR =aTR

<aTC

= 100 – 4QaQ aQ

and

MC =aTC

=QaQ

Thus, profit is maximum where

MR = MC

100 – 4Q = Q

5Q = 100

Q = 20

The output 20 satisfies the second order condition also. The second order

condition requires that:

a2TR<

a2TC<0

aQ2 aQ2

In order words, the second-order condition requires that

aMR-

aMC<0

Q Q

Or

a(100 – 40)

-

a(Q)

<0aQ aQ

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- 4 – 1 <0

Thus, the second-order condition is also satisfied at output 20.

CONTROVERSY OVER PROFIT MAXIMISATION OBJECTIVE:

THEORY vs. PRACTICE

According to the traditional theory, profit maximisation is the sole

objective of a business firm. In practice, however, firms have been

found to be pursuing objectivies other than profit maximisation. For

the large business firms, pursuing goals other thon profit

maximisation is the distinction between the ownership and

management. The separntion of manllgement from the ownership

gives managers an opportunity to set goals for the firms other than

protit maximisation. Large firms pursue goals such as sales

maximisalioll, mllximisulioll of lilllllagcrial utility function,

maximisation of firm's growth rate, making a target profit, retaining

market share, building up the net worth of the firm, etc. Secondly,

traditionnl theory assumes perfect knowledge about current murket

conditions and the future developments in the business

environment of the firm. Thus a business firm is fully aware of its

demand and cost functions in both short and long runs. The market

conditions (Ire assumed to be certain. On the contrary, it is also

recognised that the firms do not possess the perfect knowledge of

their costs, revenue, and their environment. They operate in the

world of uncertainty. Most of the price and output decisions are

based on probabilities.

Finally, the marginality principle in which MC and MR are same

has been found to be absent in the decision-making process of the

business firms. Hall and Hitch have found, in their study of pricing

practices in UK, that the firms do not pursue the objective of profit

maximisation and that they do not use the marginal principle of

equalising MR and MC in their price and output decisions. Most firms

aim at long-run profit maximisation. In the short-run, they set the

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price of their product on the basis of average cost principle to cover

average cost and its components, average variable cost and

average fixed cost.

It also takes into account normal profit usually 10 per cent.

Gordon, a famous economist, has concluded that the real business

world is much more complex than the one which is based on

hypothesis and assumptions. The extreme complexity of the real

business world and ever-changing conditions makes it difficult for a

business firm to use its past experience in order to forecast

demand, price and costs. The average-cost principle of Rricing is

widely used by the firms and the marginal costs and marginal

revenu~ are ignored. On the basis of many such studies, it can be

said that the pricing practices are related to pricing theories.

THE FAVOUR OF PROFIT MAXIMISATION

The arguments against the profit-maximisation assumption,

however, should not mean that pricing theory is not related to the

actual pricing policy of the business firms. Many economists has

strongly supported the profit maximisation objective and the

marginal principle of pricing and output decisions. The empirical

and theoretical policies support the marginal rule of pricing in the

following way:

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

concluded that the firms do apply the marginal rules in their pricing

and output decisions. Fritz Maclup has argued that empirical studies

by Hall and Hitch, and Lester do not provide conclusive evidence

against the marginal rule and these studies have their own

weaknesses. He further argued that there has been a

misundestanding regarding the purpose of traditional theory. The

traditional theory explains market mechanism, resource allocation

through price mechanism and has a predictive valu. The

significance of marginal rules in actual pricing system of firms could

not be considcred becausc of lack of communication between the

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busincssmcn and the researchers as they use different terminology

like MR, Me and clasticitics. Also, Maclup is of the opinion that the

practices of setting price equal to the average variable cost plus a

profit margin, is not inequitable with the marginal rule of pricing.

ARGUMENTS IN FAVOUR OF PROFIT MAXIMISATION

HYPOTHESIS

The traditional theory supports the profit maximisation hypothesis

also on the following grounds:

Profit is essential for survival of a business: The

survival of all the profitoriented firms in the long run depends

on their ability to make a reasonable profit depending on the

business conditions and the level of competitior. Profit is the

biggest incentive for work. It is the driving force behind the

business enterprise. It encourages a man to work to do the

best of his ability and capacity. Making a profit is a necessary

condition for the survival of the firm. Once the firms are able

to make profit, they try to maximise it.

Achieving other objectives depends on the ability of a

business to make profit: Many other objectives of

business are maximisation of managerial utility function,

maximisation of long-run growth, maximisation of sales

revenue. The achievement of such alternative objectives

depends wholly or partly on the primary objective of making

profit.

Profit maximisation objective has a greater predicting

power: As comparcd to other business objectives, profit

maximistion assumption has been found 10 be good in

predicting ccrtain aspects relatcd to a business. Friedman

supports this by saying that the profit maxilllisation is

considered to be good only if it predicts the business

behaviour and the business trends correctly.

Profit is a more reliable measure of efficiency of a

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business: Thought not perfect, profit is the most efficient

and reliable measure of the efficiency of a firm. It is also the

source of internal finance. The recent trend shows a growing

dependence on the internal finance in the indlstrially

advanced countries. In fact, in developed countries, internal

sources of finance contribute more than three-fourths or lotal

linance. Keeping this in mind, it can be said that profit

maximisation is a more valid business objective.

Alternative objectives of Business Firms

The traditional theory does not distinguish between owners and

managers' interests. The recent theories of firm, which arc also

called managerial and behavioural theories of firm, assume owners

and managers to be separate entities in large corporations with

different goals and motivation. Berle and Means were the two

economists, who pointed out the distinction between the ownership

and the management, which is also known as Berle-Means-Galbraith

(BMG) hypothesis. The B-M-G hypothesis states the following:

The owners controlled business firms have higher profit rates

than manager controlled business firms, and

The managers have no in::entive for profit maximisation. The

managers of large corporations, instead of maximising profits,

set goals for themselves that helps in controlling the owners

also. In this section, some important alternative objectives of

business firms, especially of large business corporations are

also discussed.

Baumol's Hypothesis of Sales Revenue Maximisation

According to Baumol, "maximisation of sales revenue is an

alternative to profitmaximisation objective". The reason behind this

objective is to clearly distinct ownership and management in large

business firms. This distinction helps the managers to set their goals

other than profit maximisation goal. Under this situation, managers

maxi mise their own utility function. According to Baumol, the most

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reasonable factor in managers' utility functions is maximisation of

the sales revenue.

The factors, which help in explaining these goals by the

managers, are following:

Salary and other earnings of managers are more closely

related

to seals revenue than to profits.

Banks and financial corporations look at sales revenue while

financing the corporation.

Trend in sale revenue is a good indicator of the performance

of

the business firm. It also helps in handling the personnel

problems.

Increasing sales revenue helps in enhancing the prestige of

managers while profits go to the owners.

Managers find profit maximisation a difficult objective to fulfil

consistently over tillle and at the same level. Profits may

fluctuate with changing conditions.

Growing sales strengthen competitive spirit of the business

firm in the nlilrkd and vice versa.

So far as cmpirical validity of sales revenue maximisation

objective is concerned, realistic evidences are unsatisfying. Most

empirical studies are, in fact, based on inadequate data because the

necessary data is mostly not available. If total cost lilllction

intersects the total revenue function (TR) function before it reaches

its highest point, Baumol's theory fails. It is also argued that, in the

long run, sales maximisation and profit maximisation objective can

be merged into one. In the long rnll, sales maximisation lends to

yield only normal levels of profit, which turns out to be the

maximum under competitive conditions. Thus, profit maximisation is

not inequitab!c with sales maximisation objective.

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MARRIS's HYPOTHESIS OF MAXIMISATION OF FIRM'S

GHOWTH RATE

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

subject to managerial and financial constraints. Marris defines firms'

balanced growth rate (G) as follows:

G = Gd = Gc

where,

Jd = growth rate of dcmand for firms product.

Gc = growth rate of capital supply to the firm.

In simple words, a firm's growth rate is considered to be

balanced when demand for its product and supply of capital to the

firm increase at the same rate. The two growth rates according to

Marris, are translated into two utility functions such as:

Manager’s ut i I ity function

Owner’s utility function

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

(Uo) may be specified as follows:

Um = f (salary, powcr, job security, prestige, status) and

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

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

firms' products and supply of capital. Therefore, maximisation of Uo

mcans maximisation of demand for a firm's products or growth of

supply of capital.

According to Marris, by maximising these variables, managers

maximise both their utility function and that of the owner's. The,

managers can do so because most of the variables such as salarics,

status, job security, power, etc., appearing in their own utility

function and those appearing in the utility function of the owners

such as profit, capital market, share, etc. are positively and strongly

correlated with the size of the firm. These variables depend on the

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maximisation of the growth rate of the firms. The managers,

therefore, seek to maximise a steady growth rate. Marris's theory,

though more accurate and sophisticated than Baumol's sales

revenue maximisation, has its own weaknesses. It fails to deal

satisfactorily with the market condition of oligopolistic

interdependence. Another serious shortcoming is that it ignores

price determination, which is the main concern of profit

maximisatioll hypothesis. In tbe opinion of many economists,

Marris's model too, does not seriously challenge the profit

maximisation hypothesis.

Williamson's Hypothesis of Maximisation of Managerial

Utility Function

Like Baulmol and Marris, Willamson argues that managers are very

careful in pursuing the objectives other than profit maximisation.

The managers seek to maxi mise their own utility function subject

to a minimum level of profit. Managers' utility function (U) is

expressed below: V = f(S, M, ID)

where,

S = additional expenditure on staff

M = Managerial emoluments

ID = Discretionary investments

According to Williamson's hypothesis, managers maximise

their utility function subject to a satisfactory profit. A minimum

profit is necessary to satisfy the shareholders and also to secure the

job of managers. The utility fU'1ctions which managers seek to

maximise, include both quantifiable variables like salary and slack

earnings anti non-quantitative variable such as prestige power,

status, job security, professional excellence, etc. The non-

quantifiable variables are expressed in order to make them work

effectively in terms of ex; ense preference defined as satisfaction

derived out of certain types of expenditures. Like other alternative

hypotheses, Williamson's theory too suffers from certain

weaknesses. His model fails to deal with the problem of oligopolistic

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interdependcncc, Willinmsoli's theory is said to hold only where

rivalry between firms is not strong. In case there is slrong rivalry,

profit maximisation is claimed to be a more appropriate hypothesis.

Thus, Williamson’s managerial utility function too does not offer a

more satisfactory hypothesis than profit maximisation.

Cyert-March Hypothesis of Satisfying Behaviour

Cyert-March hypothesis is an extension of Simon's hypothesis of

firms' satisfying behaviour. Simon had argued that the real business

world is full of uncertainly liS accurate and adequate data are not

readily available, If data are available, managers have little time

and ability to process them, Managers alsc work under a number of

constraints. Under such conditions it is not possible for the firms to

act in terms of consistency assumed under profit maximisation

hypothesis. Nor do the firms seek to maximise sales and growth.

Instead they seek to achieve a satisfactory profit or a satisfactory

growth and so on. This behaviour of business firms is termed as

satisfaction behaviour.

Cyert and March added that, apart from dealing with uncertainty,

managers need to satisfy a variety of groups of people such as

managerial staff, labour, shareholders, customers, financiers, input

suppliers, accountants, lawyers, etc. All these groups have

confiicting interests in the business firms. The manager's

responsibility is to satisfy all of them. According to the Cyert-March,

"firm's behaviour is satisfying behaviour, which implies satisfying

various interest groups by sacrificing firm's interest or objectives."

The basic assumption of satisfying behaviour is that a firm is an

association of different groups related to various activities of the

firms such as shareholders, managers, workers, input supplier,

customers, bankers, tax authorities, and so on. All these groups

have some expectations from the firm, which are needed to be

satisfied by the business firms. In order to clear up the conflicting

interests and goals, managers fonn an objective level of the firm by

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taking into consideration goals such as production, sales and

market, inventory and profit.

These goals and objective level are set on the basis of the

managers past experience and their assessment of the future

market conditions. The objective level is also modified and revised

on the basis of achievements and changing business environment.

But the behaviouraI theory has been criticised on the following

grounds:

Though the behavioural theory deals with the activities of the

business firms, it does not explain the firm's behaviour under

dynamic conditions in the long run.

It cannot be used to predict the firm's activities in the future.

This theory does not deal with the equilibrium of the business

industry.

This theory fails to deal with interdependecne or the linns and

its impact on linn's behaviour.

ROTHSCHILD's HYPOTHESIS OF LONG-RUN SURVIVAL AND

MARKET SHARE GOALS

Rothschild suggested another alternative objective and alternative

to profit maximisation to a business firm. Accordingto Rothschild,

the primary goal of the firm is long-run survival. Some other

economists have suggested that attainment and 'retention of a

market share constantly, is an additional objective of the business

firms. The managers, therefore, seek to secure their market share

and long-run survival. The firms may seek to maxi mise their profit

in the long run though it is not certain.

Entry-prevention and Risk-avoidancel

Another alternative objective of firms as suggested by some

economists is to prevent the entry of new business firms into the

industry. The motive behind entry prevention may be any of the

following:

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Profit maximisation in the long run.

Securing a constant market share.

Avoidance of risk caused by the unpredictable behaviour of

new firms.

The evidence related to the firms to maximise their profits in the

long run, is not certain. Some economists argue that if management

is kept separate from the ownership, the possibility of profit

maximisation is reduced. This means that only those firms with the

objective of profit maximisation can survive in the long run. A

business firm can achieve all other subsidiary goals easily by

maximising its profits. The motive of business firms behind entry-

prevention is also to secure a constant share in the market.

Securing constant market share also favours the main objective of

business firms of profit maximisation.

A Reasonable Profit Target

A business firm has variolls objectives to achieve. The survival of a

firmdepends on the profit it can make. So, whatever the goal of the

firm may be, it has to be a profitable firm. The other goals of a

business firm can be sales revenue maximisation, maximisation of

firm's growth, maximisation of managers’ utility function, long-run

survival, market share or entry-prevention. In technical sensc,

maximisation of profit, as a business objective, may not sound

practical , but profit has to be there in the objective function of the

firms for its survival. The firms may differ on the level of profit and

the extent to which it is to be achieved by various firms. Some firms

set standard profit as their objective, while some of them may set

target profit and some reasonable profit as their objective to be

achieved. A reasonable profit, as a business objective, is the most

common objective. The policy question related to setting standard

or criteria for reasonable profits are as follows:

Why do modem corporations aim at a reasonable profit rather

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than attempting to maximise profit?

What are the criteria for a reasonable profit?

How should reasonable profits be determined?

Following are the suggestions as given by various economists

to answer the above policy questions:

1. Preventing entry of competitors: Under imperfect

market conditions, profit maximisation generally leads

to a high pure profit, which attracts competitors,

especially ill case of a weak monopoly. Therefore, the

firms adopt a pricing and a profit policy that assures

them a reasonable profit. At the same time, it also

keeps the potential competitors away.

2. Maintaining a good public image: It is often

necessary for large corporations to project and maintain

a good public image. This is because if public opinion

turns against it and government officials 'start

questioning the profit figures, firms may find it difficult

to work smoothly. So most firms set their prices lower

than that to earn the maximum profit but higher enough

to ensure a reasonable profit.

3. Restraining trade union demands: High profits

make trade unions feel that they have a share in the

high profit and therefore they demand for wage-hike.

Wage-hike may interrupt the firm’s objective of

maximising profit. Any delay in profit is sometimes used

as a weapon against trade union activities.

4. Maintaining customer goodwill: Customer's goodwill

plays a significant role in maintaining and promoting

demand for the product of a firm. Customer's goodwill

depends on Jhe quality of the product and its fair price

to a large extent. Firms aiming at bcllcr profit prospects

in the long run, give up their short-run profit

maximisation objective in favour of a reasonable profit.

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5. Other factors: The other factors that interrupts the

profit maximisation objective include the following:

A. Managerial utility function, which is preferable for,

profits maximisation to firms.

B. Friendly relations between executive levels within

the firm.

C. Maintaining internal control over management by

restricting firm's size and profit.

Standards of Reasonable Profits

Standards of reasonable profits are determined when a firm

chooses to make only reasonable profits rather than to maximise its

profit. The questions that arise in this regard are as follows:

What form of profit standards should be used?

How should reasonable profits be determined?

These questions can be understood after going through the

following explanatory points.

FORMS OF PROFIT STANDARDS

Profit standards is determined in terms of the following:

Aggregate money terms

Percentage of sales, and

Percentage return on investment.

All these standards are determined for each product separately.

Among all the fonns of profit standards, the total net profit of the

firm is more common than other standards. But when the purpose is

to discourage the competitors, then the target rate of return on

investment is the appropriate profit standard, provided the cost

curves of competitors' are similar. The profit standard in terms of

ratio to sales is not an appropriate standard because this ratio

varies widely from linn to firm, evens irthey nil hove the snme

return on capital invested. These differences are following:

Vertieal integration of production process

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Intensity of mechanisation

Capital structure

Turnover

SETTING THE PROFIT STANDARD

The following arc the important criteria that are considered while

selling the standards for a reasonable profit.

Capital-attracting standard: An important criterion of profit

standard is that it must be high enough to attract external

capital such as debt and equity. For example, if the firm's

stocks are sold in the market at 5 times their current earnings,

it is necessary for a firm to earn a profit of 20 per cent of the

total investment But there are certain problems associated

with this criterion, which are as follows:

Capital structure of the firms such as the proportions of

bonds, equity and preference shares, which affects the

cost of capital and thereby the rate of profit.

If the profit standard is based on current or long run

average cost of capital or not. The problem in this case

arises as it may also vary widely from company to

company.

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

company depends on its own sources for financing its growth.

This standard involves the aggregate profit that provides for an

adequate plough-back for financing a desired growth of the

company without resorting to the capital market. This standard

of profit is used when liquidity is to be maintained by a firm

and a debt is to be avoided as per the profit policy of the firm.

This standard is socially less acceptable than capital attracting

standard. From society's point of view, it is more desirable that

all carnings are distributed to stockholders and they should

decide the further investment pattern. This is based on a belicf

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that an individual is the best judge of his resource use and the

market forces allocate funds more efficiently, On the other

hand, retained eamings, which are under the control or the

managemcnt are likely to be wasted on low-earning projects

within a business firm. But to choose the most suitable policy

among marketing and management the abilities of the

management and outside investors are to be considered. This

helps in estimating the earnings prospects of a firm.

Normal earnings standard: Another important criterion for

setting standard of reasonable profit is the normal earnings of

firms of an industry over a period. This serves as a valid

criterion of reasonable profit, provided it should take into

consider the following points:

o Attracting external capital

o Discouraging growth of competition

o Keeping stockholders satisfied.

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

then only comparable firms are chosen. However, none of these

standards of profits is perfect. A standard should, therefore be

chosen after giving due consideration to the existing marke

conditions and public attitudes. Different standards arc used for

different purposes because no single criterion satisfies all conditions

of the customers.

PROFIT AS CONTROL MEASURE

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

perfonnances of the individuals of the large business firms.

Researches have concluded that the business individuab of middle

and high ranks often deviate from profit objective and try 10

maximise their own utility functions. They give importance to job

security, personal ambitions for promotion, larger perks, etc. But

this often conflicts with firms' profit-making objective. The reasons

for conflicts as given by Keith Powlson are as follows:

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More energy is spent in expanding sales volume and product

lines than in raising profitability.

Subordinates spend too much time and money doing jobs

perfectly regardless of its cost and usefulness.

Individuals depend more to the needs of job security in the

absence of any reward.

In order to control the conllicts and directing the individuals

towards the profit objective, the top management uses

decentralisation and control-by-profit techniques. Decentralisation

is achieved by changing over from functional division of business

activities such as production branch, sales division, purchase

department, etc. to a system of commodity wise division. By doing

so, managerial responsibilities are fixed in terms of profit. Under the

general policy framework, managers enjoy self-sufficiency in their

operations. They are allotted a certain amount to spend and a profit

target to be achieved by the particular division. Profit is then-the

measure of performance of each individual, not of the sales or

quality. This kind of reorganisation of management helps in

assessing profit-performance of every individual. The two important

problems that arise in the determination of profits are as follows:

Either the profit goals are set in terms of total net profit for

the divisions or they should be restricted to their share in the

total net profit.

Determination of divisional profits when there is a vertical

integration. The most appropriate profit standard of divisional

performance is calculated by deducting current expenses

from revenue of the firm.

Profit is essential for survival of a business. In the absence of

profits, the organisations will use up their own capital and close

down. It also helps in replacing obsolete machinery and equipment

and thus ensures the continuity of a business.

Conclusion

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Profit maximisation is the most popular hypothesis in economic

analysis, but there are many other important objectives, which are

not to be avoided by any firm. Modem business firms pursue

multiple objectives. The economists consider a number of

alternative objectives of business firms. The main factor behind the

multiplicity of the objectives, especially in case of large business

firms, is the separation of management from the- ownership.

Moreover, profit maximisatjon hypothesis is based on time. The

empirical evidence against this hypothesis is not conclU3ive and

unambiguous. The alternative hypotheses are also not so strong to

repiace the profit maximisation hypothesis. In addition to it, profit

maximisation hypothesis has a greater explanatory and predictive

power than any of the alternative hypotheses. Therefore, profil

maximisation hypothesis still fornls the basis of firms' behaviour.

PROFIT PLANNING AND FORECASTING

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

earning profit while considering the various risks as well. A firm is

faced with a number of untertainties. 1bese uncertainties are in -

terms of nature of consumer needs, the diverse nature of

competition, the uncontrollable nature of most elements of cost and

the continuous technological developments. The uncertainty about

the pattern and extent of consumer demand for a particular product

increases the degree of risk faced by the firm. The nature of

competition is related to either product, price or to both

simultaneously. Prodoct competition is more important till 'the

product reaches the stage of maturity. Price competition begins a

fier the product is established and reaches the maurity stage.

During the growth stage, the risk of obsolescence of a product and

shortening of the product life cycle is more. The degree of risk

involved in product competition is greater than in price competition.

When the prices rise continuously, no firm can be certain of its

internal cost structure. This is because it does not have any control

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over the prices of raw materials or the wages to be paid to the

individuals. In course of time, continuous technological

improvements may make production completely obsolete. If an

improved process is available, a firm can restrict its risk by

neglecting its fixed investment. If it does not have an access to the

improved processes, it may have to go out of business. Unless a

firm is prepared to face the uncertainties, as a result of risk

element, its profits will be changed. To plan for profits, a thorough

understanding of the relationship of cost, price and volume is

ext~emely helpful to business individuals. The most important

method of determining the cost-volumeprofit relationship is break-

even analysis, also known as cost-volume-profit (C-V-P) analysis.

Break-even analysis involves the study of revenues and costs of a

firm in relation to its volume of sales. It also includes the

determination of that volume at which the firm's costs and

revenues will be equal. The break-even point (BEP) may be defined

as that level of sales at which total revenue is equal to the total

costs and the net income is zero. This is known as no-profit no-loss

point. The main objective of the break-even analysis is not simply to

find out the BEP, but to develop an understanding between the

relationships of cost, price and volume.

