Managerial Economics

MANAGERIAL ECONOMICS
BY
Prof. Pradeep Datar
M.A. (Economics)
Published by
Symbiosis Center for Distance Learning,
Pune.
Symbiosis Center for Distance Learning (SCDL)
No part of this book may be reproduced or copied or transmitted in any form with
out prior permission of the publisher.
April 2004
PREFACE Dear Reader, This book on Managerial Economics is written to present a s

imple text to the students who have limited exposure to Economics and are pursui
ng a programme in management studies.The book is also designed to provide standa
rd reading materials especially for the students of M. B. A., M. M. M., C.A., Di
ploma and Degree Courses in Business Management. This book will satisfy the need
s of the students who are pursuing a Distance Learning Programme in management s
tudies. The book, I hope, would also help refresh the practicing managers. The b
ook mainly lays emphasis on the applied part of the principles of Economics. The
text of the book relies on standard works on the subject. I am deeply indebted
to my teachers as well as colleagues, for inspiring me to write this book. To ca
p it all, my special thanks to the Director and the respected staff of Symbiosis
Center for Distance Learning (SCDL) for their kind cooperation. Prof. Pradeep D
atar Pune. April, 2004
ABOUT THE AUTHOR The author of this book is a Lecturer in the Department of Econ
omics at S.P. College, Pune since 1980. He has written a few books on Economics
both in English and Marathi. He has also been associated as a visiting faculty a
t various management institutes in and around Pune. As a member of the visiting
faculty, he has been teaching a variety of subjects related to Economics, such a
s Managerial Economics at Master in Marketing Management Course., D. B. M.; Degr
ee in Hotel Management and Catering Technology; Economics of Labour at M.P.M., I
ndian Economic Environment at M.M.M. level etc. All these courses are affiliated
to Pune University. Furthermore, he has also worked as a visiting faculty at SI
MS, Pune; teaching Managerial Economics to PGDBM students and delivered lectures
on Monetary Economics to the students pursuing a course in M. A. Economics. The
author has judiciously used his wide academic experience, knowledge and observa
tion about the current economic affairs at Global and Indian level, to present u
pdated information which can immensely benefit the students pursuing a programme
in Management Studies. Mrs. Swati Chaudhari Director - S. C. D. L.
CONTENTS
Chapter No. 1 2 3 4 5 6 7 8 9 Introduction to Managerial Economics Types of busi
ness Organizations Profit Demand Analysis Production and Costs Pricing and outpu
t determination in different markets Cost- Benefit Analysis Macro Economic Analy
sis Government and Private Business Reference Book TITLE Page No. 1 17 65 83 141
185 257 285 319 351
Chapter 1
INTRODUCTION TO MANAGERIAL ECONOMICS
Preview Introduction, Definition of Managerial Economics, Nature and Scope of Ma
nagerial Economics, Significance of Managerial Economics, Economic Problem.
INTRODUCTION Managerial Economics generally refers to the integration of economi
c theory with business practice. While economics provides the tools which explai
n various concepts such as Demand, Supply, Price, Competition etc. Managerial Ec
onomics applies these tools to the management of business. In this sense, Manage
rial Economics is also understood to refer to business economics or applied econ
omics. Managerial Economics lies on the border line of management & economics. It
is a hybrid of two disciplines and it is primarily an applied branch of knowled
ge. Management deals with principles which help in decision making under uncerta
inly and improve effectiveness of organization. Economics on the other hand prov
ides a set of propositions for optimum allocation of scarce resources to achieve
the desired objectives. 1. 1. Definitions of Managerial Economics
Prof. Spencer Sigelman : Managerial Economics deals with integration of economic
theory with business practice for the purpose of facilitating decision making a
nd forward planning by management. Prof. Hague : Managerial Economics is concern
ed with using logic of economics, mathematics & statistics to provide effective
ways of thinking about business decision problems. Prof. Joel Dean : The purpose
of Managerial Economics is to show how economic analysis can be used in formulat
ing business polices.
2.
3.
Introduction to Managerial Economics
1
4.
Prof. Mansfield : Managerial Economics attempts to bridge the gap between the pur
ely analytical problems that intrigue many economic theories and the problems of
policies that the management must face. Mc Nair and Meriam : Managerial economic
s consists of the use of economic modes of thought to analyse business situation
s.
5.
The definitions given above highlight the following points : i) ii) iii) iv) v)
Economic theory provides the basis for the decision making process. There is som
e difference between the generalizations based on abstraction and actual practic
es. Besides economic theory, mathematics & statistics help in decision-making. A
n attempt is made to arrive at generalizations regarding business policies. Sinc
e decisions have repercussions on the working of firms in future, and most firms
envisage to continue operations over a period of time, forward planning becomes
an important element.
The problem of decision making arises whenever a number of alternatives are avai
lable For example : What should be the price of the product? What should be the
size of the plant to be installed? How many workers should be employed? What kin
d of training should be imparted to them? What is the optimal level of inventori
es of finished products, raw mater spare parts, etc.? The significance of a good
system of forward planning can be appreciated from the fact that it helps in se
lecting the plant to be installed and it is not possible to change its capacity
as and when required. Also different production process require different skills
which have to be provided. Similarly, based on the long-term plans, funds have
to be arranged : either procured from outside or retained out of the earnings of
the firm. Economics provides the solution to some of these problems to enable t
he firm to achieve its objective. For example, the demand for a product is influ
enced by factors such as (i) the distribution of income, (ii) prices of related
products, and (iii) data on demand at some future point of time facilitates the
task of forward planning. Similarly, the theoretical explanation of the problem
of input-mix (the ratio in which machines, men and other resources are to be emp
loyed) is provided by production function along with the prices of inputs. This
indirectly facilitates the choice regarding the technique of production to be em
ployed and the plant to be installed. 2
Managerial Economics
The propositions of economics, however, require to be modified keeping in mind t

he constraints of availability of requisite data and the time at the decision-ma
ker. 2. 1. Nature of Managerial Economics : It is true that managerial economics
aims at providing help in decision-making by firms. For this purpose, it draws
heavily on the propositions of micro economic theory. Note that micro economics
studies the phenomenon at the individuals level : behavior of individual consumer
s, firms. The concepts of micro economics used frequently in managerial economic
s are : (i) elasticity of demand, (ii) marginal cost, (iii) marginal revenue, (i
v) market structures and their significance in pricing policies, etc. Some of th
ese concepts, however, provide only the logical base and have to be modified in
practice. Micro economics assists firms in forecasting. Note that macro economic
theory studies the economy at the aggregative level and ignores the distinguish
ing features of individual observations. For example, macro economics indicates
the relationship between (i) the magnitude of investment and the level of nation
al income, (ii) the level of national income and the level of employment, (iii)
the level of consumption and the national income, etc. Therefore, the postulates
of macro economics can be used to identify the level of demand at some future p
oint in time, based on the relationship between the level of national income and
the demand for a particular product. For example, there is a relationship betwe
en the level of national income and demand for electric motors. Also, the demand
for durable goods such as refrigerators, air-conditioners, motor cars depends u
pon the level of national income. Managerial Economics is decidedly applied bran
ch of knowledge. There fore, the emphasis is laid on those propositions which ar
e likely to be useful to the management. Managerial Economics is prescriptive in
nature and character. It recommends that a thing should be done under alternati
ve conditions. For example, If the price of the synthetic yarn falls by 50%, it
may be desirable to increase its use in producing different types of textiles. T
hus, managerial economics is one of the normative sciences and reflects upon the
desirability or otherwise of the propositions. For example if the analysis sugg
ests that the benefit-cost ratio of a large plant is less than that for a smalle
r plant and the benefit-cost ratio is used as the criterion for project appraisa
l it is recommended that the firm should not install a large plant. Contrast thi
s with the positive sciences which state the propositions without commenting upo
n what should be done. For example, if the distribution of income has become mor
e uneven, it is stated without indicating what should be done to correct this ph
enomenon. Managerial Economics, to the extent that it uses economic thought, is
a science, but it is an applied science. Economic thought uses deductive logic (
if X is true, then Y is
2.
3.
4.
5.
3
true). For example, if the triangles are congruent, their angles are equal. To h
ave confidence in the findings, the propositions deduced are subjected to empiri
cal verification. For example, empirical studies try to verify whether cost curv
es faced by a firm are really Ushaped as suggested by the theory. Furthermore, t
here is an attempt to generalize the propositions which provide a predictive cha
racter. For example, empirical studies may suggest that for every 1% rise in exp
enditure on advertising, the demand for the product shall increase by 0.5%. From
the above it follows that managerial economics uses a scientific approach. In p
ractice, some firms may use simple rules based on past experience. However, the
quality of discussions made can be improved using a systematic approach. This is
attempted in managerial economics. 3. Scope of Managerial Economics :
The scope of Managerial Economics is so wide that it embraces almost all the pro
blems & areas of the manager and the firm. It deals with demand analysis and for
ecasting, production function, cost analysis, inventory management advertising p
rice system, resource allocation, capital budgeting etc. While an in-depth treat
ment is given to these aspects in the relevant chapters, a cursory treatment of
these aspects has been attempted here, merely to explain the scope of the subjec
t. 1.
Demand analysis and forecasting :
It analyses carefully and systematically the various types of demand which enabl
e the manager to arrive at a reasonable estimate of demand for products of his c
ompany. He takes into account such concepts as income elasticity and cross elast
icity. When demand is estimated, the manager does not stop at the stage of asses
sing the current demand but estimates future demand as well. This is what is mea
nt by demand forecasting.
2.
Production Function :
We know that resources are scarce and also have alternative uses. Inputs play a
vital role in the economics of production. The factors of production, otherwise
called inputs, may be combined in a particular way to yield the maximum output.
Alternatively, when the price of inputs shoot up, a firm is forced to work out a
combination of inputs so as to ensure that this combination becomes least cost
combination. In this way, the production function is pressed into service by man
agerial economics.
3.
Cost Analysis :
Cost analysis is yet another area studied by managerial economics. For instance,
determinants of cost, methods of estimating costs, the relationship between cos
t & output, the forecast of cost and profit-these are very vital to a firm. Mana
gerial Economics
4
touches these aspects of cost-analysis, an effective knowledge and application o

f which is cornerstone for the success of a firm. 4.
Inventory Management :
An inventory refers to stock of raw materials which a firm keeps. Now the proble
m is how much of the inventory is ideal stock. If it is high, capital is unprodu
ctively tied up, which might, if the stock of inventory is reduced, be used for
other productive purposes. On the other hand, if level of inventory is low, prod
uction will be hampered. Therefore, managerial economics will use such methods a
s ABC analysis, a simple simulation exercise and some mathematical models with a
view to minimize the inventory cost. It also goes deeper into such aspects as t
he need for inventory control; it classifies inventories and discusses the costs
of carrying them.
5.
Advertising :
It may sound strange when we say that advertising is an area which managerial ec
onomics embraces. While the copy, illustration, etc., of an advertisement are th
e responsibility of those who get it ready for the press, the problems of cost,
the methods of determining the total advertisement costs and budget, the measuri
ng of the economic effects of advertising these are the problems of the manager.
To produce a commodity is one thing; to market it is another. Yet the massage a
bout the product should reach the consumer before he thinks of buying it. Theref
ore, advertising forms an integral part of decision-making and forward planning.
6.
Price System :
It has already been pointed out that the pricing system as a concept was develop
ed by economics and it is widely used in managerial economics. The central funct
ions of an enterprise are not only production but pricing as well. While the cos
t of production has to be taken into account while pricing a commodity, a comple
te knowledge of the price system is quite essential to determination of price. F
or instance, an understanding of how a product has to be priced under different
kinds of competition, for different markets is essential to the pricing of those
commodities. An understanding of the pricing of a product under conditions of O
ligopoly is also essential. Pricing is actually guided by considerations of cost
plus pricing and the policies of public enterprises. Further, there is such a t
hing as price leadership and non-price competition. It is clear from these facts
that the price system touches upon several aspects of managerial economics and
aids or guides the manager to take valid and profitable decisions.
7.
Resources Allocation :
Scarce resources obviously have alternate uses. How best can these scarce resour
ces be allocated to competing needs? The aim, of course, is to achieve optimizat
ion. For
5
this purpose, some advanced tools, such as linear programming, are used to arriv
e at the best course of action for a specified end. Generally speaking, two kind
s of problems are of the utmost importance and concern to the manager. First, ho
w should he arrive at an optimum combination of inputs in order to get the maxim
um output? Secondly, when the prices of inputs increase, what type of sub-situat
ion should he resort to? Or, alternatively, what type of combination of inputs s
hould he work out in order to ensure the least-cost combination? 8.
Capital Budgeting :
This is another area which calls for a thorough understanding on the part of the
manager if he is to arrive at meaningful decisions. Capital is scarce, and it c
osts something. Now the problem is how to arrive at the cost of capital; how to
ensure that capital becomes rational; how to face up to budgeting problems; how
to arrive at investment decisions under conditions of uncertainty; how to effect
a cost-benefit analysis, etc. These areas cannot be ignored by any manager. It
is obvious form the foregoing discussion that managerial economics is applied ec
onomics. It makes use of the tools which have been developed not only be economi
cs but by other disciplines as well. The subject matter of managerial economics
covers two important areas, namely, decision-making and forward planning. These
two areas are essential to every stage of planning, production, marketing, etc.
Managerial economics, therefore, plays a vital role in the successful business o
perations of a firm.
Some other areas covered by Managerial Economics are : 1. 2. 3. 4. Linear progra
mming, its assumptions and solutions. Decision making under risk and uncertainty
. Profit planning and investment analysis. Sources of information on new project
s, methods of project appraisal, social benefit cost analysis etc. Significance
of Managerial Economics./ How Does Economics Contribute to Management?:
While performing his functions, a manager has to take a number of decisions in c
onformity with the goal of the firm. Many of the decisions are taken under the c
ondition of uncertainty and therefore involve risk. Uncertainty and risk arise m
ainly due to uncertain behaviour of the market forces, i.e. the demand and suppl
y, changing business environment, government policy, external influence on the d
omestic market and social and political changes in the country. The complexity o
f the modern business would add complexity to the business decision - making. Ho
wever, the degree of uncertainty and risk can be greatly reduced if market condi
tions could be predicted with a high degree of reliability.
6
Taking appropriate business decisions requires a clear understanding of the tech

nical and environmental conditions under which decisions are to be taken. Applic
ation of economic theories to explain and analyse the technical conditions and t
he economic environment in which a business undertaking operates contributes a g
ood deal to the rational decision-making. Economic theories have therefore gaine
d a wide application to the analysis of practical problems of business. With the
growing complexity of business environment, the usefulness of economic theory a
s a tool of analysis and its contribution to the process of decision- making has
been widely recognized. Prof. Baumol has pointed out three main contributions o
f economic theory to business economics. First, one of the most important things
which the economic (theories) can contribute to the management science is buildin
g analytical models which help in recognizing the structure of managerial proble
ms, eliminating the minor details which might obstruct decisionmaking, and in co
ncentrating on the main issue. Secondly, economic theory contributes to the busi
ness analysis a set of analytical methods which may not be directly applied to spe
cific business problems but they do enhance the analytical capabilities of the b
usiness analyst. Thirdly, economic theories offer clarity to the various concept
s used in business analysis, which enables the managers to avoid conceptual pitf
alls. 5. Economic Problem :
THE SOURCE OF ECONOMIC PROBLEMS Resources and scarcity The resources of a societ
y consist not only of the free gifts of nature, such as land, forests and minera
ls, but also of human capacity, both mental and physical, and of all sorts of ma
n-made aids to further production, such as tools, machinery and buildings. It is
sometimes useful to divide those resources into three main groups : 1. 2. 3. Al
l those free gifts of nature, such as land, forests, minerals, etc., commonly ca
lled natural resources and known to economists as LAND; All human resources, men
tal and physical, both inherited and acquired, which economists call LABOUR; and
All those man-made aids to further production, such as tools, machinery, plant
and equipment, including everything man-made which is not consumed for its own s
ake but is used in the process of making other goods and services, which economi
sts call CAPITAL.
These resources are called FACTORS OF PRPDUCTION because they are used in the pr
ocess of production. Often a fourth factor, ENTEPRENEURSHIP (from the French wor
d entrepreneur, meaning the one who undertakes tasks), is distinguished. The ent
repreneur is the one who
7
takes risks by introducing both new products and new ways of making old products
. He organizes the other factors of production and directs them along new lines.
(When it is not distinguished as a fourth factor, entrepreneurship is included
under labour.) The things that are produced by the factors of production are cal
led commodities. Commodities may be divided into goods and services : goods are
tangible, as are food grains, cars or shoes; services are intangible, as they ar
e valued because of the services they confer on their owners. A car, for example
, is valued because of the transportation that it provides and possibly also for
the flow of satisfaction because of the transportation that it provides and pos
sibly also for the flow of satisfaction the owner gets from displaying it as a s
tatus symbol. The total output of all commodities in one country over some perio
d, usually taken as a year, is called Gross National Product, or often just Nati
onal Product. In most societies goods and services are not regarded as desirable
in themselves; no great virtue is attached to piling them up endlessly in wareh
ouses, never to be consumed. Usually the end or goal that is desired is that ind
ividuals should have at least some of their wants satisfied. Goods and services
are thus regarded as means by which the goal of the satisfaction of wants may be
reached. The act of making goods and services is called production, and the act
of using these goods and services to satisfy wants is called consumption. Anyon
e who helps to produce goods or services is called a producer, and anyone who co
nsumes them to satisfy his or her wants is called a consumer. The wants that can
be satisfied by consuming goods and services may be regarded, for all practical
purposes in todays world, as insatiable. In relation to the known desires of ind
ividuals for such commodities as better food, clothing, housing, schooling, holi
days, hospital care and entertainments, the existing supply of resources is woef
ully inadequate. It can produce only a small fraction of the goods and services
that people desire. This gives rise to one of the basic economic problems : the
problem of scarcity. Every nations resources are insufficient to produce the quan
tities of goods and services that would be required to satisfy all of its citize
ns wants. Most of the problems of economics arise out of the use of scarce resour
ces to satisfy human wants. 6. Meaning of Economic Problem :
Now, if we put together the four characteristics namely, human wants are unlimit
ed, that human wants vary in their intensity, that means or resources are relati
vely limited, and they have alternative uses, but if used to satisfy one want, t
he same means cannot be used to satisfy any other want it becomes clear that eve
ry man begins to face the problem of economizing his means. The problem of econo
my is how to use the relatively limited resources
8
with alternative uses in the face of unlimited wants. Naturally, everyone will s
o try to use his relatively limited resources with alternative uses that he gets
maximum satisfaction out of his resources. In view of limited resources and unl
imited wants, he will try to satisfy those wants which are most urgent or intens
e and then those wants slightly less urgent and so on thus sacrificing the satis
faction of those wants which are lower on the scale of preference for which he m
ay not have resources. This is the problem of economy how to economics or make t
he maximum use of limited resources. In the light of the above situation, Lionel
Robbins writes : Economics is a science which studies human behavior as a relati
onship between ends and scarce means which have alternative uses. Economic Proble
m at the Family Level Almost in every community, family is the basic unit of soc
ial organization. Just as, every individual has to face the basic economic probl
em namely unlimited wants and limited means with alternative uses exactly in the
same way, every family, poor or rich, Indian, European and American, ancient or
modern, finds that it has unlimited wants (e.g. food grains, clothing, shelter,
education of children, medicines during sickness, insurance, tax-payment, guest
s, recreation, religious and social ceremonies, etc.) ; but the resources at its
disposal are relatively limited. Every family, poor or rich, therefore faces th
e basic economic problem how to make the best use of the limited resources so as
to secure maximum satisfaction out of them. The Indian family may be thinking i
n terms of Rs.5,000/- which may be its monthly income, whereas an average Americ
an family earning U.S. $ 5,000 a month may be thinking in terms of that as a fai
rly big amount. But as we have observed, each family in relation to its wants, f
inds that the resources at its disposal are limited, that they have alternative
uses and therefore the problem of economizing them must be faced. No family can
avoid this basic economic problem. Economic Problem at the Universal Level Or Ec
onomic Problem A Universal Problem The same basic economic problem unlimited wan
ts and relatively limited resources - arises at all levels of human organization
. Thus whether we are thinking of a Grampanchayat, or of Zilla Parishad, or of a
club or hospital or university or the national government, all have to face the
same basic economic problem. Thus whether it is the Government of India or the
Government of the richest country namely the United States, the problem of econo
my is always there. The Government of India with an annual revenue of about Rs.1
,00,000/- corers has innumerable demands on its resources such as meeting mounti
ng defense expenditure, expanding expenditure in respect of development that is
to be brought about in various sectors like agriculture, industries, transport,
education and so on and so forth, with no limit on its increasing wants. The Gov
ernment of India therefore continually faces
9
the basic problem of economy of how to make the best use of its limited resource
s. In the some way, the Federal Government of the United States, the richest gov
ernment, faces the same basic economic problem. Though in absolute terms, its an
nual revenues are enormous running into billions or trillions of dollars, its ne
eds are also unlimited expanding and modernizing defense forces, establishing mi
litary bases all over the world giving economic and military assistance to frien
dly countries, meeting expanding expenditure on space and military research, exp
loring oceans and so on and so forth. And therefore even the richest Government
of the United States is always confronted by the same basic economic problem unl
imited wants and limited resources with alternative uses. Every nation, poor or
rich, small or great, with small population or with huge population, has to face
this basic economic problem; no nation can ever escape it. Thus there is someth
ing universal about the problem of economy. The basic problem of economy arises in
the case of an aboriginal, a villager, a city dweller, in the case of the poor
as also the rich, in the case of an Indian, a Frenchman and an American, in the
case of associations like clubs, schools, hospitals and government organizations
right from the village level to the national level. The problem of economy was
there in ancient times and it is there before everybody at present. The problem
of economy unlimited wants and limited means with alternative uses has been fore
ver confronting mankind. The economic problem is a universal problem. Economic p
roblem does not recognize boundaries of caste, creed, colour , religion, culture
Basic Economic Problems Seven more general questions that must be faced in all
economies, whether they be capitalist, socialist or communist, & mixed are expla
ined below. 7. 1) Seven Questions faced by all economies : What commodities are
being produced and in what quantities? This question arises directly out of the
scarcity of resources. It concerns the allocation of scarce resources among alte
rnative uses (a shorter phrase, resource allocation, will often be used). The qu
estion What determines the allocation of resources or resource allocation? have oc
cupied economists since the earliest days of the subject. In free market economi
es, most decisions concerning the allocation of resources are made through the p
rice system. The study of how this system works is the major topic in the THEORY
OF PRICE. By what methods are these commodities produced? This question arises
because there is almost always more than one technically possible way in which g
oods and services can be produced. Agricultural goods, for example, can be produ
ced by farming
2)
10
a small quantity of land very intensively, using large quantities of fertilizer,

labour and machinery, or farming a large quantity of land extensively, using on
ly small quantities of fertilizer, labour and machinery. Both methods can be use
d to produce the same quantity of some good; one method is frugal with land but
uses larger quantities of other resources, whereas the other method uses large q
uantities of land but is frugal in its use of other resources. The same is true
of manufactured goods; it is usually possible to produce the same output by seve
ral different techniques, ranging from ones using a large quantity of labour and
only a few simple machines to ones using a large quantity of highly automated m
achines rather than another, and the consequences of these choices about product
ion methods, are topics in the THEORY OF PROCDUCTION. 3) How is societys output o
f goods and services divided among its members? Why can some individuals and gro
ups consume a large share of the national output while other individuals and gro
ups can consume only a small share? The superficial answer is because the former
earn large incomes while the latter earn small incomes. But this only pushes th
e question one stage back. Why do some individuals and groups earn large incomes
while others earn only small incomes? Economists wish to know why any particula
r division occurs in a free market society and what forces, including government
intervention, can cause it to change. Such questions have been of great concern
to economists since the beginning of the subject. These questions are the subje
ct of the THEORY OF DISTRIBUTION. When they speak of the division of the nationa
l product among any set of groups in the society, economists speak of THE DISTRI
BUTION OF INCOME. 4) How efficient is the societys production and distribution? T
his questions quite naturally arises out of question 1, 2 and 3. Having asked wh
at quantities of goods are produced, how they are produced and to whom they are
distributed, it is natural to go on to ask whether the production and distributi
on decisions are efficient. The concept of efficiency is quite distinct form the
concept of justice. The latter is a normative concept, and a just distribution
of the national product would be one that our value judgments told us was a good
or a desirable distribution. Efficiency and inefficiency are positive concepts.
Production is said to be inefficient if it would be possible to produce more of
at least one commodity without simultaneously producing less of any other by me
rely reallocating resources. The commodities that are produced are said to be in
efficiently distributed if it would be possible to redistribute them among the i
ndividuals in the society and make at least one person better off without simult
aneously making anyone worse off. Questions about the efficient of production an
d allocation belong to the branch of economic theory called WELFARE ECONOMICS.
11
Questions 1 to 4 are related to the allocation of resources and the distribution

of income and are intimately connected, in a market economy, to the way in whic
h the price system works. They are sometimes grouped under the general heading o
f MICRO ECONOMICS. 5) Are the countrys resources being fully utilized, or are som
e of them lying idle? We have already noted that the existing resources of any c
ounty are not sufficient to satisfy even the most pressing needs of all the indi
vidual consumers. Surely if resources are so scarce that there are not enough of
them to produce all of those commodities which are urgently required, there can
be no question of leaving idle any of the resources that are available. Yet one
of the most disturbing characteristics of free market economies is that such wa
ste sometimes occurs. When this happens the resources are said to be involuntari
ly unemployed (or, more simply, unemployed). Unemployed workers would like to ha
ve jobs, the factories in which they could work are available, the managers and
owners would like to be able to operate their factories, raw materials are avail
able in abundance, and the goods that could be produced by these resources are u
rgently required by individuals in the community. Yet, for some reason, nothing
happens : the workers stay unemployed, the factories lie idle and the raw materi
als remain unused. The cost of such periods of unemployment is felt both in term
s of the goods and services that could have been produced by the idle resources,
and in terms of the effects on people who are unable to find work for prolonged
periods of time. Why do market societys experiences such periods of involuntary
unemployment which are unwanted by virtually everyone in the society, and can su
ch unemployment be prevented from occurring in the future? These questions have
long concerned economists, and have been studied under the heading TRADE CYCLE T
HEORY. Their study was given renewed significance by the Great Depression of the
1930s. In the USA and the United Kingdom, for example, this unemployment was ne
ver less than one worker in ten, and it rose to a maximum of approximately one w
orker in four. This meant that, during the worst part of the depression, one qua
rter of these countries resources were lying involuntarily idle. A great advance
was made in the study of these phenomena with the publication in 1936 of the Gen
eral Theory of Employment, Interest and Money, by J. M. Keynes. This book, and t
he whole branch of economic theory that grew out of it, has greatly widened the
scope of economic theory and greatly added to our knowledge of the problems of u
nemployed resources. This branch of economics is called MACRO ECONOMICS. 6) Is t
he purchasing power of money and savings constant, or is it being eroded because
of inflation? The worlds economies have often experienced periods of prolonged a
nd rapid changes in price levels. Over the long swing of history, price levels h
ave sometimes risen and sometimes fallen. In recent decades, however, the course
of prices has almost always been upward. The 1970s, 1980s and 1990s saw a perio
d of
12
accelerating inflation in Europe, the United States and in most of the world, mo
re particularly in the less developed countries. Inflation reduces the purchasin
g power of money and savings. It is closely related to the amount of money in th
e economy. Money is the invention of human beings, not of nature, and the amount
in existence can be controlled by them. Economists ask many questions about the
causes and consequences of changes in the quantity of money and the effects of
such changes on the price level. They also ask about other causes of inflation.
7) Is the economys capacity to produce goods and services growing from year to ye
ar or is it remaining static? Why the capacity to produce grows rapidly in some
economies, slowly in others, and not at all in yet others is a critical problem
which has exercised the minds of some of the best economists since the time of A
dam Smith. Although a certain amount is now known in this field, a great deal re
mains to be discovered. Problems of this type are topics in the THEORTY OF ECONO
MIC GROWTH.
13
Exercise : 1. 2. 3. 4. 5. Define Managerial Economics. Explain the Nature and Sc

ope of Managerial Economics. What is the Significance of Marginal Economics? Wha
t is an economics problem? There is something Universal about and economic proble
m Discuss.
14
NOTES
15
NOTES
16
Chapter 2
TYPES OF BUSINESS ORGANISATIONS
Preview Introduction, A firm, plant, Industry, Types of Business organizations Proprietary Firms, Partnership Firms, Joint Stock Companies, Public Sector Unde
rtakings, Co-operative Societies ,Non-profit organizations, Business Organizatio
n in new millennium, Organization Goals Profit Maximization, sales Maximization,
Satisfying Theory, other goals or objectives of firms.
INTRODUCTION Organisation of production requires bringing together various facto
rs of production and coordinating the efforts of all the participants in the pro
cess of production. The level at which this is done is the level of a firm. Prod
uction with the profit motive is modern concept, in the sense that it has become
dominant only after the Industrial Revolution. Before the Industrial Revolution
, most of the economies of the world were agricultural economies. The profit mot
ive was always a secondary motive in an agricultural economy. But in modern time
s the profit motive became the only dominant motive of production. A firm is a u
nit of production where production is done with the sole aim of profit maximizat
ion. 1. Definition of a firm as a producing unit.
For the sake of understanding this concept of the firm, let us study some defini
tions of the firm given by eminent economists. 1. 2. 3. Hansn : The firm may be
defined as an independently administered business unit. "A firm is a centre of c
ontrol where the decisions about what to produce and how to produce are taken."
"A firm is a business unit which hires productive resources for the purpose of p
roducing goods and services."
Types of Business Organisations
17
4.
Harvey Leibenstein : A firm is " an independent organization whose destiny is de
termined by the magnitude of the aggregate pay off and in which the aggregate pa
y off depends directly on its performance and especially on the production and s
ale of services or goods." In the words of Prof. Lipsey, "The firm is defined as
the unit that uses factors of production to produce commodities that it then se
lls either to other firms, to households or to the central authorities (meaning
government, public agencies etc.) The firm is thus the unit that makes the decis
ions regarding the employment of factors of production and the output of commodi
ties." How much to consume is decided by the households. In keeping with prefere
nces of the consumers, the firms decide how much to produce, how to produce etc.
Through advertisements, a firm may try to increase its sales, but the decisions
to buy belong to the buyers. The decisions regarding choice of techniques and q
uantify of a commodity are taken by the firm. The firm is assumed to take consis
tent decisions in relation to the choice open to it. The internal problems regar
ding the process of decision - making i.e. who reaches decision, how are they re
ached etc. are ignored. We take firm as a single unit - smallest possible unit.
It is taken as our atom of behavior on the demand side. Again, just as the house
hold is assumed to seek satisfaction maximization, the firm is assumed to seek m
aximization of its profits. The firm may be a proprietorship firm or a partnersh
ip firm or a Multi-National Corporation. That it is a unit of decision - making
is our criterion. Therefore, for an economist, Tata Engineering and Locomotive C
ompany Ltd. is a firm. Again, what form of business organization and management
experts? An economist assumes that the firm is internally properly organized and
is capable of taking decisions.
5.
From the above definitions, it will be seen that there is a substantial differen
ce in all these definitions and still in their own way they describe the firm co
rrectly. This is so because these economists have given prominence to the questi
ons which were more important for them or for their country or when they were wr
iting, and so if we study the various features of firm as revealed by these defi
nitions, the concept will be more clear. The following features of a firm emerge
from these definitions: 1) It is a centre where decisions about what, where, ho
w and how much to produce are taken. It is a centre where the means of productio
n are hired or purchased and used for production. It is a centre, where the succ
ess of production is reviewed in its entire context and decisions are taken.
2) 3)
18
4)
It is a centre, where the means of production are collected, the production is d
one, and the sale and distribution of production is also affected. It is a centr
e, where all the decisions about production are taken. These include decisions r
egarding the distribution of the product, advertising, sale and those regarding
facing competition also.
5)
From the above features of a firm, it will be clear that a firm has to perform s
everal functions simultaneously - i.e. to produce a commodity, to sell and distr
ibute the commodity, to advertise the commodity and to perform all those things
which will be required to survive competition. To cap it all, the firm is expect
ed to make as much profits as possible. Theoretically speaking, a firm is expect
ed to organize all the factors of production in the most profitable manner. If o
ne studies the structure and function of modern firm the above definitions will
appear to be too simple, because in modern times the firm is expected to perform
so many other functions. Formerly, the entrepreneur was taken to be an independ
ent factor of production. Even today the entrepreneur is no doubt a very importa
nt factor of production but he has become so highly indispensable that it is ver
y difficult to separate him from the production unit of the firm because ultimat
ely the will to produce is provided by the entrepreneur. The mere presence of al
l the factors of production and a market does not guarantee production. The will
be to produce is very important and it cannot be separated from the entrepreneu
r. Thus, the entrepreneur becomes inseparable from the firm. 2. The firm and the
industry
For understanding the difference between a firm and an industry, it would be adv
isable to understand the nature of a competitive industry. A competitive industr
y has three basic characteristics: (a) Large number of firms, (b) Homogeneous pr
oduct; and (c) Freedom of entry and exit. In a competitive industry, there is a
large number of firms so that the action of a single firm has no effect on the p
rice and output of the whole industry. Every firm therefore enjoys the freedom t
o increase or decrease its output substantially by taking the price of the produ
ct as given. Secondly, every firm in a purely competitive industry, it must be m
aking a product which is accepted by customers as being identical with that made
by all the other producers in the industry. This is known as the condition of h
omogeneity. This ensures that all firms have to charge the same price. The buyer
s, of course, are to decide that the product is the same. The buyers should not
find any real or imaginary differences between the products sold by any two pair
s of firms, Finally, there should be no barriers to the entry of new firms (or e
xit of old firm) to (or from) the industry.
19
We considered competitive industry because we wanted to contrast such an industr

y with a monopoly. Under monopoly, there is only one firm producing a product. E
ntry into the industry is not free; because if entry of an additional firm is al
lowed, it no longer remains a monopoly. Thus, under monopoly, the firm is the in
dustry or the distinction between the firm and the industry disappears under con
ditions of monopoly. Between these two extremes, we get a wide range of marked s
tructures where there are more than one firms product. Strictly speaking, all fi
rms producing the same i.e. homogeneous product make an industry and whatever al
l such firms supply becomes the supply of the industry. In practice, however, we
speak of the cotton textile industry, though all cotton textile units do not pr
oduce identical textile products. Though the sugar produced by sugar factories m
ight have different grades of quality, we speak of one sugar industry. Similarly
, we speak of the automobile industry, steel industry, cement industry and so on
. It should, therefore, be clear that all firms, producing a given product, toge
ther make an industry. 3. The firm and the plant
A plant is a technical unit of a given capacity of output. For example, we speak
of sugar plant What is it? It is nothing but an assembly of several machines, l
inked together (not necessarily physically but by processes also) capable of pro
ducing a given quantity of sugar per day. There is, for example, a weighing syst
em which weighs the sugarcane, the conveyor system what takes the cane for crush
ing, the crushing machinery, and the machinery for removing impurities and so on
, until finally sugar is filled in gunny bags. This whole plant taken together i
s capable of producing a given quantity of one product sugar. A plant thus produ
ces any one product, obviously in cooperation with other factors of production.
A sugar plant will produce sugar in co-operation with workers, managers, technic
ians etc. and after the necessary amounts of raw material; other chemicals and f
uel are supplied to it. The firm, on the other hand, is an economic unit. The de
cisions are taken by the firm. What quality of sugar is to be produced, how much
of it is to be produced, to which market it should be sold and from which farme
rs the sugarcane should be purchased etc. are decisions to be taken by the firm.
It is not necessary that a firm has only one plant. Thus, for example, a sugar
factory (i.e. a firm engaged in the production of sugar) may have a sugar plant,
an alcohol plant (i.e. a distillery), a cattle - feed plant (producing cattle f
eed out of bagasse) - all under one management. When we say one management, we a
re implying one firm though there are various plants, it is also possible that a
plant supplies goods to more than one firms. The difference, basically, is that
between a technical unit and an economic unit.
20
One last word about a firm. We speak of the producer or the entrepreneur. Whenev
er we speak of a producer or an entrepreneur we imply a firm that takes decision
s. Internally the decisions might be taken by a group of directors, managers or
a sole proprietor - our unit on the supply side is the firm. 4. Types of Busines
s Organisations
Introduction:
A business organization is concerned with how production and sale of a commodity
are organized. In this chapter, we study various forms of business organization
.
l
Types of Business Organization :
The main types of business organization are as follows: i) ii) iii) iv) v) vi) v
ii) ix) A. One -man Business or Individual or Sole Proprietorship or Proprietary
Firms. Partnership Joint Stock Company Joint Hindu Family Firms Co-operative Or
ganizations State Enterprise/Public Enterprises Joint Sector Organizations Busin
ess Organizations of the New Millennium Private Sector :
viii) Non-Profit Organizations and
In a capitalist economy, the first four types of business organizations are set
up in the private sector. The private sector is owned by private individuals, fa
milies or groups of individuals. It is characterized by private ownership in the
means of production, economic freedoms and profit motive. In addition to the fi
rst three types of business organization, there are also Joint Hindu Family Firm
s in the private sector in India and Business Organizations of the New Millenniu
m. B. Public Sector :
The public sector includes public or state enterprises like railways, post sand
telegraphs, etc. The public sector is owned and controlled by the State. In Indi
a we have also a number of public enterprises like Hindustan Machine Tools, Life
Insurance Corporation, Bharat Heavy Electrical Ltd. etc. They are constituted a
s companies, public corporations and departmental undertakings.
21
C.
Co - operative Sector :
There are many co-operative organizations in the private sector. But they are no
n-capitalist in nature, e.g., Co-operative credit societies, consumers co-opera
tive societies, producers cooperative societies, service societies, etc. D. Joi
nt Sector :
Joint sector organizations or enterprises are jointly owned by the public and pr
ivate sectors. But day-today management is left to the private sector. The follo
wing chart indicates various forms of business organization: Types of Business O
rganization
Private Sector
Public Sector
Joint Sector
(7) State Enterprises
(8) Public Private Organizations
Capitalist Form
Non - Capitalist Form
1) Proprietary Firms 6) Co-operative or Proprietorship Organizations 2) Partners
hip 3) Joint-Stock Company 4) Joint-Hindu Family Firms 5) Business Organizations
of the New Millennium Let us now study the types of business organizations as g
iven in the above chart. 1. SOLE PROPRIETORSHIP OR PROPRIETARY FIRMS :
(A) Definition : Individual or sole proprietorship which is also called sole tra
der ship or single entrepreneurship or proprietary firms is the most common, the
simplest and the oldest form of business organization. In such a unit, a single
man called proprietor organizes a business. It is owned, managed, controlled an
d directed by him.
22
He fixes the amount of capital to be invested, (his own or borrowed), uses his o
wn labour and that of his family members, hires factors, whenever necessary, org
anizes production as efficiently as possible and markets the product at the high
est possible prices. He assumes full responsibility for all business risks. He a
lone enjoys all profits, if he is successful and suffers all losses, if his busi
ness fails. (B) Characteristics: The definition of sole proprietorship Proprieta
ry Firm gives its characteristics or features which are as follows: (i) Ownershi
p by a Single Person: A single person initiates a business whose ownership lies
in his hands. He enjoys full powers to fix the lay-out of his business firm. Org
anization and Control: A single person organizes and manages his business accord
ing to his experience and efficiency. He has full powers to conduct his business
in any manner he likes. He need not consult any one. He is also not required to
take approval or agreement from others.
(ii)
(iii) Capital: The owner uses his own capital. He may also borrow capital to inv
est it in his business and thereby expand it. (iv) No Sharing of Profits and Los
ses: All the profits of business earned by the owner are enjoyed by him alone. T
hese profits of business are not shared with other persons. On the other hand, i
f there are losses, he has to bear them alone entirely. Unlimited Liability: His
liability is unlimited for all his debts. If he fails to clear his business deb
ts, all his private property can be attached by his creditors. Easy to Form: It
can be easily set up. It is not subject to any special legislation. So no legal
formalities are involved in starting such a concern by any person who is of majo
r age, i.e. 18 years and above.
(v)
(vi)
(vii) Legal Status: A sole trading concern cannot be legally separated from its
owner or proprietor. The owner and organization are the same. The life of such a
concern depends upon the life of its proprietor. This type of organization is f
ound in agriculture, retail trade, hotel, printing press, tailoring etc.
(C) Merits and Demerits of Sole Proprietorship or Proprietary Firm :
MERITS OF PROPRIETORSHIP OR PROPRIETARY FIRM : (i) Easily Started: Such a concer
n can be easily started without any legal formalities. There is also little gove
rnment interference. Also it is simple to manage and control and
23
requires a small amount of capital for generally it adopts labour - intensive te

chniques. He can also get finance on personal credit. (ii) Prompt Action: The pr
oprietor can take quick decisions and prompt action regarding his business, its
location, method of production etc. He need not consult others about these probl
ems.
(iii) Personal Interest: He would always take personal interest in the business
with a view to finding out causes of loss and waste of resources. He would then
take measures to remove them. Thus he would maximize his profits. (iv) Requireme
nts of Consumers: He has direct contact with his customers, so he can personally
attend to all their requirements. He can produce goods according to their desir
es, tastes and needs. His attempts to meet their needs will help him to increase
his sales and profits. Thus it is suitable for small business. (v) Cordial Rela
tions: He has direct and continuous contact with his employees. So he can establ
ish cordial relations with them. This is because he will be in a continuous touc
h with them. He can also supervise them directly. Hence any scope for conflict b
etween workers and himself can be avoided.
(vi) Efficiency, Hard Work and Direct Gain: He will always attempt to work hard,
efficiently and continuously. This helps to enjoy maximum profits and avoid any
loss for his liability is unlimited. (vii) Business Secrecy : He can carry on h
is business in secrecy. He is not required to give publicity to the activities o
f his concern nor disclose his profits to the public. He can also make use of an
y new idea for his business. (viii) Winding Up: Just as a sole trader can easily
start a business, so also he may easily wind up his business at any time. (ix)
Economy in Expenses : Its overhead expense are low. Hence it is economical. The
number of employees employed by him is low. Hence the working expenses can be mi
nimized. (x) Flexibility and Elasticity : Any change in business can be easily i
ntroduced without consulting any body. So it is flexible and elastic. It can eas
ily and quickly adapt to changes in the market conditions.
(xi) Transferability : It is easily transferable to heirs. (xii) Self - Employme
nt : It promotes self-employment, self-reliance, development of one s personalit
y, self-confidence etc.
24
(xiii) Lower Tax Burden : It is also subject to lower tax burden than other form
s of business organizations. (xiv) Concentration of Wealth : It helps prevent co
ncentration of wealth and income in the hands of a few persons. DEMERITS OF PROP
RIETORSHIP OR PROPRIETARY FIRM : (i) Limited Capital : The amount of capital whi
ch an individual can command is limited. He has to depend mainly on his own savi
ngs. So it would be difficult for him to expand his business activities much. It
may also be difficult for him to raise additional capital by borrowing from ban
ks. Hence the size of his business is small. Unlimited Liability and Risks : It
may be very risky for him to invest in a particular business. This is because if
he adopts a wrong policy, he may lose everything and also become insolvent. Thi
s is because his liability is unlimited. This implies that if his debts exceed h
is business assets and if he suffers a loss, he will have to use his private pro
perty to clear his debts. So the unlimited liability restricts his business acti
vities.
(ii)
(iii) Lack of Skill for Efficient Management : It may not also be possible for h
im to attend personally to all the activities of his concern such as corresponde
nce, maintaining accounts, advertisements, supervision, arrangement of finance e
tc. He cannot undertake all activities alone efficiently. Further his business a
ctivities may be spread in different places and he may not possess all the quali
ties and skill required for an efficient management, supervision and control. (i
v) Limited Ability of Management : The limited managerial ability may make it di
fficult for a sole proprietor to face competition in his business which is subje
cted to many changes. (v) No Economies of Scale : A sole trader cannot secure ma
ny of the economies of large - scale production such as purchase of raw material
s at low prices, advantages of specialization etc., and minimize its cost of pro
duction or running business.
(vi) Weakness in Bargaining and Competition : On account of the limitations of c
apital, ability and skill, the proprietor is likely to remain weak in respect of
bargaining and competition. (vii) Wrong Decisions : All the decisions about his
business are taken by the sole proprietor. Some of his decisions may prove to b
e wrong. This may involve him in losses and ruin. (viii) Closure on Death : Such
a concern may be closed on the death of the proprietor. This is because he may
not have heirs to run it or they may not like to continue in his business. Hence
the business may not be continued.
25
2.
PARTNERSHIP :
(A) Definition and Meaning : The Indian Partnership Act, 1932, defines the partn
ership as "the relation between two or more persons who have agreed to share pro
fits of a business carried on by all or any one of them acting for all."
The English Partnership Act, 1890, defines partnership as "the relation which su
bsists between persons carrying on a business in common with a view to profit."
So a partnership refers to an organization owned and managed by two or more pers
ons. They pool their capital and undertake all risks associated with their busin
ess. Thus there is joint ownership, management, control and risk - taking. The p
ersons who own the partnership concern are called "partners" Collectively, all p
artners constitute a "firm".
(B) Characteristics or Features of a Partnership Firm :
(i) Contract : It is formed voluntarily by an agreement between two or more pers
ons carrying on a particular business for common benefit. It may also be formed
to carry on certain trade, profession or lawful occupation. Age Limit : Only per
sons who have attained the major status can become partners. In other words, min
ors cannot become partners.
(ii)
(iii) A Partnership Deed : A partnership is formally based upon a partnership de
ed or agreement. It indicates the names of partners, the shares of individual pa
rtners in the capital, their rights and duties, proportion for sharing profits a
nd losses by each of them etc. (iv) Registration : The registration of a partner
ship firm is voluntary. It may or may not be registered. However, if the partner
s so desire, it can be registered at any time. (v) Joint - Ownership : The partn
ers are joint owners of the property of the firm. Its property must be used only
for the business purpose for which the partnership was formed. It cannot be use
d by any partner for his personal purposes.
(vi) Joint - Management : All the partners enjoy equal rights of management. So
every partner can participate in management. But for the sake of convenience, a
single partner may be given right to manage the firm. (vii) No Remuneration : No
remuneration is paid to any partner for services rendered by him to the firm. E
ach partner is supposed to work in the best possible manner for promoting the in
terest of the firm.
26
(viii) Statutory Limit or Number of Partners : It consists of minimum two person

s and maximum 20 persons in the case of general business and maximum 10 persons
in the case of banking. (ix) Business Activity : Any business selected by the pa
rtners can be undertaken. All of them or any of them can carry on business activ
ity for all. (x) Sharing of Profit and Losses : There is a sharing of profits an
d losses. Profits can be distributed according to the partnership agreement or t
he capital ratio. Profit may be shared equally by partners, if nothing is mentio
ned in the partnership deed. A manager who is an employee of the firm may also b
e given a part of the profits.
(xi) Mutual Confidence and Faith : A partnership is based upon mutual confidence
and trust of partners in each other or one another. Every partner must be hones
t regarding the partnership dealings and should provide all the facts and inform
ation regarding their business to all partners. (xii) Combination of Capital, Ab
ilities and Skill : In a partnership firm, some offer capital, some management a
nd organizational abilities and others, technical skills etc. (xiii) Working and
Dormant Partners : Some of the partners who provide only capital, and enjoy lim
ited liability as in England are called Sleeping or Dormant or Special Partners
while others who run and manage the concern are called Active or Working or Gene
ral Partners. But, in India all partners have unlimited liability. (xiv) Unlimit
ed Liability : The liability of all partners is unlimited. Hence all partners ar
e, jointly and severally, held responsible for the losses or debts of the firm t
o the full extent of their personal assets. Creditors are entitled to attach ass
ets of any one partner or those of others so as to recover their dues. (xv) NonTransferability of Interest : A partner cannot transfer his powers or rights to
any third party to do any work of the firm on his behalf. If he cannot do it him
self, he has to retire from the partnership firm. However, a partner may admit a
nother person as a new partner if other partners give their consent. (xvi) Princ
iple of Agency : Every partner carries on business activities on behalf of the f
irm. So he binds the firm and other partners for every commitment that he makes
in conducting business. Likewise he is bound by the business activities of the o
ther partners. Thus every partner becomes a principal at one time and an agent o
f the firm at another time. Hence a partnership firm can be run by one or more p
artners acting on behalf of all partners.
27
(xvii)Dissolution : A partnership firm may not last long. It may be dissolved by

any partner after giving a written notice to other partners and a new partnersh
ip may be formed by the remaining partners. It may also be dissolved due to the
death of a partner or due to an adjudication of a partner as an insolvent. Such
partnership firms are found among builders, solicitors, chartered accountants, s
mall factories etc. (C) MERITS AND DEMERITS OF PARTNERSHIP : MERITS OF PARTNERSH
IP : (i) (ii) Easy to Form : A partnership firm can be easily formed. Its format
ion does not involve legal formalities. More or Additional Capital : Under the p
artnership, more funds can be raised by all partners to start a business on a la
rge scale. Because of the reputation of the partners and their contacts, it will
not be difficult for a partnership concern to borrow from banks on easy terms.
(iii) Greater Efficiency due to Division of Labour : There is a greater efficien
cy in the working of partnership concerns because different partners can be assi
gned those tasks for which they are best suited as per their qualifications, exp
erience, abilities, talents and aptitude. Thus, there would be specialization in
the task of every partner. (iv) Expansion of Business : A partnership firm can
expand its business by admitting more partners and raising more capital from the
m and thereby attempt to earn more profits. (v) Flexibility : It is also quite f
lexible and capable of adapting itself to changed circumstances of business by m
eans of quick decisions and prompt action by the partners, i.e. it can quickly a
dapt itself to change in demand for its product, by increasing and decreasing it
s business operations and by changing its business policy. Thus the organization
al structure of a partnership firm is flexible. The decision taking by a partner
ship firm does not involve any legal procedure. Its operations are not also subj
ect to any restriction by a government. (vi) Co-operation : It may elicit full c
o-operation from workers by keeping a close touch with them, by understanding an
d solving their difficulties. (vii) Advantages of Large-scale Production : It ca
n secure all the advantages of large scale production such as advantages of divi
sion of labour, bulk purchases of raw materials at lower price, best use of mach
inery etc. (viii) Business Secrecy : All the activities of partnership concerns
need not be given any publicity. Hence they can carry on their activities under
secrecy so far as the outsiders are concerned. It is not compulsory for a partne
rship concern to publish its profit and loss account and its balance sheet. Outs
iders are not given its business secrets. 28
(ix) Business Risks and Rewards : Business risks are equally shared by all the p
artners. In case business fails, they would suffer losses. But if it succeeds, t
hey will enjoy profits. Hence, they will try to manage it efficiently and make t
heir business profitable by putting the assets of the firm to the best uses so a
s to avoid waste. (x) Close Watch : Every partner has a right to take part in th
e partnership business. Since there is unlimited liability, every partner will k
eep a close watch on the activities of other partners so that losses are avoided
and profits are maximized. Thus the interest of every partner is protected.
(xi) Unlimited Liability : Since there is unlimited liability, the business stat
us of a partnership firm is raised. Hence it will be easy for it to get loans fr
om financers. (xii) Management and Organizational Abilities : In a partnership f
irm, there is a combination of capital, abilities and skill. Some partners offer
capital. Some partners are experts in management and organization. Some of them
possess technical skill. As a result of the pooling of the expert services of a
ll partners, it is possible to run a partnership firm efficiently. (xiii) Dissol
ution : In case a partner is not happy with the working of his partnership firm,
he can legally dissolve it. He can do so by giving a written notice to the othe
r partners indicating his decision to resign from it. (xiv) Mutual Consent : All
the business decisions are taken with mutual consent of all partners. They hold
mutual consultations and discussions on important matters. Thus every partner b
enefits form the advice of other partners. As a result, their wisdom is pooled f
or the benefit of the firm. DEMERITS OF PARTNERSHIP (i) Unlimited Liability and
No Risk Business : On account of the principle of unlimited liability, any bad o
r irresponsible partner may ruin all the partners. This is because his activitie
s will be binding on all other partners. Every partner runs a considerable risk
for any one of them is, jointly or severally, held responsible for the debts or
losses of the firm. Further due to unlimited liability, the partners may not und
ertake any risk in business or take any hasty step to expand business. Hence the
spirit of enterprise is checked. Limited on Size of Business : It is also diffi
cult to increase the size of business on account of limited amount of capital wh
ich the partners can raise or provide from their own sources. A partnership firm
cannot also admit more than 20 members for raising additional resources. This l
imitation on the number of partners restricts the growth of a partnership form.
(ii)
29
(iii) Short - Lived : A partnership can be dissolved by any partner by giving a

written notice to other partners. So this type of business is short-lived. Also
default, bankruptcy or insanity of any one of the partners leads to dissolution
of the firm unless a provision is made in the partnership deed to the contrary.
(iv) Non - Transferability : A share in a partnership firm cannot be transferred
by any partner without the consent of all the partners. He cannot also transfer
his powers or rights to any third party to do any work of the firm on his behal
f. (v) Differences of Opinion : The partners may not agree upon certain matters
of business policy. There might by differences of opinion, clashes of interest,
mistrust, disputes etc. Such differences among partners may result in dissolutio
n of partnership firms.
(vi) No Trust : The activities of a partnership firm are kept secret from outsid
ers. It is not required to publish its accounts. It is also not subject to legal
restrictions. Hence people may not fully trust a partnership concern. (vii) No
Government Control : There is no government control or supervision on the activi
ties of a partnership concern. Hence there is lack of public confidence in such
concerns. (viii) Leakage of Important Information : Some of the partners may lea
k important information to outsiders. This may happen when there are differences
of opinion among the partners. Hence it may be difficult to maintain business s
ecrecy in a partnership firm. (ix) Joint Liability and Dishonest Activities of S
ome Partners : The activities of a partner are binding on the partnership firm.
Some partners may not behave properly. Some of them may be dishonest. Hence they
may misuse their rights and bring the firm into difficulties and ruin its busin
ess. As a result, the honest and efficient partners will have to suffer losses.
3. JOINT - STOCK COMPANY :
Introduction : In a modern economy, the predominant form of business organizatio
n is the Joint - Stock Company which is called Corporation in the U. S. A. Such
form of business organization is necessary to undertake any business or industry
on a large scale. This is because it overcomes the drawbacks of sole proprietor
ship and partnership. (A) Definition : In the words of Mr. Kuchhal, a joint -sto
ck company is "an incorporated association which is an artificial legal person,
having independent legal entity, with a perpetual succession, a carrying a limit
ed liability." As per the Indian Companies Act of 1956, a joint - stock company
is a company which has a permanent paid-up or nominal share capital or a fixed a
mount of capital divided into shares held and transferable as stock by sharehold
ers who are its members. 30
Thus a joint-stock company is a voluntary incorporated association of shareholde

rs or stockholders who contribute to the common stock, (i.e., capital) of which
they are the owners. But all of them do not directly manage it. It is managed by
some directors elected by shareholders. Their liability is limited to the value
of shares held by them. They share in profits and losses.
(B) How Is It Formed ? : Minimum seven persons have to come together to start a
joint stock company. Those who take initiative to start it are called promoters.
The promoters of a company have to get it incorporated by filing with the Regis
trar of Companies various documents such as Memorandum of Association, Articles
of Association, Prospectus, List of Persons who have agreed to act as directors
etc. The Memorandum of Association : This gives information about the company, n
amely, its place of location, its objects, the amount of capital to be raised et
c. The Articles of Association : This gives us information about the rules and r
egulations and bye-laws of the company. The Registrar of Joint - Stock Companies
is given these documents. After going through these documents, the Registrar is
sues a Certificate of Incorporation. After this, the company comes into existenc
e.
Hence the registration of a joint - stock company is compulsory. (C) Features of
a Joint - Stock Company :
(i) Voluntary Organization : A joint - stock company is a voluntary organization
or association of shareholders. Legal Person : It is a legal or an artificial p
erson as a result of law. It has no physical existence. But it functions as a se
parate and independent legal person. It is distinct from its shareholders and it
s directors.
(ii)
(iii) Perpetual Succession : It has a perpetual or continuous succession under t
he law because it continues to exist even if some shareholders or directors die
or become insolvent or leave the company by transferring their shares. (iv) Comm
on Seal : It has a common seal to be affixed on its contracts and legal document
s. (v) Open Membership : Its membership is open to any person in any part of a c
ountry.
(vi) Limited Liability : Liability of shareholders is limited to the nominal val
ue of shares held by them.
31
(vii) Free Transferability of Shares : The shareholders are free to transfer or

sell their shares to any person. (viii) Management by Elected Board of Directors
: It is owned by its shareholders. But it is managed by a Board of Directors el
ected by shareholders. (ix) Fragmented Rights of Ownership : the shareholders en
joy a fragmented right of ownership due to shares purchased by them. (x) Dividen
ds : The profits of a joint - stock company are annually distributed as dividend
s among its shareholders.
(D) How is Capital Raised By a Joint Stock Company?:
(a) Methods of Raising Capital : A company raises its capital in two ways, namel
y, (i) (ii) Through the sale of shares or stocks and Through the sale of bonds o
r debentures.
Sale of shares of stocks (b) Types of Share Capital : A company divides its shar
e capital as : (i) (ii) Registered or Authorized Capital, Issued Capital and
(iii) Paid - up Capital. (i) (ii) Authorized Capital : Authorized Capital refers
to the maximum amount which can be raised by a company by selling shares. This
may be, say, Rs. 20 crores. Issued Capital : Issued Capital refers to that part
of the authorized capital which is issued to the public for subscription by divi
ding into shares. This may be, say, Rs. 16 crores.
(iii) Subscribed Capital : Subscribed Capital refers to that part of the issued
capital which is actually subscribed by the public. This may be say, Rs. 14 cror
es. (iv) Paid - up Capital : Paid - up Capital refers to that part of the subscr
ibed capital which the public directly pay-up to the company, as a part payment
of the value of their shares. This may be, say, Rs. 10 crores. The remaining amo
unt of the subscribed capital is paid after further calls from the company.
(c)
Types of Shares : The capital of a company can be divided into three types of sh
ares : (i) (ii) Equity or Ordinary Shares, Preference Shares and
(iii) Deferred Shares. 32
(i)
Equity or Ordinary Shares : Such shares form the main basis of the finance of a
company. The holders of such shares get dividend only after the preference share
holders are paid out of its profits. Hence they bear maximum risk. This is becau
se they do not get any dividend if the company does not make any profit. At time
s when profits are high, they get much more than the rate of dividend paid to pr
eference shareholders. The ordinary shareholders have the right to vote to elect
the Board of Directors of the Company. They have also the right to vote on poli
cy decisions of the company. Hence they control the affairs of their company.
(ii)
Preference Shares : These shareholders enjoy a preferential or prior right over
equity shareholders to the profit of a company. They are entitled to a fixed rat
e of dividend after paying interest on debentures and before any dividend is pai
d to equity shareholders. However, preference shares are classified as : (a) (b)
(c) (d) (a) Simple or Non-Cumulative Preference Shares, Cumulative Preferences
Shares, Participating Preference Shares and Redeemable Preference Shares.
Simple or Non-Cumulative Preference Shares : People holding such shares are enti
tled to a fixed rate of dividend only in the year in which profits are made. The
y get the dividend before it is paid to other types of shareholders. Cumulative
Preference Shares : Such shareholders are entitled to a fixed rate of dividend e
ven when there are no profits in any year. These claims will stand as arrears to
be paid first out of subsequent year s profit before it is paid to other types
of shareholders. Participating Preference Shares : The holders of such shares ar
e paid a fixed rate of dividend before it is paid to other classes of shareholde
rs. They are also entitled to participate in the balance of profits,in a certain
proportion along with equity shareholders, after reasonable claims of these equ
ity shareholders are met. Redeemable Preference Shares : Capital raised by issui
ng such shares must be paid back after a certain period of time either out of pr
ofits or by raising fresh capital by issuing new shares or by selling some of th
e assets of the company.
33
(b)
(c)
(d)
The preference shareholders do not enjoy normal voting rights. However they have
a prior claim on the assets of the company in the event of its liquidation. (ii
i) Deferred Shares : They are called the Promoters or Management s of Founders
shares. The holders of such shares are paid dividend last out of the profits le
ft after meeting the claims of ordinary and preference shareholders and the rese
rve funds. Normally they are issued to promoters of a company but they may also
be issued to public. If dividend paid to other classes of shareholders is restri
cted, the deferred shareholders will enjoy a bigger share of profits. But if the
re are no profits, they do not get anything. The deferred shareholders enjoy spe
cial or preferred voting rights. But the Indian Companies Act. Of 1956, has elim
inated the system of issuing deferred shares by public limited companies. Howeve
r a private limited company can issue deferred shares also. Sale of Bonds or Deb
entures Debentures : A company may also raise additional finance by borrowing fr
om the public for a specific period of time, say, 15 to 25 years, at a particula
r rate of interest. This is done by issuing debentures or bonds. A debenture is
an undertaking by a company to repay the borrowed money on or before the specifi
ed date at a particular interest rate, irrespective of profit or loss made by th
e company. The capital raised by selling debentures is like taking loans form th
e public. Hence, a debenture-holder is a creditor of a company with no voting ri
ght. As such, he cannot directly interfere with the activities of its management
.
A Debenture may be classified as (i) secured and (ii) simple.
(i) (ii)
A secured debenture is secured against the assets or property of a company. A si
mple debenture is not secured against its assets or property.
A company is also free to issue convertible debentures which can be converted in
to equity shares after a period of time, say, 5 to 10 years, at a ratio fixed in
advance. (E)
Types of Joint - Stock Companies :
On Ownership Basis, all types of the registered companies in the private sector
can be classified as : (a) (b) Public Limited Companies and Private Limited Comp
anies.
34
In the public sector, we have government companies in which 51% of the paid-up s
hare capital is held by the government. (F) Distinction Between Private Limited
Companies and Public Limited Companies (Limited By Shares) : (1) A private limit
ed company can be formed with two to fifty members maximum excluding employee sh
areholders of the company. But a public limited company can have any number of t
he members of the public but it should have a minimum 7 members. Public limited
companies are required to issue prospectus before allotting shares. But it is no
t necessary in the case of private limited companies. Public limited companies m
ust submit statutory reports to the Registrar of Companies. But private limited
companies are not required to do so. A public limited company has to send its du
ly audited accounts to its shareholders. But a private limited company is not re
quired to publish its accounts for the information of the public. However a priv
ate limited company must send three certified copies of its balance sheet to the
Registrar of Companies. The shares of a private limited company cannot be freel
y transferred on stock exchanges. But the shares of public limited companies can
be freely transferred on stock exchanges. The share of a private limited compan
y openly invites public to subscribe to its shares or debentures. But a private
limited company cannot appeal to the public to do so. A private limited company
can start its business after it is registered. But a public limited company can
do so only after it gets a certificate for commencement of business. A private l
imited company should have minimum two directors. But a public limited company m
ust have at least three directors. A private limited company may increase its nu
mber of directors without the government s approval. But a public limited compan
y can do so only after getting the government s approval.
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10) In the case of a public limited company only an individual can be appointed
as its manager. But a private limited company can appoint a firm a as its manag
er.
35
(11) A private limited company can issue different classes of shares with dispro
portionate voting rights. But there are restrictions in this respect on a public
limited company. A partnership may be converted into a private limited company
to enjoy the advantages of limited liability. (G) Management of Joint - Stock Co
mpanies : There is separation between ownership and management in a joint-stock
company. Its ownership is in the hands of shareholders. But they do not manage i
t directly. They elect a Board of Directors which manages the company. The polic
ies of the company are laid down by the directors. These policies are executed b
y salaried managers and executives. (H) Merits and Demerits of Joint-Stock Compa
nies : MERITS OF JOINT - STOCK COMPANIES : (i) Limited Liability : The principle
of limited liability is applicable to a joint-stock company. Hence we write wor
d "Ltd." after the name of a company. Since the liability of shareholders is lim
ited, risk faced by them are reduced. Hence even if a company suffers losses, th
ey need not pay more than the face value of shares purchased by them. So the cre
ditors of the company cannot make personnel attachments on their private propert
y. Hence people are induced to invest their money in such companies. Large Amoun
t of Capital : Large - scale production is facilitated under the company form of
business organization. This is because it is easy for a company to raise a larg
e amount of capital, by accepting fixed deposits from the public. Thus the savin
gs of the people can be productively used.
(ii)
(iii) Transfer of Shares : The shares of a company are transferable whenever one
likes. Hence it would encourage small savers to invest in the shares of compani
es. If they do not like to keep their funds in a particular company, they would
be free to sell their shares on stock exchange and invest in some other companie
s. Thus the money of a share holder is not blocked. At the same time, this does
not affect the company in any way. This is because the sales of shares of a comp
any by some are counterbalanced by the purchase of these shares on a stock excha
nge by others. (iv) Shares of Different Varieties : The shares of a company are
of different types, namely, equity shares, simple preference shares, cumulative
preference shares etc. The equity shares may be purchased by people who want tak
e greater risks. On the other hand, those who do not want to take any risk may i
nvest in cumulative preference shares. Thus, by providing a wide choice to share
holders, it is possible for a company to raise a large amount of capital. 36
(v)
Risky Enterprises : A joint-stock company can start a risky enterprise. This is
because the risks associated with a business are greatly reduced due to the limi
ted liability of shareholders and a small value of the shares of each shareholde
r. Further an individual may purchase shares of different companies so as to min
imize the loss still further. So even if there is a loss in the case of one comp
any, the individual shareholders may not be affected much.
(vi) Less Danger of Misappropriation of funds : There is a less danger of misapp
ropriation of funds. This is because the audited accounts of the companies must
be published. (vii) Combination of Capital and Business Abilities : Many individ
uals possessing a large amount of capital and not having capacities to start and
run a business can invest in companies. Other persons, having no capital but po
ssessing capacities to manage a business, can secure jobs as managers and execut
ives in companies. (viii) Efficient Management : In a joint-stock company, the o
wnership and management are separated. The shareholders are owners but they do n
ot manage it. It is managed by experts in different fields, who work under the d
irection of the Board of Directors. (ix) Economies of Scale : A joint - stock co
mpany can enjoy the economics of scale such as advantages of specialization and
division of labour etc. by making full use of managerial skills and abilities an
d other factors of production. (x) Continuity and Stability : Since it has a per
petual succession, a company continues to carry on its business even if some of
the original shareholders leave the company or die or become insolvent. So it is
permanent and stable in nature. So the business activities can be undertaken wi
th a long-term objective.
(xi) Legal control : Since companies are subject to rules and regulations of the
Companies Act, they are supposed to work in the interest of their shareholders.
(xii) Democratic Management : There is democratic management in a joint-stock c
ompany. This is because the directors are elected by shareholders from time to t
ime. The elected board of directors manage the company successfully because of t
heir wide experience, abilities and efficiencies. (xiii) Research : Because of i
ts continuous existence and a large amount of resources at its disposal, a compa
ny can conduct research and experiments, and apply the fruits of research to ind
ustrial uses. This will enable it to improve the quality of its product, reduce
its cost of production and thereby enjoy good profits in due course. DEMERITS OF
JOINT - STOCK COMPANIES : (i) Lack of Personal Interest and Inefficient Managem
ent : The actual management of a joint - stock company is in the hands of salari
ed executives. They have no personal interest in the functioning of their compan
y. Hence they may not always manage the 37
affairs of their company efficiently. Some of them might even leak out secrets o
f their company to rival companies. (ii) Indifference of Shareholders and Oligar
chy : On account of their : limited liability, many of the shareholders are indi
fferent. They may not take an active part in the affairs of their company. They
are also scattered. They are interested only in dividend. So a few big sharehold
ers manage to get directorships and take all decisions. So, in actual life, ther
e is oligarchy rather than democracy in the management of a company. Further the
se few directors manage to remain in power by some means or the other and enjoy
vast powers of management and decision making. So shareholders are owners only i
n name. (iii) Promotion of self - interests and misuse of power by directors : A
few big directors, who control the affairs of the company, try to promote their
own interests in various ways at the cost of other shareholders. Further when t
he directors are dishonest, they may commit some frauds and cheat and exploit th
e shareholders. They may also purchase inputs from their friends and relatives a
t high prices and resort to other corrupt practices. They may also claim excessi
ve fees. (iv) To Risky Ventures : the directors may be inclined to start very ri
sky enterprises which may fail. Hence they will involve the shareholders in loss
es. (v) Extravagance : The directors may not behave in a responsible manner. The
y may spend in an extravagant way.
(vi) Favouritism : The selection of the staff to work in various departments may
not be made by directors or managers on the basis of merit, but on the basis of
favouratism, influence, personal relations etc. They may employ their friends a
nd relatives in high posts paying high salaries. Hence the general working of a
company is likely to suffer. (vii) Unethical Practices : Directors possess insid
e information of the working of their company. Hence they may dispose of their s
hares at high prices by creating an impression that their company is going to ma
ke good profits when, in fact, the things are otherwise. So those who buy such s
hares will suffer losses. In the opposite case, when a company is likely to make
good profits, they may try to create an impression that it would suffer losses.
This impression will induce other shareholders to sell their shares. They buy t
hem through their agents. Hence they can get all the profits for themselves. The
transferability and marketability of shares is also responsible for unhealthy s
peculative activities on stock exchanges on the part of some directors. As a res
ult, the interests of shareholders are ignored with the result that a large numb
er of them may be ruined.
38
(viii) Conflict : There is no close personal contact between employees and manag
ement. Hence there is likely to be a conflict between employees and the manageme
nt. At times, this may result in strikes and lockouts. So the company s output w
ould suffer causing thereby a loss to the shareholders. (ix) Political Corruptio
n : A number of joint-stock companies may pay a large amount of money as donatio
ns to political parties. They are given for the personal benefit of directors an
d / or for the benefit of the company at the cost of the public. (x) Concentrati
on of Economic Power and Wealth and Inefficient Management : Most of the importa
nt companies in a country are dominated by a few wealthy individuals. As they ar
e elected as directors, there would be a concentration of wealth and economic po
wer in their hands. They manage to get themselves re-elected by some means or th
e other. However such people may lack adequate experience and skill. Hence they
may not be in a position to manage the affairs of the company efficiently.
(xi) Delay in Taking Decisions : The Board of Directors of a joint-stock company
cannot take quick decisions and prompt action to meet the changes in demand for
its product. This is because there is a lot of discussion and consultation befo
re taking any decision. This causes unnecessary delay. Hence when quick decision
and prompt action are required, a company form of organization is not suitable
as a partnership concern or even a private proprietorship concern. CONCLUSION :
The joint-stock system has much contributed to economic progress. This is becaus
e it is responsible for tremendous industrial progress, production and trade. 4.
JOINT - HINDU FAMILY FIRMS OR ORGANISATIONS : Such organization undertaking bus
iness activities exist in India. They are also called Hindu Undivided Family Bus
iness (HUF). In a Hindu Joint Family firm, all members of a family come under k
arta , a common head, who is the eldest member in the family. The Hindu Law dete
rmines their rights and liabilities. Such organizations were important in the pa
st. But now their importance has declined. This is because they are not suitable
for many economic activities in modern times. Joint Hindu Family have some of t
he features of a partnership firm. However, the ownership of a joint family firm
is not due to A contract but due to inheritance. Hence the male members of join
t family firms are called co-parceness and not partners. 5. CO-OPERATIVE SOCIETI
ES OR CO-OPERATIVE FORM OF BUSINESS ORGANISATIONS : Introduction : The co-operat
ive movement started in England and Germany in the middle of the 19th century. B
ut, in India, it began only in 1904 after the Co-operative Societies
39
Act, 1904, was passed. This Act was passed mainly to provide credit to farmers a
nd prevent them from borrowing from money-lenders. Since 1904, the co-operative
movement has made considerable progress in India. (A) Definition of Co-operation
: In a wide sense, "co-operation means working together for a common purpose".
Hence, in the co-operation, the main principle adopted is" all for each and each
for all". As per the International Labour Organization (ILO). Co-operation is a
voluntary association of individuals with limited income on the basis of equal
rights and responsibilities for achieving certain economic interests common to a
ll of them. This is done by forming a democratically controlled organization and
making an equitable contribution to its capital and accepting a fair share of r
isks and benefits of the organization. (B) Principles of Co-operative Organizati
ons : (i) (ii) A co-operative organization is a voluntary association. It is est
ablished to promote common economic interests of all its members and thereby pro
mote their general welfare.
(iii) Its management is democratic in nature. There is one vote for one member.
(iv) (v) (vi) All members enjoy equal rights and status. Its business is very of
ten confined to the members only. Profit motive is not supreme. It stresses mutu
al help, honest means and moral values. It believes in the principle of "all for
each and each for all".
(C) Features of Co-operative Organizations : (i) Voluntary Association : A co-op
erative society is a voluntary association of individuals having limited means,
formed to promote and protect their common economic interests. Democratic Manage
ment : The members of the managing committee are elected by the members of a soc
iety on the basis of "one head" one vote", whatever be their individual share ho
lding.
(ii)
(iii) Equality : A co-operative society functions on the basis of equal rights,
equal status and responsibilities of members.
40
(iv) Equitable Contribution : The members make an equitable contribution to its