DETERMINATION OF THE BREAK-EVEN POINT

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

method is convenient for a firm producing single prdducts only. The break-even

volume is the number of units of the product, which must be sold to earn revenue.

This revenue should be enough to cover all expenses, both fixed and variable. The

selling price of all units covers not only its variable cost but also leaves a margin

called contribution )l1argin to contribute towards the fixed costs. The break-even

point is reached when sufficient number of units has been sold so that the total

contribution margin of the units sold is equal to the fixed costs. The formula for

calculating the break-even point is:

Fixed costs

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BEP = contribution margin per unit

Where the contribution margin is: selling price Variable costs per

unit.

Example 1: Suppose the fixed costs of a Factory are Rs. 10,000 per yenr, the variable

costs are Rs. 2.00 per unit and the selling price is Rs. 4.00 per unit. The break~even

point would be:

BEP =Rs. 10,000

= 5,000 units(4-2)

In other words, the company would not make any loss or profit

at a sales volume of 5,000 units as shown below:

Sales RS.20,000 Cost of goods sold: Variable cost @ Rs.2.00

Rs 10,000

Fixed costs Rs. 10,000 Rs.20,OOO Net Profit Nil

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

the break-even point in terms of any common unit of product. It is

convenient for them to determine their break-even point in terms of

total rupee sales. The break-even point is the point where the

contribution margin is equal to the fixed costs. The contribution

margin is expressed as a ratio to sales. For example, if the sales is

Rs. 200 and the variable costs of these sales is Rs. 140, the

contribution margin, ratio is (200 - 140)/200 or 0.3.

The formula for calculating the break-even point is:

BEP =Fixed costs

contribution margin ratio

Example 2:

Sales Rs. 10,000 Variable costs Rs. 6,000Fixed costs RS. 3,000

With the help of given information, calculate net profit.

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

0.4

BEP =Fixed costs

contribution margin ratio

3,000= Rs. 7 500

0.4

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

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

in a week. In the next week, sales amount to Rs. 19,000 producing a

profit of Rs. 1,200. Find out the BEP.

Solution.

Increase in sales 19,000 - 15,000 = Rs. 4,000

Increase in profit 1,200 - 400 = Rs. 800

Increase in variable costs 4,000 - 800 = Rs. 3,200

Over sales of Rs. 4,000, variable costs are Rs. 3,200.

Hence VC per rupee of sale is 3,200 + 4,000 = 0.80.

Fixed costs will be as under:

Variable cost 15,000 x 0.80 12,000Profit 400VC + Profit 12,400

Sales value 15,000Fixed cost 2,600

=

S – V=

15,000 – 12,000

=

3,000= 0.2S 15,000 15,000

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=2,600

= Rs. 13,0000.2

Break-even Point as a Percentage of Full Capacity

Full capacity can be defined as the maximum possible volume

attainable with the firm's existing fixed equipment, operating

policies and practices. Break-even point is usually expressed as a

percentage of full capacity. Considering the example I, the full

capacity of the firm is 10,000 units; the break-even point at 5,000

units can be expressed as 50 per cent of full capacity.

Multi-product Manufacturer and Break-even Analysis

Most manufacturers produce more than one type of product. The

determination of BEP in such cases is a little complicated and is

illustrated below:

Example 4: A manufacturer makes and sells tables, lamps and chairs. The cost

accounting department and the sales department have supplied the following data:

~Selling Price

VC

Per unit

% of rupee

Sales volume

Product

Rs. Rs.

Tables 40 30 20

Lamps 50 40 30

Chairs 70 50 50

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

Annual fixed cost - Rs. 20,000

Calculate (1) BEP and (2) Profit if firm works at 50 per cent of

capacity.

Solution. The contribution towards fixed cost in each case

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Now, BEP =

FC

Contribution margin ratio

is: .Table Rs. 10

Lamps Rs. 10

Chairs Rs. 20

Now, these contributions are to be converted into percentages

of selling prices, the formula to be applied is:

Contribution percentage =Selling price - VC

x 100Selling price

Thus, the contribution percentage for individual items is:

40 - 30 1

Table ---x 100 = - xl 00 = 25 per cent

40 4

50 - 40 1

---x 100 = - xl 00 = 20 per cent

50 5

70 - 50 2

---x 100 = -x 100 = 28.57 per cent

70 7

Now, we multiply the contribution percentage of each of the products by the

percentage of sales volume for that particular product and add the figures obtained.

This gives the total contribution per rupee of sales volume for tables, lamps and

chairs. This is done as follows:

Contribution % of Sales

Tables 25.00 % X 20 % = 5.00 %

Lamps 20.00 % X 30 % = 6.00 %

Chairs 28.57 % X 50%= 14.28%·

25.28 % say 25 %

--

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

sales given the present product sales mix. The calculations

required in the question are as follows:

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

BEP =Fixed costs

=20,000

Rs. 80,000Contribution marginper unit 25%

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

also be made easily. If the firm produces at 80 per cent of

capacity, the profit will be calculated as under:

Profit = Total revenue - Total costs

= 80% of (1,50,000) - Fixed costs - Variable costs

= 1,20,000 - 20,000 - 75% of (1,20,000)

= 1,20,000 - 20,000 - 90,000

= Rs. 10,000

Break-even Charts

Break-even analysis is very commonly presented by means of

break even charts. Break-even charts are also known as profit-

graphs. A break-even chart prepared on the basis of example 1

above is given in Figure 5.2. In this figure, units of product are

shown on the horizontal axis OX while revenues and costs are

shown on the vertical axis OY. The fixed costs of Rs. 10,000 are

shown by a straight line parallel to the horizontal axis. Variable

costs are then plotted over and above the fixed costs. The resultant

line is the total cost line, combining both variable and fixed costs.

There is no variable cost line in the graph. The vertical distance

between the fixed cost and th~ total cost lines represents variable

costs. The total cost at any point is the SU!TI of Rs. 10,000 plus Rs.

2.00 per unit of variable cost multiplied by the number of units sold

at that point. Total revenue at any point is the unit price of Rs. 4.00

multiplied by the number of units sold. The break-even point

corresponds to the point of intersection of the total revenue and the

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total cost lines. A perpendicular from the BEP to the horizontal axis

shows the break-even point in units of the product. Dropping a

perpendicular from BEP to the vertical axis shows the break-even

sales value in rupees. The firm would suffer a loss at any point

below the BEP. Total costs are more than total revenue. Above the

BEP, total revenue exceeds total costs and the firm makes profits.

Since profit or loss occurs between costs and revenue lines, the

space between them is known as the profit zone, which is to the

right of the BEP, and the loss zone, which is to the len of the BEP.

The following Figure 5.2 shows Break-even Chart.

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

terms of sales value rather than in physical units. The only

difference is that the volume on the X-axis is measured in terms of

sales value. In that case, a perpendicular frqm the point BEP to

either axis would show the break-even rupee sales value. The same

type of chart could be used to depict the BEP in relation to full

capacity. In this case the horizontal axis would represent the

percentage of full capacity, instead of physical units or the sale

value.

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Break-even Chart-A Variation

The break-even chart is a variation of the traditional break-even

graph. This graph is prepared with the variable cost line instead of

fixed cost line, starting at the zero axis. On it is superimposed the

total cost, the line which includes the fixed cost and is, therefore,

parallel to the variable cost line. This graph is as much useful as the

contribution to fixed cost and profit. It is more deafly shown below in

the Figure 5.3.

Profit-Volume Analysis

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

relationship of profits to sales volume. The profit-volume graph

shows the relationship ofa firm's profit to its volume. Total profit or

loss is measured on the vertical axis above the X-axis and the loss

below it. The volume is measured on the X-axis, which is drawn at

the point of 'Zero-Profit'. Volume is usually expressed in tenns of

percentage of full capacity. The maximum loss, which occurs at zero

sales volume, is equal to the fixed cost and is shown on the vertical

axis below the X-axis. The maximum profit is earned when the firm

works at full capacity. The point of maximum profit is shown on the

vertical axis above the X-axis. The two points of maximum loss and

the maximum profit are joined by a line, which is known as the profit

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line, also called PN line. The profit line can also be established by

detennining the profit at any two points within the given range of

volume and drawing a straight line through these points. The point,

at which the profit line intersects the X-axis, is the break-even point.

The space between the X-axis and the profit line shows the profit

zone, which is to the right of BEP, and the loss zone, which is to the

left of BEP. The usefulness of the graph lise in the fact that it shows

the profit or loss earned by the firm by working at different levels of

its full capacity. The following Figure 5.4 shows the profit volume

analysis.

Assumptions

1. All costs are either variable or fixed over the entire range of

the volume of production. But in practice, this assumption may

not hold well over the entire range of production.

2. All revenue is variable in nature. This assumption may Lot be

valid in all cases such as the case where lower prices are

charged to large customers.

3. The volume of sales and the volume of production are equal.

The total products, produced by the firm, are sold and here is

no change in the closing inventory. In practice, sales and

production volumes may differ significantly. However, these

assumptions are not so unrealistic so as to weaken the validity

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of the break-even analysis.

4. In the case of multi-product firms, the product-mix shoulu be

stable. Fora multi-product firm, the BEP is determined by

dividing total fixed costs by an average ratio of variable profit,

also called contribution to'sales. If each product has the same

contribution ratio, the BEP is not affected by changes in the

product-mix.

However, if different products have different contribution

ratios, shift in the product-mix may cause a shift in the break-even

point. In real life, the assumption of stable product-mix is somewhat

unrealistic.

Managerial Uses of Break-even Analysis

To the management, the utility of break-even analysis lies in the

fact that it presents a picture of the profit struture of a business

firm. Break-even analysis not only highlights the areas of economic

strength and weaknesses in the firm but also sharpens the focus on

certaIn leverages which cun be opernted upon to enhance its

profitability. Through brenk-even analysis, it is possible for the

management to examine the profit structure of a business firm to

the possible changes in business conditions. For example, sales

prospects, changes in Cust structure, etc. Through break-even

analysis, it is possible to use managerial actions to maintain and

enhance profitability of the firm. The break-even analysis can be

used for the following purposes:

Safety margin

Volume needed to attaintarget profit

Change in price Change in price

Expansion of capacity

Effect of alternative prices

Drop or add decision

Make or buy decision

Choosing promotion-mix

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Equipment selection

Improving profit performance

Production planning

Safety Margin

The break-even chart helps the management to know the profits

generated at the various levels of sales. But while deciding the

volume at which the firm would operate, apart from the demand,

the management should consider the safety margin associated with

the proposed volume. The safety margin refers to the extent to

which the firm can afford a decline in sales before it starts occurring

losses. The formula to determine the safety margin is:

Safety Margin

=

(Sales – BEP) x 100

Sales

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

Safety Margin

=

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

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

sales up to 37.5 per cent of the present level. A decreasing safety

margin indicates that the firm's resistance capacity to avoid losses

has become poorer. A margin of safety can also be negative. A

negative safety margin is the percentage increase in sales

necessary to reach the BEP in order to avoid losses. Thus, it reveals

the minimum extent of effort in terms of sales expected by the

management. Suppose in the same example sales are us low as

4,000 units. The safety margin would be:

Safety Margin

=

(4,000-5,000) x 100

4,000

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= 25%

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

least by 25 per cent to avoid losses.

Volume Needed to Attain Target Profit

Break-even analysis is also utilised for determining the volume of

sales, necessary to achieve a target profit. The formula for target

sales volume is:

Target Sales Volume =Fixed costs + Target profit

Contribution margin per unit

.

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

profit is Rs. 6,000, the target sales volume would be calculated as follows:

10,000 + 6,000= 8000 units2

Change in Price

The management is also faced with a problem whether to reduce

the prices or not. The management will have to consider a number

of points before taking a decision related to the change in the

prices. A reduction in price results in a reduction in the contribution

margin as well. This means that the volume of sales will have to be

increased to maintain the previous level of profit. The higher the

reduction in the contribution margin, the higher will be the increase

in sales needed to maintain the previous level of profit. However,

reduction in prices may not always lead to an equal increase in the

sales volume, which is affected by the elasticity of demand. But the

information about elasticity of demand may not be easily available.

Breakeven analysis helps the management to know the required

sales volume to maintain the previous level of profit. On the basis of

this knowledge and experience, it becomes much easier for -the

management to judge whether the required increase it sales will be

feasible or not. The formula to determine the new sales volume to maintain the same

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level of profit, given a reduction in price, would be as under:

Qn =FC + P

SPn - VC

where Qn = New volume of sales

FC = Fixed cost

P = Profit

SPn = New selling price

VC = Variable cost per unit (n denotes new)

Example 6(a): Continuing with the same example 6, if we propose a

reduction of 10 per cent in price from Rs. 4.00 to Rs. 3.60, the new sales volume

needed to maintain the previous profit ofRs. 6,000 will be:

10, 000 +

6,000=

16, 000= 10,000 units

3.60 – 2.00 1.60

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

in sales. The management can also easily decide whether this

increase in sales volume is profitable for t~e business firm or not.

If a firm proposes the price increase, the question to be

considered is by how much the sales volume should decline before

profitable effect of the price increase gets eliminated.

Example 6(b): If the firm in example 6 considers an increase in

price by 12Y2per cent to Rs. 4.50, the new volume to maintain the

old profit would be:

Q 2 =10, 000 +

6,000=

16, 000= 6,400 units

4.50 – 2.00 2.50

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

were less than 1,600 units or 20 per cent, it would be profitable for

the firm to increase the price. But if the decline were more than

1,600 units, the proposed price increase would reduce the profit.

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Change in Costs

Break-even analysis' helps to analyse the changes in variable

cost and fixed cost, which are explained as follows.

Change in variable cost: An increase in variable costs leads

to a reduction in the contribution margin. In such a situation, a firm

determines the total sales volume needed to maintain the prescnt

profits withcut any increase in price. A firm also determines the

price lhut should be set to maintain the present level of profit

without any change in sales volume. The formulae to determine the

new quantity or the new selling price, given a change in variable

costs, are:

1. The new quantity will be:

Qn =FC +P

SP - VC n

2. The new selling price will be:

SPn = SP + (VCn- VC)

Example 6(c): Continuing with the example 6, if variable cost

increases from Rs. 2 to Rs. 2.50 per unit.

Q 2 =10, 000 +

6,000=

15, 000= 10,667 units

4 – 2.50 1.50

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

Change in fixed cost: An increase in fixed costs of a firm is

caused either by external circumstances such as an increase in

property taxes or by a managerial decision such as an increase in

executive salaries. In both the cases, the affect is to raise the break-

even point of the firm, while keeping the prices unchanged. The

same determination is undertaken by the firm regarding the sales

volume while keeping the profit level same as before. The formulae

to determine the new quantity or the new price, given a change in

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fixed costs, would be:

1.

Qn= Q +FCn – FC

SP - VC

2.

SPn = SP +FCn – FC

Q

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

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

Expansion of Capacity

The management may also be interested in knowing whether to

expand production capacity or not, through the installation

equipment. Though even analysis, it wuuld be possible to examine

the various applkutions of this proposal or installation of the

additional equipment. The following example illustrates the points

involved.

Example 7: A textile mill is considering a proposal to increase

its investment in fixed assets. If it decides to do so, fixed expenses

will go up by Rs. 5,00,000 per year without affecting the percentage

of variable expenses. With the present plant, the maximum

production is estimated at an amount, which would enable the

company to make annual sales of Rs. 60,00,000. The increased

production with the additional plant would permit the company to

make annual sales of Rs. 80,00,000. The relevant cost, sales and

profit data for 1997 are:

Sales Rs. 50,00,000 Costs and expenses: Fixed Rs. 15,00,000 Variable Rs. 32,00,000 Rs. 47,00,000

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Net profit Rs. 3,00,000

There are a number of points involved in the decision on

expansion of capacity. The information regarding the expansion of

capacity is as follows:

Existing Plant Expanded Plant Capacity 0% 100 % 0% 100 %

Rs. (in Lakhs) Rs. (in Lakhs)Sales - 60 - 80Fixed costs 15 15 20 20Variable costs - 38.4 - 51.2Profit (Loss) (15) 6.6 (20) 8.8

The expansion of capacity, to enable the firm so as to expand

its sales potential from Rs. 60,00,000 to Rs. 80,00,000, will

increase the maximum profit potential of the firm from Rs.

6,60,000 to Rs. 8,80,000. But there are certain risks involved.

Answer the following on the basis of above information:

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

the

break-even point?

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

present profit with the increased fixed costs?

Solution. It is evident that the break-even point of the firm

would be pushed up from Rs. 41, 66,667 to Rs. 55, 55,556. This

means that if the sales remain at the present level, the firm would

operate at a loss.

The minimum sales volume needed to maintain the present

profit would be Rs. 63,88,889, i.e., an increase of about 28 per cent

there is another aspect. To earn the maximum profit possible at the

present sales capacity, i.e., Rs. 6,60,000 with the increase in fixed

costs, the minimum sales volume needed would be Rs. 73,88,889,

i.e., an increase of 48 per cent. So the decision on the question of

expanding capacity hinges on the possibilities of expanding sales by

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the various percentages indicated above. The fact that the present

sales volume is 20 per cent less than the maximum possible sales

volume of the existing plant may be an indication that if may be

difficult to expand sales. Another way of presenting the same

infonnation is the profit-volume chart. On the assumption that

production efficiency and prices will remain unchanged, the profit-

volume chart can help in presenting the following:

The break-even points before and after expansion, and

At what capacity utilisation, the profit will be the same as at

100 percent capacity utilisation before expansion. The following

Figure 5.5. shows the profit volume chart.

In order to arrive at the data to plot on the figure, the sales,

cost and profit at either 100 per cent or nil capacity for both existing

and expanded plants should be calculated:

As can be seen from Figure 5.4, the break-even point for both

the plants lies above 70 per cent capacity utilisation. The capacity

utilisation of the expanded plant, which gives the same profit as

100 per cent capacity utilisation of the existing plant, can be easily

found. At 92 per cent of capacity utilisation, the expanded plant will

give a profit of Rs. 6,60,000.

Effect of Alternative Prices

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The break-even chart can be modified to show the profit position at

difTerent price levels under assumed conditions of demand and

costs. Figure 5.5 shows the pr,ofit position at alternative prices for

the firm in example 1. As can be seen from the figure, the break-

even point becomes lower as the price increases. But it is not

necessary that the profit potential at higher prices may actually be

achieved by the firm. A price of Rs. 4 per unit with a demand at

7,000 units will give a higher profit than a price of Rs. 5 with a

demand at 4,000 units. It is not desirable for a firm to take every

price into consideration. The analyst, while choosing a trial price,

relies largely upon their experience and judgement. Customary

price is one such price. The following Figure 5.6 shows the effect of

BEP in alternative prices.

Drop or Add Decision

An economist takes the decisions regarding the following:

Addition of a new product keeping in consideration, its

cslimated revenue and cost.

Deletion of a product from the product-line keeping in

consideration, its consequent effects on revenue and cost.

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Break-even analysis is also useful in taking decisions related to

product planning. It can be understood with the help of following

example:

Example 8: The following are the present cost and output data of a

manufacturer:

Product PrLe Variable costs % of(Rs.) Per unit sales

(Rs.)Book-cases 60 40 30Tables 100 60 20Beds 200 120 50

Total fixed costs per year: Rs.

75,000 Sales last year: Rs. 2,50,000.

The manufacturer is considering whether to drop the line of

taoles and replace it with cabinets. If this drop-and-add decision is

taken, the cost and output data would be as follows:

Product Price Variable costs % of sales(Rs.) Per unit

(Rs.)Book-cases 60 40 50

Tables 160 60 10Beds 200 120 40

Total fixed cost per year: Rs.

75,000 Sales this year: Rs.

2,60,000.

On the basis of ubove informntion delermine if the change worth

undertaking by the business firm?

Solution. On the basis of the information given in the question,

the profit on the present product line is computed as follows:

Rs. 60 - 40x 30% = 0.10

60

Rs. 100 - 60

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x 20% = 0.08100

Rs. 200 - 120x 50% = 0.20/0.38

200

Thus, the contribution ratio is 0.38, by adding 0.10, 0.08 and

0.20.

Total contribution = Rs. 2,50,000 x 0.38 = Rs. 95,000.

Profit = Rs. 95,000 - Rs. 75,000 = Rs. 20,000.

Profit on the proposed product line would be as under:

Rs. 60 - 40x 50% = 0.17

60

Rs. 160 - 60x 10% = 0.06

160

Rs. 200 - 120x 40% = 0.16

200

Thus, the contribution ratio is 0.39.

Total contribution = Rs. 2,60,000 x 0.39 = Rs. 1,01,400.

Profit = Rs. 1, 01,400 - 75,000 - Rs. 26,400.

Hence the proposed change is worth undertaking.

Make or Buy Decision

Many business firms may opt to produce certain components or

ingredients, which are part of there finished products, or purchasing

them from outside suppliers. For instance, an automobile

manufacturer can make spark plugs or buy them. Breakeven

analysis can enable the manufacturer to decide whether to make or

buy. With the help of following example, this can be easily

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understood:

Example 9: A manufacturer of sc.ooters buys certain

components at Rs. 8 each. In case he makes it himself, his fixed and

variable costs would be Rs. 10,000 and Rs. 3 per component

respectively. Should the manufacturer make or buy the component?

If the manufacturer needs more than 2,000 components per

year, to make or produce the components is more profitable than to

buy. There are some special considerations, which helps in choosing

the best option, are as follows:

Solution. This can be detennined after calculating break-even

point of the manufacturer's firm, The break-even point is as follows:

BEP =Fixed costs

Purchse price – Variable Cost

=10,000

8 - 3

=10,000

= 2,0005

Quality: By manufacturing a certain part of the product

itself, the firm is able to exercise control over quality. This

may also lead to reduction in assembly costs and increase in

consumer goodwill. This helps in enhancing the future sales.

The outside suppliers may also possess a highly specialised

knowledge, which may outshine the know-how of the firm. In

this situation a firm, a firm may feel that it cannot match with

the quality assured by outsiders. Here, a firm is advisable to

buy the high quality products from other firms so as to avoid

the loss due to poor quality. This could also result in fewer

sales.

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

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may secure the advantage of co-ordinating the flow of parts

more effectively. Sometimes, the suppliers are unable to meet

the demand or make deliveries within the required time

period. So, this is also an advantage for the firm to produce

high quality products and to give its best for the betterment of

society.

Defence against monopoly: A firm can also manufacture

parts to protect itself against a monopoly in supply. If a firm

produces some of it products itself, the other firms are less

likely to overcharge or dictate thelT: in any respect. So

producing a part of the product is also beneficial for a firm.