capital. (v) Thrift and Self-help : It promotes thrift, self-help and mutual ass
istance.
(vi) Sharing of Risks and Profits : The members have to bear a fair share of ris
ks and enjoy a fair share of profits from their co-operative society. (vii) Serv
ice Motive : Although a society enjoys profits, its main objective is service fo
r promoting common economic interests of the members as well as for promoting se
lf-reliance, brotherhood, honesty and social relations among them. (viii) Evils
of Capitalism : It eliminates some of the evils of capitalism, e.g., exploitatio
n of consumers, workers, concentration of wealth and economic power in a few han
ds, etc. (ix) Legal Status : A co-operative society enjoys a legal status, for i
t is registered under the Co-operative Societies Act. (x) Government Control : S
uch societies are controlled and regulated by the government.
(D) Types of Co-operative Societies : There are various types of co-operative so
cieties such as Consumers Co-operative Societies, Producers Co-operative Socie
ties, Co-operative Credit Societies, Cooperative Service Societies, Co-operative
Farming Societies, Co-operative Marketing Societies, Co-operative Housing Socie
ties, etc. (E) Merits and Demerits of Co-operative Societies : Merits of Co-oper
ative Societies. (a) (b) Voluntary Association : They are formed voluntarily. In
dividuals are free to join or leave the societies. No Evils of Capitalism : Such
societies can eliminate some of the evils of capitalism and communism for they
lie in between the two extreme economic systems. They check the malpractices of
monopolists and capitalists. Purchases and Sale of Goods : There is no speculati
ve buying of goods. There is also no problem of sales promotion by means of adve
rtisement. No Malpractices and Reasonable Prices : They can also remove malpract
ices in business like black-marketing, adulteration of goods, etc. The consumers
also get various goods at low prices. Legal Status : A co-operative society has
an independent legal status.
(c) (d)
(e)
41
(f) (g)
Common Benefits : People with small means can easily form such societies to prom
ote their common interests. They do not involve many legal formalities. Team Spi
rit : They are democratically managed, i.e. they are managed by elected represen
tatives. The members have right to vote. Such societies help develop team spirit
among their members. Social Values : They promote social values such as mutual
sacrifice, mutual help etc. and bring about an economic equality. They stress eq
ual distribution of wealth. Service Motive : They provide various types of servi
ces to their members. They also obtain voluntary services from their members. He
nce their cost of operation is low. Liability : In such a society, the liability
of members in limited to the extent to which they hold the shares therein. Conc
essions and Encouragement : The government provides various facilities to promot
e their growth by means of assistance, concessions etc. For e.g. the low income
groups can form housing societies to solve their housing problem in cities and t
owns. Debt, Insolvency etc. : They are not affected by debts, insolvency or insa
nity of their members. Hence they are relatively stable.
(h) (i) (j) (k)
(l)
(m) Undistributed Profits : Their undistributed profits add to their capital whi
ch can be used to expand their activities. Demerits of Co-operative Societies. (
a) Malpractices : Some of the members of a society may be unscrupulous. They may
resort to malpractices to exploit weak members and to promote their personal in
terest. This would result in conflicts, rivalry, quarrels and failure of the soc
iety to function properly. Limited Finance : As compared to a joint-stock compan
y, the power of a co-operative society to raise finance is limited. So it is fin
ancially weak. Inefficient Management : Members of the management of such societ
ies may be selected on personal considerations. They may not be honest and compe
tant. They may not also possess skill and efficiency to run them efficiently. He
nce their efficient management is difficult. They cannot also secure the service
s of experts and specialists nor can they get trained personnel. This is because
they cannot afford to pay high salaries. Rivalry : There may be rivalry among t
he members of the society to secure control over the management of societies. La
ck of zeal : Their member may not possess zeal, enthusiasm and urge to members a
nd may not extend whole-hearted co-operation. They try to get only the services
rendered by a co-operative society and enjoy their benefits.
(b) (c)
(d) (e)
42
(f)
Lack of Co-operative Spirit : Lack of co-operative spirit and Lack of knowledge
of the principles of co-operation on the part of members may obstruct the growth
of co-operative organizations. Business Secrecy : In such societies, business s
ecrecy may not be maintained because their affairs are carried on democratically
. Government Control : They are subject to too much government control and regul
ations. Hence they might not be in a position to work efficiently. Limits of Exp
ansion : Such organizations cannot extend their activities much due to limited f
inance and limited management skill. Limited Buyers : The sales of a co-operativ
e society are generally restricted to a limited number of buyers. Political Part
ies : The political parties may use such societies to promote their interests.
(g) (h) (i) (j) (k)
However, in spite of their limitations, they have an important role to play in i
mproving the conditions of the poor people. Hence they should be made more effec
tive. 6. PUBLIC ENTERPRISES / PUBLIC SECTOR UNDERTAKINGS (P.S.Us) :
(A) Definition : The public enterprises refer to enterprises which are owned, ma
naged and controlled by the government either Central or State or Local self gov
ernments. They are called "state enterprises" or "public undertakings". They inc
lude Indian Railways, river projects, basic and key industries, various public u
tility undertakings providing road transport, water, electricity, gas etc. (B) T
he Main Features of Public Enterprises : (1) (2) (3) (4) (5) State Control : The
y are owned, managed and controlled by the departments concerned of the governme
nt or by the government bodies. Management : Some of them may be managed by prof
essionals. Accountability : They are accountable to the public because they are
accountable to the government which represents the people. Separate Funds : They
are assigned separate funds to undertake their activities. Legal Status : Each
public enterprises is a separate legal entity, for it is established by law. Som
e of the public enterprises enjoy autonomous status operating as per the state p
olicy and general directives from the government. So they are influenced more by
the state policy than the enterprises in the private sector. Profit : Some of t
hem may work for promoting welfare of the people rather than making profits. Som
e of them are run on commercial principle so as to make profits. But profit-maki
ng is not their main motive for, at the same time, they have to promote social e
nds. 43
(6)
(C) Forms of Public Enterprises : There are three forms of organization adopted
for the management of public enterprises. 1) 2) 3) 1) Departmental Management Co
mpany Management or management by boards and Public Corporations. Departmental M
anagement : There are some undertakings which are run by the government departme
nts e.g. posts and telegraphs, railways, defence industries, information and bro
adcasting, atomic energy etc. Normally enterprises which are strategically impor
tant and which provide steady income to the government are departmentally-manage
d.
The main features of the Departmentally - managed Undertakings are :
1. 2. 3. 4. 5. They are managed by various departments of the government. The ci
vil servants are assigned the job of running them. The ministries concerned exer
cise control over them. They are financed by the government by means of annual a
ppropriations from the treasury. They are accountable to the public through the
government.
Their defects are : Such departmentally-run enterprises are subject to a number
of criticisms such as lack of initiative, rigidity in operations, ignorance of c
onsumers requirements, red-tapism, delay in taking decisions, wrong decision, p
oliticallymotivated decisions, etc. Hence their working efficiency suffers. It t
hese defects are eliminated, they can be run efficiently. This can be achieved,
to a large extent, if an autonomy is given to such enterprises in their day-to-d
ay working. 2) Joint Stock Company Form of Management : Certain enterprises, whi
ch may be entirely owned by the government, are operated as private limited comp
anies. The main features of the Government Companies are : 1. 2. 3. 4. They are
owned by the government. They are commercial in nature. They are dynamic and qui
ck in decision - making. They are registered as private limited companies. Their
financial operations are subject to a close scrutiny by the government.
44
5.
Their attempt to eliminate some of the defects of the departmentally run enterpr
ises.
Some of the important government companies in India are : The Bharat Heavy Elect
ricals Ltd., (BHL), the Hindustan Steel Limited (HSL), the Hindustan Antibiotics
Limited (HAL), the Bharat Aluminum Company Limited (BACL), the Steel Authority
of India Limited (SAIL), etc. 3) Public Corporations : Public corporations refer
to autonomous organizations created by statutes or special acts of the legislat
ure to run the nationalized to run the nationalized enterprises or newly set up
public undertakings.
Their main feature are :
1. 2. They are created by special acts of the parliament. So they are legal enti
ties owned by the government. They enjoy internal and financial autonomy, i.e. t
hey are financially independent autonomous institutions. So they are free from t
he parliamentary control in respect of their day-to-day management t and financi
al operations. They take all decisions independently. Their powers and functions
are clearly laid down by respective acts of the parliament. They are run like c
ommercial concerns. They attempt to blend the public ownership and private initi
ative and flexibility for they are free from bureaucracy in administration and m
anagement. They are supposed to eliminate the defects of the departmentally - ru
n enterprises as well as those of company type undertaking of the state. They ar
e managed by Boards of Directors appointed by the government who need not be for
m the cadre of civil servants.
3. 4. 5. 6. 7.
Some of the corporation set up in India are the Life Insurance Corporations (LIC
), the State Road Development Corporation (SRDCs), the State Trading Corporation
(STC), The Damodar Valley Corporation (DVC), the Reserve Bank of India (RBI), t
he Oil and Natural Gas Commission (ONGC), the Air India, the Indian Airlines Cor
poration, the Industrial Finance Corporation of India (IFCI), Food Corporation o
f India etc. (D) Advantages (i.e. Merits) and Disadvantages (i.e. Demerits) of P
ublic Enterprises : Merits of Public Enterprises 1) Use of Profit : Some of the
public enterprises like post and telegraphs are not run for earning profit while
other enterprises like Hindustan Machine Tools (HMT) as in 45
India are run for making profits. But the profits earned by them are utilized fo
r improving services rendered or for further expansion of their activities. Thus
profits earned by state enterprises can be used to promote general welfare. 2)
Nature of Investment : There are certain fields in which the private sector will
not invest either because it is too risky or because the yield on such investme
nt is too low and spread over a very long period. The government has, therefore,
to undertake such investment in the interest of society, e.g. construction and
management of river linking projects. Sufficient Capital : It is also quite like
ly that the private sector may not be in a position to raise enough capital for
a project or an industry. But the government can raise any amount of capital fro
m various sources for investment in any project or an industry. Hence such proje
cts or industries are started in the public sector. Public Welfare : In certain
fields, the state enterprises may work more efficiently than private enterprises
. This is particularly the case with public utility services like electricity, w
ater, railway service etc. If they are left to the private sector, the consumers
may be exploited. Hence they are organized by the government on the monopoly ba
sis to secure economies of scale. Economies of Large-scale Production : On accou
nt of large-scale production, they can enjoy the economies of large-scale produc
tion. Consumer Interests and Quality of Goods : As compared with the private sec
tor enterprises, the quality of goods or services provided by the public enterpr
ises is likely to be better. They will also be made available at reasonable pric
es. Hence the interests of consumers would be safeguarded. Labour Relations : Th
e scope for conflicts between workers and the public enterprises would be minimu
m. This is because the workers are likely to be more contented due to security a
nd justice in service. Industrial Development : When a country has a few entrepr
eneurs and the skilled labour is limited. The government may set up a number of
industries by inviting foreign skilled labour to help it to accelerate the pace
of industrial development. It may also attract very efficient personnel and best
managerial talent by offering high salaries and better service conditions. No W
astes : All wastes of economic resources in the form of existence of excess capa
city in the private sector industries, competitive advertisement etc. can be eli
minated if they are nationalized and run by the government.
3)
4)
5) 6)
7)
8)
9)
10) Check on Concentration of Economic Power and Private Monopoly : The public e
nterprises can help to check the concentration of economic power in the hands of
a few individuals and the growth of private monopolies. 46
11) Balanced Development : They can contribute to a balanced regional developmen

t by locating public enterprises in less developed areas and thereby reduce the
regional income inequalities. 12) Ultimate Control by People : The working of th
e public enterprises is subject to the criticism of the people and the Members o
f Parliament. Hence, if there is anything wrong in the working of the public ent
erprises, it would be set right. So the public enterprises are ultimately contro
lled by the people themselves.
Demerits of Public Enterprises :
1) Inefficient management : The government officials may take a long time in tak
ing decisions as well as action. Hence the government enterprises may be run wit
h excessive social cost of operation. This may be so because all of them may not
possess much business experience. No Incentive for Hard Work : The public enter
prises may not create incentives for hard work for their workers. The managers m
ay not take any risk. This is because their acts are questioned. Bureaucracy and
Red-tapism : Bureaucracy, red-tapism and corruption may obstruct the growth of
public enterprises. The bureaucrats may not take quick action because they have
followed the established procedures. Hence they may cause losses to the public e
nterprises. This would involve a burden to the taxpayers. Lack of Incentives : B
ecause of lack of incentives, personal initiative may be lacking and the respons
ibilities may be avoided. This is because the government officials may work in a
routine way. In other words, they may not work enthusiastically and efficiently
. Extravagance : The officials in charge of managing these enterprises may plan
in a big way and spend extravagantly. This would cause much loss to the public s
ector year after year. Friction : There may also be an internal friction between
various officials in a public enterprise. Hence its efficiency would suffer. Po
litical Considerations : Political considerations may determine appointments, tr
ansfers and promotions. Hence right man may not be placed in the right place. Su
ch a policy is detrimental to the efficient working of the public enterprises. F
urther bribery and corruption may predominate. Also an enterprise may be located
in a particular area out of the political rather than economic considerations.
Rigidity : There may be rigidity in the working of the public sector enterprises
due to strict rules and regulations.
2)
3)
4)
5)
6) 7)
8)
47
9)
Transfers : There might be frequent transfers of the government officials. This
would disturb the smooth working of the government enterprises.
10) Helplessness of Consumers : Individual consumers will be helpless when goods
and services are provided by big public enterprises. They may not much care for
the public. They may not get proper treatment from the officers in the public e
nterprises. 11) Personal Liberty : Extension of the public sector may result in
centralization of powers and a loss of personal liberty. Also it may reduce reso
urces available for investment in the private sector. Hence the working to the p
rivate sector industries would suffer. 12) Government Interference : Due to too
much interference form the government, the executives in charge of the public en
terprises may not take their own decisions to run them properly. 13) Workers In
terests : The workers interests may not always be protected resulting in labour
unrest. However the authorities may, sometimes, yield to the pressure of worker
s demand due to the political considerations. 14) Prices : The public enterpris
es may go on increasing prices of their goods and services periodically. This wo
uld result in a decline in the welfare of the people. Some of these disadvantage
s can be largely eliminated if autonomy is ensured in their internal working and
proper incentives are provided for their successful working. This would reduce
economic inequalities and promote public welfare. 7. JOINT - SECTOR ENTERPRISES
: In India, the concept of joint-sector was accepted by the Government of India
through its Industrial Licensing Policy of 1970. The Government reiterated it in
its Industrial Policy decision of February, 1973. In simple terms, the joint-se
ctor is a form of partnership between the private sector and sector and the gove
rnment. In this, the government and public financial institution provide a part
of the capital and the other part of the capital comes from the private sector a
nd investing public. However the day-to-day management of the joint-sector enter
prises is left in the hands of the private sector which possesses the technical
and managerial expertise. However on the Board of Directors of a joint-sector, t
he government is adequately represented to regulate its functioning. The Board o
f Directors would lay down the policies for the joinsector enterprises. The gove
rnment has to guide their management and operations.
48
Thus the joint-sector enterprises are controlled by the government and the priva
te sector jointly. The joint-sector can be used to promote socio-economic object
ives of the government such as regional dispersal of industries, etc. Thus a joi
nt-sector involves a social control over industries without resorting to their n
ationalization, i.e. it lies between private enterprise and outright nationaliza
tion. In India, some of the important joint-sector enterprises are Indian Teleph
one Industries Limited (ITI), Hindustan Machine Tools (HMT), etc. The state gove
rnment in India have also entered into joint ventures with the multi-national co
rporations. 8. NON - PROFIT ORGANISATIONS : Non - Profit organisation can be cla
ssified into public sector organisations and private sector organisations. Some
organisations created by the Government in the public sector are directed toward
s meeting the basic needs of the people. Many private sector organisations are c
reated by socially oriented people with a view to meet certain needs of the soci
ety which are not yet fulfilled. In both these cases profit making is not a goal
. It is possible to classify non- profit organisation into public utilities and
social service organisations. Water supply, postal services, general hospitals,
etc., are examples of public utilities. On the other hand, organisation of volun
tary social workers, also known as NGOs (non-governmental organisations) working
in the fields like rehabilitation of disabled persons, pensioners homes, adult
education, non-formal education, schools for the blind or the deaf, HIV/AIDS aw
areness etc., are examples of this type. The following chart illustrates this cl
assification : Non-Profit Organisation
Public Sector
Private Sector
Public Utilities
Social Service Organisations
49
Organisation : Public sector non - profit organization can take various forms li
ke departmental establishments, autonomous boards / corporations etc. Their orga
nizational patterns, merits and demerits are as discussed earlier under public s
ector undertakings. Some characteristics, however are worth noting. (i) (ii) Mos
t of these organizations enjoy a certain degree of autonomy to make room for fle
xibility and quick decision; Such organizations have a provision for advisory bo
ards or committees which can provide broad guidelines for the functioning of the
organization as well as for the purpose of a general monitoring;
(iii) Normally local or regional branches / boards have the freedom to adjust th
eir activities to the local needs of the society; (iv) The beneficiaries or the
users can send their suggestions / complaints for improving the performance of t
hese organizations; Annual accounts are audited and placed before the house conc
erned like the municipal corporation, legislative assembly or the parliament.
(v)
Private sector organizations usually prepare their own constitution and get the
organization registered under the Public Trust Acts as well as / or Societies Ac
t. The members constituting such charitable social service organization constitu
te what is known as the General Body which meets once a year to review the repor
t and to accept the accounts. The day - to - day functioning is taken care of by
the Executive Committee or the Management Council or some such committee under
any other name like the business council, supervisory board etc. Whatever the ty
pe of non-profit organization, a common characteristics is that it serves some v
ery important need of the people which either cannot be met through the market m
echanism or, if left to market mechanism, users are likely to be exploited or go
unserved. The pricing policy of such organizations depends upon whether the org
anization is aided or funded by some other philanthropic organization. At times
the services are rendered free of charge and the costs are entirely borne by the
funding agencies or the government, as the case may be. Sometimes the prices ar
e subsidized for keeping them low and within the reach of the low income benefic
iaries. Sometimes prices / fees are discriminatory being linked to the annual in
come of the users. In some cases, the prices just cover the costs. In modern tim
es, and especially in more developed countries, voluntary agencies are being ent
rusted with task which earlier were performed by the government. This arrangemen
t of voluntarism has various advantages. Such voluntary organizations 50
(i) (ii) (ii) (iv)

can provide quality service for they are run by committed social workers, can en
sure peoples, participation due to their service motive, can be flexible in proc
edure and approach and this suits the people, are close to the people and theref
ore, can remain in touch with the users and can monitor the way in which needs o
f the people are met, can take a feed back and re-adjust their methods / procedu
res to instill more efficiency or better quality in service.
(v)
9.
BUSINESS ORGANISATIONS OF THE NEW MILLENNIUM : By the turn of the century, mainl
y due to the technological developments, the firms all over the world started ex
periencing phenomenal changes and challenges. The following can be listed as the
major ones : (i) With a systematic removal of barriers to trade, under the WTO
system, the markets widened suddenly and extended to global dimensions. Relaxati
on of exchange controls and freedom of convertibility of currencies expanded inv
estment opportunities and subsequent flows of capital.
(ii)
(iii) Mass production of personalized products replaced mass production of the y
ester years. (iv) Aggressive sales promotion and attractive marketing campaigns
became an inevitable part of the firm s business strategy. Widening of markets a
nd reduction in average costs shifted the point of optimum production so high th
at the firms kept growing and reaping advantages of largescale production. The i
ncidence of industrial sickness and closures reached unforeseen dimensions.
(v)
(vi)
(vii) The process of acquisitions and mergers was accelerated out of the surviva
l instinct of the firms. (viii) Advertising, mainly through the powerful electro
nic media, reached unprecedented proportions and started designing the tastes of
the consumers. (ix) The competition that emerged was in pleasing the consumers
by apparently satisfying his need which, in reality, were actually tailored by t
he gigantic firms with their clever manipulation.
51
10. DISTINCTION BETWEEN PRIVATE SECTOR AND PUBLIC SECTOR : (i) On the Basis of E
conomic System : The private sector is fully owned and managed by private indivi
duals and private firms. There is private ownership in the means of production.
But the public sector is fully owned and managed by the State. There is public o
wnership in the means of production. On the Basis of Economic System : The priva
te sector is based upon capitalism. But the public sector is based upon socialis
m.
(ii)
(iii) On the Basis of Motive : The private sector is profit-motivated. But the p
ublic sector is to promote social welfare by rendering various types of services
to public. (iv) On the Basis of Principle of Pricing : In the case of the priva
te sector, the prices of goods and services are determined by the market forces
of supply and demand. The prices are fixed in such a way that the profits are ma
ximized. For maximizing profits, the marginal cost is equated to marginal revenu
e. In the case of the public sector, the prices are administratively fixed. They
are not determined by market forces. The objective of social welfare is given e
mphasis while fixing the prices in the public sector. (v) On the Basis of Contro
ls : The private sector is controlled by individuals, partnership firms and join
t-stock companies. But the public sector is controlled by the State.
(vi) On the Basis of Nature of Investment : The private sector is interested mai
nly in the investments in those industries which provide reasonable profits in a
short period, e.g., light consumer goods industries, durable consumer goods ind
ustries, etc., producing TV sets, medicines, cloth, transistors, etc. But the pu
blic sector invests in those industries or projects in which the private sector
will not invest either because it is too risky or because the yield on such inve
stment is very low and spread over a very long period, e.g., defense industries,
river projects, iron and steel industry, fertilizer industry, railways, posts a
nd telegraphs, oil exploration etc. 11. SPECIFIC ORGANISATIONAL GOALS / MOTIVATI
ON / OBJECTIVES OF FIRMS : Introduction : The decision-making of firms is guided
by the goals and objectives which they seek to achieve. Over time different ass
ertions have been made regarding their objectives. This is particularly so since
corporations have emerged as an important form of organization. Even in develop
ing economies, corporations contribute a significant percentage of manufacturing
activities. The objectives of the firm as put forth by Williamson, Marris, Simo
n, Cyert and March start from this basic fact, i.e. the emergence of corporation
s as an important form of organisation. Since the interests of managers may be d
ifferent from those of owners, different hypothesis have been presented by these
authors regarding the objectives of the firm. Those modify the decision-making
process. 52
A)
MAXIMIZATION OF PROFIT / TRADITIONAL APPROACH : Profit maximization has been the
most important assumption on which economists have built price and production,
theories. This hypothesis has however been strongly questioned. This issue will
be dealt with later. Let us first look into the importance of the profit maximiz
ation hypothesis and theoretical conditions of profit maximization. The conventi
onal economic theory assumes profit maximization as the only objective of busine
ss firms. Profit maximization as the objective of business firms has a long hist
ory in economic literature. It forms the basis of conventional price theory. Pro
fit maximization is regarded as the most reasonable and analytically most produ
ctive business objective. The strength of this assumption lies in the fact that
this assumption has never been unambiguously disproved . Besides, profit maxim
izations assumption has a great predictive power. It helps in predicting the beh
avior of business firms in the real world and also the behavior of price and out
put under different market conditions. No alternative hypothesis explains and pr
edicts the behaviour of firms better than the profit maximization assumption.
Maximum Profit Conditions :
There are two conditions that must be fulfilled for the profit to be maximum : (
i) necessary conditions and (ii) secondary conditions. The necessary condition r
equires that marginal revenue (MR) must be equal to marginal cost (MC). Marginal
revenue is obtained from the production and sale of one additional unit of outp
ut. Marginal cost is the cost arising due to the production of one additional un
it of output. The secondary condition requires that the necessary condition must
be satisfied under the condition of decreasing MR and rising MC. i.e. MC curve
must cut the MR curve from below. The fulfillment of the two conditions makes th
e sufficient condition.
Controversy over Profit Maximization :
Although profit maximization has been the most widely known objective of busines
s firms, some economists have raised doubts on the validity of this objective. T
he important objections to this objective are the following. First, profit maxim
ization assumption is too simple to explain the business phenomenon in the real
world. In fact, businessmen are themselves not aware of this objective attribute
d to them. Second, it is claimed that there are alternative and equally simple o
bjectives of business firms that explain better the real world business phenomen
on, e.g. sales maximization, a target rate of return, a target market share, pre
venting price competition and so on.
53
Third, it is argued that firms do not have the necessary knowledge and a priori
data to equalise MR and MC. Hence firms cannot attempt to maximize their profits
in the manner suggested by the conventional theory.
In Defense of Profit Maximization Assumption :
The conventional economic theory defends the profit maximization assumption on t
he following grounds. First, only those firms survive in the long run in a compe
titive market which are able to make a reasonable profit. Once they are able to
make profit, they would always try to make it as large as possible. All other ob
jectives are subjugated to this primary objective. Second, profit maximization a
ssumption has been found extremely accurate in predicting certain aspects of a f
irm s behaviour. Friedmen argues that the validity of profit maximization hypoth
esis cannot be judged by a priori logic or by asking the business executive. The
ultimate test is its ability to predict the business behaviour and trends. Thir
d, profit maximization assumption is a time-honored objective of a business firm
and evidence against this objective is not conclusive or unambiguous. Fourth, t
hough not perfect, profit is the most efficient and reliable measure of efficien
cy of a firm. If is also the source of internal finance. In developed economies,
internal source contributes more than three fourths of the total finance. B) RE
ASONABLE PROFIT TARGET : We have noted that profit maximization is theoretically
the most sound and time-honoured objective of business firms. But profit maximi
zation in a technical sense, i.e. making MC = MR, is beset with serious computat
ional and data problems. Most goods and services are produced in large quantitie
s - bulks and batches. Only few goods like ships, planes, turbines, big plant an
d machinery, etc., are countable in units. Business books of accounts do not rev
eal unit cost and revenue. For Example HMT or TITAN would not be able to find co
st of one additional wrist watch produced and the addition to its total revenue.
In practice, therefore, modern firms and corporations do not aim at profit maxi
mization. Instead they have "a standard", "a target" or "a reasonable profit" wh
ich they strive to achieve. Why do modern corporations aim at a "reasonable prof
it" rather than attempting to maximize profits?
Reasons for Aiming at "Reasonable Profits"
For a variety of reasons, modern large corporations aim at making a reasonable p
rofit rather than at maximizing the profit. Joel Dean has listed the following r
easons.
54
1.
Preventing entry of competitors : Profits maximization under imperfect market co
nditions generally leads to a high pure profit which is bound to attract compe
titors, particularly in case of a weak monopoly. The firms therefore adopt a pri
cing and a profit policy that assures them a reasonable profit and, at the same
time, keeps potential competitors away. Projecting a favourable public image : I
t often becomes necessary for large corporations to project and maintain a very
good public image, for if public opinion turns against it and government officia
ls start raising their eyebrows on profit figures, corporations may find it diff
icult to sail smoothly. So most firms set prices lower than that conforming to t
he maximum profit but high enough to ensure a "reasonable profit". Restraining t
rade union demands : High profits make trade unions feel that they are deprived
of their due share and therefore they raise demands for wage hike. Wage-hike may
lead to wage - price spiral and frustrate the firms objective of maximizing pr
ofit. Therefore, profit restrain is sometimes used as a weapon against trade uni
on activities. Maintaining customer goodwill : Customers goodwill plays a signi
ficant role in maintaining and promoting demand for the product of a firm. Custo
mers, goodwill depends largely on the quality of the product and its, fair pric
e . What consumers view as fair price may not be commensurate with profit maximi
zation. Firms aiming at better profit prospects in the long run, sacrifice short
-run profit maximization in favour of a "reasonable profit . Other factors : Som
e other factors that put restraint on profit maximization include (a) managerial
utility function being preferable to profits maximation for executive, (b) cong
enial relation between executive levels within the firm, (c) maintaining interna
l control over management by restricting firm s size and profit, and (d) foresta
lling the anti-trust suits.
2.
3.
4.
5.
C)
SALES REVENUE MAXIMIZATION : Baumol has suggested maximization of sales revenue
as an alternative objective to profitmaximization. The reason behind this object
ive is the separation of ownership and management interests. This dichotomy give
s managers opportunity to set their goals other than profit maximization which m
ost owner-businessmen pursue. Given the opportunity, managers choose to maximize
their own utility function. According to Baumol, the most plausible factor in m
anagers utility functions is maximization of the sales revenue. The factors whi
ch explain the pursuance of this goal by the managers are the following. First,
salary and other earnings of managers are more closely related to sales revenue
than to profits. Secondly, banks and financial corporations look at sales
55
revenue while financing the corporation. Thirdly, trend in sales revenue is the
readily available indicator of performance of the firm. It helps also in handlin
g the personnel problem. Fourthly, increasing sales revenue enhances the prestig
e of managers while profits go to the owners. Fifthly, managers find profit maxi
mization a difficult objective to fulfill consistently over time and at the same
level. Profits may fluctuate with changing conditions. Finally, growing sales s
trengthen competitive spirit of the firm in the market and vice versa. D) MAXIMI
ZATION OF FIRM S GROWTH RATE : Prof. Morris has suggested another alternative ob
jective i.e., maximization of balanced growth rate of the firm, which means maxi
mization of demand for firm s product or growth of capital supply . According
to Morris, by maximizing these variables, managers maximize both their own util
ity function and that of the owners. The managers can do so because most of the
variables (e.g., salaries, status, job security, power, etc.) appearing in their
own utility function and those appearing in the utility function of owners (e.g
. profit, capital, market share, etc.) are positively and strongly correlated wi
th a single variable, i.e. size of the firm. Maximization of these variables dep
ends on the maximization of the growth rate of the firms. The managers therefore
seek to maximize the steady growth rate. Morris s theory, though more rigorous
and sophisticated than Baumol s sales revenue maximization, has its own weakness
es. It fails to deal satisfactorily with oligopolistic interdependence. Another
serious shortcoming of his model is that it ignores price determination which is
the main concern of profit maximization hypothesis. Morris s model too does not
seriously challenge the profit maximization hypothesis. E) SATISFYING BEHAVIOUR
: Some economists like Cyert R. M. and J. G. March argue that the real business
world is full of uncertainty, accurate and adequate data are not readily availa
ble; where data are available managers have little time and ability to process d
ata; and managers work under a number of constraints. Under such conditions it i
s not possible for the firms to act in terms of rationality postulated under pro
fit maximization hypothesis. Nor do the firms seek to maximize sales, growth or
anything else. Instead they seek to achieve a satisfactory profit , a satisfac
tory growth , and so on. This behaviour of firms is termed as Satisfaction Beha
viour . The underlying assumption of Satisfaction Behaviour of firms is that a
firm is coalition of different groups connected with the various activities of
the firm e.g., shareholders, managers, workers, input supplier, customers, banke
rs, tax authorities and so on. All of these groups have some kind of expectation
s - often conflicting - from the firm, and the firm seeks to satisfy all of them
in one way or another. The behavioural theory has however been criticized on th
e following grounds. First, though the behavioural theory deals realistically wi
th the firm s activity, it cannot explain the
56
firm s behaviour under dynamic conditions in the long run. Secondly, it cannot b
e used to predict exactly the future course of firm s activities. Thirdly, this
theory does not deal with equilibrium of the industry. Fourthly, like other alte
rnative hypothesis, this theory, too fails to deal with interdependence and inte
raction of the firms. F) LONG-RUN SURVIVAL AND MARKET SHARE GOALS : Another alte
rnative objective of a firm - as an alternative to profit maximization - was sug
gested by Rothschild. According to him, the primary goal of the firm is long - r
un survival. Some others have suggested that attainment and retention of a const
ant market share is the objective of the firms. The managers therefore seek to s
ecure their market share and long-run survival, the firms may seek to maximize t
heir profit in the long-run, though it is not certain. G) ENTRY - PREVENTION AND
RISK AVOIDANCE : Yet another alternative objective of the firms suggested by so
me writers is to prevent entry of new firms into the industry. The motive behind
entry-prevention may be (a) profit maximization in the long run, (b) securing a
constant market share, and (c) avoidance of risk caused by the unpredictable be
haviour of the new entrants. The evidence on whether firms maximize profits in t
he long run is not conclusive. Some argue that where management is divorced from
the ownership, the possibility of profit maximization is reduced. Some argue th
at only profit-maximizing firms can survive in the long run. They can achieve al
l other subsidiary goals easily if they maximize their profits. No doubt, preven
tion of entry may be the major objective in the pricing policy of the firm, part
icularly in case of limit pricing. But then, the motive behind entry-prevention
is to secure a constant share in the market. Securing constant market share is c
ompatible with profit maximization. H) THE HOMEOSTATIC THEORY Prof.Kenneth Bould
ing was critical of the traditional theory on the ground that it ignored the inf
ormation that could be available to the firm and assumed the availability of inf
ormation which could never be available. The theory therefore, was of no use as
a guide to practical policy. For this reason he advocates the homoeostatic theor
y. According to the homeostatic approach, there is some state of the system whic
h it is designed to maintain. If any disequilibrium in this state occurs, counte
racting forces start operating and the desired state is re-established. the orga
nism has a usual tendency to maintain its stability by keeping its mood and conf
iguration stable. Only when some stress is applied, the organism causes a deviat
ion from normal state. Such a deviation brings about changes in mood and configu
ration and the effects of the stress are nullified.
57
In explaining the approach, Boulding says," There is some desired quantity of al

l the various items in the balance sheet, and that any disturbance of this struc
ture immediately sets in motion forces which will restore the status quo. Thus,
if a customer purchases a product, this diminishes the firms stocks of finished
product, and increases its stock of money. In order to restore the status quo,
the firm must spend the increased money stock to produce more finished products
. A firm adjusts its entire behavior to maintaining a given state or position. I
ts existing asset-structure, for instance, is what it would seek to preserve. An
y change in this structure would be responded by countervailing action. A fall i
n liquidity, to take another example, would prompt the firm to restore its origi
nal liquidity position. The homeostatic theory is useful as a first approximatio
n regarding the motivation of a firm. But when we extend this theory to complex
areas of decision-making, it breaks down. Main objections raised against the the
ory can be summed up as following: i) It is static theory and does not allow any
change in the original state, ii) it has nothing to say regarding normal and id
eal structure of a balance-sheet which the firm tries maintain. iii) a study of
the decision taken by firms does not be what Boulding says. Even in the short-ru
n certain fluctuations arise which actually show a lack of an adequate homeostat
ic mechanism. I) THE LIFE-CYCLE APPROACH Like all organism, the firm, too is an
organism, according to the life-cycle theory. The firm therefore, has its own la
w of growth and survival. It exhibits a cycle of birth, growth, decay and death.
A firm is born when there is an opportunity and a scope for its existence. An e
xisting firm may face unfavorable circumstances in terms of rising costs of inpu
ts or falling demand. When such a firm incurs losses, it may continue to operate
for a while; but will ultimately close down. This is because the resources avai
lable to the firm can be utilized productivity in some other field. In the early
stages the firm has the advantage of a new market or a new product and can forg
e its way ahead with strong competitive courage and capability. With growth, it
consolidates its position and gets structured with internal efficiency and manag
erial acumen. At a later stage rival firms may cause an erosion of its market ma
inly due to their superior techniques or marketing advantages. The firm s object
ive then becomes increasing competitive strength. But as the industry approaches
maturity, demand is saturated, costs of further market penetration get high and
the firm aims at long-term growth and flexibility, though these objectives beco
me difficult to attain. The firm may survive for some time or may face decay, at
such a time. This is an evolutionary approach and it does apply to all organism
s living in a dynamic world. However, in the short -run, evolutionary characters
do not become apparent. Again, the theory leaves out several other consideratio
ns which are relevant.
58
12. OTHER GOALS OR OBJECTIVES OF FIRMS : Normally, it is the entrepreneur who de

cides about the size of the firm which he wants to manage or start. This he will
decide after finalizing the aims and objectives of the firm. So we have to cons
ider the other possible objectives of a firm in addition to the goals we have al
ready discussed in a free enterprise economy. The following are the other object
ives of a firm in a free enterprise economy: 1. Personal Ambitions: Many times a
firm desires to increase its own individual importance in the business world. M
any times this craving is found among firms owned by one single individual or fa
mily. This is done in more than one way. Some may have a desire to earn a name a
s a great donor others may desire to eliminate labour dissatisfaction, while som
e others may be out to provide comforts for their workers and so on. This being
a personal choice any whim of the entrepreneur or owner may be the aim of the fi
rm. Political Dominance: In a democracy, political parties and elections are ine
vitable. Many industrialists or businessmen have a desire to back a particular p
olitical party and to acquire political importance. Facing Competition: Every bu
sinessman or producer has to face competition. By reducing the cost of productio
n to the minimum, a producer may survive or face competition. But if every produ
cer does this, his cost reaches the rock-bottom and further reduction in cost is
not possible. Under these circumstances, a producer may even prefer to incur lo
sses and continue to reduce the price even though he cannot reduce the cost. Thi
s is done on the presumption that sooner or later, some of the competitors may b
e out of the business and then those who survive may be able to make profit and
make up their losses. Under these conditions, the aim of production is not to ma
ke profit but to drive away competitors. Establishment of Monopoly : Establishme
nt of monopoly of a particular product may even be the aim of production. For es
tablishing monopoly, more than one trick are employed by the producers - adverti
sing on a very large scale, dumping, selling the product at two different prices
in two markets, offering rewards, etc. It is very difficult to establish and ma
intain monopoly over the production of any commodity. Thus, in such an effort, m
aximization of profits becomes a secondary objective of production and establish
ing monopoly becomes the primary objective. Maximization of Long-run profits: Mo
dern production has become very complicated. Production necessarily being on a l
arge scale includes several things, such as advertising, printing price lists an
d labels, supplying these lists to retailers, etc. This involves a lot of expend
iture in terms of money and time. Under these circumstances, it becomes more des
irable to keep long term maximum profit as the goal of production. This enables
the producer to neglect short term marginal losses.
2.
3.
4.
5.
59
6.
Reasonableness of Price of Production Policy: In modern times, while planning pr
oduction and the price strategy, it is necessary to take into account the probab
le effects of the strategy. If the price appears to be too high, the government
may interfere and fix the price. In rare cases even the consumers boycott canno
t be ruled out. Avoiding any of these may even be the objective of production. W
e have discussed several objectives of production, other than profit maximizatio
n. In practice, we find that all these objectives do exist. But finally profit maximization remains the only most important motive of production because witho
ut obtaining maximum profit no firm can remain in business for ever. The index o
f the success of production is the rate of profit. Even the success of a joint s
tock company is gauged by the rate of dividend. So theoretically speaking, profi
t maximization must be taken to be the only goal of production. Even while deter
mining the ideal size of the unit of production, we have taken profit maximizati
on as the only motive of production.
60
Exercise: 1. 2. 3. 4. What is plant , firm and industry ? Explain Proprieta

ry firm as a form of business Organization. State its merits and demerits. Expl
ain partnership form of business organization. State its merits and demerits. Ex
plain the features / characteristics of a cooperative organization. Point out it
s merits and demerits. Write short notes on a) b) c) d) e) f) Profit maximizatio
n Prof. Baumol s sales maximization goal, Reasonable Rate of profit as an organi
zation goal Satisfying behavior theory as an organization goal The Homeostatic T
heory The Life Cycle Approach
5.
61
NOTES
62
NOTES
63
NOTES
64
Chapter 3
PROFIT
Preview Meaning of Profit, Accounting Profit vs. Economic Profit, A brief review
about the theories of profit, Measurement of profit, Profit Policies and Reason
s for limiting profit, standard of limited profits. 1. MEANING OF PROFIT :
Profit means different things to different people. "The word Profit has differ
ent meanings to businessmen, accountants, tax collectors, workers and economists
and it is often used in a loose sense that buries its real significance. In gen
eral sense, profit is regarded as income accruing to the equity holders, in th
e same sense as wages accrue to the labour, rent accrues to the owners of rentab
le assets; and interest accrues to the money lenders. To a layman, profit means
all incomes that flow to the investors. To an accountant, profit means the exc
ess of revenue over all paid-out costs including both manufacturing and overhead
expenses. It is more or less the same as net profit . For all practical purpos
es, businessmen also use this definition of profit. For taxation purposes, profi
t or business income means profit in accountancy sense plus non-allowable expens
es. Economist s concept of profit is of Pure Profit , also called economic pro
fit or just profit . Pure profit is a return over and above the opportunity co
st, i.e. the income which a businessman might expect from the second best altern
ative use of his resources. These two concepts of profit are discussed below in
detail. Accounting Profit Vs. Economic Profit The two important concepts of prof
it that figure in business decisions are economic profit and accounting profi
t . It will be useful to explain the difference between the two concepts of prof
it. In accounting sense, profit is surplus of revenue over and above all paid-ou
t costs, including both manufacturing and overhead expenses. Accounting profit m
ay be calculated asAccounting profit = TR - (W + R + I + M) where W = Wages, R =
Rent, I = Interest and M = cost of materials. Obviously, while calculating acco
unting profit, only explicit or book costs, i.e. the cost recorded in the books
of accounts, are considered.
Profit
65
The concept of economic profit differs from that of accounting profit. Econo
mic profit takes into account also the implicit or imputed costs. The implicit c
ost is opportunity cost. Opportunity cost is defined as the payment that would b
e necessary to drawforth the factors of productions from their most remunerativ
e alternative employment . In simple terms, opportunity cost is the income foreg
one, which a businessman could expect from the second best alternative use of hi
s resources. For example, if an entrepreneur uses his capital in his own busines
s, he foregoes interest which he might earn by purchasing debentures of other co
mpanies or by depositing his money with joint stock companies for a period. Furt
hermore, if an entrepreneur uses his labour in his own business, he foregoes his
income (salary) which he might earn by working as a manager in another firm. Si
milarly, by using productive assets (land and building) in his own business, he
sacrifices his market rent. These foregone incomes - interest, salary, and rent
- are called opportunity costs or transfer costs. Accounting profit does not tak
e into account the opportunity cost. It should also be noted that the economic o
r pure profit makes provision also for (a) insurable risks, (b) depreciation, an
d (c) necessary minimum payment of shareholders to prevent them from withdrawing
their capital. Pure profit may thus be defined as residual left after all cont
ractual costs have been met, including the transfer costs of management, insurab
le risks, depreciation and payments to shareholders, sufficient to maintain inve
stment at its current level Thus. Pure profit = Total revenue - (explicit cost
s + implicit costs). Pure profit so defined may not be necessarily positive for
a single firm in a single year - it may be even negative, since it may not be po
ssible to decide beforehand the best way of using the resources. Besides, in eco
nomics, pure profit is considered to be a short term phenomenon - it does not ex
ist in the long run under perfectly competitive conditions. An entrepreneur brin
gs together various factors of production such as land, labour and capital. He e
nsures co-ordination between the factors and supervises the productive activity.
He looks after purchase of raw materials, production, marketing, recovery of re
ceivable and personnel. The most important function performed by an entrepreneur
is, however to undertake risk and uncertainty in business. The reward which is
paid to an entrepreneur for discharging this function is called Profit. In this
chapter, we propose to study the emergence of profit.
(A) Gross Profit and Pure (Net) Profit
When cost of production is deducted from the total sales proceeds, the residual
portion is called Gross Profit. Gross Profit = Total Receipts - Total Expenditur
e An entrepreneur is required to make following payments out of the Gross Profit
:
66
(a)
Remuneration for the factors of production contributed by the entrepreneur himse
lfHe must pay rent for the use of land. If the land is owned by him, he must pay
notional reward for the use of land, because, he is otherwise required to pay r
ent if he hires land from some other person.
(b)
Depreciation and Maintenance Charges Some portion should be deducted from gross
profit by way of depreciation on machinery and other assets.
(c)
Extra - Personal Profits This includes i)
Monopoly Profits : If a producer is a monopolist, he may be earning monopoly pro
fits. These are profits not because of the business skill or ability of the entr
epreneur, but because he is a monopolist in his field. Monopoly profits must be
deducted from gross profits to arrive at net (pure) profits. Chance Profit : An
entrepreneur may earn high profits just by chance , say because of an outbreak
of war. This is not a part of net profits.
ii)
(d)
Net Profits : When all the above payments are made out of gross profit, the resi
dual portion is called Pure (Net) Profit. The reward which an entrepreneur gets
(i) for undertaking risk and uncertainty, (ii) for co-ordinating and organizing
production and (iii) for innovating is called Pure Profit.
2.
THEORIES OF PROFITS :
Various theories have been developed to explain the emergence of Profit. It is w
orthwhile to explain some of the theories of profit. (1) Risk Taking Theory The
Risk-Taking Theory was developed by the American economist Hawley. According to
him, profit arises because considerable amount of risk is involved in business.
Profit is, therefore, the reward for risk-taking. Hawley s theory has been criti
cized on several grounds. In the first place, Hawley has not classified the type
s of risks. Secondly, as Cawer has pointed out, profit is not the reward for ris
k-taking. It is the reward for riskavoiding. An entrepreneur is required to mini
mize his, risk, if he cannot eliminate it totally. A successful entrepreneur is
he who earns good profits by eliminating the risk.
Profit
67
On the other hand, a mediocre businessmen is not able to reduce the risk in busi
ness; and therefore, is subjected to losses. (2) Uncertainty-Bearing Theory of P
rofit : Uncertainty-Bearing Theory of profit was developed by the American econo
mist, Prof. F.H. Knight. He has classified the risks under the two heads. (a) Ce
rtain risks such as risk of fire, risk of theft, risk of accident etc. are less
important because they can be passed on to an insurance company. An entrepreneur
can take an insurance policy by paying the premium. Since such risks are covere
d by insurance, they are called "Insurable Risks." There are other risks which c
annot be passed on to an insurance company or to the paid managers. Every busine
ss involves great amount of uncertainty and the losses arising there from cannot
be estimated with precision. The prices of raw materials may suddenly increase,
the supply of raw materials may be restricted and introduction of new substitut
es in the market may reduce the demand for the product. When demand declines, la
rge stocks may remain unsold in the go-down. A producer may have to face keen co
mpetition. if the market is characterised by monopolistic competition. All these
factors are uncertain and losses arising there from cannot be insured with any
insurance company. These risks and losses must be borne by the entrepreneur hims
elf. According to Prof. Knight, profit is, therefore, the reward for uncertainty
-bearing.
(b)
Uncertainty theory of profit has gained wide popularity since its publication. A
fter the Industrial Revolution, production is carried out on a large scale and i
n anticipation of demand. Producers take into account the tastes and fashions of
the people and produce the goods accordingly. Sudden change in the tastes and f
ashions may affect the demand for products. If a particular fashion is receded i
n the background, goods may not be sold at all. The losses arising out of such u
ncertainty cannot be estimated with precision. According to Prof. Knight, profit
is, therefore, a reward of uncertainty. Uncertainty theory has been criticized
on the ground that profit is the reward paid to an entrepreneur for discharging
several duties. Prof. Knight has overlooked other duties and has glorified the u
ncertainty; the theory has no sound foundations either in logic or in practice.
A number of illiterate producers who have not studied the theory, are able to an
ticipate precisely the profits or losses that would arise in future. (3) Innovat
ion Theory of Profit. Innovation Theory was developed by Joseph Schumpeter. Acco
rding to him, profit is the reward paid to an entrepreneur for his innovative en
deavours.
68
Schumpeter has made distinction between invention and innovation. A scientist ma

y make an invention, but this invention is exploited on a commercial basis by an
entrepreneur. The basis on which the invention is exploited depends upon the in
novative nature of the entrepreneur. If he is successful in exploiting the inven
tion it is innovation. According to Schumpeter, profit is the reward for innovat
ion. Schumpeter s theory has been criticized on several grounds. Profit is the r
eward for discharging so many duties; but Schumpeter has overlooked the other du
ties. Another point of criticism is that Schumpeter has neglected the fact that
profit is also the reward for risk and uncertainty bearing. The most serious cri
ticism of this theory is that a particular producer who exhibits an innovative c
haracter may earn super-normal profits in the shortrun. But the super normal pro
fits will attract new firms to the industry. If new firms enter the industry, th
e super-normal profits would be shared between the existing as well as the new f
irms. In the long run, super normal profits would, therefore, disappear. It is s
aid that profits are caused by innovation and disappear by imitation. Schumpeter
s theory is, therefore, to be taken to a limited extent. (4) Dynamic Theory of
Profit The Dynamic Theory of Profit was developed by the renowned economist, J.B
. Clark. Prof. Clark points out that the whole world is dynamic. Changes after c
hanges are taking place every day; and the economic consequences of these change
s are of a far reaching character. Prof. Clark has pointed out the following typ
es of changes. a) b) c) d) e) Changes in the quantity and quality of human needs
; Changes in the techniques of production Changes in the supply of capital Chang
es in organization of business Changes in population
These changes can occur at any time. Techniques of production may change and imp
roved machinery may be introduced. This may reduce the cost and increase the pro
fit and output. But to purchase the improved machinery, a larger amount of fixed
capital is required. This may necessitate the admission of a new partner or con
version of the partnership firm into a joint stock company to raise capital on a
large scale. All these changes can occur suddenly, and an entrepreneur has to f
ace them properly. A producer who overcomes these hurdles is successful in earni
ng higher profits. He must adjust himself to the changing times. A producer who
cannot address himself to the dynamic world lags behind. In order to survive and
grow every producer must change the methods to suit the changing needs. Accordi
ng to Prof. Clark, profit is the reward paid for dynamism.
Profit
69
Profits in a Static Society According to Prof. Clark, profit cannot arise in a s

tatic society. In a static society there are no changes. Population is stable an
d the demand is stationary. Since the demand is limited, output is also limited.
The general price level and factor prices being stable; the cost of production
is constant. The selling price and the margin of profit are also constant. A pro
ducer has to produce a limited quantity of goods and it is sold immediately, the
moment it is produced. Since demand is constant, a producer does not run the ri
sk of uncertainty. In static society, there are no inventions and producers are
not required to make innovations. Producers in a static society have not to face
any changes in the tastes, fashions and output. They produce a given quantity a
nd sell it in a routine manner. A producer in a static society works like a paid
manager. He performs only the routine duties and gets normal profit. The normal
profit which he gets may be called Wages for Management . According to Prof. C
lark, a producer in a static society gets only normal profits, because pure prof
it does not arise. Conclusion Prof. Clark s Dynamic Theory of Profit has been cr
iticized on several grounds. He has classified the changes under five categories
but has overlooked many other important changes. In this dynamic world, the Gov
ernment policy may suddenly change. A change in the Monetary Policy of the Centr
al Bank may bring about an expansion or contraction in the supply of money. This
may lead to an expansion or contraction in the supply of capital. Ultimately it
may affect the fortunes of business. Prof. Clark has overlooked such important
factors. 3. MEASUREMENT OF PROFIT :
Our discussion of profit so far, has made it clear how difficult it is to have a
simple definition of profit that is acceptable to all. The measurement of profi
t is also equally difficult. For one thing, the economic concept of profit-and l
oss and the legal concept of profit-and-loss are not the same. This is especiall
y difficult when it comes to the measurement of net profit. For calculating net
profit, it is necessary to deduct all costs from the total revenue. But the incl
usiveness of costs itself involves many difficulties. All these problems, theref
ore, deserve a more careful and detailed analysis. (A) Economic Profit and Accou
nting Profit : Let us take an example to understand the difference between the e
conomic concept of profit and the accounting concept of profit. Suppose an indiv
idual starts at his residence the business of repairing scooters. At the end of
the year, he gets a total revenue of Rs.1,50,000/-. Out of this, let us say, he
spent Rs.50,000/- on the wages of his helper, tools and spare parts, etc. What r
emains is a sum of Rs.l,00,000/-. Apparently, one would be tempted to conclude t
hat this is his profit. But it is not so. The place that is available to him mig
ht have saved him a sum of, say Rs.30,000/-. In other words, the place of work m
ight have an opportunity cost. His own transfer earnings may be say 70
Rs.60,000/-. Had he borrowed the money capital, the interest would have been say
Rs.l0,000/-. Besides, a provision will have to be made for the wear and tear of
the tools and instruments, i.e. a certain amount will have to be deducted for d
epreciation. Thus, calculated, the total costs would be (i) Helper s wages, spar
es etc. Rs.50,000 + (ii) Rent Rs.30,000 + (iii) Entrepreneur s management wages
: Rs.60,000 + (iv) Interest : Rs.l0,000 + (v) Depreciation Rs.5,000. This takes
the total cost equal to Rs.l,55,000 against the total revenue of Rs.l,50,000 sho
wing a let net loss of Rs.5,000. The loss in the above example does not become a
pparent because the entrepreneur uses some of the factors owned by himself and t
herefore, the remunerations to these are not actually paid. It should be obvious
from the above example that these difficulties may not arise in respect of larg
e industrial units. In such units, ownership is with the shareholders while the
management is entrusted to the salaried managers. Thus, most of the costs enter
the account books and the accounting and economic concepts of costs in such case
s come closer. According to the financial accounting principle, the assets of a
concern have claims from two sides : from the owners and from the lenders. There
fore, in any business unit, Assets = Liabilities + Proprietorship Therefore, Ass
ets - Liabilities = Proprietorship or the net worth The balance sheet of any con
cern shows, during a given period, the total liabilities and the net worth after
these are deducted. Similarly, the profit and loss account or the income statem
ent shows the changes in the balance sheet of the unit from the beginning of the
year and those at the end of the year is the net income or profit. The funds st
atement is based on this profit and loss statement. This statement indicates the
financial standing of the business concern. The funds statement shows the amoun
t of cash available and how it has been invested. While preparing all these stat
ements, the accountant has to include items, the truth about which can be tested
. But in doing so, many difficulties arise. For example, while preparing the bal
ance-sheet, the cost of the asset that is taken is the one at which the asset wa
s purchased. The current value of the asset is not considered. Similarly the cha
nges in the value of money are ignored. It is also incorrect as is done in finan
cial accounts, to calculate net profits by deducting from the total revenue of y
ear the total costs incurred during that year. The economic concept of net profi
t will have to be altogether different. In the valuation of any asset, the econo
mist is guided by the concept of opportunity cost. For example, the accounting m
ethod will take into account the original price of a machine; but in the economi
c concept, the replacement cost of the machine would be used. For valuation of
Profit
71
the machine, further alternatives would be to take the price of a similar machin
e, if the same is not available; or to consider the total expected return of the
machine and from that calculate the present worth of the machine. We are famili
ar with the various cost concepts. Thus, the differences in the profit concepts
arise out of the differences in cost concepts. The modern method used for valuat
ion is based on the cash flow technique. It will also be necessary to remember t
hat the sum total of all the individual machines added together will not be the
correct value of the total establishment. This is because the goodwill enjoyed b
y the concern will also have to be included in its total worth. This is how the
economic and the accounting approaches differ and make measurement of profit mor
e complicated. (B) Factors Leading to Differences in the Economic and the Tradit
ional Concepts of Valuation The above discussion makes it clear how valuation of
asset is important in the measurement of profits. Let us now consider those fac
tors which underline the differences in the economic and the accounting approach
es to the problem. These factors are : (a) Depreciation, (b) Inventory Valuation
and (c) the unaccounted value changes in the assets and the liabilities. a) Dep
reciation : Depreciation is the loss in value caused by the continuous use of an
asset. Every durable asset has a certain life at the end of which it has got to
be replaced. For such a replacement, a provision in the form of depreciation is
required to be made. There are various methods of calculating this depreciation
. Following are the important ones among them.
i)
Staright Line Method This is the simplest method of all. What is done is the lif
e of an asset is first estimated and then the share of one year in the total val
ue of the asset is deducted. What remains is taken as the value of the asset for
the next year. In this way, at the end of the life-time of the asset, the firm
will have collected an amount equal to the value of the asset. If, for example,
the price of a machine is P, the scrap-value at the end of its life-time is S an
d the life of the machine is Y years, then the amount of depreciation (D) will b
e given by the formula : D = P S Y
72
If P = Rs.25,000/-; S = Rs.5,000/- and Y = 20 years, the annual amount of deprec

iation will be 25,000 5,000 = 2000. This means that the 20 annual allotment towa
rds, depreciation will have to be Rs.2000 only.
(ii)
Diminishing Balance Method In this method, the amount of depreciation is large i
n the initial years. Suppose the annual amount of depreciation is taken as 10 pe
r cent of the value of the machine. Then, in the first year the depreciation wil
l be 10 per cent of the value of the machine; but during the second year, it wil
l be l0 per cent of the total value minus the depreciation fund created during t
he first year. By this method, the value of the machine will never become zero a
nd the amount of depreciation will go on diminishing.
(iii) Annuity Method In this method, equal annual amounts are first calculated f
or the length of the life of an asset. However, along with the annual allotment,
the interest that can be earned is also calculated.
(iv) Service Unit Method Instead of considering the life of an asset in years, t
he actual working hours can be taken. This is the basis of service unit method.
If a machine can work for l,000 hours, then the value of the machine divided by
l,000 will be the hourly rate of depreciation. The total number of hours for whi
ch the machine was actually used during a given period can thus give us the amou
nt of depreciation during that period. The original value of machine minus depre
ciation will give its value for the remaining period. Whatever method used for t
he valuation of assets, in the accounting sense, some problems remain unsolved.
Thus, for instance, every asset has a limited life and at the end of it, the ass
et needs to be replaced. At the time of replacement, new and more efficient mach
ines may be available. If such new machines are to be purchased, how much money
will be required and at what rate depreciation will have to be provided cannot b
e decided before hand, by any of these methods. This makes measurement of profit
difficult. (b) Inventory Valuation Another difficulty that is encountered is in
respect of inventory valuation. This difficulty would not arise if the prices o
f all products and the level of all production were constant. But this never hap
pens. The raw materials are purchased at different prices. The costs of producti
on also change from time to time. This makes the
Profit
73
valuation of of stocks of finished products very difficult. Let us first conside

r the two most widely used methods of inventory valuation. i) First-In-First Out
Method (FIFO) : In this method, it is assumed that goods which entered the firm
s stock first were used first. Then, in this assumption, the cost of producing
the given output is estimated. Last-In-First Out Method (LIFO) : In this method,
the cost of production is calculated on the assumption that the material which
was last to enter the inventory of the company was used first.
ii)
It is obvious that a change in the use from either of the two methods mentioned
above to the other one must lead to a change in estimate of profit. There would
be a great divergence between the profits estimated by these two methods especia
lly when the above mentioned changes in prices etc. are very rapid. The profit w
ould appear to be abnormally high if it is calculated on the basis of FIFO in ti
mes of inflation and abnormally low in times of deflation. The methods, however,
are in use due to their convenience from accounting point of view. It is thus,
clear that by either method, it is difficult to state precisely the value of the
inventory. This is mainly because of the changes in the value of money. Taking
a stable value of money, i.e. valuation at constant prices would also not serve
the purpose. Thus, due to these difficulties in the valuation of inventories, th
e measurement of profit is rendered difficult. (c) The Unaccounted Value Changes
in the Assets and the Liabilities Besides the above two factors which create di
fficulties of valuation, there is a third category of changes in the value of as
sets and liabilities that poses a challenge to valuation. The research that is u
ndertaken to improve the quality of the product, the expenses on improving the e
fficiency of management etc. increase the value of the establishment. These cost
s create assets, which cannot be precisely valued. They do increase profits but
cannot be expressed in terms of money, and therefore, measurement of changes in
the value of assets becomes difficult. Thus, it is clear, how difficult the prec
ise measurement of profits is. By simply using historical cost the profits are l
ikely to be either inflated or deflated. It is, therefore, necessary to calculat
e costs and profits at constant price to take utmost care in calculating depreci
ation, to take cognizance of modern methods like cost flow techniques, managemen
t accounting and so on, and to use opportunity costs wherever necessary. Even th
en, a correct amount of profit may not be found out. But we shall be close to th
e correct estimate. The calculation of profit will also vary according to the pu
rpose for which the calculation is required. 74
4.
PROFIT POLICY :
By and large, we say that an entrepreneur aims at maximum profits. But how much
profit should be taken as the maximum ? This is a difficult question to answer
. A scientific thought to this question must provide a guidance on the following
two lines : (a) What profit should an entrepreneur expect in any enterprise, an
d (b) How far is profit influenced by factors, which are external to the firm. I
t must be understood at the outset that the freedom of an entrepreneur to decide
his rate of profit depends on the nature of the market and other constraints in
cluding legal provisions, business conventions, consumer resistance and so on. P
rofit is usually expressed as gross profit, or as net profit or as a per cent re
turn to capital invested. In modern business, the common practice is to express
profit as a per cent net return to capital. (a)
Profit Expectations : The profit that an entrepreneur should expect can be subje
cted to a number of criteria. The following four criteria are widely accepted :
i) The rate of profit should be sufficient to attract share capital if felt nece
ssary. When new shares are to be issued for expansion, the old shareholders shou
ld not have a feeling of having suffered a capital loss. New shares must therefo
re be sold at a price that gives the old shareholders a satisfaction that they a
re in possession of sound shares. Their rate of profit should be enough to comma
nd a good price for the new issue of shares. The rate of profit should be compar
able to that in similar companies. Many times, there are many independent units
under the same management. In all these siter-concerns, the rates of profitabili
ty should be comparable. The profit rate should be comparable to the profit rate
s in the past. The profits should be large enough to allow for a plough-back for
business expansion. It is, however, necessary to see that reinvestment of profi
ts does not cause a dwindling in the reasonable rate of profit.
ii)
iii) iv)
(b)
External Factors : Besides the criteria mentioned above, there are certain exter
nal factors that influence the profitability of a firm in modern times. These fa
ctors are :
i) Full Employment : Under conditions of full employment, maintenance of cordial
labour relations is of utmost importance. Excessive profits, under such circums
tances, become an invitation to labour unrest. Care should be taken to keep prof
its within reasonable limits.
Profit
75
ii)
Potential Rivals : In any business, the possibility of emergence of rival firms
must be taken into consideration. Abnormal profits attract rivals and wipe out p
rofits. To keep away the rivals, it becomes necessary to control profits. Whethe
r this will be possible depends upon many factors, but an effort should be made
to abide by this rule. Consumers Confidence : It is also necessary to maintain
the confidence of the consumers in the reasonableness of the firm s prices. Thos
e entrepreneurs who are tempted to exploit the situation of reaping huge profits
usually lose the sympathies of their customers. It pays in the long-run to over
come such temptations and continue to enjoy the confidence of the customers. Pol
itical Climate : In modern times, entrepreneurs are also required to take note o
f the political climate in the country. This is especially true where a firm sup
plies products to government departments, or public enterprises. Charges of prof
iteering and exploitation may invite public inquiries and this will cause a grea
t deal to the firm. It is, therefore, advisable to keep profit rates low and cre
ate an image of a firm with fair dealings.
Thus, profit policy involves many important considerations and all the factors n
oted above go into the formulation of a sound profit policy.
iii)
iv)
5.
REASONABLE PROFIT TARGET :
We have already studied that modern firms and corporations may not aim at profit
maximization. Instead they set a standard , a target or a reasonable profit
which they strive to achieve. We have also studied the reasons for aiming at Re
asonable Profits in the previous chapter. Let us now look into the policy questio
ns related to setting standards or criteria for reasonable profits. The importan
t policy questions are : a) b) What are the criteria for determining the profit
standard? How should reasonable profits be determined? Let us now briefly exam
ine the policy implications of these questions. a) Standards of Reasonable Profi
ts :
When firms voluntarily exercise restraint on profit maximization and choose to m
ake only a reasonable profit , the questions that arise are : (i) what form of
profit standard should be used, and (ii) how should reasonable profits be determ
ined ?
76
Forms of Profit Standard The profit standards may be determined in terms of (a)
aggregate money terms, (b) percentage of sales, or (c) percentage return on inve
stment. These standards may be determined with respect to the whole product line
or for each product separately. Of all the forms of profit standards, the total
net profits of the enterprise usually receive the greatest attention. But when
purpose is to discourage the potential competitors, then a target rate of return
on investment is the appropriate profit standard, provided competitors cost cu
rves are similar. b) Setting the Profit Standard
The following are the important criteria that are taken into account while setti
ng the standards for a reasonable profit . Capital attracting standard An impor
tant criterion of profit standard is that it must be high enough to attract exte
rnal capital. For example, if stocks are being sold in market at five times thei
r current earnings, it is necessary that the firm earns a profit of 20 percent o
n the book investment. There are however certain problems that are associated wi
th this criterion : (i) capital structure of the firms (i.e. the proportions of
bonds, equity and preference shares) affects the cost of capital and thereby the
rate of profit, (ii) whether profit standard has to be based on current or long
run average cost of capital as it varies widely from company to company and may
at times prove treacherous i.e. unpredictable. Plough back standard In case a
company intends to rely on its own sources for financing its growth, then the m
ost relevant standard is the aggregate profit that provides for an adequate "plo
ugh-back" for financing a desired growth of company without resorting to the cap
ital market. This standard of profit is used when maintaining liquidity and avoi
ding debt are main considerations in profit policy. Plough back standard is howe
ver socially less acceptable than capital-attracting standard. The reason, that,
it is more desirable that all earnings are distributed to stockholders and they
should decide the further investment pattern. This is based on a belief that ma
rket forces allocate funds more efficiently and the individual is the best judge
of this resource use. On the other hand, retained earnings which are under the
exclusive control of the management are likely to be wasted on low-earning proje
cts within the company. But one cannot say for certain as to which of the two al
locating agencies is actually superior. It depends on the relative abilities of
management and outside investors to estimate earnings prospects."
Profit
77
Normal earnings standard Another important criterion for setting standard of rea
sonable profit is the normal earnings of firms of an industry over a normal pe
riod. Company s own normal eanrings over a period of time often serve as a valid
criterion of reasonable profit, provided it succeeded in (i) attracting externa
l capital, (ii) discouraging growth of competition, (iii) keeping stockholders s
atisfied. When average of normal earnings of a group of firms is used, then onl
y comparable firms and normal periods are chosen. However, none of these standar
ds of profit is perfect. A standard is therefore chosen after giving due conside
ration to the prevailing market conditions and public attitudes. In fact, differ
ent standards are used for different purposes because no single criterion satisf
ies all the conditions and all the people concerned.
78
Exercise : 1. 2. 3. 4. 5. 6. 7. 8. Give a brief review about the theories of pro

fit. Critically evaluate F.H. Knight s Uncertainly Bearing Theory of Profit. Dis
tinguish between gross and net profit. How would you distinguish between Account
ing Profit and Economic Profit? "Profit is a reward of the entrepreneur for inno
vation" Discuss. State and explain Dynamic Theory of Profit. Explain how profit
can be measured in practice. Write notes on: (a) Profit Policy (b) Standards of
reasonable profit (c) Reasons for limiting profits.
Profit
79
NOTES
80
NOTES
Profit
81
NOTES
82
Chapter 4
DEMAND ANALYSIS
Preview Introduction: Concept of demand, Individual Demand and Market Demand, De
terminants of Demand, Law of demand, Elasticity of demand, Measurement and its u
ses. Demand Forecasting-methods/ techniques of demand forecasting. Introduction
to Index Numbers. 1) CONCEPT OF DEMAND
In Economics, Demand does not mean simple desire. Thus, a poor mans desire to have
a motor-car or middle class persons desire to have an air-conditioned bunglow in
a city or suburb will not have any influence on the production of cars and bungl
ows. Nor does Demand mean need. For example a beggars need for more bread, clothing a
nd shelter will have absolutely no influence on the production of those three go
ods, however urgently they may be needed by a beggar. In Economics Demand means des
ire backed by adequate purchasing power or enough money to purchase desired goods
. In fact, in Economics, demand means specific quantity of a commodity actually pu
rchased or bought. Further, since quantity purchased will depend upon price of t
he commodity in question, it follows that demand means at a specific price. Unless
the price per unit of the commodity is stated, the concept of demand will not b
e clear. Demand in Economics also means demand per unit of time, say per day, per mo
nth, per year and so on. Thus, it can be said that in Pune, demand (i.e. quantit
y actually purchased) for milk per months is 1,50,000 liters when the price of m
ilk is Rs. 15 per litre. Or at an individual level, a person demands (i.e. actua
lly purchases) one litre of milk per day (or 30 litres of milk per month), when
the price of milk is Rs. 15 per litre.
Demand Analysis
83
Other examples explaining the concept of demand may be as follows : In India, de

mand (i.e. actual quantity that is purchased) for wheat per year is 40 lakh tone
s, when the price of wheat is Rs. 15 per Kg. Though not generally mentioned in a
ny book, along with price and unit of time, it would be logical to mention speci
fic market in which buying and selling transactions are taking place, say demand
in a village, in Pune, in Mumbai, in India and so on. Thus, now the full statem
ent of the concept of demand would be as follows: At a price of Rs. 15 per litre
in village A, 100 litres of milk are demanded (i.e. actually bought) per day. I
n Pune, at the price of Rs. 15 per litre, 1,50,000 litres of milk are demanded (
actually purchased) per day. In Mumbai, at the price of Rs. 15 per litre, 4,50,0
00 litres demanded (actually purchased) per day. In Maharashtra at an average pr
ice of Rs. 15 per litre, 50 lakh litres of milk are demanded (actually Purchased
) per day. The above examples should make the concept of demand clear. Omission
of price per unit of a commodity, or unit of time or of specific market would le
ave the concept of demand vague. Determinants Of Demand : Demand for a commodity
depends on a number of factors. a) Factors Influencing Individual Demand
An individual s demand for a commodity is generally determined by factors such a
s : i) PRICE OF THE PRODUCT : Price is always a basic consideration in determini
ng the demand for a commodity. Normally, a larger quantity is demanded at a lowe
r price than at a higher price. INCOME : Income is an equally important determin
ant of demand. Obviously, with the increase in income one can buy more goods. Th
us, a rich consumer usually demands more goods than a poor consumer. TASTES AND
HABITS : Demand for many goods depend on the person s tastes, habits and prefere
nces. Demand for several products like ice-cream, chocolates, behl-puri, etc. de
pend on an individual s tastes. Demand for tea, betel, tobacco, etc. is a matter
of habit. People with different tastes and habits have different preferences fo
r different goods. A strict vegetarian will have no demand for meat at any price
, whereas a non-vegetarian who has liking for chicken or fish may demand it even
at a high price. Similar is the case with demand for cigarettes by non-smokers
and smokers. 84
ii)
iii)
iv)
RELATIVE PRICES OF OTHER GOODS : SUBSTITUTES AND COMPLEMENTARY PRODUCTS : How mu
ch the consumer would like to buy of a given commodity, however, also depends on
the relative prices of other related goods such as substitutes or complementary
goods to a commodity. When a want can be satisfied by alternative similar goods
, they are called substitutes. For example, peas and beans, groundnut oil and ti
l oil, tea and coffee, jowar and bajra etc., are substitutes of each other. The
demand for a commodity depends on the relative prices of its substitutes. If the
substitutes are relatively costly, then there will be more demand for the commo
dity in question at a given price than in case its substitutes are relatively ch
eaper. Similarly, the demand for a commodity is also affected by its complementa
ry products. When in order to satisfy a given want, two or more goods are needed
in combination, these goods are referred to as complementary goods. For example
, car and petrol, pen and ink, tea and sugar, shoes and socks, sarees and blouse
s, gun and bullets etc. are complementary to each other. Complementary goods are
always in joint demand. Thus, if a given commodity is a complementary product,
its demand will be relatively high when its related commodity s price is lower t
han otherwise. Or, when the price of one commodity decreases, the demand for its
complementary product will tend to increase and vice versa. For example, a fall
in the price of cars will lead to an increase in the demand for petrol. Similar
ly a steep rise in the price of petrol will cause a decrease in demand for petro
l driven motor cars and its accessories.
v)
CONSUMER S EXPECTATIONS : A consumer s expectations about the future changes in
the price of a given commodity also may affect its demand. When he expects its p
rices to fall in future, he will tend to buy less at the present prevailing pric
e. Similarly, if he expects its price to rise in future, he will tend to buy mor
e at present. ADVERTISEMENT EFFECT : In modern times, the preferences of a consu
mer can be altered by advertisement and sales propaganda, albeit to a certain ex
tent only. Thus, demand for many products like tooth-paste, toilet-soap, washing
powder, processed foods, etc., is partially caused by the advertisement effect
in a modern man s life. Factors Influencing Market Demand :
vi)
b)
The market demand for a commodity originates and is affected by the form of chan
ge in the general demand pattern of the community of the people at large. The fo
llowing factors affect the common demand pattern for a commodity in the market.
1) PRICE OF THE PRODUCT : At a low market price, market demand for the product t
ends to be high and vice versa.
Demand Analysis
85
2)
DISTRIBUTION OF INCOME AND WEALTH IN THE COMMUNITY : If there is equal distribut
ion of income and wealth, the market demand for many products of common consumpt
ion tends to be greater than in the case of unequal distribution. COMMUNITY S CO
MMON HABITS AND SCALE OF PREFERENCES : The market demand for a product is greatl
y affected by the scale of preferences by the buyers in general. For example, wh
en a large section of population shifts its preference from vegetarian foods to
non-vegetarian foods, the demand for the former will tend to decrease and that f
or the latter will increase. GENERAL STANDARDS OF LIVING AND SPENDING HABITS OF
THE PEOPLE : When people in general adopt a high standard of living and are read
y to spend more, demand for many comforts and luxury items will tend to be highe
r than otherwise. NUMBER OF BUYERS IN THE MARKET AND THE GROWTH OF POPULATION :
The size of market demand for a product obviously depends on the number of buyer
s in the market. A large number of buyers will constitute a large demand and vic
e versa. Thus, growth of population is an important factor. A high growth of pop
ulation over a period of time tends to imply a rising demand for essential goods
and services in general.
3)
4)
5)
6)
AGE STRUCTURE AND SEX RATIO OF THE POPULATION : Age structure of population dete
rmines market demand for many products in a relative sense. If the population py
ramid of a country is broad-based with a larger proportion of juvenile populatio
n, then the market demand for milk, toys, school bags etc. - goods and services
required by children - will be much higher than the market demand for goods need
ed by the elderly people. Similarly, sex ratio has its impact on demand for many
goods. An adverse sex ratio, i.e. females exceeding males in number (or, males
exceeding females as in Mumbai), would mean a greater demand for goods required
by the female population than by the male population (or the reverse). FUTURE EX
PECTATIONS : If buyers in general expect that prices of a commodity will rise in
future, etc. present market demand would be more as most of them would like to
hoard the commodity. The reverse happens if a fall in the future price is expect
ed. LEVEL OF TAXATION AND TAX STRUCTURE : A progressively high tax rate would ge
nerally mean a low demand for goods in general and vice-versa. But a highly taxe
d commodity will have a relatively lower demand than an untaxed commodity - if t
hat happens to be a remote substitute. INVENTIONS AND INNOVATIONS : Introduction
of new goods or substitutes as a result of inventions and innovations in a dyna
mic modern economy tends to adversely affect the demand for the existing product
s, which as a result of innovations, definitely become obsolete. For example, th
e advent of latest digital media like Compact Disks (C.Ds) has made audio & vide
o cassettes obsolete.
7)
8)
9)
86
10) FASHIONS : Market demand for many products is affected by changing fashions.
For example, demand for commodities like jeans, shirts, salwar-kameej etc. are
based on current fashions. 11) CLIMATE OR WEATHER CONDITIONS : Demand for certai
n products are determined by climatic or weather conditions. For example, in sum
mer, there is a greater demand for cold drinks, fans, coolers, air conditioners
etc. Similarly, demand for umbrellas and raincoats are seasonal. 12) CUSTOMS : D
emand for certain goods are determined by social customs, festivals, etc. For ex
ample, during Diwali holidays, there is a greater demand for sweets, crackers, v
ehicles and white goods; and during Christmas, cakes, sweets and confectioneries
are in more demand. 13) ADVERTISEMENT AND SALES PROPAGANDA : Market demand for
many products in the present day are influenced by the sellers efforts through
advertisements and sales propaganda. Demand is manipulated through selling effor
ts. Of course, there is always a limit. When these factors change, the general d
emand pattern will be affected, causing a change in the market demand as a whole
. 2. DEMAND SCHEDULE :
A tabular statement of price-quantity relationship is known as the demand schedu
le. It narrates how much amount of a commodity is demanded by an individual or a
group of individuals in the market at alternative prices, per unit of time. The
re are, thus, two types of demand schedules : (i) the individual demand schedule
, and (ii) the market demand schedule. INDIVIDUAL DEMAND SCHEDULE A tabular list
showing the quantities of a commodity that will be purchased by an individual a
t various prices in a given period of time (say per day, per week, per month or
per annum) is referred to as an individual demand schedule. Price of X in Rs. (p
er kg.) 30 25 20 15 10 Quantity Demanded of X per week (in Kg.) 2 4 6 10 16
Demand Analysis
87
This illustrates a hypothetical (purely imaginary) demand schedule of an individ