Choosing Promotion-mix

Sellers often use several methods of sales promotion, such as

personal selling, advertising, etc. But the proportion of all these

methods in the promotion mix varies from seller to seller. A retail

shop may have to consider whether or not to employ a certain

number, say, five additional salesmen. Similarly, a manufacturer

may have to decide if he should spend an additional sum of Rs.

20,000 on advertising his product or not. Break-even analysis

enables him to take appropriate decisions by showing how the

additional fixed costs influence the break-even points. This can be

explained with the help of the following illustration:

Example 10: A manufacturer sells his product at Rs. 5 each.

Variable costs are Rs. 2 per unit and the fixed costs amount to Rs.

60,000. Find the following:

1. The break-even point.

2. The profit if the firm sells 30,000 units.

3. The BEP if the firm spends Rs. 3,000 on advertising.

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

spending Rs. 3,000 for advertisement.

Solution: Tle calculations are as follows:

FC

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BEP = SP - VC

=60,000

= 20,000 units5 - 2

Profit = Total revenue - Fixed cost - Variable cost

= (5 x 30,000) - 60,000 - (2 x 30,000)

= 1,50,000 - 60,000 - 60,000

= Rs.30,000

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

3,000, i.e., Rs. 63,000. Hence, BEP would be:

BEP =FC

SP - VC

=63,000

= 21,000 units5 - 2

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

Profit is:

Target sales volume

=

Fixed cost + Target profit

Contribution margin

=63,000 + 30,000

3

=93,000

= 31,000 units3

Equipment Selection

Break-even analysis can also be used to compare different ways

o(doing jobs. For instance, use of simple machines, is usually best

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for small quantities. But when bigger quantities are to be produced,

faster but usually costlier machines are to be employed.

Sometimes, a choice is to be made in between three or more

methods, depending upon the most economical one. The following

example explains how to determine these ranges.

Example 11: A manufacturer has to choose from amongst three

machines for his factory. The conditions, which he wants to be

fulfilled regarding the three machines, are as follows:

1. An automatic machine which will add Rs. 20,000 a year to his

fixed costs but the variable costs per unit will be only 40 p.

2. A semi-automatic machine which will add Rs. 8,000 a year to

his fixed costs but variable cost$ per unit will be Rs. 2 and

3. A hand-operated machine which will add only Rs. 2,000 a year

to his fixed costs but will cause variable costs per unit of Rs. 4.

Calculate the range of output over which automatic, semi-

automatic and hand-operated machines would be most economical.

How would you choose between hand-operated and automatic

machines, supposing the semi automatic machine does not exist?

Solution. The cost formulae for the three machines would be,

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

Now setting pairs of equations to each other, and solving

them to final the Value of S:

1. Automatic vs. Semi- Nutomatie

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

or, 1.60S = 12,000

or, S =12000

= 7,500 units 1.60

2. Semi-automatic vs. Hand-operated:

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

or, 2S = 6,000

or, 8 = 3,000 units

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

The semiautomatic machine is to be used over the range of 3,000 -

7,500 units.

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

however, the choice is to be made between hand-operated and

automatic machines, the former; is to be used up to 5,000 units

and, thereafter, the latter would be more economical. This is

calculated as under:

2,000 + 48 = Rs. 20,000 + 0.40

or, 3.60S = 18,000

or, 8 = 5,000 units.

IMPROVING PROFIT PERFORMANCE

There are four specific ways in which profit performance of a

business can be improved, which are as follows:

Increasing the volume of sales: Considering the example

I, the present volume of sales is 8,000 units and the

maximum production capacity 10,000 units. If the sales are

increased to the maximum production capacity, there will be

an increase in variable expenses only. The profit will increase

from, Rs.6,000 to Rs. 10,000. It will be seen that though the

increase in sales volume has been only to the extent of 25

per cent, profit has increased by 67 per cent.

Increasing the seIling price: An increase in the price

increases the contribution margin and reduces the break-

even point. Continuing with Example I, if the selling price is

increased by 10 per cent, the profit will increase from Rs.

6,000 to Rs. 9,200 showing an increase of more than 50 per

cent.

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Reducing the variable expenses per unit: If the variable

expenses are reduced by 10 per cent to Rs. 1.80, the profit

will increase from Rs. 6,000 to Rs. 7,600 at the present

volume of sales. This increase is more than 25 per cent,

which is more than the percentage reduction in variable

expenses. In cost-volume-profit relationship, the higher

proportionate increase in profit than the change in selling

price or the volume of sales or the variable expenses is called

the leverage effect. At times, it is not possible to increase the

prices, but to increase the volume of sales and to reduce the

variable expenses is possible.

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

a change in variable expenses and the selling price, would

lead to an equal change in the profits. For example, if the

fixed expenses are reduced from Rs. 10,000 to Rs. 9,000 in

the above illustration, profit will increase from Rs. 6,000 to

Rs. 7,000. As a change in the fixed costs does not change the

contribution margin per unit, there is no leverage effect.

Production planning

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

give maximum contribution towards profit and fixed costs. This will

be clearly understood from-the following illustration:

Example 12: The management of Swadeshi Cotton Mills,

Kanpur, is interested in finding out the quantities of cloth X and Y

for production in a week in order to maximiese profits. The total

hours required to produce 100 metres of each cloth are 20 and 25

respectively. The total hours available per week are 9,600. The

maximum possible sales of cloth X and Y for one week as estimated

are: X = 30,000 metres, Y for 40,000 metres.

The following table shows, the variable costs and selling price per metre:

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- Particulars Pcr mctrc

Cloth X Cloth YVariable cost Rs.2.00 RS.3.00

Selling price RS.2.60 RS.3.80

The total expenses for one week are estimatcd at Rs. 21,400.

Find out the production plan, which the, company should follow.

How much profit shall be earned by following this production plan?

Solution. The contributions of Cloth X and Yare Re. 0.60 and Re.

0.80 per metre respectively, which are calculated by subtracting

variable cost of each from selling price. Hence, priority should be

gi~en to the production of cloth Y as it contributes more towards

meeting the fixed cost. The maximum of cloth Y that can be sold is

40,000 metres, which would require 10,000 hours. However, the

total hours available are 9,600. Hence, the maximum of cloth Y that

can be produced is 38,400 metres (9,600 x 4). The production plan

to be followed is given below:

_._-- Cloth X Nil

Cloth Y 38,400 metres

This plan shall provide profits as shown below:

Total Revenue = Rs. 38,400 x 3.80 = Rs. 1,45,920

Total cost:

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

Fixed cost 21,400 1,36,600

Net porfit Rs. 9,320

Policy Guidelines Originating from Break-even Analysis

There are certain useful conclusions in terms of policy guidelines,

which may be drawn from break-even analysis as a result of the

effect of changing conditions on a firm's operations, policies and

actions. A high BEP indicates the weakness regarding the profit

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position of the firm. To reduce the BEI therefore, the selling price

should be increased, variable and fixed costs should be reduced. If

the variable costs per unit asre large (Business 8 in Example 13), an

increase in selling price or a reduction in variable costs would be

morc eLective. Whether it is more desirable to raise prices or

practicable to cut down variable costs, depends upon competitive

market conditions, the elasticity of demand for firm's product and

the efficiency of its operations. When the cOi.lribution margin rer

unit is comparatively large (Business A in Example 13), the firm is

advised to lower the BEP by reducing the level of fixed costs.

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

business or vice-versa. Business A with a higher contribution

margin can survive even if the prices drop to 50 paise per unit.

Business B with a lower contribution margin will have to close down

its operations if prices drop to 50 paise. In a period of boom, whcn

both the prices as well as sales rise, a firm with a higher percentage

of fixed costs to sales earns higher profits as compared to a

business with a higher percentage of variable expenses to sales. On

the other hand, in a period of depression, when both the prices as

well as sales decrease, the business with a higher percentage of

fixed costs to sales suffers greater losses than the business with a

higher percentage of variable expenses.

Example 13: The following example of two businesses, A and B,

illustrates some of the points contained in the text above.

Business A Business BSelling price per unit Re. 1.00 Re.I.OO

Variable cost per unit Re.0.20 Re.0.60

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

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

among A and B is profitable for the business firm to suspend

operations? Give explanations to support your answer.

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Solution. The break-even point of both the businesses is

6,250 units or Rs. 6,250. If the sales are 10 pefcent above the BEP,

business A gains Rs. 500 while business B gains only Rs. 250. If the

sales are below the BEP, say 5,000 units, business A loses Rs. 1,000

and business B loses only.

Rs. 500. If the market collapses and the prices also go down

to 50 paise per unit and sales drop to, say, 3,000, business A

suffers a loss of Rs. 4, 100 while business B suffers a loss of only

Rs. 2.500 (the amount of fixed expenses only ns it would find it

unprofitable to continue operntions). But one signifiennt point is

that whilc business A can continue to operate and contribute 30

paise per unit, sold towards fixed expenses. Business B will find it

profitable to suspend operations.

Limitation of Break-even Analysis

There arc some important limitations of break-even analysis,

which arc to be kept in mind while using break-even analysis.

These limitations are as follows:

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

may suffer from various limitations of such data, such as

negligence towards imputed costs, arbitrary depreciation

estimates and inappropriate allocation of overhead costs.

Break-even analysis, therefore, can be sound and useful

only if the firm in question maintains a good accounting

system and uses proper managerial accounting techniques

and procedures. The figures must also be adequate and

sound. If break-even analysis is based on past data, the

same should be adjusted for changes in wages and price of

raw materials.

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

assumption of given relationship between costs and

revenues. On the one hand and input, on the other. Costs

and revenues may change over time making the projection,

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based on past data wrong. Therefore, break-even analysis is

more useful only in situations relatively stable while it does

not work effectively in volatile, erratic and widely changing

ones.

Costs in a particular period may not be caused entirely by

the output in that period. For example, maintenance

expenses may be the result of past output or a preparation

for future output. It may therefore, be difficult to relate them

to a particular period.

Selling costs are especially difficult to handle in break-even

analysis. This is because changes in selling costs are a

cause and not a result of changes in output and sales.

A straight-line total revenue curve prcsumcs that any quantity

should be sold at onc price only. This implies a horizonwl

demand curve and is true only under conditions of perfect

competition. The situation of perfect ~ competition is rare in

real world, which restricts the application of many total

revenue curves.

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

revenue-volume relationship is linear. This is realistic only

over narrow ranges of output. For example, this type of

analysis is worthwhile in deciding if the selling price should be

50 or 60 paise, volume should be attempted at 80 per cent of

capacity rather than 85 per cent, advertising expenditure

should total Rs. 1,00,000 or Rs. 1,15,000 or the product

should be put in a package costing 70 paise rather than 90

paise.

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

and its use should be restricted to the short run only. The

break-even analysis should better be limited to the budget

period of the firm, which is usually the· calendar year.

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

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if too many products, departments and plants are taken

together and graphed on a single break-even chart: it will be

difficult for the fim1 to distinguish between the good and bad

performances of the business firm.

Break-even analysis assumes that profits arc a function of

output ignoring the fact that they arc also caused by other

factors such as technological change, improved management,

changes in the scale of the fixed factors of production and so

on.

To conclude, it can be said that break-even analysis is a

device, simple, easy to understand and inexpensive and is there

fore, useful to management. Its usefulness varies from a firm to

another firm and also among industries. Industries suffering from

frequent and unpredictable changes in input prices, rapid

technological changes and constant shifts in product mix will not

benefit much from break-even analysis. Finally, break-even analysis

should be viewed as a guide to decision-making and not as a

substitute for judgement, logical thinking.

PROFIT FORECASTING

Profit planning cannot be done without proper profit forecasting.

Profit forecasting means projection of future earnings after

considering all the factors affecting the siz.e of business profits,

such as firm's pricing policies, costing policies, depreciation policy,

and so on. A thorough study including a proper estimation of both

economic as well as non-economic variables may be necessary for a

firm to project its sales volume, costs and subsequently the profits

in future.

According to joel Dean, a famous cconomist, there are three

approaches to profit forecasting, which are as follows:

Spot Projection: Spot projection includes projecting the

profit and loss statement of a business firm for a specified

future period. Projecting of profit land loss statement means

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forecasting each important element separately. Forecasts are

made about sales volume, prices and costs of producing the

expected sales. The prediction of profits of a firm is subject to

wide margins of error, from forecasting revenues to the inter-

relation of the various components of the income statement.

Brcak-even analysis: It helps in identifying functional

relations of both revenues and costs to output rate, kecping in

consideration the way in which output is related to the prolits.

It also helps in doing so by relating profits fo output directly

by th.e usual data used in break-even analysis.

Environmcntal analysis: It helps in relating the company's

profits to key variabk, in the economic environment such as

the general business activity and the general price level.

These variables are not considered by a business firm.

All those factors that control profits move in regular and

related patterns such as the rate of output, prices, wages, material

costs and efficiency, which are all inter-related by their connections

with the national markets and also by their interactions in business

activity. Theories of business cycles are based on the hypothesis,

which is shown by the national values of production, employment,

wages and prices during any fluctuation in business activities. There

is no clear pattern in detailed analysis. These patterns helps in

increasing the possibility that the profits of a business firm, can be

forecast directly by finding a relation to key variables. The need is

to find a direct functional relation between profits of a business firm

and activities at national level that shows statistical signi ticance.

In practice, these three approaches need not be mutually

exclusive. Theses approaches can also be used jointly for maximum

information. In projecting the profit and lo.ss statement, the

functional relations can be used, arising out of the ratio of cost to

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output and to its other determinants. In the same way, by

measuring the impact of outside economic forces upon the firms'

profit helps in facilitating good spot guesses. It can also enhance

the accuracy of break-even analysis.

REVIEW QUESTIONS

1. Distinguish between the following concepts or profit:

A. Accounting profit and economic

profit. B. Normal profit and monopoly

profit.

C. Pure profit and opportunity cost.

2. Examine critically profit maximisation as the objective of

business firms. What are the alternative objectives of

business firms?

3. Explain the first and second order conditions of profit

maximisation.

4. Profit maximisation is theoretically the most sound but

practically unattainable objective of business firms. Do your

agree with this statement? Give reasons for your answer.

5. Explain how profit is used as a control measure. 'What

problems are associated with the use of profit figures as a

control measure?

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LESSON NO-6

NATIONAL INCOME

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

nation. Economic activities generate two kinds of flow in a modern

economy namely, product-flow and money-flow. Product-flow refers

to flow of goods and services from producers to final consumers.

Money flow refers to flow of money in exchange of goods and

services. In this exchange of goods and services, money income is

generated in the form of wages, rent, interest and profits, which is

known as factor earning. Based on these two kinds of flows, national

income is defined in terms of:

Product flow

Money flow

DEFINITION OF NATIONAL INCOME

National Income in Terms of Product Flow

National income is the sum of money value of goods and services

generated from total economic activities of a nation. Economic

activities result into production of goods and services and make net

addition to the national stock of capital. These together constitute

the national income of closed economy'. Closed economy refers to

an economy, which has no economic transactions with the rest of

the world. I lowcvcr, in an opcn ecollomy, natiollul incomc ulso

includes the net results of its transactions with the rest of the world,

i.e., exports less imports.

Economic activities should be distinguished from the non-

economic activities from national income point of view. Broadly

speaking, economic activities include all human activities, which

create goods and services that can be valued at market price.

Economic activities include production by farmers (whether for

household consumption or for market), production by firms in

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industrial sector, production of goods and scrvices by thc

govcfl1ment cntcrpriscs, and services produced by business

intermediaries (wholesaler and retailcr), banks and other financial

organisations, universities, colleges and hospitals. On the other

hand, noneconomic activities arc those activities, which produce

goods and serviccs that do 110t have economic value. The non-

economic activities include spiritual, psychological, social and

political services, hobbies, service to selr serviccs of housewives

services of members of family to other mcmbers and cxchangc of

mutual services between neighbours.

National Income in Terms of Money Flow

While economic activities generate flow of goods and services, on

the other hand, they also generate money-flow in the form of

f~lctor payments such as, wages, interest, rent, prolits and earnings

of self-employed. Thus, national insome can also be obtained by

adding the factor earnings after adjusting the sum for indirect

taxes, and subsidies. The national income thus obtained is known as

national income at factor cost.

The concept of national income is linked to the society as a

whole. However, it differs fundamentally from the concept of private

income. Conceptually, national income refers to the money value of

the final goods and services resulting from all economic activities of

a country. However, this is 110t true for the private income in

addition, there are certain receipts of money or of goods and

services that are not ordinarily included in private incomes but are

included in the national incomes and vice versa. National income

includes items such as employer's contribution to the social security

and welfare funds for the benefit of employees, profits of public

enterprises and servIces of owner occupied houses. However, it

excludes the interest on war-loans, social security benefits and

pensions. Instead, these items are included in the private incomes.

The national income is therefore, not merely an aggregation of the

private incomes. However, an estimate of national income can be

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obtain by summing up the private incomes after making necessary

adjustment for the items excluded from the national income.

MEASURES OF NATIONAL INCOME

The various measures of national income are as follows:

Gross National Product (GNP)

There are several measures of national income used in the analysis

of national income. GNP is the most important and widely used

measure of national income. GNP is defined as the value of final

goods and services produced during a specific period, usually one

ycar, plus the diflcrence between foreign receipts and" pnyment.

The GNP so defined is identical to the concept of 'Gross National

Income (GNl)', Thus, GNP = GNI. The difference between the two is

that while GNP is estimated on the basis of product-flows, the GNI is

estimated on the basis of money flows.

Net National Product (NNP)

Net National Product (NNP) is the total market value of all final

goods and services produced by citizens of an economy during a

given period of time minus depreciation, i.e., Gross Nationnl

Product less depreciation.

NNP = GNP - Depreciation

Depreciation is that part of total productive assets, which is

used to replace the capital worn out in the process of creating GNP.

In other words, while producing goods and services including

capital goods, a part of total stock of capital is used up. This part of

capital that is used up is termed as depreciation. An estimated

value of depreciation is deducted from the GNP to arrive at NNP.

The NNP, as defined above, gives the measure of net output

available for consumptionhy the society (including consumers,

producers and the government), NNP is the real measure of the

national income. In other words, NNP is same as the national

income at factor cost. It should be noted that NNP is measured at

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market prices including direct taxes. However, indirect taxes are

not included in the actual cost of production. Therefore, to obtain

real national income, indirect taxes are deducted from the NNP.

Thus,

National income = NNP - Indirect taxes

National income: Some accounting relationships

Relations at market price GNP = GNI

o Gross Domestic Product (GDP) = GNP less net income

from abroad

o NNP = GNP less depreciation

o NDP (Net Domestic Product) == NNP less net income

from abroad

Relations at factor cost

o GNP at factor cost = GNP at market price less net

indirect taxes.

o NNP at factor cost = NNP at market price less net

indirect taxes

o NDP at factor cost = NNP at market price less net

income from ahroad

o NOP at factor cost = NDP at market price less net

indirect taxes

o NOP at factor cost = GOP at market price less

depreciation

Methods of Measuring National Income

For mcasuring the national income, the national economy is viewed

as follows:

The national economy is considered as an aggregate of

producing units combining different sectors such as

agriculture, mining, manufacturing and trade and commerce.

The whole national economy is viewed as a combination of

individuals and household owning different kinds of factors of

production, which they use themselves or sell-their factor

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services to make their livelihood.

National economy is also viewed as a collection of consuming,

saving and investing units (individuals, households and

government).

The above notions of a national economy helps to measure

national Income by following three different methods:

Net output method

Factor-income method

Expenditure method

These methods are followed in measuring national income in

a ‘closed economy',

Net Output Method

This is also called as net product method or value-added method.

This method is used when whole national economy is considered as

an aggregate of producing units. In its standard form, this method

consists of three stages:

1. Measurement of gross value of domestic output in

the

various branches of production: For measuring the

gross value of domestic product, output is classified

under various categories on the basis of the nature of

activities from which they originate. The output

classification varics from country to country dey'ending

on (i) the nature of domestic activities, (ii) their

significance in aggregate economic activities and (iii)

availability ofrecjuisite data. For example, in USA, about

seventy-one divisions and sub-divisions are used to

classify the national output, in Canada and Netherlands,

classification ranges from a dozen to a score and in

Russia, only half-a-dozen divisions are used. According

to the CSO publication, If fleen sub-categories are

currently used in India. After the output is classified

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under the various categories the value of gross output is

is computed in two alternative ways by:

A. Multiplying the output of each earegory of acctor

by their respective market price and adding them

together.

B. Collecting data regarding the gross sales and

changes in inventories from the account of the

manufacturing firms to compute the value of

GDP. If there arc gaps in data then some

estimates are made to fill the gaps.

2. Estimation of cost of materials and services

used

arid depreciation of physical assets: The next step

in estimating the net national income is to estimate (he

cost of production including depreciation. Estimating

cost of production is, however, a relatively more

complicated and difficult task because of non-

availability of adequate and requisite data. Much morc

difficult task is to estimate depreciation since it

involves both conceptual and statistical problems. For

this reason, many countries adopt faclorincome

method for estimating their national income. However,

countries adopting net-product method find some

means to calculate the deductible cost. The costs are

estimated either in absolute terms (where input data

are adequately available) or as an overall ratio of input

to the total output. The general practice in estimatmg

depreciation is to follow the usual business practice of

depreciation accounting. Traditionally, depreciation is

calculated at some percentage of capital, permissible

under the tax-laws. In some estimates of national

income, the estimators have deviated from the

traditional practice and have instead estimated

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depreciation as some ratio of the currenL output of

final goods. FoI1owing a suitable method, deductible

costs including depreciation are estimated for each

sector. The cost estimates are then deducted from the

sectoral gross output to ohtain the net sectoral

products. The net sectoral products are then added

together. The total thus obtained is taken to be· the

measure of net nationa I products or national income

by product method.

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

obtain the net value of domestic product: Net value of domestic

product is often called the value added or income product.

Income product is equal to the sum of wages, salaries,

supplementary labour incomes, interest, profits, and net rent paid

or accrued.

Factor-Income Method

This method is also known as income method and factor-share

method. factorincome method is used when national economy is

considerl:d as a combination of factor-owners and users. Under this

method, the national income is calculated by adding up all the

inconlcs accruing to the basic factors of production used in

producing the national product. Factors of production are c1assi ficd

as land, labour, capital and organisation. Accordingly,

National income = Rent + Wages + Interest + Profits

However, it is conceptually very difficult in a modern economy to

make a distinction between earnings from land and capital and

between the (;arnings from ordinary labour and organisational

efforts including entrepreneurship. Therefore, for estimating

national income factors of production arc broadly grouped as labour

lInd capital. Accordingly, national income is supposed to originate

from two primary factors, viz., labour and capital. However, in some

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activities, labour and capital are jointly supplied and it is difficult to

separate labour and capital from the total earnings of the supplier.

Such incomes are termed as mixed incomes. Thus, the total factor-

incomes are grouped under three categories:

Labour incomes

Capital income

Mixed incomes.

Labour Income: Labour incomes included in the national income

have five components:

Wages and salaries paid to the residents of the country

including bonus, commission and social security payments.