ual consumer Mr A for commodity X. CHARACTERISTICS OF DEMAND SCHEDULE 1) The dem
and schedule does not indicate any change in demand by the individual concerned,
but merely expresses his present behaviour in purchasing the commodity at alter
native prices. It shows only the variation in demand at varying prices. It seeks
to illustrate the principle that more of a commodity is demanded at a lower pri
ce than at a higher one. In fact, most of the demand schedules show an inverse r
elationship between price and quantity demanded.
2) 3)
MARKET DEMAND SCHEDULE It is a tabular statement narrating the quantities of a c
ommodity demanded in aggregate by all the buyers in the market at different pric
es in a given period of time. A market demand schedule, thus, represents the tot
al market demand at various prices. Theoretically, the demand schedules of all i
ndividual consumers of a commodity can be compiled and combined to form a compos
ite demand schedule, representing the total demand for the commodity at various
alternative prices. The derivation of market demand from individual demand sched
ules is illustrated in the table given below. Here it is assumed that the market
is composed only of three buyers. Price in Rupees (per unit) Units of Commodity
X Demanded per day by Individuals A+ 4 3 2 1 1 2 3 5 B+ 3 4 5 9 C+ 3 5 7 10 Qua
ntity Demanded in the market for X = 7 11 15 24
Apparently, the market demand schedule is constructed by the horizontal addition
s of quantities at various prices shown by the individual demand schedules. It f
ollows that like an individual demand schedule, the market demand schedule also
depicts an inverse relationship between the price and quantity demanded.
88
4.
THE DEMAND CURVE :
A demand curve is a graphical presentation of a demand schedule. When price-quan
tity information of a demand schedule is plotted on a graph, a demand curve is d
rawn. Demand curve thus depicts the picture of the data contained in the demand
schedule. Conventionally, a demand curve is drawn by representing the price vari
able on the Y-axis and the demand variable on the X-axis. Fig. given below illus
trates the demand curve based on the data contained in Table. In this figure, th
e quantity demanded is measured on the horizontal axis (X-axis) and the price pe
r kg. is measured on the vertical axis (Y-axis). Corresponding to the price-quan
tity relations given in the demand schedule, various points like a, b, c, d and
e are obtained on the graph. These points are joined and the smooth curve DD is
drawn, which is called the demand curve. The demand curve has a negative slope.
It slopes downwards from left to right, representing an inverse relationship bet
ween price and demand. Y D
30
Price (Per Kg.)
a b c d e D X
2 4 6 8 10 12 14 16 Quantity Demanded
25 20 15 10 5
O
Individual Demand Curve The figure, given above, represents an individual demand
curve. Likewise, by plotting the market demand schedule graphically, the market
demand curve may be drawn. DERIVATION OF MARKET DEMAND CURVE Market demand curv
e is derived by the horizontal summation of individual demand curves for a given
commodity. Figure given on the next next illustrates this:
Demand Analysis
89
Y
Price (Per Unit)
As Demand
Y
Bs Demand
Y
Cs Demand
Y
Market Demand
D(A) +
D(B) +
D(C) =
D(Market)
O
XO
XO
Quantity Demanded of X
XO
X
Derivation of Market Demand Curve It may be observed that the slope of the marke
t demand curve is an average of the slopes of individual demand curves. Essentia
lly, the market demand curve too has a downward slope indicating an inverse pric
e-quantity relationship, i.e. quantity demand rises when the price falls, and vi
ce-versa. 5. THE LAW OF DEMAND :
The general tendency of consumers behaviour in demanding a commodity in relatio
n to the changes in its price is described by the law of demand. The law of dema
nd expresses the nature of functional relationship between two variables of the
demand relation, viz., the price and the quantity demanded. It simply states tha
t demand varies inversely with change in price. Statement of the Law The law may
be stated thus : "Other things being equal, the higher the price of a commodity
, the smaller is the quantity demanded and lower the price, larger is the quanti
ty demanded." In other words, the demand for a commodity expands (i.e., the dema
nd rises) as the price falls and contracts (i.e. the demand falls) as the price
rises. Or briefly stated, the law of demand emphasises that, other things remain
ing unchanged, demand varies inversely with price. The conventional law of deman
d, however, relates to the much simplified demand function : D = f(P) Where, D r
epresents demand, P the price and f connotes a functional relationship. It, howe
ver, assumes that other determinants of demand are constant and only price is th
e variable and influencing factor. The relation between price and quantity of de
mand is usually an inverse or negative relation, indicating a larger quantity de
manded at a lower price and a smaller quantity demanded at a higher price. 90
EXPLANATION OF THE LAW OF DEMAND The law of demand is usually referred to the ma
rket demand. The law of demand can be illustrated with the help of a market dema
nd schedule, thus : i.e. as the price of a commodity decreases, the correspondin
g quantity demanded for that commodity increases and viceversa. Price of Commodi
ty X (in Rs.) per unit 5 4 3 2 1 Quantity Demanded per week 10 20 30 40 50
This table represents a hypothetical demand schedule for commodity X. We can rea
d of from this table that with a fall in price at each stage, quantity demanded
tends to rise. There is an inverse relationship between price and quantity deman
ded. Usually, economists draw a demand curve to give a pictorial presentation of
the law of demand. When the data of table are plotted graphically, a demand cur
ve is drawn as shown in Figure given below. (Here, incidentally, the demand curv
e being a straight line is a linear demand curve. Demand Curve
Y 5
Price (Per Unit)
D
4 3 2 1 O 10 20 30 40 50 Quantity Demanded of X D X
In this figure, DD is a downward sloping demand curve indicating an inverse rela
tionship between price and quantity demanded. From the given market demand-curve
one can easily locate the market demand for a product at a given price. Further
, the demand curve geometrically represents the mathematical demand function : D
x = f (Px)
Demand Analysis
91
ASSUMPTIONS UNDERLYING THE LAW OF DEMAND The above stated law of demand is condi
tional. It will hold good only if certain conditions are given and constant. Thu
s, it is always stated with "other things being equal". It relates to the change
in price variable only, assuming other determinants of demand to be constant. T
he law of demand is, thus, based on the following ceteris paribus assumptions. 1
) NO CHANGE IN CONSUMER S INCOME : Throughout the operation of the law, the cons
umer s income should remain the same. If the level of a buyer s income changes,
he may buy more even at a higher price, invalidating the law of demand. NO CHANG
E IN CONSUMER S PREFERENCES : The consumer s tastes, habits and preferences shou
ld remain constant. NO CHANGE IN FASHION : If the commodity in question goes out
of fashion, a buyer may not buy more of it even at a substantial price reductio
n. NO CHANGE IN THE PRICES OF RELATED GOODS : Prices of other goods like substit
utes and complementary goods remain unchanged. If the prices of other related go
ods change, the consumer s preferences would change which may invalidate the law
of demand. NO EXPECTATIONS OF FUTURE PRICE CHANGES OR SHORTAGES : The law requi
res that the given price change for the commodity is a normal one and has no spe
culative consideration. That is to say, the buyers do not expect any shortages i
n the supply of the commodity in the market and consequent future changes in the
prices. The given price change is assumed to be final at a time. NO CHANGE IN S
IZE, AGE-COMPOSITION AND SEX RATIO OF THE POPULATION : For the operation of the
law in respect of total market demand, it is essential that the number of buyers
and their preferences should remain constant. This necessitates that the size o
f population as well as the age-structure and sex-ratio of the population should
remain the same throughout the operation of the law. Otherwise, if population c
hanges, there will be additional buyers in the market, so that the total market
demand may not contract with a rise in price. NO CHANGE IN THE RANGE OF GOODS AV
AILABLE TO THE CONSUMERS : This implies that there is no innovation and arrival
of new varieties of products in the market which may distort consumer s preferen
ces. NO CHANGE IN THE DISTRIBUTION OF INCOME AND WEALTH OF THE COMMUNITY : There
is no redistribution of income either, so that the levels of income of the cons
umers remain the same.
2)
3)
4)
5)
6)
7)
8)
92
9)
NO CHANGE IN GOVERNMENT POLICY : The level of taxation and fiscal policy of the
government remain the same throughout the operation of the law. Otherwise, chang
es in income tax, for instance, may cause changes in consumers income or change
s commodity taxes (sales tax or excise duties) may lead to distortions in consum
er s preferences.
10) NO CHANGE IN WEATHER CONDITIONS : It is assumed that climatic and weather co
nditions are unchanged in affecting the demand for certain goods like woollen cl
othes, umbrellas etc. In short, the law of demand presumes that except for the p
rice of the product, all other determinants of its demand are unchanged. Apparen
tly, the validity of the law of demand or the inference about inverse relationsh
ip between price and quantity demanded depends on the existence of these conditi
ons or assumptions. EXCEPTIONS TO THE LAW OF DEMAND OR EXCEPTIONAL DEMAND CURVE
: It is almost a universal phenomenon of the law of demand that when the price f
alls, the demand expands and it contracts when the price rises. But sometimes, i
t may be observed, though, of course, very rarely, that with a fall in price, de
mand also falls and with a rise in a price, demand also rises. This is a paradox
ical situation or a situation which is apparently contrary to the law of demand.
Cases in which this tendency is observed are referred to as exceptions to the g
eneral law of demand. The demand curve for such cases will be typically unusual.
It will be an upward sloping demand curve as shown in Figure given below. It is
described as an exceptional demand curve.
Price (Per Unit)
Exceptional Demand Curve
Demand Analysis
93
In this fugre, DD is the demand curve which slopes upward from left to right. It
appears thus that when OP1 is the price, QQ1, is the demand and when the price
rises to OP2 demand also expands to QQ2. Thus, the upward sloping demand curve
expresses a direct functional relationship between price and demand. Such upward
sloping demand curves are unusual and quite contradictory to the law of demand
as they represent the phenomenon that more will be demanded at a higher price a
nd vice versa". The upward sloping demand curve, thus, refers to the exceptions
to the law of demand. There are a few such exceptional cases, which may be categ
orised as follows : 1) GIFFEN GOODS: In the case of certain inferior goods calle
d Giffen goods, as introduced by Robert Giffen when the price falls, quite often
less quantity will be purchased than before because of the negative income effe
ct and people s increasing preference for a superior commodity with the rise in
their real income. Probably, a few appropriate examples of inferior goods may be
listed, such as foodstuffs like cheap potatoes, cheap bread, pucca rice, vegeta
ble ghee, etc., as against superior commodities like good potatoes, cake, basmat
i rice, pure ghee. ARTICLES OF SNOB APPEAL : Sometimes, certain commodities are
demanded just because they happen to be expensive or prestige goods, and have a
snob appeal . These are generally ostentatious articles, and purchased only by
rich people for using them as status symbol . Thus, when prices of such article
s like say diamonds rise, their demand also rises; similarly, Rolls Royce cars,
Johney Walker Scotch Whiskey are another outstanding illustration. SPECULATION :
When people speculate in changes in the price of a commodity in the future, the
y may not act according to the law of demand at present. Say, when people are co
nvinced that the price of a particular commodity will rise still further, they w
ill not contract their demand with the given price rise; on the contrary, they m
ay purchase more for the purpose of hoarding. In the stock exchange market, some
people tend to buy more shares when the prices are rising, in the hope that the
rising trend would continue, so they can make a good fortune in future. CONSUME
R S PSYCHOLOGICAL BIAS OR ILLUSION: When the consumer is wrongly biased against
the quality of a commodity with the price change, he may contract his demand wit
h a fall in price. Some sophisticated consumers do not buy when there is a stock
clearance sale at reduced prices, thinking that the goods may be of bad quality
. CHANGES IN QUANTITY DEMANDED AND CHANGES IN DEMAND:
2)
3)
4)
6.
In economic analysis, the terms changes in quantity demanded and
emand have different meanings.
94
changes in d
The term changes in quantity demanded or variation in demand relates to the la

w of demand. It refers to the changes in quantities purchased by the consumer on
account of changes in price only. Thus, we may say that the quantity demanded o
f a commodity increases when it s price decreases, or the quantity demanded decr
eases when it s price increases. But, it is incorrect to say that demand decreas
es when price increases or demand increases when price decreases. For "increase"
and "decrease" in demand refers to "changes in demand" caused by the changes in
various other determinants of demand, price remaining unchanged. Changes in qua
ntity demanded in relation to the price are measured by the movement along the d
emand curve, while changes in demand are reflected through shifts in the demand
curve. The terms" changes in quantity demanded essentially means variation in de
mand referring to " expansion" or "extension" or "contraction" of demand which a
re quite distinct from the terms "increase" or "decrease" in demand. A) EXPANSIO
N OR (Changes in Q. D.): EXTENSION AND CONTRACTION OF DEMAND
A variation in demand implies "expansion" or "contraction" of demand. When with
the fall in the price with the commodity is brought, there is expansion of deman
d. Similarly, when a lesser quantity is demanded with a rise in price, there is
contraction of demand. In short, demand expands when the price falls and it cont
racts when the price rises. Thus the terms "expansion" & "contraction" are used
in stating the law of demand. The terms "expansion" and "contraction" of demand,
should, however, be distinguished from increase or decrease in demand. The form
er is used for indicating increase in demand, while the later is used for indica
ting changes in demand, and Variation in demand is the connotation of the law of
demand. It expresses a functional relationship between quantity demanded and pr
ice. a change in demand due to change in price is called expansion or contractio
n. Expansion and contraction refer to the same demand curve. A change in demand
due to causes other than price is called increase or decrease in demand. In grap
hical exposition, expansion or contraction of demand is shown by the movement al
ong the same demand curve. A downward movement from one point to the another on
the same demand curve implies expansion of demand, for instance, movement from a
to b in the following figure. It suggests that when the price decreases from OP
to OP1, demand expands from OQ to OQ1. While an upward moment from one point to
another on the same demand curve implies contraction of demand, eg: movement fr
om a to c in the diagram.
Demand Analysis
95
Price (Per Unit)

c
Quantity Demanded of X
Expansion and Contraction of demand The fig. shows that when price rises from OP
to OP2 demand contracts from OQ to OQ2. In short, a change in quantity demanded
in response to the change in price is explained by the terms expansion or contr
action of demand. Further, expansion or contraction implies a movement on the sa
me demand curve which means the demand schedule remains the same. B) INCREASE AN
D DECREASE IN DEMAND (Changes in Demand): These two terms are used to express ch
anges in demand. Changes in demand are result of the change in the conditions or
factors determining demand, other than the price. A change in demand, thus impl
ies an increase or decrease in demand. When more of a commodity is bought than b
efore at any given price, there is increase in demand. Similarly, when with pric
e remaining unchanged less of a commodity is bought than before, there is decrea
se in demand. In other words, an "increase" in demand signifies either that more
will be demanded at given price or the same will be demanded at a higher price.
Thus, an increase in demand means that more is now demanded than before, at eac
h and every price. likewise, "a decrease in demand signifies either that less wi
ll be demanded at given price or the same quantity will be demanded at a lower p
rice. Thus increase and decrease in demand are shown by shifting the demand curv
es. The terms" increase" or "decrease" in demand are graphically expressed by th
e movements from one demand curve to the another. In other words, the change in
demand is denoted by the shifting of the demand curve. In the case of an increas
e in demand, the demand curve is shifted to the right. In the following figure (
A), thus, the movement of demand curve from DD to D1D1 shows an increase in dema
nd. In this case, the movement 96
Co nt ra ct io n
a
Ex
pa
ns
ion
b D
from point a to b indicates that the price remains the same at OP, but more quan
tity OQ1 is now demanded, instead of OQ. Thus increase in demand is QQ1. Similar
ly, as in Fig B, a decrease in demand is depicted by the shifting of the demand
curve towards it s left.
Y D1 D
Price (Per Unit) Price (Per Unit)
Y D D2
Increase
P
a
b D1
Decrease
P
c
a D D2
D O Q (A) Q1 X O Q2 (B) Q
X
Increase & Decrease in demand In the above fig, thus, the movement of demand cur
ve from DD to D2D2 show a decrease in demand. In this case, movement from point
a to c, indicates that the price remains same at the OP, but less quantity OQ2 i
s now demanded than before. Here decrease in demand is QQ2. REASONS FOR CHANGE (
Increase or Decrease in Demand) A change in demand occurs when the basic conditi
ons of the demand change. Thus an increase or decrease in demand is brought abou
t by many kinds of changes. Some of the important changes are: 1) 2) 3) 4) 5) 6)
7) 8) Change in Income Change in the pattern of income distribution. Change in
tastes, habits and preferences. Change in fashions and customs. Change in the su
pply of the substitutes and in their prices. Change in the supply or demand supp
ly of the complementary goods and change in their prices. Change in population.
Advertisement and Publicity persuasion.
Demand Analysis
97
7.
ELASTICITY OF DEMAND :
INTRODUCTION Demand for goods varies with price. But the extent of variation is
not uniform in all cases. In some cases the variation is extremely wide; in some
others it may just be nominal. That means, sometimes demand is greatly responsi
ve to changes in price; at other times, it may not be so responsive. The extent
of variation in demand is technically expressed as elasticity of demand. Accordi
ng to Marshall, the elasticity (or responsiveness) of demand in a market is grea
t or small, depending on whether the amount demanded increases much or little fo
r a given fall in price; and diminishes much or little for a given rise in price
. A) ELASTICITY OF DEMAND : PRICE ELASTICITY OF DEMAND The term "elasticity of d
emand", when used without qualifications is commonly referred to as price elasti
city of demand. This is a loose interpretation of the term. In a strict logical
sense, however, the concept of elasticity of demand should measure the responsiv
eness of demand for a commodity to changes in its determinants. There are, thus,
as many kinds of elasticities of demand as its determinants. Economists usually
consider three important kinds of elasticity of demand : (1) Price elasticity o
f demand, (2) Income-elasticity of demand and (3) Cross-price elasticity of dema
nd or just cross elasticity. "Price elasticity" refers to the degree of responsi
veness of demand for a commodity to a given change in its price. "Income elastic
ity" refers to the degree of responsiveness of demand for a commodity to a given
change in the income of the consumer. "Cross elasticity" refers to the responsi
veness of demand for a commodity to a given change in the price of a related com
modity - substitute or complementary product. In the present chapter, we shall s
tudy them one by one. B) PRICE ELASTICITY OF DEMAND The extent of the change of
demand for a commodity to a given change in price, other demand determinants rem
aining constant, is termed as the price elasticity of demand. The coefficient of
price elasticity of demand may, thus, be defined as the ratio of the relative c
hange in demand to the relative change in price. Since the relative change of va
riables can be measured either in terms of percentage change or as proportional
change, the price elasticity coefficient can be measured : The percentage change
in quantity demanded e = The percentage change in pri
Price elasticity of demand can also be measured alternatively as Net change in Q

uantity demanded Net change in price e = : Or
rice elasticity formula can be stated as : e= Q P : Q P Q P X = Q P Q P X e= P Q Q =
the original demand (Say Q1) = the original price (Say P1) the change in demand.
It is measured as the difference between new demand (say Q2) and the old demand
(Q1) Thus, Q = Q2 - Q1 P= the change in Price. It is measured as the difference
between new Price P2 and the old price (P1) Thus, P = P2 - P1 The above formula
, in fact, relates to point-price elasticity of demand, that is, the coefficient
signifies very small or marginal changes only. To illustrate the use of the for
mula, let us consider the following information from the demand schedule : Price
of Tea (Rs.) 20 (P1) 22 (P2) Quantity Demanded (Kg.) 10(Q1) 9(Q2)
P
Q=
Demand Analysis
99
Thus, P = 22 - 20 = 2, and P = P1 = 20 Q = 09 - 10 = 1, and Q = Q1 = 10 (Here, m

inus signs are ignored) Therefore e= Q X P 1 X = 2 = 1 P Q 20 10
e
This means, the elasticity of demand is equal to one or unity. Using the above f
ormula, the numerical coefficient of price elasticity can be measured from any s
uch given data. Apparently, depending upon the magnitude and proportional change
involved in the data on demand and prices, one may obtain various numerical val
ues of coefficients of price elasticity, ranging from zero to infinity. TYPES OF
PRICE ELASTICITY : DEGREE OF ELASTICITY OF DEMAND Demand may be elastic or inel
astic, depending on the degree of responsiveness of the demand for a commodity t
o a given change in its price. By elastic demand, we mean that demand responds g
reatly or relatively more to a price change. It however, does not imply that the
consumers are fully responsive to a price change. What it means is simply this
that a relatively larger change in demand is caused by a smaller change in price
. Similarly, inelastic demand does not mean that demand is totally insensitive.
It only means that the relative change in demand is less than that of price. It
means demand responds to a lesser extent only. Measuring numerical coefficient o
f price elasticity in different cases, we will find that its value ranges from z
ero to infinity. When the elasticity coefficient is greater than one, demand is
said to be elastic; and it is inelastic when the numerical coefficient is less t
han one; and when it is exactly one (or unity), the demand is unitary elastic. T
reating this concept in a more elaborate manner, we may mention the following fi
ve types of price elasticity of demand : 1) 2) 3) 4) 5) Perfectly elastic demand
Perfectly inelastic demand Relatively elastic demand Relatively inelastic deman
d Unitary elastic demand when e = when e = O when e = >1 when e = <1 when e = 1
100
1)
Perfectly Elastic Demand (e = )
An infinite demnd t the given price is cse of perfectly elstic demnd. Whe
n demnd is perfectly elstic, with slight or infinitely smll rise in the pri
ce of the commodity, the consumer stops buying it. The numericl coefficient of
perfectly elstic demnd is infinity (e = .
)
In fct, the degree of elsticity determines the shpe nd slope of the demnd c
urve. Thus, elsticity of demnd cn be scertined from the slope of the demnd
curve. The slope of demnd curve reflects the elsticity of demnd. In the cse
of perfectly elstic demnd, the demnd curve will be horizontl stright l
ine. Thus, the demnd curve in Figure A given below implies, tht t the ruling
price of OP, the demnd is infinite, while slight rise in price would men z
ero demnd. This figure indictes tht t price OP, person would buy s much o
f the given commodity, s cn be obtined, i.e. n infinite quntity, nd tht
t slightly higher price he would buy nothing. Perfectly, elstic demnd is c
se of theoreticl extremity. It is hrdly encountered in prctice.
(A) Y e=
Price (Per Unit)
P
D D
O
X
Quntity Demnded
Types of Price Elsticity of Demnd In economic theory, however, the demnd for
the product of firm in perfectly, competitive mrket is ssumed to be perfec
tly elstic. Theoreticlly, perfectly elstic demnd or the horizontl demnd cu
rve (s shown in Figure bove), from the firm's point of view implies tht it c
n sell s much s it produces t the ruling mrket price, since t the given pri
ce (sy OP in Figure shown bove), buyers tend to hve n infinite demnd for it
s product in the mrket.
Demnd Anlysis
101
2)
Perfectly Inelstic Demnd (e = 0)
(B) Y e= 0 D
Price (Per Unit)
P1 P2 P3
O
D X Q Quntity Demnded
When the demnd for commodity shows no response t ll to chnge in price, t
ht is to sy, whtever the chnge in price the demnd remins the sme, then it
is clled perfectly inelstic demnd. Perfectly, inelstic demnd hs, thus,
zero elsticity (e = 0). In this cse, the demnd curve would be stright vert
icl line s in Figure B shown bove. This figure indictes tht whether the pri
ce moves from Op1 to OP2 or Op3, the quntity demnded remins the sme OQ only.
Perfect inelsticity is gin theoreticl considertion rther thn prctic
l phenomenon. However, commodity of bsolute necessity like slt seems to hv
e perfectly inelstic demnd for most consumers.
3)
Reltively Elstic Demnd ( e > l )
(C) Y e>1
Price (Per Unit)
D P1 P2 D
X Q1 Q2 Quntity Demnded O
When the proportion of chnge in the quntity demnded is greter thn tht of p
rice, the demnd is sid to be reltively elstic. The numericl vlue of relti
vely elstic demnd 102
Mngeril Economics
lies between one nd infinity. Thus, wht Mrshll clled s elsticity of demn
d being greter thn unity referred to 'reltively elstic' demnd or 'more els
tic' demnd. A reltively elstic demnd will be represented by grdully slop
ing, i.e. rther fltter demnd curve s shown in Figure(C) bove. In this Fig
ure(C) bove when the price flls by P1 P2, the demnd expnds by Q1 Q2 which is
reltively lrge in proportion to the chnge in price. Q e = P =>1
Q P Therefore, elsticity is greter thn one, it is more relistic concept,
s mny commodities cn hve more elstic demnd. 4) Reltively Inelstic Demnd
( e < l )
(D) Y e<1 D
Price (Per Unit)
P1
P2
D O Q1 Q2 X
Quntity Demnded
When the proportion of chnge in the quntity demnded is less thn tht of pric
e, the demnd is considered to be reltively inelstic. The numericl vlue of r
eltively inelstic demnd lies between zero nd one. Hence, the concept "relti
vely inelstic" or 'less elstic" demnd is the sme s wht Mrshll presented
s elsticity being less thn unity. A reltively inelstic demnd will be repre
sented by rpidly sloping, i.e., rther steeper, demnd curve s shown in Fi
gure (D) bove. In Figure (D) when the price flls by P1 P2, the demnd expnds
just by Q1 Q2 which is reltively smll in proportion to the chnge in price. Q e
= P
=<1 Q P Therefore, elsticity is less thn one. This is lso very relistic co
ncept.
Demnd Anlysis
103
5)
Unitry Elstic Demnd (e = 1)
(E) Y D
Price (Per Unit)
e=1 1
P1 P2 D
O
Q1
Q2
X
Quntity Demnded
When the proportion of chnge in demnd is exctly the sme s the chnge in pri
ce, the demnd is sid to be unitry elstic. The numericl vlue of unitry el
stic demnd is exctly 1. In the cse of unitry elstic demnd, the demnd curv
e would be rectngulr hyperbol symptotic to the two xis, s shown in Figur
e (E ) bove. In Figure (E), when the price flls by P1 P2,, the demnd expnds
by Q1 Q2 which is in the sme proportion to chnge in price. Q e = Q P P = 1
Hence, elsticity is equl to unity. This is theoreticl norm, which helps to
distinguish between elstic nd inelstic demnd in generl. The different kinds
of price elsticity of demnd discussed bove hve been summrised in Tble A o
n the next pge.
104
Mngeril Economics
Tble A PRICE ELASTICITY OF DEMAND

(Definition e = Percentge chnge in the quntity demnd : Percentge chnge in
price)
Numericl Vlue e=
Terminology Perfectly (or infinitely elstic) Perfectly (or completely) inelsti
c Reltively elstic Reltively inelstic Unitry elstic
Description Consumers hve infinite demnd t prticulr price nd none t ll
t even slightly higher thn this given price. Demnd remins unchnged whteve
r my be the chnge in price. Quntity demnded chnges by lrger percentge t
hn does price. Quntity demnded chnges by smller percentge thn does pric
e. Quntity demnded chnges by exctly the sme percentge s does price.
e=O e>1 e<1 e=1
C)
MEASUREMENT OF ELASTICITY There re five different methods of mesuring price el
sticity of demnd- (1) Percentge Method (2) Point elsticity Method (3) Totl
outly Method (4) Point Geometric Method nd (5) Arc elsticity Method.
(1)
Percentge Method : The following formul is used
e= % Chnge in Quntity Demnded % Chnge in Price % Chnge in Q.D. = New Qunti
ty Demnded Old Quntity Demnded X 100 Averge Quntity Demnded New Price Old
Price X 100 Averge Price
% Chnge in Price =
(2)
Point Elsticity Method The clcultion of the coefficient of price elsticity h
s been lredy discussed in the previous sub unit using the rtio :
Q e = Q P P P P
Q e = Q
Demnd Anlysis
105

Q P e = P Q
(3)
Totl Outly Expenditure or Revenue Method
Dr. Alfred Mrshll suggested tht the esiest wy of scertining whether or no
t demnd is elstic is to exmine the chnge in the totl outly of the consumer
or the totl revenue of the seller. Totl outly (or Totl Revenue) = Price per
unit x Quntity demnded Dr. Mrshll lid down the following propositions :
1)
When with chnge in price, the totl outly remins unchnged, demnd is unit
ry elstic (e = 1). The totl outly remins constnt in the cse of unitry el
stic demnd, becuse the demnd chnges in the sme proportion s the price. Thi
s is illustrted in Tble B given below : Tble B TOTAL OUTLAY METHOD Price (per
unit) (Rs.) Originl Chnge 1 Chnge 2 5 8 1 Quntity demnded (Units) 16 10 80
Totl Outly (or revenue) (Rs.) 80 80 80 Elsticity of Demnd
} e=1 } (unitry)
(2)
When with rise in price, the totl outly flls, or with fll in price, the
totl outly rises, elsticity of demnd is greter thn unity. This hppens bec
use the proportion of chnge in demnd is reltively greter thn tht of price
. In short, when the price nd totl outly move in opposite directions, demnd
is reltively elstic (see Tble C below). Tble C TOTAL OUTLAY METHOD Price (pe
r unit) (Rs.) Originl Chnge Chnge 5 8 4 Quntity demnded (Units) 20 10 4 Tot
l Outly (or revenue) (Rs.) 100 80 160 Elsticity of Demnd
} e<1 } (Elstic)
106
Mngeril Economics
(3)
When with rise in price, the totl outly lso rises, nd with fll in price
, the totl outly flls, elsticity of demnd is less thn unity. This hppens
becuse the proportion of chnge in demnd is reltively less thn the proportio
n of chnge in price. Briefly, thus, when the price nd totl outly move in the
sme direction, demnd is reltively inelstic (see Tble D below). Tble D TOT
AL OUTLAY METHOD Quntity demnded (Units) 13 10 14 Totl Outly (or revenue) (R
s.) 65 80 28 Elsticity of Demnd
Price (per unit) (Rs.) Originl Chnge Chnge 5 8 2
}e<1 } (Inelstic)
We my now summries the totl outly method s follows : Price (per unit) 1. 2.
3. Increses Decreses Increses Decreses Increses Decreses Totl Outly Con
stnt Constnt Decreses Increses Increses Decreses Types of Elsticity e=1 (
Unitry) e> 1 (Reltively elstic) e<1 (Reltively inelstic
Thus, from the behviour of the totl outly or the totl revenue, we cn infer
the nture of price elsticity of demnd. Likewise, from given price elsticit
y, we cn conclude bout the nture of chnge in the consumer's totl outly or
the seller's totl revenue. In the cse of unitry elstic demnd, with ny chn
ge in price, the totl revenue remins unltered. But when there is elstic dem
nd, the totl revenue would chnge in the opposite direction of the price chnge
. In the cse of inelstic demnd, the totl revenue would chnge in the sme di
rection s the price chnges. The totl outly method of mesuring elsticity is
, however, less exct. It cn indicte only the type of elsticity, but not its
exct numericl vlue. To get the exct numericl vlue, we hve to resort to th
e rtio method or the point method. However, the economic significnce of the to
tl outly or the totl revenue method is tht it tells more directly
Demnd Anlysis
107
wht hppens to the totl outly or revenue s prcticl guide for determining
price policy nd its effect on demnd nd revenue.
(4)
Point Geometric Method
Dr. Alfred Mrshll lso suggested nother method clled the geometricl method
of mesuring price elsticity t point on the demnd curve. The simplest wy o
f explining the point method is to consider liner (stright-line) demnd cur
ve. Let the stright-line demnd curve be extended to meet the two xes, s show
n in Figure shown below. When point is tken on the stright-line demnd curve
(like point P in Fig below), it divides the stright-line demnd curve into two
segments (prts). The point elsticity is, thus, mesured by the rtio of the l
ower segment of the curve below the given point to the upper segment (the upper
prt) of the curve bove the point. For brevity, we my gin put tht Lower seg
ment of the demnd curve below the given point Upper segment of the demnd curve
bove the point L or, to remember through symbols, we my put it s e = U where,
e, stnds for point elsticity, L stnds for lower segment nd U for the upper s
egment. Point elsticity =
Price (Per Unit)
Point Method
Price (Per Unit)
Point Method
108
Mngeril Economics
In the Figure on the previous pge, AB is stright-line demnd curve, P is g

iven point. Thus, PB is the lower-segment, PA is the upper segment. e= L U = PB
PA
If fter ctul mesurement of the two prts of the demnd curve, we find tht P
B = 4 cm. nd PA = 2 cm., the elsticity t point P = 3 2 = 1.5.
If, however, the demnd curve is non-liner, then drw tngent t the given po
int, extending it to intercept both the xes (See figure) Point elsticity t po
int P in Figure is mesured s (5) PB PA
Arc Elsticity Method : This method is used to mesure elsticity of demnd on
n rc of the demnd curve. The formul is (Q0 Q1) (Q0 + Q1) e= x 2 2 (P0 + P1) (P
0 P1) (Q0 Q1) X (Q0 + Q1) (P0 P1) (P0 + P1)
e= x
Here, Q0 = Originl demnd Q1 = New demnd P0 = Originl price P1 = New price Th
ere cn be different nswers to elsticity of demnd rnging from zero to infini
ty. 8. FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND :
Whether the demnd for commodity is elstic or inelstic will depend on vri
ety of fctors. The mjor fctors ffecting elsticity of demnd re :
1.
Nture of Commodity
Certin goods by their very nture tend to hve n elstic or inelstic demnd.
By nture, goods my be clssified into luxury, comfort or necessry goods. In g
enerl, demnd for
Demnd Anlysis
109
luxuries nd comforts is reltively elstic nd tht of necessries reltively i

nelstic. Thus, for exmple, the demnd for food grins, cloth, vegetbles, sug
r, slt etc. is generlly inelstic.
2.
Avilbility of Substitute
Where there exists close substitute in the relevnt price rnge, its demnd wi
ll tend to be elstic. But in respect of commodity hving no substitute, the d
emnd will be somewht inelstic. Thus, for exmple, demnd for slt, pottoes,
onions, etc., is highly inelstic s there re no close or effective substitutes
for these commodities, while commodities like te, coffee or beverges such s
Thums Up, Mngol, Gold Spot, Fnt, Limc etc. hve wide rnge of substitutes
nd therefore they hve more elstic demnd in generl.
3.
Number of Uses
Single-use goods will hve generlly less elstic demnd s compred to multi-us
e goods, e.g., for commodities like col or electricity hving composite demn
d, elsticity is reltively high. With fll in price, these commodities my be
demnded gretly for vrious uses. It is, however, lso possible tht the demn
d for commodity which hs vriety of uses my be elstic in some of the uses
, nd my be inelstic in some other uses, e.g., col used by rilwys nd by co
nsumers s fuel. But the former's demnd is inelstic s compred to the ltter'
s.
4.
Consumer's Income
Generlly, the lrger the income of consumer, his demnd for overll commoditi
es tends to be reltively inelstic. For exmple, the demnd pttern of millio
nire is rrely ffected even by significnt price chnges. Similrly, the redis
tribution of income in fvour of low-income people my tend to mke demnd for s
ome goods reltively inelstic.
5.
Height of Price nd Rnge of Price Chnge
There re certin white goods like costly luxury items or bulky goods such s do
uble door refrigertors, Colour T.V. sets, D.V.D. plyers etc. which re highly
priced in generl. In their cse, smll chnge in price will hve n insignifi
cnt effect on their demnd. Their demnd will, therefore, be inelstic. However
, if the price chnge is lrge enough, then their demnd will be elstic. Simil
rly, there re divisible goods like pottoes nd onions, etc. which re reltive
ly low priced nd bought in bulk, so smll vrition in price will not hve mu
ch effect on their demnd, hence demnd tends to be inelstic in their cse.
6.
Proportion of Expenditure
Items tht constitute smller mount of expenditure in consumer's fmily bud
get tend to hve reltively inelstic demnd, e.g., cinegoer who sees film
every fortnight is not likely to give it up when the ticket rtes re rised. B
ut one who sees film every
110
Mngeril Economics
lternte
cse with
or smll
or lrge
dy perhps my cut down the number of films seen per week. So is the
mtches, sugr, kerosene cndles, broomstick, hircut etc. Thus, chep
expenditure items tend to hve more demnd inelsticity thn expensive
expenditure items.
7.
Durbility of the Commodity
In the cse of durble goods, the demnd generlly tends to be inelstic in the
short run, e.g., furniture, motor cycles, T.V. sets etc. In the cse of perishb
le commodities, on the other hnd, demnd is reltively elstic, e.g. milk, vege
tbles etc.
8.
Influence of Hbit nd Customs
There re certin rticles which hve demnd on ccount of conventions, custom
s or hbit with which these rticles re closely ssocited nd in these cses,
elsticity is less, e.g. Mngl Sutr to Hindu bride or cigrettes to smoker
or lcohol to n lcoholic hve inelstic of demnd.
9.
Complementry of Goods
Goods which re jointly demnded hve less elsticity, e.g. bll-point pen nd r
efills, motor cycle nd petrol etc. hve inelstic demnd for this reson.
10. Time
In the short period, demnd in generl will be less elstic, while in the long p
eriod, it becomes more elstic. This is becuse (i) it tkes some time for the n
ews of price chnge to rech ll the buyers; (ii) consumers my expect further
chnge, so they my not rect to n immedite chnge in price; (iii) people re
reluctnt to chnge their hbits ll of sudden, but grdully, in the long ru
n, their hbits my chnge nd so too the demnd pttern; (iv) durble goods tk
e some time to exhust their utility. In the long run, lpse of time results in
their wering out, then these re demnded more; (v) demnd for certin commodit
ies my be postponed for some time, but, in the long run, it hs to be stisfied
.
11. Recurrence of Demnd
If the demnd for commodity is of recurring nture, its price elsticity is
higher thn tht of commodity which is purchsed only once. For instnce, moto
rcycles, V.C.D. plyers, T.V. sets etc. re purchsed only once, hence their pri
ce elsticity will be less. But the demnd for cssettes or Compct Disks my re
min reltively elstic.
12. Possibility of Postponement
When the demnd for product is postponble, it will tend to be price-elstic.
In the cse of consumption goods which re urgently nd immeditely required, th
eir demnd will be inelstic. For exmple life sving drugs during sickness, hb
ituted goods etc.
Demnd Anlysis
111
9.
PRACTICAL SIGNIFICANCE OF THE CONCEPT OF ELASTICITY OF DEMAND :
The concept of elsticity of demnd hs wide rnge of prcticl ppliction in
economics nd business.
1.
Its importnce to the Businessmn
The elsticity of demnd for the product he produces is the prime concern of eve
ry producer. It guides him in determining the price policy for his product. He f
inds tht it will be profitble to rise prices, provided the demnd is inelsti
c. And in the cse of products hving highly elstic demnd, it is better to l
ower their prices so tht, with little mrginl profit, their sles will be mo
re, hence their totl revenues, nd thus the totl profit will be lrge.
2.
Importnce to Government
In determining fiscl policy, the concept of elsticity of demnd is very import
nt to the government. The Finnce Minister hs to consider the elsticity of de
mnd while selecting commodities for txtion. Tx imposition on commodities for
getting substntil revenue becomes worthwhile only if txed goods hve n in
elstic demnd. Otherwise, if their demnd is more elstic, then it will contrc
t very much with rise in price s result of dded txtion (like sles tx o
r excise duty), hence the totl revenue yield would not be much different from t
he erlier one. Tht is, there will not be ny significnt rise in revenue. Tht
is why, generlly txes re levied on commodities like petrol, cigrettes, lco
hol, steel, white goods like refrigertors, wshing mchines etc. which hve n
inelstic demnd.
3.
Its Importnce to the Trde Unionists
The concept of price-elsticity is useful to trde union leders in wge brgin
ing. The union leder, when he finds tht demnd for their industry's product is
firly elstic, will sk for high wge for workers nd suggest the producer t
o cut the price nd increse sles which will compenste for his loss in totl p
rofit.
4.
Its importnce to Economists
The concept is highly useful to the economists in understnding nd solving mny
problems. For instnce, the concept is useful in solving the mystery s to how
frmers my remin poor despite bumper crop. Since griculturl products, prt
iculrly foodgrins, hve n inelstic demnd, when there is bumper crop it c
n be sold only by cutting down prices substntilly. Hence, the totl income of
frmers will be lower inspite of bigger crop. Thus, for policy-mkers, it impl
ies tht higher frm incomes depend, mong other things, upon restriction of the
supply of foodgrins nd other frm products.
5.
Its importnce in Interntionl Trde
If demnd for Indin goods in foreign countries is inelstic, Indi cn rise th
e price of its commodities substntilly nd still export the sme quntity t
higher price, thus, getting lrger mount of money nd higher profit from their
exports.
112
Mngeril Economics
Thus, during 1950s when demand for Indian jute manufactures in foreign countries
was highly inelastic, realizing this fact Government of India raised the price o
f jute manufactures by practically trebling export duty on these goods forcing f
oreign importers to pay nearly three times the price as compared to old price an
d yet selling same quantity as before, thus getting higher amount of profit by e
xporting the same amount of jute manufactures as before. Similarly, during 1970s,
petroleum oil-exporting countries formed OPEC, a monopolistic organization of o
il-exporting countries and raised the price of crude oil from 3 dollars per barr
el to nearly 30 dollars per barrel and still could export the same quantity as b
efore, thus making enormously larger profits than before. This made the Middle E
ast oilproducing Arab countries very rich as petroleum has as yet no substitute.
For example, Indias oil bill rose nearly ten times though importing the same qua
ntity as before from the Middle East. All this could happen because of the highl
y inelastic demand for crude oil produced in the Middle East countries which are
the main supplier of crude oil to the world. Thus, in international trading tra
nsactions, trading nations make an effort to know the degree of elasticity of de
mand for their goods in foreign countries with a view to fix prices of export go
ods at a level that would give exporting countries maximum profit. 10. INCOME EL
ASTICITY OF DEMAND : As indicated in the beginning, we can now switch over to an
other determinant of demand viz. income and consider elasticity of demand by hol
ding all other determinants, including price, constant. Income elasticity of dem
and for a product shows the extent to which a consumer s demand for that product
changes consequent upon a change in his income. Income elasticity of demand can
be defined as the ratio of proportionate change in the quantity demanded of the
commodity to a given proportionate change in income of the consumer. (A) MEASUR
EMENT OF INCOME ELASTICITY The formula for measuring income elasticity of demand
can be stated thus : Formula 1 : Ey = Proportionate change in quantity demanded
Proportionate change in consumer s income
Example : A 20% rise in income causes a 30% increase in demand for a product
, what will be the income elasticity of demand for X" ?
Demand Analysis
113
X"
Solution : According to formula mentioned above : Ey = 30 20 = 1.5
Formula 2 A second formula which is mathematically more rational is suggested as

under : Q2 - Q1 Y2 - Y1 Ey = Q2 + Q1 Y2 + Y1 In this formula Q1, is the ini
xpenditure on any commodity X" (which represents the demand for the product X"
) and Q2 is the new expenditure on the same commodity after a change in income.
Y1 denotes initial income and Y2 stands for changed or new income. Example : A c
onsumer spends Rs.60/- per month on sugar when his income is Rs.l,500/ - per mon
th. When his income increases to Rs.1800/- per month he spends Rs.84 on sugar. W
hat will be the income elasticity of demand for sugar in this case? Solution : A
ccording to the above formula 84 - 60 Ey = 84 + 60 24 144 24 144 1
=
=
x
=
x
= Ey =
11 = 1.8 6 >1
(Income elasticity of demand in this case is 1.8 positive)
114
B)
Types of Income Elasticity of Demand According to the value of income elasticity
of demand, we can classify income-elasticity into the following types : 1.
Negative Income Elasticity : When the demand for a product decreases as income i
ncreases and conversely where demand for a product increases as there is fall in
income, the income elasticity of demand is negative. The demand for inferior go
ods is of this type. Zero Income Elasticity : When a change in income has no eff
ect upon the quantity demanded of a product, the income elasticity of demand wou
ld be zero. Demand for salt is an example of this type. Unit Income Elasticity :
Income elasticity of demand will be equal to unity (i.e.1) when demand for the
product increases in the same proportion in which income increases. Unit elastic
ity of demand is considered to be a dividing line between necessaries and comfor
ts. In other words the income elasticity of demand for necessaries will be less
than unity : while the income elasticity of the demand for comforts will be more
than unity. Both these cases are noted below. Low Income Elasticity of demand :
When the income elasticity of demand for a product is positive i.e. greater tha
n zero, but less than one, we say that the income elasticity of that demand is r
elatively less. Such a variety of relatively less income elasticity or incomeela
sticity of demand suggests that the commodity concerned must be necessary. This
is because as income increases the percentage of income spent on necessaries goe
s on diminishing, according to the Engel s Law of family expenditure. High Incom
e Elasticity
As opposed to the above category, we get high income elasticity of demand for pr
oducts which satisfy the consumers comforts and luxuries. In other words, the i
ncome elasticity of demand for articles of comforts and luxuries is greater than
unity. The income elasticity for different products differs widely. Income - el
asticity of demand tends to be very high in respect of luxury articles like gold
, jewellery, precious stones, paintings, cars etc. As against this, income elast
icity of demand is very low in respect of commodities like salt, vanaspati, matc
hes, kerosene, washing soap etc. Besides the type of a commodity i.e. whether it
is a necessary or comfort or luxury, the proportion of a consumer s income spen
t on the commodity is also a major factor influencing income elasticity of deman
d.
2.
3.
4)
5)
C)
Uses of the Concept of Income Elasticity of Demand The concept of income elastic
ity of demand is useful in many areas of economic policy formulations as well as
analyses of various situations.
Demand Analysis
115
1)
Economic Development : In case of economic development, when notional income is
increasing, we can find out how much will be the increase in the demand for a gi
ven product, by considering the income elasticity of demand for that product. Ec
onomic Fluctuations : Economic fluctuations are the characteristic features of a
capitalistic economy. Phases of prosperity and depression alternate in such an
economy. The concept of income elasticity can be a very useful guide in finding
out what products would be demanded during the phase of prosperity. Similarly, d
uring the phase of depression, certain necessaries will continue to be demanded.
As noted above, necessaries are commodities with very low income elasticities.
Economic Planning : The concept of income elasticity of demand is of great help
to the planners who are planning for the economy as a whole. When economic devel
opment is being planned, the planners have to set targets of production in terms
of physical quantities for various sectors of the economy. With the help of inc
ome elasticity, the planners can estimate the possible increase in demand for th
e product as a result of the targeted rate of growth of the economy. This would
make the physical targets more realistic and would serve to maintain physical ba
lances - a difficult task for the planners. Demand Forecasting : Firms are requi
red to forecast the demand for their product. With the help of statistical infor
mation regarding trends in growth of income as well as changes of distribution o
f income, the firm can forecast the demand for its product by using income elast
icity of demand for that product as a guide. Foreign Trade : In the area of fore
ign trade, a country needs to take into account the income elasticity of demand
for its imports as well as exports. A country exporting agricultural products an
d articles of necessity faces an income-elastic demand, compared to a country wh
ich is exporting articles of luxury. This difference influences terms of trade.
Income elasticity of demand serves as a guide in the matter of balance of paymen
ts disequilibrium also. For example, India has been an exporter of jute, tea, co
ffee and spices; but the demand for all these commodities is incomeinelastic. Th
e rate of growth of India s exports therefore has remained relatively low. As ag
ainst this, India s demand for imports like electronics, machinery, consumer dur
able etc. is income-elastic. Consequently, the rate of growth of India s imports
has remained high. Thus we have been facing the problem of an increasing trade
deficit in India during the last few years.
The list of areas where income elasticity of demand is useful can be increased f
urther by mentioning public finance, labour policy, industrial policy etc. where
the concept is useful.
2)
3)
4)
5)
11. CROSS ELASTICITY OF DEMAND : In practice, commodities are seldom independent
of one another. Among the wide range of
116
products that we see at the market, we find that most of these goods are related
. On the basis of the relationship, we can group these products either as substi
tutes or as complements or as a third group of goods which are neutral. In the c
ontext of the relationship between goods, the concept of cross elasticity of dem
and can be used. Cross elasticity of demand may be defined as the ratio of propo
rtionate change of quantity demanded of commodity X to a given proportionate c
hange in price of the related commodity Y . With the help of formula, similar t
o the one we noted earlier, we can say : Ec = Percentage change in quantity dema
nded of X Percentage change in the price of Y
If we assume the two commodities X and Y are substitutes of each other and that
the price of Y rises but that of X remains constant, the quantity demanded of X
will increase because the consumers will substitute X for Y, since Y has become
costlier. Conversely, if the price of Y falls leaving the price of X unchanged,
the quantity demanded of x will decrease because the consumers will now substitu
te Y for X since Y has become cheaper than before. Cross elasticity can also be
measured by another formula as given below Ec = OX2 OX1 OX2 + OX1 : PY2 PY1 PY2
+ PY1
In this formula QX2 is the new demand for X, QX1 is the original demand for X; P
Y2 is the new price of Y and PY1 is the original price of Y. If X and Y are perf
ect substitute for each other, the cross elasticity of demand will be infinity.
It means that the slightest rise in the price of Y will cause an almost infinite
rise in the demand for X and the slightest fall in the price of Y will reduce t
he demand for X to almost zero. If, on the other hand, two goods are not substit
utes at all, the cross elasticity of demand will be zero. A change in the price
of one commodity will not affect the quantity demanded of the other commodity. I
t will thus be clear that the cross elasticity of demand for substitutes varies
between zero and infinity. If the relationship between X and Y is that of comple
mentary, the cross elasticity in such a case will be negative. A rise in the pri
ce of Y will mean not only a decrease in the quantity demanded of Y but also a d
ecrease in the quantity demanded of X because both are demanded together. For ex
ample, ball-point pens and refills are complementary goods. When the price of re
fills rises, it causes a fall in the demand for refills as well as for ball-poin
t pens, because both are demanded together.
Demand Analysis
117
Commodities X and Y will be the perfect substitutes only when they are totally i
dentical. In that case, they will not be two different commodities at all. There
fore, in practice, infinite cross elasticity of demand cannot be found. In pract
ice, the cross elasticity of demand can thus be positive, zero or negative. The
cross elasticity is positive when X and Y are good substitutes (and almost infin
ity when X and Y are almost substitutes). It is zero when X and Y are not relate
d to each other or do not possess any substitutability : they are independent of
each other. It is negative when X and Y are complimentary goods. In the first c
ase, a rise in the price of Y (price of X remaining constant) will cause an incr
ease in the quantity demanded of X. In the second case, a rise or fall in the pr
ice of Y (price of X remaining unchanged) does not affect the quantity demanded
of X at all. In the third case, a rise in the price of Y (the price of X remaini
ng unchanged) will cause a decrease in the quantity demanded of X. Example : Bec
ause the price of Y increases from Rs.10 to Rs.12 per kg., the sale of a firms pr
oduct commodity X rises to 220 kg. from 200 kg. per week. Find out the cross ela
sticity and state the relationship between commodities X and Y. Solution : Ec =
OX2 OX1 OX2 + OX1 220 200 220 + 200 220 200 220 + 200 : PY2 PY1 PY2
=
:
=
X
20 Solution : Ec = 420 Ec = 11 21
X
The cross elasticity of demand is positive and X and Y are substitutes. 12. USES
OF CROSS ELASTICITY OF DEMAND : Perfect substitutes are seldom found in practic
e. Perfect complementarity is equally rare. But, broadly speaking, there is comp
limentarity or competition i.e. substitutability among several commodities. Unde
r such circumstances, the entrepreneur can judge the effect of his pricing polic
y on the quantities demanded of the products of others and vise versa on the bas
is of the cross elasticity of demand.
118
13. DEMAND FORECASTING : (A) Meaning and Importance A forecast is a guess or ant
icipation or a prediction about any event which is likely to happen in the futur
e. Forecasts are made either through experience or through statistical methods.
As individual may forecast his job prospects, a consumer may forecast an increas
e in his income and therefore purchases, similarly a firm may forecast the sales
of its product. Predictions of future demand for a firm s product or products a
re called demand forecasts. Demand Forecasting is the method of predicting the f
uture demand of a firm s product. (B) Necessity of Forecasting Demand As mention
ed above, demand forecasts may be based on judgment of the experienced staff of
a business concern or on scientific analysis (with the help of statistics). When
a firm is small in size it may not need or afford an organized forecasting syst
em. They can base their forecasts on the judgment or foresight of their experien
ced staff. However, as a firm increases in size and produces a number of product
s and uses modern techniques of production, it becomes necessary for the firm to
forecast the demand for its various products, in a more scientific manner. Such
forecasts are more accurate and thus help the firm to produce efficiently, with
the help of the available resources. Forecasts have become a part of business m
anagement of most of the firms. Forecasts are necessary for :
(1)
Fulfillment of objective of the Plans
Every business unit, industry or the government starts with certain pre-decided
objectives. These objectives can be fulfilled with the help of accurate demand f
orecasts.
(2)
Preparation of a Budget
Scientific forecasts are useful to the entrepreneur to take business decision. E
very business unit has to prepare a budget. A budget includes the cost and expec
ted revenues. Expected revenues can be estimated only on the basis of demand for
ecasts.
(3)
Stabilization of Employment and Production
Demand for a product changes according to seasons or business cycles or tastes e
tc., the supply, however, cannot be changed suddenly if however, it is possible
to estimate the demand for a firm s product, it can be possible to produce accor
ding
Demand Analysis
119
to the expected demand. This can avoid wastage of scarce resources of the firm.
So also the employment policy can be decided in advance, with the help of these
forecasts.
(4)
Expansion of firms
When a firm has to decide whether it should expand or not and to what extent it
should expand, it has to consider the expected demand for its product, at a futu
re date. Demand forecasts become useful in such cases.
(5)
Other Uses
Demand forecasts are also useful to a firm, for long-term investment decision. B
udgeting policies and Warehouse and Inventory Control.
(C) Factors Influencing Demand Forecasts A number of factors affect the demand f
orecasts. Each of these factors has to be studied together with the other factor
s while forecasting demand. Thus, these factors outline the scope of demand fore
casting.
1.
Time-Period
Forecasts can be for a short-period, long period or very long (secular) period.
a) Short-period These forecasts are for a period of one year and are based on th
e judgment of experienced staff of the firm. Within this short period the sales
promotion policies of the firm or the tax-policies of the government do not chan
ge. Short period forecasts are important for deciding the production policy, pri
ce policy, credit policy and marketing and distribution of the firm s product. b
) Long-period forecasts These are forecasts for a period of 5 to 10 years and ar
e based on scientific analysis and statistical methods. Long period forecasts ar
e important to decide about whether a new factory is to be established, a new pr
oduct can be introduced, or capital needs are to be raised. c) Very-long period
forecasts These are for a period of over 10 years. Secular factors like growth o
f population, development of the economy, the political situation in the country
, the changes in the international trade, sociological factors, like age of marr
iage, changes in traditions, have to be considered for forecasting the demand ov
er a very long period.
2)
Level of Forecasts
Forecasts can be made at the level of the firm or the industry or the nation.
120
a)
A firm A firm forecasts the sales of its products. It bases its forecasts on the
forecasts of the industries and the nation.
b)
An Industry Forecasts at this level are prepared by the trade association. These
are based on statistical data and market survey. These forecasts are available
to all the firms of the industry.
c)
The Nation These forecasts are national level forecasts and are based on indices
such as national income and national expenditure.
3)
General and Specific Forecasts
Forecasts can be of a general type, giving a total picture of the demand for all
the products of a firm or demand from all the markets of the firm s product. Th
ese are not very useful to a firm. Specific demand forecasts give specific infor
mation. Product-specific demand forecasts give the forecasts of each of the prod
ucts produced by the firm. Area, specific demand forecasts give the forecasts ea
ch of the markets for the firm s he markets for the firm s product.
4)
Established Products and New Products
Established goods, are goods which are already established in the market; inform
ation about these goods is available, the present demand, the number of substitu
tes to the product, the level of competition, the markets are known. New product
s are those which are yet to be introduced in the market, information about thes
e products is not known. Thus depending on whether the product is an established
or new product, different methods are used for forecasting demand.
5)
Product-Classification
For the purpose of Demand Forecasting products can be classified as a) b) a) Cap
ital Goods and Consumer goods Durable goods and Perishable goods The demand for
capital goods (machinery, spare parts) is a derived demand. It is derived from t
he demand for the product produced by the capital goods. This demand is highly f
luctuating.
Demand Analysis
121
The demand for consumer goods depends on the incomes of the consumers. An increa
se in income leads to an increase in the demand for consumer goods, but a fall i
n the income does not immediately lead to a decrease in the demand for consumer
goods; (e.g. Sugar, Food grains, Soaps etc.) b) The demand for durable goods can
be postponed. Thus if prices of these goods increase, then the demand falls, be
cause people will postpone their consumption of these goods (e.g. washing machin
es, refrigerators, mixers etc.) The demand for perishable goods like vegetables
and fruits depends on the current incomes and current demand. Thus, depending on
the type of product, demand forecasts and methods of forecasting demand will be
different.
6)
Other Factors
The level of uncertainty, the nature of competition, the number of substitutes t
o a product, the elasticities of demand for the product are important factors wh
ich have to be considered while forecasting the demand for a product. These fact
ors depend on the type of product, on the market for the product and on the time
-period. Thus, tastes and preferences and fashion have to be considered while fo
recasting demand for readymade garments. Weather forecasts are important for the
firms producing raincoats, rainy-shoes and umbrellas.
D)
Techniques or Methods of Forecasting Demand The methods of forecasting demand de
pend upon, whether the product is an established good or a new good, and on the
level of forecasts, i.e. macro or micro level. Macro-level forecasts are used in
national economic planning. These are forecasts about general business conditio
ns, and these forecasts make use of information regarding the macro-variables, l
ike government expenditure, savings, the aggregate demand etc. Micro level forec
asts are at the level of the firm or industry. These forecasts make use of macro
-level information. We are concerned with these types of forecasts. As mentioned
above, the methods of forecasting demand for established goods and for new good
s are different. We shall first study the methods of forecasting the demand for
established goods and then for new goods.
122
(a)
Methods of Forecasting Demand for Established Goods Information about establishe
d goods is available and so forecasts can be based on this information. There ar
e two basic methods of forecasting the demand for established goods. 1) 2) Inter
view and Survey Approach (short period forecasts) Projection Approach (long peri
od forecasts)
(I)
Interview and Survey Approach : (for short Period Forecasts) To anticipate the e
xpected sales of a commodity, it is necessary to collect the information regardi
ng the expected expenditures of the consumers. The interview and survey approach
, tries to collect this information, in different ways, and forecasts are based
on this information. Depending on how this information is collected, we have dif
ferent sub-methods of this survey approach.
1)
Opinion-Polling Method
This method tries to collect information, directly or indirectly, from the prosp
ective consumers. This is possible through the market research department of the
firm or through the wholesalers and retailers. If consumers cannot be contacted
personally or directly, then they are contacted through mail or now-a-days they
can be contacted on internet and the information regarding their expected exp
enditure is collected. This method is useful when the product and consumers come
into direct contact or when the number of consumers is small. This method is al
so useful when the consumer is another firm. Limitations 1) 2) 3) Individual con
sumers are not sure of their purchase Plans It is difficult and costly to contac
t all the consumers Useful only in the short period
2)
Collective Opinion method
Large firms have an organised sales department. The salesmen have technical trai
ning about how to collect the information from the buyers. Many times the produc
tion manager, sales manager, finance managers come together and make use of this
information to finalise the forecasts. These forecasts are based on information
which is more certain and thus forecasts based on this information may be more
accurate.
Demand Analysis
123
Limitations 1) 2) 3) This method based on value-judgement and has no scientific

basis Useful only in the short period It is difficult and costly to contact all
the consumers.
(3)
Sample-Survey Method
The total number of consumers for a firm s product is called the population. Whe
n the number of consumers is very large (size of population is large), it is not
possible to contact each and every consumer. A few consumers are contacted, thi
s forms the sample. Information is collected from the consumers in the sample an
d forecasts are based on this information. These forecasts are then generalized
for the whole population. This is possible through the advanced statistical meth
ods. Limitations a) b) Information collected may not be accurate. The sample sel
ected must be a random sample, so that when the results are generalized for the
population, accurate forecasts are made very often, the sample is not a random s
ample. Consumers do not co-operate by giving a correct idea of their expected pu
rchases. Sometimes, the consumers themselves make unplanned purchases.
c)
(4)
Panel of Experts
Panel of experts consists of either persons from within the firm or from outside
. These experts come together and forecast the demand for the firm s product. If
forecasts are based on judgement of these experts, the forecasts will have no s
cientific basis, and thus, may be less accurate. If however, forecasts are made
on the basis of statistical information and with the use of scientific methods,
the forecasts will be more accurate.
(5)
Composite Management Opinion
The opinions of the experienced persons with the firm are collected and a commit
tee or the general manager of the firm analyses this information and forecasts t
he demand for the firms product. This method is quick, easy and saves time and c
ost, but is not based on scientific analysis and thus may not give very accurate
results.
124
(II)
Projection Approach (for long period forecasts) In this method, the past experie
nce is projected into the future. This can be done with the help of statistical
methods. (1) (2) Correlation and Regression Analysis Time series Analysis
In both these methods, past data is collected, a trend
onal relationship (correlation) is established between
ne with the help of Regression. Once a relationship is
le to project this into the future. 1) Correlation and
is observed then a functi

the variables. This is do
established, it is possib
Regression Analysis
As mentioned above, the past data regarding the factors affecting demand can be
collected. It is possible to express this on a graph. This is a scatter diagram.
For example, if we collect the past data about the sales and advertisement expe
nditure of a firm, it is possible to express this in the form of a scatter diagr
am, as shown below :
Y A
Sales
A
O
Advertisement Expenditure
X
Now, with the help of Regression Techniques, like, the least square method or th
e maximum likelihood method (correlation), it is possible to get the best fit, i
.e. a best possible functional relationship between the variables. In the above
diagram, we get this functional relationship as a straight-line AA. There are so
me independent variables (Advertisement expenditure, in our example) and some de
pendent variables (sales, in our example). The relationship (cause effect) betwe
en these variables is the correlation and the technique of establishing
Demand Analysis
125
this relationship is regression. If the past correlation is assumed to remain th

e same in the future, we can use this relationship to estimate the demand for th
e future. In simple correlation, we have a relationship between two variables an
d a relationship between more than two variables is multiple correlation. For ex
ample Simple Correlation C = f(Y) where C is the consumption (Demand), and Y is
the consumers income. Suppose, from past-experience, we have a specific function
al relationship C = a + .8y Then, if we know the changes in Y (income) we can pr
edict or project the changes in consumption, and thus forecast the demand for th
e product. Limitations a) Assumption made is that the correlation between the tw
o variables will continue in future also, this might not happen. E.g. Number of
students and the demand for text books, may have a direct relationship, but when
the text-books change, this relationship no longer holds good in future. Correl
ation does not necessarily mean that there is a cause effect relationship betwee
n the two variables Eg. suppose, in a particular year, the incomes of consumers
have increased, and in the same year the demand/sales of cassettes have increase
d, can we conclude that there is a direct (positive) correlation between income
and demand for cassettes ? Even though it appears that there is a positive corre
lation between income and demand for compact disks, it is just chance that in th
at year both income and demand for compact disks increased. There is no cause-ef
fect relationship and thus forecasts based on this relationship will not be corr
ect.
b)
2)
Time-Series Analysis Demand forecasts for a period of more than 2-3 years are ba
sed on Time-Series Analysis. Time-series Analysis is similar to correlation anal
ysis. It is based on the assumption that the relationship between the dependent
and independent variables will continue to hold in the future.
126
(b)
METHODS OF DEMAND FORCASTING NEW PRODUCTS As mentioned above, new goods are good
s which are new to the market. The information regarding these new goods is ther
efore, not available. However, firms producing these goods find it necessary to
estimate the future demand for their product. Thus, indirect methods of forecast
ing are used to estimate the demand for new products. Joel Dean suggests the fol
lowing methods.
1)
Evolutionary Method
Some new goods evolve from already established goods. The demand forecasts of su
ch new goods can be based on the information about the already established goods
from which it is evolved. Thus, the demand for coloured T.V. s could be based o
n the assumption that, it has been evolved from black and white T.V. s, thus the
information about black and white T.V. s can be used to estimate the demand for
coloured T.V. Limitations a) b) The new products should have been evolved from
existing product. It ignores the problem of how the new product differs from the
established product.
2)
Substitution Method
Some new goods are substitutes of already established goods. Since most new good
s are substitutes of already established goods, this method has wide-uses. New L
.C.D., T.Vs are substitutes of already established Colour & Black & White T.Vs.
Limitations (a) (b) Some new products have many uses and each use has a differen
t substitutability, forecasting demand of such new goods becomes difficult. When
a new substitute is added to the market, the existing firms react in different
ways (changes in price, advertisement etc.)
3)
Growth Pattern Method
If there is some relationship between the new good and an already established go
od. It is possible to estimate the demand for the new good by studying how the e
stablished good has grown. Thus, we can study the growth pattern of all the toot
hpaste in the market, and make use of this information to forecast the demand fo
r the new toothpaste. Limitations a) b) This method is very time-consuming and h
as limited use. This is useful for the forecasts of the new goods at a later sta
ge of growth.
Demand Analysis
127
4)
Opinion-Polling Method
The expected consumers/buyers are directly contacted and their opinion about the
new product is gathered. If the number of expected consumers is very large, the
n a sample is selected and the results obtained from the sample are generalised
for the population. This is very useful method and is used by many firms to esti
mate the demand for their new product. A new drug, for example, is to be introdu
ced in the market, the firm concerned will contact the doctors and gather their
opinion about the drug, before it is introduced in the market. Limitations a) b)
c) Individual consumers are not sure of their purchase plans It is difficult an
d costly to contact all the consumers. Useful only in the short period
5)
Sample-Survey Method
The new product is first introduced in some sample-markets and the results seen
in the sample market are generalised for the total market. Limitations a) b) The
sample chosen, should be a correct representation of the toal. Tastes and prefe
rences differ from market to market.
6)
Indirect Opinion-Polling Method
The opinions of the consumers are indirectly collected through dealers who are a
ware of the needs of the consumers. However, the success of this method depends
on the judgement of these dealers. Limitations a) b) Based on value judgement, t
herefore, has no scientific basis, and forecasts may not be accurate. Limited sc
ope.
C)
Criteria for a Good Demand Forecast A forecast is said to be good when the expec
ted demand is close to the actual demand. A firm has to choose the best method o
f forecasting, so that the forecasts are good. The following are the criteria wh
ich need to be considered before forecasting the demand for a product.
128
a)
Accuracy : Forecasts must be as close to reality as possible. There is no point
in spending so much money and time if the forecasts do not give a real picture o
f the market demand. Durability : Forecasts require a lot of time and money, thu
s they should be such that they can be used for a long period, they should be du
rable. The relationship between the variables should be stable, for the forecast
s to be durable. Flexibility : Forecasts should be adjustable. Business means a
lot of uncertainty and to accommodate this uncertainty, the forecasts should tak
e into account all the possible factors affecting the forecasts. Acceptability :
Advanced statisical techniques are available to the firms for forecasting deman
d. But because they are very complex, these methods are not acceptable by most f
irms. Firms prefer simple and easy method for forecasting the demand for their p
roduct. Availability : Sufficient and upto-date data must be available for the f
orecast to be good. Also, the forecasts must be available to the firms on time,
so that the firms can make the necessary arrangements to produce and supply thei
r product in the markets. Plausibility : Forecasts should be plausible. They sho
uld be understood by the executives who are going to make use of it. Economy : E
conomy or the cost-factor is very important in demand forecasting, because good
forecasts require both time and money. While incurring costs on forecasting, a f
irm should weigh the costs and benefits. If accurate forecasts are going to give
very high returns, then it is worth spending more money on forecasting demand.
If however, accuracy of forecasts will mean a lot of money, but will not make mu
ch difference to the return, in such cases, a slight degree of inaccuracy would
not matter and it will save money at the same time.
b)
c)
d)
e)
f) g)
14. INTRODUCTION TO INDEX NUMBERS : 1) MEANING OF INDEX NUMBERS Index number is
defined by the classical economist Edgeworth as : "a number by its variations to
indicate the increase or decrease of a magnitude not susceptible to accurate me
asurements." In fact, the index number is a statistical device for measuring dif
ferences in the magnitude of a group of related variables over two different sit
uations. The two different situations may refer to two different periods or tw
o different places. The group of variables may be phenomena like the price of co
mmodities, the quantity of goods produced, marketed or consumed etc. An index nu
mber compares one group of related variables with another
Demand Analysis
129
group in a relative sense. The comparison may be between periods of time, or bet
ween places. Thus, we may have index numbers comparing the prices of a specified
group of commodities at different times or in different countries or localities
, the level of production in different years and so on. Index numbers measure ch
anges in accordance with a reference base or comparison base expressed as 100. T
hus, index numbers are always expressed in the form of percentages, compared wit
h the base year index which is always assumed to be 100. Because an index number
is a measurement of relative and not absolute changes in the variable over a pe
riod, it is a coefficient or relative measure of movement of a statistical varia
tion from a standard giving a general trend. Thus, index numbers are applied to
the measurement of the general movement of prices, cost of living, wages, produc
tion, consumption, employment etc. Since changes in such variates are not easily
capable of direct quantitative measurement, they are relatively measured in ter
ms of percentage by the technique of index numbers. As R.G.D. Allen states, the
range of index number is very great and they can indicate changes in variables s
uch as wage rates, shipping freights, security prices, commodity prices, volume
of output, sales and profits. Therefore, index numbers are generally used by bus
inessmen, economists and social workers to measure changes in prices, wages, sal
es, production, stocks, exports, imports and cost of living etc. Index numbers a
re described as "economic barometers". They are indispensable to economists, bus
inessmen, planners, policy-makers and statesmen alike. 2) CLASSIFICATION OF INDE
X NUMBERS From the point of view of "what they measure", index numbers may broad
ly be classified as : "Price Indices, Quantity indices and Special purpose indic
es.
1.
Price Indices
A price index number is a sort of average of the individual price relative to a
set of commodities, and it measures the price changes of all such commodities co
llectively. Thus, price indices measure and permit compariason of the prices of
certain goods. Price indices may either be of : (1) Wholesale prices or (2) reta
il prices. Thus, price indices may further be classified as : (1) (2) Wholesale
price index numbers, and a) b) Retail price index numbers Consumer price index n
umbers or cost of living index numbers
Wholesale price index numbers measure the changes in the general price level of
a country. It is interesting to note that such indices published in India are kn
own as Economic Advisers Index Numbers of Wholesale Prices. 130
Retail Price Index Numbers are compiled to measure the changes in retail prices
of various commodities such as consumption goods, stocks and shares, bonds and g
overnment securities, treasury bills etc. which have bearing on various economic
aspects. Moreover the common man is "largely affected by the retail prices than
the whole-sale price level in the country. In India such indices are available
in the form of : (1) (2) (3) Index Number of Security Prices Labour Bureau Index
Number of Retial Prices (Urban Centre); and Labour Bureau Index Number of Retai
l Prices (Rural Cedntre)
Consumer s price index numbers are the specialised forms of retail price indices
in which only prices of those commodities are considered which enter into the c
onsumption of different classes of people. Consumers price index numbers are co
mpiled to measure the changes in the cost of maintaining a consumption pattern (
i.e., standard of living) of a class of people over a period of time. Therefore,
these indices are popularly known as cost of living index numbers. There are th
ree prominent types of cost indices available in India. (1) (2) (3) Cost of livi
ng index numbers of the employees of the Central Government. The middle-class co
st of living index numbers, and The working class cost of living index numbers
However, the first two are ad hoc enquiries and the data are compiled after maki
ng family budget enquiries. The working class cost of living index numbers are p
ublished by the Labour Bureau, Ministry of Labour, Government of India. Cost of
living index numbers are of great practical use to trade, commerce and industry.
Wage policies are laid down and wage disputes may be settled on the basis of th
ese indices.
2.
Quantity Indices
A quantity index number expresses the relative average of the volume of producti
on in different sectors of an industry. Thus, quantity index numbers measure and
permit comparison of the volume of goods produced or distributed or consumed. T
he index of production is the leading type of quantity index number. There are i
ndices of industrial production, agricultural production and so on and so forth.
Production indices are highly useful as indicators of the level of output in th
e economy. The growth rate and the direction in which an economy is moving is sh
own by how much is being produced and whether the present production level has g
one up or gone down as compared to the previous levels.
Demand Analysis
131
3.
Special Purpose Indices
A large variety of index numbers used for specific purposes may be included unde
r this heading. To study the various special kinds of problems such index number
s are compiled. For instance, there are import-export indices, stock-exchange sh
are price indices, labourproductivity indices, etc.
3)
PRINCIPLES AND PRACTICAL STEPS INVOLVED IN THE CONSTRUCTION OF A PRICE INDEX NUM
BER THE BASIC PRINCIPLES INVOLVED IN CONSTRUCTION OF A PRICE INDEX NUMBER ARE :
1) 2) 3) 4) 5) The object of the index number be determined. A base year is sele
cted and the price of a group of commodities in that year are noted. Prices of t
he selected group of commodities for the given years that are to be compared are
noted. The index number for the base year prices is always denoted as 100. Chan
ges in the prices of the given years (current years, in statistical terms) are s
hown as a percentage variation from the base.
Thus, the construction of a price index number involves the following steps : a)
b) c) d) e) The choice of the base year; The choice of commodities whose prices
are to be taken into account The collection of data, i.e. price quotations, fo
r the selected group of items in the base year and the current year; assigning p
roper weights to different items. If so desired, to remove ambiguity or bias; an
d Averaging the data so as to express the prices of the given years as percentag
e of the prices of the base year.
4)
PROBLEMS OF CONSTRUCTION OF INDEX NUMBERS The construction of an index number in
volves the consideration of the following major problems :
(1)
Purpose of Index Number It is absolutely necessary that the purpose of the index
number should be clearly and unambiguously defined, since most of the later pro
blems will depend upon the purpose.
132
Before collecting data and making calculations, it is important that one knows w
hat one wants to measure and how to make use of the given measure. Once the purp
ose is clear, the rest of the procedure is easy to apprehend. One must be sure o
f which type of index number is to be computed - whether it is wholesale price i
ndex number, consumer s price index number, the quantity index number and then p
roceed accordingly. Similarly, it is also necessary to determine the scope of th
e index number - such as, the regional coverage or the place, the frequency of c
ompilation, etc. Indeed, the scope will be determined on the basis of the object
. (2) SELECTION OF BASE PERIOD Base period is a point of reference for compariso
n to measure the relative changes in the level of a phenomenon (e.g. price level
in the case of a price index number) for the current period. Usually, against t
he base year s norm (100), the relative changes for all the other years are comp
ared. Suppose the price levels of two time periods, that of 1994 with that of 19
90, the former is called current period and the latter base period. The base per
iod, therefore, is the basis of comparison. Selection of the base year needs to
be done with utmost care. The base year should be a normal economic year. It sho
uld neither be a year of economic crisis nor of unprecedented boom. There should
not be any erratic forces in operation like political upheavals, war, floods, f
amines etc. If by change an abnormal or inappropriate base year is chosen, the i
ndices related to such a base year present distorted figures and conclusions. Fo
r instance, a base period at the peak of a boom or inflation makes the index num
bers appear unusually low at most other periods. Conversely, a base at the troug
h of economic depression makes all the indices appear unusually high. (3) SELECT
ION OF ITEMS Selection of items is another problem. Out of unwieldy list of comm
odities, the required representative items are to be selected according to the p
urpose and type of the index number. In selecting items the following points are
to be considered. a) b) c) d) items should be representative of the tastes, hab
its and traditions of the people.; they should be cognizable; they should be suc
h as are not likely to vary in quality over two different periods and places; th
e economic and social important of the various items of consumption should also
be considered; and 133
Demand Analysis
e)
the items must be fairly large in number, because reliability greatly depends on
the adequacy of the number.
The right selection of items presents the real difficulties. As a general workin
g rule, a reasonable number of commodities should be selected, consistent with e
conomy in time, money and labour, simplicity and accuracy of measurement. (4) PR
ICE QUOTATIONS Collection of price quotations for the commodities selected is a
somewhat more difficult problem. The price of a commodity varies from market to
market and even at one market, from shop to shop. It is not possible, therefore,
to obtain price quotations from all the markets where a commodity is bought and
sold. A selection of representative markets is to be made. There may be a numbe
r of such agencies. viz. business firms, chambers of commerce, news corresponden
ts, trade associations, government agents etc. Select an agency which is most re
liable. To check the accuracy of price quotations supplied by an agency, obtain
such quotations from more than one reporting agency. Another problem associated
with the price quotation is the frequency of price quotation. That is, how often
the price quotations should be obtained, on weekly or monthly basis. Usually, i
n the case of weekly index numbers, one quotation per week for each commodity is
considered sufficient. For instance, the Economic Advisers Index Number of Whol
esale Prices in India is a weekly index number and is based on price quotations
obtained every Friday. But if a monthly base is considered, a more frequent quot
ation may be desirable. (5) PROBLEM OF WEIGHTING The items included in the index
numbers are not of equal importance. So the different items included in the ind
ex number must be weighted according to their importance. The purpose of weighti
ng is to make the index truly representative of the population it is to measure.
The system of weighting may be either arbitrary or rational. Arbitrary or chanc
e weighting means that the statistician is free to assign weights to different i
tems, which he thinks fit or reasonable. Rational or logical weighting means som
e criteria have to be fixed for assigning weights. However, it is impossible to
give a comprehensive definition to the term "rational weights". Weights which ar
e perfectly rational for one investigation may be equally unsuitable for another
. In fact, a decision regarding rational weights depends on the purpose of the i
ndex number and the nature of the data related to it.
134
(6)
SELECTION OF AN AVERAGE Since an index number is a technique of averaging all th
e changes in a group of values over a period of time, the problem is to select a
n average which summarises the changes in the component items adequately. Usuall
y, the arithmetic mean is employed for constructing the index numbers. For arith
metic mean is simple to calculate.
(7)
SELECTION OF FORMULA A large number of formulae has been devised for constructin
g index numbers. They are simple aggregate indices, weighted aggregate indices a
nd Laspeyre s formula, Paasche s formula. etc. for computing weighted averages o
f price relatives. The device of a particular formula will depend upon the infor
mation available and the accuracy desired.
(8)
THE PROBLEM OF DYNAMIC CHANGES In a dynamic economy, there is a continuous chang
e in the nature of consumption and commodities which adds to the difficulties of
comparison and the construction of index numbers over a period of time. (a) (b)
(c) (d) Many new commodities may come into existence and the old may disappear.
The quality and quantity of commodities may change from time to time, e.g. the
quality of a l09- model motor car is quite different from that of a 1990 model.
Income, education, fashion and other factors may change the consumption pattern
of the people and indices compiled for a period of time may become incomparable.
In the modern world, due to changes in fashions, tastes, outlook of the people
and technological advancement, more and more new goods appear in the market whil
e old goods often disappear, over a period of time. Thus, a comparison of either
price level or quantity levels from two separate and distant points of time bec
omes difficult. Therefore, most index number series are to be revised periodical
ly, every decade or so. A new and more modern samples of comparable items have t
o be included.
(9)
DIFFICULTY IN USAGE An economic statistic an has to be very careful in using the
index numbers for economic analysis. The following points must be borne in mind
in this regard.
a)
An index number deals with averages - the average tastes and habits, earning and
spending of an average number of people. Since it deals with averages, it canno
t deal with one individual s money and changes in its purchasing power since an
individual may not be affected by a rise or fall in the price level to the exten
t indicated by the index number.
Demand Analysis
135
b)
An index number constructed for one purpose may not be useful for another. A who
lesale price index cannot be compared with a cost of living retail price index.
Similarly, the cost of living index number of textile workers cannot be used to
measure changes in the value of money of the middle-class group. Index numbers d
o not provide a reliable basis for comparison of international prices, so that d
ifferences in changes in the value of money between two countries may be measure
d. As items included in the index number of different countries differ in patter
n and quality, comparison is not possible. The base years will also not be the s
ame. Moreover, there are various methods of averaging the use of different types
of averages by different countries in the computation of index numbers gives di
fferent results, thereby making comparison even more difficult. As a result of a
ll these difficulties, the index number is seriously limited in its utility, i.e
. in comparing the purchasing power of money over time and space. In the face of
these difficulties and inaccuracies in its construction, the index number can s
imply be regarded as a mere approximation indicating the rising or falling trend
s.
c)
6.
LIMITATIONS OF INDEX NUMBERS The following are the limitations of index numbers
:
(1)
Approximation They are only approximate indicators of the relative changes, due
to the fact that one cannot conceive of absolute accuracy in their construction.
There can be errors not only in the collection of data but also in the selectio
n of the base, selection of representative items and selection of appropriate we
ights. Any such error means inaccuracy in the construction of index numbers.
(2)
Sample-based An index number is generally based on samples. Thus, the problem of
computing an index number is the problem of describing a universe from the samp
le. If proper and adequate samples are not selected, then the computed indices m
ay not be truly representative. Therefore, Ilersic said that, "the index numbers
are often unrepresentative as they are usually based on imperfect data."
(3)
Disregard qualitative change The index numbers of prices or production may not t
ake into account variations in quality, which may be significant. Naturally, a s
uperior commodity will cost more at any given time than an inferior commodity, a
nd a rise in the price index may be due to an improvement in quality and not to
a rise in prices but very often there is no information on this point.
136
(4)
Arbitrariness Weights are assigned arbitrarily.
(5)
Differences An index number can be calculated in so many different ways and diff
erent methods give different answers. Unless a proper method is used in a given
situation, the results may be misleading and inaccurate.
(6)
Limited Scope An index number is useful for the purpose for which it is designed
. Hence its use is limited to a particular phenomenon only. Thus, indices constr
ucted for one purpose should not be used for other purposes where they may not b
e fully appropriate and given erroneous conclusions. They are not intentionally
comparable.
Demand Analysis
137
Exercise : 1. 2. 3. 4. 5. What is demand in Economics ? Explain the determinants

of market demand. State and explain the law of demand. What is price elasticity
of demand ? What are its types? Explain the methods of measurement of price ela
sticity of demand. Write short notes on. (a) Total outlay Method of measuring el
asticity of demand (b) Demand Forecasting. (c) Determinants of demand (d) Criter
ia for good demand forecasting (e) Significance or Practical uses of price elast
icity of demand. (f) Increase and decrease in demand. (g) Techniques of demand f
orecasting for new products. (h) Expansion and Increase in demand (i) Exceptiona
l demand curve (j) Cross elasticity of demand (k) Income elasticity of demand (l
) Index Numbers.
138
NOTES
Demand Analysis
139
NOTES
140
Chapter 5
PRODUCTION AND COSTS
Preview Meaning of Production function, Law of Variable proportion and Laws of R
eturns to Scale, Economies Diseconomies of scale, Law of Supply and Elasticity o
f Supply, Cost Concepts Accounting (actual) Costs, Economic Cost, Opportunity co
sts, Individual and Social Cost, Explicit and Implicit Cost, Fixed Cost and Vari
able Cost, Avoidable and Unavoidable Costs, Incremental and Sunk Costs, Common a
nd Traceable Costs, Historical (past) and Replacement (present) Costs, Short Run
Cost, Short Run Cost Curves and their use on decision making, Determinants of C
ost, Break Even Point (i.e. The Traditional Concept of Equilibrium of a firm). I
NTRODUCTION Uptill now we have studied demand analysis i.e. individual demand cu
rve, market demand curve, law of demand and elasticity of demand and demand fore
casting. In our study of demand side the demand was expressed as Da = f (Pa, Pb,
I, P3 ---- n). Now we will shift our attention to the study of supply side of t
he product pricing i.e. "Theory of Production" and cost. By production or the ac
t of production involves "transformation of inputs into output". By output we me
an supply of product which depends upon cost of production which again depends u
pon input price & relationship between input and output which is called producti
on function. Theory of production means nothing but study of production function
. 1. PRODUCTION FUNCTION :
Production function is the relation between Input and output. The production fun
ction is the name given to the relationship between the rates of input of produc
tive services and the rate of output of a product. Thus the production function
expresses the relationship between the quantity of output and the quantities of
various inputs used for the production. With the technological advances, the flo
w of output increases form the given input. The two aspects which are stressed u
nder production function are :
Production and Costs
141
1) 2)
Maximum quantity of output that can be produced from any chosen quantities of va
rious inputs Minimum quantities of various input that are required to yield a gi
ven quantity of output The production function can be studied in three ways :
1) 2) 3)
Law of Variable proportion : Where quantities of some factors is kept fixed but
the other factors is varied. Laws of Return to Scale : Where quantities of all f
actors is varied Optimum combinations of inputs.
The cost of production is also influenced by input prices. Input price depends u
pon demand for factors of production which ultimately depends upon marginal prod
uctivity of the factor. The demand for factors is derived from marginal producti
vity curve which is actually taken in economics as a part of theory of distribut
ion. That means theory of production is related to factor prices such as wage, r
ate of interest which is a micro aspect. Macro aspect i.e. aggregate wages, shar
e of profit in national income are related to production function. Production fu
nction can be algebraically expressed as : Q = f (N, L, K, T) Where Q = Quantity
of output N, L, K, T = quantities of factors (Inputs) f = unspecified form of f
unctional relationship between N, L, K, T where through mathematical methods we
can work out quantitative measure of this relationship. The inputs or the facto
rs of production can be classified into fixed and variable inputs. The fixed inp
uts are those which do not change in quantity irrespective of the level of outpu
t. As output increases the fixed inputs used per unit of output declines. In the
short run a firm uses fixed inputs such as land, building, plant & machinery. T
he variable inputs are those inputs whose quantity changes along with a change i
n the output. It means, the variable inputs are required more & more to increase
production. The practical observation of the production function indicates 2 no
rmal relationships : 1) When the quantity of a variable input increases while ot
her inputs remain fixed, the output also increases. It means, there is a direct
relation between variable input and output. Input and output do not increase in
the same proportion. There may be a phase when output increases faster than incr
ease in a particular variable input. This is a phase of increasing returns to th
e variable input. When input and output increase in the same proportion, it is a
phase of constant returns.
2)
142
2.
PRACTICAL IMPORTANCE OF PRODUCTION FUNCTION :
The concept of production function is practically significant and useful for the
following reasons : 1) Production function gives us idea of the optimum level o
f the output and the optimum employment of the variable inputs. A firm which wan
ts to maximize the efficiency with given prices of inputs should try to find out
the optimum proportion between fixed and variable input. This can be discovered
with the help of production function. Production function tells management the
budget constraint for increase in output. As generally output cannot be increase
d without an increase in the input. It follows that the expansion of a firm requ
ires more funds to employ more inputs. The firm can judge how far it is worthwhi
le and profitable to increase output. The production function explains the degre
e of substitution and complementarity of different factors of production. From t
his the firm can select its expansion path. It means, if the firm wants to incre
ase output in what proportion it should increase its various inputs can be judge
d from the observed behaviour of production function. The management should ende
avour to produce an upward shift in production function which can definitely imp
rove its financial performance under the given market conditions. Because, such
upward shift in production function involves technological progress and indicate
s the possibility to generate surplus. The use of better methods of production,
reorganization of production activity and creating more incentives and motivatio
n to produce more can help a firm to produce such upward shift. The theory of pr
oduction function can also explain the possibility of disguised unemployment. Wh
en we excessively employ only one factor in the production of a certain commodit
y, we reach a stage when the marginal product of that factor becomes zero or neg
ative. This stage is called disguised unemployment which is supposedly present i
n the agricultural sector in countries like India. Such disguised unemployment i
ndicates that it is possible to divert surplus labour to other sectors where the
ir marginal product would be greater than zero. Therefore, it gives policy guida
nce to both management and government about the priority in the development proc
ess. As production function is an engineering concept, we can study the behaviou
r of production function under different conditions. It can explain inter - firm
, inter regional or international differences in the productivity. It can explai
n why the reward to the factors and the rate of industrial growth are not same a
t all the places in all the countries. Thus the concept of production function s
upplemented with other tools of economic analysis is relevant for rational decis
ion - making in practical business.
2)
3)
4)
5)
6)
143
Linear Homogeneous Production Function