Supplementary labour incomes including employer's

contribution to social security and employee's welfare funds

and direct pension payments to retired employees.

Supplementary labour incomes in kind such as free health,

education, food, clothing and accommodation.

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

other free ofcost services provided to the employees arc

included in labour income.

Bonuses, pensions, service grants are not included in labour

income as they are regarded as 'transfer payments'. Certain

other categories of income such as incomes from incidental

jobs, gratuities and tips are ignored because of non-availability

of data.

Capital Incomes: According to Studenski, capital incomes include

following Incomes:

Dividends excluding inter-corporate dividends

Undistributed profits of corporation before-tax

Interests on bonds, mortgages and savings deposits

(excluding

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interests on bonds and on consumer credit)

Interest. earned by insurance companies and credited to the

insurance policy reserves

Net interest paid by commercial banks

Net rents from land and buildings including imputed net rents

on owneroccupied dwellings

Royalties

Profits of government enterprises.

The data for the first two incomes is obtained from the firms'

accounts submitted for taxation purposes. There exist difference in

definition of profit for national accounting purposes and taxation

purposes. Therefore, it is necessary to make some adjm.ments in

the income-tax data for obtaining these incomes. The income-tax

data adjustments generally pertain to (i) Excessive allowance of

depreciation made by tax authorities, (ii) Elimination of capital

gains and losses since these do not reflect the changes in current

income, and (iii) Elimination of under 0,' overvaluation of

ir:ventories on book-value,

Mixed Income: Mixed incomes include income from (a) fanning

(b) sole proprietorship (not included ,Ilnder profit or capital income)

(c) other professions such as legal and l.ledical practices,

consultancy services, trading and transporting. Mixed income also

includes incomes of those who earn their living through various

sources such as wages, rent on own property and interest on own

capital.

All the three kinds of incomes, viz., labour incomes, capital

incomes and Inixed incomes added together give the measure of

national income by factorincome method.

Expendit4re Method

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

This method is used when national economy is viewed as a

collection of spending units. It measures national income at the final

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expenditure stages. In other words, this method measures final

expenditure on 'GDP at market prices' at the stage of disposal of

GDP during an accounting year. In estimating the total national

expenditure, any of the following two methods are followed:

First method: Undcr this mcthod all the 111011';y cxpcnditurc

III IIlllrkc( prkc arc computed and added up to arrive at total

national expenditure. The items of expenditure which are

taken into account under the first method are (a) private

consumption expenditure, (b) direct tax payments, (c)

payment? to the non-pro;it-making institutions and charitable

organisations like schools, hospitals and orphanage, and (d)

private savings.

Second Method: Under this method the value of all the

products finally disposed of are computed and added up to

arrive at the total national expenditure. Under the second

method, the following items are considered

Private consumer goods and services

Private investment goods

Public goods and services

Net investment from aboard.

This method is extensively used because the requisite da!J

required by this method can be collected with greater ease and

accuracy.

Treatment of Net Income from Abroad

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

discussed the methods of measuring national income of a

'closed economy'. However, most modem economics are 'open

economy'. These open economics exchange goods and

services with rest of the world. In this exchange of goods and

services, som\: nations make net income through foreign trade

through exports while some lose their income to the foreign

nations through imports. These incomes are called as Net

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Factor Income from Abroa:d (NFIA). The net earnings or losses

in foreign trade affect the national income. Therefore, in

measuring national income the net results of external

transactions are adjusted to the total national income arrived

through any of the three methods. The total income from

abroad is added and net losses to the foreigners are deducted

from the total national income. All the exports of merchandise

and of services such as, shipping, insurance, banking, tourism

and gifts are added to the national income. On the contrary, all

the imports of the corresponding items are deducted from the

value of national output to arrive at the approximate measure

of national income.

Net Investment From Abroad: Net investment from abroad

refers to the di ITerllliee between investment a nation made

abroad and the in vcst· mcnt 111nde h~, thc rc~t or Ill(' world

ill Ihnt 1If1liOIl. Thi'1'\\ ill\',\~tll"\I1I~ <I' \ mldeu (0 the l\lIt

i01l1l1 i Ilcume clllcullllcd II lieI' addillg or deduct illg N I: 1..\

from it.

Choice of Methods

As discussed above, there are standard methods of measuring the

national incOJ11I.: such as net output method, factor-income

method and expenditure method. 1\11 the I three methods would

give the same measure of national income, provided rcquisitc data

for each method arc adequately available. Therefore, any of the

three methods can be adopted to measure the national income.

However, not all the methods arc suitable for all economies and

purposes. Hence, the problem of choice of method anses.

The two main considerations on the basis of which a particular

method is chosen are:

The purpose of national income

analysis

Availability of necessary data.

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

method would be more suitable. In case, objective is to analyse the

factor-income distribution then, suitable method would be income

method. If objective at hand is to find out the expenditure pattern

of the national income then the expenditure method is more

suitable. However, availability of adequate and appropriate data is

relatively more important considerations in"selecting a method of

estimating national income.

However, the most common method is the net output method

because of the following reasons:

It requires classification of economic activities and output,

which is much easier to classifY than the income or

expenditure.

The most common practice is to collect and organise the

national illcom!.; data by the division of economic activities.

Therefore, easy availability of data on economic activities is

the main reason for the popularity of the .output method.

However, it should he borne in mind that no single method can

give an accurate measure of national income. This is because no

country's statistical system provides the total data requirements

for a particular method.

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

to measure the national income. The combination of methods again

depends on the nature of required data and the sectoral breakdown

of the available data.

Measurement of National Income in India

In India, a systematic measurement of national income was first

attempted in 1949. Earlier, some individuals and institutions made

many attempts. Dadabh'\i Narojoji made the earliest estimate of

India's national income in 1876 for the year 1867-68. Since then,

mostly the economists and the government authurities made many

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attempts to estimate India's national income.

These estimates differ in coverage, concepts and methodology

and they are not comparable. Besides, earlier estimates were made

mostly for one year, only some estimates covered a period of 3-4

years. It was therefore, not possible to construct a consistent series

of national income and assess the pcrforniance of the economy over

a period of time. It was only in 1949 that National Income

Committee (NIC) was appointed with PC. Mahalanobis, as its

Chairman and D.R. Gadgil and V.K.R.V. Rao as its members. The NIC

not only highlighted the limitations of the statistical system that

existed at that time but also suggested ways and means to improve

data collectiol1' systems. On the recommendation of the

Committee, the Directorate of National Sample Survey was set up to

collect additional data required for estimating national income.

Besides, the NIC estimated country's national income for the period

from 1948-49 to 1950-52. In its estimates, NIC also provided the

methodology for estimating national income, which was followed

until 1967.

After the NIC, the task of estimating national income was taken

over by the Central Statistical Organisation (CSO). Until 1967, the

CSO followed the methodology laid down by the NIC. Thereafter, the

CSO adopted a relatively improved methodology and procedure,

which had become possible due to increased availability of data.

The improvements pertain mainly to the industrial classification of

the activities. The CSO publishes its estimates in its publication

Estimates of National Income.

Methodology

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

estimate national income of our country. The output method is used

for agriculture and manufacturing sectors, i.e., the commodity

producing sectors. Income method is used for the service sec(ors

including trade, commerce, transport and governmeni' services. In

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its conventional series of national income statistics from 1950-51 to

1966-67, the fSO had categorised the income in 13 sectors.

However, in the revised series, it had adopted the following 15

break-ups of the national economy for estimating the national

income.

(i) Agriculture (ii) Forestry and logging (iii) rishing. (iv) Mining

and quarrying (v) Large-scale manufacturing (vi) Small-scale

manufacturing (vii) Construction (viii) Electricity, gas and water

supply (ix) Transport and communication (x) Real estate and

dwellings (xi) Public Administration and Defence (xii) Other services

and (xiii) External transactions. The national income is estimated at

both constant ar.d current prices.

Growth and Composition of India's NaConallncome

The following Tables present the growth and change in composition

of India's national income, both at factor cost and current prices.

Table. 6.1 presents the decennial trends in national income

aggregates like GDP, GNP, NDP, NNP, Netfactor income from

abroad, capital consumption and indirect tax and subsidies. Table

6.2 presents the change in the composition of national income

classified under five broad categories. Table 6.3 presents the

decennial annual average growth rate of GNP and GDP at constant

prices. It can be seen from Table 6.2 that the composition of India's

national income has changed considerably over the past four

decades. The share of ~griculture has declined from 55.8% in GDP

in 195051 to 31.3% in 1994-95 and that of industrial sector

increased from 15.26 to 27.5 % during th; same period.

Table 6.1: National Income Aggregates-1960-61 to 1994-95

(Decennial) (At current prices) (Rs. Crores)

ANationalIncomeAggregates

1960-61 1970-71 1980-81 1990-91 1992-93

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(AtF:actor C Jst)

1GrossDomesticProdllct (GDP

15,254 39,708 1,22,427

4,27,60

06,27,60

0

2

.

Fixed CapitalConsumption

940 2,921 12,08751,884

71,569

3

.

Net DomesticProduct (NDP)= (1-2)

14,314 35,787 1,10,340 4,20,77

5

5,56,344

4

.

Net FactorIncome fromAbroad

-72 -284 34506,833

-11409

Contd....

5.Indirect TaxesLess Subsideis

947 3,455 13,586 58,205 77,653

6.Gross NationalProduct (GNP)= (1 + 4)

15,182 39,424 122,772 4,65,82

7

6,16,504

7.Net National Profit (NNP)= (6-2)

14,242 36,503 1,10,685 4,13,94

3

5,44,935

8.GDP (at marketprices)= (1+5)

16,201 43,163 1,36,013 5,30,86

5

705,566

9.GNP (at Marketprice) = (8 + 3)

16,129 42,879 1,36,358 5,24,03

2

9,31,016

10

.

NDP (at Marketprice) = (8 – 2)

15,261 40,292 1,23,926 4,78,98

1

6,63,997

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11

.

NNP (at marketprice) = (9 – 2)

15,189 39,958 1,24,271 4,72,14

8

6,22,588

Source : CMIE, Basic Statistics Relating to Indian Economy, Aug

1994 Table 13.3

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

(Rs. Crores)

Sectors

Sectors 1960-

61

1970-

71

1980-

81

1990-

91

1994-95 at 1980-

81 prices

1.Agricuitural and Allied sectors 45.8 45.2 38.1 31.8

31.3

2.Manufacturing and Mining, etc.

20.7 21.9 25.928.8

27.5

3.Transport, Trade and Communication

12.1 13.2 16.719.6

19.0

4.Finance and Real Estate

11.9 10.0 8.88.3

11.1

5.Community and Personal Services

9.4 9.7 10.5 11.6 11.1

6.Commodity Sector (1 + 2) 66.5 67.1 64.0 60.5

58.8

7.Non-commodity Sector (3 + 4 + 5)

33.5 32.9 36.039.5

42.2

8.All Sectors 100.

0100.

0100.

0 100.0

100.0

Tavie 6.3: Annual Average Growth Rate of GNP and GDP (AT Current

Prices)(% share in GDP)

Period GNP (%) GDP (%)1950-51 to 1960-61 4.08 4.09

1960-61 to 1970-71 3.74 3.78

1970-71 to 1980-81 3.47 3.34

1980-81 to 1990-91 5.57 5.76

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1990-91 to 1994,-95 3:95 4.08

1950-51 to 1994-95 4.04 4.07-- -----------

Inflation and Deflation

The term 'inflation' is used in many senses and it is difficult to give

a generally accepted, precise and scientific definition of the term.

Popularly, inflation refers 1O a rise in price level. Kemmerer states,

"Inflation is too much money and deposit currency that is too much

currency in relation to the physical volume of business being

done." This is what Coulburn also means when he defines inflation

as, "Too much money chasing too few goods". According to T.E.

Gregory, inflation is "abnormal increase in the quantity of money".

The implication in these definitions is that prices rise due to an

increase in the volume of money as compared to the supply of

goods. This is the quantity approach to the rise in the price level.

However, it should be noted that prices may rise due to other

factors also such as rise in wages and profits. Besides, there can be

an inflationary pressure on prices without actually rising of the

prices.

Keynesian Definition

Kl:YlH:S rdales inl1ation to a price level that comes into existence

after the stage of full employment. While, the quantity approach

emphasises the volume of money to be responsible for rise in the

price level. Keynes distinguishes between two types of rise in

prices (a) rise in prices accompanied by increase in production (h)

rise in prices not accompanied by incrl:ase in production. If an

economy is working at a low level, with a large number of

unemployed men and unutilised resources then expansion of

money or some other. factors leading to an increase in demand will

result not only in a rise in the price level but also rise in the volume

of goods and services in an economy. This will continue until all

unemployed men tind employment arid capital and other resources

are more fully utilised, i.e., the stage of full employment. Beyond

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this stage, however, any increase in the volume of money or rise in

demand will lead to a rise in prices but lIO corresponding rise in

production or employment.

Keynes states that the initial rise in prices up to the stage of full

employment is a good thing far the country 'since there is an

increase in. output and employment. Reflation or partial inflation is

used to designate such a rise in the price level. The rise in prices

aller the stage of full employment is bad far the country since

there is no corresponding increase in production or employment.

Inflation is used to express such a rise in the price level. Therefore,

inllation refers

to a rise in the price level after full employment has been attained.

(

According to Keynes, "inflation" can be applied to an

underdeveloped country like India where unemployment of men

and resources exist side by side with inflationary rise in prices. This

is due to the existence of bottlenecks, such as limited amount of

capital, machinery, transport facilities and absence of technical

know-how. As a result of these bottlenecks and shortages, a rise in

the price level may not lead to increase output beyond a certain

stage, even though the country may not have reached the stage of

full employment. We can distinguish between three kinds of

inflation on the basis of their causes, viz., demand-pull, cost-push

and sectoral inflation.

Demand-pull Inflation

The most common cal;lse for inflation is the pressure of ever-rising

demand on a stagnant or less rapidly increasing supply of goods

and services. The expansion in aggregate demand may be due to

rapidly increasing private investment or expanding government

expenditure for war or economic development. At a time whe.n

demand is expanding and exerting pressure on prices'cattempts

are made to expand production. However, this may not be possible

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either due to nonavailability o(uqemployed resources or shortages

of transport, power, capital and equipment. Expansion in aggregate

demand, after the level of full employment, results into rf~e in the

price level. In a developing economy I ike India, resources are used

for growth, for creating fixed assets and production of consumer

goods. Necessarily, large expenditure will create. large money

income and large demand but without a corresponding increase in

supply of real output.

We should emphasise here the role played by deficit financing

and increase in money supply on the level of prices in a developing

COU1Hry. Ollen. the government of a developing country resorts to

deficit spending Lo finance economic development i.e., borrowing

from the central bunk und cOllllllercial banks, which, in turn, leads

to increase in money supply in the country. This exerts a strong

pressure on the level of prices. An increase in" foreign demand for

the exports of a country may also raise the price level in a country.

Expansion in foreign demand aM consequent expansion in exports

will raise income of the people. This will push up demand for goods

and services within a country. In case the additional money income

is used to buy imports or is hoarded then it will not have inflationary

effect in the country. Thus, inflationary pressure is built by

increasing aggregate demand in excess of the available resources.

The increase in aggregate demand can be due to increase in

government expenditure or increase in private investment and

private consumption or release of pent up demand of consumers

immediately after a war or increase in exports and so on. Deficit

financing and increase in money supply further aggregate the

situation by boosting demand still further. In all these cases,

inflation is the result of demand-pull factors. It must be emphasised

here that demand-pull inflation cannot be sustained unless there is

increase in money supply.

Cost-push Inflation

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In certain circumstances, prices are pushed up by wage increases,

forced upon the economy by labour leaders under the threat of

strike. Costs can also be raised by manufacturers through a system

of fixing a higher margin of profit. The common man generally

blames profiteers, speculators, hoards and others for pushing up the

costs and prices. Again, the government is responsible for raising

the costs by imposing new taxes and continuously raising the tax

rates of existing commodity. Therefore, rising rates of commodity

taxes, in a sellers market, will enable the producers to raise the

prices by the full amount of taxes. Under conditions of rising prices,

business and industrial units find it easy to pass on the burden of

higher wages to the consumers by raising the prices. 1 II us, rise in

wages; profit margin and taxation are responsible for cost-push

inflation.

In periods when wages, prices and aggregate demand are all

rising and creating an inflationary situation, it is d-ifficult to find out

active and passive factor. In many cases, it is neither demand-pull

inflation nor cOSt-push inflation, but it is a combination of both.

However, it is possible and often useful to separate the dominant

factors. If aggregate de~and is responsible for the inflationary

situation, it may persist so long as excess demand persists and in

the extreme case, it may develop into hyperint1alion cwn thoug.h

(osl-push fOt'\'l'S nl".' nhsl'llt. t)11 the other hand, cost-push

inllation cannot pcrsist for long, unless thcrc is increase ill aggrcg:llc

<lClll:1I\(1. I r illf1ntillll is cOlllrolled lilnllip"l1llllli\('lilry IIIll! 1i""'111

Ill,'lli",h, aimcd at controlling aggregate dCllland then we have

demand-pull inllation. Un thc other hand, if wages and prices

continue to rise even whcn demand ceases to grow, we have cost-

push int1ation.

Sectoral Demand Shift Theory of Inflation

Under dcmand-pull inflation, we have shown how expansion in

aggregatc demand without a proportionate increase in the supply of

goods and services leads to an inflationary situation. However, it is

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not necessary to have a general increase in demand to bring about

inflationary pressure. Sometimes, the increase in demand may be

confined to some sector of the economy and this increase in

demand and the consequent rise in the price in a particular sector

may spread to other sectors Suppose the demand for agricultural

goods rises because of inadequate supplies of' these goods. There

would be a consequent rise in the price' of agricultural goods. Thus,

the rise in prices spreads to all other sectors in the economy,

through rise in the prices of raw materials and wages. The rise in

prices in the agricultural sector may push up prices in the industrial

sector. Therefore, the inflationary rise in the price level is due to

sectoral shifts in demand.

The "sectoral demand" emphasises the fact that prices are

highly flexible upwards but relatively rigid downwards, for example,

there may be rise in prices in the agricultural sector where there is

scarcity whereas price stability in the industrial sector where there ..

is an excess supply. However, in course of time, prices all over the

economy will assume an upward trend. The "sectoral demand" is

also useful to explain the simultaneous existence of inflation and

recession, i.e., inflation in some sectors and recession in certain

other sectors. Industries coming under inflationary pressure will

experience persistent rise in price but industries suffering from

recession may not experience a fall in the price level. Modern

economists have coined the word "Stagflation" to refer to this

situation in which stagnation in some sectors of the economy is

present while other sectors are subject to a highly inflationary

situation.

Other Classifications of Inflation

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

without any interruption. It may ultimately end into hyper-

inflation.

Suppressed inflation: Suppressed inflation refers to a situation

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in which price level is not allowed to rise with the use of price

controls and rationing, even though conditions exist for rise in

the price levcl. The price level may rise when the control

measures are lifted.

Suppressed inflation results in (a) postponement of present

demand to a future date (b) diversion of demand from one kind

of goods to another, i.e., from those goods which are subject to

price control. and rationing to those whose prices are

uncontrolled and non-rationed. Suppressed inflation has many

dangers. First, it creates administrative problems of controls

and rationing. Secondly, it leads to corruption of the price

control administration and risc of hlack IIlarkcls. Thirdly. it

CHllses 1I1leCOIIOlllic diversion of productive resources from

essential goods industries whose prices are· tixed or

controllable to those . industries whose products are less

essential but prices are uncontrollable.

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

rise in the price level, prices may be rising slowly and this is

referred as creeping inflation. In course of time, the rise in the

price level becomes more marked and alarming. This is

referred as running inflation. Ho.vcver, when the rise in the

price level is staggering and extremely rapid, it is often

referred to as galloping inflation or hyper-inflation, which a

country should avoid at all costs.

Consequences of Inflation on Production and Employment

Inflation affects both production and distribution of income in a

country. Inflationary rise in prices may not affect adversely the

production of national income. When all aV2.ilabk men and

materials are employed then the stock of real wealth in the form of

land and building is not diminished and the total real income or

output available for distribution between the different sections of

people remains the same. However, in course of time when inflation

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has gone beyond a certain limit, it may lead to reduction in

production and increase in unemployment due to the following

reasons:

Firms may find it profitable to hoard rather than produce

and sell

Agriculturists may refuse to sell their surplus stocks in the

hope of

getting higher prices

Production may be interrupted by bitter labour strikes.

Therefore, beyond a certain stage, surplus stocks accumulate,

profits decline and invcstmcnt. prodllClillll and incomc rail and

lIncmpl()ymcnll\l·i~l's.

On Distribution of Income

It is true that in times of general rise in the price level, if all groups

of prices, such as agricultural prices, industrial prices, prices of

minerals, wages, rent and profit rise in the same direction and by

the same extent, there will be no net effect on any section of people

in the community. For example, if the prices of goods and services,

which a worker quys rises by 50 per cent and if the wage of the

worker also rises by 50 per cent then there is no change in the real

income of the worker, i:e., his standard of living will remain

constant. However, in practice, all prices do not move in same

direction and- by saine percentage. Hence, some classes of reople

in the community are affected more favourably than others. This is

explained as follows:

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

gain during

inflation because of the emergence of windfall profits. The

prices of

goods rise at a far greater rate than costs of production

whereas wages,

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interest rates and insurance premium are all mere or less fixed.

Besides, the producers keep such assets, as commodities, real

estate, etc., whose prices rise much more than the general

level of prices. Thus, the producing and trading classes gain

enormously during an inflationary period. However, farmers

may gain only if their output is maintained or increased.

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

living on past savings, fixed rents, pensions and other fixed

income groups called as the middle classes. Those persons who

are working in government and private concerns find their

money incomes more or less fixed while the prices of the goods

and services, which they buy are rising very rapidly. Those with

absolui~ly fixed incomes derived from interest and rent-known

as the renter class, realise that their money income is

absolutely worthless and their past savings have insignificant

value in front of high prices. In fact, the worst sufferers in

inflation are the middle classes who are considered as the

backbone of any stable society.

Working Classe~: During inflation, the working classes also

suffer, firstly because wages do not rise as much as the prices

of those commodities and services, which the workers buy.

Secondly, there is also time lag between rise in th~.price level

and wages. However, these days, many groups of workers are

organised in trade unions and their wages rise simultaneously

with rise, in the cost of living. Therefore, it can be presumed

that organised workers may not suffer· much during inflation.

However, there are many grOlIl)S of workers who arc not

organised for example, the agricultural labourers, who find no

way of pushing up their wages in the face of rising prices and

cost of living.