This is a particular production function which assumes constant returns to scale
. It states that if all inputs are increased in the same proportion, the output
also increases in the same proportion. It means, the change in scale of producti
on does not have any effect on efficiency of the firm. The returns to scale are
constant. According to Stigler, the production function is "the name given to re
lationship between rates of input of productive services to the rates of product
output and it is economists summary of technological knowledge". We have also sa
id that in the simplest form, it is the relationship between "Input and output"
and further this relationship can be studied with reference to two laws : A. B.
Law of variable proportion Laws of returns to scale
In case of former quantities of some factors are fixed while that of others are
varied and in case of later all factors are variable. Before discussing law of v
ariable proportion let us consider the following definitions which will help in
understanding the law. 1. Total Physical Product : Total quantity of output prod
uced in physical units by a firm during a period of time. Marginal Product : The
change in total product caused as a result of one additional unit of variable f
actor employed in combination with fixed factors is called marginal product. T.
P. M. P. = Variable factor units 3. Average Product : It is the total pr
s in a given time period divided by the quantity of a variable factor that is us
ed to produce it. A. P. = T. P. Variable factor Units
2.
Alternative way of describing relationship between total product, marginal produ
ct and average product is : All these measures " Total product", "Marginal Produ
ct" and "Average Product" are related in a simple mathematical way which can be
explained with the help of table given under the law of variable proportion. 144
It is necessary to make clear distinction between (a) Short run, (b) Long run an
d (c) Very long run. These are the three time spans for decision - making for a
firm. At any given time a firm is less than perfectly flexible which means when
firm enters in Industry, it comes with certain size or capacity and commitment.
It has commitment to buy contain minimum material inputs or have leased land for
some years or firm has some fixed obligations at any given time and therefore w
e say it is a less than perfectly flexible. Short Run : It is period of time dur
ing which at least one of the firms input can not be varied. It is not possible
to tell how long short run will last. For a small house painting firm it may be
for 2 days because two days are enough to buy more equipment and hire more worke
rs / painters. But for steel making firm short run lasts for 4 years even as 4 y
ears is the time it takes to change furnace and built separate plant, building,
add more furnaces etc. In other words steel plant has a commitment to its presen
t plant for 4 years. Long Run : It is the period of time long enough to make all
the changes that a firm wants to make within limits of existing or present prod
uction function. This is the second time span in which business decisions are ma
de. Except level of technology, everything else changes in the long run. When ne
w technology is introduced and production function itself changes then it is a c
ase of a very long run. Very Long Run : It is the period of time long enough tha
t the whole new technology can be introduced and production function itself is c
hanged. 3. The Law Of Diminishing Returns or The Law of Variable Proportion. Or
The Laws of Returns :
Introduction : Law of variable proportion occupies an important place in economi
c theory. This law examines the production function with one factor variable, ke
eping the quantities of other factors fixed. In other words, it refers to the in
put output relation when the output is increased by varying the quantity of one
input. When the quantity of one factor is varied, keeping the quantity of the ot
her factors constant, the proportion between the variable factor and the fixed f
actor is altered; the ratio of employment of the variable factor to that of the
fixed factor goes on increasing as the quantity of the variable factor is increa
sed. Since under this law, we study the effects on output variations in factor p
roportions, this is known as the law of variable proportions. The law of variabl
e proportions is the new name for the famous "Law of Diminishing Returns" of cla
ssical economics. Statement of the Law : 1) As equal increments of one input are
added; the inputs of other productive services being held, constant, beyond a c
ertain point the resulting increments of product will decrease, i.e., the margin
al product will diminish". (G. Stigler) 145
2)
As the proportion of one factor in a combination of factors is increased, after
a point, first the marginal and then the average product of that factor will dim
inish". (F. Benham) An increase in some inputs relative to other fixed inputs wi
ll, in a given state of technology, cause output to increase; but after a point
the extra output resulting from the same additions of extra inputs will become l
ess and less". (P. A. Samulson)
3)
It is obvious form the above definitions of the Law of variable proportions (or
the law of diminishing returns) that it refers to the behaviour of output as the
quantity of one factor is increased, keeping the quantity of other factors fixe
d and further it states that the marginal product and average product will event
ually decline. Assumptions of the Law of Variable Proportion : The law of variab
le proportion (or diminishing returns) as stated above holds good under the foll
owing conditions : 1) 2) 3) The state of technology is assumed to be given and u
nchanged. It there is improvement in technology, then marginal and average produ
ct may rise instead of diminishing. There must be some inputs whose quantity is
kept fixed. It is only in this way that, we can alter the factor proportions and
know its effects on output. The law is based upon the possibility of varying th
e proportions in which the various factors can be combined to produce a product.
The law does not apply to those cases where the factors must be used in fixed p
roportions to yield a product. Homogeneous nature of units of variable factor is
assumed. It is assumed that units of variable factor are divisible in to smalle
r homogeneous units. This assumption may not always be true. While discussing th
e Law of Returns money and monetary value of output is not at all taken into con
sideration. Only physical relationship between factor inputs and output of produ
cts is considered.
4) 5) 6)
Explanation of the Law of Diminishing Returns (Variable proportion) with the hel
p of a table :
146
Fixed Factor (say land & Capital F F F F F F F F F F F F F

Variable Factor (Labour units) 1 2 3 4 5 6 7 8 9 10 11 12 13
Total Product (units) 5 15 30 50 70 90 105 115 120 124 127 127 118
Average Product (units) 5 7.5 10 12.5 14.0 15 15 14.3 13.3 12.4 11.5 10.5 9.07
Marginal Product (units) 5 10 15 20 20 20 15 10 5 4 3 0 -9
} }
Increasing Returns Constant Returns
}
Diminishing Returns
Negative Returns
Average Marginal Relationship : Observations of the table : The above table show
s that eventually the total product also starts declining. But first to decline
is the marginal product. The relationship between them is as follows : 1) 2) 3)
4) 5) 6) 7) As long as average product is rising, marginal product would be larg
er than the average product. M. P. is less than A. P., when A. P. is decreasing.
The A. P. remains constant when M. P. and A. P. are equal. Also, when A. P. is
maximum M. P. equals A. P. Total product is maximum when M. P. is zero. M. P. be
comes negative when T. P. falls. It will be noticed from the table that when 1 t
o 4 workers are employed, the marginal product goes on increasing. This is the p
hase of Increasing Returns . When workers 4, 5 and 6 are employed we notice tha
t in their case, that M. P. is 20, 20, 20. This is the phase when the Law of Co
nstant Returns is in operation. 147
8)
Form 7 to 11 workers, it is noticed that though T. P. is increasing, the M. P. g
oes on decreasing. This is the phase of Diminishing Returns . This phase may al
so be called the phase of Diminishing Marginal Returns . Thus, we observe that
the Law of Diminishing Marginal Returns (M. P.) is in operation in the third p
hase.
Thus, the Law of Returns states that, if one factor of production (Land or Capit
al) is held constant and other factor is varied, for sometime the Law of Increas
ing Returns, then the Law of Constant Returns and finally the Law of Diminishing
Returns come into operation. Diagrammatic illustration of the law of diminishin
g returns (variable proportion) Three stages of the Law of Variable Proportions
or diminishing returns The following figure is a diagrammatic presentation of th
e Laws of Returns roughly representing the figures in the table given before.
Y H
F T.P., A.P., M.P.
T.P. Curve
Stage I
Stage II
Stage III
S
A.P. Curve
M Units of Variable factor (labour) employed M.P. Curve
X
Three stages of the law of diminishing returns (variable proportions) point H is
the maximum point of T. P. when M. P. = O. 148
It will be observed from the figure that the T. P. curve goes on increasing to a
point and after that it starts declining. A. P. and M. P. curves also rise and
then decline. M. P. curve starts declining earlier than the A. P. curve. The beh
aviour of the output when the varying quantity of one factor is combined with a
fixed quantity of other can be divided into three distinct stages, which are exp
lained below : Stage I : Increasing Returns In this stage T. P. to a point incre
ases at an increasing rate. In the figure from the origin to the point F, slope
of the total product curve T. P. is increasing i.e. up to the point F, i.e. T.P.
increases at an increasing rate, which means that M. P. rises. From the point F
onwards during the Stage 1, the T. P. curve goes on rising but its slope is dec
lining which means that from point F onwards the T. P. increases at a diminishin
g rate i.e. M. P. falls but it is positive. The point F where the total product
stops at an increasing rate and starts increasing at a diminishing rate is calle
d the point of inflexion . Corresponding vertically to this point of inflexion,
M. P. is maximum, after which it slopes downwards. The stage I ends where the A
P curve reaches its highest point S. Stage 1 is known as the stage of increasin
g returns because A. P. of the variable factor increases throughout this stage.
It should be noted that the M. P. in this stage increases but in a later part i
t starts declining but remains greater than the A. P. so that the A. P. continue
s to rise. Stage II : Diminishing Returns In stage II, the T. P. continues to in
crease at a diminishing rate until it reaches its maximum point H where the seco
nd stage ends. In this stage both the M. P. and A. P. of the variable factor is
zero (when T. P. is highest as shown by point H). Stage II is important because
the firm will seek to produce in its range. This stage is known as the stage of
diminishing returns as both the A. P. and M. P. continuously fall during this
stage. Stage III : Negative Returns In stage III T. P. declines and therefore T.
P. curve slopes downwards. As a result M. P. of the variable factor in negative
and the M. P. curve goes below the X axis. This stage is called the stage of ne
gative returns, since the M. P. of the variable factor is negative during this s
tage. Explanation of the Various Stages 1)
Increasing returns : In the beginning, the quantity of fixed factor is abundant
relative to the quantity of the variable factor. As more and more units of varia
ble factors are added to constant quantity of fixed factor then fixed factor get
s more intensively & effectively utilized and production increases at a rapid ra
te.
Let us consider the example through the table mentioned in the three stages of l
aw of variable proportion. Through out the three stages fixed variable i.e. mach
inery (capital)
149
remains constant. The variable factor i.e. no. of workers increase as a firm exp
ands its production. A worker contributes 5 units per day to the firms output. T
he total product reaches 50 units per day when the 4th worker contributes to the
production. Fuller utilization of capital is possible due to the addition of a
variable factor. One worker cannot take full advantage of the capabilities of ca
pital. When the fourth worker joins it is possible to use the full potential of
the capital. Moreover increasing returns can also be attributed to the principle
of division of labour of specialization of work. The question may arise that if
fixed factor is abundant as compared to variable factor, why fixed factor be no
t taken in accordance to the availability of variable factor. The answer is that
fixed factors are fixed i.e. they are indivisible. The number of machinery cann
ot be changed in the short run. 2)
Diminishing returns : The peculiar feature of this stage is that the marginal pr
oduct falls through out the stage and finally touches to zero. Corresponding ver
tically is the point H which is the highest point of the TP curve. Here stage II
ends.
In the table given on page 147, the third stage is set in by hiring 7th worker w
ho adds only 15 units per day as compared to 20 units per day added by the 6th w
orker. Total product increases but gain form 7th worker is not as great as gain
from 6th worker. Explanation to this can be given as once the point is reached a
t which variable factor is sufficient to ensure full utillisation of fixed facto
r, then further increase in variable factor will cause MP as well as AP to fall
because fixed factor has now become inadequate (as against it was abundant earli
er) relative to the quantity of variable factors. In stage two fixed factor is s
carce as compared to variable factor. According to Mrs. Joan Robinson, a famous
economist, the factors of production are imperfect substitutes for on another, t
he stage of diminishing returns occur. Fixed factor is scarce and variable facto
r then fixed factor would not have remained scarce. The paucity of fixed could h
ave been made up by such perfect substitutes. If one of the variable factor adde
d to the fixed factor were perfect substitute deficiency of fixed could have bee
n made up but elasticity of substitute between factors is not infinite, substitu
tion is not possible and diminishing returns occur.
3)
Negative returns : In this stage, marginal product falls below X axis i.e. neg
ative because total product starts falling. In our example this is set in by hir
ing 13th worker. The total product falls from 127 units to 118 units. The large
number of variable factors impairs the efficiency of the fixed factor. The exces
sive variable factor as compared to less fixed factor results in a fall of total
output. In such a situation, a reduction in the units of the variable factor wi
ll increase the total output.
Limitation of the Law of Diminishing Returns : There are a number of exceptions
to this law. This law does not apply to all conditions in agriculture.
150
(i)
New methods of cultivation : As mentioned earlier, this law assumes no change in
the technique of production. Scientific rotation of crops, better quality seeds
, modern implements, fertilizers, better irrigation facilities, however are the
changes which take place in agriculture. The marginal product under these condit
ions, will in fact increase. New methods of cultivation, therefore, are an excep
tion to the law.
(ii)
New Soil : When new land (soil) is brought under cultivation, the marginal produ
ct will increase for a time; thus the law of diminishing returns does not operat
e in the beginning.
(iii) Insufficient Capital : If capital is not sufficient, increased used of cap
ital, will give more than proportionate return, but later the marginal return wi
ll decrease. The early stage is an exception to the law of variable proportion.
Application of the Law of Diminishing Returns : The law of diminishing returns a
pplies to agriculture, because land if fixed. From society s point of view as Re
cardo assumed and other factors are variable. However, the law has universal app
lication and operates in all fields of productive activity where one or more fix
ed factors are combined with one or more variable factors. Thus, if an industria
l enterprise capital is kept fixed and other factors are increased, the marginal
product will initially increase but will ultimately diminish. Thus, the law als
o operates in industries like mining, fisheries and also in building industries.
4. Returns to Scale or Laws of Returns to Scale :
Under the law of diminishing returns (i.e. variable proportion) we have studied
the behaviour of output (T. P., M.P. and A. P.) when factor proportions are chan
ged. That is, we have seen the behaviour of output by keeping the quantity of on
e or some factors fixed and changing the quantity of other (e.g. Labour) Now, we
will undertake the study of changes in output when all factors of production or
inputs are increased together. In other words, we shall now study the behaviour
of output in response to changes in scale. An increase in the scale means that
all inputs or factors are increased in the same proportion. Increase in the scal
e thus occurs when all factors or inputs are increased keeping factor proportion
s unchanged. The study of changes in output as a result of changes in the scale
forms the subject matter of "returns to scale".
151
The Laws of Returns to Scale :

Y
Marginal Product
Constant Returns To Scale
Sc ale
ing as cre De
Re tu rn s
To
ns tur Re
Inc re as ing
To ale Sc
X O Scale or Proportion
1)
Law of Increasing Returns to Scale : Meaning : If the increase in all factors le
ads to more than proportionate increase in output, returns to scale are said to
be increasing. Thus, if all factors are doubled, and output increases by more th
an double, then the returns to scale are increasing. If for instance, all inputs
are increased by 25%, and output increases by 40% then the increasing returns t
o scale will be prevailing. This is because of greater specialization of labour
and machinery. This phenomenon according to Prof. Baumol also occurs because of
dimensional relations. For example, if the diameter of a pipe is doubled, the fl
ow of water through it is more than doubled. Another reason for increasing retur
ns is because of the indivisibility of some factors. These factors are available
in large and lumpy units and can therefore be used with utmost efficiency at on
ly larger output. This reason is given by Prof. Mrs. Joan Robinson, Kaldor and L
erner.
2)
Law of Constant Returns to Scale :
Meaning : If we increase all factors of production (i.e. scale) in a given propo
rtion and the output increases in the same proportion, returns to scale are said
to be constant. Thus, if doubling or trebling of all factors causes a doubling
or trebling of output, returns to scale are constant. In mathematics, the case o
f constant returns to scale is called linear and homogeneous production functi
on or homogeneous, production function of the first degree .
3)
Law of Diminishing or Decreasing Returns to Scale :
Meaning : If the increase in all factors leads to a less than proportionate incr
ease in output, returns to scale are decreasing. When a firm goes on expanding a
ll its inputs, then eventually diminishing returns to scale will occur. Diminish
ing returns to
152
scale eventually occur because of increasing difficulties of management, coordin

ation and control. When the firm has expanded to a too gigantic size, it is diff
icult to manage it with the same efficiency as previous. This in other words, me
ans that the firm starts suffering from the diseconomies of scale. 5. ECONOMIES
AND DISECONOMIES OF SCALE :
Introduction : An attempt is made in this sub -unit to outline the economies of
large - scale production with reference to the Laws of Returns.
a)
Diseconomies of Small - Scale Production:
Any firm which is newly established operates on a small scale in the initial sta
ges. Production on a small scale is, however, found to be disadvantageous on the
following grounds. (a) A new firm is required to acquire land, construct factor
y building, install machinery and provide other infrastructural facilities. A lo
t of time is wasted in erecting the factory. Meanwhile, the firm has to spend on
preliminary expenses. All these expenses are debited to the profit and loss acc
ount for the first operating year. If the total expenditure incurred during the
first year is taken into account, the average cost of production works out to be
very high in the initial stages. The workers appointed in the factory take some
time to adjust themselves to the techniques of production. Till this adjustment
is made, there is lot of wastage of raw materials and power. Naturally, the ave
rage cost of production is high. In the initial stages, production is on a small
scale because the product is not yet known in the market. The firm is not sure
whether the entire production would be sold. Every new firm, therefore, decides
to produce on a small scale till it gets a real feel of the market . In the ini
tial stages small - scale production may, therefore, lead to a high average cost
and losses.
(b)
(c)
b)
Economies of Scale:
But with the passage of time, the firm is fairly established in the market. Its
products are constantly in demand. The workers also acquire proficiency in produ
cing high quality goods. As a result, the firm decides to increase the scale of
production. Ultimately, a number of economies of scale accrue to the firm. These
economies are classified as internal and external economies. It is worthwhile t
o explain the economies at length : Internal economies are those advantages of l
arge - scale production which accrue to a firm on account of its superior techni
ques and management. They are broadly classified under the following heads:
153
(a)
Technical Economies : A firm that produces goods on a large scale can install im
proved and up - to - date machinery. On account of new machines, a firm is able
to effect a substantial reduction in the cost of production. It is also possible
in a big firm to avail the benefits of specialization and division of labour. Q
uality of goods produced by such a firm is, therefore, superior.
(b)
Commercial Economies : A firm that produces on a large - scale is required to bu
y raw materials on a large scale. Bulk buying enables a firm to procure the mate
rials at a lower cost. A firm making purchases on a large scale acquires a stron
g bargaining power in the market. It can secure favorable credit terms from the
suppliers. A big firm can negotiate with transport operators and can secure conc
essional freight rates for transportation of raw materials and finished products
. A big firm enjoys high reputation and its products are in constant demand in t
he market.
(c)
Managerial Economies : A firm producing on a large scale can afford to hire the
services of expects in various fields such as purchases, production, marketing a
nd finance. These experts utilize their knowledge and experience towards maximiz
ation of profits.
(d)
Financial Economies : A firm which is producing on a large scale can avail the b
enefits of cheaper finance. A firm which has acquired reputation and a high cred
it - rating can raise new capital quickly, easily and on much favourable terms.
(e)
Risk and Uncertainty : A firm which produces on a large scale can earn large pro
fits. It can build up huge reserves out of undistributed profits. Capacity of su
ch a firm to sustain losses is, therefore, big. On the other hand, a smaller fir
m with slender reserves cannot withstand the losses incurred in the business.
c)
External Economies :
The above advantages of large - scale production may accrue to an individual fir
m because they arise out of the superior technique and management of the firm. I
f in a particular region, many such firms are concentrated they may promote some
common activities. These activities may bring several benefits for all the firm
s, in an industry. For example, in such a region facilities of transport, bankin
g, post - office etc. may be developed and all the firms can take the benefits o
f these services. What is more important is that, a number of new firms dealing
in ancillary products are developed in this region. These firms may manufacture
spare parts on a large scale. The big firms can buy the spare
154
parts at a lower cost. If the big firms produce the spare parts themselves, the
cost would be higher. It would, therefore, be profitable for big firms if they b
uy the parts from small firms. Similarly, various firms concentrated in a partic
ular region can start a Research Institute. The benefits of this research can be
passed on to all the firms. All such economies are called external economies.
d)
Diseconomies of Large - Scale Production :
Large - scale production may encounter certain
n course of a firm s expansion, a stage may be
large to manage. It may face several problems
very large. Let us note these disadvantages of
diseconomies and disadvantages. I

reached when the firm becomes too
just because its size has become
large - scale production.
Internal and External Diseconomies : As a firm expands beyond a certain limit, i

t becomes unmanageable and unwieldy. The top executive may find it impossible to
look into even the broad functioning of various departments. Delegation of resp
onsibilities and decentralization of very large number of work can not be stretc
hed too far. Co-ordination of various activities becomes impossible. A very larg
e number of workers may cause factions and groupism amongst them. This may distu
rb the healthy atmosphere and may cause indiscipline, quarrels, and rivalries. A
large establishment with thousands of employees makes work impersonal and the r
elations between the employers and employees becomes formal. This fact causes st
rains on industrial relations. With increase in the number of salaried administr
ative, managerial and sales staff, personal touch with dealers and customers is
lost. Because these salaried employees have to stake in the company, efficiency,
urge, punctuality, integrity and inventiveness disappear and their place is tak
en by disinterestedness, routine dealings and work to rule. The internal disecon
omies of large - scale production can be summarized thus : (i) (ii) Management a
nd supervision becomes difficult and waste of time and material results. For wan
t of a personal touch, strikes, lockouts and such other eventualities causing st
oppage of work or obstructions to work increase.
(iii) No direct contact with customers is possible. So, tastes of consumers are
ignored. Products are standardized and no specialized services to consumers are
possible. (iv) (v) (vi) Large - scale production may cause overproduction and th
is may result in losses. Large producers have to fight for capturing and maintai
ning markets. This may result in cut-throat competition. Large firms cannot easi
ly adapt to ups and downs in business.
(vii) Large - scale production may involve imports of raw materials and exports
of products.
155
(viii) There are additional elements of risk due to possibilities of war, change
d international relations and so on. Expansion of industry and overcrowding of i
ndustrial units in a locality also causes diseconomies which can be called exter
nal diseconomies. The competition among firms to secure raw materials and other
resources for itself causes their prices to rise. Moreover, with increase in dem
and for resources, additional resources which become available are naturally of
a lower quality compared to those already employed. For example, the best worker
s are selected first and as more and more workers are required, a firm has to ap
point whosever are available rather than who are suited for the work. Thus, not
only wage - rates increase, but productivity per worker goes down. The same appl
ies to machinery spare parts, raw materials, distribution channels and so on. Si
milar external diseconomies flow from concentration of industries in certain loc
alities. Overcrowding of cities, traffic congestion, pollution of air and water,
strain on civic amenities like drinking water, public health, sanitation etc. a
nd problems of housing, education, medical care and law and order are some of th
e consequences. They affect efficiency of labour, availability of quick transpor
t, timely deliveries of finished products and an overall strain on the whole ind
ustrial system. 6. a) SUPPLY ANALYSIS : Meaning of Supply : In economics, supply
during a given period of time means the quantities of goods which are offered f
or sale at particular prices. Thus, the supply of a commodity may be defined as
the amount of the commodity which the sellers (or producers) are able and willin
g to offer for sale at a particular price, during a certain period of time. Supp
ly is a relative term. It is always referred to in relation to price and time. A
statement of supply without reference to price and time conveys no economic sen
se. For instance, a statement such as : "the supply of milk is 500 liters" is me
aningless in economic analysis. One must say, "the supply at such and such a pri
ce and during a specific period." Hence, the above statement becomes meaningful
if it is said "at the price of Rs.20. per liter, a dairy - farm s daily supply o
f milk is 500 liters." Here, both price and time are referred to with the quanti
ty of milk supplied. Secondly, supply is what the seller is able and willing to
offer for sale. The ability of a seller to supply a commodity, however, depends
on the stock available with him. Thus, stocks is the determinate of supply. Simi
larly, another determining factor is the will of the seller. A seller s willingn
ess to supply a commodity, however, depend on the difference between the reserva
tion price, the minimum or cost price the seller must get and the prevailing mar
ket price or the price 156
which is offered by the buyer for that commodity. If the ruling market price is
greater than the seller s reservation price, he (the seller) is willing to sell
more. But at a price below the reservation price, the seller refuses to sell. In
short, supply always means supply at a given price. At different prices, the su
pply may be different. Normally, the higher the price, the greater the supply an
d vice versa. b) Determinants of Supply : There are a number of factors influenc
ing the supply of a commodity. They are known as the determinants of supply. The
important determinants of supply are : 1)
Price : Price is the single largest factor influencing the supply of a commodity
. More commodity is supplied at a higher price and less commodity is supplied at
a lower price. The change in the quantity supplied in response to the change in
price is known as the variation in supply. Even expectations about the future p
rice affect the supply. If a dealer expects the price to rise in the future, he
will withhold his stock at present and so there will be less supply now. There a
re several factors other than the price, influencing the supply. The changes in
these factors lead to changes in the supply of the commodity. The change in the
supply may be in the form of the increase or decrease in supply. These other fac
tors are given below. Natural Conditions : The supply of some commodities, such
as agricultural products, depends on the natural environment or climatic conditi
ons like rainfall, temperature, etc. A change in these natural conditions will c
ause a change in the supply. For instance, a good monsoon will produce a good ha
rvest; so the supply of the agricultural products will increase. On the other ha
nd, their supply decreases during the drought conditions. State of Technology :
The improvement in the technique of production leads to increased productivity a
nd results in an increase in the supply of manufactured goods. Transport Conditi
ons : The difficulties in transport may cause a temporary decrease in the supply
, as goods cannot be brought in time to the market. So, even at the rising price
s, the quantity supplied cannot be increased. Factor Prices and their Availabili
ty : When the factors of production are easily available at low prices, more inv
estment is encouraged due to better returns. Under such circumstances the supply
of the commodity which these factors help to produce may tend to increase and v
ice versa. Government s Policy : The government s economic policies like industr
ial policy, fiscal policy, etc., influence the supply. If the industrial licensi
ng policy of the government is liberal, more firms are encouraged to enter into
registrations and
157
2)
3) 4)
5)
6)
high custom duties may decrease the supply of the imported goods but it would en
courage the domestic industrial activity, so that the supply of domestic product
s may increase. An increase in tax such as excise duties will reduce the supply
while granting of subsidy will increase the supply. 7) Cost of Production : If t
here is a rise in the cost of production of a commodity, its supply will tend to
decrease. So, with the rise in the cost of production, the supply curve tends t
o shift leftward. Conversely, a fall in the cost of production tends to increase
the supply. Prices of other Products : The prices of substitutes or related pro
ducts also influence the supply of a commodity. If the price of wheat rises, the
farmers may grow more of wheat and less of rice. So the supply of rice will dec
rease. Again, if the prices of fountain pens rise, the prices of ink will also t
end to rise. If the price of sugar rises, the price of jaggery (gur) will also t
end to rise.
8)
7.
THE LAW OF SUPPLY :
The law of supply reflects the general tendency of the sellers in offering their
stock of a commodity for sale in relation to the varying prices. It describes s
eller s supply behaviour under given conditions. It has been observed that usual
ly sellers are willing to supply more with a rise in prices.
Statement of the Law :
The law of supply may be stated as follows : Other things remaining unchanged, t
he supply of a commodity expands with a rise in its price and contracts with a f
all in its price. The law, thus, suggests that the supply varies directly with t
he change in price. So, a larger amount is supplied at a higher price than at a
lower price in the market.
Explanation of the Law ;
The law can be explained and illustrated with the help of a supply schedule as w
ell as a supply curve, based on imaginary data, as follows : Price of Ballpen (p
er unit) Rs. 10 12 14 16 Quantity Supplied (in 000 per week) 10 13 20 25
158
Y
Supply Curve
Price Per Unit
S 16 14 12 10 S
O
5
10
15
20
25
X
Quantity Supplied (Units) X axis = Units of Ball Pen Y axis = Price per Unit Whe
n the data of Table are plotted on a graph, a supply curve can be drawn as shown
as shown in Figure. From the supply schedule, it appears that the market supply
tends to expand with the rise in price and vice versa. Similarly, the upward sl
oping curve also depicts a direct relation between price and quantity supplied.
Assumptions Underlying the Law of Supply :
The law of supply is conditional, since we have stated it under the assumption :
"other things remaining unchanged". It is based on the following ceterius parib
us assumptions : 1)
Cost of production is unchanged : It is assumed that the price of the product ch
anges, but there is no change in the cost of production. If the cost of producti
on increases along with the rise in the price of product, the sellers will not f
ind it worthwhile to produce more and supply more. Therefore, the law of supply
is valid only if the cost of production remains constant. It implies that the fa
ctor prices, such as wages, interest, rent etc., are also unchanged. No change i
n technique of production : The technique of production is assumed to be unchang
ed. This is essential for the cost to remain unchanged. With the improvements in
technique, if the cost of production is reduced, the seller would supply more e
ven at falling prices. Fixed scale of production : During a given period of time
, it is assumed that the scale of production is held constant. If there is a cha
nging scale of production, the level of supply will change, irrespective of the
changes in the price of the product.
2)
3)
159
4)
Government policies are unchanged : Government policies like taxation policy, tr
ade policy, etc., are assumed to be constant. For instance, an increase in or to
tally fresh levy of excise duties would imply an increase in the cost or in case
there is fixation of quotas for the raw materials or imported components of a p
roduct, then such a situation will not permit the expansion of supply with a ris
e in prices. No change in transport costs : It is assumed that transport facilit
ies and transport costs are unchanged. Otherwise, a reduction in transport cost
implies lowering of cost of production, so that more would be supplied even at a
lower price. No speculation : The law also assumes that the sellers do not spec
ulate about the future changes in the price of the product. If, however, sellers
expect prices to rise further in future, they may not expand supply with the pr
esent price rise. The prices of other goods are held constant : The law assumes
that there are no changes in the prices of other products. If the price of some
other product rises faster than that of the product in consideration, producers
might transfer their resources to the other product which is more profit - yield
ing due to rising prices. Under this situation, more of the product in considera
tion may not be supplied, despite the rising prices.
5)
6)
7)
Exceptions to the Law of Supply (Backward - sloping Supply Curve) :
The law of supply states that supply, tends to rise with a rise in price is a un
iversal phenomenon. There are, however, a few exceptions to this law. Supply of
labour and savings are two such exceptions commonly pointed out by the economist
s. It may be observed, in these cases, that the supply tends to fall with a rise
in prices at a point. This paradoxical situation of supply behaviour is represe
nted by a backward sloping or regressive supply curve over a part of its length
as shown in the following Figure. It is also known as an exceptional supply curv
e, as such a thing happens only in some exceptional cases like labour supply or
savings.
Y 200 S1
Wage Rate
180 160 150
M
S O 50 55 60 65 X Leisure
Quantity Supplied of Labour in hours
Backward Sloping Supply Curve of Labour 160
In figure the curve SMS1 represents a backward - sloping supply curve for labour
as a commodity. Here, the wage - rate is regarded as the price of labour and th
e labour supply is determined in terms of labour - hours the worker is willing t
o work at a given wage rate. It is observed that as wages increase, a worker mig
ht work for a lesser number of hours than before. To illustrate the point, say,
when the wage rate is Rs. 150 per hour, the worker works for 50 hours per week a
nd gets Rs. 7,500; when it is Rs. 160 per hour, he works for 60 hours per week,
and gets Rs.8,800; at Rs. 180, he works for 65 hours and gets Rs. 11,700 and at
Rs. 200, he works for 60 hours and gets Rs. 12,000. As exception to the law is a
lso seen in the case of persons who want to have a fixed income from their inves
tment. As interest rates rises, the amount on investment required to reach the s
ame amount of interest yields is obviously less. For instance, a person wants to
earn Rs.100 per year require an investment of Rs. 1,000 and at 20 per cent, he
will require an investment of Rs.500. Thus, as the rate of interest rises, the v
olume of investment required declines. In this case, he will decrease his saving
s and investment when the rate of interest rises and increase his savings and in
vestment when the rate of interest falls, which is contrary to the usual law of
supply. 8. EXPANSION AND CONTRACTION IN SUPPLY :
The law of supply refers to the change in supply due to a change in price. If, w
ith a rise in price, the quantity supplied rises, it is called expansion of supp
ly. If with a fall in price, the quantity supplied declines, it is called contra
ction of supply. The change in the quantity in accordance with the price change
is, thus, called either as "expansion" (or extension) or "contraction" of supply
and refers to the same supply curve. In figure, the movement from point a to b
on the supply curve shows expansion and b to a shows contraction of supply.
161
9.
INCREASE AND DECREASE IN SUPPLY :
These two terms are introduced to explain the change in supply without any chang
e in price. Sometimes, there might be more supply forthcoming in the market with
out a change in
Y Y
Price (Per Unit)
Price (Per Unit)
S S1 a P S S1 O Q M X b
S2 S P S2 S O K Q X b a
Quantity Supplied (Increase In Supply)
Quantity Supplied (Decrease In Supply)
Fig. A
Fig. B
price, in which case it is called increase in supply. There might be less supply
forthcoming in the market without a change in price, then it is called decrease
in supply. The change in supply due to causes or determinants other than price
is called "decrease" or "increase" in supply, and can be shown on different supp
ly curves. In figure A, at price OP, the supply is QQ. Later on, at the same pri
ce, when the supply increases from OQ to OM, it is called increase in supply. It
cannot be shown on the initial supply curve, but the supply curve shifts to the
right as S1S1 curve. Likewise, in figure B, when at price OP, the supply become
s OK instead of OQ, it means a decrease in supply. This can be shown by leftward
shifts which need not be parallel.
The Causes of Change in Supply :
There are many causes which bring about a change (increase or decrease) in the c
onditions of supply. The important ones among them are : 1)
Cost of Production : Given the price, the supply changes with the change in the
cost of production. If the cost of production increases because of higher wages
to workers or higher price of raw materials, there will be a decrease in supply.
If the cost of production falls due to any of the above reasons, the supply wil
l increase. Supply also Depends on Natural Factors : There might be a decrease i
n the supply due to floods, paucity of rainfall, pests, earthquakes, etc. Absenc
e of the above calamities or an exceptionally good as well as a timely monsoon m
ight increase supply.
2)
162
3)
Change in Technique of Production : This has an important influence on supply. A
n improvement in the technique of production might go a long way in increasing t
he supply. For instance, introduction of highly sophisticated machines increases
the supply of goods. Policy of Government also Influences Supply : Taxes on pro
duction, sales, import duties and import restrictions may reduce supply. It may
also be deliberately reduced by government policies. Development of Transport :
Improvement in means of transport obviously increases the supply of goods as the
y facilitate the movement of goods from one place to another. Business Combines
: The producers also might reduce the supply by entering into an agreement among
themselves through their business combines like trust, cartel or business syndi
cate, with a view to raising prices in the market.
4)
5) 6)
10. ELASTICITY OF SUPPLY : Supply changes due to change in price. The extent of
change in supply in accordance with the change in price is called elasticity of
supply. When, with a little change in price (rise or fall), there is a considera
ble change in quantity supplied (expansion or contraction) the supply is said to
be elastic. When, with a considerable change in price, there is little change i
n quantity supplied, the supply is said to be less elastic. More precisely, with
a small fall in price, when there is a big contraction of supply or with a smal
l rise in price, when there is a big expansion of supply, the supply is said to
be elastic. If, with a big fall in price, there is very little contraction of su
pply or with a big rise in price, there is a very small expansion of supply, the
supply is said to inelastic. a) Elasticity of supply may be defined as the rati
o of the percentage change or the proportionate change in quantity supplied to t
he percentage or proportionate change in price : Thus, es = Percentage change in
Quantity Supplied -----------------------------------------------------------------------------------Percentage change in price
Elasticity of supply can also be measured alternatively as Net change in Quantit
y Supplied ---------------------------------------------------------------- Orig
inal Quantity Supplied Net change in Price -------------------------------------------------Original Price
es =
163
Representing it in symbols, thus elasticity of supply formula can be stated as :

QS P es = -------------- ---------------QS P QS P -------------- x --------------QS P
=
QS P Therefore, es = -------------- x -------------P QS QS = The Original Quantity
Supplied Q = Net change in Quantity Supplied P = The original Price P = Net chang
e in Price. For example, if, as a result of a change in the price of a commodity
from Rs. 40 to Rs. 45 per unit, the total Quantity supplied of the commodity by
the sellers is increased from 1,000 units to 1,200 units, then the elasticity o
f supply may be calculated as under : 200 es = -------------- x 5 40 ------------- = 1.6 1000
164
There are, thus, various degrees of elasticity of supply. It may be relatively e

lastic, relatively inelastic or may have perfect elasticity or inelasticity. Dif
ferent types of supply elasticity s have been illustrated in the following Figur
e.
(Per Unit)
(Per Unit)
Elasticity of Supply - Extreme Cases The panel (a) of Figure represents the supp
ly curve of zero elasticity. Irrespective of the price, the producer would be su
pplying OQ quantity (es = 0). The (b) represents the supply curve of infinite el
asticity. At OP price, the producer would be supplying any amount of the commodi
ty. (es = ).
(Per Unit) (Per Unit)
Elsticity of Supply - Usul Cses In the bove figure in pnel () the curve SS
represents the supply curve of unit elsticity. Any vrition in price will be
ccompnied by n eqully proportionte vrition in the mount supplied (es = 1
). Similrly, in pnel (b), the curve S1, represents reltively inelstic supp
ly, (es < 1), nd S2 represents elstic supply, (es > 1).
Production nd Costs
165
b)
Mesurement of Elsticity of Supply : There re two methods of mesuring elstic

ity of supply : (1) the rtio method, nd (2) the point method. es = Q Q x P
The coefficient of elasticity of supply(ies) may vary between zero to infinity.
The Point Method :
On a given supply curve, the elasticity of supply at point P is measured by the
ratio of the distance along the tangent (drawn to the curve at the point) from t
he point P on the supply curve to the point where it intersects the horizontal a
xis and the distance along the tangent from the point P on the supply curve to t
he point where it intersects the vertical axis.
Price (Per Unit)
F
Price (Per Unit)
F
Measurement of Point Elasticity of Supply To find out the elasticity on the supp
ly curve at point P as in the above Fig., draw a tangent TF to the supply curve
SS at point P intersecting the horizontal axis at T. Draw a perpendicular PB for
m point P and intersecting at point B on the horizontal axis. The elasticity of
supply at point P is measured as : TB Es = OB In panel (1) TB < OB, therefore, as es
< 1 at point P. In panel (2) TB > OB, therefore, es > 1 point P. 166
c)
Factors Determining Elasticity of Supply :
The elasticity of supply of commodities depends on a number of factors, such as
: 1) Nature of commodity : In the case of some commodities like antiques, old wi
nes, old stamps, old and original handwritten manuscripts, etc. their supply rem
ains fixed or constant as they cannot be reproduced in their original form or sh
ape. In the case of such commodities price changes will have no influence on the
ir supply. In the case of houses, high artistic works, paintings and statutes, e
tc. it may take quite some time for their supply to expand in response to rise i
n their prices. In respect of commodities like cloth and other factory-made good
s of daily consumption, response of supply in response to change in their prices
would be fairly quick. 2) Level of Technology : Higher level of technology in a
country generally helps to bring about a relatively quicker response from the s
upply side to change in their prices. Thus, if a community depends for its cloth
only on handloom technology, changes in price of cloth would take relatively lo
nger time for supply to respond, than if that community possesses technology con
sisting of modern automatic spinning and weaving machines. Time Element : Time e
lement is very important factor in determining elasticity of supply. Generally,
shorter the time-span, less responsive will be the supply side; and longer the t
ime-span, generally more responsive would be the supply side of the commodity to
changes in price. Thus, if price of a commodity rises, that may cause no respon
se from supply side in one or two hours or even one or two days(except in the ca
se of commodities like shares and internationally traded goods like gold, silver
and other valuable metals in case of which future trading takes place on teleph
one, telex etc.). Rise in price of houses may bring only gradual response from t
he supply side of houses, as it takes some time to build new houses. 4) Scale of
Production : Goods produced on a small scale have a relatively inelastic supply
, while gods produced on a large scale have a relatively elastic supply. Size of
the Firm and the Number of products produced : When the big firms produce a var
iety of products at a time, they can easily transfer the resources from one prod
uct to the other so that the supply may become more elastic. Natural Factors : N
atural factors like climate, monsoon, fertility of the soil, etc., considerably
affect the elasticity of supply of agricultural goods. The supply of agricultura
l goods is relatively inelastic, because these natural factors are beyond the co
ntrol of
3)
5)
6)
167
man. The seasonal nature of cultivation is the main contributory factor, making
the supply of agricultural commodities less elastic. 7) Mobility of Factors : In
those industries where there is a high degree of mobility of factors of product
ion, supply will be more elastic. Immobility of factors causes inelasticity of s
upply.
11. COST CONCEPTS :
Meaning and Importance :
The cost of production of an individual firm has an important influence on the m
arket supply of a commodity. The product prices are determined by the interactio
n of the forces of demand and supply. We have seen that the basic factor underly
ing the ability and willingness of firms to supply a product in the market is th
e cost of production. A firm aims at maximizing its profits; profits depend on t
he costs of production and the prices of products. Thus, given the market price
of the firm s; product, the amount a firm is willing to supply in the market wil
l depend on the cost of production. It is therefore, necessary to have a clear i
dea about the concept of the cost of production. Costs may be nominal costs or r
eal costs. Nominal cost is the money cost of production. It is also called expen
ses of production. The real cost is the opportunity cost of production (see belo
w). Money costs and real costs do not coincide with each other. Types of Costs :
1) Accounting Costs : Accounting costs are the costs of production of the firm.
These are money costs or expenses of production. These costs are paid for by th
e producer and are also known as entrepreneur s costs. These are the explicit co
sts, and they enter the accounts books of the firms. These costs include : (i) w
ages to labour, (ii) interest on borrowed capital, (iii) rent or royalty paid to
owners of land which is borrowed by the firm, (iv) cost of raw materials, (v) r
eplacement and repairing charges of machinery, (vi) depreciation of capital good
s, and (vii) normal profits of the manufacturer (amount sufficient to induce him
to continue production). Accordingly costs may be classified as : (a) Productio
n costs, including material costs, wage cost and interest cost (b) Selling costs
, including costs of advertising and (c) Other costs, including insurance charge
s, taxes etc. These accounting costs are important from the point of view of the
producer. He must make sure that the price of the product, must cover these cos
ts and normal profits, or else, he cannot afford to continue production.
168
How do we measure the cost of inputs?

Economists might want to discuss the production behaviour of firm for a number o
f reasons : (a) To predict how the firm s behaviour will respond to a given chan
ge in the conditions it faces. To help the firm make the best decisions it can i
n achieving its objectives. To find out how well the firms use scarce resources.
(b) (c)
The same measure of cost may not be correct for each of these purposes.
Economists know exactly how to define costs in order to solve problems like (b)
and (c). Only if we assume that, the businessman (accountant) uses the same conc
ept of costs, the economist s definition will be useful for problems like (a). T
he economic costs are based on a common principle that is sometimes called user
cost, but is commonly known as opportunity cost.
2)
Economic costs :
The economist s idea of cost is based on the fact that resources are scarce and
have alternative uses. Thus if resources are used for the production of some com
modities, then it means that the production of some alternative commodities are
foregone. Thus, by economic costs is meant those payment which must be received
by resource - owners in order to ensure that they will continue to supply the re
sources for production. Explicit costs, implicit costs and normal profits togeth
er form the full costs of a firm (economic costs).
3)
Opportunity Costs (Alternative or Transfer costs)
Since productive resources are limited, the production of one commodity can only
be at the cost of another. The commodity that is sacrificed is the opportunity
cost of the commodity produced. Thus, economists define the cost of production o
f a particular product as the value of the foregone alternative products, that r
esource used in its production could have produced. The opportunity cost of a pr
oduct, is therefore, the opportunity lost of not being able to produce some othe
r product. Resources can be used for a number of purposes. The opportunity cost
of these resources to a firm is the value in their next best alternative use.
169
Example Thus, if Rs. 20 lakhs are invested in project A at a 10 per cent rate of
return, and if this amount was not invested in project A, it would have been in
vested in project B (next best alternative use of Rs. 20 lakh) at 9 per cent rat
e of return. Then the opportunity cost of Rs. 20 lakh in project A is 9 per cent
, which is the value of this amount in its next best alternative use. Similarly,
if a consumer uses Rs. 20,000 to buy a washing machine, he cannot use this mone
y to buy a microwave oven. By buying a washing machine, he has forgone the oppor
tunity of buying a microwave oven. Thus, the opportunity cost of buying a washin
g machine is the opportunity cost of not being able to buy a microwave oven. The
refore we can say that the opportunity cost of producing X having considered Px
in terms of Y given Py is = Px Py (a) Significance of Opportunity Costs : The co
ncept of opportunity costs is an important tool to measure the implicit costs of
a firm. The implicit costs distinguish the accounting costs from the economic c
osts. Thus, the economic profits to a firm can be calculated with the help of im
plicit costs of a firm, and these costs are imputed on the basis of the opportun
ity cost principle. This concept is, therefore, used for, (a) measuring profits,
(b) policy decision of the firms, (c) forming capital budget and (d) alternativ
es available to the firm. The opportunity cost principle has a wide application
in economic theory. It is useful in the determination of values internally and i
nternationally. It is also used to understand income distribution. (b) Limitatio
ns : There are, however, some limitations in its application. (i)
Specific : It does not apply to productive services which are specific. A specif
ic factor has no alternative use. Its opportunity (transfer) cost is, therefore,
zero. Factors are not homogeneous : Units of productive services are not homoge
neous, this obstructs their transfer.
(ii)
(iii) Wrong - Assumption : The theory is based on the assumption of perfect comp
etition which rarely exists. (iv)
Individual and Social Costs : A product may cost the firm Rs. 5,000 per unit, bu
t to the society it will cost something in the form of bad - health due to the s
moke
170
and soot that this firm let out. This creates problems for measuring opportunity
costs. Conclusion : Inspite of these limitations, the theory of opportunity cos
ts, is the most widely used theory of cost at present.
4)
Explicit and Implicit Costs :
Costs of production have also been classified as explicit and implicit costs. Fr
om the point of view of the firm, we can say that economic costs are those payme
nts a firm must make, or incomes it must earn, to owners of factors of productio
n to attract these resources away form other uses. These payments or incomes may
be either explicit or implicit.
(a)
Explicit Costs :
The money payment, which a firm makes to those outsiders who supply labour ser
vices, raw materials, transport services, electricity etc. are called explicit c
osts. Thus, explicit costs are out - of - pocket costs, i.e. payments made for r
esources purchased or hired by the firm. These are expenditure costs, like, the
salaries and wages paid to the employees, prices of raw materials, fixed or over
head costs, and payments into depreciation and sinking fund accounts. These are
firm s accounting expenses.
(b)
Implicit Costs :
But in addition, the firm often uses resources which the firm itself owns. The c
osts of self owned resources which are employed by the firm are nonexpenditure
or implicit costs, like, the salary of the proprietor, or the interest on the e
ntrepreneur s own investment, rent on own land used by the firm.
To the firm the implicit cost are the money - payments which the self - owned an
d employed resources could have earned in their next best alternative use.
Thus, since implicit costs are nonexpenditure costs and actual payment is not
made, these costs have to be calculated or imputed. Implicit costs are calculate
d on the basis of the opportunity cost principle. Implicit costs are ignored whi
le calculating the expenses of production. These costs do not enter the account
books of a firm.
(c)
Normal Profits as a cost :
Explicit costs, implicit cost and normal profits together form the full costs o
a firm (economic costs). The entrepreneur must be sure of normal profits if he i
s to continue in business. Thus, normal profits are also costs.
171
(d)
Economic (or Pure), Profits :
From the above discussion of accounting and economic costs, it becomes clear tha
t economists and accountants use the term profits differently. By profits th
e accountant means total revenue minus explicit costs. But to the economist pro
fits means total revenue minus all costs (i.e. explicit costs, implicit costs a
nd normal profits). Therefore, when an economist says that a firm is just coveri
ng its costs, he means that all explicit and implicit costs are being covered an
d that the entrepreneur is therefore, receiving a return just large enough to ke
ep him in his present job. If a firm s total revenue is more than all the econom
ic costs, then the residue is to the entrepreneur. This residue is economic or p
ure profit. It is not a cost, because by definition, it is a return more than th
e normal profits required to keep the entrepreneur in his present line of produc
tion.
Other Production Costs :
As discussed above, the term cost has varied meanings. We shall now discuss some
important types of costs of production. i) Fixed Costs and Variable costs ( F.C
. and V.C ) : This distinction between fixed and variable costs is relevant in t
he short period only. In the short period, some factors, like capital, machinery
, land, management, are fixed and some factors, like labour, electricity, raw ma
terial, etc are variable. Costs on fixed factors are called fixed costs and cost
s on variable factors are called variable costs. The costs which remain fixed ir
respective of the level of output are called fixed costs. These costs remain fix
ed till the capacity output is reached. Fixed costs include costs on capital, la
nd, and salaries of top managers who are permanent employees. Variable costs are
those costs which vary with the level of output. Variable costs include costs o
f raw material, electricity charges, wages etc. Fixed costs do not change with c
hange in production. Variable costs, however, change with the change in producti
on. F.C. + V.C. = T.C. (Total Cost). In the long period, however all factors are
variable and so all costs are variable. The difference between the fixed and va
riable costs disappears in the long period. ii) Avoidable and Unavoidable costs
: At times a firm faces a problem of retrenchment or contraction. Costs which ca
n be avoided due to contraction of the firm are called avoidable costs and the c
osts which cannot be avoided because of contraction are unavoidable costs. E.g.:
A firm decides to close it s showroom. By closing the showroom it can
172
avoid the rent of the showroom, wages to workers in the showroom, electricity ch
arges etc. these are avoidable costs. However, it has to continue to employ the
salesman who move from place to place; the salaries of these salesman cannot be
avoided because of contraction of the firm; these become unavoidable costs. iii)
Incremental and Sunk Costs : At times the firm undertakes expansion. It might s
et up a new factory or introduce a new product. Costs which increase because of
expansion of a firm are called incremental costs, and costs which have to be bor
ne whether there is expansion or not are called Sunk costs. For example, if a fi
rm wants to purchase a machine, it has to bear the following costs: 1) 2) 3) 4)
Cost of purchase. Installation charges. Maintenance charges Operational charges.
Now, instead of purchasing the machine a firm decided to hire a machine (not exp
ansion), it does not have to bear the cost of purchase and the maintenance or in
stallation charges. These are costs which increase only through expansion and ar
e incremental costs. However, by hiring a machine the firm cannot avoid operatio
nal charges. These costs have to borne by the firm whether there is expansion or
not; these are Sunk costs. iv) Common and Traceable costs : Today, most firms a
re multiple product firms, i.e. firms producing more than one product. Some cost
s are common to all the products of multiple product firm. These are common cost
s. However, there are some costs which are traceable to a particular product of
a multiple product firm; these are called traceable costs. For example, consider
a press, publishing a newspaper and a monthly magazine, some costs like a cost
of printer, salaries of publishers etc are common to both these products; these
are common costs. However, the raw material used or a cutter used for the magazi
ne or newspaper can be specific to a particular product; these are traceable cos
ts. v) Historical and replacement costs: Cost of purchase of a capital asset, wh
en it was initially purchased, say, 1994 is the historical cost of the asset. Ov
er a period, the value of every asset depreciates; and a time comes when it beco
mes necessary to replace the asset.
173
The cost of the asset when it is to be replaced say in the year 2004, is the rep
lacement cost of the asset. vi) Short run and Long run costs: All the costs disc
ussed previously are important. However, for our present study we shall concentr
ate on firms fixed and variable costs. This distinction between FC and VC depend
s on the time period. In the short period some costs are fixed and some are vari
able. We shall now study the short run costs with reference to total marginal an
d average costs. To understand the meaning of these costs and relationship betwe
en them, we will make use of cost curves as shown on next page.
Firms Cost curves :
(A) Short run Cost Curves: Short run is a period within which some costs change,
(because some factors like labour change), whereas some costs do not change (be
cause some factors like machinery, capital, do not change). Thus, we talk of fix
ed costs and variable costs in the short run. a) Total Fixed Costs (TFC): Some f
actors like machinery, land, capital remain fixed in the short period, the total
cost of all these factors is the total fixed costs. TFC s do not change in the
short period. They are the same for any level of production (see figure mentione
d below). The TFC curve is a horizontal straight line parallel to X axis. b) Tot
al Variable Costs: (TVC) : Some factors like raw material, electricity, spare pa
rts and labour change as the output changes. The cost on these factors is the to
tal variable costs. The total variable costs increase with increase in productio
n(see fig shown on next page). We have a rising TVC curve. c) Total Costs (TC) :
The sum of total fixed costs and total variable costs is the total cost. This i
s the total cost of production. TC = TFC + TVC The TFC is constant, but TVC incr
eases as production increases, so TC also increases as production increases. The
TC curve is also a rising curve and the vertical distance between the TVC and T
C curve, for any level of production is the same and is equal to TFC(see the fig
ure shown on next page).
174
d)
Average Fixed Costs(AFC) and Average Variable Cost (AVC) : AFC is the per unit f
ixed cost of production which is calculated as: AFC = TFC / Units of Output Sinc
e TFC is constant as production increases; the AFC decreases as production incre
ases (see fig shown below). AVC is the per unit variable cost of production whic
h is calculated as AVC = TVC / Units of Output The AVC curve is a U shaped curve
, which means that, initially AVC decreases as output increases and later AVC in
creases as output increases (see fig shown below).
e)
Average Cost of Production (AC): Average cost is the cost per unit of output pro
duced which is calculated as: AC = TC / Units of output OR AC = AFC + AVC The AV
C curve is also a U shaped curve, which means that initially, AC decreases as ou
tput increases and later AC increases as output increases (see the fig shown nex
t page).
175
Cost
Units of outputs
f)
Marginal Cost: The marginal Cost is the change in total cost caused due to one a
dditional unit of output produced. MC is therefore, the rate of change of total
cost. It is calculated as, MC = TC / Output The MC curve is a U shaped curve whi
ch implies that the MC decreases as output increases initially, but ultimately t
he MC starts decreasing with increase in Output (as shown in the above fig). thi
s also means that TC (and TVC) initially increases at a decreasing rate and late
r it increases at an increasing rate. The relationship between TVC and MC is the
same as the relationship between TC and MC because TVC changes at the same rate
as TC, since TFC is constant. MC = MVC + MFC, but MFC = 0, therefore, MC = MVC
Also, the relationship between AVC and MC is the same as the relationship betwee
n AC and MC. Thus, the MC curve cuts both the AVC and AC curves at their respect
ive lowest points.
Units of output 1 0 1 2 3 4 5 176
Total Fixed Costs 2 15 15 15 15 15 15
Total Variable Costs 3 0 5 9 12 16 25
Total Costs (2) + (3) 4 15 20 24 27 31 40
Average Fixed Costs (2) : (1) 5 15 7.5 5 3.75 3
Average Variable Costs (3) : (1) 6 0 5 4.5 4 4 5
Average Costs (5) + (6) 7 20 12 9 7.75 8
Marginal Costs
8 5 4 3 4 9
(B) Why Short Run Average Cost Curves are U - shaped? The average cost (AC) is m
ade up of average fixed cost (AFC) and average variable cost (AVC). The total fi
xed cost is fixed as output increases, so the AFC declines as output increases.
In the initial stages the AVC also declines as output increases. Thus, upto same
level of output the AC (AFC + AVC) also declines as output increases. However,
even though AFC falls continuously as output increases, the AVC increases steepl
y, after reaching a minimum. This rise in AVC more than offsets the fall in AFC
and the AC (AFC + AVC) starts rising as output increases. We can explain the sho
rt - run average cost curves with the help of the Law of Variable Proportion. Th
e marginal cost and average cost falls as output increase, in the initial stage
of production because : (i) The fixed factor is used in a better and better way
in the initial stage of production therefore, the AFC falls steeply and thus AC
falls steeply. The average variable cost falls initially till the normal capacit
y of the machine is used up, because the variable factors are used only to assis
t the fixed factors, the AC falls steeply.
(ii)
But after a certain stage, the AC will register a sharp rise because, (i) The fi
xed factors are used up, and further production is possible only with more of va
riable factors, the TVC cost increases sharply as output increases, therefore, t
he AVC also increases sharply, and it cannot be offset by the slow fall in AFC o
ver larger output. Thus fixity of factors causes the AC to rise sharply over lar
ger output. Further, factors of production are not perfect substitutes of each o
ther; thus if the fixed factor is used up, the variable factor cannot be used in
stead of the fixed factor. Thus, both the AFC and AVC and so the AC rises as out
put increases.
(ii)
An initial fall in AC as output increases, and then a rise in AC as output incre
ases further, gives the AC curve a U - shaped curve. One can conclude that the s
hort run AC curve is U - shaped and this is explained by the Law of Variable Pro
portion, which operates only in the short - run. 12. DETERMINANTS OF COSTS : The
determinants of demand have already been discussed in the Chapter "Demand Analy
sis and Forecasting." The idea was to identify the more important determinants o
f demand, so
177
that each determinant might be taken care of at the time of a forecast. Now, the
more important determinants of cost have to be identified, so that each determi
nant might be forecast, and we are able to arrive at a realistic picture of cost
behaviour in the future. There are so many factors which determine cost that is
virtually impossible to enumerate them. However, it is possible to identify the
more important factors of cost which influence cost pattern or cost behaviour.
When the factors which influence or constitute cost are spelt out, it is possibl
e to build up the cost function. Generally speaking the prices of inputs, the ra
te of output, the size of the plant, the technology used broadly constitute the
cost. In other words, cost is a function of prices, of inputs, the rate of outpu
t, the size of the plant and technology. Therefore, the cost function may be wri
tten as : Cost = f (I, O, P,T) Where I - denotes the prices of such inputs as la
bour and capital material.
O - denotes the rate of output, i.e., how fast or slow the fixed plant is utiliz
ed. P - denotes the size of the plant T - denotes the state of technology. These
constituents of cost help one to conceive cost behaviour as a single comprehens
ive cost function which expresses the complex relationship of cost to its many c
onstituents. Each component of this complex function is a separate function by i
tself; and the sum of these separate functions pluralistically yields the comple
x function. For example, consider the first determinant in this complex function
, that is input. Now the cost - input relationship is a seperate function. Simil
arly, the cost output relationship is another separate function; and so on. Cons
ider now the cost - input relationship.
Cost - Input Relationship :
In the cost - input relationship, it is the prices of various inputs which make
up the cost. For example, O = AL K1
Where, O = the mount of output A = constnt L nd K denote lbour nd cpitl
nd 1- re the production co efficient or elsticities
178
Mngeril Economics
Now, the cost - input function cn lso be written s C = f (L Kb Mc) where C d
enotes the cost which is function of L (lbour) nd the price of the fctor
lbour. K denotes the quntity of cpitl, b the price of cpitl nd Mc denotes
mterils nd the price of mterils. These input fctors, nmely, lbour, cpi
tl nd mterils, multiplied by their quntities, determine the cost. The qunt
ities which re bought, however, depend upon their prices. It hs lredy been i
ndicted tht producers generlly try to combine the fctors of production in su
ch wy s to minimize cost. In other words, they go on substituting one fctor
for nother till ll the costlier fctors re replced by the fctors which re
cheper. This is known s the process of substitution. The purpose of this subs
titution is to enble the mngement to rrive t the lest - cost combintion o
f fctors or inputs; nd this process goes on till stge is reched t which f
urther substitution is not possible. This process is known s the mrginl rte
of substitution. In the costing of inputs, cost function is developed on the s
me lines on which the production function is developed. The objective of the pr
oduction function is twofold : to rrive t the lest cost combintion nd to c
hieve the mximum output. In the cost function, the lest - cost combintion of
inputs is determined. For exmple, if lbour is costly, the producer goes in for
cpitl intensive technique. On the other hnd, if cpitl is costly, the lb
our intensive technique is dopted. In other words, reltion of substitution b
etween lbour nd cpitl is estblished. But wht hppens when cpitl is const
nt nd the price of lbour or the price of mterils rises ? it is difficult to
nlyse this sitution becuse lbour is costly, the producer cnnot use less o
f lbour nd more mterils. This would be bsurd becuse lbour nd mterils c
nnot be substituted for ech other. The ingenuity of the mngeril economist
rises when he goes beyond this limittion nd find out whether there is some fc
tor influencing lbour nd mterils like. If lbour is costly nd the price of
mterils is constnt, cpitl - intensive technique would be used. On the ot
her hnd, if mterils re costly, reserch receives n impetus, for it becomes
necessry to find substitutes. These fcts indicte tht the cost - input functi
on is one of the complex functions of cost nlysis.
Cost - Output Reltionship :
Cost generlly vry with the level of output. When we nlyse how nd why the co
st vries, wht we hve in mind is to determine how costs vry over period of
time. This time period is crucil fctor in ny nlysis of costs, nd is gene
rlly broken into two prts, nmely, short - run, nd long - run fctors. It hs
often been climed tht, in the short - run, certin fctors do not chnge; for
exmple, the size of plnt, the stte of technology, etc. In the long - run,
however, these fctors dpt themselves to chnged conditions. In other words, i
n the short run, only certin fctors, vry nd not ll; for exmple the rw mt
erils vry in price; so do wges becuse these fctors, nmely, rw mterils
nd lbour, re subject to the forces of demnd nd supply. In other words, this
is short - run phenomenon.
Production nd Costs
179
And so one rrives t n nlysis of short-run cost behviour nd long-run cost
behviour. Costs, of course, re of severl kinds - fixed cost, vrible costs,
verge costs nd mrginl costs. However, the totl cost is the summtion of fi
xed nd vrible costs. Fixed nd vrible costs hve lredy been delt with. F
or the purpose of the cost - output nlysis, wht is needed is study of the t
otl cost, the verge cost, nd the mrginl cost, both in the short - run nd
in the long - run. The reltionship between the totl cost the verge cost, the
mrginl cost, the totl fixed cost, nd the verge fixed costs is illustrted
in tble given previously. 13. BREAK EVEN POINT :
The Trditionl Concept of Equilibrium of Firm
Equilibrium of the Firm : By totl Revenue nd Totl Cost Curves : We hve noted
tht, firm will be sid to be in equilibrium when it tends to stbilize t
given level of output nd is reluctnt either to increse or to decrese its out
put. Since mximizing money - profits is ssumed to be the objective of the firm
, the firm will try to ttin tht level of output which fetches mximum profits
. Once this level is ttined, the firm will tend to stbilize this level of out
put. In other words, equilibrium of the firm will be estblished where its outpu
t mximizes its money profits. Since profit is the difference between totl reve
nue nd totl cost, to mximize this difference becomes the objective of firm.
We hve lredy considered the behviour of costs in reltion to vritions in
the output of firm. Now we shll consider the behviour of revenue of firm.
To simplify our nlysis, we shll ssume tht the firm is producing one product
only. Tble indictes the movements of totl cost nd totl revenue s the leve
l of output which corresponds to the longest verticl distnce between totl rev
enue nd totl cost, the ltter being less thn the former. The following figure
illustrtes the equilibrium of firm with the help of Totl Revenue (TR) nd T
otl Cost (TC) curves. This is known s 'brek - even chrt' or Cost - volume
profit nlysis, in the business world. The TR nd TC curves in figure re totl
revenue nd totl cost curves respectively. The TR curve origintes form point
O since totl revenue is zero when production is zero. However, firm is requir
ed to incur fixed costs even when its level of production is zero. Totl cost is
more thn revenue until OA level of output is reched. At OA level of output, T
R = TC which mens the firm is mking neither profits nor losses. Point D in the
figure,
180
Mngeril Economics
Y K
Totl Cost & Totl Revenue
TC G TR
E J
D L H
F
M
O
A
B Output (Units)
C
X
Equilibrium of firm with the help of TR &TC method which is point of interse
ction of TR nd TC curves, is therefore, known s the brek - even point. As out
put increses beyond the level OA, TR curve rises bove the TC curve nd the gp
between the two goes on incresing. This widening of the gp between the two cu
rves indictes incresing profits. The verticl distnce between TR nd TC curve
s indictes totl profits. This verticl distnce is longest t OB level of outp
ut, where EF is the totl profit nd EF is the longest possible verticl line th
t cn be drwn between the two curves TR nd TC s drwn here. Hence, OB is the
profit mximizing level of output nd t this level of output the firm will be
in equilibrium. If production increses further, profits will decline. At point
G, TR nd TC re gin equl. Point G, therefore, is the second brek - even poi
nt. OC level of output is gin no- profit no -loss level of output. If output
is increses beyond OC the firm will incur losses which will increse s output
is incresed beyond OC. In order to decide the lrgest verticl distnce betwee
n TC nd TR, we cn drw number of tngents to the TR nd TC curves. Of ll th
eses tngents, we hve to find pir of lines which re prllel to ech other
nd t the sme time, the points of tngency re on stright line drwn perpen
diculr to X xis. In fig. JK/LM re the prllel lines nd E nd F re the poin
ts of tngency. These two points (E nd F) re on the stright line BFE which is
drwn perpendiculr to the X xis. To ensure tht EF is the longest verticl di
stnce between TR nd TC. EF is the totl profit t OB level of output. This met
hod cn illustrte the equilibrium of the firm. Besides, it is most widely used
in business to find out totl profits of firm. But this method hs two limitt
ions : (i) The longest verticl distnce between TC nd TR curves is difficult t
o find out t glnce. We hve to drw mny tngents to the two curves before w
e come cross pir of tngents which re prllel to ech other. (ii) Secondly
, the price per unit of the commodity cnnot be shown in the sme digrm. It is
true tht TR : Units produced would be the price per unit. In fig. BE : OB is t
he price. But still we cnnot precisely show the price s prticulr distnce.
Hence, the method is not very significnt especilly in the context of problems
in the theory of vlue we re required to discuss with the help of equilibrium
of the firm. Insted, the equilibrium s bsed on mrginl nlysis, i.e., by th
e curves of mrginl revenue nd mrginl cost, proves to be more useful.
Production nd Costs
181
Exercise : 1. 2. 3. 4. Explin The Lw of Vrible proportion with the help of t