Inflation, lilus, brings shi fts in the distribution of incomc hctwccn

di !Tcrellt sections of people. The producing classes such as

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agriculturists, manufacturers and traders gain at the expense of

salaried and working classes. The rich become richer and the poor

becomes poorer. Thus, there is a transfer of income from poor to

rich classes. Inflation, therefore, is unjust. Besides, those who are

hard hit by inflation are the young, old, widows and-small savers,

i.e., all those who are unable to protect themselves. But the most

unfortunate thing is that monetary arid fiscal authorities which are

entrusted with the task of maintaining price stability are often

responsible for creating inhltionary conditions, for example, a

country at war resorts to printing of currency notes as one of the

methods of financing war. Similarly, the government of a developing

economy may resort to deficit financing as . one of the methods of

financing development projects; In these cases, inflationary finance,

like taxation, brings in additional revenue to the public authorities.

However, taxation cannot destroy an economy except in rare cases

by eliminating whole groups of people. Inflation, on the other hand,

can destroy fixed income group, pauperise the middle classes and

destroy the very foundations of an economy. No wonder inflation

has been termed as "a species of taxation, cruellest of all" and

"open robbery". Inflation, particularly the hyperinflation of the

German type, will therefore endanger the very fow(jations of the

existing social and economic system. It will create a sense of

frustration distrust, injustice and discontent and may force people

to revolt against the government. It is, therefore, "economically

unsound, politically dangerous and morally indefensible". Therefore,

it should be avoided and even if it occurs it should be controlled.

Control of Inflation

Inflation should be controlled in the beginning stage, otherwise it

wiil take the shape of hyper-inflation which will completely run the

country. The different methods used to control inflation are known

as anti-inflationary measures. These measures attempt mainly at

reducing aggregate demand for goods and services on the basic

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assumption that inflationary rise in prices is due to an excess of

demand over a given supply of goods and services. Anti-inflationary

measures are of four types:

Monetary policy

Fiscal policy

Price controlnnd mtioning

Other methods

Monetary Policy

It is the policy of the central bank of the country, which is the

supreme monetary and banking authority in a country. The

central bank may use such methods as the bank rate, open

market operations, the reserve ratio and selective controls in

order to control the credit creation operation of commercial banks

and thus restrict the amounts of bank deposits in the country.

'this is known as tight money policy. .\ Monetary policy to control

inflation is based on the assumption that a rise in prices is due to

a larger demand for goods and services, which is the direct result

of expansion of bank credit. To the extent this is true, the central

bank's policy wi}1 be successful.

Fiscal Policy

It is the policy of a government with regard to taxation,

expenditure and public borrowing. It has a very important

influence on business and economic activity. Taxes determine the

size or the volume of disposable income in the hands of the

public. The proper tax policy to control inflation will avoid tax

cuts, introduce new taxes and raise the rates of existing taxes.

The purpose being to reduce the volume of purchasing power in

the hands of the public and thus reduces their demand. A

precisely similar effect will be achieved if voluntary or compulsory

savings are increased. Savings will reduce current demand for

goods and thus reduce the inflationary rise in prices.

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As an anti-inflationary measure, government expenditure

should be reduced. This .indicates that demand for goods and

services will be further reduced. This policy of increasing public

revenue through taxation and decreasing public expenditure is

known as surplus budgeting. However, there is one important

difficulty is this policy. It may be easy to increase revenue in times

of inflation when people have more money ineome !:Jut difficult to

reduce public expenditure. During war as well as during a period

of development expenditure it is absolutely impossible to reduce

the planned expenditure. If the government has already taken up

a scheme or a group of schemes, it is ruinous to give them up in

the middle.; Therefore, public expenditure cannot be used as an

anti-inflationary measure. Lastly, public debt, i.e., the debt of the

government may be managed in such a way that the supply of

money in the country may be controlled. The government should

avoid paying back any of its previous loans during inflation so as

to prevent an increase in the circulation of moneY: Moreover, ifthe

government manages to get a surplus budget it should be used to

cancel public debt held by the central bank. The result will be anti-

inflationary since money taken from the public and commercial

banks is being cancelled out and is removed from circulation. But

the problem is how to get abudgct surplus, \vhich is extremely

difficult, if not impossible.

Price Control and Rationing

This is the most important and effective method available during

war particularly oecause both monetary and fiscal policies are more

or less useless during this period. Price control implies the

establishment to legal upper limits beyond which prices of particular

goods should not risco The purpose of rationing, on the other hand,

is to distribute the goods in short supply in an equitable manner

among all people, irrespective of their wealth and social status.

Price control and rationing g.enerally go together. The chief

objection behind use of this method to fight inflation is that they

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restrict the freedom of the consumers and thus limit their welfare.

Besides, its success depends on administrative efficiency, which in

many underdeveloped countries is very low.

Other Methods

Another important anti-inflationary device is to increase the

supply of goods through either increased production or

imports. Production may be increased by shifting factors of

production from the production of less inflation sensitive

goods, which are in comparative abundance to the

production -of those goods which are in short supply and

which are inflation-sensitive~ Moreover, shortage of goods

internally may be relieved through imports of inflation

sensitive goods, either on credit or in exchange for export of

luxury goods and other non-essentials.

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

push inflation. It is suggested that wages, salaries and profit

margins should be controlled and fixed through a system of

income freeze. Business units may particularly welcome

wage freeze. However, wage freeze is not so easy or just,

unless trade unions agree to the proposal and there is also

freezing of prices. At the same time, the Government should

not raise the rates of commodity taxes. Thus, it is difficult to

control c'ost push inflation through controlling wages and

other incomes. The best method is to bring a rapid increase

in production, which will automatically check prices and

wages also.

Inflation in an: Underdeveloped Economy

Basically, inflation is supposed to occur after reaching the stage of

full employment, for till that stage is reached an increase in

effective demand and price level will,be fr)lowed by an increase in

output, income and employment. It is after the stage of fuli

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employment when all men are employed that a rise in the price

level will not be accompanied by an increase in production and

employment. Theoret.ically, therefore, it is not possible to imagine

an inflationary situation existing side by side with full employment.

It is in this context that the question of inflation in an under

developed country like India, which has both widespread

unemployment and underemployment is raised.

Bottleneck Inflation

It is interesting to observe that Keynes himself visualised the

possibility of an inflationary situation even before full employ·.lent

was reached. Such: a situation can arise even in advanced

countries, if there are difficulties in perfect G\lasticity of supply of

goods and services. It is possible that full employment is not

reached but even then, there is no scope for increased production.

The factors responsible for imperfect ela<;ticity of supply are law of

diminishing returns, absence of homogeneous factors and

unemployed resources, which cannot be used to increase

production. All these factors are lumped together and are known as

bottlenecks. As monetary demand increases with the increase in

money supply, supply of goods does not increase in proportion, due

to imperfect elasticity. The difficulties or handicaps, which prevent

supply from increasing in the face of rising demand, are known as

bottlenecks. The result is that the cost of production is pushed up

and price level is raised. Apart from these, other bottlenecks are as

follows:

Market imperfections' in underdeveloped countries, such as

imperfect knowledge on the part of producers and consumers,

mobility of factors, divisibility of factors and lack of

specialisation. All these are responsible f9r inefficient use of

resources. There is, thus, imperfect elasticity of supply in an

underdevelopeJ country.

Underdeveloped countries face shortage of technical labour,

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capital, equipment and transport and power facilities.

Therefore, these countries are unable to grow

becauserofthese.bottlenecks.

Unemployment and underemployment are extensively present

in an underdeveloped country. The existence of unemployment

in the advanced country helps increase' output, whenever

there is increased demand. However, this is not so in a country

like India with a large magnitude of disguised unemployment

and open unemployment. According to or.V.K.R.V. Rao,

disguised unemployment is not so resrollsive to an increase in

effective demand.

Underdeveloped countries generally have II high mnrginul

propensity to consume. or.Rao believes that this factor

prevents an increase in the supply of goods and services. For

instance, in the field of agriculture, increased production may

be _ consumed at home ~nd, therefor;-:, less may be

forthcoming to the market.

A special feature of underdeveloped countries is that a large

volume of primary production is exported. Therefore, the

supply available for home consumption is reduced. The

problem of inflationary rise in prices i~ worsened whenever the

income earned from exports is spent on domestiC goods and

not on imports.

Since World War II, many of the underdeveloped countries have

started resorting to extensive borrowing from the banks and

deficit fi.nrmcing with the idea of speed ing up economic

develop!nent. For one thing, much of this expenditure is on

social and ccor:omic overheads, such as education, transport

and powcr and on capital goods industries such as

development of iron and steel industry. This implies that there

is an increase in the production of consumption goods.

Therefore, the volume of purchasing power with the general'

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public is increased, resulting in increased demand for

consumption goods.

All these factors explain the existence of inflationary pressure in

all underdeveloped country, even though the stage of full

employment has not been' reached. The existence of bottlenecks

such as· shortage of technical know-how and scarcity of capital

equipment has worsened the various problems related to

underdeveloped countries. It is, therefore, correct to use th~

concept of inflation even in underdeveloped countries, provided we

remember the existence of special bottlenecks.

Deflation

I I' prices an; abnormally high, it is indeed desirable to have a fall in

prices. Such a fall in the price level is good for the community, as it

will not lead to a fall in the level of production or employment. The

process designed to reverse the inllationary trend in prices, without

creating unemployment, is generally known as disinflation. But if

prices fall from the level of full employment, then income and

employment will be adversely affected and this situation is termed

as deflation. The foll0wing Figure 6.1. shows if the price level

continues to rise even after the stage of full employment has been

reached, it is cnlled intlntiol\. Decline in prkt' level as a result of

anti-inl1ationary measures is known as disinflation. If prices litll

below 1'1111 OlllploYlIlt'lll. lho ~illlr,li\l11 i~ ~\nlh'd 11011,,111111.

Whllt' 11IC111lhlll IIIII,II\'~ excess demand over the avai lable

supply. uel1l1tion implies dcticiency of dcmand to lift what is

supplied. While inflation means rise in money incomes, deflation

stands for fall in money incomes.

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Effects of Deflation

The following are the adverse effects of deflation:

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

production, business activity and employment. During

deflation, prices fall due contracting demand for goods and

services. Fall in price results in losses' and sometimes forcing

many firms to go into liquidation. In the face of declining

demand for goods, firms arc forced to close down either

completely or leave part of their plants idle. Thus, production

of income is curtailed and unemployment is increased. 111is

is a serious defect of deflation, as compared to inflation in

which normally there may not be an adverse effect on

production and employment.

On distribution: Deflation adversely affects distribution of

income too. In the first place, producers, merchants and

speculators lose badly during this period because price~ of

their goods fall at a far greater rate than their costs, most of

which tend to be fixed or sticky. Besides, most of these people

are debtors who use borrowed funds in their businesses. They

have to repay their debts in money, which has now more value

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because of deflation. For some debtors, who do not have

adequate means to repay their loans had to go into liquidation.

Deflation implies fall in price level or rise in the value of

money: All those who have fixed incomes will be far better off

because their money income is fixed. In other words, the fixed

income groups will enjoy a rise in their real income. Therefore,

it is assumed that salaried persons and wage C<llners wi II

bcnefit by denatioll. Ilowcvcr, this is not completely true since

there is increasing unemployment. Therefore, only those who

are successful in keeping their jobs will be able to gain from

the rise in the value of money. As a matter of fact, during

deflation, there is great suffering and mystery all round and

millions of families are literally thrown onto the streets to make

their living through begging. The only group of people who

may really gain is that small minority, known as the renter

class who get their income by way of fixed interest and rents.

Methods of Control

Anti-deflation measures are the opposite of those, which are used to

combat inflation. Monetary policy aimed at controlling deflation

consists of using the discount rate, open-market operations and

other weapons of control available to the central bank of a country

to raise volume of credit of commercial banks. This policy is known

as cheap money policy. This is based on an idea that with the

increase in the volume of credit, there will be an increase in

investment, production and employment. However, monetary policy

is basically weak, for it assumes that the volume of credit can be

expanded by the central bank. This may not be so, because even

when commercial banks are prepared to lend more to businesses to

enable them to expand their investment, the latter may not be

willing to do so for fear of possible failure of their investments.

Fiscal policy to fight deflation is known as deficit financing, i.e.,

expenditure in excess of tax revenues. On one hand government

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attempts to reduce the level of taxation to provide large amount of

purchasing power with the public. While, on the 'other hand, the

government increases its expenditure on public work programmes

such as irrigation, construction of roads and railways. By this

programme government will (:I) provide employment for those who

may be thrown out of employment in the private sector, (b) add tei

national wealth, and (c) counteract the deficiency of private demand

for goods and services. The budget deficit can be financed through

borrowing from the public of their idle cash balances or banks. The

basic idea of fiscal policy is to expand demand for goods or to

counteract the decline in private demand. Therefore, fiscal policy is

the most important policy for economic stabilisation.

Other measures to control deflation include price support

programmes, i.e., to prevent prices from falling beyond certain

levels and lowering wage and other costs to bring adjustment

between price and cost of production. Price support programme has

been extensively used in the USA in recent years but it is very

difficult to carry it through. The government will have to fix the

prices below which the commodities will not be sold and undertake

to buy the surplus stocks" It is difficult for the government to secure

the necessary funds for such transactions as well as to devise ways

and means to dispose of the surplus stocks in other countries.

Therefore, the best solution for deflation is to have a ready

programme of public works to be implemented as and when

unemployment makes its appearance.

Compariso!between Inflation and Deflation

Inflation is rise in prices unaccompanied by increase in employment,

while deflation is fall in prices accompanied by increasing

unemployment. Inflation distorts the distribution of income between

different groups of people in' the country in such an unjust manner

that the rich gain at the expense of the poor. Deflation, on the other

hand, reduces national income through contraction of production

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and increas~ in unemployment.

Inflation is unjust and demoralising. Deflation, on the other hand,

inflicts on the people the harsh punishment of general

unemployment. There exist factories and mills on one hand and

workers ready to \';ork on the other hand, however, the whole team

remaining idle, on the other. Inflation at least implies that all factors

are employed in some way or the other. There is one more reason

why deflation is worse than inflation. Inflation can be controlled

except occasionally it gets out of control. However, deflation, if once

started, injects so much pessimism into businessmen and bankers

that it is highly difficult to control. However, there is nothing to

choose between the two and the proper objective should be to aim

at economic stabilisation at the level of full employment.

Inflationary and Deflationary Gaps

Keynes developed the concept of inflationary gap'. InfliJtionary gap

refers to, "excess of anticipated expenditures over the availahle

output al base pril'.c.~." Inflationary gap occurs when there is an

excess of demand over available supplies. Let us take a simple and

hypothetical example to illustrate the eme~gence of inflationary

gap.

During 'a period of war, the volume of money expenditure in a

country increases, because or" the government's expenditure on

the armed forces and armaments. Increased government

expenditure resulting in increased income with the community will

lead to increased consumption expenditure and investment. The

disposable income of the community, which constitutes aggregate

demand for goods and services, is as follows:

(Rs. Crores)

1. National income received during a given year:

20,000

2. Taxes paid to the government: 5,000

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3. Gross disposable income (I -2): 15,000

4. Saving by the community at 10% oft',e income: 1,500

5. Net disposable income with the community:

13,500

The net disposable income with the people represents aggregate

demand for goods and services ofa community. As against the

aggregate demand, the aggregate supply comes from gross

national product. However, not all output is available for the

community. The government diverts some resources such as food

grains, cloth, for war purposes, then the total output available for

civilian consumption is less than the gross national pro,duct (GNP).

For instance,

(Rs. CIJres)

1. National product (real income): 20,000

2. Appropriated for war purposes: 8,000

3. Available for civilian consumption: 12,000

Now the net disposable income, which the community will like to

spend is Rs. 13,500 crores but the available output for civilian

consumption is only Rs. 12,000 crores. There is excess of demand

o'Ver available supply ~') tne extent of Rs. 1,500 crores, which is

referred to as the inflationary gap. The basic fact is that so long as

the amount of disposable income with the people and the volume of

goods and services available for them are the same, there will be

price stability; but whcn thL~ forillcr is Illore' thnllthe lillieI', nn

i1t1llllinllllry lJ.lIp willllppc\;\r :ll\d IIIl' price level will rise; il~ 011 Ihe

olher hUlld. the volume of goods llnd services is InrgN 1111\11 lht'

VI""I1I\' Ill' dhl'".'lld"ll 1111'111111', "dI1lllllilllllll,\' gllp \\'ill i'l'llI'lll,

Though Keynes assoeialed un inflationary gap with war, we

cun I\lso spcak of inflationary gap during periods of economic

development Since 1951, India has undertaken economic

development, financed partly through created money. As a

result, there has been enormous increase in money expenditure

and money income but without a corresponding increase in the

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volume of consumptioll goods (part of the increase in production

has been in capital goods). Besides, there is a ~' time interval or

gap between investment and output of goods and services.

Naturally, there is excess demand resulting in inflationary

pressure on the general price level. Inflationary gap can be

illustrated by using the Keynesian concepts of aggregate

demand and aggregate supply, The following Figure 6.2 shows

the' inflationary gap.

In Figure 6.2, the horizontal axis represents volunie of income

and the vertical axis represents volume of total expenditure (C +

I + G). The 450 vertical axis represents equilibrium line of Y = E

and line C + I + G represents the total expenditure. At point E,

the economy is in equilibrium because at E the supply of goods

and services or real income (OY) is equal to the demand for them

at EY. Therefore, OY is' regarded as equilibrium income as well as

full employment income at current prices.

Suppose, the Government increases its expenditure either for war

or development purposes, by an amount equal to EA. Then the new

aggregate demand is shifted upwards and beco~es C' +' l' + G'. C'

of- l' -\- G' is parallel to C + r + G line by the amount MEA. The real

output (or income)remains constant at OY but the mOlletary

demand for this output is not EY but Y A, there is, thus. an excess of

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demand and equal. to.EA. EA, therefore, represents inflationary

gap, which is responsible for pushing up the price level.

Wiping out Inflationary Gap

The inflationary gap can be wiped out in various ways. Essentially, it

starts with additional expenditure by the government, which in turn

calls for additional expenditure by the community. Through

economy in government expenditure, the excess of aggregate

demand can be reduced. However, this is not always possible in

practice, as government expenditure cannot be cut down during

wartime or period of economic devdopment. To remove this

inflationary gap. various mtlhods can be adopted, such as:

There cun be a rise ill voluntary saving by the community.

The government may use the tax system to mop up the surplus

purchasing power with people; this will reduce C + I by the

same amount as the increase in government expenditure.

The output of goods and services may be increased so as to

absorb the excess demand. In Figure 6.2, such an increase in

real income should be YY1• But, as mentioned already, there is

no scope for such an increase in real income, as the economy

is already at full employment level.

Deflationary Gap

Deflationary gap is the opposite of inflationary gap. If the volume

of goods and services is larger than the aggregate demand for

them, a deflationary gap will arise. Deflationary gap arises when the

C + I of- G line is pushed down to C' + I' + G'. The decline in

demand may be because of reduction in government expenditure or

decline in private investment or fall in private consumption demand.

This is shown in Figure 6.3. OY, = Volume of real income available

for the community

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As regards wiping out the deflationary gap, the government

should increase its expenditures or help to raise the expenditure of

the general public. The government can raise its own expenditure

by investing in public works and financing them by borrowing from

banks. The expenditure of the community C + I can be raised by

reducing laxes and other incentives. If the C' + j' + G' is raised to

the original level then the deflationary gap will disappear.

Stagflation

Inflationary gap occurs when aggregate demands exceeds the

available supply and deflationary gap occurs when aggregate

demand is less than the available supply. These are two opposite

situations. However, we may show how deflationary forces follow

inflation, which has not been controlled. For instance, when inflation

goes unchecked for sometimes and priCes reach very high levels,

aggregate demand contracts and slumps follows. Consumption

demand (C) declines because of high price levels. The middle and

lower income groups have to curtail th<f" consumption of many of

the goods. Increase in private investment (I) does not take place

because investors are afraid of future and there is decline in

consumer demand at the height of inflation. In fact, the decline in

consumer demand and private investment will reinforce each other

and create a deflationary situation. Further, un excessive rise in the

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price 'level will affect exports adversely and thus create a slu1np in

the export industries as well. It is, thus, possible to visualise a

situation in which inflationary and deflationary pressures are

present simultaneously. The existence of an economic recession at

the height of inflation has been called as stagflation (stagnation +

inflation).

Trade Cycles '

Wesley C. Mitchell, a noted American authority 011 business cycles,

wrote: "Business cycles are a species of fluctuations in the economic

activities of organised communities." The adjective ,'business'

restricts the concept to fluctuations in the activities, which are

systematically conducted on commercial basis. The noun 'cycles'

bars out fluctuations, which do not recur with a measure of

regularity. Mitchell has, thus, described all the important features of

a business cycle admirably. According to him, features of trade

cycle are:

It occurs only in organised communities, which are

money economies.

Refers to fluctuations or changes in business

conditions.

Implies regular and periodical changes in business and

economic activities.

According to Keynes, "A trade cycle is composed of periods of

good trade characterised by rising prices and low unemployment

percentage, alternating with periods of bad trade characterised by

falling prices and high unemployment percentage. "

Characteristics of Trade Cycles

From the above definition, it should ,be clear that trade cy~les is

rhythmic fluctuations of the economy, that is, periods of prosperity

followed by periods of depression. However, the waves of prosperity

and depression need not always be of the same length and

amplitude. Further, trade cycles varied tremendously in magnitude.

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Whde some have smaller cyclical fluctuations in economic activity,

others have great intensity of fluctuations. Expansion in some

cycles reaches the full employment level and stays there. However,

in some cycles, the peak is reached even before full employment.

Sometimes, the cyclical fluctuations may be prolonged for one

reason or the other.

The American Economic Association emphasised the following

important characteristics of trade cycle:

Prices IInd production gencrnlly risc 01' 1111\ togctht.'r, Till'

C:\l'l:ptl(\l\ i~ agricultllre, where during 1I dowllwlIrd phllsc or

business ey(k~, ",h,'1\ prices are falling. (he agricullurists

may tend to produce more, so liS to onset the loss of lillling

prices 11I1l1 thus 11I1I1IIlH11I tht' SilIlI\: 11"\'c1 <If income.

The total output and employment Jluctuate by a larger

percentage in durable and capital goods industries than in

non-durable and consumption goods industries.

Large changes in total output, employment and the price

level are normally accompanied by large changes in

currency, credit and velocity of circulation of Illoney.

Prices of manufactures are comparatively rigid while prices of

agricultural goods are normally flexible.

Profits fluctuate by a much larger percentage than other types

of income.

Industries are so inter-connected that fluctuations in one will

be passed on to others also, Thus, cyclical fluctuations affect

all industries.

Cyclical fluctuations tend to be international, in the sense

that prosperity and depression spread from one country to

another through foreign trade,

Phases of a Trade Cycle

Every trade cycle is characterised by two main phases namely, the

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upward phase and the downward phase of'the trade cycle. These

two phases further have four or five different sub-phases, such as

depression, recovery, full employment, boom and recession. In

monetary terminology, the same phases . correspond to

depression, deflation, full employment, disinflation and deflation.