hree stges. Stte nd explin Lw of Supply? Wht re its exceptions? Wht is e
lsticity of Supply? Wht re the types of elsticity of Supply? Write short not
es on : () Methods of mesurement of elsticity of supply (b) Diseconomies of l
rge scle production (c) Opportunity Cost nd Actul Costs (d) Explicit & Impli
cit Cost (e) Pst nd Present Cost (f) Fixed nd Vrible Costs (g) Avoidble n
d Unvoidble Costs (h) Incrementl & Sunk Cost (i) Increse nd decrese in qu
ntity supplied nd increse nd decrese in supply. (j) Determinnts of cost of
production (k) Short run cost curves. Explin with illustrtion the Lws of Retu
rns to Scle.
5.
182
Mngeril Economics
NOTES
Production nd Costs
183
NOTES
184
Mngeril Economics
Chpter 6
PRICING AND OUTPUT DETERMINATION IN DIFFERENT MARKETS
Preview Introduction, Mening of Mrket, Trditionl view, Modern View, Clssifi
ction of Mrkets bsed on the Notion of Competition, Pure nd Perfect Competiti
on, Determintion of Price nd output under perfect Competition, Price in Short
run nd long rung, Equilibrium of Firm nd Industry Under Perfect Competition, I
mperfect Competition, - Monopoly, Distinction between perfect competition nd Mo
nopoly, Determintion of Price nd Output (Equilibrium Under Monopoly); Monopoli
stic Competition (Fetures), Determintion of Price nd Output under Monopolisti
c Competition, Oligopoly nd Duopoly (Fetures), Pricing Methods / Pricing Prct
ices, Introduction to Cost Pricing. INTRODUCTION Demnd nd Supply re the power
ful forces operting in ny mrket. They ct nd rect upon ech other nd deter
mine the price of product. In the previous chpters, we hve lredy studied t
he nture of Demnd nd Supply. In this chpter we propose to study the mrket w
here these forces re constntly t work. An ttempt is, therefore, mde in the
following few prgrphs to define the term 'mrket' nd explin the nture of c
ompetition. 1) Wht is 'Mrket'?
In the trditionl sense, mrket is plce where buyers nd sellers meet ech o
ther to effect business trnsction. It is plce, street or building whe
re number of shops deling in prticulr commodity re locted. Severl exm
ples of mrket in Pune cn be given for exmple Mhtm Phule Mrket is retil
mrket in vegetbles wheres, Gultekdi Mrket Yrd is wholesle mrket in vege
tbles. In Mumbi, Zveri Bzr is the mrket for gold nd silver ornments. The
dimond mrket in Mumbi is locted in two sky-scrpers t Oper House viz.- P
nch - Rtn nd Prsd Chmbers. Wholesle textile business in Mumbi is concen
trted in Swdeshi Mrket, Mulji Jeth Mrket nd Mnglds Mrket. Similrly, m
ost of the Indin nd foreign bnks re concentrted ner Hornimn Circle nd N
rimn Point in Mumbi. These res, therefore, constitute the Mumbi Money Mrke
t. Dll Street in Mumbi is known for the Bomby Stock Exchnge. It is the lrg
est cpitl mrket in shres, stocks,
Pricing nd Output Determintion in Different Mrkets
185
debentures nd government securities. It will be seen from these exmples tht t
he mrket for prticulr commodity is concentrted in prticulr building or
street in city. 2) Ntionl Mrkets
Like prticulr street in city, the entire city my sometimes specilize in
the production of prticulr commodity. In course of time, the city cquires t
he sttus of ntionl mrket. Thus, Ahmedbd hs specilized in the mnufctu
re of textiles, Bnrs in silk, Kshmir in shwls nd Fridbd in bngle-mkin
g industry. Similrly, Coimbtore in South Indi hs developed big mrket in s
pinning. The mrket for lether goods is concentrted in Knpur, nd Kolkt whe
res hosiery mrket is centered in Ludhin. Recently, Surt hs specilized in
dimond polishing. 3) Modern View
Above exmples would indicte how vrious mrkets re developed t vrious plce
s in country. Mening of the term mrket, s understood in the bove sense is,
however, trditionl; nd is not cceptble to the economists. In economics, th
e term mrket is understood in different sense. According to Jevons, n eminen
t English economist, it is not necessry for the sellers to exhibit their produc
ts t prticulr plce or building. The goods my be stored in wrehouse,
nd the buyers nd sellers my be wy form ech other by thousnds of miles sti
ll, they my be ble to tlk to ech other over telephone or through the post-of
fice nd finlize the trnsction of sle or purchse. The sme view hs been ex
pressed by Cournot, the renowned French economist. According to him, the buyers
nd sellers my be wy form ech other; but they my be ble to estblish cont
cts through communiction, so s to finlize the trnsctions. If they re ble
to spek with ech other, prices in different prts of country, would tend to
equlity esily nd quickly. Thus, ccording to the modern view, () (b) (c) It
is not necessry tht mrket for commodity should lwys be locted on prti
culr street or in building. The buyers nd sellers my be wy form ech othe
r nd yet they my constitute mrket over telephone or through internet. When
buyers nd sellers re in close contct with ech other, prices previling in di
fferent prts of country would tend to equlity.
It is cler tht modern economists hve considerbly widened the scope of the te
rm 'mrket'. If this mening is ccepted, the entire world my be described s
single mrket.
186
Mngeril Economics
4.
Clssifiction of Mrket bsed on the Nture of Competition :
MARKET
Perfect Competition
Imperfect Competition
Pure
Perfect
Monopoly Duopoly
Oligopoly Monopolistic Monopsony Competition
Competition in the mrket cn be either perfect or imperfect. The Clssicl econ
omists ssumed the existence of perfect competition, nd ll their nlysis is b
sed on this ssumption. The drem of the Clssicl economists is, however, hrd
ly relized in prctice. It hs been pointed out tht the rel world is full of
imperfect competition. In prticulr, Mrs. Jon Robinson of the Cmbridge Univer
sity nd Prof. Edwrd Chmberlin of Hrwrd University hve done pioneering n
lysis of imperfect competition. Bsed on their nlysis, competition in the mr
ket is clssified s under. (A) Pure nd Perfect Competition : Usully, distin
ction is mde in economic theory between pure competition nd perfect competitio
n. The concept of perfect competition is much broder in scope thn pure competi
tion. It includes ll the fetures of pure competition plus some more fetures o
f the two forms; let us discuss first the fetures of pure competition. )
Lrge Number of Buyers & Sellers (Firms)
The number of buyers nd sellers operting under pure competition is very lrge.
The position of n individul seller is like drop in the ocen. An individul
seller cnnot, therefore, fix the price nor cn he chnge it by his individul
ction. Similrly, no single buyer cn fix the price or chnge it by his ction.
Even if he increses or reduces his demnd, it does not mke ny effect on the
totl demnd in the mrket. Price of product is determined by the interction
of totl demnd nd totl supply in the mrket. Nturlly, it is beyond the cp
city of n individul seller or buyer to determine or influence the price. Eve
ry seller nd buyer under pure competition is Price-Tker nd not Price-M
ker.
b)
Homogeneous Products
The products sold by different sellers under pure competition re homogeneous i.
e. exctly like in qulity. Usully, product which is cpble of being stnd
rdized is sold by the sellers. For exmple, rice produced in different prts of
Indi is clssified under different stndrd grdes such s Reshm Bsmti, Km
od,
187
Kli, Much, Ambemohor etc. Since every buyer is buying the stndrd vriety, he
does not bother to know s to which prticulr frmer hs grown tht rice. He is
interested in ensuring tht ll the rice in the bg is homogeneous, i.e. exctl
y like in qulity. c)
Free Entry & Free Exit of Firms
Another importnt feture of pure competition is tht there is free entry nd ex
it of firms. An entrepreneur who hs the necessry cpitl nd skill cn strt
ny business of his choice. In every industry, new firms re, therefore, opened f
rom time to time. Similrly, n existing producer is free to close down his busi
ness if he so chooses. As result, some firms re going out of the industry. Si
nce there re no hindrnces to the entry of new firms nd exist of existing firm
s, the number of totl firms under pure competition lwys remins very lrge.
(C) Perfect Competition : It hs been lredy remrked tht the concept of perfe
ct competition is broder thn pure competition. This mens tht perfect competi
tion does exhibit the bove fetures of pure competition viz. lrge number of bu
yers nd sellers, homogeneous products nd free entry nd exist of firms. In dd
ition to these, perfect competition exhibits the following fetures. )
Perfect Knowledge
All the buyers nd sellers operting under perfect competition hve perfect know
ledge of the mrket conditions. For exmple, every seller knows the totl qunti
ty supplied nd sold on prticulr dy or during week. Similrly, every buye
r knows wht is hppening in the other corner of the mrket.
b)
No Discrimintion
Under perfect competition, no seller should discriminte between buyers. He cnn
ot sy tht he would sell his product only to white nd hndsome people; nd not
to the blck nd ugly people. The seller must deliver the goods so long s ever
y buyer, visiting his shop, is willing to py the required price. Similrly, no
buyer would discriminte between sellers. He cnnot sy tht he would buy only f
rom prticulr seller nd tht he would not buy from others. A buyer hs no re
son to discriminte between sellers so long s every seller is chrging the sm
e price.
c)
No Cost of Trnsporttion
Under perfect competition, it is ssumed tht the cost of trnsporttion does no
t exist for crrying goods from one plce to nother.
d)
Mobility of Fctors of Production
Vrious fctors of production re ssumed to be perfectly mobile from one plce
to nother nd from one occuption to nother. For exmple, worker would migr
te
188
Mngeril Economics
from industry cn be diverted to nother industry if the return on investment is

going to be higher. It is ssumed tht ll the fctors of production re perfec
tly mobile nd tht there re no hindrnces to their movement. Mobility of fcto
rs of production is guided under perfect competition, by self-interest nd profi
t-motive, the principle so nicely elborted by Adm Smith in his Book, 'Welth
of Ntions'. e)
Automtic Price Mechnism
The most significnt feture of perfect competition is the existence of n utom
tic price mechnism. Price of product is determined by the interction of tot
l demnd nd totl supply in the mrket. Since there re mny sellers nd mny
buyers, no individul seller or buyer cn fix or influence the price. The forc
es of demnd nd supply re very powerful nd lwys remin outside the control
of n individul seller or buyer. Price mechnism is not only utomtic but is
delicte.
(D) Demnd Curve under Perfect Competition : Under perfect competition, the numb
er of firms in the industry is very lrge. Ech firm is very smll in size. A si
ngle firm ction does not ffect the mrket supply. Thus, ech firm is price-t
ker under perfect competition. The price is determined in the mrket nd every
firm hs to ccept this price.
MARKET
Price (Per Unit) Price (AR)
FIRM
DM
SM
PM SM
EM DM QM
OP0
AR Perfectly Elstic Demnd Curve X Output (Units)
X O Quntity Demnded/Supplied
O
In the fig DM DM is the mrket demnd curve nd SM SM is the mrket supply curve
, EM is the point of mrket equilibrium where mrket demnd nd mrket supply
re equl to OQM. This gives the equilibrium price in the mrket (OPM). This pri
ce is ccepted by every firm. (OP0) under perfect competition. Thus the demnd c
urve of the firm is perfectly elstic under perfect competition. (A) Determinti
on of Price And Output Under Perfect Competition : INTRODUCTION Perfect Competit
ion is sid to exist when the number of buyers nd sellers operting in the mrk
et is very lrge. Then buyers nd sellers hve perfect knowledge of the conditio
ns previling in different prts of the mrket. All the sellers re selling homo
geneous products which re exctly like in qulity. Moreover, no seller would d
iscriminte between buyers nd no buyer
189
would discriminte between sellers. Tht is to sy, seller hs no reson to re

fuse to sell to prticulr buyer who is willing to py the required price. Sim
ilrly, no buyer would hesitte to buy form prticulr seller who is chrging
the sme price. Under perfect competition, no buyer or seller cn fix the price
of product, nor cn he influence it by his own ction. Price is determined by
the interction of demnd nd supply. Demnd nd Supply re powerful forces whic
h constitute the essence of price-mechnism under perfect competition. The price
mechnism determines the price nd output of vrious products. It is, therefore
, worthwhile to explin the working of the price mechnism under perfect competi
tion.
Generl Rule Of Price Determintion :
Under Perfect Competition, generlly, demnd nd supply ply n eqully importn
t role in determining the price. They ct nd rect upon ech other nd determin
e the price t the equilibrium point. This is clled Equilibrium Price. Determin
tion of equilibrium price cn be explined with the help of the following demn
d nd supply schedule nd demnd nd supply curves. Demnd for & Supply of Texti
les Price (Rs. Per metre) 250 240 230 220 210 Quntity Demnded (million metres)
19 20 22 25 30 Quntity Supplied (million metres) 28 26 22 17 10
The bove demnd schedule cn be shown with the help of the following digrm. E
quilibrium Price
Y D S
Price per unit
P S O M
E
D X
Quntity Demnded/Supplied
190
Mngeril Economics
In the figure quntity demnded nd sold is shown on the X- xis nd the price i
s shown on the Y- xis. DD is the demnd curve showing totl demnd t different
prices, nd SS is the supply curve representing the quntity supplied t differ
ent prices. The demnd curve nd the supply curve blnce ech other t point E.
This point is clled on Equilibrium point. Under perfect competition, the equil
ibrium price would, therefore, be Rs.230/- per metre nd t this price quntity
OM would be sold in the mrket.
Chnges in Equilibrium Price :
The equilibrium price, determined by the interction of demnd nd supply need n
ot remin constnt. It cn chnge with every chnge in the reltive positions of
demnd supply. For exmple, if some festivl is forthcoming, demnd for produ
ct would increse. The supply being constnt, price would rise. Similrly, durin
g slck seson, demnd my fll, but supply being constnt, price would fll,
Chnges in supply would lso influence the equilibrium price. For exmple, in
prticulr yer, the cotton crop my be ffected on ccount of nturl clmitie
s. Supply of cotton in this cse is reduced; but demnd being constnt, price of
cotton textiles would rise. There is third possibility; demnd nd supply my
both chnge simultneously. In ll the three cses, the equilibrium price would
chnge. It is worthwhile to see how chnges in demnd, chnges in supply nd ch
nges in both, ffect the equilibrium price. (A) Chnges in Demnd Y Chnges in
Demnd
D D1 S
Price Per Unit
P1 P
F E
S O M M1
D
D1
X
Quntity Demnded/Supplied In figure chnges in demnd re shown by different de
mnd curves DD nd D1D1. The supply is shown by the supply curve SS. Demnd for
product my increse on ccount of festivl, growth of popultion or on cco
unt of some other fctor. In figure originl equilibrium price is shown t point
E i.e. OP. But on ccount of higher demnd curve
191
D1D1 different picture would emerge. The new demnd curve D11 intersects the s
upply curve t point F. The new price would, therefore, be OP1. Thus it is cler
tht supply being constnt, every increse in demnd would led to rise in th
e equilibrium price. D E. (B) Chnges in Supply Similrly, demnd being constnt
, every chnge in supply would chnge the price. This is cler form the followin
g figure. Chnges in Supply
Y D S1 S
Price Per Unit
P1 P
E1 E
S1
S M1 M
D X
O
Quntity Demnded/Supplied In figure, the quntity is shown on the X-xis nd th
e price is shown on the Y- xis. DD is the demnd curve nd SS is the originl s
upply curve. These curves blnce ech other t point E; i.e. equilibrium point.
OP is, therefore, the equilibrium price. Now, S1S1 is the new supply curve whic
h shows reduction in the supply. The new supply curve S1S1 intersects the dem
nd curve t new equilibrium point E1. OP1 would, therefore, be the new price.
This mens tht the totl supply hs diminished from OM to OM1; nd t the sme
time, price hs risen from OP to OP1. (C) Chnges in Demnd nd Supply The third
possibility is tht demnd nd supply both my chnge simultneously. On ccoun
t of these chnges, new equilibrium price would be estblished. This would be
cler form the following figure.
192
Mngeril Economics
Chnges in Demnd nd Supply

Y D D1 S S1
Price Per Unit
P1 P
E
E1
D1 S S1 O M M1 D X
Quntity Demnded/Supplied In figure, DD is the originl demnd curve nd SS is
the originl supply curve. They blnce ech other t point E. The equilibrium p
rice is, therefore, OP. Now D1D1 is the new demnd curve which shows higher de
mnd, nd S1S1 is the new supply curve. The new equilibrium price would, therefo
re, be OP1.
Lws of Demnd, Supply & Price :
From the foregoing discussion the following lws of demnd, supply nd price cn
be stted : (d) Under perfect competition, price of product is determined by
the interction of totl demnd nd totl supply in the mrket. This is clled '
Equilibrium Price.' If demnd increses, supply being constnt, the price would
rise. If demnd flls, supply being constnt, price would fll. If supply is red
uced, demnd being constnt, price would rise nd if supply increses, demnd be
ing constnt, the price would fll. If chnge occurs in demnd nd supply simu
ltneously, new equilibrium price is estblished.
(e)
(f)
(g)
Price in the Short Run nd Long Run :
The bove lws of demnd, supply nd price, however, constitute the generl frm
ework of price determintion. As Mrshll hs elegntly pointed out, time elemen
t plys n importnt role in determintion of price. Mrshll hs clssified the
period of time under four heds; but for the ske of simplicity we cn reduce t
his clssifiction of period only under three heds viz.
193
(i)
Mrket Period (ii) Short Run, nd (iii) Long Run.
It is worthwhile to see how price is determined in the mrket, in mrket period,
Short period nd the Long run or period. (i)
Mrket Period :
According to Mrshll, mrket period reltes to few hours or few dys. Perishbl
e goods such s fish, eggs, lefy vegetbles etc. re sold in this mrket. The s
upply of these goods on ny prticulr dy is fixed. It cnnot be incresed or d
ecresed within the mrket period. At the sme time, such goods being perishble
, their supply cnnot be held bck from the mrket. The entire supply is to be d
isposed off on the sme dy; becuse it cnnot be stored or preserved. In such c
ircumstnces, price would be determined ccording to the totl demnd in the mr
ket. If on prticulr dy, more customers come to buy, the supply would be les
s nd the supply being constnt, price would rise. Thus, in the short run, deter
mintion of price in the mrket period is shown in the following figure : Price
in Mrket Period
Y D2 D D1 S
Price Per Unit
P2 P P1 D2 D D1 O S X
Quntity Demnded/Supplied In figure, SS is the supply curve representing perfec
tly inelstic or fixed supply in the mrket period. Since supply cnnot be inc
resed or decresed in very short period, the supply curve is verticl to the
X-xis. Demnd is shown by different demnd curves, i.e. DD, D1D1 nd D2D2. Acco
rdingly, OP would be the price if demnd is shown by the curve DD. If on the nex
t dy, only few customers come, demnd would be shown by D1D1 nd the price wo
uld fll to OP1. If on some other dy, demnd is higher it would be shown by D2D
2 nd the price would rise to OP2. Thus, price in the mrket period is determine
d from the demnd side, nd supply plys pssive role. 194
Mngeril Economics
(ii)
Short-Run :
In the short-run, supply of goods cn be djusted to the demnd to some extent,
becuse, some fctors remin fixed, wheres other fctors cn be chnged in the
short - period, the price in the short period is thus determined with the help o
f the ctive role of both supply s well s demnd. Y S
D
Price Per Unit
P D S X
O
Q Quntity Demnded/Supplied
In figure, the supply curve is positively sloping, the equilibrium price is OP
t which quntity supplied equntity demnded equls OQ. (iii) Long - Run : In th
e Long - run, supply of goods cn be djusted to the demnd, Dr. Mrshll hs t
ken n exmple of durble goods, which re sold in the long run. Durble goods s
uch s whet, rice, oil, textiles etc. cn be stored for some time. Their supply
cn be incresed or reduced ccording to the demnd. Since the supply is djust
ble, supply curve is horizontl to the X-xis. The sellers of durble goods re
unwilling to sell unless they recover minimum price. This price is bsed on t
he cost of production. Producers of durble goods would not, therefore, sell unl
ess the cost of production is recovered. If the price is less, they would hold b
ck the supply from the mrket. On the other hnd, if they re getting the minim
um expected price which covers the cost of production, they would be prepred to
sell more. i.e., they would increse the supply t the sme price. Determintio
n of price in the long run is shown in the following digrm :
195
Y D
Price Per Unit
Long Run Norml Price D1 D11
P
S
D11 D O Quntity Demnded/Supplied In figure the supply curve is horizontl to t
he X-xis becuse it is djustble to demnd. Here, price of the product would b
e OP which covers the cost of production. In this cse, n increse or decrese
in demnd would not influence the price becuse it is bsed on the cost of produ
ction. If less people come, smll quntity would be supplied nd if more peopl
e come, lrger quntity would be sold t the sme price. It will be seen tht
in the long run, supply plys dominnt role nd demnd is pssive in determini
ng the price. D1 X
Conclusion :
Under perfect competition, price is determined by the interction of totl demn
d nd totl supply in the mrket. The price which is so determined is clled the
Equilibrium Price. The equilibrium price my chnge on ccount of chnges in th
e reltive positions of demnd nd supply. The most significnt point to be emph
sized here is tht the time element plys n importnt role in determintion of
price in the short nd long run. In the short run demnd is ctive, wheres in
the long run supply is ctive in determining the price. By introducing the impor
tnce of time element, Dr. Mrshll hs mde significnt contribution to the t
heory of vlue. (B) Equilibrium of Firm And Industry Under Perfect Competition I
NTRODUCTION In the previous sub-unit, we hve studied how price of product is
determined by the interction of demnd nd supply. We hve lso seen the import
nt role plyed by the time element in the theory of vlue. We hve thus studied
the rules of price determintion under perfect 196
Mngeril Economics
competition. However, we hve not yet studied how firm or n industry would m
ximize its profits. An ttempt is, therefore, mde in this chpter to explin ho
w equilibrium position of firm or n industry is reched under perfect competi
tion.
Firm And Industry :
Before explining the equilibrium of firm or n industry it is necessry to re
vise the distinction between firm nd n industry. Any business unit orgnized
under one ownership nd mngement is clled firm. The firm my be orgnized
s sole proprietorship, prtnership or joint stock compny. The form of org
niztion cn be nything. It is necessry tht the business should be owned nd
mnged by one mngement. An industry is group of firms deling in the sme l
ine of business. The ownership nd mngement of ech firm my be different; but
since ll such firms re engged in the production of the sme commodity, they
re collectively clled n industry. Thus Swdeshi Mills in Mumbi is firm de
ling in textiles. Similrly, Shrirm Mills is nother firm nd Kohinoor Mills is
still nother firm deling in textiles. But when we tke into ccount ll the t
extile firms in Indi we describe them collectively s the cotton textile indust
ry of Indi.
Concept of Equilibrium :
The term equilibrium is frequently used in economic theory. Thus, there is n eq
uilibrium of consumer, n equilibrium of firm or n equilibrium of n indust
ry. Since the concept occupies centrl position in the theory of vlue it is n
ecessry to know the mening of the term equilibrium. A consumer who spends his
income on vrious goods my derive stisfction from the consumption of those go
ods. When consumer mximizes his stisfction he is sid to be in equilibrium. I
n the cse of firm, equilibrium is reched when the firm's profits re mximiz
ed. The ultimte im of every firm is to mximize its profits. Accordingly, the
firm tries to rech the stge of mximum profit by djusting its output. In the
initil stges, when production is on smll scle, the mrgin of profit is sm
ll. But when the scle of production is incresed the verge cost goes on dimin
ishing nd the mrgin of profit goes on incresing. After some time, the disdv
ntges of lrge-scle production begin to operte. As result, the difference b
etween the selling price nd the cost goes on diminishing. Even though the mrgi
n of profit is reduced, there is still some ddition to the totl profits. It is
, therefore, worthwhile to crry on production for some more time. Finlly, po
int is reched when cost of production exceeds the selling price. From this poin
t, losses begin to occur. Every firm would, therefore, stop to produce. At this
point, the totl profit is mximum nd the firm is sid to be in equilibrium. Li
ke firm, n industry cn lso chieve its equilibrium when ll the firms in th
e industry re in equilibrium.
197
Equilibrium of Firm :
There re two methods to study the equilibrium of firm. Viz. () (b) Totl Cos
t nd Totl Revenue method, nd Mrginl Cost nd Mrginl Revenue method.
Before we exmine these methods, it is worthwhile to know the ssumptions on whi
ch our nlysis is bsed : (i) (ii) It is presumed tht firm is mnged s s
ole proprietry concern. This would enble us to study the behviour of n indiv
idul. Every individul proprietor ims t profit mximiztion nd he exhibits r
tionl economic behvior.
(iii) It is lso ssumed tht the firm is producing only one commodity. It is po
ssible to consider firm producing more commodities, but in tht cse, our nl
ysis would become more complicted. For the ske of simplicity we, therefore, s
sume tht the firm is producing only one commodity. Equilibrium of firm with M
rginl Cost nd Mrginl Revenue Method The totl cost incurred to produce gi
ven quntity is clled the Totl Cost (TC). Now, the ddition mde to the totl
cost on ccount of production of one more unit of output is clled the Mrginl
Cost (MC). Similrly, the revenue received from the sle of given output is c
lled Totl Revenue (TR) nd the ddition mde to the totl revenue on ccount of
sle of one more unit is clled Mrginl Revenue (MR). (i) (ii) Mrginl Revenu
e should be equl to Mrginl Cost i.e. MR = MC The mrginl cost curve should c
ut the mrginl revenue curve from below t the equilibrium point.
Firm's equilibrium, rrived t by this method is shown in the following digrm
: Equilibrium of Firm MR = MC
Y MC
Cost/Revenue
G T R H Q S E K D
AC
AR MR
O
L
M N
X
Output 198
Mngeril Economics
In figure, MC is the mrginl cost curve nd MR is the mrginl revenue curve. S
imilrly, AC is the verge cost curve nd AR is the verge revenue curve. When
OM output is produced, MC nd MR curves blnce ech other t point E. At this
point the firm's profits re mximum nd the firm is in equilibrium. If smller
output is produced thn OM the mrginl cost is smller thn mrginl revenue, w
hich mens tht ddition to the cost is less thn ddition to the revenue by pro
ducing more output. This mens tht there is scope to ern more profits be incre
sing output. Output will, therefore, be incresed from OL to OM. When productio
n is OL, verge cost is LH nd verge revenue is LG. Profit per unit is HG. Si
nce there is mrginl profit, output will be crried on upto OM. After the point
OM, mrginl cost would exceed the mrginl revenue; nd the firm's profit will
begin to fll, becuse more is dded to cost thn to revenue by incresing outp
ut. For exmple, if ON output is produced, KN is the verge cost nd SN is the
verge revenue. There is profit per unit to the extent of SK, which is less t
hn QD (profit per unit t output OM). Therefore, it would not be worthwhile to
produce ON output. The firm should stop production when its output is OM, nd it
s profits re mximum.
Equilibrium of Firm under Perfect Competition :
The conditions equilibrium of firm re pplicble to ll the types of mrkets.
i.e. they re pplicble to perfect competition, monopoly, monopolistic competi
tion etc. These conditions re i) MR = MC nd ii) MC Curve must cut MR curve fro
m below. An ttempt is mde below to exmine the equilibrium of firm under per
fect competition. Equilibrium under Perfect Competition
Cost / Revenue
X Output (units) Under perfect competition, no firm cn fix the price or influen
ce it by its own ction. Price is determined by the interction of totl demnd
nd totl supply in the mrket. Under these circumstnces the firm hs to stisf
y both the conditions to chieve its equilibrium, viz.,
199
(i) (ii)
Its mrginl revenue should be equl to mrginl cost, nd Mrginl cost curve s
hould cut the mrginl revenue curve from below.
The generl rule of firm's equilibrium under perfect competition is shown in the
figure. In figure, the curve PL shows mrginl revenue s well s verge reven
ue. The curve MC shows the mrginl cost. When price is OP, mrginl cost curve
cuts the mrginl revenue curve from below, t point R. Therefore, the firm will
be in equilibrium when its output is OM nd the price is OP.
Short - Run Equilibrium
Although we hve discussed the generl rule of firm's equilibrium under perfect
competition, it is worthwhile to follow Dr. Mrshll's clssifiction of time period into short-run nd long-run. In prticulr, we would like to see how fi
rm chieves its equilibrium in the following circumstnces : (i) (ii) When the f
irm erns supernorml profits. When the firm erns only norml profits.
(iii) When the firm begins to incur losses. (iv) (i) When the firm is obliged to
stop production.
Super - Norml Profits : In figure, Op1 is the price, P1 L1 is the verge reven
ue curve - MC is the mrginl cost curve which intersects the verge revenue cu
rve t point Q from below. Therefore, t point Q the firm is in equilibrium nd
OM' is the idel output. Here verge cost is M'G nd profit is equl to GQ. Thi
s firm is erning supernorml profit equl to P1QGH. Since ll the firms in the
industry re working more or less under the sme cost conditions, ll of them wo
uld be in equilibrium. The fct tht the existing firms re erning super-norml
profits my ttrct new producers to the industry. But in the short-run it will
not be possible for them to strt new firms.
200
Mngeril Economics
Short-Run Equilibrium of Firm

Y MC Q AC L1 (AR) = MR
Price Cost / Revenue
P1 F H P E R G
L (AR) = MR
P2 S
L2 (AR) = MR
O
M2
M
M1
X
Output (units) (ii) Norml Profit : In figure, OP is the price nd PL is the ve
rge nd mrginl revenue curve. Here, the firm is in equilibrium t point R nd
the idel output is OM. This form is erning only the norml profit. Therefore,
there would be no reson for new producers to enter this industry. Like this fi
rm, the entire industry is in equilibrium t point R. Thus in the short-run, bot
h the firm nd the industry, re in equilibrium. (iii) Losses : In figure, if th
e price flls to OP2 the firm will be in equilibrium t point S; becuse t this
mrginl cost curve intersects the mrginl revenue curve from below. But t th
is point, when output is OM2, the firm is mking losses becuse the verge reve
nue of SM2 is less thn the verge cost of EM2. Thus the firm is incurring lo
ss P2SEF. If the firm desires to continue to produce, it must incur this minimum
loss. It is obvious tht greter production would men grter loss. Since ll
the firms under perfect competition re working more or less under the sme cos
t conditions, ll the firms would hve to incur losses; if they continue to prod
uce more. Some of the firms, which re incurring losses, my think of closing do
wn the production. But in prctice, firms cnnot stop their production nd cnno
t void losses. This is becuse, every firm hs to incur some fixed costs on cc
ount of bnk interest, insurnce, deprecition, rent etc. even if production is
stopped. By stopping the production, firm cn only reduce its vrible cost on
ccount of rw mterils, wges nd power. Thus, if firm decided to close dow
n production it cn sve vrible costs; but it cnnot sve fixed costs. Every f
irm, therefore, decides to continue to produce so long s it is ble to recover
its vrible costs. In other, words, firm would produce more even if it incurs
loss equl to the fixed costs. Here, every firm tkes n optimist view tht "
hlf glss of wter is better thn nothing".
201
(iv) Closing - down Production : Closing - down Production

Output (units) If the price flls further nd is less thn the verge vrible
cost, the firm cnnot fford to crry on its production. Becuse, here the firm
is neither ble to stop its fixed cost, nor the verge vrible cost. Even in t
he short-run the firm will hve to stop its production. This would be cler form
the bove figure. In the bove figure, price hs fllen to P4. This price does
not cover even the verge vrible cost. The firm will, therefore, hve to stop
its production t point D, price OP3 nd output OM2.
Long - Run Equilibrium
In the long-run every firm gets sufficient time to djust its output in reltion
to the demnd. It lso finds time to buy new mchinery or to implement new tech
niques of production. In the firly long run, the firm cn chnge the compositio
n of vrious fctors of production. In the short-run firm reches its equilibr
ium when MR = MC. This principle is lso pplicble to the long-run equilibrium.
In the long-run one more thing is, however, necessry. i.e. the mrginl cost,
mrginl revenue, verge cost nd verge revenue should ll be equl. Thus, un
der perfect competition in the long-run firm is in full equilibrium when MR =
MC = AC = AR = Price If the price is more thn the verge cost, the firm my e
rn supernorml profits nd this would ttrct new firms to the industry. Entry o
f new firms would result in greter production, nd reduction in supernorml
profit. In the long run, ll firms would, therefore, 202
Mngeril Economics
ern only the norml profit. Similrly, if the price is less thn the verge co
st, losses would occur nd this my drive some of the firms out of the industry.
The firm's equilibrium under perfect competition in the long run is shown in th
e following digrm. In the following figure, mrginl cost, mrginl revenue n
d price re ll equl t point E. The firm is, therefore, in equilibrium in the
long run when its output is OM nd price is OP. Y Long - Run Equilibrium of Fi
rm
P
AR = MR = Price
M Output (units)
X
Equilibrium of Industry
When ll the firms engged in n industry re in equilibrium, the industry s
whole is in equilibrium. This mens tht equilibrium is estblished by totl sup
ply nd totl demnd in the industry. If demnd is more thn the supply, product
ion my be incresed, Conversely, if demnd is less thn the supply, output my
be curtiled. Such chnges in the output cn not tke plce when the industry is
in equilibrium. Equilibrium of the industry is determined by totl demnd nd t
otl supply. The price is lso fixed by totl demnd nd totl supply of the ind
ustry; nd not by ny single firm. It is, therefore, necessry tht, for equilib
rium of the industry size of production should be stbilized t certin point.
There should be no tendency for firms to increse or curtil their output. When
idel size of output is chieved, there is no tempttion for new firms to enter
the industry nd there should be no reson for existing firms to go out of the
industry. Thus, when output is stbilized t the optimum point, mrginl cost wi
ll be equl to mrginl revenue nd the firm would ern only norml profit. All
the firms would ern norml profits. If they ern super-norml profits or incur
losses, it would led to n entry or exit of firms; ultimtely, equilibrium of t
he industry would be disturbed.
203
Conclusion It will be seen form the foregoing discussion tht firm mximizes i
ts profit nd chieves n equilibrium position when its mrginl cost, is equl
to mrginl revenue. When ll the firms in n industry re in equilibrium, the i
ndustry s whole is lso in equilibrium. In the long-run equilibrium of n ind
ustry, output is stbilized t n optimum or idel size nd there is no entry or
exit of firms; becuse in the long run every firm is erning only the norml pr
ofit. (B) Imperfect Competition : In the rel world, perfect competition is seld
om relized. Wht we experience is the imperfect competition in its severl form
s. In the 20th century, mrkets ll over the world hve become imperfect on cco
unt of severl fctors. Buyers nd sellers do not possess perfect knowledge nd
the products sold re no more homogeneous. They re often differentited s to t
heir size, design nd colour. The number of buyers nd sellers is lso smll. De
pending on the number of sellers operting in the mrket, imperfect competition
is further clssified under the following heds : 1) Monopoly 2) Monopolistic Co
mpetition 3) Monopsony 4) Oligopoly 5) Duopoly 1) Monopoly : The other extreme t
ype of mrket, is the one where there is bsence of ny competition. This is s
itution, where there is only one producer, it is clled Monopoly. () Pure nd
Perfect Monopoly For pure monopoly to exist, the following conditions must be s
tisfied : (i) (ii) (b) One firm producing in the mrket, The commodity produced
should hve no substitute.
Impure Monopoly Impure or simple monopoly exists in the mrket of commodity, w
here there is only one producer of the commodity; nd the commodity hs no close
substitute. Since there is only one producer, the distinction between the firm
nd the industry does not exist under monopoly.
(c)
The following fetures re seen under simple or limited monopoly : (i) Single Pr
oducer : For monopoly to exist only one producer should be in the mrket. The pr
oducer my be n individul, prtnership firm, the Government or Joint-stock
Compny. No Close Substituties : To void ny possibility of competition in the
mrket, there should be no close substitutes for the product of the monopolist.
This mens tht the cross-elsticity of demnd for the monopolists product is l
ow.
Mngeril Economics
(ii)
204
(iii) Brriers to entry of firms : The bsis of monopoly is the brriers or rest
rictions of new firms into the mrket; these cn either be nturl brriers or
rtificil brriers. (iv) Demnd Curve under Monopoly : the bove fetures expli
n the demnd curve or the verge revenue (AR) curve under monopoly. The demnd
curve for firm (which mens the industry under monopoly) is downwrd sloping.
It is the monopolist who is the price-mker in the mrket.
Y
AR/Price
AR/Demnd Curve
O
X Units of output
The Demnd Curve Under Monopoly Under monopoly, there is only one seller who con
trols the entire supply in the mrket. Since there is the only producer nd se
ller he cn fix the price of his product. In order to mximize his profit, he m
y rise the price frequently. He my exploit the consumers by chrging n exorbi
tnt price. Since there re no sellers, the buyers hve no lterntive thn to b
uy from the monopolist. Indeed, ll buyers re put t the mercy of the monopolis
t. Mny times, monopolies re creted under Lw. Urbn trnsport, supply of cook
ing gs nd electricity nd such other public utilities re usully mnged s m
onopolies. Such monopolies re clled Nturl Monopolies. On the other hnd, if
producer cquires monopoly on the bsis of Ptent Lws, it is cse of n Art
ificil Monopoly. (d) Distinction between Perfect Competition nd Monopoly : Mon
opoly differs from perfect competition in the following importnt respects. ()
Under perfect competition, there re mny buyers nd mny sellers. No individul
seller or buyer is ble to fix or chnge the mrket price. The price under perf
ect competition is fixed by the interction of totl demnd nd totl supply in
the mrket. It is beyond the scope of n individul seller to influence the pric
e by his own ction. On the other hnd, under monopoly there is only one seller
who is free to fix the price, or chnge it, whenever he likes. 205
(b)
Under perfect competition there re mny firms in n industry; nd ll of them
re selling homogeneous products; but under monopoly the distinction between firm
nd industry receeds in the bckground. Since there is only one seller, firm n
d industry is the sme under monopoly. Under perfect competition there is free e
ntry nd free exit of firms. There re no hindrnces to the new producers who de
sire to enter the industry. But under monopoly entry of new firms is prohibited.
For exmple, in Indi no new firm cn be strted to del in rilwys; becuse t
he monopoly of rilwys hs been entrusted to the Indin Rilwys. Under perfect
competition every seller is chrging the sme price in the long run nd is mki
ng norml profits. If prticulr firm chrges slightly higher price the cust
omers would turn to other sellers. But under monopoly, there is only one seller,
nd he cn rise the price ny time; nd the customers hve no other lterntiv
e thn to buy from the sme monopolist. Under perfect competition firm ttins
its equilibrium when mrginl cost is equl to verge cost, mrginl revenue,
verge revenue nd price. But under monopoly, verge cost is much lower thn t
he price. Since under monopoly, verge cost is much lower thn the price, the m
onopolist cn ern supernorml profits in the long run. Under perfect competitio
n, however, firm cn ern only the Norml profits in the long run. If it erns
supernorml profits, there will be entry of new firms nd this profit would be
shred by ll the firms. Ultimtely, the firm would ern only the norml profit.
Under monopoly, the entry of new firms being prohibited, the monopolist cn er
n supernorml profit in the long run. Since there mny firms operting under per
fect competition, totl output in the society is lrger nd the price chrged is
lso resonble. But under monopoly, totl output is smller nd the price chr
ged is unresonble.
(c)
(d)
(e)
(f)
(e)
Determintion of Price nd output (Equilibrium Under Monopoly) :
Mrginl Cost nd Mrginl Revenue :
Under monopoly, the firm is price-mrker, firm cn therefore fix the price o
f its product, given the output. The demnd curve (AR curve) is therefore, downw
rd sloping under monopoly, nd so the MR curve is below the AR curve The condit
ions of equilibrium re the sme s under perfect competition, i.e.
206
Mngeril Economics
MR = MC nd MC curve cuts MR curve from below. Y

AR MR
MR O
AR X Output (units) Short - run
A monopolist cn mke either norml profits or supernorml profits in the shortrun. A monopolist mking sub-norml profits will remin in production in the sho
rt-run so long s its AVC is covered. Thus, in the short-run under monopoly, the
re re three possibilities s shown below. Y
Norml Profits MC A1 AC
P1
E1 AR MR O Q1 Output (units) Norml Profits X
In the figure, E1 is the point of equilibrium, OQ1 is the equilibrium output nd
OP1 is the equilibrium price. AC = A1Q1 AR = A1Q1 207
AC = AR, the firm mkes norml Profits. Super-Norml Profits

A2
Output (units) In the bove figure, E2 is the point of equilibrium, OQ2 is the e
quilibrium output, OP2 is the equilibrium price. AC = A2Q2 AR = R2Q2 AR > AC, th
e firm mkes Super- Norml profits equl to the re given by P2R2A2C2. Sub-Norm
l Profits Covering AVC
208
Mngeril Economics
In the figure, E3 is the point of equilibrium, OQ3 is the equilibrium output, OP

3 is the equilibrium price. AC = A3Q3 AR = R3Q3, AVC = R3Q3 AR < AC, the firm m
kes sub-norml profits equl to C3A3R3P3. Even though the firm mkes losses, it
continues to produce in the short-run becuse AVC re covered.
Long - run equilibrium under Monopoly
A firm under monopoly my mke norml profits in the long-run; however, it tries
to mke super-norml (bnorml) profits in the long-run. The LRAC is fltter th
n the short-run verge cost curve, but the conditions of equilibrium re the s
me s in the short-run. E0 is the point of equilibrium, OQ0 the equilibrium out
put, OP0 equilibrium price. AR = R0Q0. AC = C0Q0, AR > AC so the firm mkes supe
r - norml profits equl to P0R0C0P. A Fig showing Long Run Equilibrium under Mo
nopoly Y LRMC
Po P
Ro LRAC Co Eo AR MR
O
MC Qo Output (units)
(f)
Price Discrimintion Under Monopoly :
INTRODUCTION By following Tril nd Error method, monopolist fixes the price o
f his product so s to mximize his profit. There is second lterntive open t
o the monopolist. He cn discriminte between buyers nd chrge different prices
to different customers. This is clled Price Discrimintion or Discriminting M
onopoly. An ttempt should, therefore, be mde to explin how price discriminti
on is prcticed by the monopolist.
209
(1)
Wht is Price Discrimintion? Insted of chrging uniform price to ll the con
sumers monopolist my divide the mrket into different clsses of people. One
mrket segment my consist of poor, wheres nother mrket segment my be inhbi
ted by the rich. The monopolist my chrge lower price to the poor nd middle
clss people wheres he my chrge higher price to the rich customers. Chrgin
g different prices to different customers for the sme product is clled Price D
iscrimintion. Exmples of price discrimintion re mny. A surgeon my chrge R
s. 5000/- for operting middle clss ptient, wheres he my chrge Rs. 10000/
- for the similr opertion of rich ptient. The skill used in both the opert
ions is the sme; but the fees chrged to different ptients re different. Simi
lrly, different prices re chrged by cinem house for different clsses of v
iewers. All the viewers see the sme movie; but they hve to py higher price
for occupying set in the first clss or blcony. Rilwy compnies lso chrg
e different fres to first clss, second clss nd ir-conditioned clss psseng
ers. As mtter of fct, the pssengers in different comprtments rech the des
tintion t the sme time. But they hve to py different fres for trveling by
II clss, I clss or AC clss. Similrly, n electricity compny cn chrge low
er rtes for domestic consumption nd higher rtes for commercil consumption. A
lthough there is some difference in the comforts provided to different clsses o
f customers, this difference is negligible. Difference in the prices chrged is,
however, substntil. Thus, monopolist cn chrge different prices to differe
nt segments of mrkets so s to mximize his profit.
(2)
When is Price Discrimintion Possible? Chrging different prices to different cu
stomers is rendered possible in the following circumstnces :
()
Legl Snction :
Public utilities such s rilwy or electric supply compnies, cooking gs suppl
y compnies re llowed under Lw to chrge different prices to different clsse
s of consumers.
(b)
Nture of Commodity :
Price discrimintion is possible where personl service sold to the customers c
nnot be resold. Thus surgeon my chrge lower fee for opertion of poor p
tient thn rich ptient for similr opertion. Similrly, n dvocte my chr
ge very high fees to rich client, wheres he my chrge lower fee to poor
client for similr court litigtion.
(c)
Geogrphicl Brriers :
If two mrkets re seprted from ech other on ccount of geogrphicl brriers
it my enble monopolist to chrge different prices in two different mrkets.
In
210
Mngeril Economics
interntionl trde, mrkets re seprted by rising the protection wll nd di
fferent custom duties re chrged on the imports from different countries.
(d)
Ignornce of Buyers :
Price discrimintion is possible if the consumers in one mrket do not know tht
lower price is chrged in nother mrket. Ignornce of consumers thus enbles
the monopolist to chrge different prices. Sometimes, the consumers my exhibit
n irrtionl feeling tht they re pying higher price for better qulity of
goods. It is likely tht the customers my know tht lower price for bertter
qulity of goods. It is likely tht the customers my know tht lower price is
being chrged in nother mrket; but the difference in price being negligible t
hey my not go to the other mrket. This my enble the monopolist to chrge dif
ferent prices in different mrkets.
(3)
Conditions of Price Discrimintion The foregoing discussion should explin the s
itutions when price discrimintion is possible. For price discrimintion to be
successful the following conditions should be fulfilled : () The two mrkets in
which the product is sold should be kept seprte. i.e. There should be no cont
ct between buyers in the two mrkets. If buyers in one mrket know tht the pri
ce chrged in nother mrket is lower, they would buy the product in nother mr
ket nd sell it in their own mrket. This will led to equlity of price in both
the mrkets nd price discrimintion would no more be possible. No possibility
of resle of the product. The elsticity of demnd in different mrkets should b
e different. Price discrimintion my not be possible if elsticity of demnd is
the sme in both the mrkets. Mrket must be imperfect.
(b)
(c) (4)
When is it Profitble? Hving known the conditions of price discrimintion, it i
s worthwhile to know when it is profitble to the monopolist. In other words, it
is necessry to study the position of equilibrium when the monopolist mximizes
his profit. The principles which pply to the equilibrium of firm re lso p
plicble in this cse. An dditionl ssumption to be mde here is tht the mono
polist is selling his product in two different mrkets. This would mke our nl
ysis complicted but it does not ffect the bsic principle of equilibrium, viz.
firm is in equilibrium when its mrginl cost is equl to mrginl revenue. O
ne more ssumption is tht the elsticity of demnd in two different mrkets is
different.
(5)
Conditions of equilibrium under price-discrimintion () MR = MC (B) MRA = MRB w
here A nd B re two mrkets.
211
On the bsis of these ssumptions, let us understnd when price discrimintion w

ould be profitble. Let us presume tht the monopolist sells his product in mrk
et A nd mrket B. Demnd in mrket A is inelstic or rigid nd demnd in mrket
B is very elstic i.e. responsive to the chnges in price. Under such circumst
nces the monopolist would rise the price in mrket A. His sles in this mrket
would not be ffected becuse demnd is inelstic. On the other hnd, the demnd
in mrket B being elstic, slight reduction in the price would increse the s
les. The monopolist would, therefore, rise the price in mrket A nd would red
uce it in mrket B. The volume of sles in mrket A would remin more or less th
e sme, but sles in mrket B will increse, on ccount of reduction in the pric
e would increse the sles. The monopolist would, therefore, rise the price in
mrket A nd would reduce it in mrket B. The volume of sles in mrket A would
remin more or less the sme, but sles in mrket B will increse, on ccount of
reduction in the price. Nturlly, the monopolist would hve to divert the supp
ly form mrket A to mrket B. If sles in mrket A re slightly reduced on ccou
nt of higher price, this loss would be compensted by n increse in sles in m
rket B. A pertinent question tht rises here is tht how long supply would be t
rnsferred form mrket A to mrket B ? the nswer to this question is tht the s
upply would be diverted so long s the mrginl revenue erned in mrket B is hi
gher thn the mrginl revenue erned in mrket A. The trnsfer of supply from m
rket A to mrket B would be stopped when mrginl revenue in both the mrkets i
s equl. At this point, totl profit erned by the monopolist is mximum nd he
is in equilibrium. (6) Equilibrium under Discriminting Monopoly
Y
Price /Cost/Revenue Price /Cost/Revenue
Y
Price /Cost/Revenue
Y
MC C
P1 E1 AR1 MR 1
P2
E2
E MR
AR2 MR 2
O
Q1
X
O
Q2
X
Output
O
Q
X
Output
Output
Mrket A
Mrket B
Totl A+B (figure 3)
Consider two mrkets, mrket A with reltively inelstic demnd nd mrket B wit
h reltively elstic demnd. In figure 3, E is the point of equilibrium where MR
= MC, OQ is the totl output of the firm. This is to be sold in the two mrkets
t different prices. In Mrket B, E2 is the point t which MC = MR which is rel
ted to MR2. OQ2 is the output sold in mrket B nd t price OP2. 212
Mngeril Economics
In Mrket A, E1 is the point t which MC = MR which is relted to MR1. OQ1 is th

e output sold in mrket A sold nd t price OP1. Thus, OQ = OQ1 + OQ2. The price
in mrket A is higher thn the price in mrket B; nd the sles in mrket A re
lower thn the sles in mrket B. The totl revenue to the firm, however, incre
ses becuse of price-discrimintion. (7) Dumping Where monopolist is chrging
higher price in the home mrket nd lower price in the interntionl mrket,
it is clled Dumping. In Dumping, the losses incurred in the interntionl mrke
t re compensted in the home mrket. The wepon of dumping is successfully hnd
led by the monopolist. In Indi, dumping is encourged with view to promoting
the exports. The Indin exporters re selling their products brod t lower pri
ces. The losses they incur in foreign mrkets re converted in the home mrket w
here higher price is chrged. If the monopolist is unble to recover his losses
he is given subsidy or n Export Bounty, by the Government of Indi. The incen
tive of export bounties hs contributed to higher exports nd ernings of foreig
n exchnge. (8) Degrees of Price Discrimintion The degrees of price discrimint
ion hve been elegntly shown by Prof. A. C. Pigou. According to him, there re
three degrees of price discrimintion. () Under the first degree, the monopolis
t chrges the highest price. This does not leve ny consumer's surplus to the b
uyers. An exmple of this degree is provided by surgeon or brrister who ch
rges the mximum fees. Under the second degree of price discrimintion the monop
olist does not chrge different prices to individul customers. Insted, he cls
sifies the customers into certin groups ccording to the level of their incomes
. Thus, he my clssify the customers into the rich, middle clss nd poor custo
mers. He chrges different prices to different groups of people. The exmple of
this type is provided by rilwy compny tht chrges different fres to II cl
ss, I clss nd Air-conditioned clss pssengers. Under this degree, the lowest
price which the poorest customer from every group cn ber is chrged. Therefor
e, it leves some surplus to other consumers who re reltively better off thn
others in tht group. Under the third degree, different prices re chrged in di
fferent mrkets. The exmple is provided by dumping where lower price is chrg
ed in the interntionl mrket nd higher price is chrged in the home mrket.
213
(b)
(c)
(9)
Conclusion Thus monopolist cn prctice price discrimintion by chrging diffe
rent prices to different customers. It is lso prcticed under dumping where dif
ferent prices re chrged in interntionl nd the home mrket. Such price discr
imintion, () (b) (c) dds to the power of the monopolist, dds to the profit o
f the monopolist, nd dds to the totl output thn the output under pure monopo
ly.
2)
Monopolistic Competition - Fetures
(i) Firly Lrge Number of Firms The number of sellers operting under this type
of competition is lrger thn under oligopoly but less thn under perfect compe
tition. There my be 20-25 sellers engged in the sme line of business. They r
e producing commodities which re close substitutes for ech other. Every seller
hs to compete with others to increse his sles. Since every seller is selling
stndrdized product for long time, he cquires monopoly of tht product. W
hen such monopolistic producers re competing mongst themselves, it is clled m
onopolistic competition. The competition being very keen, the sellers hve to fi
nd out different methods to mintin their sles nd profit. Professor Chmberli
n hs elegntly shown the methods used by such monopolistic producers. Most of t
hese methods re hzrdous nd ech seller tries to be rich t the cost of other
s. This competition is, therefore, clled cut-throt competition nd the methods
followed re clled 'Beggr thy Neighbour tctics'. It is worthwhile to outline
the slient fetures nd the methods of monopolistic competition. (ii) Product
Differentition Under monopolistic competition, every seller tries to distinguis
h his product from the products mnufctured by others. He clims tht his Rese
rch nd Development Deprtment hs developed new product fter considerble re
serch. As mtter of fct, the product so introduced in the mrket is not new.
The sme old product is sold under different trde nme, style, design nd co
lour. Thus, by chnging the outwrd ppernce of the product, the generl publi
c is mde to believe tht it is new product. Bsiclly, it does not differ in
qulity nd the process of mnufcture. But the people re fooled by stting th
t it is product different thn the old one. This is clled Product Differenti
tion. For exmple, Hindustn Lever Ltd. sells bthing sops under different trd
e mrks such s Lux nd Rexon. Bsic contents nd ingredients in both the sops
re the sme. They different. Lux my be used by one populr ctress, wheres R
exon my be used by nother populr ctress
Mngeril Economics
214
from the films. Differences thus exist only in outwrd ppernce, not in their
contents. Such method of product differentition helps the producers under mon
opolistic competition to increse their totl sles. (iii) Selling Costs Every p
roducer operting under monopolistic competition spends huge mounts on publicit
y. He follows ll the medi of dvertising such s press, rdio, television, ho
rding, sites, neon signs etc. Every effort is mde to keep the product before th
e eyes of the consumers, throughout the yer. Whether he likes it or not, he hs
to spend huge mounts on publicity. This is becuse when others re spending, h
e cnnot fford to lg behind in the rce. Every producer therefore ttempts to
spend more thn his rivls. (iv) Multiplicity of Prices Due to fctor-immobiliti
es, or trnsport costs or ignornce of mrket, single uniform price cnnot be
estblished in the mrket chrcterised by monopolistic competition. On the cont
rry, similr products which re differentited by brnd nmes nd dvertisement
s re sold t different prices. Every producer enjoys the freedom to price his o
wn product; this freedom is within certin limits. Every producer hs his own pr
ice-policy. Under perfect competition, this freedom is not vilble to n indiv
idul firm. (v) Elstic Demnd The Averge Revenue Curve of firm under monopol
istic competition is not prllel to the X-xis s it is under condition of perf
ect competition. Becuse, the products of ll firms re not identicl, buyers c
n hve preferences. So it is not possible for firm to sell n infinite mount
of the product t the ruling price s it is ssumed to hppen under perfect comp
etition. Therefore, under monopolistic competition, the Averge Revenue Curve of
firm is not prllel to the X-xis s it is under perfect competition. Under
monopoly, the Averge Revenue Curve of the firm is steep becuse there re no cl
ose substitutes for the product. Under monopolistic competition, on the other h
nd, firms product does have close subsitutes, and therefore, the Average Revenu
e Curve cannot be steep. Thus, the AR Curve faced by a firm under monopolistic c
ompetition is shallow indicating a highly elastic demand. Therefore, if a firm r
educes the price of its product while prices of rival products are unchanged, th
ere would a sizable increase in the sales of the firm.
Pricing and Output Determination in Different Markets
215
(vi) Price War Another method followed to extinguish the rivals from the market,
is a reduction in the selling price. In order to attract new customers, a parti
cular producer may reduce the price of his product. Naturally, other producers a
re required to reduce their prices in order to retain their customers. Price red
uction is sometimes carried to such an extent that it takes the form of a price
war. An example of price war is provide by the Indian shipping industry. The Sci
ndia Steam Navigation Company Limited was started by Seth Walchand Hirachand on
the 19th June 1919. He purchased a second-hand ship called S. S. Loyally and sta
rted the voyage. In course of time, the company made good progress, acquired mor
e fleet and began to compete with the British Shipping Companies. In these days,
shipping industry was controlled by the British and the British ship-owners did
not like that an Indian company should come up to share the profits. In order t
o extinguish the Scindia Steam, the British shipowners reduced the freight charg
es. The Scindia too was required to reduce its freight. The reduction in freight
rate went to such an extent that the British shipowners began to advertise in t
he newspapers that they were prepared to carry the cargo from Bombay to Rangoon
free of charge. They thought that the Scindia would not be able to withstand the
shocks of the price war; but the Scindia could manage in such critical times an
d could come up as the nation s largest shipping company in the private sector.
(vii) Gift Articles Price war is, however, harmful to all the sellers because it
reduces the profits of all. Producers working under cut-throat competition have
, therefore, found out a novel method of increasing the sales. Instead of reduci
ng the price, they hand over small gift articles to the buyers who buy the produ
ct. The gift scheme is operative only for a limited period and it is advertised
in the newspapers on a large scale. This enables a producer to achieve a substan
tial increase in sales within a short-time. For example, there are many tooth-pa
ste manufacturing companies such as Colgate, Palmolive, Promise, Close-up, Babul
, Cibaca etc. In order to increase the sales, a particular company may hand over
a tooth-brush free, to a buyer who buys the tooth-paste. Companies like Nescafe
or Cadbury organize cross-word competitions. An essential condition for submitt
ing an entry form in the crossword contest is that a certain number of used wrap
pers are to be attached to the entry form. Since many customers participate in t
he contest it results in an automatic increase in sales within a short time.
216
(viii) Unfair Methods Under cut-throat competition, a number of unfair methods a

re used to extinguish the rivals from the market. Some of these methods may be d
escribed in brief. (a) A producer who maintains a skilled and qualified staff, i
s able to produce high quality products. On the basis of quality he can capture
the whole market within a short time. Other producers who cannot compete with hi
m may, therefore, snatch away key persons from his factory, by paying them highe
r salaries. Thus, when the Chief Production engineer is snatched away the qualit
y of goods is deteriorated and the firm loses its control on the market. The oth
er producer, who has snatched away the engineer, may gain control on the market.
A firm which has prospered becomes a target of attack by the rival producers. T
hey may get hold of the Union Leader in the prosperous company; and may ask him
to arrange a strike. This would affect the production schedule of the prosperous
company and at the same time, help the rivals to gain control over the market.
The rivals may try to lower the reputation of the prosperous producer. They pass
on false information to the government departments. They may make several alleg
ations that the prosperous producer is evading excise duty, sales tax and income
tax. Government departments may institute raids on the prosperous producer. Thi
s may lower his reputation and he might be extinguished form the market. Thus, t
he methods followed under cut-throat competition are hazardous, harmful and immo
ral. Thus, the market form with characteristics noted above, contains elements o
f both monopoly as well as competition and therefore it is called monopolistic c
ompetition. Products like tooth paste, tooth brush, soaps, detergents, cigarette
s, different brands of alcohol, different brands of body talcum powder, cosmetic
etc. are produced under the conditions of monopolistic competition. (1) Determi
nation of Price and Output under Monopolistic Competition : The foregoing accoun
t would indicate how monopolistic competition is characterized by product differ
entiation, selling costs, price war and unfair methods. It is worthwhile to see
how price of a product is determined under monopolistic competition. Every produ
cer operating under monopolistic competition is selling his product under a part
icular brand or trade name. Before, fixing the price he has to take into
(b)
(c)
217
account the prices of substitutes. The prices charged by rivals enable him to fi
x his price. A producer who has introduced a new product in the market, would ne
cessarily fix the price which is lower than the price charged by his rivals. The
price, fixed in this manner, may not, however, remain constant. The producer ma
y be required to reduce his price, if the competitors have reduced their respect
ive prices. Although an individual producer, under monopolistic competition, is
free to fix his price, he cannot fix it without taking into account the prices c
harged by rivals. The price policy under monopolistic competition is thus depend
ent on the prices charged by other rival firms. It is, therefore, worthwhile to
see how price is fixed and the equilibrium position is reached under monopolisti
c competition in the short-run.
Short-run Equilibrium under Monopolistic Competition
Under monopolistic competition, equilibrium of a firm is arrived at in the same
manner as under other forms of competition. A firm s profit is maximum and the f
irm is in equilibrium when its marginal cost is equal to marginal revenue. This
would be clear form the following diagram : Short - Run Equilibrium Under Monopo
listic Competition : Profit
In figure, MR is the marginal revenue curve and AR is the average revenue curve.
Similarly, AC is the average cost curve and MC is the marginal cost curve. Here
, the price is OP and the total profit is TSPP . The profit is shown by the shad
ed area. This profit is supernormal. An existing firm can also incur losses in t
he short- run. If the position of demand and cost is unfavorable, the firm may i
ncur losses as shown below :
218
Losses under Monopolistic Competition Y MC T S E AR MR O X Output AC

P P1
In figure, AC is the average cost curve and it is higher than the average revenu
e curve AR. Here the firm would incur a loss of STPP . Thus, in the short-run a
firm working under monopolistic competition can earn supernormal profit as well
as incur a loss or may earn normal profits.
Long-run Equilibrium under Monopolistic Competition
The supernormal profit earned by a firm may not last long; because new firms may
be attracted to the industry, and the excess profits would be shared between ex
isting and new firms. The supernormal profits earned in the short-run would, the
refore, disappear in the long-run. Another characteristic of long term equilibri
um is that a number of substitutes are available in the market. The marginal rev
enue curve is, therefore, elastic. The following figure would show how the firm
would earn normal profits under long-run equilibrium. Long Run Equilibrium under
Monopolistic Competition Y
Cost/Price/Revenue
MC T AC
P E AR
MR X O M Output
219
In figure, AR is the average revenue curve and MR is the marginal revenue curve.
Similarly, MC is marginal cost curve and AC is the average cost curve. The aver
age cost curve touches the average revenue curve at point T. At point E, MC = MR
, OM is the ideal output and OP is the price. At this price and output the firm
s profit is maximum and it is in equilibrium. (2) Group Equilibrium under Monopo
listic Competition We have seen how equilibrium of a firm is reached under monop
olistic competition. We have now to see how and when the equilibrium of all the
firms is reached. Under monopolistic competition the number of sellers is large
and each seller is selling his product under a particular Trade name. These prod
ucts are not homogeneous, but are differentiated from each other. It is therefor
e, difficult to analyse the conditions of group equilibrium where different firm
s are selling different products. For the sake of simplicity of analysis, we wou
ld, therefore, make the following assumptions : (a) (b) (c) (d) Competing firms
are selling more or less the same product. The share of every firm in the total
sales is equal. All firms are working with same efficiency.
The number of sellers is large and there is free entry and exit of firms. Under
these assumptions, let us see how group equilibrium is reached. If these firms a
re earning supernormal profits in the short-run new firms may be attracted to th
e industry. The new firms would charge a lower price so as to secure some custom
ers. This will compel the old existing firms to reduce their prices. Naturally,
the supernormal profits earned in the short-run will disappear in the long-run.
All the firms would then earn only the normal profit as shown in figure. Thus, w
hen all the firms are earning normal profit, the long-run group equilibrium woul
d be reached. This position is similar to the one prevailing under perfect compe
tition. The only difference is that under perfect competition, output is very la
rge, whereas under monopolistic competition output is much less. Another point o
f distinction is that under perfect competition an inefficient firm is thrown ou
t of the industry whereas under monopolistic competition even an inefficient fir
m can survive.
(3)
Comparison of Long-run Equilibrium under Perfect Competition and Monopolistic Co
mpetition Both under perfect competition and under monopolistic competition the
firm makes normal profits in the long-run. However, the price-output situation i
s different in the two cases. This is seen clearly in figure.
220
Y RMC
Cost/Price/Revenue
RAC Pm Pp E1 Ep ARp = MRp
Em MRm O Qm Qp Output
ARm X
The description of the figure showing the comparison between Long run equilibriu
m under perfect competition and monopolistic competition is as below. Perfect Co
mpetition 1. ARp = MRp (i.e. average revenue equals marginal revenue) 2. Ep equi
librium where LRMC = MRp 3. OQp equilibrium output. (also optimum output because
LRMC is minimum at this output). 4. OQp > OQm Output under perfect competition
is more than output under monopolistic competition. 5. Full capacity used up bec
ause equilibrium output is optimum output. 1. Monopolistic Competition ARm (i.e.
average revenue is falling) MRm (marginal revenue is below the average revenue.
) Em equilibrium where LRMC = MRm OQm equilibrium output (less than optimum outp
ut OQp) OQm < OQp Output under monopolistic competition is less than under perfe
ct competition. Waste of capacity is equal to Qm Qp because equilibrium output i
s less than optimum output. "Wastes of competition." Firm not in full equilibriu
m. OPm equilibrium price is more than OPp price under perfect competition. Firm
makes normal profits. (ARm = AC = E1Qm) at OQm output.
2. 3.
4.
5.
6. Firm is in full - equilibrium ARp = MRp = LRMC - LRAC 7. OPp equilibrium pric
e is less than price OPm under monopolistic competition. 8. Firm makes normal pr
ofits. (ARp = AC - Ep Qp) at OQp output.
6. 7. 8.
221
We can the conclude, that, the long - run price is lower and output is higher un
der perfect competition as compared to under monopolistic competition. 3)
Monopsony
Another type of imperfect competition is called Monopsony. Under Monopsony, ther
e are many sellers but only one buyer. The buyer is influential and determines t
he price of the product. He may exploit the sellers by offering a very low price
. An example of monopsony in India is provided by the Cotton Corporation of Indi
a who purchases all cotton grown by the farmers. Since there is only one buyer t
he CCI can influence the prices of cotton. Monopsony is the opposite form of Mon
opoly.
4)
Oligopoly and Duopoly :
Oligopoly is a type of imperfect market. A few firms exist in the industry. An e
xtreme case of Oligopoly is Duopoly since Duopoly is an extension of an oligopol
y market, it is not necessary to discuss its features separately, where only two
firms exist in the market. The following are the features of Oligopoly : (i)
Small number of Producers : The small number of firm dominates the market of the
commodity. Each firm has a large share of market supply, therefore, all firms a
ction results in a reaction of other firms in the market. This means that firm u
nder Oligopoly are mutually dependent on each other. In Duopoly, the number of f
irms is two. These firms are also dependent on each other. Product may be homoge
nous or there may be product differentiation : Duopolistic or Oligopolistic firm
s producing raw materials or intermediate products, generally produce homogeneou
s products, as for example, the production of coal, copper or any other metal; w
hereas, firms producing automobiles, computers are firms which differentiate amo
ngst their products.
(ii)
(iii) Restrictions to Entry : Under Duopoly and Oligopoly, there are restriction
s to the entry of new firm into the industry. These restrictions are generally f
inancial or technological in nature. However, entry is not impossible under Olig
opoly / Duopoly but it is difficult. (iv)
Advertisement : If product differentiation exists, it becomes necessary to adver
tise the firms product. This is done to convince the buyers about the superiorit
y of the product over the products of rival firms. However, if the products are
homogeneous advertisement may take the form of informative advertisement. Price
- Control : Firms under oligopoly / duopoly are mutually dependent. Thus all fir
ms actions results in the reaction by other firms.
(v)
222
If one firm reduces the price of its product, other firms will follow. The first
firm will again reduce its price, the other firms will again follow. This proce
ss can continue till the price falls even below the cost of production. This sit
uation is called a price - war. Thus, there is a tendency that one of the firms
not reducing its price to start with. Similarly, if a firm increases the price o
f its product, other firms will not follow. The first firm will therefore, lose
its customers. To start with, therefore, the first firm will not increase its pr
ice. The above explanation leads us to the conclusion, that prices tend to be st
icky or rigid under oligopoly / duopoly. (vi)
Demand Curve under Oligopoly / Duopoly :
Y D1
P
Price (AR)
K
D2 O Quantity Demanded X
Demand Curve under Oligopoly Since firms under Oligopoly - Duopoly are mutually
dependent, there is a situation of action and reaction by firms. This explains t
hat prices tend to be rigid at OP under Oligopoly / Duopoly. If any firm tries t
o increase the price of its product above OP, other firms will not react. This r
esults in a large fall in the quantity demanded of the firm which increases the
price of its product. The demand curve (D1K) is thus relatively elastic. If howe
ver, a firm reduces the price of its product, other firms will also reduce their
prices and there would be a price war. The quantity demanded of the firms prod
uct would increase less than proportionately, the demanded curve (KD2) is theref
ore, relatively inelastic. Thus, the demand curve under Oligopoly, is a kinky de
mand curve. Price tends to be rigid at the kink, K.
223
More about Equilibrium under Oligopoly :

Oligopoly, as we have already noted, is a market structure in which a small numb
er of large firms producing either homogeneous or differentiated products domina
te an industry. A characteristic feature of oligopoly is that any change in the
output or price of one firm almost always provokes retaliation from other produc
ers. This reaction can take many forms. All the firms may come together to form
a cartel or they may openly or tacitly accept the price leadership of the larges
t firm or firms may enter into non-price competition or a situation of price rig
idities may prevail. Producers of differentiated products in oligopoly are actua
lly free to set their own prices. But experience shows that they try to maintain
status quo. This is so because a price-cut initiated by any one firm can trigge
r off a chain of reactions. A price-cut once introduced is not reversible. A pri
ce - war may start. Ultimately all stand to lose. Under such circumstances non-p
rice competition on the basis of quality design, service, sales - promotion etc.
is preferred to a price competition. Oligopoly prices therefore are found to be
rigid. Various models have been suggested to demonstrate the equilibrium and pr
ice - and output determination under oligopoly. Prof. Paul Sweezy s model is per
haps the most popular one and hence we shall consider that one model only. This
model provides an explanation of price - rigidity, i.e. why price is not changed
. The individual oligopolist sees the situation somewhat like this. If he raises
the price his rivals would not follow suit and would do the same thing quickly.
As a result, at a price higher than the customary one, demand is seen to be hig
hly elastic; while at a price lower than the ruling one, the demand is seen to b
e highly inelastic. See figure given here. In this diagram, DD1 is the demand cu
rve which is more elastic in the portion DP1 and less elastic in the portion P1D
1. Y
D P
AR,MR,MC
P1 H
MC1 MC
D1 R Q Output MR
O
X
Figure showing Oligopoly Equilibrium: Kinked demand curve model 224
The equilibrium condition is the profit maximizing condition i.e. MR = MC. Note
that the DD1 curve is the AR curve. The marginal revenue curve (MR) is discontin
uous between points H and R. It is this gap HR that explains price-rigidity. Acc
ording to the usual condition MC = MR, we can find out the profit maximizing out
put. Marginal cost curves like MC, MC1 cut the discontinuous portion HR of the M
R curve so as to give the same equilibrium output OQ. The price therefore remain
s unchanged at OP though costs rise or fall. If the second option of a cartel is
chosen by the oligopolists, and if it is a perfect cartel, the price would be d
etermined by the joint MC and MR curves of all firms taken together. All the fir
ms would then adjust their individual supplies to the cartel price as given. Som
e firms may earn profits and other may earn only normal profits. Due to such dif
ferences in profitability, cartels do not last long. At times, therefore, profit
s are pooled together and are then distributed. But this arrangement also cannot
satisfy all. Price Leadership is another possibility when there is one big or e
stablished firm, it sets the price and others accept that price for adjusting th
eir supplies. If the product is homogeneous, one price may get fixed. If product
s are differentiated, a range a prices may move together. Thus, for example, cig
arettes, bathing soaps, washing soaps, electric fans; etc. are produced in oligo
polistic conditions, in India, and a particular grade of the product is priced b
etween a certain price - range. A change in the price is usually effected by the
price - leader and others follow suit. To conclude, therefore, we can say that
oligopoly is more common but since it can take various forms, a single model can
not explain its price and output equilibrium. Non-price competition makes things
more complex. Rivals use advertising quality changes, competition. A determinat
e economic explanation as a guide to policy is therefore not possible though bro
adly one can describe how output and pricing policies are determined by the olig
opolists.
Miscellaneous Issues in Monopolistic Competition :
Having discussed the determination of price and output under monopolistic compet
ition we are now required to study some miscellaneous issues. These issues are a
s follows : (a) (b) (c) (a) Selling Costs Non - Price Competition Wastes of Mono
polistic Competition Selling Costs :
(i)
Meaning :
Selling cost is the cost of increasing the sales of the firm. It is the cost whi
ch the firm bears in order to try to increase the demand for its product. Sellin
g Costs can
225
be looked at the cost borne by the firm to convince the consumer to demand one c
ommodity instead of another. In effect it means that the cost borne by the firm
to create demand for its product is the selling cost. Many times the consumers
do not know what they need. It is the producers who have to make the consumers
aware of their needs. This is done through selling costs. Sales promotion includ
es not only taking orders for their goods but also creating demand for their g
oods. Under conditions of perfect - competition, it is assumed that the consumer
s have perfect knowledge about the market and thus the concept of selling costs
is not relevant under perfect competition. Selling costs is a feature of an impe
rfect market condition. Selling costs include not only cost on advertisement (wh
ich forms a large part of selling costs), but also salaries of sales - managers
and sales- representatives, cost on exhibitions, show - room expenditure, cost o
n attractive wrappings, gifts, etc., thus any expenditure which the firm makes,
in order to promote its sales, is selling cost.
(ii)
Selling - cost curve is U - shaped :
Y
Selling Cost
O
S1 Quantity Sold
X
As the sales of the firm increase, the average selling cost (ASC) first decrease
s (upto OS1 sales), and then the ASC increases (after OS1 sales), thus the ASC c
urve is a U-shaped curve. Total Selling Cost Quantity Sold
ASC =
ASC decreases upto OS1 sales because of (i)
Economies of specialization : As output and sales increase, a large amount is us
ed for promoting sales and the firm can employ experts to increase its sales or
226
it can advertise through mass media. These methods of promoting sales are expens
ive but the sales increase to an extent that the average selling cost (ASC) decr
eases. (ii)
Economies of repetition : As a firm advertising, initially it does not influence
the minds of the consumers. But repeated advertising, slowly has an impact on t
he minds of the consumers and the sales increase. And ASC decreases.
ASC increases beyond OS1 sales because of (i)
Difficulties in trying to influence the buyers preferences : Once the weak cons
umers are influenced, it is difficult to influence the more hardened consumers
(who are already using another brand of the product), and so the expenditure on
sales increases but sales do not increase much. The ASC therefore, increases. C
ounter - advertisement by competitors : Once a producer reaches a high level of
sales, his competitors are affected and they try to defend themselves by adverti
sing their product. The producer now has to spend more money to increase the sal
es. The ASC increases.
(ii)
(iii) Factors influencing selling costs : (1) (2)
Type of Product : With product differentiation, the sale - expenditure increases
. Introduction of new goods : Firms producing commodities, like clothes, cosmeti
cs, where the fashion and styles charge, have to bear large selling costs. Techn
ology changes : Firms producing commodities, like machines, also have to resort
to advertisement, but this is of the informative type. Other factors : The numbe
r of competitors, the psychology of the consumers, the elasticity of demand and
promotional elasticity of a product also affect the selling costs of a firm.
(3)
(4)
(iv)
Selling Cost and the Demand (Average Revenue) Curve of the firm :
There are two effects of the selling costs on the demand curve of a firm. (1) Th
e demand curve shifts to the right : Selling costs result in higher quantity bei
ng demanded at every price. So, the original demand curve DD shifts to the right
to D1D1. The demand curve becomes relatively inelastic (Steeper) : Selling Cost
s result in consumer preferences being stronger. If a consumer likes a particula
r
(2)
227
brand of a product, a charge in the price of the product will not affect the qua
ntity demanded of the product, by the consumer. The demand becomes relatively in
elastic (Steeper). In the figure the original demand curve DD is less steeper (l
ess inelastic) than the new demand curve D1D1.
Y
Price per unit
X
Quantity Demanded
Effect of Selling Costs on the Demand Curve of a firm
The average cost curve of the firm, AC, moves upwards to AC1 because of selling
costs as shown in the following figure :
Y
Average Cost
O Production (v) Effect of Selling costs on the Price of the Product :
X
The selling costs are initially borne by the producers, but ultimately they are
passed - on to the consumers in the form of a higher price of the product. This
is possible because through selling costs, the demand for the firm s product bec
omes relatively inelastic, because consumer preferences become stronger. (b) Non
- Price Competition : We have seen earlier that under monopolist competition th
e sellers reduce their prices in order to attract new customers. The reduction i
n price may go to such an extent that it may become a price war. Since this type
of competition is based on price reduction, it is called price competition .
228
Price competition is, however harmful to all the sellers. Instead of competing b
y price - reduction they, therefore, use some other methods. When they compete o
n grounds other than the price, it is called Non-Price Competition . Non-Price
Competitions is usually practiced through advertising or gift articles. It is tr
ue that spending large amounts on advertising or gift articles amounts to losses
. But this loss is preferable to the loss incurred on account of price-reduction
. There is a vital difference between the two types of losses. In the first plac
e, reduction in price is against the business ethics. On the other hand, nobody
raises any objection if a producer spends too much amount on advertising. If the
producers find that the expenditure on advertising does not promote sales, they
can curtail it. But when price is reduced it cannot be increased immediately. I
f expenditure on advertising is fruitful its benefit is permanent. Similarly, th
e losses incurred on account of price reduction are permanent. Most of the produ
cers operating under cut-throat competition, therefore, prefer to spend more on
advertising, rather than effecting a reduction in price. This does not mean that
advertising is done through newspapers, radio or television. Since any expendit
ure on sales promotion is included in the selling costs, the producers under mon
opolistic competition spend on the following schemes of sales promotion. (i)
Gift Articles : To promote sales, a producer may hand over a gift article to the
buyers who purchases the product at the usual price. A customer who receives th
e article is permanently attracted to the product. For example, various breads a
re manufactured and sold by companies like Hindustan, Bharat Bakery, Modern Bake
ry, Kwality, Blue Diamond, etc. A few years ago a new bread was introduced by Ba
keman Company. The Bakeman bread at once captured the market because from the ve
ry beginning the company was giving stickers along with the bread. Initially the
stickers contained pictures of various models of cars. Thereafter, they contain
ed the photographs of the actors and actresses in the popular T.V. series viz. M
ahabharat. The children, therefore, developed a hobby of collecting these sticke
rs. Since every Bakeman bread was accompanied by a free sticker, the sales of th
is bread have surpassed the sales of all other breads in the Indian market. Simi
larly, toothpaste manufacturers in India give a free toothbrush along with the t
oothpaste to the buyers. Crossword Contests : Some producers organize crossword
contests or painting contests for children. An essential condition is that the e
ntry form to be submitted in the contest, is to be accompanied by a certain numb
er of used wrappers companies like Nescafe or Cadbury organize such contests. Th
e
(ii)
229
companies which organize such contests also award prizes to the winners. For exa
mple, the winner of the first prize can visit Singapore or Honkong at the cost o
f the Company. Thus, by giving free gift articles or by organizing crossword con
tests, the producers are able to achieve a tremendous increase in their sales. S
ince in this type of competition, the price of the product remains unaltered, it
is called Non-Price Competition. (c) Wastes of Monopolistic Competition : Monop
olistic competition results in the waste of resources in the following manner :
(i)
Selling Costs : Products under monopolistic competition are spending huge amount
s on advertising and publicity. Much of this expenditure is wasteful from the so
cial point of view. It is argued that instead of spending so much amount on publ
icity; producers can reduce the price. This would be beneficial to the consumers
and the society at large. Excess Capacity : Under imperfect competition, the in
stalled capacity of every firm is large, but it is not fully utilized. Total out
put is, therefore, less than the output which is socially desirable. Since produ
ction capacity is not properly capacity under perfect competition is fully utili
zed leading to full employment of factors of production.
(ii)
(iii) Unemployment : Idle capacity under monopolistic competition leads to unemp
loyment. In particular, unemployment of workers leads to poverty and misery in t
he society. If idle capacity is fully used, the problem of unemployment can be s
olved to some extent. (iv)
Cross Transport : Under monopolistic competition expenditure is incurred on cros
s transportation. Goods produced in Ahmedabad are sold in Chennai and goods prod
uced in Chenni are sold in Ahmedabad. If these goods are sold locally, wasteful
expenditure on cross transport could be avoided. Lack of Specialization : Under
monopolistic competition there is little scope for specialization or standardiza
tion. Product differentiation practiced under this competition leads to wasteful
expenditure. It is argued that instead of producing too many similar products,
only a few standardized products may be produced. This would ensure better alloc
ation of resources and would promote economic welfare of the society. Inefficien
cy : Under perfect competition, an inefficient firm is thrown out of the industr
y. But under monopolistic competition inefficient firms continue to survive.
(v)
(vi)
230
Thus under imperfect competition, inefficiency is worshipped and efficiency is d

ispensed with. PRICING METHODS OR PRICING PRACTICES INTRODUCTION As already disc
ussed, firms pursue a variety of objectives with different weightages to differe
nt objectives. The pricing policy of a firm must therefore conform to the compos
ite objective accepted by a firm. This can be ensured by following certain guide
lines or pricing objectives . Several such pricing objectives have been suggest
ed; and are actually being pursued by firms. One such pricing objective is stabi
lity. Firms tend to keep-prices stable and short-run fluctuations in costs, dema
nd etc. are not allowed to influence the price. Maintaining one s share of the m
arket is another such objective. This is a norm which can be monitored and hence
is accepted as an important one. A decline in the market share can be taken as
an indication of falling popularity of the product. Target Return on Capital is
another objective adopted by firms. A certain target rate of return on capital p
rovides a guarantee of a floor limit. Pricing policy also, at times, aims at mee
ting or preventing competition as a goal. This approach underlines a long-run vi
ew of the pricing policy. Finally, when private firms help the government in car
rying out socio-economic programmes like supply of medicines or school books or
nutrition s food etc., they follow the principle of Ethical Pricing, i.e. reason
ableness of pricing that would create a good image of the firm. The aforesaid pr
inciples act as pointers to a proper pricing policy. The method of pricing to be
chosen is a major decision. Basically there are two methods of deciding the sel
ling price : 1) Full Cost Pricing and 2) Marginal Cost Pricing. In the first one
, cost is the decisive factor; while in the second one, various other considerat
ion are involved. 1) FULL COST OR COST PLUS PRICING According to this method, th
e price is set to cover costs; material, labour, overheads and a certain percent
age of profit. Costs to be included in the price are normally actual costs, expe
cted costs or standard costs. Actual costs are costs actually incurred in the pr
oduction period. Expected costs are based on forecasts of production and prices.
Standard costs are based on the forecasts made on the basis of the assumption t
hat the efficiency, sales, prices, etc., will be normal. For the profit make-up
to be included in costs, various practices are followed. Sometimes profit is exp
ressed as a percentage of costs. By simple arithmetic, a formula is usually evol
ved. For example, let us say, a producer produces 10 units of product X. He then
estimates overhead costs, labour costs and material cost. Supposing allocable t
o X and divides it by 10. This gives per unit overhead,
231
labour, material cost. Supposing they are Rs.10, Rs.10 and 5, and profit mark-up
is 12% of costs, the price of product X per unit will be Rs.1- + 10 + 5 + 3 = R
s.28. Though relating profit to costs is easy, it is not scientific. Profit shou
ld be related to investment. Whatever the method of deciding costs and profit ma
ke-up, the cost plus the profit gives what is known as cost plus or full cost pr
ice. This is also known as basic price because as and when any of the cost compo
nent charges, necessary adjustments in price are made accordingly. If, for insta
nce, labour cost increase, the per unit increase in labour costs can be added to
the basic price to give the selling price of the product. Inadequacies of Cost
Pricing (1) This method ignores demand. The price the consumer is willing to pay
is important for purposes of calculating profits. The price the consumer is wil
ling to pay has no relation with costs. Thus, a price based on cost is one-side.
This method is easy to operate; but is ignores the nature of competition in the
market. Whatever price is fixed is bound to invite reactions form rival firms.
But this the method ignores. It also ignores the future possibilities of competi
tion as a result of the price policy. The cost-plus method assumes that costs ca
n be allocated to individual products. This assumption, as is clear form the exa
mple, we have taken, is unrealistic. Many costs are common and cannot be traced
to individual products. It considers full costs. This is not always logical. For
planned expansion, incremental costs rather than full costs should be taken as
a basis. Also to base future prices on present or past costs is equally illogica
l. Cost plus pricing suffers from the fallacy of circular reasoning. Sales depen
d upon price, production depends upon sales, costs depend upon production (becau
se costs change as level of production change) and price is said to depend upon
costwhich completes the circle !
(2)
(3)
(4)
(5)
Justification of cost plus pricing In spite of the above mentioned inadequacies,
the method is widely used for several reasons which are : (1) In practice, busi
nessmen may not strictly adhere to the cost plays formula. Many times this formu
la gives a comparative picture of prices of different products. But in personal
interviews many businessmen say that they follow this method because
232
this method sounds just, in the sense that cost plus a reasonable profit is take
n as price, there is no profiteering and no exploitation of the consumer. (2) Pr
ofit maximization is not the only, or even the principal objective of all firms.
The firms want to ensure that they are earning profits which they feel are fai
r . This can be done by adding the profit mark-up to the cost; by following full
-cost method. It is possible that the faith that in the long run only normal pro
fit can be earned might be at the roots of popularity of this method. In the lon
g run, this method ensuring fair return to capital appears to be logical. In pra
ctice, firms are uncertain about the shape of their demand curve and about the r
eturn to capital appears to be logical. For pricing new products, this method is
suitable. If the new product fetches a price that covers full cost, the product
can remain in the market. Otherwise, the firm can conclude that it cannot affor
d to produce that product. When there is competition in the product market, and
costs are more or less the same for all the firms, cost plus pricing can introdu
ce a particular level of prices and avoids a price-war. If an average level of p
roduction is taken into account for calculating price, this method is secure in
the sense that excessive profits during prosperity compensate for the losses dur
ing depression.
(3)
(4)
(5)
(6)
(7)
Role of Cost-plus Pricing (1)
For product Tailoring : Many times there already exists a great deal of competit
ion in the field where a firm wishes to enter. As such a common level of prices
has already been established in the market. Under such circumstances, the produc
ers can first determine the price and work back by calculating the retailers mar
ginal distribution costs, own profit and what remains is the cost of production.
A product that first in such a cost by its design, etc., is then selected for p
roduction. This is known as product-tailoring. For Refusal Pricing : When produc
ts are supplied according to specifications given by the customer; minimum price
can be decided by full cost method. For example, while supplying school uniform
s, minimum price below which the offer cannot be accepted, can be fixed on the b
asis of this method. For Monopsony Pricing : When there is only one or very few
buyers for a product, it is desirable to charge full cost price only. This is so
because the bulk buyers are mostly business concerns who may otherwise decide t
o produce the commodity
233
(2)
(3)
themselves. For example, let us suppose, the university wants to get some books
printed. The printing press should charge at full cost rates otherwise the Uni
versity may decide to print the books in its own press if rates quoted are high.
(4)
For Public Utility Pricing : When the Government (or a private company) supplies
public utilities like electricity, water, telephone, etc., to the people, cost
of service, is considered as the proper basis. Even when an element of profit th
is included in price, the method is cost plus pricing.
Pricing of Multiple Products The economic theory assumes that a firm produces on
ly one homogeneous commodity. This is done to simplify the analysis. But, in pra
ctice, a firm produces many commodities and, in Managerial Economics, it is nece
ssary to take cognizance of this fact and examine the problem of pricing multipl
e products. Opportunities to produce Multiple Products : A firm gets an opportun
ity to produce multiple products due to the following reasons. (1)
Excess Capacity : The reason for adding a new product to the product-time is usu
ally to increase profits or to increase competitive strength. To attain this goa
l, a firm may use its excess capacity (i.e. unused capacity to produce) if it is
there.
A simple example will make this point clear. Suppose, a press printing a daily n
ewspaper installs new machinery which can print 1 lakh copies. This means half t
he capacity of the machine is unused. To utilize this excess capacity, the press
may think of starting a new weekly, fortnightly etc. In the above example, exce
ss capacity in technical factor is considered. Similar, excess capacity, may occ
ur in the fields of management, distribution etc. The existence of such an exces
s capacity provides an opportunity to add new products to the line.
(2)
Seasonal Variations : Some times the demand is specific to certain seasons, i.e.
, the commodity is in demand in a particular seasons. For instance, the demand f
or umbrellas. In other seasons, the machinery and other factors may remain unemp
loyed. This provides an opportunity to produce some other commodities during off
season. Cyclical Changes : When demand fluctuates as a result of business cycle
s, i.e., when demand increases and decreases alternatively, the firm suffers. Th
ese ups and downs in business are more accentuated in respect of durable consume
rs goods and luxuries. The producers of such products, therefore, may add some
new products which are not affected (or less affected) by these ups and downs in
demand.
(3)
234
(4)
Secular Shifts : When there are secular changes in conditions of demand and supp
ly like changes in the tastes of the consumers, income of the consumers, availab
ility of raw material, etc., it may be necessary to drop old products and add ne
w products to the line. For example, in the face of competition of mill cloth, t
he handloom industry had to introduce a variety of designs to increase its compe
titive strength. Vertical Integration : Vertical integration of different produc
tion processes also offers an opportunity for increasing the number of products.
For example, printing of books and publication are two processes which can be i
ntegration if the publisher purchases a printing press. Now, after printing all
the books he is publishing, if the press remains idle for some period of the yea
r, this excess capacity may be utilized by accepting outside jobs like printing
of visiting cards, receipt books, hand-bills etc. Research : Research creates ne
w methods of production, new techniques, etc. Old techniques then become outmode
d. New products are therefore, discovered which can be produced with the help of
tile machinery, at hand.
(5)
(6)
Policy of Adding Products In a dynamic business world, monopoly power does not l
ast long and competition forces firms to introduce new products. Hence, the poli
cy of adding new products becomes important, in practice. In selecting new produ
ct; the following problems arise. (1)
Standards of Profitability : The products to be selected are to be considered in
order of profitability - the most profitable getting priority. Here, the questi
on is what concept of profit should be adopted? Should the firm use incremental
profit as a test? That is, should the addition product is made to bear its sha
re of common costs? If the new product is to be adopted temporarily, the former
concept of profit will be appropriate; but id the new product is to be added per
manently, the latter concept will be suitable.
Once the concept of profit is finalized, the problem of measurement of profit ar
ises. Contribution of each unit to total profits, percentage return to investmen
t and total money profits are the each unit to profit is a better measure of pro
fitability. If, no the other hand, new products are being added on a large scale
, percent return to additional investment is a desirable measure of profitabilit
y. It is not possible to forecast the profit contribution of a product throughou
t its life. But such forecasts are usually made for a period of 3 to 5 years and
on that basis, order of preferences is prepared for addition to the product-lin
e.
235
(2)
Product Strategy : Profit is just one consideration in the policy of adding new.
But there are other objectives as well and a strategy of choosing new products
has to be evolved, which keeps in view all these objectives. This strategy has
to be evolved with an eye on the policies of rival firms.
Complementarity is an important part of this strategy. If products in a productline are complementary to one another, they create demand for one another. For e
xample, if an electric supply company starts the production of electrical applia
nces like fans, irons etc., the demand for these appliances increases the demand
for electricity. Some times, it is desirable to establish the reputation that t
he firm supplies all alternatives. For example, for a company producing paints a
nd varnishes, it is desirable that it produces all types and shades of paints. T
his establishes the company s reputation and the customers rely on the company f
or all their requirements Besides the above considerations, common raw material,
common processes of production, common distribution channels, etc., are additio
nal considerations which are important in the product strategy.
(3)
Criteria for New Products : What has been referred to above as additional consid
eration can be considered in details as criteria for choosing new products. They
are : (a) Interrelation of demand characteristics : New products and existing p
roducts may have a demand relationship of either complementarity or of alternati
ve character. A firm may decide to produce alternatives to retain its goodwill a
nd it may also win over new customers if it successfully establishes a reputatio
n as a firm producing up-to date alternatives. Similarly, in case of complementa
ry goods we supply the whole range is a good motto for the firm. If a firm is
already producing household appliances like choppers, mixers, toasters, etc., it
is desirable to add heaters, geysers, cookers, etc., and make the range a s com
plete as possible. (b) Distinctive know-how : When a company has some distinctiv
e know-how, it is desirable to add products that can be based on the same know-h
ow. For example, a firm producing electronic appliances can add more electronic
appliances only. (c) Common production facilities : We have already seen that ne
w products utilizing existing production facilities and excess capacity are desi
rable. (d) Common distribution channels : It is also desirable to select a new p
roduct that can be brought to the market through the existing distribution chann
els. For example, a company producing medicines can add a few cosmetics, but not
readymade garments. (e) Common raw materials : It is obviously economical to ad
d a product that uses the same raw materials being used for existing products or
that which uses the by products of existing products. A textile mill can start
the production of towels and bed-sheets or raw cotton blankets. (f0 Benefit to p
resent product lint :
236
So far we have considered the benefits of existing products to new products. Her
e we have to consider the benefit of new products the established ones. This cri
terion suggests the benefits accruing to the old products (i) of demand inter-re
lationship, (ii) of research for new products, and (iii) of market surveys for n
ew products. Policy of Dropping Products The policy of dropping old products is
as important as that of adding new products. (1) How does the problem arise? : S
ometimes the choice of the product proves wrong Sometimes some other company is
merged with a company when the products of that company which are unprofitable a
lso come into the product line. Sometimes due to product improvements effected b
y rival companies, the existing products become out dated. In all these circumst
ances, the need arises for dropping old products. What are the choices? : When t
he profit s or sales of a product are found unsatisfactory, the company may try
to improve distribution or reduce costs of production or improve the quality of
the product. Bulk sales or buying from others and selling under the firm s label
can also be tried. When all these efforts are rendered useless the only alterna
tive is dropping the products, i.e., to stop its production.
(2)
Cost of Multiple Product In a firm producing many products, the problem of deter
mining costs of individual articles is of great practical importance. The accoun
ting allocation of production cost is useful only for a few-business decisions.
They are mainly useful for computing enterprise profits. But these product-costs
supplied by conventional cost accounting are, according to Joel Dean defective
in several respects : (i) Over - heads that do not vary with a decision are neve
rtheless allocated to individual products; (ii) the method of allocation is scie
ntific, but arbitrary; (iii) No distinction is made between joint and alternativ
e products, and (iv0 there is no recognition of the significance of controllabil
ity of the product mix in estimating costs. The analysis of the economic charact
eristics of the managerial problems and of the production process can help recti
fy these defects.
Jointness of Products : The problem of allocation arises when costs are common.
This may happen with respect to joint products or alternative products.
As we have already seen, joint products are produced together (meat and raw hide
s and skins). In the case of joint products there are two possibilities : one th
at the proportions of joint products are variable, i.e. one of the two can be in
creased by keeping the other constant. If this is the case, the cost of each can
be found out by keeping one product
237
constant and observing how much is the increase in costs by increasing the produ
ction of the other product. In the second possibility, where the proportions are
fixed, like meat and skins, it is not possible to find out individual product c
osts. When products are alternative, (case of dressed chicken and eggs as we saw
earlier), the costs can be estimated by the use of the concept of opportunity c
osts. For example, the cost of dressed chicken is the earnings foregone of eggs
that could be sold. When products are in joint supply, the product-mix is diffic
ult to control when the proportions are fixed. In other cases, product-mix can b
e controlled. The problem then is easy, as the output of one product can be incr
eased by keeping the other constant.
Allocation of Variable Overheads : The only problem that now remains is allocati
ng short run common overhead costs which are variable. This can be done in vario
us ways :
(1) Share in common costs can be estimated by proportions in traceable costs, e.
g., if direct labour cost is traceable and is 10% of the common can also be trea
ted allocable. The some method may be applied by taking together all traceable c
osts, e.g., adding direct labour and direct material to find proportion in total
costs. The most closely associated traceable cost can be selected as the basis
of the allocation of common cost, e.g., the cost of electricity (common cost) ca
n be estimated individually by taking into account the machine hours worked for
the product.
(2)
(3)
Any of these or a different method can be accepted. Thus the jointness of produc
tion, is not a difficult problem. To sum up, in case of multiple products, the p
roblem wit cost allocating arises where costs are not traceable. In such cases,
more logical methods of allocation than those followed in accounting practices a
re desirable. Such methods can be found for joint products with variable proport
ions and alternative products. In case of joint products with fixed proportions,
however, the allocation has to be arbitrary, as no logical method of allocation
can be thought of. 2) GOING RATE PRICING
While full-cost pricing takes into account the cost of production, without refer
ence to demand, the going rate pricing emphasizen the market conditions. The fir
m does have control over its own price and output. However, the firm adjusts its
own pricing finding and allocation of costs
238
is very difficult. In many cases, where costs are difficult of measurement, this
method id adopted. In cases, where a price leader exists and he charges a price
in keeping with what the followers are charging, some firm may follow this poli
cy. Where demand is elastic and where price competition is likely to set in moti
on a price-war, a firm may begin its calculations form price rather than from co
sts. Thus, for instance, a firm may accept a certain price as a going rate price
and then adjust its costs by providing for a certain margin of profits. This me
thod of pricing is simple to grasp and can be of help where the products have re
ached a mature stage. In such a situation, customers as well as rival firms pref
er a stable price. This method seeds to maintain price-stability and allows chan
ges in costs where necessary. Hence cost control is a problem in this method. In
a way, this method is exactly opposite the above one; the one we saw earlier wa
s a method of cost-plus pricing. While the one we are discussing here is a metho
d of price-minus costing. B) Marginal Cost Pricing
One of the most sound pricing practice is the full-cost pricing which we discuss
ed in great detail. Going-rate pricing is, as we saw, approaching the problem fo
rm the opposite end. Going-rate pricing, however, is not a policy that could by
followed on a permanent and a longterm basis. This is obviously because of the f
act that a firm cannot accept the responsibility of controlling costs, all the t
ime. Many elements of costs are such as are hardly within a firm s control. Tran
sport costs, fuel costs, taxes are just a few examples worth mentioning. The sec
ond approach to pricing which calls for our attention now is marginal pricing. M
arginal analysis occupies an important position in the classical economic theory
. A firm s equilibrium can be explained by comparing marginal revenue and margin
al cost at each level of output. Where marginal revenue just covers marginal cos
t, a firm can stabilize its production or output. What price should be charged?
One that is given by the average revenue curve (or the demand curve) at the equi
librium level of output, is the answer. The marginal cost pricing appears to sug
gest that price charged should be equal to the marginal cost. This policy must e
ntail losses and this fact can be ascertained by a look at the diagrams explaini
ng equilibrium of a firm. What marginal cost pricing suggests is that it sets th
e lower limits a firm can set a price that ensures the targeted or possible leve
l of profitability. The method of pricing we are discussing is marginal cost p
ricing while the sub-title we have given is incremental cost pricing. Are they
the same? Strictly speaking, they are not the same. The incremental principle i
s commonly used in business decisions. When a firm takes any decision, it involv
es a course of action. This course of action must have some impact upon total co
st and total revenue. According to the incremental principle, the decision can b
e considered sound if incremental revenue i.e. increase in revenue exceeds incre
mental cost or increase in costs. It is possible that both these quantities woul
d be negative. In other words, a course of action may involve a fall in cost as
well as a fall in revenue. However, the action can
239
be justified if a fall in revenue is less than the fall in costs. As against thi
s, marginal cost refers to the change in total revenue following a unit change i
n total revenue following a unit change in output. Marginal revenue, in the same
way, is a charge in total revenue following a unit change in output. In spite o
f this technical difference, business discussion usually ignores the difference
and the two terms are used interchangeably. In the context of pricing, marginal
cost would be the proper expression to denote the method. In this method of pric
ing, fixed costs are ignored, because marginal cost represents addition to total
cost, which takes place due to variable costs only. When fixed costs are high,
full-cost pricing is likely to make the price uncompetitive. Marginal cost prici
ng avoids this possibility. Orders are not turned down because the price offered
does not cover average cost. Whatever excess of price over average variable cos
t is available can be used for meeting profit requirements and contribution towa
rds fixed costs. Marginal cost pricing helps the firm to become more aggressive
at the market. The firm can take a full-life perspective and can plan to cover f
ull costs over a long period. Where full-cost pricing is difficult for reasons n
oted earlier, marginal cost pricing is found to be very convenient, though not n
ecessarily satisfactory. This method has been criticized on the following counts
. (1) (2) In practice, this method faces many difficulties. Many business do not
possess the knowledge of finding out marginal cost and marginal revenue. Pricin
g has to take into account, future costs and prices. Due to uncertainties involv
ed on both sides, there always arises a discrepancy between planned profits and
actual profits. It is pointed out that a strict adherence to marginal cost prici
ng leads to frequent price changes. Such changes are not liked by the buyers. Mo
reover, they create problems in planning, distribution and credit sales and purc
hases. A price-cut is usually irreversible and in the absence of a necessary upw
ard revision of prices, the firm stands to lose. For a firm producing different
products, the cost of operating this method is very high. This is because the op
eration involves the creation of a machinery that calculates and monitors demand
elasticity s, sales forecasts etc. Adherence to marginal cost pricing puts the
firm to losses because overhead costs are not covered by this price.
(3)
(4) (5)
(6)
The criticism is not fully warranted. The points that this method will put the f
irm to losses is based on the assumption that MC > AC. We have seen that this ho
lds goods only when c0sts are diminishing. When costs are rising, MC > AC. Again
, full-cost principle may suggest that one should not produce so long as all the
costs are fully covered. This is obviously wrong. Fixed costs must be incurred
even with zero production level. Wisdom, therefore, lies in 240
producing when incremental costs are covered. This, however, would be a short-te
rm policy. Marginal cost pricing therefore should be viewed as measure of sugges
ting the floor-price of a product and as a guide for modifying profit-maximizing
price when market conditions so demand. 4) SOME OTHER APPROACHES
Full-cost marginal-cost are the two basic methods we noted so far. In practice,
we come across a very wide, variety of practices in pricing. Let us consider the
major approaches, to pricing which lie at the basis of actual pricing practices
. These approaches are not alternatives but can act as complementary or suppleme
ntary to one another. (A) Intuitive Pricing : This psychological and subjective
approach to pricing is surprisingly very common. Intuitive pricing, as the term
itself suggests, is a response or a reaction to the feel of the market. The appr
oach can be variously applied. Price based on pure lunch can be taken as a start
ing point. At the other end, price based on full cost is taken as a basis. This
priceestimate can then be modified according to the market conditions and the na
ture of competition. Thus, though the approach is intuitive, the price cannot be
entirely left to the intuition of the entrepreneur. The success of pricing poli
cy can be judged by whether the price that the firm needs and that which the buy
ers want is the same, or at least, the two come very close. This is hardly possi
ble and requires a great deal of knowledge on the parts of both sellers and buye
rs. Some managements can guess correctly the future treads in demand and competi
tion. Their intuitive prices prove to be successful. (B) Experimental Pricing :
In search of an optimum price, the firm takes some cognizance of the demand for
the product, and proceeds, to fix a price by a trial- and - error method. This i
s experimental pricing. Usually a sample of test markets is selected, and price
is varied to see the reactions. These reactions are observed and then a price th
at maximizes profits is fixed. This method is widely used in respect of new prod
ucts. This method has the potential of providing a scientific base for pricing p
olicy. However, in oligopolistic structure, where buyers cannot be separated, th
is method has got to be applied with caution. (C) Imitative Pricing As the name
itself suggests, the firm fixes its price equal to, or in some proportion of, th
e price of another firm. We have already noted the possible price-leadership sit
uation in the context of oligopoly. A firm that initiates a change in price in t
he price-leader. Other known as price - followers, make adequate change in price
. Price-leader usually has a large share in the market or an established reputat
ion or a sound profit history. Others, therefore, hope to gain by the leader s e
xperience without risking their own market share.
241
Imitative pricing perhaps is the easiest method to follow and finds popularly in
many fields. Especially in retail trade or in other manufacturing areas where m
onopolistic competition exists, prices are kept imitative so as not to disturb t
he inter-firm competitive structure. The firm can then conveniently concentrate
on non-price competition. The disadvantage of this method is that it sacrifices
flexibility and leaves no room for adjustments as per local conditions. 5) SOME
GUIDELINES FOR FIXATION
The foregoing discussion concerned some of the approaches to pricing. We shall n
ow try to provide practical guidelines evolved by people through their business
experience. These guidelines are important in bridging the gap between theoretic
al prescriptions and practical applications. (A) Single Product Pricing
1.
Pioneering Price
Every product has a life-cycle : a product is new, it clicks and gets establishe
d; but after some time stagnation and decline phases follow. Once this fact is a
ccepted, two possible approaches emerge for a pioneering price. They are : (a)
Skimming Price : The entry of a new product into the market is usually preceded
by a great deal of research and promotional expenditure. For a new product, the
demand initially is not likely to be price-elastic. A firm can decide to skim th
e cream of the market by charging a high price. Subsequently price can be reduce
d to reach lower income customers. Penetration Price : Alternatively a firm can
begin by charging a very low price to penetrate the market. In the short-run the
firm may make losses; but in the long-run profits can be earned. This is becaus
e, after capturing a large part of the market, the firm can gradually raise the
price. Where large-scale production is likely to reduce costs considerably, this
policy is helpful.
(b)
2.
Price in Maturity After the take-off a product reaches maturity stage. During th
is stage, competition is keener, substitutes are available and preference for th
e product becomes weaker. There aspects of maturity therefore become relevant fo
r reckoning : (a) (b) technical maturity reflected in increasing standardization
with set prototypes and less product variation; market saturation with weakened
preference and a higher ratio replacement sales to new sales; and
242
(c)
stability of production methods, market shares and price-structures. During this
stage, therefore, price should be set carefully by taking into account estimate
d elasticity of demand, competitive degeneration as well as the possibilities of
non-price competition.
3.
Cyclical Price : In course of its life, a product experiences fluctuations in de
mand. Firms may decide to respond to these fluctuations by reducing off-season p
rices and raising prices when conditions are brisk. Alternatively, a firm may de
cide to maintain its quality- and - price reputation by keeping the price unchan
ged throughout recession and prosperity.
4.
Backward Cost Pricing When competition is keen and quality as well as price are
consequential to the buyers, a selling - price is determined first and by workin
g backward, the product design can be arrived at. A wide variety of products inc
luding electrical appliances automobiles are subjected to this type of pricing;
by cause the market is flooded with competitive products.
5.
Refusal Pricing Many products are such as to serve specific needs of the users.
Surgical equipment is an example of this type. High price and profiteering canno
t be followed - in such cases. Therefore, cost plus limits as floor price are as
certained. No price-reduction is possible. So, at less than this, he seller just
refuses to supply the product.
6.
Psychological Consideration Many times producers resort to tactics which actuall
y exploit the consumers psychologically. Double-pricing is one such tactic. On t
he price-tag two prices ate printed with upper one, which is a higher one, cross
ed. The consumer get a feeling that price is lowered by the company and therefor
e sales get boosted. Prestige pricing is another tactic. A high price is maintai
ned where buyers attach prestige considerations to the product. Customary prices
are charged in respect of commodities having kinked demand curves. These are a
few guidelines for single product, i.e. where the firm is producing a single pro
duct. However, when a firm is producing many products-and such firms are many a problem of product line pricing arises.
(B) Product Line Pricing A modern firm produces a wide range of products. Under
such circumstances, the problem of pricing these multiple products in a product
line is of vital importance.
243
1.
Alternative Policies of Price Relationship
In pricing products in a line, various alternatives are possible. Important amon
g them are : (a) Price that are proportional to full cost : According to this po
licy common costs are allocated to individual products. Traceable costs are then
added to them and then by6 adding a profit mark-up the selling price is fixed.
This is the cost plus price we have discussed earlier. Prices the are proportion
al to incremental costs : Without considering common costs only incremental cost
s may be taken into account and prices may be fixed in proportion of three produ
cts - A, B and C costs are increasing by Rs.4,000/-, Rs.3,000/- and Rs.1000/- re
spectively, the expected revenue form the three products will be distributed ove
r these in the proportion 4:3:1. By dividing the expected revenue from each by t
he units of that product, we get the price. This removes the defect of arbitrari
ness in the first method. But this does not recognize the extent of composition
in the market or the elasticity of demand. Prices with profit margins proportion
al to conversion costs : Conversion cost is the cost of converting raw material
into final product. This may not be the same for all the products in the line. E
.g. the milk collected by a dairy can be pasturised and bottled or can be powder
ed and filled into tins. The conversion costs of these two are obviously differe
nt. If these costs are 4:6 then the profit also may be divide in the proportion
4:6. With this profit added to costs the price can be fixed. Price that produce
contribution margins that depend upon the elasticity of demand of different mark
et segments : The market is divided into segments according to elasticity. Elast
ic demand has to escape with a low profit margin while inelastic demand can be b
urdened with a high profit margin. Firms can take advantage of the ignorance of
customers or a desire for distinction or just the laziness of customers. These p
rovide opportunities for changing different prices. The more complicated the pro
cess and design of the product the more are opportunities for such discriminatio
n. E.g. the price differences in the case of A and B grade sugar cannot be much.
But with different cases and dials, two wrist-watches with the same machines ca
n be sold at a difference of a hundred rupees. In this method, differences in el
asticity are taken maximum advantage of. Prices that are systematically related
to the stage of the market and the competitive development of individual members
of the product line : Every product has to pass through three stages : It is in
troduced reaches the height
(b)
(c)
(d)
(e)
244
of popularity then lags behind. It is possible that different products in a line

are in different stages. An old product should have a law price. A product that
is on the top of popularity can bear a high price. A new product has to be lowpriced. That is why Mr. E. S. Freeman compares a product line with a family. You
ng children have a share in costs. The old members of the family earn just enoug
h for their upkeep or live by the pension they get for the work done when they w
ere in this price. But the total cost of the family is covered by the total fami
ly earnings. This analogy explains the price policy under consideration most elo
quently. What each product should earn is dependent upon the nature of the compe
tition in the market and the elasticity of demand for each product. 2.
Factors to be considered in pricing
Of the alternative pricing policies suggested above, whichever is chosen, the fo
llowing factors need to be considered : (a)
Demand Relationship in the Product Line : Products in the same line have many ty
pes of demand relationships. They may be complementary products, e.g. torches an
d cells produced by the same company. They may be alternative products e.g. diff
erent models of a radio set produced by the same company. A new product can be i
ntroduced in the market by taking advantages of these demand relationships. This
is how new models of radio-sets are introduced, or this is why a company produc
ing tooth past introduces it s tooth brush (complementary) and tooth powder (alt
ernative) as well. Differences in the elasticity of demand provide an opportunit
y for increasing profits by taking advantage of the ignorance of customers or th
eir craze for distinction. Competitive Differences : All markets where products
form one product line are sold do not have the same degree of competition. The n
umber of competing firms the firm s share in the total market supply and differe
nces in the nature of competing products indicate the extent of competition. The
competition also depends upon the costs of entry, the costs of acquiring new pa
tents. Capital and technical difficulties in starting a new firm etc. the less t
he possibility of emergence of competition, the more, obvious are the opportunit
ies of increasing profitability by charging high prices. Cost Estimates : Each s
et of process will produce a particular product-mix (i.e. proportions of sales o
f various products in the line) and a corresponding total revenue and total cost
. This is so because as price changes, demand changes and so does the total reve
nue. Similarly, because supply changes, costs will also change. That set of pric
e is the best which fetches the maximum profit. The cost estimate to be used her
e will be dependent on the objectives
245
(b)
(c)
of the firm. If for example, profits are subject to letal restriction, full cost
should be included. If using excess capacity is the objective, incremental cost
s are relevant and a nominal profit will be considered satisfactory. 3.
Some Problems of Product - Line Pricing
(1)
Pricing Products that Differ in Size : It is desirable to charge different price
s for different sizes of a product? Price can be the same if costs and satisfact
ion accruing to the consumer are the same. E.g. in the case of footwear for adul
ts, costs do not differ much and it is not the that a man wearing a bigger shoe
simply because their feet are of different sizes. But if it is decided to vary p
rices according to sizes, it is desirable to have a systematic pattern. E.g. if
a shirt of 75 cm is charged at Rs.40 and that of 80 cm is charged at Rs.45, than
that of 85 cm should be charged Rs.50. This has an appearance of equity.
While pricing alternative sizes, it is advantageous to reduce the price as the s
ize increases. E.g. the price of a 20ml. bottle of hair oil should be less than
the price of two bottles of 100 ml. taken together. This saves packing costs and
encourages demand.
(2)
Pricing Products that Differ in Quality : When there are products of different q
uality in a product line, their prices will be determined in accordance with the
objectives of the firm. Sometimes the objective is to bring prestige to the ent
ire line. Then some high price products are kept deliberately. This increases th
e sale of low and medium priced products. If a company prices its quality neckti
es at Rs.50 each it can sell cheap ties in large numbers. It is these cheap ties
that really fetch profit.
If price competition is the objective the firm produces low quality products and
charges minimum prices. This enables the firm to project its image as a firm c
harging reasonable prices .
(3)
Charm Prices : There has been a belief in the business would that prices ending
in odd figures give a feeling that they are reasonable and they appear to be les
s than what they actually are. This increases sales. This is why prices like Rs.
9.95, Rs.24.95 are charged in place of Rs.10 or Rs.25. Pricing Special Designs :
When a product is custom made or prepared on special order and specifications,
what price should be charge ? As already seen, if the customer himself is a prod
ucer, full cost price is desirable. Alternatively, what businessmen calla parit
y price or what economist call opportunity cost should be charged.
(4)
246
(5)
Charging Different Prices at Different Times : When the demand is seasonal at le
ast fixed costs are required to be borne in the off-season. To cover such costs
concessional prices can be charged in the off-season. For instance, fans in wint
er and blankets in summer can be sold at concessional prices. It is possible to
win new customers by keeping price low at a time when demand is less. E.g. when
matinee shows are screened at lower charges, it is possible to attract spectator
s who are not habituals. The same group may later be habituates and may start vi
siting regular shows. Pricing Repair Parts : Many firms producing spare parts ea
rn more than firms producing the whole machine. Because of the irregularity of d
emand and the risk of obsolescence, the price of spare parts are required to be
kept high. It is desirable to distinguish between parts that can be produced eas
ily which must be sold at a competitive price and parts requiring specialized te
chniques that can be sold at a high price.
(6)
(6)
Pricing in Public Sector Undertakings (PSU)
The price policy of public enterprises has special significance: i) ii) iii) iv)
v) The price fixed by a public enterprise should be such as to enable it to rai
se adequate resources for re-investment; The price policy of a public enterprise
should be such as to enble it to operate at the lowest cost possible and maximi
se efficiency; The price policy should be such as to enble consumers at all leve
ls to buy and make use of the goods and services produced by the public enterpri
se; It will have to calculate costs and benefits to the various sections of the
community and The price policy in a public enterprise shall have to consider the
requirements of foreign trade, competition from private enterprises, inter-ente
rprises relationship, etc.
All these factors make the price policy of public enterprises really significant
as well as difficult Responsibility for pricing : In a Private company, managem
ent has the responsibility of fixing prices for the goods the company produces,
though, of course, the broad principles of the price policy are laid down by the
Board of Directors representing the general body of shareholders. In public ent
erprises the pricing function is "diffused over the minister, the department and
the managers". The government has the ultimate responsibility to decide about t
he way a public undertaking will conduct its affairs. This is particularly so wh
en the quantum of profits which the undertaking has to earn is to be decided. Ev
en when the government, through the minister concerned,
247
decides about the general price- profit policy in a PSU, the actual details of t
he price structure will have to be worked out by the managers of the undertaking
. In general, therefore, the government decides the price policy while the manag
ers of particular enterprises decide the price structure within the general fram
ework of the government s price policy. Features of pricing in public enterprise
s In order to appreciate the pricing policy in public enterprises in India, it i
s necessary to understand the distinctive features of pricing of public enterpri
ses. These features may relate to the demand side or on the supply side. 1) On t
he demand side, the main problem is one of maintaining conditions of full compet
ition between the public and private sector units. A public enterprise may attra
ct demand because of its special strength. Government enterprises working under
competitive conditions are: Ashoka Hotel and Janpath Hotel and the shipping Corp
oration Ltd. The pricing problem becomes more significant and highly complicated
when a public enterprise operates under conditions of monopoly. A private monop
oly will generally aim at profit maximizing price but a public enterprise may or
may not follow such a policy. Essentially, the price policy of the public enter
prise will depend upon the profit target fixed by the government. Generally, the
public enterprise enjoying a high degree of monopoly power may opt for a high p
rice structure. On other hand, such government undertaking may opt for a low pri
ce structure, if among other things, the management in under a bias for full uti
lization of resources or maximum production of the commodity or service. The Rai
lways, the Indian Airlines Corporation (till recently) and the Electricity Board
s are monopolies. Hindustan Steel Ltd. and the Fertiliser Corporation of India a
re operating in a seller s market. In these cases, the possibility of inter-unit
competition does not exist or is only nominal. In such cases, it is the lowest
possible costs which determine the prices in the long run," unless the Governmen
t creates, openly or covertly, unequal conditions of competition in favour of pu
blic enterprises." On the cost and supply side, public enterprises are generally
set up with large capacities even from the beginning and naturally, larger prod
uction up to the full capacity will be accompanied by declining costs. At the sa
me time, public enterprises may get hold of some or all factors at lower prices.
For instance, government enterprises may have the advantages of bulk contracts
of purchases and concessions available to government. Moreover a government ente
rprise can get hold of cheap capital either through government subscription or u
nder government guarantee. This is indeed a great advantage for capital intensiv
e projects. Public enterprises may incur some social costs which private enterpr
ise may not bear at all or may shift to other agencies. For example a public ent
erprise may engage large labour force, spend more heavily on employees- housing,
or provide generous medical facilities and consumer amenities than a private en
terprise may be willing to do.
2)
3)
248
4)
Public enterprises are subject to the investigations by parliamentary committees
, criticism by members of parliament, audit by the Comptroller and Auditor- Gene
ral and public criticism in press. As a result, they are very careful in their e
xpenditure. This leads to delay in taking important decisions and higher costs n
aturally follow. Moreover, public enterprises may have to incur higher costs bec
ause they are subject to certain external pressures. For instance, a public ente
rprise may be forced to go slow in its construction work. Or the Government may
decide to over-capitalise the enterprise from the start and hence may force the
enterprise to have heavy overhead capital in the early periods. Or complementary
resources may not have been developed and may subject an enterprise to unfavora
ble cost conditions.
5)
Thus there are many distinctive features of pricing in government enterprises wh
ich are not generally met with in private enterprises. Price Policies of Public
Enterprises in India Government undertakings in India have not developed any pre
cise and uniform policy of pricing. Each undertaking has been following a price
policy conditioned by certain internal and external circumstances. Some of the f
ollowing features of price polity are to be met with in India. i) Profit as the
basis of price policy public enterprises in India generally follow a policy of p
rofitability. Profits of a public enterprise indicate its efficiency (apart from
its monopoly character) as well as serve important sources of self-financing. T
he Indian Railways and the Reserve Bank of India are two important Government un
dertakings which contribute considerable amounts to the general exchequer. Sindr
i Fertilizers,Hindustan Antibiotics, Hindustan Machine Tools, etc. were some of
the public enterprises whose profits were ploughed back for expansion. No profit
basis Some Government enterprises have been required by law or by the Memorandu
m and Articles of Association to follow a "no- profit no- loss" price policy. Th
e Hindustan Antibiotics and the Hindustan Insecticides have been following this
rule. These corporations have been marketing their products on "no profits no lo
ss basis." Import-parity Price Those public enterprises whose products are in di
rect competition with imported goods have adhered to a policy of import - parity
prices. The Hindustan Shipyards Ltd. accepted the principle of selling the ship
s in the Vishakhapatanam shipyard at a price approximately equal to the cost of
building a similar ship in the United Kingdom.
ii)
iii)
Guidelines on Pricing Policy The Government of India has issued three guidelines
on Pricing Policies for the public sector enterprises, viz., a) Public enterpri
ses should be economically viable units and an all out effort should be made to
increase their efficiency and to establish their profitability at the earliest;
249
b)
Public enterprises which produce goods and services in competition with the dome
stic producers, the normal market forces of demand and supply will operate and t
heir productivity will be governed by the prices prevailing in the market; and P
ublic enterprises which operate under monopolistic and semi-monopolistic conditi
ons, the pricing of their products should be on the basis of the landed cost of
comparable imported goods which would be the normal ceiling. According to the Bu
reau of Public Enterprises (1986-87). "it has been accepted in principle that pr
ices of products produced and services rendered by public enterprises should be
so determined that at a satisfactory level of capacity utilization these enterpr
ises not only cover their costs of production, but also generate a reasonable am
ount of surplus"" Profit making in public enterprises is considered quite consis
tent in public purpose. There may be situations where profitability in the stric
t sense of the term may be somewhat of secondary importance. For instance, the p
rices of infrastructural services and basic industrial and agricultural inputs,
such as transport, coal, steel, petroleum products and fertilizers, have to be r
egulated /administered in line with economic costs to prevent a spiralling effec
t on prices. In general, the prices of such products and services should be rati
onalized in a manner as to cover total costs and bring about a fair margin of re
turn by means of general improvements in efficiency and greater utilization of c
apacity." With this policy, the Government took a number of decisions in raising
the prices of steel, coal, petroleum products, fertilizers, aluminium, molasses
, alcohol. Similarly the price of indigeneous crude oil was revised. These price
escalations are motivated by the desire to earn more revenue for the Government
. The critics however believe that instead of absorbing the rise in costs by imp
roving efficiency and productivity, the govt. has been adopting the rather easy
method of raising administered prices. The Government intends to generate more p
rofit by the use of its monopoly power. The critics further state that this is i
n direct conflict with the guidelines on pricing policy laid down by the Governm
ent.
c)
(7)
Pricing in co-operative societies
In India, the co-operative sector has expanded considerably in the last 50-70 ye
ars. However co-operative management in India, for most of its part, has come un
der criticism for the lack of professionalism, absence of marketing skills, lack
of productive efficiency and cost-heavy structures. Of late there are signs of
the emergence of a professionally managed co-operative sector. In the areas of f
ood processing, milk production, transport, production of sugar etc. several coo
perative institutions have made their mark. Pricing of products/services in thes
e co-operative organizations now needs our attention. Production in the co-opera
tive sector, in a way, stands between that in the public sector and the same in
the private sector. Like the public sector, the co-operative sector also has to
fulfill certain social objectives and a purely commercial approach is, therefore
, ruled out. At the 250
same time, some co-operative organizations are operating in competition with pri
vate sector organizations and are expected to remain economically viable. As suc
h, the pricing policy of co-operative societies conforms to the norms of public
sector pricing where the situation so demands. Alternatively, in some cases, the
y have to face market competition and have to set competitive prices or leave th
e prices to the market forces. 1) Cost-based pricing : In many cases, pricing ai
ms at covering the total cost. This is applicable to societies where goods/servi
ces are of an essential nature and the benefits of the services are required to
be distributed among the users in the form of cheap or fair priced availability
of goods/services. Distribution of food grains, lift irrigation services are exa
mples of this type. In some cases cost-plus pricing method is followed in this c
ase, the price is fixed to equal average maintenance of certain quality of produ
cts/services. In the first case the price is said to equal the average cost; whi
le in the latter case, some profit is ensured for the organization. In cases whe
re all the beneficiaries are only the members of the co-operative society, fullcost pricing (or price equating average cost) is followed. In cases where the nu
mber of users is much larger than the number of members, cost-plus pricing is fo
llowed. The credit and micro-credit societies belong to the former category. 2)
Subsidized pricing : Many co-operative societies are following certain social ob
jectives. Weavers societies, handicrafts societies or farm-service societies ar
e examples of this type. Such societies have objectives like providing employmen
t, preserving traditional skills, supplying cheap inputs or supplying onsumers p
roducts ay fair prices. Such societies are therefore based on average cost minu
s subsidy per unit basis. Sometimes the subsidy is available in a lumpsum and so
metimes it is paid in thus form of rebate per unit of the product sold, as in ca
se of handloom fabrics. Demand- based Pricing : In many producers co-operatives
pricing is required to follow the dicates of demand. In keeping with the law of
demand, the price is an important independent variable and lower the price the
greater is going to be the demand. The society would therefore be free to charge
a high price and get a limited demand or charge a low price and get a higher de
mand. Sometimes, if the society enjoys a certain amount of monopoly, it can reso
rt to price discrimination. Discrimination can be as between and the rest of the
society or as between different uses or as between different places. As a case
of discriminating prices one can cite the example of dual pricing of sugar which
was followed in India. I this case, the government imposed a certain percentage
of levy on sugar factories most of which are in the co-operative sector. This l
evy sugar quantity was purchased by the government at a low price and was distri
buted through fair - price shops at remaining sugar produced by the factories, t
hey were given the freedom to price sugar in such a way as to compensate for the
loss they incurred in selling the levy sugar to the government and also to char
ge a costplus price and supply 251
3)
the sugar to the market as free sale sugar. Other pricing practices like penetra
ting price and price skimming are also at a loss in the beginning for penetratin
g the market and then raise the price when the favourable conditions at the mark
et so as to earn maximum possible profit. It is necessary to remember that such
commercial and competitive practices can be followed by a very small number of c
o-operatives which are competitive enough both in terms of quality as well as co
st of production. For example, co-operatives like Anand Milk Union Ltd. (amul) c
an afford to follow such practices. 4) Competitive Pricing : When a society is e
mbarking upon a new venture, it has to price its product on the basis of going r
ate and many times such a rate has got to be comparable to imported products. Wh
en there exists competition among the local producers, the price has got to be c
omparable to the range of prices of similar products produced by other firms, Fo
r example, societies producing milk and milk products, or those producing mango
pulps or orange syrups and squashes have to set prices which are comparable to o
ther firms prices of their existing products. Sometimes, sealed bids are sell t
he bagasse in their factories by following this method. The pricing methods disc
ussed above are subject to regulations and rules framed by the government, in th
is regard. CO-operatives are in the jurisdiction of the state government in Indi
a and, in many cases, the prices charged by co-operatives need an approval of th
e stat government. This is especially true in respect of prices of commodities l
ike milk, sugar, cotton and cotton-yarn, etc. This is because the commodities co
ncerned have either the potential of generating cost-push inflation or they are
essential consumption goods which can exclude poor consumers when the goods are
priced high.
252
Exercise : 1. How is the price of a product determined under conditions of perfe

ct competition in the short run and in the long run? Explain how price is determ
ined under monopoly? What is price discrimination? When is it possible and profi
table? How is the price determined under monopolistic competition in both the sh
ort and long run ? Write Short notes on : (a) Perfect Competition (b) Monopoly (
c) Monopsony (d) Selling costs (e) Wasteges of competition. (f) Short run cost c
urves (g) Imitative pricing (h) Intuitive pricing (i) Customary prices (j) Featu
res of oligopoly (k) Non-price competition (l) Pricing in public sector undertak
ings (m) Cost plus pricing (n) Pricing in cooperative societies (o) Changes in e
quilibrium price. 5. What guidelines for price fixation can be suggested?
2.
3.
4.
253
NOTES
254
NOTES
255
NOTES
256
Chapter 7
COST BENEFIT ANALYSIS
Preview Introduction, Private versus Public Goods, Government Investment, Overal
l Resource Allocation -Steps in Cost-Benefit Analysis-Justification for the use
of Cost-Benefit Analysis. INTRODUCTION The cost-benefit analysis, in a very narr
ow sense, would just be limited to finding out the benefit cost ratio which happ
ens to be a measure inter alia, to analyse various investment opportunities and
to find out the worth of each of them. However, in its broader sense, cost benef
it analysis refers to the analysis undertaken to judge any project f investment
whether government or private and find out its worth and facilities its comparis
on with other available opportunities of investment. In this sense, the cost-ben
efit analysis refers to finding out the worth of investment and enable ranking o
f optional investments by using any one of the methods (or more than one methods
in combination). It should be obvious that anybody contemplating investment mus
t try to judge its cost benefits. But whatever has been said here, regarding the
broader sense has a reference to a micro level decision, whether by a private
or by a public sector undertaking. However, in the broadest sense, the cost-ben
efits can be adopted on a macro level either at the level of the economy as whol
e, as a part of a five year plan, or for the public sector activity where such a
partial or overall analysis is more important a guide for the government as wel
l as for the business world. 1. PUBLIC GOODS VS PRIVATE GOODS :
The Product Divisibility There are certain goods the availability of which to us
ers can be decided in a discriminatory manner. A good may be priced in the marke
t and only those may be allowed the use of it who pay its stipulated price. To p
ut it differently, such a good may be priced and the principle of exclusion may
be applied to its use. Those who do not agree to pay its market price, or those
who cannot pay for it, are excluded from its use. In this way, the good becomes
divisible so far as its use is concerned. Thus, the ability to price a good, its
divisibility of a good and the
Cost Benefit Analysis
257
exclusion principle, all go together. The indivisibility characteristic is also

stated to mean that each individual has an access to the entire amount of public
good. His use of it does not reduce its availability to others. Tuning in of a
radio or TV programme by one does not deprive anyone else from enjoying the same
programme. On the other hand, it may be that in the case of a certain good, som
e members of the society cannot be prevented from its consumption, provided some
other members have the access to its use. A typical example would be the defenc
e service. Once the country is protected against foreign aggression, every citiz
en is more or less equally protected and benefited. A section of the society can
not be excluded from enjoying the benefit of this protection. The defence servic
e, in other words, is indivisible. It cannot be priced in the market in order to
deprive some members of the society from its use or its benefits. In some cases
a consumer cannot surrender the use of a service even if he wants to. An indivi
dual cannot ask to be left undefended by the defence arrangement of the state, o
r refuse the benefit of a reduction in air pollution or that of street lighting
etc. People voluntarily decide to pay for the supply of good which can be priced
and to which the exclusion principle applies because those who do not pay can b
e excluded from its use. If, for example, an individual does not voluntarily agr
ee to pay the market price for the milk, the market would refuse to supply him t
he required quantity. But we have seen that this exclusion principle can not be
applied to the indivisible goods. And this creates a problem of raising the nece
ssary finances in their case. For example, in the case of defence service, every
individual would argue that even if he does not pay for it, the supply of the s
ervice will still be there. So he would rather avoid the payment and let others
contribute for providing the defence service. Under the influence of this argume
nt, very few would pay voluntarily, hoping that through the contributions and ef
forts of others the service will be there. This is referred to as the problems o
f free riders - which means that everybody would like to have the benefit of the
good without sharing the cost of its supply and so the necessary finances canno
t be raised on a voluntary basis. As a result the provision of such a good or se
rvice has to be made through compulsory contributions by the members of the soci
ety - such as through taxation. In the case of a good which cannot be priced, th
e buyers would decide, through their demand, preferences, whether or not it is t
o be supplied at all; and in case it is to be supplied, then they will also deci
de about the quantity of its supply. But in the case of an indivisible good, suc
h decisions cannot be taken through market mechanism. The society has to decide
the way in which these decisions will be taken and financed and these decisions
need not be unanimous. As seen above, since very few individuals beneficiaries w
ill be ready to pay for it voluntarily, there is to be some form of compulsion i
n providing the necessary finance. The decisions regarding these goods are, ther
efore, left to the government agencies. The indivisible goods, whose benefits ca
nnot be priced, and therefore, to which the principle of exclusion does not appl
y, are called pure public goods. Pure private goods, are completely
258
divisible and to them the principle of exclusion applies in full measure. In the
market, any one who disagrees to pay (or cannot pay) the requisite price would
be excluded from their consumption. It must be noted that the indivisibility of
a good does not necessarily imply that every citizen of the society has actually
an equal share in its benefits. People living near the political boundaries of
a country may, for obvious reasons, be relatively less protected. People living
near public parks are actually more benefited even when the parks are accessible
to all the members of the society. Thus, the main criterion of indivisibility i
s that the good in question should be equally available to to all the members of
the society (or a section there of) irrespective of the ability or willingness
of the individual members to pay for it. The financing of the concerned activity
has to be through public expenditure and not through market pricing. This concl
usion implies that the pure public goods must be in the hands of public sector o
nly. It, however, does not prove as to which sector (Public or Private) should p
rovide the pure private goods. In order to get an answer to this question we hav
e to consider the following additional factors: i. ii. iii. The level of the eff
iciency at which the public and private sectors may be expected to operate and p
roductive resources at disposal of the two sectors; The political and social con
siderations such as the philosophy that the economy should not be dominated by p
rivate monopolies. Additional characteristics of pure public and pure private go
ods.
Externalities Another important characteristic of pure pubic goods is the existe
nce of externalities. The term externalities refers to the economic effects whic
h flow from the production or use of the good to other parties or economic units
. Such economic effects may also be called spill-over effects, neighbourhood eff
ects or third party effects. Such an externality may be an economic gain or an e
conomic loss to other economic units and would be referred to as pecuniary exter
nality. (This is in contrast with a technological externality in which the consu
mption/ production levels of an economic unit affects those of others in the eco
nomy.) This affects the prices in the economy which in turn transmit their effec
ts on to production and consumption decisions of other economic units. This caus
es a divergence between the "internal" (or "private") and "social" marginal cost
s (or benefits) of the goods in question. Thus, for example, a powerhouse using
coal would cause a lot of ash-throwing in the neighbourhood through its chimneys
. Similarly, the railways using a lot of coal in firing the steam locomotives pu
t the residential and other areas near the railway loco-shades to a lot of suffe
rings on account of smoke nuisance. This is a cost to society but not to the ind
ividual undertakings like the power house or the railways. Similarly, driving th
e smoke-emitting buses and trucks in the cities add to the social cost of these
transport facilities. An example of the externalities in the form of an
259
economic gain would be the benefits of social overhead like a road to areas and
the industries served by it. These externalities are of two types: i. ii. market
-external effects, and non-market-external effects
When the external effects cannot be priced in the market with reference to the d
emand and supply behaviour, they are termed non-market-external effects. It means
that through the market mechanism, individual economy units cannot be protected
from the economic loss (or cannot be excluded from the economic gain) resulting
from the public good in question. Thus, in our above example, it is highly diffi
cult to apportion the economic gains of the new road amongst its beneficiaries.
Even if it was possible to identify some of the beneficiaries such as those who
actually use the road, other beneficiaries would be left out. Therefore, the pri
cing of economic benefits of a road would not be strictly satisfying the rule of
exclusion. It would follow that such public goods as have non-market external e
ffects should be preferably in the hands of the public authorities (provided the
y can run these undertakings efficiently) since they can decide about the creati
on and location of industries producing public goods irrespective of their comme
rcial profitability of the same. Thus, it follows that those amongst pure public
goods which have non-market external effects would qualify for inclusion in the
public sector. Those pure public goods which have market external effects may b
e left in the hands in private sector from this point of view. (However, remembe
r that even then the characteristics of indivisibility of pure public goods stil
l tells us that they should be in the hands of the public sector only). By contr
ast, a pure private good is supposed not to have any externalities. In its case,
there will be no difference between private and social marginal costs of supply
. The market pricing would, therefore, be representing the social cost of supply
ing the goods and so even if it is left in the hands of private sector, its supp
ly would be at the socially optimum level. Ordinarily, therefore, the provision
of pure private goods should be entrusted to the private sector. But on account
of various reasons this may not be adhered to in every case. The government migh
t decide to step in where merit wants are concerned. Other relevant considerat
ions could be the cost conditions (discussed below), resource availability, soci
al and political philosophy, and so on. Marginal Cost A likely characteristic of
a pure public good is that its marginal cost would be zero or close to zero. It
means that an additional member of society can be benefited by its use without
appreciably adding to its total cost. To put it differently, the use of a pure p
ublic good by one more member of the society does not reduce its availability to
the others. A good example of it is the tuning in of your radio set. Still anot
her example is that of a bridge over which an additional vehicle may pass withou
t any additional cost to the society. It must, however, be 260
remembered that mostly this principle applies in reality, only to a limited exte
nt. One cannot say that we can keep on adding to the number of vehicles that may
use the same bridge; we cannot have the same defence budget if our population k
eeps on increasing, and so on. Also it may be added that a large number of membe
rs of the society may not be able to enjoy the benefits of the public good witho
ut adding to the cost of its supply. Similarly, the provision of the public good
s may be increased or decreased for budgetary reasons or due to extraneous facto
rs. Pure public goods which possess this characteristic have a strong case for i
nclusion in the public sector since public goods are indivisible also. In the ca
se of private goods, on the other hand, the argument is basically in the favour
of large-scale production - for which either the society should agree to monopol
istic type of private enterprise or should go in for public sector. Decreasing A
verage cost Another likely characteristic of pure public goods is that it would
be subject to the law of decreasing costs. Being lumpy, it would be subject to t
he economies of scale. If the public good is provided in small units, then the a
verage cost is likely to be much more. For example, the average costs of operati
ng a sewerage system would be much less if it serves a wide area than when it se
rves only a portion of the city. When it comes to the choice between public and
private sectors for the provision of goods possessing this characteristic, consi
derations similar to the ones mentioned above in the case of Marginal cost cha
racteristic apply. IMPURE PUBLIC GOODS It would be noticed that it is highly dif
ficult to come across which fully satisfy all the characteristics of the pure pu
blic goods. Similarly, it is highly difficult to come across pure private goods.
In general most goods possess elements of both publicness and privateness .
The difference between goods is mostly of degree and not of kind. Such goods whi
ch are neither pure public goods nor pure private goods are called impure public
goods (also called quasi-public goods or quasi-private goods). If the elements
of publicness are predominant in the mixture of characteristics of a good, the
n it may be termed a public good; and in the opposite case, a private good. 2. S
TEPS IN COST BENEFITS ANALYSIS :
The cost-benefits analysis is a technique used for analyzing investment and for
rating the alternative investment opportunities as well as for ranking such oppo
rtunities on the basis of the rate of return to investment. Investment analysis
is very important but very difficult due to the elements of uncertainty, changin
g value of money etc., as discussed above. besides, there are capital constraint
s and social costs and benefits involved. steps above. Besides there are capital
constraints and social costs and benefits involved. Steps involved in the costb
enefit analysis are, in fact, the steps involved in capital budgeting and then i
n analysing various projects from the point of view of an individual investor. T
he cost -benefit analysis as a method for investment analysis can proceed along
the following steps:
261
1)
Identification of a Project : The first thing an investor has to do is to search
various investment opportunities for the purpose of finally selecting one of th
em. In doing so, he has to keep in mind the size of the investments he has conte
mplated and his own expertise and interest. For this purpose, the investor can g
et the necessary information from development organizations who are engaged in d
eveloping project profiles. He can also borrow ideas from the established and re
puted investors within and outside the country. It is possible that he has some
new project ideas. Whatever the case, one has to choose a few project alternativ
es for further scrutiny by carefully including the good or sound projects promis
ing a high rate of return. Formulation of the Project : Once a list of projects
chosen for scrutiny is ready, with a blue print and all details of requirements
in terms of land, building, plant and machinery, raw materials fuel, and power,
labour and technocrats etc. with prices of each, one can proceed further. The ne
xt thing he has to take into account is the capacity likely to be created and po
ssible utilization of the capacity over time and the prices at which the product
s could be sold over the time -span considered ads the life of the project. Afte
r the alternatives are formulated, each of them has to be examined in terms of i
ts feasibility. Feasibility of implementation includes technical feasibility, i.
e., the availability of land, plant and machinery, raw materials, and technical
know-how; financial feasibility, i.e., availability of finance in time and at re
asonable rates and for desired time periods; economic feasibility ,i.e., prospec
ts of employment generation, development of backward areas/ social groups etc.;
and management feasibility ,i.e., availability of management personnel for imple
menting and running the project smoothly and professionaly. It should be obvious
that some of the projects identified and selected for scrutiny could be dropped
at this stage because they are not feasible on anyone or more of the feasibilit
ies listed here. Appraisal and Selection of the Project : Appraisal of feasible
projects refers to their assessment in terms of economic viability. This can be
done with the help of projected cash outflows and inflows from each project and
then comparing them out on merit. For this purpose various measures used for eva
luating the investment worth, including costbenefit analysis, can be adopted. Th
rough this step of screening, those of the selected projects which are viable as
well as within the investment limit contemplated by the investor are selected.
Comparison of Cash-Flow : Projects which pass the third test of feasibility are
then put to best comparing the cash-flows by using the cost-benefit ratio (or an
y of the other measures discussed above). If and where critical values are invol
ved, each measure would produce several outcomes. This would enable the investor
to compare the rates of return along with the risks involved. This sort of comp
arison is of crucial importance because one determinate mathematical solution is
not available and one has to be guided by one s subjective evaluation of the ri
sk involved as well as one s attitude towards
2)
3)
4)
262
acceptance of risk. One may select a project promising high returns with high un
certainty or low profitability with low risk level. 5) Selection and Implementat
ion: Keeping in view the funds available for investment one or more of the proje
cts can be selected for implementation. The selected projects will then be imple
mented in accordance with the blue prints already prepared. While implementing t
he project after it being commissioned, it is necessary to monitor the project o
n a regular basis. This includes ensuring the projected time period involved is
observed in practice, after ascertaining the quality and quantity are as per nor
ms assumed and the marketing of the product industrial relations, repayment of l
oans and payments of dividend follow the norms anticipated while formulating the
project. Mid-term Project Evaluation: A post- compilation audit of the project
is the last step. But in respect of long term projects, amid-term appraisal is a
lways desirable. This can be done by re-calculating the measure of investment wo
rth with a view to find out the actual worth and compare it with the anticipated
worth at the stage of anticipated worth estimated at the formulation stage. Thi
s would enable the investor to find out whether the expected results have been r
ealized or not and then find out the causes responsible for divergence between t
he expected and the realized results. Such an appraisal provides opportunity for
rectifying any mistakes and improving upon the performance. JUSTIFICATION FOR T
HE USE OF COST-BENEFIT ANALYSIS :
6)
3.
We have discussed above various techniques of measuring the worth of investment.
However, the reader must have realized that all these measures use the rate of
return as the criterion for deciding the acceptance or rejection of an investmen
t project as well as for ranking of the projects. it is only the cost -benefits
analysis which provides as insight into the private as well as social costs and
benefits involved. It can also incorporate other consideration besides the monet
ory returns, for assessing the worth of an investment. In justification of the c
ost-benefits analysis, therefore, we can enumerate the following arguments: 1)
Social Costs and Benefits : As discussed in a subsequent section, the government
has to intervene, regulate and even control; the business activities even in a
market-driven economy, as and when necessary. We have also noted the distinction
between private and social costs and benefits. At the macro level it is necessa
ry to minimize the divergence between public and private costs and benefits. By
going through the exercise of finding out such divergence it becomes the duty of
the government to formulate adequate policies aimed at minimizing such cases of
divergence. However, it is in the interest of private firms to look for social
benefits and costs involved in their private project and take necessary measures
to reconcile the conflicting interests. This is possible by resorting to a modi
fied version to reconcile the conflicting interests. This is possible by resorti
ng to a discussed in detail.
263
2)
Intangible Factors : many times certain intangible factors enter into the consid
eration of project appraisal and such factors are not unimportant. The prestige
of the business firm, the reputation or the image of the firm in the market, the
moral of the employees, the long stranding tradition of then company or the ide
as and the values inherited by a company over the long period of its existence a
re some such examples. Under such circumstances, the pecuniary (ie monetary)cons
iderations may not be proper guides for acceptance or rejection of a project. It
is true that these ultra-financial criteria are difficult to quantify. But this
cannot be an excuse for discarding them. There are ways like shadow/pricing whi
ch can be adopted for computing costs or benefits of such intangible factors. Th
is is possible only with the broad-based or a comprehensive cost-benefit analysi
s. Overall Profitability : A strict adherence to the rate of return criterion wo
uld lead to the choice of a smaller investment proposal with a higher rate of re
turn. In such a case, a proposal with a smaller rate of return but a larger size
of investment would get rejected. Such a decision would lead some of the funds
unutilized. In fact the overall profitability, i.e., the rate of return related
to all the investible funds available with the company rather than funds actuall
y invested would be a better guide to investment policy. Such a criterion can be
evolved with the help of cost-benefit analysis. Certain Uncertainty Vs. Uncerta
in Certainty : uncertainty is an important element in case of any business in th
e modern dynamic competitive world. But the investor would always endeavour to m
inimize uncertainty. in this exercise he would come across a certain lucrative r
eturn whose occurrence ma be rendered uncertain due to the rapidity in the chang
es of technology and /or changes in the market conditions. As against this, some
projects would involve uncertainty which can be incorporated in the measure ado
pted, as disused earlier. This (latter) then becomes a case of certain uncertain
ty. The investor therefore is faced with a choice between certain uncertainty an
d uncertain certainty. When guided by the cost-benefits analysis rather than by
a leap in the dark(i.e. purely subjective valuations), the investor would prefer
an uncertainty which is certain i.e., estimable. Social Scale of Preferences :
A private firm guided by its own private cost and benefit is likely to ignore th
e social scale of preferences involving social investments and social urgencies.
Such a neglect would accentuate the gap between the organized sector and the un
organized sector in a dualistic developing economy. It is necessary to remember
that the development of the economy presupposes the development of the entire so
ciety and if no heed is paid to the needs of the deprived unorganized sector, it
can act as limping partner and thwart the pace of development. It is for this r
eason rather than for any other form of social obligation that the business sect
or has to care for social fall-outs of their activities. The cost benefit analys
is is a measuring rod that can be used for recognizing and incorporating the soc
ial scale of preferences into the appraisal of an investment proposal.
3)
4)
5)
264
6)
National Industrial Policy : Every country has its own set of economic policies
including the industrial policy. In India we have the industrial policy announce
d by the government of India and modification changes in the same are announced
from time to time. Besides the industrial policy, there are other policies like
the import-export policy, the MRTPA & policies under the act, the monetory polic
y, the fiscal policy etc. which have a bearing on an industry s performance. Whi
le preparing the cost-benefit analysis, cognizance has got to be taken of the im
plications of these policies upon the costs as well as the benefits accruing to
the firm. Further in view of the fact that there is a divergence between private
and social costs and benefits, the policies formulated by the government contai
n correctives for narrowing down the gaps between the private and the social cos
ts/benefits. in fact such policies are viewed as instruments of performing these
tasks, inter alia. This fact about the State policy as it effects the performan
ce of industries justifies the cost benefits analysis. Future Disposable value :
The cost- benefit analysis is the right measure for deciding the worth of an in
vestment project and such an exercise is needed to be undertaken with a certain
periodicity like a year or two years. This enables the firm to find out the curr
ent worth of the project and also enables it to project the future worth over a
period of time. Such a regularity of analyzing costs and benefits not only helps
to review the performance but also provides basis for acquisitions and mergers
etc. which have become a familiar event in the present context of liberalization
. With intense global competition and highly dynamic changes taking place in the
business world, no firm can rule out the possibility of handing over or taking
over or purchasing a share in investment of some other firm. Under such circumst
ances, a scrupulously carried out cost benefit analysis on a continuing basis ha
s become as important prerequisite. Unforeseen Circumstances : in spite of all t
he efforts at a systematic planning of future steps and the incorporation of unc
ertainty in the investment analysis, contingencies and eventualities may occur w
hich were unforeseen at the time of the launching of the project. Natural calami
ties, wars, mass riots etc., are such examples. Such calamities not only demand
urgent steps and expenses to make good the losses but also a quick quantificatio
n of such losses. For this purpose cost-benefit analysis can be of great help.
COST-BENEFIT ANALYSIS: PRIVATE AND SOCIAL :
7)
8)
4.
We have noted earlier that economics and accounting concepts of costs are differ
ent. We also saw that the economic concept of opportunity cost is more relevant
than the accounting concept of total cost or individual resource cost. This is w
hy, when we come to the distinction fbetween private and social cost-benefit an
alysis, the latter is recognized as economic costbenefit analysis to be contra-d
istinguished from financial cost-benefits analysis which his analogous to privat
e cost- benefit analysis.
265
It was well-known Cambridge economist, Prof. A.C. Pigou, who discussed at length
the divergence between (what he called) Marginal Private Net Product and Margin
al Social Net Product (MPNP and MSNP), way back in 1920 in his book economics of
welfare . this pathbreaking work not only placed the Welfare Economics branch
of economics on the right pedestal it deswerved, but also triggered off pioneer
ing line of thinking in the area of private Vs. social accounting of resource al
location emerging through the market mechanism. Modern economists treat the soci
al costs and benefits as externalities of private investment and production deci
sions. Prof. Samuelson, for instance, uses the terms Marginal Social Damage (MSP
) and Marginal Private Damage MPD to denote social and private costs of external
ities like pollution and goes further to clarify the divergence between the two
and the costs of abatement of damage involved for the private enterprise and the
society as a whle and advocates public intervention for reconciling the two aba
tement costs. Managerial economics, as a social science more concerned with the
application of economic principles to management practices, relates this diverge
nce to the cost-benefit analysis. The firms cost-benefit analysis would remain in
complete, and even irrelevant in the modern business environment, if the social
aspect of its operation is neglected. Its is therefore, necessary to understand
the distinction between private and social cost-benefit analysis. i) Private Vs.
Social Goals : In a market economy, a firm in the private sector basically aims
at maximization of money profits. Social goals, on the other hand, are differen
t. At the level of the society as whole, the macro-economic objectives of econom
ic stabilization, employment generation, reduction in the distribution of income
, promotion of regional balance in course of economic development, economic deve
lopment itself alleviation of poverty etc., are important. the divergence note
d above starts from the divergence, between objectives only. A firm is guided by
its own private motives and endeavours to make its own investment economically
viable. But whatever the firm does may entail externalities which may ne in the
contravention of socially desirable goals. It is also possible that the pursuit
of social objectives may go against personal or a private firm s interest. It is
necessary to remember that the modern business management understands that, in
its own long-term interest, a firm has to take cognizance of social obligations
as well. But individuals tend to limit their frame of reference to the present.
Hence, arises the distinction between private and social valuations of costs and
benefits. Partial Contradiction between Interests : The classical advocated of
near-complete economic freedom believed that if every individual member of the s
ociety was allowed freely to maximise his interest, maximum social benefit would
be automatically achieved. It was Karl Marx who emphatically refuted this belie
f. What he meant was, in terms of the well-known dictum, one man s food is anot
her man poison . This is of course partially true. What we have referred to as
externalities arise and lead to a conflict of interests which needs to be reso
lved. Industrialization and concentration of industrial activity at
ii)
266
one locality leads to several social costs in terms of air and water pollution,
emergence of slums, traffic congestions, accidents, strain on civic amenities an
d several health hazards. All these are social costs not included in any of the
firm s account -books. On the other hand, when a private project involves constr
uction of a swimming pool, a play field, a garden etc. which are open to public,
social exceeds private benefit. Plantation programmes undertaken for making one
s own factory environment - friendly generates social benefits for which no soc
ial cost has been incurred. The above examples clearly show that a private proje
ct may involve, alongwith private costs and benefits, certain social costs and b
enefits. Sometimes social costs exceed private costs; while at other times a pri
vate benefits would be less than social benefits. Therefore, we can say that the
re is a partial contradiction as between private and social interests. Private f
irms tend to be unmindful of both costs and benefits for the society arising out
of their pursuits of self-interest. One can not forget the Bhopal gas tragedy e
ntailing social suffering for years on end; nor can we ignore the damage being d
one by the factories at and around Agra to Taj Mahal. We must pay enough attenti
on to the social costs and benefits involved, though they are difficult to measu
re. iii) Valuation of costs and Benefits : A fundamental difference between the
private and the social costs and benefits arises due to the problem of finding o
ut the values involved. So far as the private costs and benefits are concermned
, they can be found out by taking into account the prices received in case of be
nefits and the prices paid in case of costs incurred. However when it comes to c
omparison with social costs and benefits, the problem of valuation arised due to
the difficulties in quantifying the costs and benefits. What is the cost of suf
feringd by the people due to pollution ? how to value the damage to the priceles
s heritage of Taj caused by all the industrial units in tis vicinity? For overco
ming this difficulty, one method suggested by experts for valuing social costs a
nd benefits was to value these costs and benefits at the world prices; while a U
.N. agency advsed to use shadow prices (i.e. resource costs) for the same purpos
e. In respect of the formar, the problem of valuation of items which are not tra
ded remains unresolved. Therefore, the World Bank, in 1975 suggested a synthesis
of the two approaches. According to the World Bank s approach, the tradeable i
tems would be valued at the corresponding world prices; and the non- tradeable o
nes at the shadow prices. In adopting both these methods foreign exchange earnin
gs as well as expenses or uses of foreign exchange are valued at the shadow exch
ange rae(and not at the official or market rate). Siumilarly, the labour cost, t
oo, is computed at the shadow rate. Systematic methods for calculating shadow pr
ices have been evoled in most of the developing countries. In India, the plannin
g commission has evoled sech methods and announces the shadow exchange rates and
shadow wage rates from time to time.
267
iv)
Methods of valuation : In the valuation of costs and benefits, for finding out t
he present valuve, one has to use a discount rate. In the private cost-benefit a
nalysis, the weighted average cost of capital for the project can be used for di
scounting. In respect of the social costs and benefits, our concern is to know t
he cost to the society. The government, on behalf of the society, undertakes soc
ial investmensts. Therefore, one cant trun to the rates at which the government
could have got the funds from international financial institutetions, the funds
here would be the equivalent of those employed in a private project under review
. This rate could be treated as the rate of discount for finding out the present
cost of the private project to the society. In case of the private cost-benefit
analysis, in this way, private costs and benefits valued at their respectivew m
arket prices are taken into account. This can be done by using various investmen
t appraisal techniques, on he basis of the weighted average cost of capital as t
he discount rate. By this procedure, one can take the investment decision. In th
e social cost-benefit accounting, these two are vlued at the world or shadow pri
ces and then various measures of finding out the worth of investment can be adop
ted. Again, in finding out social benefits and costs, due attention is paid to t
he social objectives like employment generation, reduction of regional dispariti
es etc. For example, if a project is located in a backward region or provides em
ployment to unskilled workers in large numbers, then the social benefits of such
a project are compounded to incorporate these benefits. If a project, on the ot
her hand, is producing goods which are luxuries or are likely to create health h
azards, the social benefits would be discounted to incorporate the undesirable e
ffects on society It is necessary to remember that the points of difference betw
een the private and the social cost-benefits analysis relate to (a) the estimate
s of costs and benefits, and (b) the discount or hurdle rates used. However, the
techniques or methods of assessing the investment worth remain the same. in oth
er words, in both these analysis, one can use the Pay Back period method or the
Internal Rate of Return Method or the Net Present Value Method etc., for the pur
pose of judging the acceptability or otherwise of any project and /or ranking of
alternative investment opportunities on the basis of their worth. For a better
understanding of the divergence between private and social costs, let us take th
e example of pollution, as is done by Prof. Samuelsonm.He then proceeds to illus
trate his point with the help of a diagram. The figure to follow on the next pag
e shows the divergence and suggests the correction of such a divergence.
268
Figure Showing Divergence between Marginal, Private and Social Costs and it s Co
rrection
Pollution Standard Inposed
Y
C
Marginal Cost of Abatment (MCA)
Marginal Social Damage (MSD)
S
Z
Marginal Cost and Damage per tonne (Rs.)
P
E T B
Marginal Private Damage (MPD)
O
Q2
Q1
R
X
Pollution Quantity (per tonne)
In the above diagram, Marginal Social Damage (MSD) and the marginal private dama
ge (MDP) lines indicate the incremental damage done to the society by the pollut
ion produced by a factory. MPD (dotted line) shows the damage including the done
; while the MSD line, which is higher, shows the total social damage including s
ufferings of the people living around or passing by and inhaling polluted air. T
he MCA line shows the marginal cost of abatements, i.e. how much the firm will h
ave to pay to reduce pollution per tonne of pollution for every increment of out
put. Without any intervention by the pollution control authority, the firm will
strike equilibrium at pint P where marginal private cost and marginal private b
enefit would be balanced. It should be noted that at this equilibrium level of o
utput of pollution, marginal private damage is QT but marginal social damage is
Q1S which is at least three times the private damage. If a pollution standard is
imposed by the government, the equilibrium point will be at E, the MPD and MSD
are equal. If this standard limit is crossed, the factory willhave to pay a pena
lty plus a pollution tax on a continuing basis. As a result, the MPD line moves
upward and ultimately the factor s own MPD plus tax/penalty would make MPD= MSD,
so that the gap between the two would be bridged and the equilibrium level will
correspond to the standard level of OQ2 which might be judged as the safe limit
of pollution. 5. Policies to Reconcile Private and Public Costs and Benefits :
AS we saw earlir, the private costs and benefits ae internal to a firm and as
external diseconomies or economies of the activites going on in the firm itself,
they are counted by the firm. The social costs and benefits,however, are the ex
ternal economies and diseconomies resulting fro the firm s activities. they are
therefore, known as externalites .
269
As some exmples of the negative externalities. i.e. social costs, Prof. Samulson
mentions the air and water pollution, risks from unsafe factories or nuclear po
wer plsnts,danger from drunken drivers or gargantuan trucks etc. these he calls
negative economies. As positive externalities, he cities the examples of radical
inventions, the radio or TV signals that we get free of charge or the benefits
of widespread public health measures that have eradicated epidemics such as smal
l-pox, polio,typhoid, plague etc. All these externalities are suggestive of a ma
rket failure or an inefficiency on the part of free markets." the general remedy fo
r externalities", observes Prof. SAmulson, is that the externality must be some
how internalized". Interms of the diagram of divergence between private andsocia
l costs/benefits, we saw that when pollution standards are imposed, the MPD corr
esponds to the MSD because of the incentive to improve (or a disincentive to deg
enenrate). Private Action providing Correctives: In most of the developing count
ries, an action on that part of the government would be necessary in such cases.
However, in advanced countries, where the legal and judiciary systems are trans
parent, private approaches may also succeed. i)
Negotiation: One such remedy is negotiation .If a factory is polluting the water
or air of a locality, the local residents can use the company and place a claim
fo compensation. The time involved and the affected people and pay compensation
to motivate the company to negotiate with the afffectd eople and pay compensati
on to the people. This corrective ,however, has three limitations: i) the negiti
atied compensation would be less than warranted by the damage; ii) the loss o da
mage must be indentifiable ; and iii) the number of firms as well as that of the
affected people must be limited.
Liability Rules: where tha law clearly lays down reules regarding liability of t
he person/s causing damage, the affected people can always take resourse to judi
cial intervention and demand compensation. The court may order a compensation wh
ich would fully (or partly) bridge the gap between MPD and MSD.
ii)
Government Action: A more effective solution to the problem of internalizing the
se externalities is an intervention by the government in the form of some action
against the generation of social costs. Such action may be in terms of a direct
control or financial penalties. i) It is observed that in most of the countries
, governments rely on direct controls in t matter of combating health and safety
-related externalization including pollution. in cases of firms or persons causi
ng damage, the government orders to keep the damage under specified limits which
are judged to be safe. Such safe limits are
270
publicized and those who exceed these limits are penalized. The pollution under
control (PUC) certificate to be kept ready for examination by environment. in th
e diagram we have already seen how such a standard -setting works. The pertinent
question however is does this solution work in practice? This brings us to the
practical problems and limitation standards involved in the imposition of these
and subsequent penalties. These limitations are: i) for choosing a minimum stand
ard, the government has to perform a cost-benefit analysis for which it must hav
e full data regarding damage and abatement costs. Such a situation is almost imp
ossibleto obtain. ii)strictly speaking the standard willl have to be zero, in wh
ich case the factory will ah veto be cloesed down unless it invents and adopts
a new pollution-free-technology. iii) The enforcement of control is not effectiv
e enough. In fact, unless the penalty imposed exceeds the cost of removing the s
hort-comings, the private firms/persons will never reach the required standards.
They may opt to pay the firm and continue doing he damage because this is a che
aper option. iv) The enforcing officials themselves must be above suspicion, or
else they could be bribed to ignore the default, v) finally, the law fails to di
stinguish between large firms and small firms, more hazardous and less harmful p
ollutants, and so on. Such a road roller application of standards cannot work. M
oreover, under such a system of rules, the big defaulters escape and the small o
nes penalty. ii) Externality taxes : Another way suggested by economists is the
imposition of an emission tax or an externality tax, in general. The rate of tax
ation will have to be high enough to induce the firm to adhere to the standards
rather then pay the tax. This measure also suffers from certain limitation: i) t
hough economists have advocated these taxes, in practice, very few governments h
ave given them atrial, may be because they think it difficult to impose and coll
ect them. For one thing, the legislative bodies should have the political will t
o follow this course of action.ii) secondly, the taxmeasure should be economical
, I,e, the cost of collection should be reasonable,andshould be cartain, not fet
ch revenue to the treasury but to hit the target of bringing round these guilty
of showering externalities on the society. But these considerations are unattrac
tive to the politicians on whose initiative rests the tax-measure legislation. i
ii) finally, there is basic conflict of objectives whichstrenthens the inaction
referred to in the preceding limitation. The success of this tax measure lies in
damage -control but this means the tax would notyield any revenue; and if it do
es, it would confirm its failure to control the dmage caused by the externality
concerned.
271
6.
COST BENEFITS ANALYSIS AND OVERALL RESOURCE ALLOCATION :
We saw that in a market economy where consumers and producers are enjoying maxim
um economic freedom, the role of the government as a producer gets limited. Howe
ver, the government is not supposed to simly watch what is happening in the econ
omy as a whole. Infact, in a modern economy, the complexities of economic relati
ons have increased so much that the government has to remain on its toes so that
no undesirable set of actions is undertaken by any of the economic palyers. The
refore, after carefully outlining the objectives of such a policy, the governmen
t has to plan macro-economic policy. The need for such a policy can be stated as
follows: i) Correctives fir shocks and disturbances: Inspite of the fact that t
he market mechanism functions automatically, the free enterprise system does not
automatically adjust itself to the variety of shocks and dusturnaces which are
bound to appear in an open economy. for adjusting the economy to such shocks and
abrrations, awell thought-out policy has got to be formulated. Speeding up the
pace of the Economy: Every government has a set of well- defined and declared ob
jectgives that the economy would be expected to attain but by itself the economy
may taker a long time to attain these objectives. A macro-economic policy and a
governmental intervention is needed to give a stimulus to forces declared objec
tives. Such an action/policy instrument becomes necessary when the economy is ei
ther going to slow or it is going in the wrong direction. Weeding out Economic E
vils: Unemployment, inflation, business fluctuations etc. are the economic evils
which need to be eradicated by adopting the right types of macroeconomic policy
instruments. These instruments would serve to stimulate the right types of forc
es and to discourage or suppose the undesirable trends in the economy. In a dyna
mic global modern economy, such situations are likely to occur from time to time
and they need to be corrected in time. Structural Changes in the Economy: The v
ery dynamism of the economy makes it necessary to adopt structural changes in th
e economy. However, there are several obstacles and frictions in switching over
to the new order. But the system demands that these changes must be brought abou
t promptly and properly. The State is, therefore, called upon to intervene and t
ake necessary legislative and regulatory measures for assisting the smooth chang
e-over. Fine Tuning of the Economy: The functioning of the economy, at any given
time, could be going through deviations from the normal and competent course. U
nder such circumstances many of the economic operations might need a fine-tuning
. This task can be performed by macro-economic policy instruments.
ii)
iii)
iv)
v)
272
[A] Cost-Benefit Considerations at the Macro Level The cost-benefit analysis is