The following Figure 6.4 shows· the different stages· of a trade

cycle. FE represents the full employment line-it may be taken as the

dividing line. Above this line, there is business prosperity and boom

and below this line, there is business depression. As a trade eycle is

a continuous phenomenon, it is essential to break it som~where. It

is customary to start at the lowest point of the upward " phase,

namely, the depression.

Depression: During depression, the level of economic activity is

extremely low. The price level is low, profit margins do not exist,

firms incur losses and unemployment is high. Interests, wages

and profits are all low. While all sections in the economy suffer,

some suffer more than others do. For instance, the producers of

agricultural goods suffer badly because the prices of agricultural

goods fall the most during depression. This is due to inability of

the farmers to adjust their output according to the market

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demilnd, which is low. The worst hits are the working classes that

suffer heavily because of unemployment. The depression is thus,

a period of great suffering, low income and unemployment.

The phase of recovery: Depression gives place to recovery. There

is revival of business and economic activity. There is greater

demand for goods and services and consequently there is greater

production. Prices, wages, interests and profits all start rising.

Employment increases and so docs the national income. There is

increase in investment, bank loans and advances, velocity of

circulation of money due to more brisk tnide. Through multiplier

and acceleration effects, the economy is proceeding upward

steadily and rapidly. The process of revival and recovery becomes

cumulative. Increased receipts result in increased expenditure

causing further incrcasc in n:ceipts. which in turn, rcsult in further

increased expendllure and so on. The wave of recovery on'ce

initi"ted soon begins to feed upon itself.

The phase of full employment: The cumulative process of

recovery continues until the economy reaches full employment.

Full employment implies that all the available men arc employed.

The economy has reached the optimum level of economic

activity. During this phase, there is an allround economic stability

referring to stability of output, wages, prices and income. Wages,

interests and profits are high, output is highest with the given

technology and employment is maximum. There may be small

percentage of unemployment, but it is not of an involuntary type

but of voluntary and frictional type. The period of full employment

has become the usual goal of most national economic policies.

The phase of boom or inflation: The phase of recovery frequently

ends not in a stable state of full employment o~ prosperity but

further leads to a boom or inflation. Beyond the stage of full

employment, the rise in investment results in increas~d pressure

for the available men and materials and rise in wages and prices.

During this period, there is hectic activity going on everywhere in

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the economy such as new buildings come up, new factories are

commissioned and many new trades are started. In a matter of

weeks or months, full employment paves the way for overiiJlI

employment, i.e., a peculiar situation in which there are more

jobs than the available workers. Money wage rise, profits increase

and interest rates go up. The demand for bank credit increases

and there is all round optimism. At the same time, bottlen~.cks

begin to appear in the economy. Factors of production,

particularly' raw materials and labour becon~e scarce,

commanding higher prices and wages and thereby distort the

cost calculations of the entrepreneurs. They now realise that they

have overstepped the mark and become overcautious. Their over-

optimism paves way for their pessimism. Generally, the failure

·01' a firm or bank bursts boom and lead to recession.

Recession: The entrepreneurs realise their mistakes and find that

many of tht: ventures started in the rosy anticipation of the boom

are not profitable. The over oplimism of the boom gives way to

pessimism characterised by feelings of hesitation, doubt and fear.

Fresh enterprises are postponed for some remote future date and

those in hand are abandoned. Credit is suddenly curtailed sharply

as the banks are afraid of failure. Business l:xrnnsion stars.

order~; :1re cancelled and workers are laid off. Liquidity

preference suddenly rises and people pref~r to hoard rather thail

invest Building activity slows down and unemployment appears in

construction· industries. Unemployment spreads to other sectors

also because the multiplier effect begins to work in the downward

direction. Uncmployment leads to fall in income, expenditure,

prices, profits and industrial and trade activities. Panic prevai l~"

in the stock market and the prices of shares fall rapidly., Once

business and economic activity start declining, it becomes almost

difficult to stop this decline and finally ,ends in a hopeless

depression.

We have described the various phases of a trade cycle, but we

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should note, that all these phases rarely display smoothness and

regularity. The movement at times may be irregular in such a

manner that one phase may not easily follow the other. Nor is the

length of each phase by any means always defined. Thus it is quite

likely that a state of fairly stable business depression may lead to

recovery or it may decline to further recession, as was tlie case

with England in 1929. Similarly, a recovery may turn into a

recession without allo''/ing for either full employment or even

boom, as witnessed in the United States in J 937. Sometimes, the

depression may be unstable and recover very rapid. So, alsc at

times prosperity phase may be fairly stable as was the case during

the period between 1924 and 1929.

Some of the important features of various phases 'of a trade

cycle should be 0 emphasised here. They are important when we

have to evaluate the worth of different trade cycle theories.

The process of revival is generally very gradual but once it

picks up,

it becomes rapid.

The boom period of the trade' cycle is marked by high level of

business activity.

The crash of the boom is always sudden and sharp.

The downward trend of the trade cycle is rather very' rapid.

The depression period is prolonged and is painful because of

widespread unemployment.

Trade Cycle Theories

The complex phenomenon of a trade cycle has received the

gr,eatest attention from economist and there arc number of

theories Oil trade cyclc. The following theories on trade cycle are

as follows:

Monctary llnd Non-monctary Thcorics: Trade cycle theories

can he classified into monetary lInd nOIHllOnctnry theories. The

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forll\el' llll\phasbl's monetary factors as thc main cause for, while

the Ialler elllphnsis 1l1l!1IlIllm'lllr)' Ihe!ll),:-I, :-Illl'lI ll:ll'lilllillll'

l'lllltllllll'IIS. psyl'll\\hlgy \II' hIlSIIll'~~llh'll and innovations as, thc

main cause for the recurrence or econOllllC fluctuations.

Climatic Theory: The climatic theory is one of the oldest

theories of

tradc cycle. The climatic theory, also known as the sunspot

theory because the spots that appear, on the face of the sun

largely influence climatic conditions. A bad climate causes the

failure of harvests, which in turn lead:i to depression in

business conditions because of a fall in the incomc of" farmers

and consequent fall in their demand for the products of

industries, A good climate, on the contrary, has quite the

opposite effect on trade and industry. The variations of

climate are said to be so regular that periods of good harvest

are followed by periods of bad Ones and consequently booms

and slumps follow each other just as the days and nights, This

theory has been discarded in modern times. While it is difficult

to deny the fact that the prospects of agriculture affect the

pwspects of industries, it is not easy to correlate such a

complex phenomenon of trade cycle exclusively with the

climatic conditions. If the theory has to be correct, then it

should accept th"t trade cycles are less important in non-

agricultural areas and when a nation becomes more

completely industrialised, trade cycles would disappear or at

least diminish in importance. This, however, is not the case; in

fact, it is advanced countries, which seem to suffer most from

the trade cycles.

Psychological Theory: Pigou attempted to explain the trade

cycle with reference to the feeling of optimism and pessimism

among businessmen and bankers. Businessmen have their

moods. Sometimes they feel depressed and at· other times,

they are jubilant and optimistic. Despair, hopelessness as well

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as optimism are catching in nature. When 0ne businessman is

pessimistic, he passes it on to the others, similarly,. optimism

spreads 'from OIlC to another. Thus. lIccording 10 the

psychological thcory. industrial l1uctuations are thc outCOIllC

of" the waves or oplilllisl)/ among businessmen. Optimism

results in prosperity and - pessimism in recession and

depression. There is an element of truth in the psychological

theory in the sense that psychological waves of optimism and

pessimism do play an imp()rtant role ill trade cycles. But

busincss con !1dcncc or abSCIll"C of it is often the result

rather than the cause-ofbusiness conditions. Further, the

theory does /lot explain satisfactorily how depression starts or

a recovery begins.

Over-Investment Theory of Von Hayek and Others: Prof.Von

Hayek in his books "Monetary Theory and the Trade Cycle"

and "Prices and Production", has developed theory of business

cycles in terms of monetary over-investment and consequent

over-production. According to him. there is a "natural" or

equilibrium rate of interest at which the demand for loanable

funds is equal to the supply of funds through voluntary saving.

At the same time, there is also market rate of interest based

on demand for and supply of loanable funds in the market.

According to Hayek's thesis as long as the market rate of

interest is same as the natural rate of interest. there will hc

stahility ill husillcss cOlldiliolls alld allY dispilrity bctwcen the

two will lead to busincss Iluctuations. For instance, a fall in the

market rate of interest below the natural rate wililcad to more

investment and, therclore, an upward swing in business

activity. On the other hand, a rise in the market rate of

interest over the natural rate of interest will lead to a fall in

investment and, therefore, a downward swing in business

activity.

Now, the market rate of interest may fall below the natural rate

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of interest because money supply increase in excess of demand for

the same. The banks lending to entrepreneurs; through whom it

eventually reaches the consumers bring about this increase in

supply of money. The increased money supply is made available to

the entrepreneurs by lowering the market rate of interest. There is a

spurt of investment activity. More capital intensive methods of

production are adopted. The demand for capital goods naturally

increases and accordingly their prices go up. As a direct

consequence of this rise in the prices of capital goods there is a

diversion of resources from the production of consumption goods to

the production of capital goods resulting in the reduction of the

supply of consumer goods. But this situation cannot continue for

long, for increase in the production of capital goods and higher

prices for them will result in larger income for the factor owners

who, in turn, can normally be expected to increase their

consumption of goods. The demand for consumption goods will also

rise and their prices too will go up. There will now be a competition

between capital goods industries and consumption goods industries

for scarce resources. Naturally, the prices ofJactor series will go up,

raising the cost of production of capital goods industries. The profit

margins of capital goods industries will, therefore, become

unattractivc. At the same time the banking system decides to

reduce the rate of credit expansion by mising the market rate of

interest above the equilibrium rate, causing illvt'~;tment to (all

abruptly. Thus, on the one hand, investment is unattractive because

of lower yield, and on the other, investment is made more

expensive because of higher rate of interest. The business

expansion and boom brought about by IbW market rate of interest

and heavy investment activity crashes when the banking system

puts a stop to additiorlal lending to firms by raising the rate of

interest. Investment and production will decline and depression will

rise.

Hayek(basic thesis can now be summarised as follows.

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Alternating stages of prosperity and depression are due to

lengthening and shortening processes of production brought about

by a change in the money supply, which causes a change in the

market rate of interest away from the natural rate of interest. The

lengthening of the process of production is brought about by

increase in moncy supply, which causes the market rate of interest

to fall below the natural rate of interest. Shortening of the process

of production is brought about by a Lleel ine in the supply of bank

money, which raises the market rate of interest above the natural

rate of interest. Therefore, the failure of the banking system to keep

the supply of money constant is responsible for business cycles.

Therefore, to control cyclical fluctuations, Hayek's solution is simple,

i.e., to keep constant supply of bank money, making allowance for

such increases or decreases in the velocity of circulation of money.

Weaknesses of Hayek's Approach

According to Von Hayek, a low rate of interest and large bank

lending to entrepreneurs result into expansion of investment and

production whereas a high rate of interest puts a stop to this

expansion and brings about a depression. Hayek's theory is,

therefore, referred to as monetary over-investment theory of

business cycles. The basic weakness of Hayek's approach is its

emphasis on the rate of interest and complete neglect of real

factors such as technological changes and innovations inC'Juencing

the volume of investment. Further, according to Hayek, the sole

cause for change in the volume of investment is the change in the

market rate of interest relative to the equilibrium rate of interest. A

lower market rate of interest in relation to equilibrium rate of

interest induces entrepreneurs to adopt more :capital-

intensivep;1ethods of production, i.e., to change the capital-output

ratio. Hayek~;however, does not mention how investment is related

to consumer demand. Further more, the importance given to the

rate of interest by Hayek as the cause of change in the volume of

investment is also questioned. Keynes has shown that the rate of

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interest is not an important factor for determining the' volume of

investment.

Finally, critics do not accept Hayek's rcmedy. to the problem of

business cyclcs. Hayck suggests that the volume of money supply

should be kept neutral, so that business fluctuations may be

controlled. I r moncy supply is nol nClllml, investment will be either

encouraged (expansion of money) or cliscouraged (contraction of

money supply) and as a result there will be business fluctuations.

This is based on the old quantity theory of money, which does not

command general accepta'1ce .. Moreover, a change in the volume

of investment is not responsible for busines's fluctuations whereas

investment financed by involuntary savings or expansion of bank

credit is to be blamed for fluctuation.

Non-monetary Over-investment Theory

Some economists like Arthur Spiethofr and D.H. Robertson have

also subscribed to the over-investment theory but in a modified

form. Their approach is based on the assumption that Say's law of

markets, which oenies the possibility of overproduction, is valid in a

barter economy but not valid to a money economy in which

transactions are not direct but indirect through money.

Spiethoff believes that over-investment is a basic cause of

business slump but this is not due to low rate of interest or to

expansion of money supply, as Von Hayek has asserted. According

to Spiethoff, over-investment and over-production in one sector may

be passed on to others. For instance, during a business depression

there is excess capacity of durable capital goods. There will be no

investment in these or other related industries. When business

recovery starts, capital goods industries start expanding, and with

that other industries that serve capital goods industries also

expand. For example, expansion of iron and steel industry will lead

to expansion of coal, mining, manganese and transportation. When

these industries expand, income will increase and consequently

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demand for consumption goqds will also increase. The upswing

continues till the investment in all industries has reached the

optimum point and in certain lines of production, there is even over-

investment. This leads to the crash of boom conditions.

D.H. Robertson believes that over-investment in some industries

is the result of indivisibilities and this imbalance is worsened by the

banking system, which brings in more money. In his opinion, the

course of economic progress is not generally smooth and as a

malleI' of (act, some degree of fluctuations may be necessary. The

real problem, however, is that the desirable fluctuations may create

excessive responses creating unstable conditions in the economy.

Robertson believes that part of this excessive response is due to

existence of indivisibility in certain investments. He cites the

example of a railway company that faced the problem of congestion

on a single tmck, wanted to go 1'01' a double track. I'll,' introduction

of,i second track would create excess capacity but the additlull:l1

traffic Illa)' not he slIrticiclll 10 f,dly IItiiisc lill' secolld traele Ilo",('ver.

lilc rnilll':IY company has 110 allcllwlivL' hut 10 inll'tlducc Ihe

Sl'l'(lIHI ll'lll.'k. II\\'l'Slllll'l\IS h"il\~ lumpy in many hcavy capital-

intensive industries result in exceSs capacity. Besides such

investmcnts arc time-consuming because they have long gcst<ltiull

periods, i.e., time gap between the decision to undertake the project

and the time project is commissioned. Two problems are created as

a result of such investment. Firstly, undertaking heavy investment

in excessive of current demand would lead to blockage of capital

and undertaking smaller investment that would be insufficient to

meet the current demand. Secondly, in a competitive system, many

entrepreneurs may go in for investments with long gestation

periods' that rt:sult into over-investment, over-production and glut

of goods in the market.

While over-investment and over-production ale results of

indivisibilities. they are encouraged by monetary factors. For

instance, the banking system may plJCC additional volume of

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money at the disposal of entrepreneurs and thus increase the

already existing state of imbalance. Increase in money supply will

cause prices to rise, thereby misleading their appraisal of

prospective profits. This price rise encourages entrepreneurs to

further over-investment. Thus, D.H. Robertson successfully

combines real and monetary factors to explain business cycks.

Overinvestment theory has definite merit in the sense that the

business boom is identified by too much investment in general or

particular industries. TIllS IS largely true. However, the real

weakness of the theory is its failure to exp~ain revival from a

business depr~ssion.

Over-Saving or Under-Consumption Theory

This is one of the earliest theories of trade cycle and has been

stated in different forms at different times. Such "Yell-known names

as Malthus, Marx and Hobson are associated with this theory.

According to this theory, in free capitalist society rich people have

large incomes but they are unable to spend all their incomes and

hence they save automatically. These savings are usually invested

in industry and hence they increase the volume of goods produced.

At the same time, the majority of people in the country have low

incomes and consequently have low propensity to consume. Thus,

consumption is not increasing correspondingly to production. As a

result, the market is flooded with goods and will be followed

bY,depression unless prices fall to a very low level in order to allow

the goods to be carried oll the market. The fundamental idea of the

under-consumption theory is based upon the conflict, which arises

from the double effect, that saving has on consumption and

production. It is the decrease in the demand lor and the increase in

t.he supply of consumer goods as a res 'jlt of saving which seems to

create under-consumption and over-production.

Like all other theories of trade cycles, this theory too is not free

from defects. It does not explain complete trade cycle. It is pointed

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out that the theory concentrates too much on over-saving and its

related evils and too little on the others. It considers savings

automatically linding their way into investments while in reality this

is not so. The availability of savings does not guide entrepreneurs in

t!lt.:ir investment policies. Thus, a mere increase in savings is

insufficient to explain occurrence of a boom.

Hawtroy's Monetary Theory

Hawtrey regards trade cycle as a purely monetary phenomenon.

According to him, non-monetary factors like wars, earthquakes,

strikes and crop failures may cause partial and temporary

depression in particular sectors of an economy. However, these

non-monetary factors cannot cause full and permanent depression

involving general unemployment of the factors of production in a

trade cycle. On the other hand, changes in the flow of money are

the exclusive and sufficient cause of changes in trade cycle. In

Hawtrey's opinion, the basic cause of trade cycle is the expansion

and contraction of money in a country. According to Hawtrey,

changes in the volume of money are brought about by changes in

the rate of interest. For instance, if banks reduce their rate of

interest, producers and traders will be induced to borrow more from

banks so as to expand their business. Borrowing from banks will

lead to more bank money and rise in the price level and business

activity. On the other hand, if banks raise their rate of interest,

producers and traders will reduce their borrowing from banks. This

will reduce the price level and business activity. Thus, in Hawtrey's

analysis, changes in interest rates lead to changes in borrowing

from banks and, therefore, changes in the supply of money.

Changes in the supply of money lead to changes in 'Jusiness

activity.

Trade Cycle in Just Inflation and Deflation

f-Iawtrey argues that the trade cycle is nothing but small-scale

replica of an outright money inflation and deflation. The upward

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phase of a trade cycle, such as revival, prosperity and boom is

brought about by an expansion of money and bank credit and also

by increase in circulation of money supply. On the other hand, the

downward swing of money supply is nothing but a monetary

denatibn.

Expansion of bank loans is made possibk by fall in rute of

interest, which induces the merchants to' increase their stocks since

banks grants loan more liberally. Therefore, merchants begin to

place more orders and increase production by employing more

resources. There is greater demand for factors of production all

round and consequently higher income and employment leading to

further increased demand of goods. In course of time, a cumulative

upward trend is set in motion. As the volume of business expands

and factors of production arc rendered fully employed, prices rise

further and further induce upward business expansion. resulting in

inflationary conditions or boom conditions. However, the boom

crashes when the ba'lking authorities suspend their policy of credit

expansion.

Why the Boom Crashes Suddenly?

The banks suspend credit and call on the borrowers to return the

loans, ci'ther because banks have reached the maximum point

beyond which they cannot givc any more loans or they are afraid

that the phase of business expansion has reached a saturation point

and hence a downward trend may set in the immediate future. Now

the sudden suspension of credit facilities by the banks comes as a

shock to entrepreneurs and merchants. Until now entrepreneurs and

merchants were enjoying liberal policy of the banks and now,

contrary to their expectations, they receive sudden notices of

immediate call-back of loans to dispose of their stocks at any price

in order to repay bank loans. This general desire of businessmen to

dispose of their stocks will definitely depress the market and bring

down the prices. With every fall in prices, the desire to dispose of

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the stocks as quickly as possible wi!! lead to confusion and collapse

of the market. Marginal and average fimls may even go into liq-

uidation, thus worsening the position still further and making the

banks extremely nervous. Banks will proceed to further contraction

and like the period of expansion, it will become cumulative.

Producers curtail output and consumers' income and outlays

decrease and contraction spirals in a downward direction, until it

touches the lowest level possible.

How the revival takes place?

When the economy is working at the level of depression, the rate of

interest is low and the bank,....: have large cash reserves. On one

hand, low interest rates make it profitable to 'borrow and invest. On

the other hand, large cash reserves induce banks to lend. This starts

the phase of revival, which because of its cumulative character,

leads to prosperity and boom conditions. This, according to Hawtrey,

the inherently unstable nature of the modem monetary and credit

system is the mother or economic fluctuations. This monetary

explanation of the trade cycle has received powerful support from

Milton Freidman, who says, "In every deep depression, monetary

factors playa criticai role~" According to Freidman, there is a direct

relation between the volume of money supply and the level or

business activity in a country. If the money supply increases at a

rate faster than the economy's real output of goods and services,

prices will decline and the economy is bound to contract. Thus,

there is direct relation between the level of income and economic

activity, on the one side and the volume of money supply on the

other. If the 'economy has to be stable, monetary expansi9n and

contraction has to be avoided.

Weaknesses of the Monetary Expansion

The weakness of monetary expansion is as follows:

Finance is the soul of commerce and trade in modern times

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and the banking system plays quite an important part in

financing trade activities. However, it is correct to say that

banks cause business crises.

Hawtrey's theory would have been all right in those days

when the gold standard was universal and when the volume of

money supply was fixed to gold reserves. Currency and credit

could expand only when gold reserves increases. These days,

gold standard does not exist clnd, therefore, Hawtrey's theory

is really weak.

Borrowing and investment will not depend upon the rate of

interest, as Hawtrey believes. A high rate of interest will not

deter people· from borrowing for investment, and a low rate of

interest will always induce people to borrow and invest.

Expansion and contraction of money alone cannot explain

prosperity and depression.

According to Hawtrey, expansion and boon'! are the result of

expansion of bank credit, but it is pointed out that the mere

expansion of bank credit by itself cannot initiate a boom.

Further, according to Hawtrey, a depression is marked by

contraction of bank loans and advances but actually, the

contraction of bank credit is the ·result of depression. .

Lowering of interest rate and willingness of banks to - give

loans and advances cannot be a -sufficient reason to stimulate

the economy to revive. Businessmen will not borrow and invest

unless they are convinced that the economy will definitcly

I"cvivc 1I11d il will he prnntllbk to bOl'rnw Hnt! invest.

In recenl years, lhe technique \It' tinlllll:ing has been changing

illlLl practically all finns, both big and small, havc becn

resorting to the policy or ploughing back of profits. The

conclusion, which follows, is that the banking system can

accentuate a boom or a depression but it cannot originate one.

In other words, expansion and contraction of bank credit can

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be a supplementary cause but not the main cause of trade

cycles.

Keynes' Theory of Trade Cycles

Keynes never worked out a pure theory of trade cycles, though he

made significant contributions to the trade cycle theory. Keynes

states, "The trade cycle can be described and ana lysed in terms of

the fluctuations of the marginal efficiency of capital relatively to the

rate of interest." According to Keynes, the level of income and

employment in a capitalist economy depends upon effective

demand, comprising of total consumption and investment

expenditure. Changes in total expenditure will imply changes in

effective demand and will lead to changes fn income and

employment in the country. Therefore, in the Keynesian system

fluctuations in total expt(nditure are responsible for fluctuations in

business activity. Now, according to Keynes, consumption

expenditure is relatively stable, and consequently it is the

fluctuations in the volume of investment that are responsible for

changes in the level of employment, income and output.