expected to provide an approach to the implementation of macro-economic policy w
hich happens to be the responsibility of the government. This approach has been
found to be useful in handling the problems related to the welfare objectives. H
owever, welfare consideration follows the net wealth consideration. This is beca
use thecost-benefit analysis is basically devised to maximize the net wealth i.e
. to maximize the difference between benefits and costs. Our objective would be
to understand the functioning of the cost-benefit analysis as such and then to f
ind out qualifiacations which can be added to this analysis for applying it in t
he formulation of a macro economic policy aiming at maximizing social benefit. W
ith a view to understand the working of the cost-benefit principles, let us star
t by assuming that economic welfare as part of total community welfare can be ma
ximized by maximizing net wealth. A little elaboration, at this juncture, is per
haps necessary. Welfare is the resultant of a state contenment and fulfillment w
hich itself is the result of the feeling of satisfaction. Since satisfaction is
a state of mind,there is no way of quantifying it. Moreever, satisfaction can re
sult from many non-economic activities. Therefore total welfare of an individual
or of the society comprises of various human activities which lead to welfare.
Here, we are concerned with economic welfare whch is assumed to be maximized by
satisfying as many of human wants as possible. For satisfying wants we need the
production and/ or acquisition of economic goods and services. There are, howeve
r, various qualification to assumptions that maximization of net wealth maximize
s social benefit. In the first plcace, the satisfaction of wants as a pre- condi
tion for wellbeing can be applied and accepted in respect of necessaries of life
and of efficiency. But when it comes to comforts and luxurious, the same can no
t be said .Secondly many economic activities generate wealth but do not lead tow
elfare. Production and trading of several commodities can be cited as an exmple
of this type. Production of cigarettes, liquor or drug-trafficking are examples
of this type. Thirdly, on the macro-level, a summation of maximum individual wel
fare does not automatically lead to maximum social welfare. This is because one
man s food, as the saying goes, is another man s poison. Finally, dividing welfa
re parameters involve value judgements which may vary from society to society an
d from one set of objectives to another . For acheiveing the maximization of net
wealth, full utilization of all the resources is necessary. Ths is because the
addition to total level of wealth which we called net wealth is nothing but the
net value of producers and consumer s goods and services produced by the econom
y during a given period -usually one year. Maximum oyutput that can be produced
during a year issubject to the constraint of production possibility which demarc
ates the boundary or the frontier which cannot be crossed, given the amount of a
vailable resources.See the following figure as an illustrsation. In this diagram
, the curve
273
AB is the frontier which is known as the production possibility curve or the pro
duction possibility frontier. With the resources being given and limited, the li
mit AB can be rached only by using the resources fullu. In this diagram, we assu
me that the economy has an option of producing either commodity X(shown along th
e X-axis) or commodity Y(shown along the Y-axis); or a combination of both X and
Y. By using all the resources, the economy can produce OB amount of commodity X
or OA amount of commodity Y.
Y
A
E C
Commodity Y
M
D
O
N
B
X
Commodity X
Figure showing Production Possibility Curve Alternatively, the economy can produ
ce a combination of X and Y as given by all the points on the curve AB or inside
the curve AB. For example, point D indicates the possible combination as OM amo
unt of commodity Y plus ON amount of Commodity X. In the same way, any other poi
nt on the AB curve, like thepoint E, would show the maximum possible amount of o
utput with varying resources. As against this, point C in the diagram indicates
under utilization of resources. As against this, point C in the diagram indicate
s under utilization of resources, since the production has been stabilized at po
int C when it is possible to move forward to any other point like D and E. It sh
ould therefore be clear what we mean by full utilization of resources. It should
also be clear that the terms maximization of output or maximization of net weal
th imply reaching any point on the production possibility frontier AB. For maxim
ization of output, we have to utilize fully all the resources available to us wh
ich means discarding any position like the one shown by point C and trying to re
ach the boundary by aiming at any combination of X and Y of our choice. By doing
this output can be maximized and employment (which means harnessing the product
ive resources for producing a given level of output) can also be maximized. If w
e want to produce more than what the production possibility curve demands, we sh
all have to reach a point which
274
would lie on another and outer production possibility curve which would lie beyo
nd AB and away from the point of origin O. This would be possible only by raisin
g the productive capacity of the economy, either by finding out or mobilizing ad
ditional resources or by increasing the productive efficiency of the existing re
sources. Such a shift in the production possibility curve indicates economic gro
wth. For achieving economic growth we shall have to maximize the output in the e
xisting conditions of resource-availability. The costbenefit analysis, under the
assumption noted above, can serve as a guide for macro economic policy. (B) ADV
ANTAGES OF COST - BENEFIT ANALYSIS : The policy objective of maximizing the diff
erence between cost and benefit has various advantages which can be noted briefl
y as follows : i) It aims at maximization of social welfare through maximization
of net wealth, on the assumption that any move that increases net wealth can in
crease social benefit and, in turn, can increase social welfare. In following th
is principle, the problem of infinite target value does not arise. This is becau
se, by assuming a definite correlation between wealth and economic welfare, the
principle can suggest measures to maximise the difference between the total bene
fit and the total cost. By using this analysis we can show the measures necessar
y for attaining maximum net wealth and optimal policy aiming at this goal. Even
when a target is partially attained, the costs and benefits can be calculated an
d whatever change has taken place in the net wealth can be ascertained at that p
oint of time. The measurement of a trade - off between different targets is alwa
ys a difficult problem. In this case, the problem does not arise because the mon
ey value of costs and benefits associated with the achievement of alternative ta
rgets can be explicitly pointed out. This enables us to measure objectively the
trade-off. In this approach, the cost of a policy measure can be explicitly iden
tified and can be incorporated in the total cost of the project. By adopting a s
uitable discounting method, the costs and benefits as arising in different perio
ds of time in future can be estimated. The problem of assigning costs and benefi
ts to various targets does not arise in this analysis.
ii)
iii) iv)
v)
vi)
vii)
275
(C) LIMITATIONS OF COST - BENEFIT ANALYSIS : The cost - benefit analysis as disc
ussed above obviously suffers form certain limitations. i) Critics have pointed
out that this analysis is applicable in a partial equilibrium framework. However
economists like A. C. Harberger have shown that it can be applied to the genera
l equilibrium analysis as well. The exactness and usefulness of this analysis is
limited by the fact that it is based on the assumption that maximization of net
wealth can ensure maximization of social welfare. We have already seen that thi
s is not so. The cost benefit analysis is applied on another assumption that the
existing pattern of distribution of income, distribution is given and has to be
kept as it is. In fact, a change in income distribution does lead to a change i
n net wealth and further in social welfare. Another limitation of the analysis i
s that it ignores the effect of diminishing marginal utility of additional wealt
h or income with every incremental dose of income or wealth being added to the e
xisting total. By assuming the positive correlation between wealth and welfare,
the analysis assumes away all difficulties involved in the calculation of presen
t and future cost as well as private and social cost. Whatever applies to costs
also applies to benefits i.e., calculation of present and future benefits as wel
l as private and social benefits involves similar difficulties.
ii)
iii)
iv)
v)
vi)
7.
Overall Resource Allocation :
Market System or Market Economy (or Market Mechanism or Price Mechanism) comes i
nto existence when custom gives place to competition and practically everyone be
gins to produce goods and services for the market with a view to make maximum pr
ofit out of the production for the market. Market System or Market Economy may b
e said to come into existence when freely fluctuating prices in the market begin
to influence allocation of the community s resources and distribution of income
and wealth produced in the community During modern times we get what is called
Market System or Market Economy . Increasing division of labour or specializa
tion has been taking place in both developing and developed countries. This mean
s everyone is at present producing goods and services (including labour of vario
us types) for the market. Everyone at present carries thousands of exchanges whi
ch alone enable him to live comfortably. Market has become the pivotal point in
modern capitalist and mixed economies. All prices have become closely interrelat
ed and influence all other prices. It is when market becomes the pivotal or cent
ral folcrum of the economy and influences allocation of resources and distributi
on of income and wealth, we say that there has emerged Market System or Mark
et Economy . 276
Market mechanism or freely fluctuating price mechanism is another system of solv

ing the basic economic problem before the community: In this system all the pers
ons are supposed to enjoy personal freedom as consumers and producers and are fr
ee to use their resources as they please without any legal or other restrictions
or barriers. Consumers, who are free to spend their income as they please, expr
ess their preferences through prices. Thus if consumers begine to prefer TV sets
than radio sets, prices of TV sets will go on rising more relatively to prices
of radio sets. Under market mechanism, since producers are free to use their res
ources as they like, and as they are motivated to make maximum profit, they will
divert their resources from production of radio sets to the production of TV se
ts. Thus more TV sets and relatively less radio sets will be produced for the ma
rket. People express their preferences through prices. Changes in free fluctuati
ng prices act as signal to producers. They switch their resources, on the basis
of price changes, to the production of goods according to the changing preferenc
es of consumers. This gives consumers what they prefer more. Naturally this resu
lts in maximization of welfare of the community everyone getting what he wants.
This also means that market mechanism brings about most efficient use of the com
munity s resources. Shift of resources from production of radio sets to producti
on of TV sets will go on until more TV sets in the market and relatively less ra
dio sets there will bring down the prices of TV sets and raise the prices of rad
io sets as there are fewer radio sets available, to a level where profits in bot
h TV manufacturing and radio manufacturing industries become equal. Market (or p
rice) mechanism is explained above with a simple model of only two commodities.
Market or price mechanism operates along the same principle even when there are
many commodities and services. Thus market or price mechanism is supposed to hel
p solve the basic economic problem - how to make the most efficient use of commu
nity s resources and how to derive the maximum satisfaction from the community s
resources. Assumption of Market (or Price) Mechanism There are certain assumpti
ons on which operation of the market (or price) mechanism is based. The importan
t assumptions are as follows: i. Each consumer knows what is in his best interes
t and acts rationally to secure maximum satisfaction. There is perfect competiti
on in the market - competition among consumers and among producers, each consume
r and producer knowing fully well what is taking place in the market and hoe pri
ces are moving.
ii.
277
iii.
Different factors of production have perfect mobility and they can move easily a
nd quickly from one industry to any other in search of higher profits.
Criticism of Market or Price mechanism But in actual life market or price mechan
ism does not operate as smoothly and efficiently as described in the above model
. This is because the above assumptions are not always and fully valid and do no
t obtain in real world. Thus consumers do not always know what is in their best
interest and do not always act rationally. The competition among consumers and p
roducers assumed in the above model is often absent. There is also not full know
ledge among consumers and producers about market conditions and happenings. Abse
nce of competition often gives rise to monopoly which can prevent entry of outsi
de units in its line of production and manipulate prices by creating artificial
scarcities. There is never perfect mobility of factors of production, especially
in the case of labour. Some factors of production are specific and can produce
only certain goods and not other goods though the prices of the latter may rise.
Different factors of production even if there is competition will find it diffi
cult to move from industry to industry in search of higher profits as depicted i
n the above model. 8. FOUNDATIONS OF MARKET SYSTEM OF ECONOMY
The market system of economy (also known as Laissez Faire capitalism or simply c
apitalism) is built on the following foundations: i. Individual, the best judge
of self-interest : In the market system or capitalist economy, it is assumed tha
t every individual is the best judge of his personal interest. Every individual
knows what is in his interest and no one does that well than himself. Every indi
vidual should therefore be left free to carry on his economic activities as a co
nsumer and as a producer and so on without being dictated by any one else includ
ing the government. ii. Consumer s Sovereignty : The above assumption implies th
at in a market system of economy, a consumer with his complete freedom to spend
his income as he likes is sovereign as a consumer dictating to producer what goo
ds he prefers and therefore should be produced. This means the market system of
economy is characterized by consumer s sovereignty. iii. Freely Fluctuating Pric
e Mechanism : The sovereign consumers express their demands and preferences thro
ugh freely operating prices or through price mechanism. Freely operating price m
echanism thus acts as a signaling system indicating to various producers ,consum
ers preferences - that they prefer TV sets to radio and radio sets to gramophon
e and so on - and influencing and
278
bringing about allocation of limited resources of the community in accordance wi

th consumers preferences. iv. Private Enterprise : In the market system in econ
omy, most of the goods and services are produced by individual producers or grou
ps of individual producers. That is why the market system is also known as priva
te enterprise economy. The government has no role to play as a producer of goods
and services except to a very limited extent where private enterprise may not b
e interested. v. Private Profit Motive : In the market system of economy most of
the goods and services are produced by individual producers who enjoy perfect f
reedom as producers without being dictated in this regard by anyone else includi
ng the government. The chief or major foundation of the market system or private
enterprise economic system is that among all motives to human activities, priva
te profit motive (i.e self-interest) is the most powerful motive which will brin
g out the best effort by every individual. And therefore under this system all p
roduction is carried on by individual producers with a view to maximize their pe
rsonal profit. vi. Institution of Private Property : Another major foundation of
the market system of economy is the institution of private property (i.e. exclu
sive right to own and enjoy one s property in land, buildings, factories, precio
us metals like gold and silver, share and other financial assets and such other
tangible and intangible goods). vii. Existence of Competition : Open and free co
mpetition among consumers and producers may be said to be the very soul of the m
arket system of economy. In this system consumers compete among themselves for g
oods and services in the market by offering competitive prices to get them, and
producers compete among themselves for getting factors of production to produce
goods and services to be sold to consumers at competitive prices. viii. Harmony
between Individual Interests and Interests of the community : Since in the marke
t systems (or private enterprise economy or capitalism) each individual is free
to strive to maximize his personal satisfaction of which he is the best judge, i
t follows that when all individuals attain maximum satisfaction of their own, co
mmunity made up of those individuals would automatically attend the maximum sati
sfaction or welfare. There is thus no clash between interest of an individual an
d that of community.
279
ix.
Non-Interference by the State (or Laissez Faire) : If under the market system ev
ery individual acting for his personal interest or personal profit can automatic
ally ensure maximum welfare, not only of himself but also that of the community,
and if there is no clash between interest of an individual and welfare of the c
ommunity, and no clash of interest between welfare of consumers and that of prod
ucers, if freely functioning price-mechanism with its competitive system can aut
omatically ensure maximum welfare of the consumers and most in the State or gove
rnment trying to interfere in the economic activities of the people telling to d
o this and not to do that and so on. People should free to carry on their econom
ic activities as consumers and as producers. The above are the foundations (that
means the assumptions) on which the Market System (also known as Market Econo
my or Capitalism) stands or functions.
280
Exercise : 1. 2. 3. Explain fully the distinction between Public goods and Priva
te goods. Give an idea about government investment in the context of Indian econ
omy. Explain with illustration, how resource allocation and income distribution
takes place in a free enterprise economy. What are the foundations of Market Eco
nomy? Compare and Contrast Private and Social Cost-Benefit.
4. 5.
281
NOTES
282
NOTES
283
NOTES
284
Chapter 8
MACRO ECONOMIC ANALYSIS
Preview Macro Economics - The Keynesian Macro Economic Theory - Income determina
tion, Consumption and Investment Function; Business Fluctuations, Inflation - Ma
cro Polices of Full Employment, Economic Stabilization. MICRO ECONOMICS INTRODUC
TION Macro-economics is the study of the aggregate behaviour of the economy as a
whole. It is concerned with the macro-economic problems such as the growth of o
utput and employment, national income, the rates of inflation, the balance of pa
yments, exchange rates, trade cycles, etc. According to Prof. Ackley: "Macro eco
nomics deals with economic affairs in the large ; it concerns the overall dimen
sions of economic life." In short, macro-economics deals with the major economic
issues, problems and policies of the present times. Macro-economics deals with
the major economic issues, problems and policies of the present times. National
income, money, total investment, savings, unemployment, inflation, balance of pa
yments, exchange rates, etc. Are the crucial economic aggregates. In macro-econo
mic analysis the behaviour of economic agents such as firms, house-holds and gov
ernment is seen in total, disregarding details at the particular level - i.e., m
icro level. An individual consumer, particular market for a given commodity, ope
ration of a firm, etc are the subject matter of Micro economics. Macro-economics
deals with the market for all goods as a whole. It is considered as the product
or commodity market in general. Similarly, labour
Macro Economic Analysis
285
market is taken as a whole for the entire labour force in the economy. Likewise,
financial market is taken as a whole which covers money market, capital market
and all banking and non-banking institutions taken together. Prior to Keynesian
revolution in economic thinking in the 1930s, the classical economists had conce
ntrated more on micro-economic approach and macro behaviour was also described a
s mere summation of individual observations. Prof. J. M. Keynes in 1936 publishe
d The General Theory of Employment, Interest and Money which revolutionized the
whole economic thinking. He suggested that macro economic behaviour should be st
udied separately. Behaviour in total is quite different then what we may try to
infer by summation of individual behaviour. He said that, for instance, saving i
s a private virtue but it is a public vice in a matured economy cause deficiency
of demand leading to depression. Keynes prescribed macro-economics as a policy
- oriented science to deal with the problems like unemployment, inflation etc. E
conomics of Keynes serves as the foundation centre for the modern economics. It
follows that the scope of macro-economics is confined with the behaviour of the
economy in total. It does not examine individual behaviour. It relates to the ec
onomy-wide total or aggregates and problems of general nature. Its policies are
general. The subject matter of macro-economics includes the theory of income and
employment, theory of money and banking, theory of trade cycles and economic gr
owth. IMPORTANCE OF MACRO - ECONOMIC STUDIES Macro - economic studies have uniqu
e theoretical and practice significance. 1) Macro - economics provides an explor
ation to the Functioning of an Economy in general: Using macro - economic tools
and technique of economic analysis one can understand the working of the economi
c system in a better way. Empirical Evidences : Macro - studies are based on emp
irical evidences of the theoretical issues. Macro - economics is more realistic.
Policy - orientation : Macro - economics is a policy - oriented science. It sug
gests a best of policy measures, such as fiscal policy, monetary policy, income
policy, etc. to deal with complex economic problem like unemployment, poverty, i
nequality, inflation, etc. faced by the country in modern times. National Income
: Macro - economics teaches the computation, use and application of national in
come data. With the help of national income statistics and accounting one can un
derstand and evaluate the growth performance of an economy over a period of time
.
2) 3)
4)
286
5)
Income and Employment Theory and Monetary Theory: Economics of employment and in
come and monetary economics are the major fields of macro - economics which have
utmost practical relevance. Planning and policy making is not possible without
the base of the understanding of these two fields. Dynamic Science: Macro - econ
omics is a dynamic science. It studies and suggests solutions to the issues and
problems from the dynamic view point. It allows for changes. One can have a bett
er idea of a dynamic perspective in the real economic would in the light of macr
o - economic tools and mode of its general equilibrium analysis.
6)
The Keynesian Macro Economic Theory : INTRODUCTION: In his book, The General The
ory of Employment, Interest and Money (popularly known as The General Theory ),
published in 1936, Prof. J. M. Keynes rejected the classical dogma of full empl
oyment equilibrium by invalidating Say s Law of markets. He, thus, propounded a
macroeconomic theory of income and employment that highlighted the real nature o
f the determinants of income in a modern economy. In contrast to the classical t
heory, the Keynesian theory is demand-oriented. It stresses effective demand as
a crucial factor in determining the level of income and employment.
Macro-economic Analysis:
The economic analysis by Keynes is a macro-economic analysis. In macro-economic
analysis, the functioning of economic system is viewed as a whole or in an aggre
gate sense. This is in contrast to the classical micro-economic approach, which
dealt with the segregated behaviour of individual economic entities (such as a p
articular consumer s demand behaviour, a particular firm s production behaviour,
etc. in the system). The basic concepts underlying the Keynesian theory are int
erpreted in aggregative terms only. Thus, in his General Theory, we come across
concepts like aggregate demand and aggregate supply, consumption implying tota
l consumption of the community, income for national income, employment for t
otal employment; output meant aggregate national output, saving implied tota
l savings in the economy; and the term investment connoting aggregate real inv
estment. As such, the economics of Keynes is also referred to as Aggregative Ec
onomics .
Short - Period Analysis:
Keynes realistically adopts the short-term variables. He believed in the short-r
un philosophy of life. To him, in the long run, we are all dead . Thus, Keynes
presumed an economic model as a short-period model in his analysis. Since it dea
ls primarily with short-term phenomena in economic life, many of the strategic v
ariables in the Keynesian theory, like consumption function, interest rates etc.
are assumed to be constant, as they would change very little in the short perio
d.
287
Again, on account of his short-period analysis of the problem, Keynes treated na

tional income as Gross National Product (GNP), rather than Net National Product
(NNP). Because he felt that in the short period, repairs, replacement etc. have
no significant relevance; so depreciation allowances, etc. are to be considered
only in the long-run analysis. So, GNP is appropriately used for measuring the c
ommunity s total income during the short run.
Generality of Approach:
Keynes theory is general. Its approach and analysis are general. It is general
in the sense that it is not time - bound. Keynesian tools of analysis are applic
able at any point of time, in any economy. Again, Keynesian, analysis being macr
o-economic, it contains generality in approach. It takes a general view of the e
conomic system as a whole. Keynes argued that the postulates of the classical th
eory are applicable to a special case of full employment only and not to general
cases. He criticized classical economists for their unrealistic assumption of f
ull employment equilibrium condition in their economic models. He observed that
there is always less than full employment in the economy; full employment is onl
y a rare phenomenon. He claimed his theory to be general in the sense that it de
als with all levels of employment and in all cases. It applied equally well to e
conomies with less than full employment, under - employment or full employment.
Thus, its generality implies its universal applicability.
The Principle of Effective Demand :
The gist of Keynesian analysis of income determination lies in the principle of
effective demand. Keynes pointed out that the level of income and output in an e
conomy is determined by the level of employment (i.e. the employment of workers
along with the exploitation of other given resources such as land, capital, etc.
) Which, in turn, is determined by the level of effective demand. In a money eco
nomy, effective demand is revealed by the total expenditure incurred by the peop
le on real goods and services, meant for consumption as well as investment. The
flow of expenditure, in turn, determines the flow of income, as one man s expend
iture becomes another man s income in the economic system. It thus follows that
Total Expenditure = Total Income. As the flow of expenditure varies, the level o
f income also varies accordingly. That is to say, if the total expenditure flow
in an economy increases, the flow of income will also increase in the same propo
rtion. And, if the aggregate expenditure flow decreases, income flow also decrea
ses likewise.
288
In real terms, the expenditure flow in the community consists of consumption exp
enditure and investment expenditure, expressing the total demand for consumption
goods and capital goods. Effective demand, thus, represents the total expenditu
re on the total output produced, at any equilibrium level of employment. It thus
denotes the value of total output of the community, which is described as natio
nal income. Obviously, national income equals national expenditure. And, as tota
l output comprises consumption goods and capital or investment goods, so the nat
ional expenditure consists of expenditure on consumption goods plus investment g
oods. In short, there are two basic determinants of effective demand in an econo
my. These are consumption and investment. The level of effective demand determin
es the level of employment which, in turn, determines the level of output and in
come in the economy. It follows, thus, that the level of employment is fundament
ally determined by consumption and investment. Since Keynes sought to explain th
e point of effective demand in a capitalist economy, free from government interv
ention, he considered consumption and investment expenditure of the community re
lating to private individuals and enterprises only. But, in modern times, a capi
talist economy is actually a mixed economy due to that, government expenditure i
s also a significant determinant of effective demand in a modern economy. Modern
economists, therefore, define effective demand as: Effective demand = C + I + G
, Where, C I G = = = Consumption expenditure of the households. Investment expen
diture of private firms. Government s expenditure on consumption and investment
goods.
It must, however, be noted that government expenditure is autonomous. Thus, it i
s the outcome of government s value judgment and policies, based on political an
d social considerations rather than economic forces. Following Keynes, we shall,
however, restrict our analysis to the consumption and investment, elements of e
ffective demand relating to the private sector only. If must be borne in mind th
at the investment and employment activities in the private sector are induced an
d not autonomous, as in the case of public sector. Again, from the Keynesian dic
tum that the level of employment and income depends on the level of effective de
mand in an economy, it also follows that the lack of effective demand implies un
employment and corresponding poverty, or low level of income. As such, to ease t
he unemployment problem, and to raise the level of income and economic prosperit
y, the level of effective demand has to be raised. Income and employment, thus,
increase only when the total demand either from consumption side or from the inv
estment side increases.
289
Analysis of The level of Effective Demand (Factors Determining Effective Demand)

: Since the level of activity in an economy is a matter of demand and supply, u
sing technical terminology, Keynes stated that effective demand is determined by
the interaction of the aggregate supply function and the aggregate demand funct
ion. That is to say, the volume of employment in an economy is determined by the
entrepreneur s considerations of the aggregate demand price and the aggregate s
upply price at that particular level of employment. Price here means the amount
of money received from the sale of output, i.e. sales proceeds.
Aggregate Supply Function (ASF):
The "supply price" for any given quantity of commodity refers to that price at w
hich the seller is willing to or induced to supply that amount in the market. He
nce, the supply schedule of that commodity shows the varying level of quantities
of the commodity the seller offers for sale at alternative prices. Similarly, t
he aggregate supply schedule for the economy as a whole refers to the response o
f all entrepreneurs in supplying the whole of the output of the economy. Keynes
measured the whole of output of the economy in terms of the amount of laboour em
ployed with a given marginal productivity. He, thus, said that the level of outp
ut varies with the level of employment, obviously, each level of employment resu
lts in a certain level of output of commodities, i.e. real income along with the
money income generated in the process of investment expenditure. Each level of
employment (of labour) necessitates certain quantities of the other factors of p
roduction like land, capital, raw materials, etc., to assist the labour employed
. All these factors of production are to be paid according to the prevailing fac
tor prices, which are known as cost of production. Thus, each level of employmen
t would involve certain money costs (including profits). Every prudent entrepren
eur must at least seek to recover the total cost of production, including normal
profit. Thus, the entrepreneur must get some minimum amount of sales revenue to
cover the total costs incurred at a given level of employment. Only if the sale
s proceeds are high enough to cover the total costs of production at a given lev
el of employment and output, the entrepreneur will be induced to provide that pa
rticular level of employment. This minimum price of revenue proceeds that the en
trepreneurs must get from the sale of output, associated with different levels o
f employment, is defined as, "aggregate supply price schedule" or "aggregate sup
ply function". Thus, the aggregate supply function refers to a schedule of the v
arious minimum amounts of proceeds or revenues which must be expected to be rece
ived by the entrepreneur class from the sale of output resulting at various leve
ls of employment. According to Keynes, using employment as a single measure of t
otal output of the economy, the supply price of employment can be determined in
terms of labour cost. We may illustrate the Keynesian aggregate supply function
hypothetically as in following Table :
290
The Aggregate Supply Function Level of employment (in lakhs of workers) (N) 1 2
3 4 5 6 Money wages (per annum in 1,000) (W) 10 10 10 10 10 10 Aggregate Supply
Price (ASF) (in crores of Rs.) (N x W) 100 200 300 400 500 600
In the table it is assumed that money wages, on an average to be paid per year,
is. Rs.10,000. Thus, the schedule shows for each alternative level of employment
how much minimum sales proceeds must be raised by the entrepreneurial class to
undertake to level of employment. It can be seen that to employ one lakh workers
during the year, entrepreneurs should expect to get a minimum of Rs.100 crores
from the economy by selling the resulting output. Similarly, for two lakh worker
s to be employed, the minimum expectation of sales proceeds is Rs.200 crores, an
d so on. Graphical Presentation : The numerical schedule of aggregate supply pri
ce of employment may be plotted graphically and the cruve so derived is called A
SF curve. Following figure illustrates the ASF curve drawn by the graphical repr
esentation of data contained in previous table. Rs. crores
Minimum Receipts/Income
ASF Y
Q
Employment (N) (In lakhs of workers)
291
In the figure, the X - axis represents the level of employment and the Y - axis
measures the expected minimum sales proceeds. The curve ASF represents the aggre
gate supply function. It is linear, because we have assumed a constant wage rate
. But, if the wage rate is changing (increasing) or costs of employment are risi
ng with an increase in employment, the ASF curve will be non-linear and upward s
loping. Indeed the aggregate supply price is correlative with the employment lev
el, in any case. However, the aggregate supply function - ASF curve - will becom
e perfectly inelastic at a point where the economy is at a full employment level
. Thus, at the full employment level, the aggregate supply function will be a ve
rtical straight line. Suppose, in our illustration, the economy reaches full emp
loyment when all its 6 lakh workers are employed, then the ASF curve will become
vertical at point Z as shown in the figure. That means, the level of employment
cannot exceed Q level (i.e.600 in our example), whatever the expectations of mi
nimum sales proceeds. It is interesting to note that modern economists measure t
he aggregate supply function in terms of real income or value of total output by
measuring GNP rather than the level of employment as Keynes did.
The Shape of ASF Curve :
As has been seen in previous figure, the ASF curve is an upward sloping curve, b
ut it is not very easy to conclude about its shape. To determine the shape of th
e curve ASF, the relationship between employment (N) and marginal productivity s
hould be traced. The value of marginal product (VMP) is called marginal producti
vity which is obtained by multiplying the marginal physical product (MP) of labo
ur with price of output (P). In a technical sense, thus, ASF is obtained by aggr
egating the expected total revenue functions of all the firms. The actual shape
of the ASF curve, however, will be determined by the aggregate production functi
ons of all firms in the economy and money wages. Apparently, the linear ASF curv
e, assumed in previous figure, is a much simplified case. It is based on the ass
umption that : (i) the money price of all outputs and inputs is constant, and (i
i) when prices are constant, the community s total outlay (national expenditure)
which is measured at these constant prices and the level of employment and inco
me, change in the same proportion. This means that if the total money expenditur
e is doubled, employment and income will also double and vice versa. In reality,
however, such proportionate relationship is rarely found. Thus, the actual ASF
curve which relates to changes in prices of all outputs and inputs, cannot be li
near. The linear ASF curve was assumed by Keynes for the sake of simplicity in a
nalysis. Again, the steepness of the ASF curve depends on the technical producti
on conditions. It depends on the productivity of labour, capital and other resou
rces employed by the economy.
Aggregate Demand Function (ADF) :
In the Keynesian terminology, the aggregate demand function refers to the schedu
le of maximum sales proceeds which the entrepreneurial community actually does e
xpect to be received from the sale of different quantities of output, resulting
at
292
various levels of employment. Thus, the quantum of maximum sales revenue expecte
d from the output produced is described as the demand price of a particular leve
l of employment. There is a positive correlation between the level of employment
and the demand price, i.e. expected sales receipts. Thus, with an increase in t
he level of employment, the aggregate demand price tends to rise, and vice versa
. The aggregate demand price - the maximum sales proceeds expected for a given l
evel of output - depends upon the total expenditure flow of the economy, which i
s determined by the spending decisions of the community as a whole. In a free ca
pitalist economy, households and firms are the two major economic sectors which
spend on consumption and investment. Now, what these sectors are expected to spe
nd in the next period is viewed as the aggregate demand price, the expectation o
f sales revenue, for the given level of output and employment by the entrepreneu
rs. A much simplified presentation of aggregate demand function may be illustrat
ed through the following hypothetical table.
The Aggregate Demand Function (Schedule)
Level of Employment (N) (in lakhs of workers) 1 2 3 4 5 6 Expected minimum sales
proceeds (expected Total Expenditure ADF) (in crores of Rs.) 175 250 325 400 47
5 550
The aggregate demand schedule links real income or output (which Keynes measured
in terms of the quantity of employment) and spending decisions, thus, the expen
diture flow in the economy as a whole. Evidently, the aggregate demand schedule
shows the aggregate demand price for each possible level of employment. The aggr
egate demand function may be represented graphically as in following figure. In
following figure, the curve ADF represents the aggregate demand schedule. It sho
ws that the aggregate demand price is the direct or increasing function of the v
olume of employment.
293
Maximum Expected Receipts (Anticipated Total Expenditure)

ADF = f (N)
Volume of Employment (In lakhs)
The ADF curve drawn in the above figure is linear. It can be non-linear, too. It
s shape and slope depend on the assumptions and nature of data related to the ag
gregate demand schedule. For the sake of simplicity, we shall, however, consider
linear functions only. Thus, it may be recalled that the statement showing the
varying levels of aggregate demand prices, i.e. expected sales revenue by the en
trepreneur for the output associated with different levels of employment, is cal
led the aggregate demand price schedule or the aggregate demand function.
Equilibrium Level of Employment - The Point of Effective Demand :
The intersection of the aggregate demand function with the aggregate supply func
tion determines the level of income and employment. The aggregate supply schedul
e represents costs involved at each possible level of employment. The aggregate
demand schedule represents the expectation of maximum receipts of the entreprene
urs at each possible level of employment. It, thus follows that so long as recei
pts exceed costs, the level of employment will go on increasing. The process wil
l continue till receipts become equal to cost. Needless to say, when costs excee
d receipts, the employment level will tend to decrease. This is what we can obse
rve by comparing the two functions as represented in the following table.
294
The Equilibrium Level of Employment

Employment (in lakhs of workers) (N) Aggregate Supply Function (in crores of Rs.
) (ADF) Aggregate Demand Function (in crores of Rs.) (ADF) Comparison Direction
of change in employment (DN)
1 2 3 4 5 6
100 200 300 400 500 600
175 250 325 400 475 550
ADF > ASF ADF > ASF ADF > ASF AD = AS ADF < ASF ADF < ASF
Increase Increase Increase Equilibrium Decrease Decrease
So long as the aggregate demand price (ADF is greater than the aggregate supply
price (ASF), the level of employment tends to increase. The economy reaches equi
librium level of employment when the aggregate demand function becomes equal to
the aggregate supply function. At this point, the amount of sales proceeds which
entrepreneurs expect to receive is equal to what they must receive in order to
just appropriate their total costs. In the given schedule above, it is Rs.400 cr
ores which is the entrepreneur s expected minimum as well as maximum sales proce
eds, so that 4 lakh workers employment is the equilibrium amount. This is the p
oint of effective demand. In graphical terms, the point of effective demand and
equilibrium of the economy can be represented in the following figure. Following
figure has two panels. Panel (A) depicts linear AD and AS curve. Panel (B shows
non-linear AD and AS curves. We have preferred linear curves for the sake of si
mplicity of analysis, though non-linear curves are more realistic. Y
ASF
(A)
Z E a b ADF & ASF
Y
(B)
ASF E
ADF ADF
R ADF & ASF
N1 N Nf Volume of Employment (N)
O
X
O
N Volume of Employment
X
Effective Demand
295
In the Figure (A), on the previous page the two curves ADF and ASF intersect at
point E, which is called the point of effective demand. In fact, the value OR, i
.e. the sales proceeds which entrepreneurs expect to receive at the point of agg
regate demand function where it is intersected by the aggregate supply function,
is called the effective demand because it is at this point that the entrepreneu
rs expectation of profits will be maximized. Thus, when the aggregate demand pr
ices are equal to the aggregate supply prices, the entrepreneurs would earn the
highest normal profits as their sales proceeds equal their total costs at this p
oint. it goes without saying that so long as the aggregate demand function lies
above the aggregate supply function, i.e. ADF > ASF, indicating that costs remai
n less than the revenue, the entrepreneurs would be induced to provide increasin
g employment till both of them are equalized. But after the point of intersectio
n of the aggregate demand function and the aggregate supply function, for a furt
her rise in employment, the aggregate supply prices become higher than aggregate
demand price, i.e. ASF > ADF, indicating that total costs exceed total revenue
expected, so that entrepreneurs would incur losses and refuse to employ that par
ticular number of workers. Diagrammatically, thus, actually only ON number of me
n will be employed where the aggregate demand function (ADF) equals the aggregat
e supply function (ASF). ON1 number of workers will provide some possibility of
maximising profits by increasing the employment further, since ADF > ASF by ab,
whereas, any number of men exceeding ON cannot be employed, because then ASF wou
ld exceed ADF, implying losses to the entrepreneurs. it is only at point E where
ADF = ASF and the normal profit is maximum that the equilibrium level of employ
ment is ON. Thus, it may be concluded that employment in an economy will increas
e till ADF = ASF. Thus, point E, the point of effective demand, is called the po
int of equilibrium which determines the actual level of employment and output. I
t should be noted that though E is the point of equilibrium, it does not imply t
hat the economy is necessarily having full employment at this equilibrium point.
According to Keynes, the equilibrium between the aggregate demand function and
the aggregate supply function can, and often does, take place at a point less th
an full employment. To him, ADF = ASF at full employment level, only if the inve
stment spending is appropriately adequate to fill the gap emerging between incom
e and consumption in relation to full employment. But, this is scarcely found in
practice. Usually, the investment outlay is insufficient to fill the gap betwee
n income and consumption, hence ADF = ASF at less than full employment. This is
how Keynes explains the points of under - employment equilibrium in a real econo
my. Of these two determinants of the level of effective demand, Keynes effectiv
e demand, however, assumes the aggregated supply function as given in the short
run. Thus, he speaks little about the aggregate supply function. Keynes did not
make a detailed study of the ASF, firstly, because he assumed a static macro-eco
nomic model of the economy, which ruled out the possibility of t5echnological an
d other changes of a dynamic nature and, secondly, he was concerned with the sho
rt period analysis during which prevailing conditions are unlikely to change. Es
pecially, changes in 296
technical conditions and technological advancement can occur only in the long pe
riod. He, therefore, assumed a given ASF curve for the economy, simply ignoring
it in the further analysis of income - employment determinants. Stonier and Hagu
e observe that another important reason why Keynes did not pay much attention to
the analysis of ASF is that he was mainly concerned with solving the problem of
unemployment caused by the cyclical phase of the Great Depression in the mid-th
irties. In view of the mounting unemployment, it was unnecessary for him, to exa
mine the problem of optimum use of the given resources. His main task was to sho
w hot to use the given unutilised resources and create more employment and incom
e. Again, he felt that the problem of ASF and especially the optimum use of the
given resources, was adequately dealt with by the classical (and neo-classical)
economists in developing the marginal productivity theory of distribution. But,
it was aggregate demand which was not adequately analysed, and rather neglected,
in the past, Keynes, thus, concentrated on the analysis of aggregate demand fun
ction. Since the aggregate supply function is assumed as given, the essence of K
eynes theory of employment and income is found in his analysis of the aggregate
demand function. that is why his theory is sometimes regarded as a theory of ag
gregate demand. the aggregate demand schedule is a vital factor in his employmen
t theory, for only if aggregate demand is large enough will all resources be use
d, with any given aggregate supply function. The aggregate demand schedule shows
how much money the community is expected to spend on the products resulting a t
various levels of employment. Thus, the Keynesian economics may also be called
the economics of spending. In the equilibrium model, ADF is known by the sum tot
al of expenditure of all the buyers in the economy. It represents money expendit
ure of all buyers on domestically produced goods to the level of aggregate emplo
yment. In fact, ADF is the schedule which indicates the alternative expenditure
totals in relation to alternative levels of employment in the economy. The volum
e of total expenditure, as given by the ADF, where it is intersected by the ASF,
is described as "effective demand". Effective demand is the point where the act
ual total expenditure of the community equals the aggregate required sales recei
pts and their expectations by the entrepreneurial class as a sales receipts and
their expectations by the entrepreneurial class as a whole. That is to say, the
level of effective demand represents an equilibrium level of expenditure at whic
h entrepreneurial expectations are just being realised, so that the amount of la
bour hired and investment incurred in the economy are unlikely to vary at this p
oint. Apparently, the aggregate demand function signifies a functional relations
hip between total expenditure and total income of the community. It must be note
d that this relationship between expenditure and income traced in the Keynesian
model is behavioural. In short, Kenyes theory stated that, in the short run, th
e equilibrium level of employment is determined by the actual level of aggregate
demand with a given aggregate supply function. The greater the aggregate demand
is at the point where it is equal to aggregate supply, the higher will the empl
oyment be; thus, it is the aggregate demand function which becomes "effective" i
n determining the level of employment. This implies that in order to raise the l
evel
297
of employment in any economy, it requires an increase in the effective demand by

raising the level of aggregate demand. In graphical terms, the higher the aggre
gate demand function curve, with a given aggregate supply function schedule, the
higher will be the level of employment;following figure illustrates this point.
Y ASF
E2 R2
Receipts/Income
ADF2
E1 R1
ADF1
O
N2 N1 Level of Employment
X
In the above figure, curve ADF1 (representing the aggregate demand function) ind
icates an employment level up to ON1 at point E1 of the effective demand. While
curve ADF2 is at a higher level and shows a higher level of employment ON2 at po
int E2 of effective demand. Thus, the diagram reveals the point that a higher ag
gregate demand function leads to a higher level of employment. In short, the poi
nt of effective demand at which the aggregate demand function intersects the agg
regate supply function is the point of macro-economic equilibrium. Indeed, effec
tive demand equals the total expenditure on consumer goods plus investment goods
. It can be said that the level of employment which depends on effective demand
also depends on the volume of consumption expenditure. Thus, consumption and inv
estment are the main determinants of effective demand, and in turn the level of
employment and income. Introduction to Consumption Function and Investment Funct
ion : According to Keynes, the aggregate demand function - the "effective" eleme
nt of effective demand - depends on two factors : (i) the consumption function (
or the propensity to consume), and (ii) the investment function (or the induceme
nt to invest). This consideration is based on the fact that effective demand is
the sum of expenditure on consumption on investment in a community. It implies t
hat if consumption is constant and investment is increases, employment will incr
ease. Similarly, if investment is constant and consumption increases, employment
will increase. Increase or decrease in both consumption and investment will cau
se an increase or decrease in the levels of employment respectively. Thus, the f
undamental idea of the 298
Keynesian economics is that an increased level of employment can only be achieve

d and maintained by an increased level of expenditure on either consumption or i
nvestment or both. In short, effective demand which determines the level of empl
oyment in an economy is determined by the size of aggregate demand expenditure o
r the aggregate demand function, which is composed of consumption and investment
functions.
Consumption Function :
The consumption appears to be a significant factor, determining the level of eff
ective demand in an economy. Consumption function, or the propensity to consume,
denotes the consumption demand in the aggregate demand of the community, which
depends on the size of income and the share that is spent on consumption goods.
The propensity to consume is schedule showing the various amounts of consumption
corresponding to different levels of income. Thus, by consumption function, we
mean a schedule of functional relationship, indicating how consumption reacts to
income variations. Keynes, on the basis of a fundamental psychological law, obs
erved that as income increases, consumption also increases, but less proportiona
tely. Secondly, he also states that the propensity to consume is relatively stab
le in the short run and, therefore, the amount of community s consumption varies
in a regular manner with aggregate income. Since consumption increases less tha
n income, there is always a widening gap between income and consumption as incom
e expands. Keynes, thus, argued that in order to sustain the level of income and
employment in the economy, investment demand should be increased because consum
ption demand is relatively a stable component of the aggregate "effective demand
". Thus, the crucial factor in employment - income theory is the investment func
tion.
Investment Function :
Investment Function or the inducement to invest is the second but crucial factor
of effective demand. Effective demand for investment or the investment demand f
unction is more complex and more unstable than the consumption function. Accordi
ng to Keynes, by investment is meant only real investment, denoting an addition
to real capital assets as well as the accumulated wealth of the society. The vol
ume of investment in an economy depends on the inducement to invest on the part
of the business community. But the induce expectations about the profitability o
f business. Thus, according to the Keynesian theory, inducement to invest is det
ermined by the business community s estimates of the profitability of investment
in relation to the rate of interest on money for investment. The estimates or t
he expectations of profitability of new investment by the entrepreneurs are tech
nically termed as the Marginal Efficiency of Capital. Thus, there are two factor
s determining the investment functions, namely, (i) the marginal efficiency of c
apital and (ii) the rate of interest. Accordingly, when the marginal efficiency
of capital is greater than the rate of interest, the greater is the inducement t
o invest.
299
Thus, in general, entrepreneurs keep a fair margin between the two variables. In
this sense, the marginal efficiency of capital and the rate of interest combine
to influence the rate of investment in an economy. Keynes defined marginal effi
ciency of capital as the highest rate of return over cost expected form producin
g an additional (or marginal) unit of a special asset. The marginal efficiency o
f capital is, thus, estimated by taking two factors into account: (i) the prospe
ctive yield of a particular capital asset, and (ii) the supply price or the repl
acement cost of that asset. The marginal efficiency of capital is estimated to b
e greater if the difference between the prospective yield and the supply price o
f a capital asset is larger. The supply price of a capital asset can be easily c
alculated and it is more or less a definite quantity, while the prospective yiel
d is a very indefinite factor as it relates to future, which is highly uncertain
. Nevertheless, entrepreneurs do make their own estimates on the marginal effici
ency of new capital assets by taking these two factors into account. Keynes, how
ever, mentioned that the marginal efficiency of capital is a highly fluctuating
phenomenon in the short run and has a tendency to decline in the long run. Once
the marginal efficiency of capital is estimated, it is to be compared with the r
ate of interest. Thus, the rate of interest is the second important determinant
of the investment function. The rate of interest, according to Keynes, depends u
pon two factors : (i) the liquidity preferences function, and (ii) the quantity
of money (or the money supply). The first factor pertains to the demand aspect,
and the second, to the supply aspect, of the price of borrowing money, i.e. the
rate of interest. Thus, the liquidity preference function determines the demand
for money. It denotes the desire of the people to hold money or cash balance as
the most liquid assets. According to Keynes there are three different motives fo
r holding cash for liquidity preference : (i) the transactions motive, (ii) the
precautionary motive, and (iii) the speculative motive. Thus, the total demand f
or money is the aggregate demand for each under the three motives. Keynes, thus,
formulates his own theory of interest called "liquidity preference theory of in
terest". He stated that liquidity preference is an important factor affecting th
e rate of interest. To him, the other factor, namely, the money supply, is not v
ery significant in the short run, because it does not change all of a sudden and
it is relatively a stable phenomenon. It is the liquidity preference function w
hich is a highly fluctuating phenomenon, specially due to the speculative motive
. Thus, assuming money supply to be constant, the rate of interest can be direct
ly related to the liquidity preference function. Hence, the higher the liquidity
preference, higher will be the rate of interest and the lower the liquidity pre
ference, the lower will be the rate of interest. Keynes, however, regarded that
the rate of interest is relatively a stable factor in the short run, and does no
t change violently. Thus, it follows that the investment function is largely inf
luenced by the behaviour of the marginal efficiency of capital which is a fluctu
ating variable in the short 300
run. Thus, the marginal efficiency of capital with a given rate of interest, is
the most significant factor determining the inducement to invest. In fact, as Ke
ynes believed, fluctuations in the marginal efficiency of capital are the fundam
ental cause of trade cycles and income fluctuations in a capital economy. It is
to be noted here that we have so far considered consumption and investment expen
diture of the community relating to private individuals and enterprises only, be
cause the original Keynesian Theory of Employment has considered consumption and
investment expenditure only, and does not take government expenditures into acc
ount. But, modern economists give due recognition to government expenditure as a
n important factor of effective demand. In todays world, government expenditure i
s day be day increasing, and it cannot be ignored in estimating the effective de
mand in a community. Thus, to be more realistic, we may formulate effective dema
nd thus : Effective demand = C + I + G, where, C I G = = = Consumption outlay fo
r the households, Investment outlay in the private sector, and Government s spen
ding for consumption as well as investment.
It should be noted, however, that government expenditure is autonomous, as it de
pends on the policies of the existing government which are largely influenced by
political and social rather than economic factors. BUSINESS FLUCTUATIONS INTROD
UCTION Business fluctuations, booms and slumps, in the economic activities form
essentially the economic environment of a country. They influence business decis
ions tremendously and set the trend of future business. The period of prosperity
opens up new and larger opportunities for investment, employment and production
, and thereby promotes business. On the contrary, the period of depression reduc
es the business opportunities. A profit maximizing entrepreneur must therefore a
nalyse the economic environment of the period relevant for his important busines
s decisions, particularly those pertaining to forward planning. This part of the
chapter is in fact devoted to a brief discussion of, main phases of business cy
cles and their causes.
301
Definition of a Business or Trade Cycle The term "trade cycle" in economics refe
rs to the wave-like fluctuations in the aggregate economic activity, particularl
y in employment, output and income. In other words, trade cycles are ups and dow
ns in economic activity. A trade cycle is defined in various ways by different e
conomists. For instance, Mitchell defined trade cycle as a fluctuation in aggrega
te economic activity. According to Haberler, "The business cycle in the general s
ense may be defined as an alternation of periods of prosperity and depression, o
f good and bad trade." The following features of a trade cycle are worth noting
: (a) (b) (c) (d) (e) A trade cycle is wave - like movement. Cyclical fluctuatio
ns are recurrent in nature. Expansion and contraction in a trade cycle are cumul
ative in effect. Trade cycles are all-pervading in their impact. A trade cycle i
s characterized by the presence of crisis, i.e., the peak and the trough are not
symmetrical, that is to say, the downward movement is more sudden and violent t
han the change from downward to upward. Though cycles differ in timing and ampli
tude, they have a common pattern of phases which are sequential in nature.
(f)
Keynes, points out that "A trade cycle is composed of periods of good trade char
acterized by rising prices and low unemployment percentages, altering with perio
ds of bad trade characterized by falling prices and high unemployment percentage
s." Keynes, thus, stresses two indices namely, prices and unemployment, for meas
uring the upswing and downswing of the business cycles. PHASES OF BUSINESS CYCLE
S The ups and downs in the economy are reflected by the fluctuations in aggregat
e economic magnitudes, such as, production, investment, employment, prices, wage
s, bank credits, etc. The upward and downward movements in these magnitudes show
different phases of a business cycle. Basically there are only two phases in a
cycle, viz., prosperity and depression. But considering the intermediate stages
between prosperity and depression, the various phases of trade cycle may be enum
erated as follows : 1. 2. Expansion Peak
302
3. 4. 5.
Recession Trough Recovery and expansion.
The five phases of a business cycle have been presented in the figure. The stead
y growth line shows the growth of the economy when there are no economic fluctua
tions. The various phases of business cycles are shown by the line of cycle whic
h moves up and down the steady growth line. The line of cycle moving above the s
teady growth line marks the beginning of the period of expansion or prosperit
y in the economy. the phase of expansion is characterized by increase in output
, employment, investment, aggregate demand, sales, profits, bank credits, wholes
ale and retail prices, per capita output and a rise in standard of living. The g
rowth rate eventually slows down and reaches the peak. The phase of peak is gene
rally characterized by slacking in the expansion rate, the highest level of pros
perity, and downward slide in the economic activities from the peak.
Business Fluctuations. A figure showing phases of Business Cycle The phase of re
cession begins when the downward slide in the growth rate becomes rapid and stea
dy. Output, employment, prices, etc. register a rapid decline, though the realiz
ed growth rate may still remain above the steady growth line. So long as growth
rate exceeds or equals the expected steady growth rate, the economy enjoys the p
eriod of prosperity - high and low. When the growth rate goes below the steady g
rowth rate, it makes the beginning of depression in the economy. In a stagnated
economy, depression begins when growth rate is less than zero, i.e. the total ou
tput, employment, prices, bank advances, etc., decline during the subsequent per
iods. The span of depression spreads over the period growth rate stays below the
secular growth rate or zero growth rate in a stagnated economy. Trough is the p
hase during which the down - trend in the economy slows down and eventually stop
s, and the economic activities once again
303
register an upward movement. Trough is the period of most severe strain on the e
conomy. When the economy registers a continuous and repaid upward trend in outpu
t, employment, etc., it enters the phase of recovery though the growth rate may
still remain below the steady growth rate. And, when it exceeds this rate, the e
conomy once again enters the phase of expansion and prosperity. If economic fluc
tuations are not controlled by the government, the business cycles continue to r
ecur as stated above. Let us now describe in some detail the important features
of the various phases of business cycle, and also the causes of turning points.
Prosperity : Expansion and Peak
The prosperity phase is characterized by rise in the national output, rise in co
nsumer and capital expenditure rise in the level of employment. Inventories of b
oth input and output increase. Debtors find it more and more convenient to pay o
ff their debts. Bank advances grow rapidly even thought bank rate increases. The
re is general expansion of credit. Idle funds find their way to productive inves
tment since stock prices increase due to increase in profitability and dividend.
Purchasing power continues to flow in and out of all kinds of economic activiti
es. So long as the conditions permit, the expansion continues, following the mul
tiplier process. In the later stages of prosperity, however, inputs start fallin
g short of their demand. Additional workers are hard to find. Hence additional w
orkers can be obtained by bidding a wage rate higher than the prevailing rates.
Labour market becomes seller s market. A similar situation appears also in other
input markets. Consequently, input prices increase rapidly leading to increase
in cost of production. As a result, prices increase and overtake the increase in
output and employment. Cost of living increases at a rate relatively higher tha
n the increase in household income. Hence consumers, particularly the wage earne
rs and fixed income class, review their consumption. Consumer s resistance gets
momentum. Actual demand stagnates or even decreases. The first and most pronounc
ed impact falls on the demand for new houses, flats and apartments. Following th
is, demand for cement, iron and steel, construction-labour tends to halt. This t
rend subsequently appears in other durable goods industries like automobiles, re
frigerators, furniture, etc. This marks reaching the Peak.
Turning - Point and Recession
Once the economy reaches the peak, increase in demand is halted. It even starts
decreasing in some sectors, for the reason stated above. Producers, on the other
hand, unaware of this fact continue to maintain their existing levels of produc
tion and investment. As a result, a discrepancy between output supply and demand
arises. The growth of discrepancy, between supply and demand is so slow that it
goes unnoticed for some time. But producers suddenly realize that their invento
ries are piling up. This situation might appear in a few industries at the first
instance, but later it spreads to other industries also. Initially, it might be
taken as a problem arisen out of minor mal-adjustment. But, the persistence of
the problem makes the
304
producers believe that they have indulged in over-investment . Consequently, fu

ture investment plans are given up; orders placed for new equipments, raw materi
als and other inputs are cancelled. Replacement of worn-out capital is postponed
. Demand for labour ceases to increase; rather, temporary and casual workers are
removed in a bid to bring demand and supply in balance. The cancellation of ord
ers for the inputs by the producers of consumer goods creates a chain -reaction
in the input market. Producers of capital gods and raw materials cancel their or
ders for their input. This is the turning point and the beginning of recession.
Since demand for inputs has decreased, input prices, e.g., wages, interest etc.,
show a gradual decline leading to a simultaneous decrease in the incomes of wag
e and interest earners. This ultimately causes demand recession. On the other ha
nd, producers lower down the price in order to get rid of their inventories and
also to meet their obligations. Consumers in their turn expect a further decreas
e in price, and hence, postpone their purchases. As a result, the discrepancy be
tween demand and supply continues to grow. When this process gathers speed, it t
akes the form of irreversible recession. Investments start declining. The declin
e in investment leads to decline in income and consumption. The process of rever
se of (of negative) multiplier gets underway. (The process is exactly reverse of
expansion). When investments are curtailed, production and employment decline r
esulting in further decline in demand for both consumer and capital goods. Borro
wings for investment decreases; bank credit shrinks; share prices decrease; unem
ployment gets generated along with a fall in wage rates. At this stage, the proc
ess of recession is complete and the economy enters the phase of depression.
Depression and Trough
During the phase of depression, economic activities slide down their normal leve
l. The growth rate becomes negative. The level of national income and expenditur
e declines rapidly. Prices of consumer and capital goods decline steadily. Worke
rs lose their jobs. Debtors find it difficult to pay off their debts. Demand for
bank credit reaches its low ebb and banks experience mounting of their cash bal
ances. Investment in stock becomes less profitable and least attractive. At the
depth of depression, all economic activities touch the bottom and the phase of t
rough is reached. Even the expenditure on maintenance is deferred in view of exc
ess production capacity. Weaker firms are eliminated from the industries. At thi
s point, the process of depression is complete.
How is the process reversed? The factors reverse the downswing vary form cycle t
o cycle like factors responsible for business cycle vary form cycle to cycle. Ge
nerally, the process begins in the labour market, Because of widespread unemploy
ment; workers offer to work at wages less than the prevailing rates. The produce
rs anticipating better future try to maintain their capital stock and offer jobs
to some workers here and there. They do so also because they feel encouraged by
the halt in decrease in price in the trough phase. Consumers on their part expe
cting no further decline in price begin to spend on their postponed consumption
and
305
hence demand picks up, though gradually. Bankers having accumulated excess liqui
dity (idle cash reserve) try to salvage their financial position by the private
investors. Consequently, security prices move up and interest rates move downwar
d. On the other hand, stock prices begin to rise for the simple reason that fall
in stock prices comes to an end and an optimism is underway in the stock market
. Besides, there is a self - correcting process within the price mechanism. When
prices fall during recession the prices of raw materials and that of other inpu
ts fall faster than the prices of finished products. Therefore, some profitabili
ty always remains there, which tends to increase after the trough. Hence the opt
imism generated in the stock market gets strengthened in the commodity market. P
roducers start replacing the worn - out capital and making - up the depleted cap
ital stock, though cautiously and slowly. Consequently, investment picks up and
employment gradually increases. Following this recovery in production and income
, demand for both consumer and capital goods, start increasing. Since banks have
accumulated excess cash reserves, bank credit becomes easily available and at a
lower rate. Speculative increase in prices give indication of continued rise in
level. For all these reasons, the economic activities get accelerated. Due to i
ncrease in income and consumption, the process of multiplier gives further impet
us to the economic activities, and the phase of recovery gets underway. The phas
e of depression comes to an end over time, depending on the speed of recovery.
The Recovery
As the recovery gathers momentum, some firms plan additional investment, some un
dertake renovation programmes, some undertake both. These activities generate co
nstruction activities in both consumer and capital good sectors. Individuals who
had postponed their plans to construct houses undertake it now, lest cost of co
nstruction mounts up. As a result, more and more employment is generated in the
construction sector. As employment increases despite wage rates moving upward th
e total wage income increase at a rate higher than employment rate. Wage income
rises, so does the consumption expenditure. Businessmen realize quick turn over
and an increase in profitability. Hence, they speed up the production machinery.
Over a period, as the factors of production become more fully employed wages an
d other input prices move upward rapidly. Investors therefore, become discrimina
tory between alternative investments. As prices, wages and other factor - prices
increase, a number of related developments begin to take place. Businessmen sta
rt increasing their inventories, consumers start buying more and more of durable
goods and variety items. With this process catching up, the economy enters the
phase of expansion and prosperity. The cycle is thus complete. INFLATION
The Meaning of Inflation
In the words of Prof. Samuelson, "Inflation occurs when the general level of pri
ces and costs is rising - rising prices for bread, gasoline, cars; rising wages,
land prices, rentals 306
on capital goods". Thus, inflation marks rising commodity prices as well as fact
or prices. Factor prices when rise, cause an increase in costs. According to Mil
ton Friedman, inflation is "process of a steady and sustained rise in the prices
". Many more definitions of inflation can be given. Instead of going into all th
ese definitions, let us outline the characteristics of inflation as they emerge
form the above - mentioned (and other similar) definitions of inflation :
(i) Inflation is a phenomenon of rising prices. However, every price - rise is n
ot inflationary, though every period of inflation indicates price - rise. In oth
er words, temporary price rise in some sectors may occur due to some causes but
they may not necessarily be indicative of inflation. Inflation is a sustained an
d appreciable rise in prices. Once started, inflation goes on feeding itself and
it is not self-limiting. It is a continuous process.
(ii)
(iii) Inflation is a general and a dynamic phenomenon. It is not limited to one
or two sectors or geographical localities of a country. Rather, it takes within
its stride the entire country and all the sectors of the economy. It is dynamic
in the sense that its severity, nature etc. go on changing (and causing changes)
over a period of time. Inflation occurs over a period of time. (iv) (v) True in
flation or pure inflation starts only after reaching the full employment level.
It cannot be anticipated, in the sense that one cannot be sure regarding the tim
ing and intensity of inflation. Inflation is characterized by an excess of deman
d or an increase in costs or usually both.
(vi)
The Causes of Inflation
The causes of inflation can be studied from two sides, i.e. from the demand side
and from the supply side.
1.
The Factors from Demand Side
(i)
Increase in Public Expenditure : There may be an increase in the expenditure of
the government because of wars or for developing the economy. This increase in g
overnment expenditure means an increase in the total demand, which leads to rise
in prices. This demand is in addition to the normal demand, which leads to a pr
ice rise. Increase in Private Expenditure : When optimism prevails in the busine
ss world, businessmen are eager to spend more money on capital goods. This incre
ases the
(ii)
307
demand for capital goods, and in turn, brings about an increase in the demand fo
r consumer s goods. This is because there is an increase in the income of the pe
ople who work in capital goods industries. Therefore, they are in a position to
spend more, and thus, there is an increase in the demand for the both types of
goods. (iii) Increase in Foreign Demand : When there is an increase in foreign d
emand for the goods manufactured in a country, exports increase and the prices o
f commodities in the country increase, as their supply cannot be increased insta
ntaneously. (iv)
Reduction in Taxation : If there is a reduction in the taxes levied by the gover
nment, people are left with more money, which can be spent. This increases their
expenditure, as well as the prices of commodities. Repayment of Internal Debts
: When the government repays old loans, more purchasing power is placed at the d
isposal of the people. A part of the amount obtained in this manner, may be re-i
nvested in various assets, but the rest of it, may be spent on consumer s goods
and services. It is responsible for increase in prices to the extent that this r
epayment of loans leads to an increase in the total demand. Changes in Expectati
on : In the context of the price - rise, the expectations of the people play a v
ery important role. When people expect a rise in prices, businessmen increase th
eir investment and this leads to an increase in the demand for capital goods. If
the consumers think that there will be an increase in prices in the future, the
y will start purchasing commodities which they will require in the future. This
increases the demand for consumer s goods. The increase in the demand for both,
consumer s and producers goods leads to the rise in prices.
(v)
(vi)
2.
Factors form Supply Side
(i)
Scarcity of the Factors of Production : If one or more factors of production are
in short supply, there is a reduction in production or hurdles may be created i
n the expansion of product6ion. This reduces the total supply and causes a rise
in price. Bottlenecks : At times, all the factors are or may be available. But b
ottlenecks are created and this makes it difficult to make these factors availab
le at the right time and place, for actual production. For example, iron ore and
coal are available at mines, but the transport facilities required to transport
these raw materials to the production site are not available. Transportation th
en becomes a bottle-neck. Therefore, in this case, production will suffer. Simil
arly, the paucity of credit facilities, labour unrest and strikes, the unreliabi
lity of transport and several other difficulties may arise and make production i
mpossible or difficult. This may cause an increase in prices.
(ii)
308
(iii) Natural Calamities : There are several natural calamities which may reduce
production. Excess of rains, drought, earthquakes, cyclones, may substantially
reduce the total annual production. Agricultural production suffers and all othe
r agro - based industries such as the sugar industry, the textile industry (cott
on and jute) the oil industry, etc., also suffer. This results in the reduction
of production and this leads to a rise in the prices. (iv)
Hoarding by Merchants : When traders and merchants know that there is a short su
pply of any commodity, they will purchase and stock large quantities of these co
mmodities. These commodities then go underground and are not available in the op
en market. Thus, there is a shortage of other commodities too and this leads to
a rise in prices. Rise in Costs : Rise in costs due to an increase in factor pri
ces is another cause from the supply side. Rent, interest and wages can rise due
to a number of reasons. The Central Bank may raise interest rates or unions may
cause a wage - rise. This may lead to inflation.
(v)
Consequences of Inflation
Effects or Consequences of Inflation can be studied under (i) Effects on Product
ion, (ii) Effects on Distribution, (iii) Other Effects, and (iv) Non - economic
Effects.
1.
Effects on Production
The effects of inflation on production are very important. As long as there is n
o full employment and inflation is proceeding at a slow rate, inflation may be h
elpful. As some of the factors of production are unemployed, there is no change
in the costs of production. But prices continue to rise, which results in larger
profits, and tempts entrepreneurs to increase investment. This increases total
production and employment. This process continues undisturbed till the full empl
oyment level is reached. But once the full employment level is reached or crosse
d, prices start rising rapidly and there is true inflation. This rapid inflation
is very dangerous to the smooth working of any economy. Hyperinflation is perha
ps the worst from the point of view of production. Inflation affects production
in the following manner : 1.
Through Investment : During a period of rising prices, because of several reason
s, investment in the field of production goes on decreasing. The value of money
falls, the propensity to save is reduced, and this results in the reduction of s
avings, which in turn reduces the rate of capital accumulation. The value of for
eign capital is reduced, and there is flight of capital from the country, which
results in reduction in investment and in turn, reduces production. Switchover o
f Business : During a period of rising prices, speculation and stockpiling appea
rs to be more profitable. To undertake production, one has to begin with
309
2.
obtaining a license, and go to the other end and maintain good relations with la
bour. This is very troublesome. Instead, if one indulges in purchase and sales o
f products property and other types of assets one can perhaps earn equal or even
more profits, and avoid all the headaches mentioned above. These opportunities
of making easy money, tempt capitalist to invest their capital in these activiti
es rather than undertake production. Thus, there is no growth in production. But
if prices rise very fast, production may even decrease. 3.
Uncertainty : During a period of rising prices, there is an atmosphere uncertain
ty in every field. This makes entrepreneurs more and more reluctant to accept an
y risks in production. This results in decrease in production. Change in the Com
position of Production: Rising prices also influences the composition of product
ion. During the period of rising prices, those who get large profits and easy mo
ney become rich. Similarly, the owners of factors of production who are in short
supply (eg. Owners of land, plots, houses etc ), get huge profits because of ri
sing prices. On the contrary, the working class, the middle class and others who
belong to fixed income group, are put to great hardships. They are not even in
a position to satisfy their basic needs because they do not have the required pu
rchasing power. As the income of the rich increases, the demand for luxuries go
on increasing. As supply always follows demand, the production of luxury article
s increases and that of necessities decreases. It is most undesirable to spend t
he resources of a country in producing luxury articles before producing adequate
necessities. So, this change in the composition of production is said to be und
esirable. Poor Quality of Output: During a period of rising prices, there is a s
carcity of goods and services on a very large scale. This results in the deterio
ration of the quality of production, because anything and everything that is pro
duced, is sold. Thus, inferior commodities flood the market. Public Unrest: When
the pangs of price- rise are felt by the labourers, they become frustrated, and
there are demonstrations, strikes, and several other types of agitations to sec
ure higher wages. Because of this, production decreases further, which leads to
further shortages and thus, price-rise. Distortion of prices: The expansion of c
urrency creates several hurdles in the pricing system, and makes it weak. It s e
ssential to have a properly functioning price mechanism in order to have smoothl
y functioning production system. This distortion of the price mechanism is anoth
er adverse effect on production.
4.
5.
6.
7.
2)
Effects on Distribution :
The effects of inflation on various groups of people on society can be summarize
d as follows:
310
a)
The creditor and debtor: During periods of inflation, creditors are put to losse
s because there is difference in the value of the unit of currency when it was l
oaned out, and when it was returned. As prices rise, the value of money goes on
decreasing with lapse of time. The case of borrowers is exactly the opposite. A
borrower is benefited as the value of money when he borrowed it, is more than wh
en he repays it. The wage and salary earners: Those who get fixed income in term
s of money, are put to losses during inflation. If workers are well organized, t
hey can secure dearness allowances or a rise in wages or salaries. But even then
, in the race between the rise in prices and the rise in wages, the rise in pric
es is more rapid, thereby putting wage earners to a great loss. The fortune unor
ganized labour is extremely pitiable. Thus, as a result of inflation, the fixed
income earners suffer great hardships. Those whose income is permanently fixed,
are put to heavier losses. Pensioners mainly belong to this class. The entrepren
eurs as a Class: The traders, merchants and manufacturers are the people who ben
efit more during inflation. Inflation is the great opportunity for them to make
huge profits. The prices of stocks of finished products hoarded by these busines
smen go on increasing continuously, and they get huge profits on these goods by
selling them in the black market. Moreover. expenses to be incurred on wages, ra
w materials and machinery, lag behind prices. This leads to a continuous rise in
profits. If the rate of growth of inflation is very high, there is a tendency o
f stockpiling by the traders. In this way, the share in the national income of t
he entrepreneurial class as a whole, goes on increasing. Investors as a class: N
ormally, investors are found to invest their money in the following two ways: 1)
In such assets which give fixed and guaranteed returns per year. For e.g. : Bon
ds, Debentures, long term, deposits in banks etc. 2) In share or equity capital
which do not give guaranteed returns. The investors belonging to the first categ
ory are put to a loss, but those in the second category may stand to gain profit
s. Because of rising prices, companies make huge profits declare large dividends
, and thus, their real income increases. In most cases, the rich invest in equit
y shares as their capacity to take risk is more. The middle class people, whose
savings are limited, invest in assets earning guaranteed returns. So here again,
the rich have an advantage. The farmers: During periods of inflation, the incom
e of farmers as a class increases. The supply of agricultural goods is normally
inelastic. So it is not possible to increase production immediately. In the mean
time, prices rise further. Moreover, whenever there is a price-hike, the prices
of agricultural goods increase sharply and quickly. This is a common experience
in developing countries. But even in this field, the small farmers are benefite
d least because they do not have large quantities of
b)
c)
d)
e)
311
agricultural goods as marketable surplus. But, the large farmers get the maximum
possible advantage.
3)
Other Consequences :
a)
Financial institutions: When inflation is limited, banks, insurance companies an
d other financial institutions get advantages because their activities are boost
ed. But as soon as prices begin to rise at a faster rate, the savings of the peo
ple are reduced, and most of the financial institutions fall in trouble. Foreign
Trade: Foreign goods become cheaper and imports increase, and simultaneously, e
xports dwindle as the prices of domestic goods rise. This creates several proble
ms in the balance of payments. If restrictions are imposed, to check imports, sm
uggling activities increase. Price structure: During inflation, the prices of al
l goods rise. But the prices of those goods whose supply is inelastic, rise more
. This disturbs the entire price structure as well as the distribution system in
the economy. For e.g., If the price of the steel furniture is very high, the av
ailable steel will be used for the manufacture of steel furniture, even though t
he manufacture of railway wagons and rails may be more necessary. Reduction in d
evelopment expenditure: Inflation has very bad effect on Economic planning and p
ublic expenditure. People who are already suffering from rising prices, cannot b
e overburdened by increasing the taxation. But the expenditure of the Government
increases with rising prices. During periods of Economic planning, large invest
ments have to be made in the Public sector. The saving capacity of the people is
reduced, and the invested amounts become less and less valuable which makes it
difficult to raise loans. Additional deficit financing is likely to increase inf
lation further. Thus, it becomes imperative for the government to reduce its exp
enditure on development plans. Several expansion programs have to be dropped. In
flation mostly affects the schemes to improve educational, medical aid, research
and other social welfare programs. Effect on Currency: If inflation rises very
rapidly, people loose faith in the currency and the currency cannot function as
a currency at all. This endangers the very existence of the economy.
b)
c)
d)
e)
4)
Non- Economic Effects :
There are several political and social effects. These are very serious and may c
ontinue to be in existence for a very long period of time. The gap between the r
ich and the poor widens. Those who toil and moil continue to become poorer, and
those who hold important positions, go on amassing wealth. This puts an end to h
armony and understanding in society. Morality and business ethics are violated a
nd people do not hesitate to do
312
anything unscrupulous to become rich quickly. Thefts, dacoity, gambling and othe
r social evils become rampant. Demonstrations, arson and looting becomes very co
mmon and there is difficulty in maintaining law and order. Political stability i
n the country is endangered. The desire to amass wealth and become rich as early
as possible gives rise to bribery, corruption, favouritism etc. Once the seeds
of corruption are sown corruption spreads very easily and becomes all- pervasive
. This gives rise to several social, economic and political evils.
MACRO POLICIES
INTRODUCTION Business cycles i.e., fluctuations in the economic activities, caus
e not only harm to business but also misery to human beings by creating unemploy
ment and poverty. Economists and the government have, of late, felt concerned wi
th the business cycles and suggested various ways and means to control the econo
mic fluctuations. The experience of the Great Depression and Keynesian revolutio
n in mid - 1930s assigned a big role to the government in economic growth, emplo
yment and preventing business fluctuations. Therefore, the government interventi
ons with the economy all over the world increased in a big way. The free enterpr
ise economies not only entered the production of commodities and services but al
so adopted a number of fiscal and monetary measures to control and regulate the
economy and prevent violent economic fluctuations. The governments in many devel
oping countries like India assumed the role of a key player in economic growth,
employment and stabilization. The problems similar to those faced in the differe
nt phases of the trade cycle are being faced by the world in modern times. The m
ajor stabilisation problem in the developing countries is the problem of control
ling prices and preventing growth rate from sliding further down. For developed
countries maintaining the growth rate to, fight against recession world over are
the major stabilisation problems. We have discussed below the major macro econo
mic stabilisation policies which are relevant to the current problems of the wor
ld.
1)
Full Employment
Full employment is the commonly accepted goal of macro economic policy in a deve
loped country. The classical economists assumed that full employment is automati
cally attained by a free and competitive market economy in the long run. Keynes,
however, pointed out that full employment in practice is a rare phenomenon. Act
ually an economy attains equilibrium at under employment level. Accepting Keynes
ian argument, countries have set full employment as an important goal in their m
acro - economic policies.
313
In the technical language of macro - economic analysis, full employment is viewe

d as an equilibrium situation in which the sum of the demands in all labour mark
ets tends to be equal to the sum of the supplies, though, of course, in many of
these markets, there is the likelihood of an excess of demand over supply, or of
supply over demand, Keynes also provides an alternative definition of full empl
oyment in that it is "a situation in which aggregate employment is inelastic in
response to an increase in the effective demand for its output." He, therefore,
suggested that an economic policy aiming at achieving full employment, should be
designed to uplift the effective demand appropriately.
2)
Economic Stabilisation
Stabilisation broadly means preventing the extremes of ups and downs or booms an
d depression in the economy without preventing factors of economic growth to ope
rate. It also implies preventing over and under - employment. Stabilisation does
not mean rigidities, it should permit a reasonable degree of flexibility for s
elf - adjusting forces of the economy. The major objective of stabilization pol
icies are : (i) (ii) preventing excessive economic fluctuations, efficient utili
zation of labour and other productive resources as far as possible;
(iii) encouraging free competitive enterprise with minimum interference with the
functioning of the market economy. The two most important and widely used econo
mic policies to achieve economic stability are (i) fiscal policy; and (ii) monet
ary policy. a) Fiscal Policy :
The fiscal policy refers to the variations in taxation and public expenditure
programmes by the government to achieve the predetermined objectives. Taxation i
s a measure of transferring funds from the private purses to the public coffers;
it amounts to withdrawal of funds from the private use. Public expenditure, on
the other hand, increases the flow of funds into the private economy. Thus, taxa
tion reduces private disposable income and thereby the private expenditure, and
public expenditure increases private incomes and thereby the private expenditure
. Since tax-revenue and public expenditure form the two sides of the government
budget, the taxation and public expenditure policies are also jointly called as
budgetary policy. Fiscal or budgetary policy is regarded as a powerful instrum
ent of economic stabilization. The importance of fiscal policy as an instrument
of economic stabilization rests on the fact that government activities in modern
economies are greatly enlarged, and government
314
tax-revenue and expenditure account for a considerable proportion of GNP, rangin

g from 10 - 25 per cent. Therefore, the government may affect the private econom
ic activities to the same extent through variations in taxation and public expen
diture. Besides, fiscal policy is considered to be more effective than monetary
policy because the former directly affects the private decisions while the latte
r does so indirectly. If fiscal policy of the government is so formulated that i
t during the period of expansion, it is known as counter - cyclical fiscal poli
cy . b) Monetary Policy :
Monetary policy refers to the programme of the Central Bank s variations, in the
total supply of money and cost of money to achieve certain predetermined object
ives. One of the primary objectives of monetary policy is to achieve economic st
ability. The traditional instruments through which Central Bank carries out the
monetary policies are : Quantitative Credit Control Measures such as open market
operations, changes in the Bank Rate (or discount rate), and changes in the sta
tutory reserve ratios. Briefly speaking, open market operation by the Central Ba
nk is the sale and purchase of government bonds, treasure bills, securities, etc
., to and form the public. Bank rate is the rate at which Central Bank discounts
the commercial banks bills of exchange or first class bill. The statutory rese
rve ratio is the proportion of commercial banks time and demand deposits which
they are required to deposit with the Central Bank or keep cash - in - vault. Al
l these instruments when operated by the Central Bank reduce (or enhance) direct
ly and indirectly the credit creation capacity of the commercial banks and there
by reduce (or increase) the flow of funds from the banks to the public. In addit
ion these instruments, Central Banks use also various selective credit control m
easures and moral suasion. The selective credit controls are intented to control
the credit flows to particular sectors without affecting the total credit, and
also to change the composition of credit from undesirable to desirable pattern.
Moral suasion is a persuasive method to convince the commercial banks to behave
in accordance with the demand of the time and in the interest of the nation. The
fiscal and monetary policies may be alternatively used to control business cycl
es in the economy, though monetary policy is considered to be more effective to
control inflation than to control depression. It is however, always desirable to
adopt a proper mix of fiscal and monetary policies to check the business cycles
.
315
Exercise : 1. 2. 3. Define Macro Economics. Explain the nature and scope of Macr
o economics. Explain J. M. Keynes analysis of income determination in the conte
xt of the principle of Effective Demand. Write Short notes on : a) Factors deter
mining Effective Demand b) Consumption Function c) Investment Function d) Fiscal
Policy e) Monetary Policy. 5. 6. 7. 8. Explain with an illustration, various ph
ases of Business Cycle. Define Inflation. Explain the Causes of Inflation. What
are the consequences of Inflation? Explain Macro Economic Polices with special e
mphasis on a) Full Employment and b) Economic Stabilization.
4.
316
NOTES
317
NOTES
318
Chapter 9
GOVERNMENT AND PRIVATE BUSINESS
Preview Introduction, Need for government intervention in the market, Price Cont
rols(Indian Experience),Causes of Price rise in India, Price controls in India,
Support prices and Administered Prices, P.D.S., Protection of consumers interes
t; Economic Liberalization, Process of Disinvestment - need and methods, Disinve
stment of PSU in India, Policy Planning as a guide to overall business developme
nt. INTORDUCTION In our discussion of business decisions regarding production, p
ricing, investment etc, in previous chapters, we assumed the existence of a fre
e enterprise system in which there is the least interference by the State with
the choices, preferences and decisions of the individuals regarding their econom
ic pursuits. The real life situation is however quite different even in the free
enterprise economies, let alone the State-controlled economies. The government
holds tremendous authority not only to influence the private business decisions
but also to control and regulate, directly and indirectly, the private business
activities. By using its powers, the government can enact the laws against produ
ction, sale and consumption of certain goods; can prevent the entry of private e
ntrepreneurs to certain industries through its Industrial Policy, can limit the
growth of private firms beyond a certain limit (e.g., MRTP Act.); and can nation
alize the industries whenever it thinks necessary and desirable. Another form of
government intervention with private business is formulation and implementation
of various kinds of economic policies such as fiscal policy, monetary or credit
policy, industrial licensing policy, commercial policy, exchange control policy
, etc. Besides, the government affects private business also in its capacity of
a competitor in the input market. Public sector industries being owned and manag
ed by the government get a preferential treatment in the allocation of scarce in
put. All these activities and policies of the State are the various forms of int
ervention with the free enterprise system, which affect the private business act
ivities. The interference raises several questions: Is government intervention w
ith free enterprise inevitable?
Government and Private Business
319
If yes, what should be the limit of government intervention or the limit of gove
rnment economic activities? How can the public and private sector in a mixed eco
nomy work in cooperation and coordination with each other? How and to what exten
t do the governments economic policies affect the private business ? We shall ans
wer some of these questions in this part of the book. 1) NEED FOR GOVT. INTERVEN
TION:
The need for government intervention with the functioning of free market mechani
sm has arisen out of failure of free market economy expected to ensure (i) that
all those who are willing to work at prevailing wage rate get employment; (ii) t
hat all those who are employed get their living in accordance with their contrib
ution to the total output, (i.e., their productivity); (iii) that factors of pro
duction are optimally allocated between the various industries; and (iv) product
ion and distribution pattern of national product is such that all get sufficient
income to meet their basic needs - food, clothing, shelter, education, medical
care, etc. The world has however experienced that the free enterprise system has
failed to orgainse the economy which would satisfy the above requirements. The
failure of the free market economy is attributed to its following shortcomings.
Shortcomings of Market System/ Limitations or Defects of Market System : Followi
ng are the important limitations of the market mechanism (i.e. of market economy
or capitalism) :
(i)
Inequalities of Income and Wealth :
One of the serious limitations of market mechanism is that it results in extreme
ly unequal distribution of income and wealth. In a free competitive economic sys
tem, those with productive resources or intellectual abilities find it easy to o
btain rising income and wealth, whereas those who have no productive resources o
r mental abilities do not get much share in annual national income and wealth. A
nd the number of such people in any society is generally so great that they cons
titute the majority. Thus, market mechanism results in unequal distribution of i
ncome and wealth and their concentration in the hands of a few people in society
. The rich go on becoming richer, while the poor who constitute majority continu
e to remain poor. These economic inequalities give rise to social and political
unrest disturbing social and political peace in the country.
(ii)
Emergence of Monopolies:
It is observed from the economic histories of the United States and West Europea
n countries that competition which is the heart of market mechanism itself gives
rise to monopolies. If for example there are a number of producers of a commodi
ty, the efficient ones who are always few because of uneven distribution of orga
nizational abilities among people, will begin to absorb the inefficient ones. Th
e final result is that only one (absolute
320
monopoly), two (duopoly) or a few (oligopoly) units in the industry remain. Thes
e units naturally begin to enjoy monopolistic power exploiting both consumers an
d workers. Also, these monopolies establish political lobbies and through corrup
tion and other favors to legislators get suitable legislation passed thus protec
ting their own interests and sacrificing the interests of vast body of consumers
.
(iii) Failure to Provide Full Employment :
It was assumed that under competitive conditions, market mechanism or price mech
anism would automatically bring about and establish equilibrium at the level of
full employment. J. M. Keynes however showed that due to several rigidities (esp
ecially wage rigidities due to emergence of trade unions in the labour market),
it so happens that the economy may get established at the level of less than ful
l employment. Thus market mechanism does not ensure full employment of labour fo
rce. Thus the labour force which could have produced much needed wealth lies une
mployed and is wasted.
(iv) Instability :
Market economy or private enterprise economy is a planless economy. In such an e
conomy where millions of consumers and millions of producers are taking their ow
n independent decisions, it is rarely that some sort of balance would be achieve
d between demand for thousands of commodities and their supply. This imbalance g
ives rise to frictional disturbances and cyclical booms and depressions. It is i
nconceivable that the modern complex economy involving millions of commodities a
nd millions of consumers and producers would always work smoothly. Market econom
y is bound to be characterized by great instability.
(v)
Wastages of Market Economy :
As we have seen, market system or market economy suffers from time to time from
economic depressions. During period of depression various factors of production
lie unutilized. These factors could have been used to produce much needed wealth
for the poorer sections of the society. Secondly, we have seen that competition
often gives rise to monopolies. Often these monopolies purposely keep certain f
actors of production idle creating artificial scarcities of their products with
a view to raise prices to the maximum, if such a step gives maximum profit. Thus
under monopoly there is tremendous wastages of productive resources. In those l
ines of production where competition exists, there appear what may be called was
tages of competition. Thousands of units in the same industry take independent d
ecisions regarding production. Often there is over-production in some industries
and there is under-production in certain other industries.
321
Also, in a competitive regime, there are wastages of advertisement. Hundreds of

producers of a similar commodity spend vast amounts on advertisement. Since riva
ls are advertising, it is possible that the final effect of advertisement by riv
al parties is neutralized. This would mean that great amount of labour and other
resources employed for advertisement are wasted. While some advertisements are
truly informative most are misleading and therefore, the claim that under free e
nterprise system or market system competition leads to the most efficient use of
community s various productive resources is not valid. On the contrary capitali
sm abounds in wastages due to unemployment, over and underproduction and vast ex
penditure on advertisements necessitated by cut-throat competition among rival f
irms.
(vi) Indifference to and Sacrifice of Social Welfare :
In a market economy or free enterprise economy, production of goods and services
is all guided by the aim of securing maximum private profit. Goods are produced
for which there is greater demand. That is how in capitalism luxury and semi-lu
xury goods, which richer sections of the community can afford to buy because the
y have the necessary purchasing power, get preference over production of mass co
nsumption goods needed by poorer sections of the community. Their production is
neglected in preference to production of luxury and semi-luxury goods for richer
sections of society. This means that very little attention is paid to the welfa
re of the society.
(vii) Poverty in the midst of Plenty :
In a market economy, inspired by private profit motive, tremendous technological
progress has taken place. This has tremendously increased productive powers of
the economy and production of various goods and services. But due to the institu
tion of private property and law of inheritance and succession (which are basic
features of free enterprise system of economy), rich become richer who continue
to exploit the vast poor masses. The vast masses of people living on bare minimu
m wages prevailing under competitive conditions cannot get continually rising sh
are in the increasing productivity and production of wealth in the commodity. In
a free enterprise economy, there is thus observed the existence of contradictor
y position of poverty in the midst of plenty.
(viii) Undesirable Psychological and Social Effects :
Capitalism with emphasis on private profit motive and money making has great adv
erse social, cultural and psychological effects. In capitalism, money becomes th
e yardstick of measuring success in every field - art, music, literature and so
on. Art, music and literature all come to be judged by their financial success a
nd not on the basis of their inherent quality or merit.
322
Emphasis on private profit motive and on money-making arouses in capitalist regi

me instincts of acquisitiveness, unscrupulousness, combativeness and immorality
suppressing good human instincts like kindness, love, cooperation and considerat
ion for the welfare of others.
(ix) Exploitation of Backward Countries and World Rivalry :
The developed capitalist countries, with a view to make higher and higher profit
s, have been exploiting backward countries in Africa and Asia through great mult
i national corporations and through the sale of arms and ammunition to both the
opposing parties or countries (Arabs versus the Jews, India versus Pakistan, etc
.) just because the defence industries owned by rich capitalists in Western coun
tries should make rising profits. Developed capitalist countries are putting res
trictions on exports from developing or backward counties thus hampering their r
apid economic development. Giant multi national corporations try to subvert nati
onal governments opposed to their interests by sabotage and various other method
s. All this has led to international rivalry, disturbances and violence which go
against economic development of poor and backward countries in Asia. Africa and
Latin America. Concluding Remarks: It would thus be seen that while free enterp
rise economy or market system has some solid achievements to its credit, it also
suffers from very serious limitations or evils, affecting both its own working
and that of other countries. 2) PRICE CONTROLS IN INDIA
CAUSES FOR RISE IN PRICES IN INDIA: A strong inflationary pressure has been buil
t into the Indian economy for a long time - precisely from the start of the Seco
nd World War - partly through ever-mounting demand on the one side and inadequat
ely rising supply on the other. The expanding demand is due to the rapid growth
of our population, rising money income, expansion in money supply and liquidity
in the country, rising volume of black money and continuous rise in demand for g
oods and services due to periodic wars, rapid economic development, etc. Supply
of goods and services too has been rising but the rise in supply has not been pr
oportionate and matching the rise in demand; this is due to monsoon, use of back
ward technology, bottlenecks in transport and power and shortages of various inp
uts. At any given time, therefore, there is demand and supply imbalance. Let us
emphasize some of the causes behind the inflationary rise in prices in India in
recent years.
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A.
DEMAND PULL FACTORS (i)
Mounting Government Expenditure - Government expenditure has been steadily incre
asing over the years. The total expenditure of both Central and State Government
s including Union Territories had risen from nearly Rs.740 crores in 1950-51 to
Rs.37000 crores in 1980-81; and nearly Rs.5, 69,400 crores in 19992000 an more t
han Rs. 11,000 crores in 2003 approximately. In a predominantly agricultural eco
nomy like India, big programmes of economic development involving huge investmen
ts have been undertaken. Mounting government expenditure implies a growing deman
d for goods and services and thus, is an important factor for the rise in price.
Beside, continuous increase in government expenditure has the effect of putting
in large money income in the hands of the general public and causing the fire o
f inflation. Deficit Financing and increase in money supply - the Government of
India is responsible for adopting deficit financing as a method of financing eco
nomic development.
Mounting Government expenditure financed through deficits pushes up the money su
pply in the country and consequently pushes up the public demand for goods and s
ervices. The Government of India has been responsible for the inflationary situa
tion in the country through its policy of deficit financing and state government
s contributed their share through their persistent financial indiscipline, reckl
ess expenditures and unauthorized over-drafts.
(ii)
(iii) Role of Black Money - It is well-known that there is a large accumulation
of unaccounted money in the hands of income-tax evaders, smugglers, builders and
corrupt politicians and government servants estimated at Rs.6,00,000 crores in
1997-98. There is considerable slush money with politicians and Government serva
nts, especially those dealing with licensing, registration, collection of taxes,
etc. A large part of the unaccounted money is used in buying and selling of rea
l estate in urban areas, extensive hoarding and black marketing in many essentia
l and inflation - sensitive goods, such as sugar, edible oils, etc. It is diffic
ult to estimate the amount of black money or the precise influence of this money
in pushing up prices but there is no denying the fact that one of the important
factors responsible for inflationary pressures in recent years is the existence
and the active role of black money. (iv)
Uncontrolled growth of population - It is the continually rising population in I
ndia which is responsible for the persistent gap between demand and supply, in a
lmost all consumer goods and services, thus exerting continuous pressure on pric
es.
324
B.
COST - PUSH FACTORS If supply of goods and services can be increased to correspo
nd with every increase in demand, price level will tend to be stable. Prices, ho
wever, rose whenever the production of food grains and other consumer goods decl
ined or was stagnant. (i)
Fluctuation in output and supply - In this connection, we may refer to violent f
luctuations in food grains output.
Such huge fluctuations in the output of food grains in certain years was a major
factor in the rise of food grains prices as well as general prices. Likewise, w
e may also refer to the fact that the supply of manufactured goods, did not incr
ease adequately in certain periods. Power breakdowns, strikes and lock-outs and
shortage of transport facilities are major factors for lower rate of production
of manufactured goods. With ever rising demand for manufactured products, the pr
oducers are in a position to push up the prices of their products. Apart from fl
uctuations in production, market arrivals have also tended to be erratic. In fac
t, the upward pressure on agricultural prices is also due to large hoarding by f
armers, and hoarding and speculation of food grains by traders and blackmarketee
rs. At one time, hoarding was done only by middlemen but now farmers have also j
oined the traders in this vicious game. With increased credit facilities from th
e cooperative societies and commercial banks, even small farmers have now more h
olding capacity. They hold on to their stock in anticipation of higher prices.
(ii)
Taxation, as a factor in rising costs - Cost-push factors consist mainly of rise
in wages, profit-margins and rise in other costs. In this connection the govern
ment and the public sector were also responsible, to a large extent, for pushing
up the price level in the country. With every budget, the government imposed fr
esh commodity taxes and gave an opportunity to the trading classes to raise the
prices, often more than the levy of the taxes.
(iii) Administered price - The public sector enterprises too were continuously r
aising the prices of their products and services which generally constitute raw
materials for other industries. A good example is the Railways which have been r
egularly raising fares and freight rates in the last few years. Likewise, there
has been regular upward revision of several administered prices such as those of
petrol, diesel, steel, cement, coal, etc., pushing up the price level further.
Every rise in administered prices adds fuel to the inflationary potential in the
country. (iv)
Hike in oil prices and global inflation - Serous inflationary pressures were als
o created because of the sharp hike in the price of crude oil since September 19
73 and the consequent upward revision of the prices of oil and oil-based goods.
In 1980 alone, there was 130 per cent increase in all fuel prices by the OPEC. T
he
325
gulf-surcharge which raised the prices of petroleum products to an unprecedented

level in one single jump is major cause for rise in price during 1990-91. C. OT
HER FACTORS The failure of the Government policy on the price front at various t
imes was a serious factor in the inflationary rise in prices. We can cite specif
ic cases. In 1973, the Government nationalized the wholesale trade in wheat alon
g with a threat to introduce a similar measure for rice. This measure completely
upset the normal trade and the price of open market wheat shot up. At the same
time, the government did not fail to procure adequate amount of food grains for
the public distribution system, nor was it able to import the necessary quantity
from foreign countries. The Government of India has generally followed a highly
vacillating and anti-peasant policy in fixing procurement prices. This is equal
ly true in fixing and controlling prices of such essential goods as sugar, vanas
pati, soap, cloth, etc. Nor are the controls properly enforced thus giving great
scope for rampant black-marketing to exist, for the benefit of the traders.
Causes for inflationary pressure in the 90 s and after 2000
All the causes we have discussed above are basic causes for the existence of gen
eral inflationary pressure in the Indian economy and they have been present and
active over the last many years. The immediate cause for the pressure on prices
since, 1990, as mentioned earlier, was the Gulf War and the consequent shortages
and increase in the prices of administered items such as coal, petroleum produc
ts, fertilizers, electricity, etc. According to the Government, the buildup of i
nflationary pressure during the Nineties was mainly attributable to: (a)
Higher fiscal deficit - large and persistent fiscal deficits over the years resu
lting in excessive growth in money supply and liquid resources with the communit
y: there was automatic monetization of fiscal deficit. Sharp reserve money (RM)
during the three years (1993-96) due to large inward remittances and heavy accum
ulation of net foreign exchange assets with RBI; this was the basis of the rise
in money supply and liquid resources with the general public at that time; Suppl
y-demand imbalances - sensitive commodities like pulses, edible oils, and even o
nions and potatoes due to shortfalls in domestic production; and
A sharp increase in procurement prices of cereals and consequent rise in the iss
ue price; The 9/11 attack on W.T.C. (U.S.A.); U.S. and allied forces invading Af
ghanisthan, Iraq and take-over of the Iraq by U.S. and allied forces global rece
ssion etc.
(b)
(c)
(d) (e)
326
3)
PRICE CONTROLS IN INDIA :
A wide range of measures are being adopted to ensure stable conditions as well a
s to prevent speculators form taking an undue advantage of the conditions of sca
rcity. Since the price situation is the outcome of shortages in basic goods and
services and a rapid growth in money supply and bank credit, various types of me
asures relating to money supply, pricing and distribution of commodities are pre
ssed into service.
Demand Management
(i)
Fiscal measures - The Government of India has generally insisted on controlling
its own expenditure and keeping in check both its revenue deficit and fiscal def
icit - this has been a major instrument of inflation - control. In July 1974, fo
r example, the Government of India promulgated three ordinances to limit the dis
posable money incomes in the hands of consumers through freezing wages and salar
ies on the one side and dividend incomes on the other. Again in January 1984, th
e Government of India announced a package of programmes to curtail public expend
iture, to postpone fresh recruitments to Government job etc.
It was only since 1990-91 that the Government of India has appreciated the impor
tance of reducing fiscal deficit. The Government of India since 1991-92 restrict
ed its borrowing from RBI through the issue of ad hoc treasury bills and thus re
duced the issue of new currency. These measures, along with monetary measures he
lped to contain the volume of monetary measures helped to contain the inflationa
ry pressure on price since 1995-96.
(ii)
Monetary measures - The monetary policy of RBI consists of extensive use of gene
ral and selective credit control measures. The main thrust has been to restrict
bank-credit against inflation sensitive goods and to influence the cost and avai
lability of commercial bank credit. The RBI relies heavily on selective credit c
ontrols on bank loans against food grains, cotton, oil-seeds and oils, sugar and
textiles so as to discourage speculative hoarding.
During the Eighties and Nineties, monetary policy has been directed essentially
to prevent any excessive increase in liquidity and at the same time to ensure th
at the genuine credit requirements of the industrial sector and the priority sec
tors are adequately met. The cash reserve ratio (CRR) was raised from 6 to the s
tatutory maximum of 15 per cent gradually. These steps resulted in a large measu
re, in mopping up excess liquidity in the economy, moderating monetary and cred
it expansion and consequently helped in bringing down the rate of inflation.
327
In general, RBI uses its monetary policy to achieve a judicious balance between
the growth of production and control of the general price level. Generally RBI u
ses Bank Rate, CRR., SLR and open market operations to increase bank credit and
expansion of business activity (in times of business recession) or to contract b
ank credit and check business and speculative activity (in periods of inflation)
.
Supply Management
Supply management is related to the volume of supply and its distribution system
. On the commodity front the Government has generally focused its attention in s
ecuring greater control over the prices of rice, wheat, sugar, oils and other co
mmodities of mass consumption. Through increase in domestic supplies, large rele
ases from official stocks and widening and streamlining of the network of public
distribution, the Government attempts to prevent an undue increase in the price
s of essential commodities. Let us touch some of the important aspects of this p
olicy. (a)
Fixation of Maximum Prices - For elimination the incentive for hoarding and spec
ulative activity in food grains, the State Governments have been asked to fix th
e wholesale and retail prices of food grains. Further, the Government also fixes
minimum procurement prices for major crops on the recommendation of the Agricul
tural Prices Commission (APC). Prices of other important goods like cloth, sugar
, vanaspati, etc., are also controlled. The system of dual prices - The Governme
nt has adopted a system of dual prices in the case of goods like sugar, cement,
paper, etc. Under this system, the weaker sections of the community are supplied
these goods through fair price shops, at controlled prices and the rest and all
owed to purchase their requirements at higher prices from the open market. Incre
ase in Supplies of Food grains - The Government attempts to increase supplies of
food grains and other essential goods in times of internal shortage through lar
ger imports. Problem of oilseeds and edible oils - In recent years, steep rise i
n the prices of edible oils along with those of pulses, tea and sugar have been
responsible for rise in the general price level. The Government has prepared med
ium and long-term plans to step up the production of oilseeds in the country. Th
e Government has announced higher support prices for groundnut, soybean and sunf
lower seed - the last two crops offer the maximum scope for augmenting the suppl
y of edible oil in the country. In the short period, the Government has been rel
ying on imports of edible oils, at reduced or confessional import duties.
In this connection, we should refer to the steps taken by the Government to incr
ease the production of all other agricultural products.
(b)
(c)
(d)
328
(e)
Public Distributions System (PDS) and consumer protection - An important aspect
of the Government s policy was strengthening of the PDS. The Government has set
up a network of fair price shops numbering nearly 4,00,000 which cover a populat
ion of over 5million and which distribute wheat, rice, sugar, imported edible oi
ls (palm oil), kerosene, soft coke and controlled cloth. The public distribution
system serves two purposes. Firstly it helps to hold down prices. Secondly, it
provides essential commodities to low income groups at relatively low prices. Bu
t whenever the PDS is hard pressed due to inadequate supply, prices of essential
goods tend to rise. PDS has been strengthened and extended to rural areas. Cont
rol over Private Trade in Food grains - To check prices and to eliminate hoardin
g and speculative activity in food grains trade, wholesale dealers in food grain
s were licensed in many States. Limits were also fixed beyond which traders and
producers could not hold stock without declaration. The Food Corporation of Indi
a has helped a lot to buy in surplus areas and sell in deficit areas and thus mo
derate the differences in prices. Other relevant measures by Government of India
to control inflation. i) ii) Adoption of OGL (Open General License) import poli
cy for importing sugar, pulses etc. Adjustment in trade and tariff policies in t
he Central Government Budgets to ensure their domestic prices of Industrial prod
ucts remain competitive. Great reduction in excise duties on a numbers of items
expected to accelerate the speed of industrial revival and raise industrial grow
th.
(f)
g)
iii)
(1)
Administered Prices :
The Government of India follows administered price policy in respect of commodit
ies which are either vital industrial raw materials, produced wholly or largely
in the public sector such as steel, fertilizer, coal and petroleum products. The
Government also fixes the rates and charges of public utilities like railways a
nd state electricity boards. The products and services produced by the public se
ctor in India constitute important raw materials for other industries and are su
bject to serious output and price fluctuations. Administered prices are normally
set on the basis of cost plus a stipulated margin of profit. There are two basi
c objectives of administered prices. : (i) to fix and maintain the prices of ess
ential raw materials so to avoid cost and price escalation; this has special sig
nificance during a period of shortages and rising prices; and to ensure economic
prices to uneconomic units so that the latter too can earn profits. 329
(ii)
Whenever there is a change in cost, the administered price is also changed. As t

he Government is generally slow and sluggish in its actions, the change in admin
istered prices may not be proportionate to change in cost and, besides, the chan
ge in price may come much later than change in cost. In fact, this has been a ma
jor criticism against administered prices in India. As the administered prices a
re often inadequate to meet cost escalation, basis industries like fertilizers a
nd cement were unable to generate sufficient financial resources for modernizati
on and expansion. The present policy of the Government is to adjust administered
prices to enable public sector units to earn sufficient profits and over a peri
od of time give up the system of administered prices.
(2)
The System of Dual Prices :
It is a commonly accepted principle in India that the basic needs of the weaker
sections of the community should be met and for this the Government should subsi
dies the prices of certain basic goods. This does not mean that the benefit of s
ubsidy and low price should go even to those who do not require it. At the same
time the burden of subsidy should not fall on the producers of these basic goods
but should be spread on the community as a whole. Such a policy is (a) in the i
nterest of the vulnerable sections, and (b) it does not discourage the producers
from expanding production and investment in the particular sector. Originally s
tarted with the price of steel, dual pricing was extended to many other essentia
l goods such as major food grains, sugar, edible oils, and cheaper varieties of
cotton cloth. Dual pricing is a form of short cut price control and it enabled t
he Government to acquire essential goods at lower controlled prices for its own
use, even though it was meant to benefit the weaker sections.
(3)
SUPPORT / PROCUREMENT PRICES : A proper price policy will have to include measur
es directed towards cereals, pulses and oil-seeds viz. their production, purchas
e, movement, sale and distribution. The level at which agricultural prices shoul
d be stabilized is important from the point of view of production and consumptio
n. In fixing food grain prices, three aspects may be kept in mind : (a) The Gove
rnment should fix and guarantee such procurement prices for various food grain a
s will provide suitable incentives to the producers. This is particularly import
ant as the volume of production has increased considerably under the influence o
f the "green revolution". The retail prices should be fixed in such a way that t
he interests of the consumers are safeguarded and at the same time there is no s
cope for hoarding
(b)
330
and speculation. Food zones are abolished and inter-state movement of the food g
rains is the monopoly of the Food Corporation of India. (c) Holding the price li
ne covers not only to cereals, but to all basic consumption goods as for instanc
e pulses, sugar, oil and vanaspati, cloth, kerosene, etc.
The Government of India announces support prices on the recommendations of the A
gricultural Prices Commission, redesignated as Commission for Agricultural Costs
and Prices. The Commission is guided in recent years by the three-fold objectiv
es of (a) (b) (c) raising productivity through assured remunerative prices to fa
rmers ; procuring sufficient quantities of rice and wheat for running the public
distribution system; and promoting a desirable inter-crop balance.
While making recommendations to the Government regarding revision of minimum pro
curement and support prices, the Commission takes into account, among other thin
gs, the changes in production costs, the inter-crop balance and the terms of tra
de between agriculture and other sectors of the economy. The basic framework for
determining support prices for major cereals has been relatively fair. The inte
rests of both farmers and general consumers have been well protected. But there
are a number of distortions: One is the announcement of higher minimum prices by
state Government to satisfy local interests. Another is that support prices for
coarse grains, pulses and oilseeds are of a notional nature and are not backed
by an organized system of official procurement. In these case also, support pric
es should be rationally determined (as in the case of wheat and rice) and should
be made effective through public purchases and public distribution.
(4)
Public Distribution System :
Rationale of PDS : The distribution of essential commodities through fair price
shops at government - controlled prices has come to be known as public distribut
ion system. There are various reasons for the setting up of the public distribut
ion system in India. 1) In order to maintain stable price conditions, an efficie
nt management of the supplies of essential consumer goods is necessary. Moreover
, as most of these commodities are agriculture-based, their prices are subject t
o large seasonal variation. Public distribution system will, therefore, have to
play a major role in ensuring supplies of essential consumer goods of mass consu
mption to people at reasonable prices, particularly to the weaker sections of th
e community. 331
State trading and buffer stock operation on the one side and public distribution
on the other are essential in the case of agricultural products. 2) A large pro
portion of agricultural products - both food grains and raw materials - come to
the market soon after the harvest when prices are depressed. It is necessary to
devise a scheme to buy such commodities at prices which ensure a certain minimum
profit to the farmers. The Food Corporation of India (FCI) and other institutio
ns have been set up to buy agricultural goods at prices that would ensure minimu
m profit for the farmers; they also help in stabilizing agricultural process. At
the same time, these goods would be supplied through public channels to consume
rs especially the weaker sections of the community - this would mean that in cri
tical times, they would receive supplies of essential commodities at reasonable
prices. The PDS has become a stable and permanent feature of India s strategy to
control prices, reduce fluctuations in prices and achieve an equitable distribu
tion of essential consumer goods among the people.
3)
Goods to be included in the public distribution system. Since distribution is a
highly complex matter, only the most essential goods of mass consumption should
be brought under the public distribution system, e.g. cereals, sugar, edible oil
s and vanaspati, kerosene, soft coke, controlled cloth, tea, toilet soap and was
hing soap, match boxes, exercise books for children, etc. Supplies to the public
distribution system. Both Central and state Governments have made arrangements
to procure essential commodities and supply them through the public distribution
outlets. In the case of food grains, FCI undertakes the necessary operations. I
n regard to sugar, FCI undertakes these operations. The State Trading Corporatio
n (STC) has been entrusted with the responsibility of importing and distributing
edible oils. Kerosene is being handled by the public sector corporations like I
ndian Oil Corporation (IOC), Hindustan Petroleum, Bharat Petroleum, etc. The pro
duction of controlled cloth has now been generally entrusted to the National Tex
tile Corporation (NTC) and distributed through the National Consumers Co-operati
ve Federation (NCCF). 5) PROTECTION OF CONSUMER INTEREST:
The consumer who is often considered as the king is practically enslaved by the
aggressive and dominant market manipulations by the large-sized corporations. Th
e tug-of-war between monopoly producers and scattered consumers obviously works
to the advantage of the producers. This is why Prof. J.K.Galbraith favoured the
organization of the advantage of the producers. This he termed countervailing po
wer. A consumer s interest has several facets and
332
its protection amounts to empowering the consumer. Such an empowerment can be ac

hieved by the consumers themselves by organizing together and further by creatin
g consumer s cooperatives. Such an option is difficult to achieve, especially wh
ere the consumers are spread over a vast area and where they lack in awareness,
education and organizational ethics. It is under these conditions that the gover
nment is called upon to step in, in order to protect the consumer s interest. On
e way of protecting the interest of the consumers is the formation of their co-o
peratives. But due to various limitations it is lengthy and tedious process. The
refore, the government, at best, can announce a set of concessions and facilitie
s for their development. The direct way with which we are concerned here is an e
ffective intervention in the price system and in the supply of commodities by un
dertaking legal measures. The consumer Protection Act, 1986, in India is such an
effort. The act provides for the settings up of quasi-judicial bodies at the di
strict, state and central levels for the redressal of consumer protection act wh
ich provides for reliefs and compensation to the consumers wherever deemed appro
priate. A consumer s interests or rights as enunciated by The Consumer Protectio
n Act 1986 are as follows: i) Protection from Hazardous Commodities: A consumer
is within his right to demand protection against the marketing of goods and serv
ices which are hazardous to life and property. Right to Information: A consumer
has a right to the information regarding the quality, quantity, potency, purity,
standard and the price of goods and services as the case may be, so that he can
protect himself against unfair trade practices like being misguided and cheated
. Right to a competitive Price: Wherever possible, the consumer must be assured
of an access to a variety of goods and services at a competitive price. This rig
ht, on the one hand accepts the freedom of retailers from the exploitative condi
tions imposed by the producers and on the other hand, contains the monopoly powe
rs of the producers. Right to be Heard: The establishment of appropriate forums
at various levels aims at hearing the grievances of the consumers. Right to Info
rmation regarding Protection: By passing an act the interests of the consumers c
annot be protected unless the consumers have full knowledge of the protection gi
ven to them. It is therefore, necessary to educate the consumers in this protect
ion given to them. It is therefore, necessary to educate the consumers in this r
egard.
ii)
iii)
iv) v)
Consumers protection involves protection from unfair trade practices for the pur
pose of promoting sales and making money at the cost of the consumers health and
wellbeing. Such practices include; a) False representation of the quality, quan
tity, grade,
333
composition, style, etc. of the product; b) False claims regarding the quality,
grade or effectiveness of a service; c) False representation regarding re-built,
removed, reconditioned or old goods as new goods; d) False claims regarding spo
nsorship, approval, performance uses or benefits which the goods really do not p
ossess; e) false representation regarding affiliation or authorized dealership;
f) misleading representation concerning the need for or the usefulness of goods/
services; and g) giving as untested or unrealistic guarantee regarding the quali
ty /performance of the goods /services. Protection of a consumers freedom to buy
the goods and services of his choice is necessary, and goods which are found def
ective must be treated as an infringement of his freedom of choice. Therefore, a
ction is required to be taken against the producers/ sellers of substandard good
s and services. For this purpose action based upon certain standards should be l
aid down, like AGMARK or ISI seal, can be taken by the government. Similarly, pr
otection against deficiency in the product or service implying a fault, imperfec
tion, shortcoming or inadequacy in the quality, nature or performance has got to
be accorded. It is necessary to remember that in respect of the protection of c
onsumer s interests, the Consumer Protection Act is not only act concerned. In f
act, the Indian ContractAct, the Sale of Goods Act, the Negotaible Instrument Ac
t, the Banking Regulation Act, the Compines Act etc.,also contain provisions reg
arding protection accorded to the consumers in cases relevant under the Act conc
erned. Because the Consumer Protection Act is specially intended and framed for
this purpose, we have discussed some of the provisions/ considerations of this A
ct. Under the various Acts, in accordance with the provisions in this regard, th
e consumer has to be provided with an access to the machinery evolved for or alr
eady existing to the redressal of his grievances. As such as aggrived parties, t
he consumers can take resourse to filing suits in the relevant course. Obviously
, this whole issue of consumer protection is shrouded with complexities and dema
nds the government to undertake the responsibility of safeguarding the interests
of the consumers not only as consumers but also as ordinary citizens of the lan
d. This is a part of the normal functions of the government and it is in conform
ity with the government s responsibility in the dispensation of natural justice.
As such, it involves various steps by way of creating machinery,monitoring the
performance and penalizing the defaulters. This in turn, created the need for ma
intaining inspection/ supervision personnel, procedures for enforcing the laws a
nd actions for penalizing the defaulters andcompensating the sufferers. Needless
to say that this is a major and pervasive intervention in the system of marketi
ng and pricing. In this context, it is essential to implement fhe suggestions an
d recommendations given by a committee headed by Anna Hazare, a great Social Ref
ormer.
334
6)
THE NEW INDUSTRIAL POLICY (1991) :
The Congress Government led by Mr. Narasimha Rao announced the new industrial po
licy in July 1991. The main aim of the new industrial policy was: (a) to unshack
le the Indian industrial economy form the cobwebs of unnecessary bureaucratic co
ntrol, to introduce liberalization with a view to integrate the Indian economy w
ith the world economy, to remove restrictions on direct foreign investment as al
so to free the domestic entrepreneur form the restriction of MRTP Act, and, The
policy aimed to shed the load of the public enterprises which have shown a very
low rate of return or are incurring losses over the years.
(b)
(c)
(d)
All these reforms of industrial policy led the government to take a series of in
itiatives in respect of policies in the following areas : (a) Industrial licensi
ng; (b) Foreign investment; (c) Foreign technology policy; (d) Public sector pol
icy; and (e) MRTP Act.
Industrial Licensing Policy
In the sphere of industrial licensing, the role of the government was to be chan
ged from that of only exercising control to one of providing help and guidance b
y making essential procedures fully transparent and by eliminating delays. (A) I
ndustrial Licensing to be abolished for all projects except for a short list of
industries related to security and strategic concerns, social reasons, hazardous
chemicals and overriding environmental reason and items of elitist consumption.
Industries reserved for the small scale sector will continue to be so reserved.
List of Industries in Respect of which Industrial Licensing will be Compulsory
1. Coal and Lignite. 2. Petroleum (other than crude) and its distillation produc
ts. 3. Distillation and brewing of alcoholic drinks. 4. Sugar. 5. Animal fats an
d oils. 6. Cigars and cigarettes of tobacco and manufactured tobacco substitutes
. 7. Asbestos and asbestos based products. 8. Plywood, decorative veneers, and o
ther wood based products such as particle board, medium density fiber board, blo
ck board. 9. Raw hides and skins, leather, chamois leather and patent leather. 1
0. Tanned or dressed fur skins. 11. Motor cars. 12. Paper and Newsprint except b
agasse-based units. 13. Electronic aerospace and defense equipment; all types. 1
4. Industrial explosives, including detonating fuse, safety fuse, gun powder, ni
trocellulose and matches. 15. Hazardous chemicals. 16. Drugs and Pharmaceuticals
(according to Drug Policy). 17. Entertainment Electronics
335
(VCRs, Colour TVs, C.D. Players, Tape Recorders). 18. White goods (Domestic Refr
igerators, Domestic Dish Washing Machines, Programmable Domestic Washing Machine
s, Microwave ovens, Air conditioners). The compulsory licensing provisions would
not apply in respect of the small-scale units taking up the manufacture of any
of the above items reserved for exclusive manufacture in small sector. (B) Areas
where security and strategic concerns predominate, will continue to be reserved
for the public sector. List of Industries to be reserved for the Public Sector
1. Arms and ammunition and allied items of defense equipments, Defense aircraft
and warships. 2. Atomic Energy. 3. Coal and lignite. 4. Mineral oils. 5. Mining
of iron ore, manganese ore, chrome ore, gypsum, sulphur, gold and diamond. 6. Mi
ning of copper, lead, zinc, tin, molybdenum and wolfram. 7. Minerals specified i
n the Schedule to the Atomic Energy (Control of production and use) Order, 1953.
8. Railway transport. (C) In projects where imported capital goods are required
, automatic clearance will be given in cases where foreign exchange availability
is ensured through foreign equity; or if the CIF value of imported capital good
s required is less than 25% of total value (net of taxes) of plant and equipment
, up to a maximum value of Rs.2 crore. In ore cases, imports of capital goods wi
ll require clearance form the Secretariat of Industrial Approvals (SIA) in the D
epartment of Industrial Development according to availability of foreign exchang
e resources. (D) In locations other than cities of more than 1 million populatio
n, there will be no requirement of obtaining industrial approvals from the Centr
al Government except for industries subject to compulsory licensing. In respect
of cities with population greater than 1 million, industries other than those of
a non-polluting nature such as electronics, computer software and printing will
be located outside 25 kms of the periphery, except in prior designated industri
al areas.
Foreign Investment
In order to invite foreign investment in high priority industries, requiring lar
ge investment and advanced technology, it has been decided to provide approval f
or direct foreign investment upto 51 per cent foreign equity in such industries.
Foreign Technology
With a view to injecting the desired level of technological dynamism in Indian i
ndustry, government would provide automatic approval for technology agreements r
elated to high priority industries 336
within specified parameters. No permission will be necessary for hiring of forei

gn technicians, foreign testing of indigenously developed technologies.
Public Sector Policy
Public enterprises have shown a very low rate of return of the capital invested.
This has inhibited their ability to regenerate themselves in terms of new inves
tments as well as in technology development. The result is that many of the publ
ic enterprises have become a burden rather than being an asset to the Government
. The 1991 Industrial Policy has adopted a new approach to public enterprises. T
he priority areas for growth of public enterprises in the future will be the fol
lowing : (a) (b) (c) Essential infrastructure goods and services. Exploration an
d exploitation of oil and mineral resources. Technology development and building
of manufacturing capabilities in areas which are crucial in the long term devel
opment of the economy and the long term development of the economy and where pri
vate sector investment is inadequate. Manufacture of products where strategic co
nsiderations predominate such as defence equipment.
(d)
Government will strengthen those public enterprises which fall in the reserved a
reas or are generating goods or reasonable profits. Such enterprises will be pro
vided a much greater degree of management autonomy through the system of memoran
da of understanding. Competition will also be induced in these areas by inviting
private sector participation. In the case of selected enterprises, part of Gove
rnment holdings in the equity share capital of these enterprises will be disinve
sted in order to provide further market discipline to the performance of public
enterprises. There are a large number of chronically sick public enterprises inc
urring heavy losses, operating in a competitive market and serving little or no
public purpose. The following measures are being adopted. (i) BIFR - Public ente
rprises which are chronically sick and which are unlikely to be turned around wo
uld, be referred to the Board for Industrial and Financial Reconstruction (BIFR)
for formulation of revival / rehabilitation schemes. A social security mechanis
m is to be created to protect the interests of workers likely to be affected by
such rehabilitation packages. Disinvestment - In order to raise resources and en
courage wider public participation, a part of the government s shareholding in t
he public sector would be offered to mutual funds, financial institutions, the g
eneral public and workers.
(ii)
337
(iii) Boards of public sector companies would be made more professional and give
n greater powers. (iv) There would be greater trust on performance imnprovement
and managements would be granted greater autonomy through Memorandum of Understa
nding (MOU) and would be held accountable.
MRTP ACT. With the growing complexity of industrial structure and the need for a
chieving economies of scale for ensuring higher productivity and competitive adv
antage in the international market, the interference of the Government through t
he MRTP Act has to be restricted. Towards this end. (i) The pre-entry scrutiny o
f investment decisions by so-called MRTP companies will no longer be require. In
stead, emphasis will be on controlling and regulating monopolistic, restrictive
and unfair trade practices rather than making it necessary for the monopoly hous
es to obtain prior approval of Central Government for expansion, establishment o
f new undertakings, merger, amalgamation and takeover and appointment of certain
directors. The thrust of policy will be more on controlling unfair or restricti
ve business practices.
(ii)
Further Liberalization by de-reservation :
a) The Government decided in April 1993 remove three more items from the list of
18 industries reserved for compulsory licensing. These three items were : motor
cars, white goods (which include refrigerators, washing machines, air condition
ers, etc.) and raw hides and skins and patent leather. The basic purpose fo dere
servation of these items was to increase the flow of investment in these industr
ies. With the growth of a large middle class, ranging between 100 to 120 milions
, the demand for the white goods like washing machine, refrigerators, air condit
ioners is growing and these items are no longer viewed as luxury goods. Similary
the demand for motor cars by the upper middle class and the affluent sections i
s also growing, more especially when the government is providing loans to busine
e executives and other senior officials to buy cars. To provide a boost to th mo
tor car and white goods industries, the government has decided to de-reserve the
se items so that their production improves as response to the market, instead of
remaining shackled by the bureaucratic process of liscenceing. Regardsing raw h
ides and skins and patent leather, the Government wants to push up their exports
. Leather and good quality shoes have a tremendous export postential and the sma
ll scale units are ill equipped to provide quality goods for the international m
arkets. In pursuance of the liberalization policy towards foreign investment, th
e Government decided in December 1996 to include 16 categories of industries in
respect of which 338
automatic approval would be accorded to foreign equity participation up to 51 pe

r cent. This additional list of industries eligible for automatic approval up to
51 per cent foreign equity cover a wide range of industrial activities in the c
apital goods and metallurgical industries, mining (up to 50 per cent), and those
having significant export potential. b) The government, however, also added ano
ther list of nine industries for which automatic approval upto 74 per cent would
be allowed. The nine industries are mining services related to oil and gas fiel
ds services, basic metals and alloy industries, not-conventional energy sources,
manufacture of navigational, meteorological, geophysical and related instrument
s and apparatus, electric generation and transmission, construction and maintena
nce of roads, ropeways, ports, harbors, construction and maintenance of power pl
ants. Besides, land transport, water transport and storage and warehousing servi
ces have also been included. The basic thrust of these changes is that there wil
l be no case-by-case approval for various proposals lying before the government.
The main aim of the major policy initiative is to facilitate foreign direct inv
estment in infrastructure sector, core and priority sectors, export oriented ind
ustries, linkage with agro and farm sectors. 7) ECONOMIC LIBERALISATION:
The first phase of economic reforms is believed to have begun in 1985 when Rajiv
Gandhi enunciated the uppermost goals of the new economic policy as improvement
in productivity, absorption of modern technology and full utilization of capaci
ty. The strategy visualized for the purpose gave increasingly greater scope for
the private sector This shift in favour of the private sector encompassed a wide
range of measures demanding a reformulation of several policies like the indust
rial licensing policy, export import policy, policy towards foreign capital, pol
icy regarding rationalization and technology upgradation etc., which are covered
by the umbrella of economic reforms. The real all-pervading beginning of econom
ic reforms were however witnessed since the installation of the P.V. Narsimha Ra
o s Congress Government in Mid-1991 The reins of the reforms were in the hands o
f Dr. Manmohan Singh the then Finance Minister, who enumerated the objectives of
the new Economic Policy as under: a) b) c) d) To increase the efficiency and in
ternational competitiveness of industrial production. To utilize foreign investm
ent and technology to a much grater degree than in the past, To improve the perf
ormance and rationalize the scope of the public sector, and To reform and modern
ize the financial sector so that it can more efficiently serve the needs of the
economy.
339
For achieving these long-term objectives, the government undertook to instill in

ternal and external confidence in to the economy by adopting stabilization measu
res, the major ones beings as follows: i) Fiscal Policy Reforms aimed at reducin
g the overall public sector defict from 12.5% to 4% of GDP by mid-nineties. This
involved raising the income level through both tax and non-tax revenues and con
trolling public expenditure. This required a greater tax-effort, a more realisti
c administered price structure, a reduction in subsidies and a better fiscal dis
cipline. Financial Sector Reforms based on stricter monitory policy first and th
en a reversal to a liberal policy, embraced a wide range of industrial areas inc
luding the Reserve Bank, Sheduled Banks, CO-operative Banks ,Foreign Banks, Mutu
al Funds Insurance Companies, Housing Finance Companies, and Stock exchanges. Me
asures as recommended by both the Narasimha Committees(1991 and 1998) and accept
ed by the Government included a restructuring of controls by the RBI and the SEB
I, norms of capital adequacy, insistence of credit rating and scaling down of in
terest rates and more autonomy to the financial institutions. All these aimed at
strengthening the financial sector and making it more competitive Social Sector
Policy was guided by the needs of human development. It aimed at revitalized ef
forts at poverty alleviation, spread of education through formal and nonformal s
treams, employment guarantee initiatives, supply of safe drinking water,revampin
g of housing programmes, immunization and other health measures and special atte
ntion to the welfare of woman, children and the privileged sections of the socie
ty. Industrial Policy was thoroughly reformed so as to provide unhindered and un
inhibited access to new initiatives by the domestic as well as foreign private s
ector. This was sought to be achieved by following a phased programme of de-regu
lation. Expecting the industries of strategic: importance in the areas of defenc
e, defence production and internal energy and such other industries related to p
rotection of environment and internal security, industrial licensing was abolish
ed. The Monopolies asn Restrictive Trade Practices Act was amended and modified
so that the big industrial houses do not need a prior permission of the Governme
nt either for expansion or for establishing a new undertaking. Areas of industri
al activity reserved for the public sector were opened to the private sector, th
ereby narrowing down the scope of the public sector. The policy regarding Foreig
n Capital was recast so as to attract foreign capital, increase foreign exchange
earnings, avail of marketing techniques. For this purpose, several reforms and
changes were made in the policy. Diract Foreign Investment, up to 51%, was permi
tted in export=oriented industrial units, trading companies too could have 51% f
oreigners held equity if they were primarily engaged in export trade. For foreig
n collaborations,
ii)
iii)
iv)
v)
340
automatic permission was granted subject to a ceiling on royalty payment of 5% o

f domestic trade of 8% of export trade or a lumpsum of Rs. 1 crore. vi) Trade Po
licy was modified, in phases, so as to remove most of the protection granted to
Indian industries and to make then internationally competitive import and export
duties were readjusted in keeping with the WTO agreement with effect from April
2001, all quantitative restrictions on imports were removed and a system of pri
ce-based system of duties, wherever necessary, was substituted. Public Sector Po
licy underwent an overhaul. The new involved a more realistic review of earlier
policy, greater autonomy to units which needed to continue in the public sector,
a progressive reduction in the budgetary support to public sector, a discipline
to make public sector undertaking (PSUs) more competitive and cost-effective an
d making all PSUs self-reliant (no losses to be incurred) With these ends in vie
w, the measures taken included a) reduction in the number of industries reserved
for the public sector from 17to 8, b) rehabilitation of sick units through BIFR
(Board for Industrial and Financial Reconstruction), c) a close monitoring to e
nsure profitability, and d) a policy of disinvestment. Besides, several steps fo
r protecting the interests of the employees were taken which included VRS packag
es, retaining programmes etc. A preview of the deals of liberalisation is not ve
ry encouraging from certain angles. It has opened up new avenues for enterprise
and has attained some success in terms of global linkages of the Indian economy.
However, the rates of industrial growth have fallen, agriculture remains neglec
ted, regional as well as personal income disparities have widened and poverty, u
nemployment and development have attained higher magnitude, as if to mock reform
s! 8) THE PROCESS OF DISINVESTMENT: NEED AND METHODS
vii)
With economic liberalization, the private sector was given more freedom and grea
ter scope in the interest of improving the overall performance of the economy as
a whole. Greater scope for the private sector may mean incremental disinvestmen
t which connotes the expansion of PSUs can be left to some private company. It m
ay also mean denationalization of the public sector units taking private sector
as a partner. In other words, disinvestment is a part of the process of privatiz
ation.
a)
Need for Disinvestment
Over a period of four decades beginnings with the 1950s, the scope of public sec
tor was continuously expanding, due to various reasons like lack of public secto
r s funds, nonGovernment and Private Business
341
interest on the part of private sector in undertaking long-term investment proje

cts and so on. With the onset of the New Economic Policy oriented towards provid
ing an upper hand to the private sector, a reversal of the erstwhile policy of p
ublic-sector-dominance was set in motion. As a part of this, the process of disi
nvestment which meant selling of the shares of a PSU to private corporates and i
ndividuals started. By selling stocks the public sector could encash part of its
investment and hence, the term disinvestment. The need for disinvestment can ar
ise due to any one or more of the following reasons: i) Phased Privatization: La
rger scope for the private enterprise menas a shrinking of the public to the pri
vate sector. This is done through disinvestment. Professionalism: Ina highly dyn
amic modern world, efficiency and competitive strength requires the association
of professional and management experts with the PSUs (public sector undertakings
). But the cream of such expertise is always attracted by the private sector by
offering them lucrative, flexible and potentially progressive working conditions
. If this expertise is to be available to the public sector, the public sector m
ust offer a share in ownership to the private sector. The public sector in India
has continuously been under criticism ofr its lack of a professional approach,
mainly due to the fact that most of these units are headed by administrative exp
erts rather than management experts. Reducing deficit: As noted earliar, the Gov
ernment of India was keen on reducing the overall deficit of the public sector t
o 4% of GDP. For this purpose it needed funds which would help bridge the gap. D
isinvestment provided an opportunity of selling stocks and raising funds. Re-all
ocation of Resources: Conceptually, the process of disinvestment amounts to real
location of resources between the private and the public sectors. This step, in
the new business environment, was expected to improve the productive efficiency
of the PSUs, thereby paving the way for improving the performance of the economy
as a whole. Capital Support to Plans: Non-Plan expenditure has been continuousl
y increasing due to a number of reasons like higher rates of D.A. for the employ
ees, a rise in the salary bill due to the Fifth Pay Commission s recommendations
, rising prices of goods purchased plan projects which needed capital support we
re therefore, starved of investible funds. Desinvestment accruals are a part of
the capital receipts and can be diverted to the capital needs of the plan projet
s. Substitute for Taxation: If we take into account the ground-level need in the
midst of present difficulties faced by the Government of India, the disinvestme
nt programme
ii)
iii)
iv)
v)
vi)
342
apparently is viewed by the government as a substitute of greater tax-effort and

curtailment of subsidies both of which are being opposed by parties in the coal
ition. Selling family silver for getting a series of square meals over a number
of days appears to be a softer option for tiding over, the temporarily, the fin
anacial crisis.
b)
Methods of Disinvestment
Disinvestment, in itself, is a method of privatization. The methods followed are
as under: 1) Partial Transfer of Ownership: Disinvestment mostly is through thi
s method of ownership transfer under which the ownership is transferred fully or
partly. In the present method we are concerned with partial ownership transfer.
Ownership can be transferred by selling a part of the shares to individuals, co
-operative societies or corporate organizations. Such a transfer results in the
creation of joint sector where the public sector and the private sector jointly
hold the stocks, jointly exercise their voting rights and jointly participate in
the exercise of control.
In India, the proposals of creating a joint ownership are contemplated on the fo
llowing three lines: i) Transfer of 25% of shares to the private sector (i.e. to
banks, to mutual funds) corporations or individuals including workers who are g
iven a share up to 5% of the total equity. This type of transfer ensures governm
ent control with private partnership that enables the unit of avail of the guida
nce and advice of the private sector. Government may retain 51% of the equity wi
th itself and transfer 49% to similar private sector patners/s. It provides for
a sizeable ownership transfer. At the same time the majority voting rights remai
n with the government. In this case, majority of the ownership i.e. 74% is trans
ferred to the effective in achieving while the government retains 26% with itsel
f. As saving clause, usually there is provision for veto a power with the govern
ment is respect of major decisions.
ii)
iii)
So far as the first variant is concerned, it is not likely to be very effective
in achieving the objective of greater operational efficiency and higher level of
competitiveness. The second variant transfers almost half ownership and as such
, is likely to bring about certain noticeable changes in the terms of revamping
of managerial practices, cost-effectiveness and the units capacity to generate p
rofits, for the simple reason that the stakes are higher for the private sector.
In case of the third variant, the private sector will be the real owner in matt
ers of policy decisions and operational control. Government s veto power is rese
rved only for ensuring that the firm s operation is consistent with the macroeco
nomic objectives. Micro-decisions are left fully in the hands of the private sec
tor.
343
2)
Total Denationalization: The second method involves a complete sellout of a PSU
to a private corporate organization- it may be domestic or foreign or a collabor
ation concern. Such a step can be taken under a number of possible situations. F
irstly, it is possible that the unit which earlier existed in the private sector
was nationalized, with a specific objective. Once the objective is fulfilled, t
he same unit can be denationalized. Secondly, it is possible (though conceptuall
y only!) that the unit was sick and was taken over by the state. After its compl
ete recovery and rehabilitation, the same can be handed back to the private sect
or. Finally, a PSU is incurring losses due to mismanagement in the public sector
. If a private body corporate comes forward with confidence to set things right,
it can buy the entire unit with all assets and liabilities. Liquidation: By goi
ng through the procedure laid down by the constitution/MOU of the PSU, the gover
nment may announce its decision of going into liquidation in case of the unit co
ncerned. A Private buyer may buy it and use the assets so purchased for the same
type of production or for some other variety of production Management buy-out:
As a special case of de-nationalization, a PSU can be sold to the employees of t
he project. All the assets could be sold to the employees organization which cou
ld be formed as a worker s cooperative, or they can form a joint companies act.
Provision of bank finance for enabling the workers to buy the assets can be made
. The employees would continue getting wages as before plus a divided from the c
ompanies pool of distributed profits. Disinvestment without privatization: one m
ore method of disinvestment which is mainly designed to overcome the capital pau
city is to sell part of the equity to other public sector organization mainly fr
om the financial system. The buyers of stocks, in such cases, can be the Life In
surance Corporation of India, the General Insurance Corporation of India, the In
dustrial Development Bank of India, and the Unit Trust of India and so on.
3)
4)
5)
c)
Methods of Implementation:
Once the decision is taken regarding the option of disinvestment to be choose a
method of disinvestment, i.e. actual implementation of the decision to part with
ownership either partially or wholly, either in favour of the employees or in f
avour of other public sector institutions etc. There are various methods of impl
ementation for achieving this end. 1) Sale of Stocks and Allotment: Like any oth
er company a PSU can announce not a new issue but existing shares - an issue wit
h a premium and a policy of allotment intending buyers may apply and will be all
otted shares. In keeping with the goals to be predetermined, the PSU concerned c
an decide upon a premium over and above the face value and can also decide the m
ode of allotment. /it would
344
include the proportion to be allotted to individuals, the same to be sold to ins

titutions and so on. 2) Negotiating joint ownership: when a part of equity is to
be made over to a prospective buyer, such a buyer has got to be identified and
then the terms and conditions of partial transfer of ownership are to be negotia
ted. When an agreement is reached and is duly signed, the process of disinvestme
nt is carried out in accordance with the agreement, i.e. whether the entire sum
is to be paid in a lump sum or whether it is to be paid partly or wholly in a fo
reign currency or whether payment to be made is through installments, etc. This
method can be adopted where specialized products are involved are a few reputed
accountability, the whole deal must be transparent and a fairly reasonable price
must be negotiated. Open auction: Another method is the auction method. Under t
his method, the government may announce its intention to sell a given amount of
shares to a particular class of buyers (e.g. individuals, resident or non-reside
nt, institutional: domestic or/ and foreign etc.) and may invite bids or offers.
The highest bid may be accepted. However, this can be qualified with other cond
itions like technical know- how, managerial track-record, market reputation and
so on. It is possible that a prospective buyer offers a second best price but ha
s a very good track- record and a reputation in the market. Such an offer may be
accepted. Informal Approach: Informally, the government department concerned or
the PSU itself may probe into the world-wide corporate sector for finding a pro
spective partner. Such a buyer may then be contacted and the terms and condition
s may be finalized. These terms and conditions would include the payment in fore
ign or domestic currency, its mode; powers etc. and such a deal would be subject
to the approval of the public authorities concerned like the disinvestment comm
ittee and parliament. Pre-planned Transfer: In cases of types (4) and (5) discus
sed above, a systematic plan can be prepared and worked out. When the company is
to be handed over to the employees, all details like price per share amount of
down payments, the mode of allotment ,loan- arrangements phased transfer of mana
gement, policy regarding managerial/supervisory staff, the form of oraganisation
to be adopted etc. are to be well planned and then the whole plan has got to be
implemented. Where the ownership is to be partially transferred to other public
sector institutions, the quota given to each such institution is fixed in consu
ltation with these institutional buyers as well as the central bank of the count
ry. 6) Systematic Denationalization: Such a step involves a phased programme.Gen
erally, stocks are dispensed with in lots and then the promoters or
3)
4)
5)
345
the business house concerned would elect/select a board of directors and take ov
er the responsibility. A phased out programmers is preferred because a sudden tr
ansfer may send shock waves in the stock market as well as among the working cla
sses and the employees. Repercussions on demand are also expected through a chan
ge in the expectations of the consumers. 7) Liquidation: Incase of liquidation,
the procedure is analogous to any private company going into liquidation. Asset
values are low, share-prices are to be valued through assessors and share holder
being the government, it receives payment in installments and on the basis of t
he price decided by the assessor/expert committee appointed for this task.
d)
Disinvestment of Public sector share holding- Indian experience:
Considering the performance and shortcomings of the Public Sector Undertakings,
the government has gone in for a programme of disinvestment of public sector ent
erprises. The 1991 Industrial Policy Statement envisaged the disinvestment of a
part of the government sharholding in selected PSUs to provide financial discipl
ine and improve their performance. In the 1991-92 budget, the government announc
ed the intention of partial disinvestment in selected PSUs in order to raise res
ources, encourage wider public participation and promote greater accountability.
Upto 20% of the government equity in 31 selected enterprises was offered to Mut
ual Funds, Financial / Investment Institutions, workers and general public. It i
s likely that such a measure may provide resources to the tune of Rs.2,500 crore
s to the Government to reduce its deficit. Disinvestment of PSU Shares : In purs
uance of Industrial policy Statement of 1991, the Government has carried out var
ious rounds of disinvestment of equity shareholding, realizing a total amount of
Rs.20,320 crores form PSUs till March 2000. The Government of India set up the
Disinvestment Commission in August 1996 to advise it on the extent, strategy, me
thodology and hiring for investment in each PSU. Till March 1998, the Government
referred 50 PSUs to the Commission for its advice. So far the Commission has gi
ven its recommendations on 41 PSUs - these recommendations include trade sale (6
units), strategic sale (18 units) and offer of shares (5 units). In other 12 ca
ses, the Commission has recommended : no disinvestment, disinvestment deferred,
and closure and sale of assets (for 4 units) As against a total budgeted estimat
e of Rs.38,307 crores during 1991-92 and 2000-01, the Government realized only R
s.20,320 crores i.e. 38.4 per cent of the budgeted amount. Obviously, Government
failed to raise the budgeted disinvestment in the capital market. Many reasons
may by ascribed for this failure, but the most important is the non346
acceptability of the shares of PSUs in the capital market. The token privatizati
on to the extent of 8 - 10 per cent of the shares of PSUs did not enthuse the In
dian / foreign investors to buy these shares because they could hardly exercise
any control on PSUs. Year wise Receipts from Disinvestment of PSUs Rs. Crores Ye
ar 1991-91 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-2000 200
0-2001 Total
Source :
Disinvestment Budgeted estimate 2,500 2,500 3,500 4,000 7,000 5,000 4,800 9,006
10,000 10,000 58,306
Receipts Actual 3,038 1,913 Nil 4,843 168 380 910 5,371 1,829 1,869 20,320
RBI, Report on Currency and Finance (1998-99) and Economic Survey (2002-2002.)
The Cabinet Committee on Disinvestment in its meeting held on June 23, 2000 gave
a clearance for disinvestment to 11 PSUs including IBP. MMTC, STC and SCI. BESI
DES THE 11 PSUs cleared, 19 other PSUs had been given clearance earlier. All thi
s is being done to fulfill the objective of raising Rs.10,000 crores form disinv
estment during the year. The Government hopes to complete the disinvestment proc
ess in Indian Airlines, Air India, ITDC, BALCO and IPCL within the financial Yea
r 2000-01.
347
Exercise: 1) 2) 3) What is the need for government s intervention in a free ente

rprise market economy? Explain the causes of price rise in India, what are its c
onsequences? Briefly outline various measures taken by the government to control
the problem of rapidly growing prices in India. Explain the policy of economic
liberalization as followed in India. Write notes on : a) b) c) d) e) f) g) h) Su
pport prices Administered prices Public Distribution System (PDS) Price controls
Consumer Protection Act Methods of implementing the policy of disinvestment Dis
investment of Public Sector Undertakings in India Limitations of market system
4) 5)
348
NOTES
349
NOTES
350
REFERENCE BOOKS FOR FURTHER READING 1) 2) 3) Economics - Samuelson. Introduction

to Positive Economics - Richard Lipsey A study of Managerial Economics - D.Gopa
lkrishna
Reference Books
351
NOTES
352
NOTES
Reference Books
353
NOTES
354
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Managerial Economics

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MANAGERIAL ECONOMICS

PREFACE Dear Reader, This book on Managerial Economics is written to present a s

The propositions of economics, however, require to be modified keeping in mind t

touches these aspects of cost-analysis, an effective knowledge and application o

Taking appropriate business decisions requires a clear understanding of the tech

a small quantity of land very intensively, using large quantities of fertilizer,

Questions 1 to 4 are related to the allocation of resources and the distribution

Exercise : 1. 2. 3. 4. 5. Define Managerial Economics. Explain the Nature and Sc

We considered competitive industry because we wanted to contrast such an industr

requires a small amount of capital for generally it adopts labour - intensive te

(viii) Statutory Limit or Number of Partners : It consists of minimum two person

(xvii)Dissolution : A partnership firm may not last long. It may be dissolved by

(iii) Short - Lived : A partnership can be dissolved by any partner by giving a

Thus a joint-stock company is a voluntary incorporated association of shareholde

(vii) Free Transferability of Shares : The shareholders are free to transfer or

(iv) Equitable Contribution : The members make an equitable contribution to its

11) Balanced Development : They can contribute to a balanced regional developmen

(i) (ii) (ii) (iv)

In explaining the approach, Boulding says," There is some desired quantity of al

12. OTHER GOALS OR OBJECTIVES OF FIRMS : Normally, it is the entrepreneur who de

Exercise: 1. 2. 3. 4. What is plant , firm and industry ? Explain Proprieta

Schumpeter has made distinction between invention and innovation. A scientist ma

Profits in a Static Society According to Prof. Clark, profit cannot arise in a s

If P = Rs.25,000/-; S = Rs.5,000/- and Y = 20 years, the annual amount of deprec

valuation of of stocks of finished products very difficult. Let us first conside

Exercise : 1. 2. 3. 4. 5. 6. 7. 8. Give a brief review about the theories of pro

Other examples explaining the concept of demand may be as follows : In India, de

This illustrates a hypothetical (purely imaginary) demand schedule of an individ

The term changes in quantity demanded or variation in demand relates to the la

Price (Per Unit)

Price elasticity of demand can also be measured alternatively as Net change in Q

Thus, P = 22 - 20 = 2, and P = P1 = 20 Q = 09 - 10 = 1, and Q = Q1 = 10 (Here, m

Tble A PRICE ELASTICITY OF DEMAND

In the Figure on the previous pge, AB is stright-line demnd curve, P is g

luxuries nd comforts is reltively elstic nd tht of necessries reltively i

Solution : According to formula mentioned above : Ey = 30 20 = 1.5

Formula 2 A second formula which is mathematically more rational is suggested as

Limitations 1) 2) 3) This method based on value-judgement and has no scientific

is observed then a functi

this relationship is regression. If the past correlation is assumed to remain th

Exercise : 1. 2. 3. 4. 5. What is demand in Economics ? Explain the determinants

Linear Homogeneous Production Function

Fixed Factor (say land & Capital F F F F F F F F F F F F F

The Laws of Returns to Scale :

scale eventually occur because of increasing difficulties of management, coordin

diseconomies and disadvantages. I

Internal and External Diseconomies : As a firm expands beyond a certain limit, i

Representing it in symbols, thus elasticity of supply formula can be stated as :

There are, thus, various degrees of elasticity of supply. It may be relatively e

Mesurement of Elsticity of Supply : There re two methods of mesuring elstic

How do we measure the cost of inputs?

Exercise : 1. 2. 3. 4. Explin The Lw of Vrible proportion with the help of t

from industry cn be diverted to nother industry if the return on investment is

would discriminte between sellers. Tht is to sy, seller hs no reson to re

Chnges in Demnd nd Supply

Short-Run Equilibrium of Firm

(iv) Closing - down Production : Closing - down Production

MR = MC nd MC curve cuts MR curve from below. Y

AC = AR, the firm mkes norml Profits. Super-Norml Profits

In the figure, E3 is the point of equilibrium, OQ3 is the equilibrium output, OP

On the bsis of these ssumptions, let us understnd when price discrimintion w

In Mrket A, E1 is the point t which MC = MR which is relted to MR1. OQ1 is th

(viii) Unfair Methods Under cut-throat competition, a number of unfair methods a

Losses under Monopolistic Competition Y MC T S E AR MR O X Output AC