Investment depends up0l) two factors: (a) marginal efficiency of

capital, and (b) the rate of interest. Investment is carried on up to

the point where the marginal efficiency of capital (the profitability of

capital) is equal to the rate of interest (i.e., the cost of borrowing

capital). Keynes argues that the rate of interest will depend upon

the liquidity preference of the people in the country and the

quantity of money available. In the short period, the rate of interest

will be stable and hence it is not responsible for causing cyclical

fluctuations in trade cycles. According to Keynes the fluctuations in

the marginal efficiency of capital are the fundamental cause of

fluctuation in trade cycles.

The following Figure 6.5 shows how trade cycle depends upon the

marginal efficiency of capital, which according to Keynes, is the

villain of the piece. The substance of Keynes' theory is that an initial

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investment outlay will generate multiplc amount of income and

employment under the int1uence of the multiplier and acceleration

effects. On the other hand, 'co;ntraction of investment will similarly

lead to multiple contractions of incom~and employment. But

whether a fresh investment will be Lindertaken will depend upon the

marginal efficiency of capital. We can explain these pOint$ a little

more elaborately.

How Recovery Starts?

Let us start at the bottom of a depression. At this point, the

marginal efficiency of capital will be high due to exhaustion of

accumulated stocks and necessity to replace capital goods. At the

same time, the rate of interest may be low because of large cash

balances with commercial banks or due to fall in the public liquidity

preference. As a result, the entrepreneurs may borrow fu~ds from

banks and make fresh investments. Under the impact of the

multiplier an<i acceleration effects, the process of increased

investment and employment gets an upward trend. There is heavy

economic activity everywhere in the primary, secondary and

tertiary sectors of the economic system. This sudden shoot in

investment activity gives rise to boom and as long as it lasts, the

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economic situution appears very easy and bright.

How the Boom Crashes?

The boom conditions thcmselves contain the very seeds;of their

own destruction. Very soon goods are accumulated beyond the

expectations of entrepreneurs and competition among them to

dispose their accumulated stocks bring crash in prices. While the

prices of finished goods are declining, their costs of production

continuously rise because factors of production are bceoming

scarce and hence are commanding hi,!~her prices. The· marginal

efficiency of capital is sandwiched between rising costs of

production-on the one side and falling prices of finished goods :In

the other. The marginal efficiency of capital, therefore, collapses

and brings about a crash in the investment market.

Ineffectiveness of the Rate of Interest

Keynes believes that the rate of interest could have prevented the

collapse of the marginal efficiency of the capital and revives the

confidence among the entrepreneurs, by exerting its pressure to

reduce cost. Uut then, the rate of interest is very high, like all

other prices and wages. The rate of interest goes up due to a rise

in the liquidity preference of the people. The marginal efficiency of

capital falls below the current rate of interest and thus, the decline

of investment is aggravated. Keynes believes that at this stage a

reduction in the rate of interest is neither easy nor adequate to

restore confidence and revive investment. In Keynes' theory of

trade cycles, the margina~ efficiency of capital has great

significance than the rate of interest. In fact, it disturbs the

equilibrium of the economy and thereby causes fluctuations in the

economy. The other factor that occupies an equally important

place in Keynes theory is the "investment multiplier". However, for

the active operation of investment multiplier, the cycle needs to be

milder in magnitude than what it actually is.

Weaknesses of the Keynesian Analysis

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Keynes' theory of the trade cycle has been regarded as quite

convincing since it explains cbm:ctly the cumulative processes,

both in the upswing as well as in the downswing. Besides, Keynes'

advocacy of fiscal policy to bring about business stability has been

widely used. However, critics have found some weaknesses in the

Keynesian analysis. First, according to Keynes, marginal efficiency

of capital is the most important factor that guides the investment

decisions of the entreprencurs. However, this important factor

depends on entrepreneurs' anticipation of future prospects that

further depend upon the psychology of investors. If'. such a .case,

Keynes' theory of trade cycles approaches close to Pigou's

psychological theory. Secondly, in Keynes' theory, the rate of

interest plays a minor role. Keynes expresses the opinion that

sizeable fall in the rate of interest can do something to. revive the

confidence among the entrepreneurs by exerting pressure on the

cost of production. However, Keynes himself has pointed out that

this has been sufficiently proved to be correct that the rate of

interest does not have any influence on investment. Thirdly, his

theory does not throw light on the periodicity aspect of the trade

cycle.

Finally, some critics like Hazlitt have pointed out that Keynes'

concept of the rate of interest does not tally with actual market

conditions. For instance, according to Keynes, in a period of

recession and depre~sion, the rate of ir:'erest ought to be high

because of strong liquidity preference but precisely during this

period, the rate of interest is low. Likewise during boom conditions,

the rate of interest ought to be lower because of the weak liquidity

preference among the people instead it is high.

Hicks' Theory of Trade Cycles

In his book "A Contribution to the Theory of the Trade Cycle," Hicks

has developed a theory mainly by combining the principles of the

'multipiier and acceleration, which he has borrowed from Keynes

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and has combined the concepts of autonomous and induced

investment, a distinction originally made by Roy Harrod. The

multiplier is related to the autonomous investment of the

Government. The acceleration principle is based on induced

investment.

The above Figure 6.6 shows the influence of the two types of

investment on the level of income and cyclical fluctuations. The

horizontal axis represents the number of years and the vertical axis

represents the level of economic activity. Line AA' represents the

progress of autonomous investment over thc years and it slants

upward at a uniform rate to indicate that autonomous investment

grows over time at a constant rate. Line EE' represents the income

(or output) corresponding to the aUlononious investment line AA·.

EE' IS at a higher level than AI\" because it rerresents the eomhined

innllellce of mllitiplk'r flnd flccelerrllioll effects n.~ n result

or ,lulollOlllllUS illvestl:lellt (AA '), III fact, the distallce bC1WL'Cil A/\'

lIlld EE' will depend upon the combined inlluence of the multiplier

and acceleration effects. Finally, line FF' represents the level of full

employment.

The Process of Cyclical Fluctuation

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Suppose the economy is at point P in the Figure 6,6 and at

this .point, a certain invention is introduced. As a result, there is

burst of autonomous investment, which may be short-lived. But the

induced investment will push output and employment upward along

the path marked PP1, away from the EE' line. Th,e upward trend

touches full employment ceiling at PI and cannot ~ise further. At

the most, the expansion can "creep along" the' ceiling but only for a

limited time. When the path has encountered the edling, it must

bounce off from it and begin to move in a downward direction.

According to Hicks, this downward swing is predictable. The

initial burst of autonomous investment is short-lived and after a

stagc, it will fall to the usual level. But the induced investment,

which was the result of the initial autonomous investment and the

initial increase in output, would continue and push ahead on path

PP1• But the induced investment is not sufficient to support a

growth of output along the path FF' but it is sufficient to support an

output which expands along the equilibrium path EE', Output,

therefore, will bounce back from FF' towards EE'.

The downward swing is gradual along the path P2RRI and rapid

along P2RR2. At first, the downward swing may appear. to be

gradual but, in practice, it will be rapid. The reason is that once

the decline in output is initiated, it gathers momentum and tends

to proceed at a fast rdte. Hicks give a monetary explanation to this

phenomenon. As the downward movement starts, it becomes

increasingly di fficult to sell goods and consequently the burden of

fixed cost becomcs oppressive. Therefore, firm after firm becomes

bankrupt and liquidity preference records a sudden and abrupt

rise and reacts most adversely on credit situation. At [he same

time the stringent conditions in the credit market, forces business

activity to fall to the lowest ebb and thereby aggravate the

situation. Thus, Hicks' theory of trade cycles makes use of

multiplier and acceleration principles, which are combined, to the

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fluctuations of autonomous and induced investment. It is induced

investment, which is finally rcsponsibleJor the upward push and

downward swing of output and income of prices and employment.

Schumpeter's Innovations Theory

Joseph Schumpeter has propounded a trade cycle theory in terms

of innovations. An innovation can be regarding new product or new

method of production, such as new machinery, new method of

organisation of factors of production, opening of a new market for

the product and development of new source of raw materials. In

other words, an innovation is anything that is introduced by a firm

or an industry to change the supply or demand conditions. An

innovation may be sufficient to cause changes in expectations of

entrepreneurs and their economic and business calculations.

These changes may cause the cost of production to change rapidly

and continuously and may shift the demand curve continuously in

such a manner that the final stage . becomes indeterminate. Any

innovation, thus, causes disequilibrium in the economic system,

making it necessary for the economic system to readjust itself at

some new equilibrium position. Thus, Schumpeter explains the un-

rhythmic movements of an economy by reference to innovations.

The Effect of Innovations

Suppose we start with an economy, which is functioning at full

employment level. Suppose an innovation in the form of a new

product has been introduced. The new industry will need to have

new plant and equipment. Since the economy is already working at

full employment level, the new plant and equipment required by

the new industry can be acquired only by withdrawing labour and

other resources from old industries. As a result of higher cost of

factor of production, the old industries will experience both an

increase in their cost of production as well as j~crease in their

output. The promoters of the new product will have to attract all f(!

ctors of production by offering higher rewarqs and the necessary

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finance may ,:i: 'me out of additional bank loans. Since the factors

of production, both in the new ;tl'd the old industries, are getting

higher money remuneration therefore, they will ',~( 'nand more

goods and services and consequently will push up prices, Thus,'ill

'<'::IS<:U ucmanu [or anu the simultaneous decreased supply of

the old goods will ~ It:"h upward the prices of these goods.

However, it is not necessary that the in 'case in the demand alld

costs of all industries should nec~ssarily be equal. The i l_:

industries, whose demand for products rises more rapidly than

production ~ lHS, will reap abnormal profits and consequently will

expand, To the extent the l (1',1 involved in such expansion is

financed by hank credit therefore. the i d1:qi"":1r\' I'I'I":'nll'l' "11

I'rk"'l <111.1 ,'\1';1.'1 i .. : Illt\gllilkd.

The Process of Rising Prices

When the new product introduced in the mark~, becomes

commercially successful and brings in profit for promoters, the rival

competing firms quickly introduce similar products and imitations.

The production of many competing varieties of products sets in

motion expansion in many related industries. Therefore, resulting

into a period of cumulative prosperity.

The Process of Falling Prices

The deflationary effect follows when the novelty of the innovation is

lost with the production of so many competing varieties or brands of

the S3me product. Abnormal profits are competed away. Some of

the firms may even incur losses and close down their businesses,

thus layoff labour and other agents of production. Therrfore, the

demand for goods is reduced. A similar deflationary effect is

experienced whcn the innovating firms return their bank loans out

of their profits and thus reduce the volume of money supply in the

economy. The "vicious circle of deflation" is generated in this

manner.

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Criticism

First, Schumpeter's theory is based upon two assumptions

regarding full employments of rf'sources in the economic system

and financing of innovation by means of bank loans. If an economy

is working below full employment, the introduction of an innovation

need not cause diversion of factors of production from older

industries and thus cause prices of goods to go up or their supply to

iecline. Again, innovation is generally financed by the promoter

themselves and hence, resort to bank .finance does not arise at all.

Secondly, innovation.s may be regarded as one cause for business

fluctuations but not the only cause, as there are many other causes

also. As Hayek correctly points out, innovations alone cannot

explain the phenomenon of trade cycles without a substantive

monetary explanation. We have described man;' theories of

business cycles and there are many morc. Therefore, none of the

theories provides a complete explanation of the causes of trade

cycles. The reason for this is that the trade cycle is not the result of

anyone single factor but is due to multiplicity of factors, of which

sometimes one and sometimes another becomes dominant.

Control of Trade Cycles

Thc trade cycle, which implies fluctuations in business activity, is

not beneficial to allY seetioll of a community. The period of

expansion is accompanied by large profits to producers and

speculators but it brings loss to lixcd income groups. The period of

depression is one of acute unemployment, poverty, suffering and

misery to the poor and of distress to the busin(;ss dass(;s as

a .result of exlensive hlltlk lIlId firms failures. Thus all sections of

people in a country, especially the working classes, are interested in

preventing and avoid ing busihess cycles .. On/ of the 1110st

important objectives of economic policy is the elimination of cyclical

fluctuations and attainment of stability at the level of full

employment. This has been, in fact, the main objective of both

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monetary and fiscal policies. We have already explained the use of

monetary policy and fiscal policy as wel'l as direct control, to check

inflations and deflations.

There is no full proof method for solving the problem of trade

cycles.

Karl Marx considered trade cycles as inevitable in a capitalist

system and the only rational method to solve the problem was to

throw it overboard and introduce a socialist economy. Like every

business firm prepares its annual balance sheet of transactions with

a view to know its assets and liabilities, every nation carrying out

economic transactions with foreign countries prepares its Balance of

Payment (BOP) Accounts periodically with a view to know stock of

its assets and liabilities and its receipts from and payments to the

rest of the world.

THE BALANCE OF PAYMENT

Definition

The balance of paYlllent is defined as a systematic record of all

economic transactions between the residents of a country and

reside~ts of foreign countries during a certain period of time.

Although the above definition of balance of payments is quite

revealing certain terms used in the definition may require some

clarification. The term's systematic record does not refer to any

particular system. However, the system generally adopted is double

entry book-keeping system. Economic transactions include all such

transactions that involve the transfer of title or ownership. While

some transactions involve physical transfer of goods, services,

assets and money along with the transfer of tille while other

transactions do not involve transfer of title. For example, suppose

that a subsidiary company of a foreign undertaking is operating in

India and 'making profit. This company may pay all its profits as

dividend to the shareholders abroad, or it may, alterilatively

reinvest its profit in India instead of paying dividends to its parent

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company abroad. Both kinds of transactions arc recorded in the

balance of payments accounts. The trnnsl'l'I' 01' titk is important

thlln lht: physi,l:l\llrl\nstl~r or rCSlHlr\:cs. The term residcnts rcfcr to

'the nationals of thc rcporting country, Tourists. diplllllll\t~;, IIlililmy

I'cr:lllllllcl, 11'llIlHlmry "lid llligrnllll)' IVllrl\l\I',~ 111111 Iii,' "n,,"·I,,'n

of foreign companies operating in the reporting clHllltr)' do not rail

in till' category or residents, Thc timc period for balance of

payments is not speci fically delincd. it can be of any period, The

generally period is one financial year of calendar.

Purpose

The balance of payment serves a very useful purpose as it yields

necessary information for the future policy formulation in regard to

domestic monetary and fiscal pulicies and foreign trade policy.

Following are the important uses of balance of payments:

It provides useful data for the economic analysis of country's

weakness and strength as a partner in the international trade.

By comparing the statements contained in the balance of

payments for several successive years, one can find out

whether international economic position of the country is

improving or deteriorating. In case it is deteriorating,

necessary corrective measures can be taken.

It reveals the changes in the composition and magnitude of

foreign trade. The changes that curb ~conomic well-being of

a country are taken care by the government.

It also pwvides indications of future repercussions based on

countries past trade performances. I f balance of payments

shows continuous and large deficits over time then it

indicates growing international indebtedness, which

ultimately leads to financial bankruptcy. Similarly. a

continuous large-scalc surplus in the balance of payments,

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particularly wht:n its magnitude goes beyond the absorption

capacity of the country indicates impending dangers of

inflation.

Detailed balance of payments accounts also reveal weak and

strong points in the country's foreign trade rdationsund

thereby invite gove.-I1ll1cnt attention to the need for

corrective measures against the weak spots.

Balance of Payments Accounts

The economic transactions between a country and the rest oCthe

world may be grouped under two broad categories:

1. Current transactions: Current transactions pertain to export

and import of goods and services that change the current

level of consumption in the country or bring a change in the

current level of national income.

2. Capital transactions: Capital transactions arc those

transactions, which increase or decrease counlry's Iota I stock

of capital, instead of affecting the current level of

consumption or national income. In other words, current

transactions arc flow transactions. In accordance with the two

kinds of transactions, balance of payments account is divided

into two major accounts:

A. Current account

B. Capital accounts

Current Account

The items, which are entered in the current account of balance of

payments, are listed in the Table. 6.4 -in the order of their

importance. The categories of items presented in the table were

published by the IMf and are currently followed in India. In the

'credit' column values receivable are entered and in 'debt' column

values payable ar.e entered. The net balance shows the excess of

credit over the debit for each item, can be negative (-) or positive

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(+). The items listed in current account can be further grouped into

visible and invisible items. Merchandise trade, i.e:, export and

imports of goods, fall under the visible items. Rest all other items in

the current account-payment and receipt for the services, such as

banking, insurance and shipping are termed as invisible. Sometimes

another category, i.e., un-required transfer, is created to give a

separate treatment to the items like gifts, donations, military aid,

and technical assistance. These are different from other invisible

items since they involve unilateral transfers.

The net balance on the visible items, i.e., the excess of

merchandise exports (Xg) over the merchandise imports (Mg) is

called as balance of trade. If Xg < Mg it is unfavourable. The overall

balance on the Current Account is known as 'Balance on Current

Account.' The 'Balance on the Current Account' either surplus or

deficit is carried over to the Capital Account.

. Table 6.4: Balance of Pa}'ments Current Account

Transactions Credit Debit Net BalanceI. Merchandise Export. Import -

2. Foreign travel Earnings Payments -

3. Transportation Earnings Payments -

4. Insurance Receipts Payments -(premium)

5. Investment Dividend Dividends -Income

6. Government Receipts Payments -

Cr;:rchase andsales of goodsand services)

7. Miscellaneous* Receipts Payments -

Current Account - Payments Surplus (+)Balance Deficit (-)

* Includes motion picture royalties, telephones and telegraph

services, consultancy fees, etc.

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Capital Account

As mentioned earlier, the items entered in the capital account of

balance of payments are those items, which affect the existing stock

of capital of the country. The broad categories of capital account

items are: (a) short-term capital movements; (b) long-term capital

movements; and (c) changes in the gold and exchange reserves.

Short-term capital movements include (i) purchase of shortterm

securities such as treasury. bills, commercial bills and acceptance

bills, etc.; (ii) speculative purchase of foreign currency; and (iii) cash

balances held by foreigners for suchfeasons as fear of war and

political instability. An item of short-term capital results often from

the net balances (positive or negative) in the Cljrrent Account. Long-

term capital movements include: (i) direct investment in shares,

bonds, real estate and physical assets such as plant, building and

equipments, in which investors hold a controlling power; (ii) portfolio

investments including all other stocks and bonds such as

government securities, securities of firms which do not entitle the

holder with a controlling power; and (iii) amortisation of capital, i.e.,

repurchase and resale of securities carlier sold to or purchased from

the foreigners. Direct export or import of capital goods fall under the

category of direct investment. It should be noted that export of

capital is a debit item whereas export of merchandise is a credit

item. Export of goods result in inflow of foreign currency, which is an

addition to the circular flow of money income, whereas export of

capital results in outflow of foreign exchange which, amounts to

withdrawal from the foreign exchange reserves. Geld and foreign

exchange reserves make the third major category of items in the

capital account. Gofd and foreign exchange reserves are maintained

to stabilise the exchange rate of the home currency and to make

payments to the creditors in case there exists payment deficits on

all other accounts.

Balance of Payments is always in Balances

The balance of payments accounting is based on the double-entry

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book-keeping system in which both sides of a transaction, i.e.,

receipts and payments are recorded. For example, exports involve

outtlow of goods and inflow of foreign currency. Similarly, imports in

volve inflo\\ of goods and outflow of foreign currency. Both, inflow

and outflow are recorded in this system. International borrowing

and lending give rise to credit to the lender and debit to the

borrower. Both are recorded in the balance of paymcnts. However,

donations, gifts, aids and assistance are unilateral transfers and do

not involve transfer of an equivalent value. In regard to these items,

there is only credit and no debit since they are nonrefundable. Yet,

the receiving country is debited to keep the record of nonrefundable

amounts and donator is credited for the record purposes. Such

entries have information value for non-economic purposes. Besides,

these transactions reduce the deficit in the current account of the

reporting country. Since in this system of balance of payments

accounting international transactions are entered on both debit and

credit sides. Balance of payments always balances from the

accounting point of view.

Disequilibrium in Balance of Payments

We have noted above that the balance-of payments is always in

balances from accounting point of view. Besides, in the accounting

procedure, a deficit in the current account is offset by a surplus in

capital account resulting from either borrowing from abroad or

running down the gold and foreign exchange reserves.

Similarly, a surplus in the current account is 011set by 1I

mlltdling Jl'licit in capital account resulting from loans llnd gills to

debtor country or by dcpklion (),' its gold and foreign exchange

reserves. In this sense also. lhe '11,lIallce (!I JlllYIJl!:lltS' 1IlwlI)'s

rcnlllills In hllllllll:C:. As :.udl. tbert' slllluid hc 1I11 qUC.Slll)11 1\1

disequilibrium in the balance of payments. However,

disequilibrium in lhe balall!:l: of payments does arise because

total receipts during the reference pl:riod need 1I0t be necessarily

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equal to the total payments. When total receipts do not m<lleh

with total payment of the accounting period, this is a position of

disequilibrium in the balance of payments. The final balance of

payments position is obtained in the manner described below.

For assessing the over-all balance of payments position, the total

receipt and total payments arising out of transfer of goods and

services and long-run capital ' movements are taken into account.

All the transactions are regrouped into autonomous and induced

transactions. Autonomous transactions take place on their own all

account of people's desire to consumc morl: or to makc a larger

profit. For example, export and imports of items in current account

are undcrtaken with a view to, make profit or consume more goods.

Another autonomous item in the current account is gift or

donations. They are voluntary and deliberate. In the capital account,

export and import of long-term capital are autonomous

transactions. In addition, the short-term capital movements

motivated by the desire

to invest abroad for higher return fall in the category of autonomous

transactions. Thus. all exports and imports of goods and services,

long-term and short-term capital movements motivated by the

desire to earn higher returns abroad or to give

gi fts and donation are the autonomous transactions. Exports and

imports take place irrespective of other trans~ctions included in the

balance of payments accounts. !-!ence, these are autonomous

transactions. If exports (Xg) equal imports (Mg) in value, there will

be no other transaction. However, if Xg is less than Mg, it leads

to short-run capital movements, e.g., international borrowing or

lending. Such international borrowings or lending are not undertaken

for their own sake, but for making payment for the deficit in the

balance of trade. Hence, these are called induced transactions. They

involve accommodating capital flows.

On the other hand, the short-term capital movemcnt's viz., gold

movemenls it and accommodating capital movements on accounts

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of thc autonomous transactions are induced transactions. These

transactions lead to reduction in the <, gold and foreign exchange

reserves of the country.

In the assessment of balance of payments position only autonomous

transactions are taken into account. The total receipt and payments

resulting from the autonomous transaction determine the deficit or

surplus in the balance of payments. I f total receipts and payments

arc unequal, the balance of payments is in disequilibrium. I I' the

total payments exceed the lotal receipts, the balance or payment

shows deficit. On the contrary, if receipts from autonomous

transactions exceed the payments for autonomous transactions, the

balance of payments is in surplus. Naturally, if both are equal, there

is neither deficit nor surplus, and the balance of payments is i~1

equilibrium. From the policy point of view, the depletion in the gold

and foreign exchange reserves is generally taken as an indicator of

balance of payments running into deficit, which is a matter of

concern for the government. However, if reserves are plentiful and

the government has adopted a deliberate policy to run it down, then

the deficit in the balance of payments is not an in he?lthy sign for

the economy. Besides, the disequilibrium of surplus nature except

the one that might cause inf1ation is not a serious matter as the

disequilibrium of deficit nature. We will be therefore, concerned

here mainly with the deficit kind of disequilibrium in the balance of

payments.

Causes and Kinds of BOP Disequilibrium

The deficit kind of disequilibrium in the balance of payments arises

when a country's autonomous payments exceed its autonomous

receipts. The autonomous payments arise out of imports of goods

and services and export of capital. Similarly, autonomous receipts

result from the merchandise exports and import of capital. It may

therefore be said that disequilibrium of deficit nature arises when

total imports exceed total exports. However, imports and exports do

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not determine themselves. The volume and value of imports and

exports are determined by a host of other factors. As regards the

determinants of imports, the total import of country depends upon

three factor: (i) internal demand for foreign goods, which largely

depends on the total purchasing power of the residents of the

importing country, (ii) the prices of imports and their domestic

substitutes, and (iii) people's preference for foreign goods. Similarly,

the total export of a country depends on (i) foreign demand for its

goods and services, (ii) competitiveness of its price and quality, and

(iii) exportable surplus.

Under static conditions, these factors remain constant.

Therefore, equilibrium in the balance of payments, once achieved,

remains stable. However, under dynamic conditions, factors that

determine imports and exports keep changing, sometimes gradually

but often violently and unexpectedly. The changes differ in their

duration and intensity from country to country and from time to

time. The changes, which occur as a result of disturbances ,in the

domestic economy and abroad, create conditions for dis-equilibrium

in the balance of payment.

Causes of Disequilibrium and the Associated Nature of

Imbalances

Price Changes and Disequilibrium: The first and the major

cause of disequilibrium in the balance of payment is the

change in the price level. Price changes may be inflationary or

deflationary. Deflation normally causes surplus in the balance

of payment. The balance of payments surplus does no! cause

a serious concern from the country's point of view. It may,

however lead to wasteful expenditure and mal-allocation of

resources. On he C1ther hand, inflrtionary changes in prices

causes deficits in the balance of payments. The balance of

payments deficit result in increased indebtedness, depletion

of gold reserves. loss of employment. and disfort:ons in the

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domestic economy and causes other economic problems in

the deficit countries. Therefore, we will discuss only the

impact of inflationary price changes on the balance of

payments position.

Inflation causes a change in the relative prices of imports and

exports. While exchange rate remains same, inflation causes

increase in imports because domestic prices become

relatively higher than the impo;L prices. On the other hand,

inflation leads to decrease in exports because of decrease in

foreign demand due to increase in domestic prices. The

increase in imports depends also 011 price-elasticity of

demand for imports in the home market and decrease in the

exports depends on the price-elasticity of foreign demand for

home-products. In case price-elasticity of imports and exports

is not equal to zero, imports are bound to exceed the exports.

As a result, there will be a deficit in the balance of payments.

If inflationary conditions perpetuate, it will produce long-run

disequilibrium. If the size of deficit is large and disequilibrium

is inflexible, it is termed as a fundamental disequjJibrium. The

price changes or fluctuations may be local, confined to one or

few countries or it may be global as it happened in the ec:(/y

1930s. If price fluctuations take the form of business cycle,

most countries face depression and inflation almost

simultaneously. Since economic size of the nations differs,

their imports are affected in varying degrees. Deficits and

surpluses in the balance of payment vary from moderate to

large. The countries with higher marginal propensity to import

accumulate larger deficits during inflationary phase of trade

cycle and a moderate deficit or even surplus, during

depression. Such disequilibrium is known as;;' cyclical

disequilibrium. This is however only a theoretical possibility.

Since little is known about the marginal propensities to

import, any generalisation would be unwise.

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Structural Changes and Dis-equilihriull1: Structural changes, in

an

economy arc caused by factors, such liS, (i) depletion orthe

cheap natural resources (ii) change in technology with which

a country is 110t in a position to keep pace, i.e., technology

lag and, (iii) change ill consulllers' !lIsle IInd preference. Such

changes incapacitate exporting countries and they lind it

difficult ,10 face competition in the intnnational market, due

toeither high cost of production or lack of foreign demand. To

quote the examples from P.T. ,Ellsworth the gradual

exhaustion of better coal in Great Britain resulted' in

increased cost of coal production despi!e improvement in

technology. This factor combined with labour problem

converted Great Britain from a net coal-exporting nation to a

net-importing one.

All such changes bring change in demand and supply

conditions. If size of foreign trade is fairly large, then the

balance of payments is adversely affected. The ultimate result

is disequilibrium in the balance of paym~nts. It is called

structural disequilibrium. The structural disequilibrium may

also originate from thc discovery of new resources, which may

invite foreign capital in a large measure. The large-scale

capital inflow may turn th~ balance of payments deficit into a

surplus.

Other Factors: In addition to the fundamental factors

responsible for disequilibrium in the balance of payments,

there are certain other factors, which may cause temporal

disequilibrium, Some of them are as follows:

Disturbances or crop failure particularly in the countries,

producing primary goods, for examplc, India.

Rapid growth in population leading to large-scale imports

of food materials.

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Ambitious developmen! projects requiring heavy imports

of technology, equipmenCs,machinery and technical know-

how.

Demonstration-effect of advanced countries on the

consumption patternof less developed countries.

Balance of Payments Adjustments

The short-term and small deficits in the balance of payments are

quite likely to cmcrge in wide range of international transactions.

These cleficits do not call for immediate corrective actions. More

importantly, irregular short-term changes in the domestic economic

policies with a view toremove the short-term deficit in the balance

of payments may do morc harms than good to the economy. Since

these changes cause dislocations in the process of reallocation of

resour'ces and short- Icrm lluctUlItiolls in the cconomy, Therefore,

short-term del1dts of snHllkr magnitude :lrc ,not II Ill:ltler or serious

COlleCI'll I'or the policy-nlllkers. 11()\\'rn·l. const:lllt delicil or 1:l1'p.

('1' 111:1p"llillllk h:,,~ n wide 1':1111<1' or I'ClII\(lInie nlld 11Itlili.'n l

implil:alions, i\ constant delicil indicates country turning inlo an

l'tl'I'I\III h(\I'I'\I\I ,'( or depiction of' its lim:ign exchange lint! gold

resnves. These countries los~ till'ir international liquidity and

credibility. This situation often leads to compromiSe with economic

and political independence of these countries. India faced a similar

situation in July 1990. Therefore, a country facing constant large

deficits in ih balance of payments is forced to adopt corrective

measures, such as changes in its internal economic policies for

wiping out the deficits, or at leasl to bring it l(l •• manageable size.

It is a widely accepted view that the conditions for an automatic

corrcctive mcchanism visualised under gold standard, bascd on

international pricemechanism do not exist. Therefore, the

government has no option but to intervene . ~ with the market

conditions of demand and supply with the policy measures available

(0 them. It should be borne in mind that policy-mix in this regard

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may vary from country to country and from time to time depending

on the prevailing economic conditions.

Measures used to Correct Deficits in Balance of Payments

The various measures used to correct deficits in balance of

payments are as follows:

Indirect measures to correct adverse BOP: Under free trade

system, the deficits in the balance of payments arise either

due to greater aggregate domestic demand for goods and

services than the total domestic supply of goods and services

or domestic prices are significantly higher than the foreign

prices. Thus, the deficit may be removed either by increasing

domestic production at an internationally comparable cost of

production or by reducing excess demand orby using the two

methods simultaneously. It may be very difficult to increase

the output in the short-run, specially when a country is close to

full-employment or when there ~re other limiting factors to its

industrial growth. Thcrcforl.:, thl.: only way to rcducl.: ddicil is I

to reduce the demand for foreign goods.

Income and Expenditure Policies: Here we discuss how

reduction in . income can lead to reduction in demand and

how it helps reducing the deficit in the balance of payments.

The t'.vo policy tools to change disposable income are

monetary llnd fiscal policies. Monetary policy operates on the

demand for and supply of money while fiscal policy operates

on the disppsable income of the people. The working and

efficacy on these policies as i,nstruments of solving balance of

payment problem is described below.

Monetary Policy

The instruments of mon~tary policy include discount 01" bank rate

policy, open market operations, statutory reserve ratios and

selective credit controls. Of these, first two instruments are adopted

in the context of balance of payment policy. This however should

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not mean that other instruments are not relevant. The government

is free to choose any or all of these instruments amI adopt them

simultttneously.

To solve the problem of deficit in the balance of payments, a

'tight maney policy' or 'dear money.p6Iicy' is ,idoptl:d. Under 'dear

money' policy, central Ilwlll:lar'y Clulil()ritics raise "[ilc discount rate.

Consequently, under nonna1 conditions, the demand 'for

institutional funds for investment decreases. With the fall in

investment and through its multiplier effect, income of the people

decreases. lf lnarginal propensity to consume is greater than zero,

demand for goods and services decreases. The decrease in demand

also implies a simultaneous decrease in imports while other things

remain same. This is how 'a tight money policy' corrects deficit in

balance of payments.

The effcacy of 'tig:,t money policy' is however doubtful under

following conditions: (i) when rates of returns are much higher than

the increased bank rate due to inflationary conditions, (ii) when

investors have already affected their investment in anticipation of

increase in the rate of interest. The tight money policy is then

combined with open market operation, i.e., sale of government

bonds and securities. These two instruments together help to

reduce demand for capital and other goods. Therefore, if all goes

well then the deficit in the balance of payments is bound to

decrease.

Fiscal Policy

Fiscal policy as a tool of income regulation includes vanatlon in

taxation and public expenditure. Taxation reduces household

disposable income. Direct taxes directly transfer the houseilOld

income to the public reserves while indirectlaxes serve the same

purpose through increased prices of the taxed commodities. Direct

taxes reduce personal savings directly in a greater amount while

indirect taxe~ do it in a relatively smaller amount. Taxation reduces

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the disposable income ofthe household and thereby the aggregate

demand including the demand for imports. Taxation also helps to

curtail investment by taxing capital at progressive rates.

The g~veinmeht can reduce income and demand also by

adopting the policy of surplus budgding in which the government

keeps its expenditure less than its revenue. Ll'~:>tion reduces

disposable income of household and public expenditure increases

household's income and their purchasing power. However,

multiplier effect of public expenditure is greater by one than the

multiolier effect of taxation. Therefore, while adopting surplus-

budget policy due consideration should be given to this fact. To

account for this fact, it is necessary that surplus is so largi.: that

the total cumulative effect of taxati?n on disposable income

exceeds the effect of public expenditure. The reduction in income

that will be necessary to achieve a certain given target of reducinG

balance of payments deficit depends on the rate foreign trade

multiplier. .

Exchange Depreciation and Devaluation

Reducing 'excess demand through price measures involves

changing relative prices of imports and exports. Relati';e prices of

imports and exports can be changed through exchange

depreciation and devaluation. Exchange depreciation refers to fall

in the value of home currency in terms of foreign currency and

devaluation refers to fall in the value of home currency in terms of

gold. However, ill terms of purchasing power, parity between

devaluation and depreciation turns out to be the same and its

impact on foreign demand is also the same. Therefore, we shall

consider them as one in their role of correcting adverse balance of

payments.

Devaluation and exchange depreciation change the relative

prices of imports and exports, i.e., import prices increase and

export prices decrease, though not necessarily in the proportion of

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devaluation. As a result of change in relative prices of exports and

imports, the demand for imports decreases in the country, which

devalues its currency and foreign demand for its goods increases

provided foreign demand for imports is price elastic. Thus, if

devaluation or exchange depreciation is· effective, imports will

decrease and exports will increase. Country's payments for imports

would decrease and export earnings would increase. This

ultimately decreases the deficits in the balance of payments in due

course of time. However, whether expected results of devaluation

or exchange depreciation are achieved or not depends on the

following condition5.

The most important condition in this regard is the Marshall-

Lerner conditidh. The Marshall-Lerner condition states that

devaluation will . improve the balance of payments only if the

sum of elasticises of home demand for imports and foreign

demand for exports is greater than unity. If (he sum of

elasticises is less than unity, the balance of payments can be

improved through revaluation instead of devaluation.

Devaluation can be successful only if the alTectcd countries do

nol devalue their currency in retaliation.

Devaluation must not change the cost-price structure in favour

of imports.

Finally, the government ensures that inflation. which may be

the result of deyaluation, is kept undcr control, so that the

effect of devaluatibn is not counter-balanced by the effect of

inflation.

Direct Measure: Exchange Control

The exchange control refers to a set of restrictions imposed on the

international transactions and payments, by the government or the

exchange cotHrol authority. Exchange control may be partial,

confined to only few kinds of transactions or payments, or total

covering all kinds of international transactions depending on the

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requirement of the country.

The main features of a full-fledged exchange control system are

as follows:

The government acquires, through the legislative

measures, a

Complete domination over the foreign exchange

transactions.

The government monopolises the purchase and sale of

foreign

exchange.

Law el iminates the sale and purchase of foreign exchange

by the

resid~nt individuals. Even holding foreign exchange

without informing the exchange control authority ;s

declared illegal.

All payments to the foreigners and receipts from them are

routed

through the exchange control authority or the authorised

agents.

Foreign exchange payments arc restricted, generally, to

the import

of essential goods and service such as food items, raw

materials, other essential industrial inputs like

petroleum products.

A system of rationing is adopted in the foreign exchange

allocation

for essential imports.

To ensure the effectiveness of the exchange control

system and to

prevent the possible evasion, strict, stringent laws like

FERA

and/COFEPOSA in India arc enactec.

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The circuitous legal procedure of acquiring

import amI export

licences is brought in force. In the process, the

convertibility of the

home-currency is sacri ficed.

Why Exchange Control?

The cxchange' control systcm as a mcasurc of' adjusting adverse

halance 01 plIYlllcnl diffcrs I'IldiclIlly (hllil lhe Indirect elHTt'di\'l'

nll'IISlIrl'·S. Wllik till" 1"lkl works through the markct forccs, the

fonncr works through a cOlllrol lIIechanism based on adhoc rules

and regulations. In contrast to the self-sustained and automatic

functioning of the market system, the exchange control requires a

cumbersome bureaucratic system of checks and controls. Yet,

many countries facing balance of payment deficits opt for

exchange control for lack of options. In fact, automatic adjustment

in the balance of payments requires the existence 0 I' thc

following conditions.

International competitive strength of the deficit countries.

A fairly high elasticity of demand for imports.

Perfectly competitive international market mechanism.

Absence of government intervention with the demand and

supply

conditions. .

The existence of these conditions has always been doubted.

Owing to differences in resource endowments technology, and the

level of industrial growth, countries differ in their economic

strength and their industries lack the competitiveness. The

protectionist policies adopted by various countries intervene with

international market mechanism. Besides, automatic method of

balance of payments adjustment requires a strict discipline,

economic strength and political will to bear the destabilising

shocks which the automatic method is expected to bring to a

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country in the process of adjustment. Since these conditions

rarely exist, the efficacy of internati'onal market mechUl1ism to

bring automatic balance of payments adjustment is orten

doubted.

For these reasons, exchange control remains the last resort for the

countries under severe str<lin of balancc or payments dclicits. The

e:-:ch:\llge contn)1 is qid to possess a superior effectiveness in

providing solutions to the deficit problem. Besides, it insulates an

economy against thc impact of eeonOl'nir. nlleluOItioliS i'1' "~I

foreign countries. Another positive advantage or exchange control

lies II' \lS cfrcctivcness in dealing with the problem or capital

movements. The governlllCnl'S I monopoly over the roreign

exchange can eflectively stop or reduce the eapit:li t"i movements

by simply refusing to release foreign exchange for capital transrcr.

Many countries, i.e., Germany, Denmark and Argentina, adopted

exchange control during 1930s because of this advantage. Although

the exchange control is positively a superior method of dealing with

disequilibrium in th~ balance of payments, it docs not pro' -ide a

perman<.:nt solution to the basic cau~es of deficit problem.

Exchange control may no doubt provide solution to balance of payment

deficits, but it also creates following problems:

When restrictions on exchange control becomes wide spread then

large number of currencies are rendered inconvertible. This restricts

foreign trade and the gains from foreign 1rade are either lost or

reduced to a minimum.

Even after the interest of an economy is secured, i.e., external deficit

is rCll1ov<.:d and insulation of e<.:onomy against external influence

is complete; the exchange-control countries instead of giving up

exchange control feel lITe to gear their int<.:rnal policks, monetary

and fiscal, towards the promotion of economic growth, a<.:hieving full

employment and its maintenance. In doing so, they adopt easy

monetary and promotional fiscal policies. Consequently, income and

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prices tend to rise, and inflationary trend is set in the economy.

Price also tends to rise, since in an insulted economy, import-

competing industries are not under compulsion to check cost

increases and to improve efficiency. As a result, exports become

relatively costlier and imports relatively cheaper and hence, exports

tend to shrink and imports tend to expand. These are the first

outcome of overvaluation of home-currency. The balance of payments

is no doubt maintained in equilibrium, but the init.ial advantage

gradually disappears.

The countries confronted with the problems arising out of exchange

control ,II'C forced to find new outlets for their exports and new sources of

imports. The dTorts in this direction give rise to bilateral trade· agreements

between the countries having common interest. The basic feature of the

bilateral trade ;Igreements is to accept each other's inconvertible currency

for exports and use the same Jor imports. Under the trade agreements, the

commodities and their quan~ilt'es or values should I also be specified.

Another outcome of exchange contr leading to bilateral trade agreement is

the emergence of disorderly cross cxcl ,anl',1.: r[lte~, i.e., the multiplicity of

inconsistent exchange rates. In other words, i .. IlIhl(;rii~)1<; currencies

have different exchange ratep betweeI: them. -

''l(in'illeonvertible currency has different exchange relation with the

countries .. ~ p,\ty to the bilateral trade agreement therefore, exchange

rates are not consis fent with each other. The multiplicity of inconsistent

exchange rates occom;;;s inevitable when countries having trade surplus

and deficits fix up official r;llt's frnlll timc to time dq1l'ndin!-,- nn their

requirelllents ,ll1d 1ll,Iintain it through arbitrary rules. Exchange rates

beconie multiple also because 'exchange arbitrage', i.e., the

simultaneous purchase and sale of exchange in di fferent markets,

becomes impossible.

Under the multiple exchange rate system, there may be a dual

exchange rate policy. In dual exchange rate policy, there is an

official rate for permissible private transactions and official

transactions and a market rate for all other kinds of transactions.

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However, the multiple exchange rate system has its own

shortcomings .. The system adds complexity and uncertainty to

international transactions. Besides, it requires efficient and honest

administrative machinery in the absence of which it often leads to

inefficient use of resources. It is, therefore, desirable for the deficit

countries to first evaluate the consequence:>, efficacy and

pract'::ability of exchanre control and then decide on the course of

action. It has been suggested that exchange control, if adopted,

should be moderate and as temporary measure until the basic

solution to the problems of balance of payments deficit is obtaired.

The exchange control problem does not provide permanent solution

to the balance-of-payments deficit and therefore, it should be

adopted only with proper understanding.

REVIEW QUESTIONS

I. What is the relevance of national income statistics in business

decisions?

2. What kinds of business decisions are influenced by the

change in national income?

3. Describe the various methods of measuring national income.

How is a method chosen for measurfng national income?

4. Distinguish between net-product method and factor-income

method.

Which of these methods is followed in India?

5. What is value-added? Explain the value-added method of

estimating national income.

6. Define inflation. Explain its effect on (a) total output, and (b)

distribution of income between, different economic classes.

7. What are the causes of price inflation? Is it inevitable in the

course of economic developm.ent?

8. What is an inflationary gap? Explain methods used to close

this gap.

9. Distinguish clearly between demand-pull, cost-push and

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sectoral infl~ltion.

10. "Inflation is unjust and in~quitable and deflation is

inexpedient." Discuss this statement fully.

11. What is meant by a trade cycle? Describe carefully the di

fTcrcnt phuses of a trade cycle.

12: Distinguish trade cycles from other economic fluctuations.

What, in your opinion; is the most adequate explanation of a

trade cycle?

13. Describe the various phases of the trade cycle. What courses

can the Government ~dopt to control a boom?

14. "T,he business cycle is purely a monetary phenomenon."

~iscuss.

15. Discuss the view that innovations alone cannot explain the

phenomenon of trade cycles without a substantial monetary

explanation.

16. Define balance of payments. If balances of payments always

balance, how is the deficit or surplus in balance of payments

known?

17. What are the causes of different kinds of disequilibrium in the

balance of payments? Suggest measure to correct an adverse

balance of payments.

18. What is the purpose of exchange control? Examine the

efficacy of exchange control as a measure to correct adverse

balance of payments.

19. What is meant by devaluation? What are the conditions for its

effectiveness as a corrective measure of un favourable

balance of payments?

20. What is the difference hetween balance of trade and balance

of payment?

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QUESTION PAPER

Paper 1.3: MANAGERIAL ECONOMICS

Time: 3 Hours Max. Ma

SECTION~A

(5 x 8 = 40)

Answer any Five questions

Note: All questions carry equal marks

1. What is Managerial Ecor.omics? How does it differ from

traditional ece

2. Give short note on "Demand Analysis".

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

and tot

4. What are the main features of pure competition? How does an

organisatil

its policies to a purely competitive situation?

5. Distinguish between the Pure Profit and opportunity Cost.

6. What is meant by Price discrimination? What are its objectives?

7. What is the difference between balance of trade and balance

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ofpaymCi

8. What is value-added? Explain the value-added method of

estimating Income.

SECTION -B

(4 x 15 = 60)

Answer any Four questions

9. Discuss some of the important economic concepts and

techniques busines~. management.

10. What are the advantages and limitations of large-scale

production', II. Distinguish between 'Production function' and

Cost filllc{ion', I iow \' dcvclop tllC production fUllction? Whlltun:

its uscs'!.

12. Explain the first and second order conditions of profit

maximization

13. Explain the effects of government interve.ntion in price fixation.

WI necessary to make this intervention effective?

14. "The Business Cycle is purely a monetary, phenomenon."

Discuss.

15. Define Inflation. Explain its effect on

(a) Total output

(b) Distribution of income between, different economic classes.

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